Valuation of Intellectual Property: Moving Beyond the Paradox

6 months ago by in Valuation Tagged: , , , , , ,

Intellectual Property (IP) valuation is easily one of the most misunderstood topics surrounding the management of intangible assets. Over the last 20 years we have seen the migration of IP valuation from being a tool for estimating IP damages into more “main stream” applications, and with the explosive growth in IP transactions, the need for assigning a monetary value to IP assets is higher than ever.  Having said that, inside the IP community there is a high degree of frustration expressed by all constituents when it relates to IP valuation: buyers, sellers, lawyers, consultants, etc.

Much of the confusion and frustration around IP valuation stem from an interesting paradox that results from the lack of alignment between IP transactions, deal pricing and reporting requirements. As long as most IP transactions are not being properly valued, while most IP valuations that are done don’t really matter since they happen after the fact, there is no incentive to develop better valuation processes nor is there ever going to be a better set of comparables to refer to.

We lay out a very pragmatic framework to approaching IP valuation: provide a high level view of the evolution of the field, explore the current landscape of valuation circumstances and the problems they present, and offer a path forward for the future.

The Evolution of IP Valuation: From Litigation to Monetization

With its origins in the IP litigation of the 1980’s and 1990’s, the valuation of IP (primarily patents) in the United States was initially limited to damages calculations in legal cases involving claims such as patent infringement.  With the introduction of tax planning involving IP, such as transfer pricing and patent donations, the valuation of intangibles became critical in non-litigation circumstances as well.  Companies were required to include in their tax reporting the fair market value (FMV) of IP involved in transactions, such as the inter company transfer of IP or the donation of a patent to a university.  New accounting GAAP rules related to business combinations, introduced in the early 2000’s, expanded the need for IP valuations even more, as companies were now required to report the Fair Value (FV) of intangibles that were purchased with a target in an M&A deal.  These “Compliance” situations – litigation, accounting, and tax reporting –carry with them a high degree of scrutiny by the court or regulating authorities, and require a third-party, IP valuation expert’s opinion in the form of a report or testimony.

In parallel to the proliferation of tax and accounting rules which mandated the valuation of IP in certain transactions, around the same time (late 1990’s- early 2000’s) the field of intellectual asset management (IAM) was starting to gain momentum with US corporations.  Large companies with significant patent portfolios were leading the way, and with the increase in sophistication of active IP portfolio management, came the need for valuation.  The types of activities where a valuation became increasingly important include: spin-offs, in kind contributions, licensing, patents sales, and other commercialization activities.  Since many of these activities are done for planning purposes or do not result in tax or accounting reporting requirements, these circumstances can be referred to as “Non-Compliance”.  In these situations, due to the low to medium degree of scrutiny and the lack of reporting requirement, the valuation is often done in house or between the parties, without the involvement of a third-party IP valuation expert.

The chart below displays the IP Valuation Spectrum, the compliance vs. non compliance situations and when a valuation expert may be needed (“Compliance” situations are highlighted in a box):

The IP Valuation Paradox

The distinction between Compliance and Non-Compliance situations is critical in understanding the problem with IP valuations. There’s a fundamental difference between the types of valuation done in compliance vs. non-compliance situations (excluding litigation, which is a special case):

In compliance situations, the valuation is usually done after the fact, when the deal has already been finalized, and so the IP valuation is not driving the transaction but rather reporting the transaction. There is single point value that needs to be recorded (as opposed to a range of values that needs to be negotiated).

Non-compliance situations fall intoone of two categories:

  1. 1. Deals involving intermediaries (brokers or patent funds) – there is usually no monetary valuation done before the deal; so the valuation is not driving the deal nor is it reported after the deal;
  2. 2. Direct negotiations between buyer/seller – There are usually valuations done on both sides for purposes of negotiations and therefore there would be a range of values that needs to be reconciled and negotiated between a buyer and a seller.  Here, too, the valuation is not always reported after the deal and so future similar deals cannot refer to it as a comparable.

Hence lies the paradox: most IP transactions today are done in non-compliance situations where the valuation is either not required, not reported or not done; and in compliance situations, where the valuation is required and reported as a single number, it doesn’t really matter since it’s done after the deal is closed.

There do we go from here? Make IP Valuations Matter, and Report Them!

The most common complaints with IP valuation usually fall into three categories:

1. Lack of active markets and a good set of comparables

2. Lack of transparency in valuation methods

3. The nature of intangible assets makes their value “contextual”, such that it’s difficult to assign one value to an asset or to agree on a value between buyer and seller

We argue that the root problem with IP valuation is not in the lack of markets, comps or methods; these are all symptoms of the real problem.  The key to a better IP valuation environment lies in more “Compliance”: higher deal scrutiny, more reporting requirements, and making IP valuation an integral part of deal pricing.  We should strive to undo the paradox: get to a point where most IP transactions are done in a compliance situation, where the IP valuation is required and reported; IP valuations should be done prior to the deal and have a meaningful impact on deal pricing.  This is a long process which could require regulatory, cultural and structural changes which could face many hurdles, but the problem needs to be identified and dealt with.

Let’s take the analogy of buying a house: we all like to refer to the real estate market as a very active market with lots of great comparable transactions for appraisers to work with.  These comps are readily available because every deal is reported somewhere: in the county records, in the local papers, in realtor’s brochures – and with a great degree of detail that allows a thorough comparison and adjustment between properties.

Why cannot intangibles be like that? As long as most IP transactions are not being properly valued, while most IP valuations that are done don’t really matter since they happen after the fact, there is no incentive to develop better valuation processes nor is there ever going to be a better set of comparables to refer to.  And while the value of intangibles will always be contextual in nature, there could be more information available in the marketplace to support a comparison and adjustment of market transactions, as is so successfully done in real estate markets. We need to make IP valuation matter, and we need to report it!

Efrat Kasznik is the President of Foresight Valuation Group, LLC, a boutique consulting firm focusing on IP valuation, strategy and litigation, and is based in Palo Alto, California

IPEG Intellectual Property Expert Group is an IP consultancy based in Europe