Valuing Intellectual Property in the Context of a Divorce Proceeding
Valuing Intellectual Property in the Context of a Divorce Proceeding
Intellectual property (“IP”) in a divorce situation is a growth area at least from Stout’s perspective. In divorce, the IP to be valued may be: personally owned or an asset of a sole proprietorship, partnership, or corporation. In addition, some of our experience flows from specific clauses of pre-nuptial or ante-nuptial agreements.
Reflecting the upsurge in relevance of IP valuation in divorce actions, Stout has chosen to publish through this article excerpts from one of our webinars on this topic.
Introduction to IP
The four primary types of IP include patents, trademarks, copyrights, and trade secrets.
A patent is a grant by the United States government of property rights to an inventor. The right to grant a patent was written into the Constitution in 1788. A patent conveys to the patent owner the right to exclude others from making, using, selling, offering for sale, or importing into the U.S. products that are covered by the claims of that patent.
Most patents granted are called utility patents. If the invention covered by a utility patent application is new, useful, and non-obvious, a patent may be granted. Utility patents have a life of 20 years from the date of application and, as a practical matter, given that the grant date is usually 2-3 years after the date of application and that a patented invention often becomes obsolete before the patent expires, the useful life of a patent is often much less.
A trademark is a word, phrase, or design that identifies and distinguishes the source of the goods of one party from those of another. The term of a trademark can last forever in certain circumstances and, with certain exceptions, must be used continuously. Examples of some companies with well-known and recognizable trademarks include McDonald’s, Pillsbury, Apple, Nike, and Coca-Cola. Some of these companies include the name of the product within the symbol/logo, while others are symbols that are recognizable. The Apple Corporation, for example, uses the apple symbol, while the swoosh is used to represent Nike.
A trade secret is valuable information that companies keep secret to give them an advantage over their competitors. A trade secret can be a formula, computer program, method, technique, customer list, or other private information that is kept secret from those outside the organization. If the information is disclosed to people outside the company, it must be protected by a confidentiality agreement, non-disclosure agreement, or other form of contract. A trade secret can last forever, assuming it is kept secret. Once a trade secret is known by the public, it is no longer protected. In order to continue to protect a trade secret, it is important that trade secret owners establish a variety of procedures to continue to protect their trade secrets from inadvertent disclosure or theft. It is not recommended to share trade secret information with others, even with employees of the same company, generally, unless they need the information in order to effectively perform their job. One of the most well-known trade secrets is held by The Coca-Cola Company (“Coca-Cola”). The secret formula for Coca-Cola is kept under lock and key in a secure location in a bank vault, and only very few people are allowed access.
A copyright is an exclusive legal right given to a creator of an original literary or artistic work, including music, books, and/or computer programs. While duration depends on a variety of factors, for works created after 1977, protection lasts for the life of the author plus an additional 70 years.
Each of these four types of IP can be relevant in a divorce situation but undisclosed marital IP assets will most often be in the form of patents.
Business Valuation vs. IP Valuation
Business valuation generally involves the determination of the enterprise value (“EV”) of a company. EV can be thought of in the context of a house. EV is akin to the value of the entire house, regardless of how the purchase of that house was financed. In order to arrive at the value of the owner’s equity in the house, it would be necessary to carve out the value of the mortgage (debt) on the house from the EV. The process is similar in arriving at the value of an equity interest in a business. Thus, it follows that the EV of a business is comprised of the market values of debt and equity of that company. The EV of a business can also be expressed as the collective value of a company’s individual assets including net working capital, tangible assets, and intangible assets.
There are three approaches that are generally accepted in the valuation community and courts for valuing a company or business, consisting of the Income Approach, the Market Approach, and the Asset Approach. Within each of these approaches there are various methodologies that can be employed to determine the EV of a business. The majority of these methodologies consider the Cash Flow generated by a company in arriving at EV.
Differentiating EV from the Value of IP Used Outside the Business
Continuing with the value of a house example, we can show how the EV of a company in a Fair Market Value context is usually not equal to the Book Value of that company. Assume you bought a house 20 years ago, and you paid $100,000 for that house. However, based on a recent home appraisal, the market value of your house is currently $200,000. If you were reviewing your personal balance sheet, your house would be listed at $100,000 even though its market value is currently $200,000. The reason is that book value for financial presentation is an accounting concept that is based on historical cost rather than current market value.
Another difference between a company’s book value and Fair Market Value is that certain assets, such as patents developed internally by a company, are not “booked” or recorded on a company’s balance sheet. Therefore, costs associated with developing the patents will be expensed in the period incurred and will not be on the balance sheet (this practice is deemed appropriate due to the lack of certainty regarding future realization of the benefits from the research and development supporting the development of the patent). Finally, a company’s assets may generate Cash Flows that support an EV that is in excess of the combined value of its assets. This excess or residual value is referred to as intangible value.
What are the components of intangible value?
There are two components of intangible value, including identifiable intangible asset value, which is derived from intangible assets that can be separated (i.e., sold, transferred, licensed, etc.) from the business and unidentifiable intangible asset value, which is derived from a company’s goodwill (either enterprise or personal). The value of a company’s IP will be captured in its EV to the extent that the IP is contributing to (and being reported in) the Cash Flows of the company. However, there are certain instances when a company’s IP may have value outside of the company’s normal business operations, including:
- Pursuit of potential infringers through litigation
- License of that IP to outside parties
- Value flowing from the sale of the IP to outside parties
In general, IP value should be captured as part of a business valuation to the extent it is being employed by the company to generate operating Cash Flows. However, there may be value associated with a company’s IP over and above that captured in EV to the extent that: 1) the IP portfolio is creating positive Cash Flows which are not being captured or recorded by the business, or 2) the IP portfolio is not being fully or reasonably deployed by the business and, therefore, it is not contributing to the business’ reported Cash Flows to the full extent of the IP’s value.
The concept of IP contributing value outside of the normal course of the business’ activities is somewhat analogous to an expensive piece of company-owned art hanging in the executive office suite of a manufacturing company. That work of art is not contributing to the Cash Flows of the business going forward and, therefore, is not a part of the operating value of the company, but since the company owns that piece of artwork, it does increase the EV of that company because it can be sold separate and apart from the business operations of that company.1
Identifying Unvalued or Undervalued Intangible Marital Assets
IP value outside the normal operations of the business is properly not included in a business valuation because its monetization is typically not viewed as part of the normal operations of the business. This normal and correct business valuation process may miss important and integral parts of the inherent value of certain types of IP. In turn, this oversight can cause the non-moneyed spouse to entirely fail to identify significant amounts of IP value that could be very significant to the total marital assets at issue.
For divorce counsel, it is typically relatively easy to identify the existence of potentially relevant IP. Below are some characteristics to look for:
- Business – If the business is unusually profitable, it’s almost always attributable to some unique assets. The unique assets may be physical assets, such as the location of key business properties, but often the high return is the result of intangible assets such as IP.
- Industry – Some IP-intensive industries include telecommunications, media & entertainment, pharmaceuticals, medical devices, and consumer goods.
Identified or readily identifiable IP – IP might already be identified as part of the business forecast or plan, but typically it is not. If the IP is not identified or only partially identified, counsel can usually find IP or additional IP through inquiry or discovery with the company. Assets such as the following can often be discovered:
- A valuable individual patent or a significant patent portfolio.
- Trademarks practically licensable outside the business — in many instances, it is not practical to license trademarks outside of the trademark owners business so there is no real value to the company’s trademarks outside of the company. However, there can be licensing opportunities associated with trademarks or copyrights, as well.
Copyrighted material practically licensable outside of the business
- Databases of results/findings
- Compilations of data
- Trade secrets are also potentially licensable, but this is rare.
Identifying the relevant IP is an important first step that has to be completed before the IP can be valued. However, after identifying the potentially relevant IP, counsel and/or other advisors have to evaluate the various IP assets to see if they are currently either undervalued or not valued at all. Once IP has been identified, and further determined to be potentially unvalued or undervalued, it then has to be valued.
Key Attributes of an IP Valuation
Like business valuation, IP valuation employs three primary valuation approaches commonly referred to as: the Income Approach, the Market Approach, and the Asset Approach. However, IP presents some special valuation issues. Some of the characteristics of IP that create special valuation issues reflect that, by definition, they are unique, legally protected assets with certain rights and associated value that is often extensively defined through court decisions. Reflecting that intangible assets have special characteristics, the below valuation methods have been developed as specialized versions of the traditional valuation approaches and are frequently used in conjunction with these traditional approaches to reflect the distinct value characteristics of various kinds of IP. These specialized approaches include:
- Hybrid – Combination of two or more of the primary approaches
- Relief from Royalty -–The IP value is represented by the present value of the notional royalty stream that ownership relieves the business from paying for use of the subject IP
- Litigation – Models based on techniques commonly used in litigation
- Rules of Thumb – Mainly used for testing, confirmation, checking results
Whenever possible, we find it is better to use at least two or more valuation methods to triangulate on the value that we will ultimately arrive at for the IP.
Differences Between Business and IP Valuation
Some important differences between business valuation and IP valuation are summarized here:
- Both business and IP valuation use the same conceptual approaches, but they require different calculation methods.
- IP valuation entails valuation of a single asset, or small group of similar assets, versus a collection of diverse assets.
- Assessing a different income stream — total company Cash Flows vs. incremental Cash Flows attributed to IP.
- Business valuation typically assumes the business will continue as a going concern, whereas IP often has a finite life or diminishing returns.
- The level, assessment, and quantification of risk vary significantly.
- By definition, IP assets are unique, which typically makes market approaches based on comparables more difficult.
- Business valuation includes certain discounts and premia foreign to IP valuation.
IP Valuation in the Context of a Marital Dispute
In certain circumstances, IP valuation can add millions of dollars to the marital estate. When working with the non-moneyed spouse in situations where there may be significant IP, counsel should consider what examination of IP is important and whether it makes sense in light of the possibility of finding additional assets. If counsel decides to consider the existence of IP assets, consider the steps below.
If unvalued or undervalued IP is suspected:
n In order to identify possible sources of unvalued or undervalued IP, consider relevant indicia such as:
- Characteristics of the relevant industry
- High profitability levels of the business
- Already identified or identifiable valuable or significant IP
- Preliminarily evaluate potential incremental value of the IP to the marital assets to ensure that the value is worth pursuing.
- Determine the actual incremental value of the IP using some sort of a phased approach to valuation starting with what are expected to be the most valuable IP assets.
As with any other type of valuation, certain cautions should be employed. For evaluating IP in the context of a marital dispute:
- Care should be taken to avoid double counting benefits from IP as part of the relevant business value and again as additional marital assets.
- Monetization scenarios must be demonstrably reasonable and practical.
- IP must be properly valued using defensible techniques.
- Incremental IP value is still a somewhat novel marital asset. Consequently, the acceptance of incremental IP value outside of the business by a finder of fact may be difficult to determine or confirm in advance.
- The identification/valuation process will likely be difficult and highly contentious.
- The process will be time consuming, expensive, and uncertain as to the outcome.
IP valuation is a well-established discipline that may, when there is significant IP in the marital estate, be instrumental in adding additional, supportable IP value to the marital assets calculation.
- One difference from the accounting for IP of note is that generally the piece of art would be included on the balance sheet, whereas most non-purchased IP is not. (Unfortunately, accounting guidance relating to IP is relatively complex and beyond the scope of this article.)