Intellectual Property Valuation explained (once and for all)
Valuation analysts and Intellectual Property professionals apparently agree that there are four standard methodologies to value Intellectual Property (IP):
1. Cost Approach: This approach is based on the historical cost to develop an IP asset which is used to determine its value. This is pretty silly because why would anyone develop an asset that they did not expect to appreciate in value?
2. Income Approach: The income approach calculates the present value of future income streams specifically attributable to the intellectual property asset. Except in the specific case of contractually obligated income, this approach requires the use of the same crystal ball that many companies used to prepare themselves for global financial crisis.
3. Market Approach: The market approach values intellectual property by comparing an IP asset to publicly available transactions involving similar assets with similar uses. Otherwise known as benchmarking, this approach assumes that markets don’t lie. Of course another crystal ball is required to decide which companies or assets to benchmark against.
4. Relief from Royalty Approach: In this approach a hypothetical situation is created to estimate what a business would pay to license its own intellectual property assets in an arm’s-length transaction. The value is then calculated as the net present value of the so-avoided hypothetical royalty charges. And the answer is just about always whatever the CFO needs.
In addition to the traditional methods used to value intellectual property, there are at least twenty-five alternative valuation methodologies:
Brand Contribution Methodology: The contribution to IP value made by a brand may be separated from the profit contributed from other elements of a business by deducting all other costs and whatever is left over is the brand value. This is also known as goodwill in other financial calculations and has many other contributions other than IP.
Replacement Cost Method: This approach measures the amount of money in today’s dollars that might be imagined is required to replace any accidentally lost IP, rather than the amount of money that was spent historically to develop the IP. Since we know IP is either worth a lot more than the cost of development, or nothing at all, this approach is doomed.
Reproduction Cost Method: This method is very similar to the ‘Replacement Cost’ method, but differs slightly in that it measures the aggregate costs in today’s dollars that would be necessary to develop an exact duplicate of the IP being valued. This is oxymoronic since, once produced, IP can’t be copied by the very nature of IP. In any case, it’s always much cheaper do something the second time around.
Technology Factor Method: This takes the net present value (NPV) of the discounted cash flow (DCF) of the revenues attributed to a technology and then multiplies these by an associated risk ‘technology’ factor to estimate a random number.
Venture Capital Method: This approach analyzes the value of future cash flows over an IP asset’s life. This has absolutely nothing to do with anything that a venture capitalist might ever do.
The Concept of Relative Incremental Value Method: By example, if an underlying trademark or brand has a value of $100 million and the domain name associated with it is generating 10% of revenues, then one can allocate a relative value of 10% of the total or, $10 million dollars for the domain name. This is called ‘kicking the can down the road’ since the trademark or brand has to first be valued by some other methodology.
Decremental Cost Savings Valuation Method: IP value is measured as the decrease in the costs experienced by the IP owner/operator compared to a hypothetical situation where they don’t own the IP. Yet another crystal ball is needed for this one.
Enterprise Value Enhancement Method: The IP owner’s enterprise value as a result of owning the IP is compared to the enterprise value if the owner did not own the IP. You guessed it, another crystal ball.
Imputed Income Analysis Method: A subset of the traditional ‘Income Approach’ method, this makes no sense and I won’t bother discussing it.
Income Capitalization or Direct Capitalization Methodology: This method actually works – it is used to estimate the value of long-life intellectual property for which net income (royalties or profit) is not expected to vary greatly over time (due to contractually-defined license fees, for example). This involves taking an estimate of expected annual royalty stream and doing an DCF calculation or similar. Unfortunately very little IP falls into this category.
Income Differential Analysis: Compares two comparable companies, say a brand company with strong IP rights and a generic competitor, and values the IP as the difference in their incomes. But as a good friend used to say to me ‘all bicycles weigh the same’, referring to the fact the the expensive lighter bikes need much heavier locks to keep them safe from thieves. The brand company with all that extra income will waste it on unnecessary costs associated with operations, marketing and overhead, and the IP benefit will be frittered away in entitlements. In effect the IP is worth nothing.
Liquidation Value method: In a bankruptcy situation the liquidators often get to sell the IP. I have been involved in such situations and I can tell you for a fact that liquidators do not give a stuff about IP – they simply want to sell it as quickly as possible with the minimum fuss. Assume something close to zero and you are close to the mark.
Premium Pricing Analysis: IP value is established by looking at the difference in the price that a branded product can command in the market compared to the average product in the market. The difference between these two prices is the price premium and a NPV of IP income can be calculated by forecasting into the future. However it must be noted that the price premium of a branded product can come with a very high cost, e.g. with lots of marketing and expensive operations, and therefore IP can actually have a negative value by this methodology.
Profit Split Methodology: This attributes a share of a company’s profitability to a particular intangible asset with the use of voodoo mathematics at its very best.
Auction Method: If a hypothetically perfect IP auction market existed, several potential buyers that each had all the available information regarding an item of IP would compete with each other to bid on the IP and thus the IP can be valued. No such perfect auction market has ever, or will ever exist.
DTA (Decision Tree Analysis) Based Methods: This is a complex version of a DCF methodology that introduces a bunch of fudge factors associated with potential future managerial decisions relating to IP. Designed to confuse even the most hard-nosed auditor this approach is usually executed by consultants that have PhDs in physics.
The Brand Value Equation Methodology (BVEQ™): In this methodology a core value for a trademark is calculated, and then each of the individual IP assets attached to the core asset have their values calculated and the whole lot is summed up. The value of the IP is then measured by the relative weight of the bound report from the IP valuation consultants, multiplied by a calibration factor related to the inverse of the average IQ of the executive team at the client.
The Competitive Advantage Technique: This works on the supposition that IP is giving an owner an advantage over its competitors. The IP valuation methodology requires the valuer to place his or her thumb in his or her mouth and then hold it up to the wind.
Monte Carlo Analysis of Value: Designed for start-ups and R&D managers, this approach gives technology managers an excuse to do whatever they feel like with complete assurance that no one in the executive team will feel confident enough to challenge the maths.
Options Pricing Technique (The Black-Scholes): A patent is really just an option to sue, or to receive license fees, or any number of other optional outcomes. The trouble with using option pricing for patents is that there is no ‘ground truth’; option pricing only works where the risk factors can be properly measured after the fact and adjusted accordingly for future calculations. For patents, no one ever knows what would have happened in the other scenarios.
Snapshots of Value Approach: This is exactly the same as the ‘Business Enterprise Value’ approach except that the scenarios are now called ‘snapshots’. Sexy; I like it.
Subtraction Method of Value or Benchmark Method of Value: This is the same as the ‘Market Approach’ but adds more IP value by increasing the mass of the valuation report.
The ValCalc Methodology: A variation on the ‘Return on Assets Employed’ approach where the value of the IP is reduced a little as a result of the reduced profits of the IP owner resulting from the premium attracted by this branded valuation methodology.
Valmatrix Analysis Technique: This proprietary system employs an algorithm containing a matrix of the twenty most important predictors of value for a trademark, patent or piece of software. Ever heard of GIGO?
Conclusion
There are at least 29 known valuation methods for IP and absolutely no consensus on the matter. In truth most efforts at valuation are undertaken to give the IP owner the number they want, together with enough complexity in the valuation approach such that a third party can’t reasonably quibble with the outcome.
Nevertheless IP assets are actually bought and sold so they must have value, unless everyone is completely deluded. My guess is that in some cases everyone is deluded and the IP assets actually have no value or a value very different to what is being paid, and in other cases IP assets do have clear and identifiable value.
Where buyers make a lot of money from purchasing IP assets this is often because there is an information asymmetry relating to the IP, where the buyer knows something that the seller does not. However in these cases it could be argued that the value is in the information asymmetry and not in the IP. That is, the IP is a necessary but not sufficient component for the ultimate value to be realised.
An important point to make here is that an IP asset rarely has an absolute value. IP value is usually relative and determined by who owns it. Except in those rarer cases where an IP asset underpins a defined income (say in a license agreement) the value of an IP asset can only be properly determined by a buyer in a IP asset transaction. But even then, most buyers over-pay or under-pay.
Where an IP asset is not being bought or sold, and is not being licensed, any attempt to value an IP asset will undoubtedly be even more incorrect. The real questions of interest are (a) ‘how incorrect?’, and (b) ‘who cares?’
I would suggest that most valuations using any of the 29 methodologies described above are usually very wrong and that IP is usually over-valued by a fair margin. This is especially the case for patents. However there are those rare occasions where IP is actually worth significantly more than the cost of development; this hope keeps everyone in the game just like the poor fishermen down at the local creek living off the memory of the 9 kg flathead that Barry caught in 1972.
If this is the case why isn’t here a market correction I hear you ask? Why doesn’t anyone care? And the answer is because everyone is a victim of the same confidence game and hence there is no competitive disadvantage from wearing over-inflated IP costs and valuations.
In truth, IP can usefully be considered as a tax on the corporate sector, the purpose of which is to give first world governments a lever to control the ongoing ascendency that their economies have over the developing world.
Put more simply, IP is effectively a corporate lottery ticket where some companies occasionally win the lottery and the rest would like to think they have a chance of winning the lottery, and where the proceeds from the lottery are used to keep outsiders from playing in the main game of competing in the market for products or services.
In this context the true value of IP could be calculated by comparing the relative productivity of a nation (compared to other nations) and attributing a so-calculated relative national IP value to the corporate IP owners in that nation on some pro-rata basis.
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