As technology continues to breakthrough and drive global economy in the millennial age, many companies, especially the technology-based ones, are discovering that intellectual property (IP) occupies a lion’s share of their value. Examples of intellectual property are brands, patents, copyrights and manufacturing processes.
Guidelines and regulations regarding the valuation of intellectual property are also changing worldwide due to different statutory laws in individual countries. The valuation of intellectual property involves assigning a monetary value to the intangible assets of a business entity. However, the intangible nature of intellectual property means that it is often difficult to value and define, making it a challenge to put a fair price on the value.
IP valuation is a major issue especially in the area of mergers and acquisitions because a typical potential acquiree will claim to have accumulated a massive amount of intellectual property and wants to be paid for it. Hence reliable valuation is important for multinational corporations involved in IP transactions. Intellectual property valuation is also useful for deriving the value of collateral to be used in a lending situation.
Due to its intangible nature, it is not possible to assign an accurate value to intellectual property. Therefore many valuations methods are used to derive a range of possible valuations. The acquirer will then use the information to develop an initial offer price and a permissible range of increased prices that reasonably encompass the calculated value of the intellectual property.
These are 4 of the best practices in intellectual property valuation:
1. Income Method
This method focuses on the future cash flow achieved from a particular piece of intellectual property. Accuracy of the projected forecast is very important and the following variables are taken into account when using this method.
- Income streams either from the product sales or patent licensure
- Estimate of useful life duration of the patent
- Patent specific risk factors and incorporating those into the valuation
- A discount rate as IP assets have their own risk of unique risk factors
- Patent related factors – new patent issuance, challenges, infringement suits, trade secrets and cooperation treaties
2. Discounted Cash Flow Method
This attempts to determine the IP value by computing the present value of cash flows from that particular piece of IP, over the economic life of the asset. As patents have a finite period of useful life, free cash flows are forecasted for the economic life of the patent and the discount rate is calculated by the time value of money and risk probability. The forecasted free cash flows should also be adjusted to increase a patent’s success.
3. Relief From Royalty Method
This method is based on deprival value theory and looks at the amount of income that a company would be deprived of if it did not own the intellectual property but rented it from a third party instead. The royalty represents the rental fee which would be paid to the licensor if this arrangement is in place.
The ability to determine an appropriate royalty fee is dependent on specific circumstances and requires the identification of suitable comparable transactions and prices involving third parties. A reliable sales forecast is required in order to derive an accurate estimate of income that comes from the intellectual property. An appropriate capital cost also needs to be determined to make this method a success.
4. Venture Capital Method
This method derives a patent’s value from the cash flows that arise from the asset’s life. However, it differs slightly from the Discounted Cash Flow Method because a fixed non-market based discount rate is used. It is usually 50 percent or in the 40-60 range and there is no major adjustment to increase the probability of a patent’s success. Cash flows are assumed to be constant and independent risk factors are lumped together.
In summary, this list of intellectual property valuation methods is not exhaustive but it is advisable to employ two to three of them to derive a more accurate estimate and value so as to gain competitive advantage.