Individuals and companies are interested in the value of intellectual property (“IP”) for a variety of purposes, such as sale/license transactions, raising capital, company valuation, litigation, internal IP management, and financial reporting, to name a few. The value of IP depends upon several factors including how it will be utilized, the time required to generate returns, the magnitude of those returns, and the risks involved. Valuing early-stage IP in this regard is no different than developing business performance forecasts. However, the process of quantifying these factors may prove challenging as there is greater uncertainty concerning commercial use, market size, profitability, and forecast time-horizon. Common characteristics of early-stage technology include the following:
To assess the value of IP, appraisers consider three approaches: Cost, Market, and Income. Each of these valuation approaches is defined and supported by the Uniform Standards of Professional Appraisal Practice (“USPAP”).
The Cost Approach, which seeks to determine the value of IP by aggregating the costs involved in its development, is often a poor basis for valuing or pricing IP. For example, suppose a company invests $5 million in developing a technology and prototype that does not work well enough to be sold or utilized commercially. It is highly unlikely that a market party would pay $5 million for a prototype that does not work. The Cost Approach challenges the valuator to consider an asset’s cost replacement that may or may not make sense logically when dealing with early-stage technology.
The Market Approach attempts to determine value by comparing the IP to similar assets that have recently exchanged under parallel circumstances. While it is used more regularly than the Cost Approach, it typically serves as a reasonableness check to other valuation approaches. The earlier the stage of technological development, the more difficult it becomes to find comparable market transactions, particularly considering the scarcity of available IP market information.
Despite the lack of historical financial data, early-stage IP is most often addressed through some variation of the Income Approach. The discounted cash flow (“DCF”) is the most frequently used method and is a projection of future net cash flows expected to be generated from the commercial use of the IP over its economic life, discounted at a rate commensurate to the subject technology’s inherent risk. Within the DCF analysis, IP appraisers will often employ the Relief from Royalty (“RfR”) methodology, which considers what the owner of the property would pay in royalties to a licensor of the IP in lieu of outright ownership. This methodology requires extensive market research to gain an understanding of the subject technology’s market. Based on the results of the initial market research phase, appraisers must make a series of extraordinary assumptions and predictions to produce a properly functioning income-based model. The assumptions that are made surrounding market size, adoption rates, robustness to litigation, royalty rates, and technology usefulness transform IP valuation into more of an art than a science. The most skilled IP valuator is one that has their finger on the pulse of the IP ecosystem (including licensing, transaction and litigation) to achieve a level of due diligence necessary to ensure that a value conclusion is reasonable.
Early-stage IP appraisers often direct their efforts toward creating a range of value conclusions that consider the likely use of the IP and illustrate the impact of key contingencies. A three pronged approach of conservative, base, and aggressive scenarios is typically employed when a range of value is necessary to illustrate a distressed value versus other potential going concern values. This, in turn, mitigates the uncertainty given the lack of empirical data when valuing early-stage IP.
A special thank you to Coulter Nash Ream, Peter Wilhelm and Andrew Sills for contributing to this blog post.