Management and Valuation of Intellectual Property

Introduction

Intellectual property assets such as patents, trademarks, copyrights are increasingly the core of many organizations and transactions. Licensing and assignments of intellectual property rights have become common in the market, and the use of these types of assets as loan security has grown. This new reality has given rise to the growing importance of the valuation of intangibles. Trading an asset requires knowing its value. The resources of a business such as technology, copyright, trademarks, and other IP are the building blocks of the Brand Value[1].

Valuation of intellectual property rights

• Is one of the key factors of the good management of intellectual property within an organization.
• Analysing the economic value and importance of the intellectual property rights created develop assistance in the strategic decisions to be taken on the assets.
• Valuation also facilitates the commercialization and transactions concerning intellectual property rights.

Purpose

Valuation of IP may be required for a variety of reasons; different stakeholders have different interests in IP. Although common perceptions of IP valuation are often based on

• the capitalization of development costs,
• including financial reporting,
• acquisitions,
• investor relations licensing and franchising,
• securitized borrowing/financing,
• equity fundraising,
• litigation issues,
• tax planning and transfer pricing,
• internal management evaluation of the performance of IP.
• Intellectual Asset Management– evaluating intellectual asset portfolio thus making decisions on future IP Investments and Analyzing the performance of existing Intellectual Property Assets.
• Financing– using IP as Collateral for raising Debt and Equity and annual valuation of the same as a part of loan covenants.
• Transaction– determining the price for Mergers and Acquisitions corporate transactions.
• Litigation-determination of lost profits in IP Infringement and valuation for determination of disposal value of IP in insolvency cases.
• Financial Reporting– Fair valuation of IP for purchase price allocation and testing of fair value for impairment purposes.
• Tax Planning– Assessing the fair value of IP for Transfer Pricing Matters and determining Royalty rates for licensing IP to subsidiaries.

Factors influencing the Valuation of Intellectual Property

• Standard of value- The most commonly used standards of value are Fair market value and Fair Price Value. It is important when undertaking an IP valuation exercise. Fair market value (Market value) can be defined as the price at which an asset or service passes from a willing seller to a willing buyer. It is assumed that both buyer and seller are rational and have a reasonable knowledge of relevant facts. Fair value (Fair price) is seen as appropriate for use in post transaction purchase price allocation. It is based on the assumptions that market participants would use when pricing the asset. Whereas fair market value seems to be more appropriate when used in the premise of value in exchange, fair value is often based on premises of value-in-use. As mentioned earlier in a common situation, IP valuation is a process to evaluate the fair market value of an IP asset.

2. Purpose of valuation- To determine the premise for calculation of value, it is necessary to understand the purpose for valuation. For instance, the valuation from the perspective of market value and investment would be completely different. In commercial situations, market value is the appropriate premise. International Value Standards define market value as “The estimated amount which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arms‐length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently, and without compulsion
3. Valuation method(s)- The methodology applied, and assumptions made while applying any particular valuation method affect the value of IP assets. Market Method is the most effective form of valuation. The Cost Method is usually refrained by companies since it ignores the novel characteristic of IP. This method is helpful for R&D costs.
4. Nature and strength of IP asset- The competitive strength of an IP asset determines the comparative valuation that it shall hold in the market. The factors such as customer responsiveness and market distribution of a product or availing service determine its IP value. The threat of new entrants and substitutes affect the value of IP assets.

Valuation of A company during Merger & Acquisition, Joint Venture or Strategic Alliance

There is been an expansion of the Companies based upon intangible assets and investment in knowledge. Indeed, according to studies, expenditures on knowledge, through investments in R&D or software[2], have grown at a higher rate than expenditures in Tangible assets the respective change in these investments has been done to put more importance on intangible assets in companies. The value of a Company’s Intellectual Property helps to know the real value of a Company.

The primary reason for considering an M & A transaction is the value of the IP assets of the target company. When companies combine their core competencies through M&A, both tangible and intangible assets of the Target Company are part of the cash flows to the Acquiring Company, and the most significant of these assets is the Intellectual Property. IP valuation enables the parties to make an informed decision on the acceptable cost of capital or deciding upon the financial leverage strategy to be followed.

It also influences positively the resulting company’s value and share prices. Virtually every business uses computer software, owns Trademarks, uses technology, produces branded goods, runs Research and Development cells, creates designs, invents devices and the value of the target firm,   therefore, becomes dependent on the value of its earnings, assets, and Intellectual Property

The competitive advantage attributes to the

• development
• integration
• reconfiguration of intangible resources.

But very few firms have the required potential to calculate the value of the IP assets. The main reason a firm acquiring intellectual property is to have a “strong legal” and “transferable” “proof of ownership” to their most important intangible assets.

The value of any intellectual property is even more volatile. As the value of assets depends on the present value of the future economic benefits or losses that can be reasonably anticipated to accrue to the owner, the valuation may yield only relative results. Government Policies, market scenarios, internal work efficiency of corporations, antitrust laws and the impact of globalization also make these Intangible Assets difficult to identify and evaluate

Deriving Wealth-Value from an IP asset is derived through

• direct exploitation like sale and licensing of the IP
•  by not exploiting an IP asset (i.e., by merely owning it),
• for example, by minimizing the negotiating power of customers, offsetting supplier power, mitigating rivalry, raising barriers to entry by competitors, reducing the threat of substitutes, etc.

Value-

• The value of an IP asset represents the potential future economic benefits to the IP owner or authorized user. For example, for a purchased patent, presumably, the benefits (value) to the buyer exceed not only the price paid but also many other costs that may be incurred by the buyer in the process of buying (such as time costs and transaction costs) or in exercising the option of buying the patent (such as opportunity costs: not being able to do or buy something else if the patent is purchased).
  • Sale or purchase of IP assets before selling or buying IP assets, proprietary technology, or a company, one needs to know the value of the relevant IP assets deciding whether to proceed with the sale or purchase and, if so, at what price.

• Merger & Acquisition (M & A); divestitures, spin-offs– Often, the primary reason for considering an M & A transaction is the value of the IP assets of the target company. In such a case, one should consider whether the stand-alone purchase or licensing-in of the relevant IP assets would suffice. If not, then only one should proceed to consider an M & A transaction. In both cases, IP valuation is crucial to making an informed decision. Valuation of the IP assets of the target company often identifies an additional value that significantly enhances the final sale or purchase price. Doing so also ensures that deals are priced and structured by keeping IP risks and value realization opportunities in mind. Further, IP valuation enables the parties to make an informed decision on the acceptable cost of capital or deciding on the financial leverage strategy to be followed. Understanding fully the strategic fit and value extraction opportunities of the target’s core and non-core IP assets facilitates post-deal IP integration and maximization of the returns from the acquisition. It also influences positively the resulting company’s value and shares price.

• Joint Venture or Strategic Alliance Before contemplating entering into a joint venture or other types of strategic alliances one should make a comparative analysis of the value of IP assets involved in the various options under consideration. In structuring a joint venture deal, the parties involved should understand that how much value IP assets contribute to it. The same is true of a strategic alliance, as both parties would be well placed to take advantage of the deal if they are not only aware of the technological contribution of the IP assets but also of their monetary value. Every business uses computer software, owns Trademarks, uses technology, produces branded goods, runs Research and Development cells, creates designs, invents devices, and furbishes techniques. The value of the target firm, therefore, becomes dependent on the value of its earnings, assets, and Intellectual Property

However, the Intellectual Property valuation, which is based on careful analysis, experience, professional knowledge, expert advice, and keen diligence may well produce near infallible answers. Valuation is an art more than a science and is an interdisciplinary study drawing upon the law, economics, finance, accounting, and investment[3].

Such a multidisciplinary investigation for assessment and valuation of the assets by the legal and financial professionals along with the IP-owner is called the “Due Diligence Report”.

Due Diligence Value

• Due Diligence valuation of IP is crucial to the transaction due to the disparity of information (about net assets value) between the seller and the buyer.
• It starts with a Letter of Intent or a Memorandum of Understanding, in which the parties agree to exchange requisite information, documents, business plans, stipulating the schedule, mode, and deadlines.
• A Confidentiality Agreement may be contracted if the IP involves certain trade secrets, protecting Attorney-Client privileges[4].
• The Rule of the Thumb is first employed to determine the importance of the Intellectual Property of the Target Firm.

Subsequently, Due Diligence must quantify the remaining useful life—physical, functional, technological, economic, and legal— and decay rates of the IP using 3 possible techniques of the mathematical valuation of Intellectual Property:

Market-Based Value

It is the purchase price determined by a market price of a comparable property. This valuation technique is impeded by several factors, such as difficulties of finding the property of comparable and compatible value to the IP in hold special purchasers, different negotiating skills, and the distorting effects of the peaks and troughs of economic cycles, etc. The market approach determines the value of an IP by comparing the price paid by other market participants for reasonably similar assets.

Market transactions method

The market transaction method is used to estimate the fair value of an asset by reference to the transaction prices or valuation multiples implicit in the transaction prices of identical or similar assets in the market.

Challenges

IPs are rarely sold in piecemeal transactions, and it usually is difficult to find comparable transactions. Furthermore, since intangible assets are unique to a particular business entity, comparison between entities would be difficult; hence, this method is rarely used in practice, except in certain cases[5].

Cost-Based Value

It is the purchase price determined by the cost to create or the cost to replace. Though this valuation-technique is easy in use, it ignores changes in the time value of money and ignores maintenance. As this method takes into account the cost of building up the business from scratch, it is more suitable in cases of build-operate-transfer deals[6].

Cost Approach

The cost approach is based on the cost of obtaining a patented invention by either internal development or external purchase. All cost-based valuation methods are based on the principle of substitution. Replacement cost represents what it would cost today to buy a substitute intangible asset of comparable utility if the same is available in the market. The replacement cost method is especially useful for purchased intangibles such as off-the-shelf software and similar licenses. The cost of the new substitute intangible asset should be adjusted for obsolescence factors to make the hypothetical new intangible asset comparable to the subject intangible asset.

Challenges

It is usually inappropriate to use the cost approach as it fails to capture the future earnings potential of the IP. It may be used as a cross-check or second method to check the reasonableness of value established by the primary method.

Value-Based on Estimates of Future Economic Benefits

It is the purchase price determined from an estimate of past and future economic benefits, called the “Discounted Cash Flow”

This technique takes into consideration the future earnings of the business and hence the appropriate value depends on the historic and potential profitability of assets, projected revenues and costs in future, the margin between the branded and the generic equivalents of a product, expected capital outflows, investment prospects, number of years of projection, discounting rate and terminal value of the business. Discounted cash flow analysis is probably the most accurate and comprehensive of appraisal techniques, and is hence, generally the preferred option[7].

Any of these methods may be used in Due Diligence to measure the real value of IP being used or required to be used in the future, examining legal touchstones like:

• The substantive type of IP assets (whether owned, registered, applied for, licensed, etc.)
• The chain of ownership and control in IP usage (such as invention, purchase, assignment, acquisition)
• Interests of any third parties in IP (such as rights infringed); tax considerations (maintenance fees, tax payments, and benefits).
• Validity and viability of rights to the IP (whether rights are transferable, lawful, enforceable).
• Modus operandi of IP transfer (schedule and medium of cash flow, etc)
• A Geographical area of the IP usage (market access, target group, etc.)
• Impact of foreign laws on IP transfer and usage (like jurisdictional issues)
• Obstructions to the use of IP (competitors’ dominating assets, fees, defects in IP, unsafe employment agreements, etc.)
• The Need for warranties and records of IP rights
• Past and potential violations of Antitrust Laws
•  Disputes related to that IP (infringement-issues, pending applications for patents, etc.).

Conclusion

Valuation of intellectual property rights is an integral part of good management of intellectual property within an organization because analyzing the economic value and importance of the intellectual property rights created developed assists in the strategic decisions to be taken on the assets for various purposes like internal asset management, Corporate Transactions- Merger and Acquisitions, Tax Planning, Financing,  etc.The valuation method to use in a given situation is complex. Several factors should be considered in the procedure, such as the type of intellectual property at stake, the level of development of the technology as well as the purpose of the valuation. The advantages and disadvantages of each methodology should also be weighted. There is no specific rule on this matter. However, there are some situations where certain methods are more likely to be used, even though in theory all methods may be applied.

References:

[1] India: What is Intellectual Property valuation at https://www.mondaq.com/india/trademark/772158/what-is-intellectual-property-valuation By Shubham Borkar and Neha Rani.

[2] Creating Value from Intellectual Assets, Policy Brief, Organisation for Economic Co-Operation, and Development (OECD), 2007.

[3]D. McGavock and M. Newell , Five Critical Questions Your CFO Should Be Asking About IP, 4

INTELLECTUAL ASSET MANAGEMENT 76, 80 (2007).

[4] Glenn A. Gunderson And Paul Kavanaugh,  Intellectual Property in Mergers & Acquisitions, trademarks In Business Transactions Forum 87 (International Trademark Association 1999)

[5] Legal Management Columns at https://v1.lawgazette.com.sg/2014-04/1016.htm

[6] H. Harish and C. Srividya, Rationale and Valuation Techniques for Mergers and Acquisitions

CHARTERED ACCOUNTANT, May 2004, 1228-1230.

[7] INTELLECTUAL PROPERTY: THE DOMINANT FORCE IN FUTURE COMMERCIAL TRANSACTIONS

COMPRISING MERGERS AND ACQUISITIONS by Madavi Singh Student, II Year, NALSAR University of Law, Hyderabad, India.