Adapted from "Marketing of Advanced Materials Intellectual Property", Twelfth International Conference on Composite Materials, July 8, 1999, Paris France by Michael Martin
Following is a discussion of valuation approaches utilized by WSURF to determine the range of acceptable economic values as a starting point for negotiations and to determine the appropriate royalty rate. Ultimately, value is established between two parties across the table.
Cost Approach
The Cost Approach values Intellectual Property assets based on the cost to create and develop or to replace the assets under consideration. This valuation method is based on the premise that no party involved in an arm's-length transaction would be willing to pay more to use the property than the cost to replace the property. The estimated cost to develop the technology may be based upon historical development costs or the projected cost to develop an asset of similar value as of the date of valuation.
The main limitation of this approach is its lack of consideration for all elements of future income and/or profit streams, market conditions, useful life, and the risk associated with receiving future economic benefits. Another limitation of this approach is the inherent assumption that the asset is "replaceable" with one of equivalent value, an assumption that often does not apply to intellectual property, which is unique by definition.
Nonetheless, the Cost Approach may be a very appropriate method for valuing assets with certain characteristics. For example, this approach may be appropriate for valuing embryonic, basic technology for which market applications cannot yet be defined. Also, if the technology is narrow in scope and thus easy to replicate or "design around," the cost approach may be appropriate.
Income Approach
For property dedicated to a business enterprise, including intellectual property, future benefits are preferably measured in terms of income generated by the Intellectual Property. The Income Approach does just this, as it values assets based on the present value of the future income streams expected from the asset under consideration. The expected future cash flow stream from the asset, usually a series of periodic amounts, may be quantified using a variety of approaches depending on the specific circumstances of each case.
The duration and timing of the cash flow stream is determined by forecasting the useful life of the property, which can be determined in any one of several ways:
- the physical or service life of the asset
- the statutory or legal life of the asset
- the economic life of the asset - the period of time during which the property is producing an adequate return
- the functional or technological life - the period after which the technology becomes commercialized but before the asset becomes technologically obsolete.
The business risk associated with the realization of the stream of expected cash flows may be captured through the use of an appropriate discount rate. The discount rate should reflect a rate of return on investment that is commensurate with the risk associated with the commercial exploitation of the assets under consideration. This discount rate is used to discount future expected cash flows back to the present in the net present value calculation.
Market Approach
The Market Approach values assets based on comparable transactions between unrelated parties. Factors to consider include the nature of the assets transferred, the industry and products involved, agreement terms, and other factors, which may affect the agreed-upon compensation. Both the Cost and Income approach can provide a basis for the initial valuation.
Relief From Royalty Approach
The Relief From Royalty Approach is based on the following premise: a property's value can be measured by what the owner of the property would pay in royalties if it did not own the property and had to license it from a third party (i.e., the licensing costs avoided by virtue of owning the property). Conversely, this approach may also quantify the amount of income that the owner would generate by licensing the intellectual property to others.
This method requires that the Intellectual Property have been developed to the point where it can be expected that products encompassing the Technologies could be produced within a reasonable period of time. Second, there was sufficient data to develop reasonable estimates of the royalty base (i.e., projected revenues). Third, there was adequate data to support the determination of a reasonable royalty rate. Finally, the Relief From Royalty Approach accounts for market conditions, the economic life of the Technologies and the risk associated with receiving future economic benefits.
Methods for Determination of an Appropriate Royalty Rate
Market Approach
Market Approach entails searching for negotiated royalty rates from comparable licensing transactions.
Profit Apportionment Approach
The need to split or share the anticipated profit "pool" between licensors and licensees of intellectual property has been recognized and endorsed by licensing practitioners, Tax Court case law, and Internal Revenue Service regulations. In the case of licensing intellectual property assets, there are several "rules of thumb" that are commonly employed when determining a reasonable profit split. A common rule of thumb is referred to as the "25% rule." Marcus B. Finnegan and Herbert H. Mintz provide a good overview of this rule in an article from The Business of Licensing: "While the percentage may be variable depending upon the facts, there is fairly common acceptance of a figure of 25% of the profits earned by the licensee as a reasonable royalty to the licensor."
Excess Earnings Approaches
The Excess Earnings Approach values a property by the incremental earnings which may be achieved by the subject assets with intellectual property protection (e.g., a patent) relative to the profitability of similar "benchmarks." Examples of "benchmarks," as used here, may include profit margins on products without intellectual property protection or more general measures of normal industry profit levels. The "excess earnings" may result from the proprietary product commanding a price premium, delivering certain manufacturing cost savings, or achieving larger sales quantities.
Cost Savings Approach
Occasionally, the only income-enhancing contribution of an intellectual property is in the form of manufacturing (or other) cost savings that accrue to the owner (or licensee) of the property. In such cases, the quantum of the cost savings may constitute an appropriate basis for determination of a reasonable royalty rate.
