Intellectual property (including patents, trademarks, copyrights, trade secrets, software, entertainment assets, customer lists, in-process research, etc.) is a large portion of the value of most business enterprises. When entering into any transaction involving intellectual property, you need to properly value these assets. This is easier said than done.
This article cannot provide a complete “how-to” on this subject. Instead, it provides foundational knowledge that will allow you to take initial steps and assess potential professional advisors.
When valuing intellectual property, you will need to:
Get Legal Advice
The laws covering patents, trademarks, copyrights, and other intellectual property are complex and require competent legal advice. It is important that you understand (i) the nature and scope of legal protections that exist, and (ii) the non-infringing alternatives that could compete with the intellectual property that you are considering.
Any transaction must be documented professionally and comprehensively. Legal resources spent at this stage will help avoid later problems.
Select a Competent Appraiser who will Follow Proper Standards
Most accountants, economists, and professors do not have the skills necessary to perform a comprehensive and proper appraisal of your intellectual property. You should expect that your financial advisor has certain credentials, and follows applicable standards. For more information on appraisal credentials, click here.
Understand the Markets Being Served
“Garbage-in, Garbage-out” is certainly applicable to intellectual property valuations. A correct valuation is dependent on knowing items such as the following:
- The nature and size of the market to be served
- The competitive advantages of your solution
- The price customers are willing to pay for your solution and related value proposition
- Costs of implementing the technology or products
- The impact of the technology on the processes used by the business to service its customers
- Length of time before new competition will enter the market
These items often require separate analysis. This will increase the cost and time involved in any assessment.
Research Comparable Transactions
Transactions that are sufficiently similar to the appraisal subject likely exist. To be useful for valuation purposes, comparable transactions need not be identical to the appraisal subject. A competent appraiser of intellectual property will have access to this data.
To avoid biased results, the search for comparable transactions should use a specific screening process. Market information accepted for appraisal purposes should pass the pre-identified screens, and data excluded should fail the same screens.
Understand the Risks Involved
An intellectual property valuation should address the upside potential that exists. However, it is easy to underestimate the:
- Costs necessary to finalize development
- Time necessary to fully exploit the technology or idea
- Possibility that unexpected challenges or competition will arise
A realistic cash flow projection is required. Future benefits should be discounted at a rate that takes into account the risks involved. The discount rate should not be mechanically based on borrowing rates or investment hurdle rates applicable to developed products.
When in-development technology is involved, future development costs should be discounted at rates no higher than what related cash reserves are earning while waiting to be deployed. Because these development costs are certain, a low rate is applicable.
Use Rules of Thumb with Caution
Because intellectual property is difficult to value, it is tempting to use simple formulas or anecdotal information. This will rarely provide an accurate answer. For example, so-called industry rates fail to consider:
- Growth Potential
- Strength of Technology
- Investment Risks
- Market Size
- Consequences to Overall Revenues and Costs
- Changing Economic Conditions
- Negotiating Power of Prior Participants
- Exclusivity, Geographic or other Limitations
A variant of industry rules of thumb is the widely used “25% Rule.” This “rule” says that a reasonable royalty rate will be equal to 25% of the gross profit earned on products that use the technology. Efforts to prove the validity of this formula have shown that the formula is not valid. This should not be surprising as the rule fails to consider:
- Differences in the classification of expenses
- Fixed expenses in cost of sales
- Impact of all selling, general and administrative costs that are affected by the product
- Consequences to overall revenues and costs
- Investment risks
- Exclusivity, geographic or other limitations
Armed with an appraisal and related competitive assessment that addresses the above items, you can confidently make business and investment decisions.
- Valuation using proper appraisal standards
- Competitive/market assessments and related financial forecasts
- Assistance with licensing assessments and negotiations
- Royalty audits to ensure full payments are made (Click here for information about royalty audits)