Common Errors Committed When Valuing Patents: Part 2 Focus on the Income Approach
Common Errors Committed When Valuing Patents: Part 2 Focus on the Income Approach
This article is the second in a three-part series of articles intended to assist those who are valuing patents. By becoming aware of common errors in patent valuation, you can help your valuators increase the quality of their valuations and improve the reliability of their results.
Three common patent valuation approaches are frequently identified as the Income, Market, and Cost approaches. In addition, there are multiple valuation methodologies within each approach and many methodologies that incorporate elements of more than one approach. In this article, we focus on common errors made when conducting patent valuations using the Income Approach.
In the first article of this series, we examined several common errors made when valuing patents that are generally relevant to all three of the valuation approaches. These issues include errors stemming from incomplete due diligence, problems resulting from the improper use of valuation results for a purpose different from the one intended, and the incorrect implementation of valuation fundamentals (i.e., standard of value, premise of value, valuation approach, and valuation date).
Common Error: Income Approach – Discount Rates Do Not Appropriately Reflect the Risk of the Future Cash Flows
The Income Approach, as defined in the American Institute of Certified Public Accountants’ (“AICPA”) Statement on Standards for Valuation Services (“SSVS”), is “a general way of determining a value indication of a business, business ownership interest, security or intangible asset using one or more methods that convert anticipated economic benefits into a present single amount.” A key component of using the Income Approach is the identification and use of an appropriate discount rate for discounting future cash flows to the date of the valuation.
The reliability of the Income Approach is dependent on the selection of a discount rate that properly accounts for the risk and uncertainty associated with the realization of the particular stream of cash flows being projected. All else being equal, the higher the discount rate, the lower the patent value, and vice versa. It should be emphasized that errors in estimating the discount rate can lead to very significant errors in valuation results. Ultimately, the discount rate used should be consistent with both the riskiness of the cash flows and the underlying methods and assumptions used in constructing the specific cash flows being modeled.
One common error is that the discount rates used do not properly reflect the risk of the future cash flows. It is commonplace to see future benefits accruing from the subject property improperly discounted using the company’s weighted cost of capital (“WACC”) or adding only a small risk premium to the WACC. It is possible that the use of such a low discount rate is correct in a particular instance but, in general, discount rates used for patent valuations should typically be much higher than the WACC of the organization that owns the subject asset.
Brief reflection suggests why the discount rate in a patent valuation is typically higher than the owner’s WACC for the entire business. The WACC for a company is the weighted cost of the firm’s total equity and debt capital base and captures the risk associated with all of the company’s assets and operations. Just as equity typically has a required rate of return that is higher than the WACC and debt has a required return that is lower than the WACC, certain assets will have a required return that is lower or higher than the overall WACC based on the risk profile of those assets. Use of a WACC to estimate the required rate of return to patent assets does not recognize that intangible assets are typically the riskiest assets of a corporation and warrant a higher rate of return than a rate that captures the riskiness of the company’s overall business for a number of reasons, including, but not limited to:
- Patents are typically exploited through investments in a single or small number of products or projects whereas investments in a company often involve investments in multiple products or projects, reducing risk through diversification.
- Patent-specific risks such as claims interpretation, validity, infringement, scope of protection, and patent-specific obsolescence may destroy the value of a patent asset but are not relevant to the other assets and operations owned by the company.
- Frequently, patents are associated with cutting edge projects or new products and often these projects are new to the company and sometimes new to the world. Such cutting edge products or projects will normally merit a substantial risk premium consistent with the vast array of risks they are facing.
- Also, patents, compared to many tangible assets, are difficult and time consuming to liquidate and are often subject to substantial liquidation discounts.
Depending upon the specific risks associated with the patent being valued, discount rates for patent valuations will frequently require the use of discount rates ranging from 20 to 40 percent and even higher in certain circumstances.
Also, discount rates used in an Income Approach are frequently mishandled in another way. As alluded to above, intangibles are generally viewed in financial literature as the most risky asset class. Thus, in order to value IP, in general, and other patents, in particular, it is necessary to adequately recognize the risk associated with actually realizing the future net cash flows that are forecasted in the Income Approach valuation model. Such risk can generally be quantified within valuation models through adjustments to either the forecasted cash flows themselves or by adjusting the discount rate being used to determine the present value of the forecasted cash flows as of the valuation date. Since there are typically some adjustments for risk both in the cash flow projections and in the discount rate, great care has to be taken to avoid double counting or undercounting risk adjustments.
Common errors we see made by some valuators include double counting risks by incorporating the same risk in multiple inputs or otherwise mismatching discount rates to cash flows. For example, for a patented, emerging technology with high barriers to success, analysts may apply low growth rates, haircut royalty rates, and otherwise adjust cash flows to artificially depressed levels but also use a high discount rate that likewise has captured most or all of the above risks. Analysts should be on the lookout for situations where they may be double or triple counting the same risk in their models when developing the discount rate.
Common Error: Income Approach – Negative Business Outcomes Are Improperly Incorporated into the Valuation
A special case of mismatching cash flows and discount rates occurs when possible negative business outcomes (i.e., project/ product failure) reflected in the valuation cash flow projections are not matched with consistent and appropriate discount rates. We see this error frequently enough that it merits special mention.
Discount rates can be “built-up” by adding various risk elements to cost of equity or weighted average cost of capital rates. For instance, a small company premium might be added to the cost of equity as part of the discount rate build-up. Alternatively, discount rates can come from various sources and studies providing “comparable” discount rate data. Importantly, some of these methods of determining a discount rate recognize the probability of negative outcomes but some do not.
For instance, a double counting of risk error is created when the valuation analyst combines a decision tree cash flow analysis (with assigned probabilities to “successful project” and “failed project” branches) with a discount rate that already includes a substantial premium for risk of project failure. This combination may cause the valuation result to be unduly low as the same risks are accounted for in both the cash flow analysis and discount rate. On the other hand, a too-high valuation may result if the substantial risk of project failure is not accounted for adequately in either the cash flow projections or the discount rate determination.
A correct valuation result, in theory, can be achieved either by adjusting the discount rate or by adding an explicit adjustment to cash flows associated with possible failure of the product/project into the valuation model.
If the discount rate and cash flow determinations are not synchronized, the resulting error can be very significant to overall determined patent values, especially when there is a high probability of product/project failure and/or substantial costs associated with such failure.
Common Error: Income Approach – Acceptable Non-Infringing Alternatives Are Not Explicitly Considered and Incorporated into the Valuation
A patent valuation attempts to quantify the future economic benefits to be enjoyed by virtue of owning the patent being valued. These economic benefits generally represent net incremental cash flows resulting from use of the patent reflecting market creation, market expansion, enhanced market share, and/ or increased selling price. Other net incremental cash flows resulting from patent ownership can include reductions in capital expenditures, cost savings in materials, and/or manufacturing costs generated by the subject asset, etc. In addition, sometimes patents reduce risk of litigation, provide strategic product development alternatives, and/or provide other benefits. Absent alternatives, the combined net incremental benefits expected to be created by the patent—properly analyzed, measured, and presented—represent the value of the patent.
However, a patent’s prospective value can change dramatically if there are available, acceptable, non-infringing alternatives to the patented invention. The fundamental economic principle here is that a prudent buyer will not pay more for a solution to a problem than the price of an available, acceptable, non-infringing alternative solution. For instance, if a patented invention is expected to increase the risk-adjusted present value of net cash flows by $1 million, and there are no acceptable, non-infringing alternatives available, the value of the patent approximates $1 million as this is the amount a potential buyer of the patent would be willing to pay to obtain the related, expected future benefits. However, if the patent owner could achieve the same economic benefit from an available, acceptable, non-infringing alternative for only $100,000, a potential, prudent buyer of the patent would never pay more for the new invention than for the available, acceptable non-infringing alternative (i.e., $100,000). In this example, even if the patent owner were going to use this patent himself, its Fair Market Value is still only $100,000. Alternatives in the market that compete against the patented invention being valued—and that are available, acceptable, and non-infringing—may provide an approximate cap to patent value. Consequently, available, acceptable, non-infringing alternatives should be carefully evaluated by the valuation analyst to determine their effect on the value of subject asset.
As a practical matter, valuators are likely to require the assistance of someone with technical knowledge and familiarity with the patented invention, and often also a patent attorney, to be able to opine that a particular available alternative is a legally and technically acceptable, non-infringing substitute for the patent being valued.
Common Error: Income Approach – Including Historical “Suck Costs” in the Analysis
A sunk cost is a past cost that has already been incurred and cannot be recovered. A common error that organizations make relating to patent valuations is improperly factoring in these historical or sunk costs in the valuation analysis. Valuations are performed as of a certain date and, when relying on an Income Approach, are forward-looking. As such, costs incurred by the patent owner prior to the valuation date are historical or sunk costs and are financially irrelevant to the go-forward worth of the patent being valued.
The forward-looking nature associated with the use of the Income Approach is one of the reasons inventions often become more valuable as they get closer to market or as the market matures. Other important reasons often include lower discount rates (reflecting the fact that many of the hurdles to commercial success have been successfully negotiated) and fewer years until forecasted cash flows begin, among others.
To avoid confusion, it should be noted that for certain non-valuation analyses, historical costs are very relevant. Historical costs are important considerations in overall evaluations of project cost and a project’s overall financial success. For example, in an analysis of an entire research and development project, all costs to create, develop, and commercialize the technology and related products are relevant. Fortunately, these analyses of entire projects are easy to differentiate from valuations, which typically are performed after the project has begun and only look forward at incremental inflows and outflows of cash.
All else being equal, the inclusion of irrelevant historical/sunk costs will produce an artificially low patent value indication. Ultimately, the Income Approach valuation analyses that include historical/ sunk costs will mislead the user of the valuation regarding the price the market may be prepared to pay to acquire the patent.
Common Error: Income Approach – Legal Life of the Assets is Modeled Instead of the Economic Life of the Asset
In the U.S., the legal life of patents for applications filed on or after June 8, 1995, is 20 years from the filing date of the earliest U.S. application. A common error some valuation analysts make is modeling the forecasted economic benefits associated with the patent through the end of the legal life of the patent instead of appropriately incorporating the patent’s economic life into the analysis.
It is important for appraisers to consider not only the legal life of the patent but also the economic life of the asset, which may encompass financial, technological, and regulatory factors, among others. In some cases, the economic life is shorter than the legal life of a patent for various reasons, such as:
- A patent may be made obsolete prior to its expiration date as a result of new, emerging technology (technical obsolescence).
- The product in which the patent is used may become outdated and cannot reasonably be made competitive (functional obsolescence). For example, a product may be functionally obsolete if its design is outdated, replacement parts are no longer available, or when the cost of repairs or replacement parts is higher than the cost of a new item.
A non-exhaustive list of factors to be considered in determining a patent’s economic life include:
- Normal product lifecycle
- Historical and expected rate of technological change in the relevant markets
- Product-specific technical and functional obsolescence
- Product-specific demand, competition, and other economic factors
- The level of maintenance expenditure required to obtain the expected future cash flows from the patent asset
- The expected useful life of another patent asset or a group of assets to which the useful life of the subject asset may depend
- The flexibility of the invention and its ability to be repurposed and included in other patents
- Any legal, regulatory, or contractual provisions that may limit the patent’s economic life
The analyst should also be sensitive to a related issue. Sometimes, for various reasons often dealing with patent prosecution, the legal life of the patent is not 20 years from the date of earliest U.S. patent application. It is incumbent on the analyst, working with legal and company personnel as appropriate, to address and understand the issue of relevant patent life.
Common Error: Income Approach – The Value of the Relevant Products is Not Properly Apportioned, Reflecting the Contribution of the Subject Patent
There are many products in the marketplace that are technologically complex, incorporating dozens and sometimes hundreds of different components, and many of these components are potentially covered by a large number of patents. A mistake made by many appraisers relates to their failure to explicitly or adequately apportion to the patent only that portion of the overall value of the product that is attributable to the patented technology.
The principle underlying apportionment is relatively straightforward: The value of the economic benefit should be consistent with the patent’s contribution to the economic success of the product. Consequently, if the analyst arrived at the value of the patented feature by directly determining the incremental cash flows caused by the patented feature, then no further apportionment may be necessary unless the value ascribed to the patented feature includes other value-contributing elements (other patented or non-patented elements), in which case apportionment may still be necessary.
However, if the analyst determined the incremental cash flows at the product level versus the patented feature level, then apportionment is typically necessary when a product contains a number of significant components, each of which contributes to the net incremental cash flows of the product. In such circumstances, the patent valuation analyst should consider apportioning the value of the entire product between the patent and other contributors of value included in the product (other patented features and non-patented features) to properly account for the value attributable to the patented component.
However, proper apportionment of product value to the patented feature (and in certain circumstances further apportionment of the patent value between a purchaser and seller or licensee and licensor) requires the application of often-complex procedures to determine the correct value to apportion to the patent. An in-depth discussion of apportionment techniques is beyond the scope of this article, however, in certain instances, apportionment insight may be gleaned from comparable licenses. For instance, if licenses exist where the components similar to the patented feature are separately licensed, these licenses may provide valuation insights. However, great care has to be exercised to ensure license comparability.
Patent valuation requires valuation analysts to synthesize a myriad of legal, technical, and economic facts and considerations to determine a value or value range for these difficult-to-value assets. In evaluating patent valuations, we frequently encounter a wide range of errors in the valuation analysis. In this article, we discussed some of the common errors that valuation analysts make when performing patent valuation assignments, with a focus on errors made using an Income Approach to valuation. The next installment in this series will focus on additional common errors made by valuators associated with Cost and Market Approaches to valuation