Common Errors Committed When Valuing Patents: Part 3 Focus on the Cost and Market Approaches
Common Errors Committed When Valuing Patents: Part 3 Focus on the Cost and Market Approaches
As more companies focus on patents, they are finding many reasons they should determine and understand the value drivers of their patents. However, a significant issue for many organizations is that they do not have personnel with the right skill sets, training, resources, tools, and expertise to perform high-quality, reliable patent valuations. That’s where Stout can help.
There are three common patent valuation approaches frequently referred to as the Income, Market, and Cost Approaches. In addition, there are multiple valuation methods within each approach and many methods that span two or sometimes all three valuation approaches. In this article, we focus primarily on common errors made when conducting patent valuations using the Cost and Market Approaches.
Common Error: Market Approach – Potentially Comparable Agreements are Not Scrutinized Closely Enough
The Market Approach, as defined in the AICPA’s SSVS, is “a general way of determining a value indication of a business, business ownership interest, security, or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold.” The premise of the Market Approach is that the value of an asset such as a patent is similar to the value of similar assets. The Market Approach can be used to establish a value for a patent either expressed as a dollar amount or, more typically, as a royalty rate.
The Market Approach typically requires appraisers to analyze transactions involving comparable patented technologies or, ideally, agreements involving the patent being valued or sold. The failure to carefully scrutinize potentially comparable transactions when implementing a Market Approach can result in values that are inconsistent with the particular facts and circumstances of the analysis being performed, thus limiting or destroying the usefulness of the valuation results. Important questions appraisers must answer relating to potentially comparable transactions include “what exactly makes agreements comparable and what adjustments, if any, should be made to the identified comparable transactions to adjust for differences between the subject assets and the identified ’comparables’ in order to achieve a reliable conclusion of value?”
In navigating this inquiry, various considerations associated with the comparable agreement should be evaluated and compared to the facts and circumstances of the patent being valued. Such considerations include, but are not limited to:
- Ideally, the agreement will include the subject patent being valued. If not, then it is preferred that the subject matter of the license be technologically similar to the subject patent. However, in some instances, an agreement for a technology that is not technologically similar to the patent being valued may provide useful insights if both technologies are incorporated into the same or similar products. For example, the value of a technology from a potentially comparable agreement may set a lower bound for the subject patent being valued if the appraiser can show that the subject patent is a more valuable technology than that licensed in the comparable agreement.
Deal term considerations
- Compensation structure
- Do the license agreements have lump-sum or running royalty rate pricing structure?
- Are there any up-front or milestone payments?
- Is there a cap on royalty payments?
- Do volume discounts or tiered pricing structure exist?
- Are there stock/equity considerations?
- Other sources of value associated with the transactions
- Other assets included in the agreement (e.g. trademarks, copyrights, trade secrets, know-how, etc.)
- Cross-licensing terms, supply/purchase agreement terms/guarantees, consulting services, etc.
- Use restrictions
- Exclusive or non-exclusive rights
- Field of use
- Geographic restrictions
- Term of the license
- Industry in which the technology is being utilized
- Specific products/services in which the patent technology will be utilized
- Market conditions at the time of the agreement
- Macroeconomic conditions
- Nature of the market for the applicable products/services
- Current size
- Growth outlook
- Nature of competition
- Availability of competitive technologies
- Design-around possibilities
- Age of the technology and technological obsolescence
- Breadth of the patent claims (narrow versus broad)
- Types of claims - apparatus versus method/process; means plus function
- Date of patent expiration
- Agreement as a result of, or influenced by, litigation or the anticipation of litigation
Once similarities and differences are identified and an understanding of how those similarities and differences impact the value of the technology related to the potentially comparable licenses versus the subject asset, it may be possible to make adjustments to the values found in the potentially comparable agreements to provide insight regarding the valuation of the subject patent. Importantly, the above considerations are equally relevant when implementing a hybrid Income/Market Approach in the form of a Relief-from-Royalty methodology for which the selected royalty rate utilized is based on comparable agreements.
Common Error: Cost Approach – Historical Cost Data is Not Updated to Current Value
The Cost Approach, as defined in the AICPA’s SSVS, is “a general way of determining a value indication of an individual asset by quantifying the amount of money required to replace the future service capability of that asset.” The premise of the Cost Approach is that no party involved in an arm’s length transaction would be willing to pay more to use the asset than the cost to replace the utility of that asset (i.e., create an alternative with very similar or the same utility).
One common implementation of the Cost Approach relates to an analysis where the appraiser quantifies the cost incurred to develop the subject patent being valued as a proxy for the cost to develop an acceptable non-infringing alternative to the subject patent. This analysis typically requires the valuator to gather historical cost data related to the development of the subject patent. It is our experience that appraisers sometimes neglect to convert historical costs to current period costs in the use of this approach. Importantly, costs should be estimated as of the valuation date and not at the historical prices in effect when the expenditures to develop the patent being valued were actually incurred. Understanding this distinction is critical if a valid conclusion is to be reached. Adjustments for technology changes, inflation, and other market changes across time are typically necessary to develop reliable valuation results using the Cost Approach. If the cost of any relevant inputs has changed (either upward or downward) since the initial expenditure, these changes should be factored into the calculations.
Further, valuation experts should only include expenditures necessary to reproduce an asset of similar utility in the current environment. For instance, advances in technology that would increase efficiency of labor inputs or otherwise be complimentary to the current creation of the subject service capacity could result in a situation where current expenditures may turn out to be significantly less than historical costs. For example, if valuing a patented technology developed ten years prior to the valuation date resulting from the use of genome sequencing techniques, an appraiser should consider that the cost of the methods to sequence genomes has decreased substantially since that technology was initially invented.
Common Error: Cost Approach – Applying the Cost Approach in Situations Where it is Not Relevant
Appraisers need to be careful in applying the Cost Approach to patent valuation because, in many circumstances, this methodology will provide a poor proxy for patent value.
The main drawback of the Cost Approach is that it does not recognize the future economic benefit provided to the owner of the asset. In most cases related to patents, cost bears little relationship to value as it does not reflect the earnings potential of the subject patent asset. That is, there is no mechanism to incorporate future revenue or profit data utilizing a Cost Approach.
Another limitation of the Cost Approach is that it assumes that an asset is “replaceable” with one of equivalent utility. However, particularly when dealing with patent assets (which by definition are unique), the assumption that an equivalent asset can be created is often untenable.
However, the Cost Approach may still be useful in establishing patent valuations in at least a few situations. A Cost Approach, properly performed, can sometimes be applied when valuing early-stage technology that has produced little or no cash flows and where potential future cash flows, if any, are significantly uncertain. Further, cost data can be useful in situations when there are many acceptable non-infringing substitutes or design-around options available for the patented inventions, as no party would be willing to pay more to use the asset than the cost to replace the asset with one of similar utility.
Common Error: Reasonableness Tests are Not Performed
Regardless of the purpose of the valuation (i.e., tax purposes, financial reporting, other regulatory/compliance purposes, due diligence for a potential transaction, etc.), it is essential for the IP valuation to be reliable and withstand close scrutiny.
We occasionally find that some patent valuators neglect to test the reasonableness of their value conclusion. Assessing the reasonableness of a value conclusion is an important quality control procedure and should be performed when possible. If a valuator cannot demonstrate that his or her valuation calculations are reasonable from multiple perspectives, it increases the likelihood that those results can be successfully challenged.
Some reasonableness tests to consider include, but are not limited to:
- Does the valuation provide sufficient reasoning and rationale to support its findings and conclusions? (This is a key question to ask when reviewing patent valuations as they can be subjective in nature.)
- Are the assumptions and inputs justified by market data and expectations?
- Are multiple approaches used for the valuation and do they reasonably converge on a range of values?
- How does the value of the patent compare to the overall value of the product, business unit, or even company?
- Do the results make sense in light of the perceived importance of the patent asset to the company/ business unit?
- How does the value conclusion compare to other due diligence data points identified during the analysis?
- How do results compare to established rules of thumb? (Although rules of thumb should never be used in isolation or as a primary valuation approach, they have traditionally been useful as thought-provoking reasonableness tests.)
Regardless of the valuation approaches applied (Market, Income or Cost), reasonableness testing can be an important part of performing cross-checks on the value of the patent.
In addition to performing IP valuations and reviewing IP valuations performed by others, we also provide training to our clients’ personnel as to how to value their IP assets. This combination gives us substantial access to IP valuation work done by non-specialists. In evaluating patent valuations, we frequently encounter a wide range of errors in the valuation analysis. In this article we have discussed some of the common errors that valuation analysts make when performing patent valuations with a primary focus on errors made using a Market or Cost Approach to valuation.