The income approach to tech valuations

The various methods that are used to value intellectual property can be grouped into three valuation approaches:

• The market approach establishes value by comparison to recent sales of comparable intellectual property (this is complicated as intellectual property is, by definition, unique and there is little publicly available sales data).
• The cost approach determines value on the basis of the estimated cost to create a replacement asset with similar utility (however, the relationship between cost and value is generally not linear).
• The income approach estimates the present value of forecast IP earnings, accounting for the asset’s development and operating risks (which are difficult to assess for early-stage technology).

This article focuses on the application of the income approach to technology-related intellectual property.

The term ‘technology’ can cover a bundle of intellectual property, including patents, patent applications, designs, trade secrets, software and in-licensed intellectual property. An obvious and essential first step is to define clearly the rights that are the subject of the valuation. As these rights can vary by jurisdiction, it is often appropriate to segment the valuation accordingly. Further segmentation can be beneficial if the competitive environment or the potential of the technology differs by application.

For any asset category it is essential to clarify the basis of value, which could be value in current use, market value (to a typical market participant) or special value (including synergies to a specific owner).

The illustration shows the analytical building blocks that are required to inform the assumptions needed to value technology-related intellectual property.

Market attractiveness
Analysis of the market size, growth and competitive forces is equally important for the valuation of technology as for business and brand valuations. Disruptive technology adds an extra layer of complexity. The best platform for market forecasting integrates insights from multiple landscapes: patent networks, consumer research, competitive forces, litigation and trends in IP deals.

The findings of the market analysis feed directly into assumptions of the target market’s size and growth. Along with the findings of the technology-related intellectual property’s commercial utility, the analysis of competitive forces drives assumptions of the speed and extent of market penetration.

Incremental commercial utility
The earnings capability of technology-related intellectual property depends on its functional performance relative to alternatives – and the resulting economic benefits. Incremental utility can result from performance of the end product or from operating efficiencies stemming from the intellectual property. Before commercialisation, relative performance can be estimated through computer simulation and prototype studies. For consumer products, conjoint analysis can be used to gauge the demand impact of new features. The step from functional proof of concept to economic validation has caused many innovations to stumble, so it is essential to evaluate technology-related intellectual property’s costs and price implications.

Together with the analysis of competitive forces, the utility assessment drives assumptions on the rate and extent of the technology-related intellectual property’s market penetration. Other relevant factors are the extent of IP protection, relative price, the nature of the buying decision and access to complementary assets.

Legal protection
Having highly differentiated technology with strong market potential is a good start. But unless the differentiating features have strong and enforceable IP protection, the differentiation will soon be eroded by competitors (for further details please see "Patent valuation: connecting tech differentiation to patent claims").

In addition to confirming the extent to which the subject intellectual property covers the differentiating features of the technology, the appraisal should consider the validity and enforceability of the patent claims and design-around risk. The likelihood of circumvention can be reduced by broad (and enforceable) patent claims or a patent thicket.

Blockbuster intellectual property provides a significant uplift in utility, is difficult to design around, has a significant useful life and is not difficult to enforce.

Useful economic life
The remaining legal life of a patent provides the ceiling to its economic life. An assessment as to whether the economic life is shorter than the legal life should include the following factors:

• the tech lifecycle within the industry;
• the barriers to entry;
• the quality of the patent claims and breadth of IP protection; and
• measures of commercial interest in the tech area, including R&D, IP licensing, patent applications and forward citations.

Development hurdles and risk
For technology that is still in development, it is important to describe all development hurdles. For pharmaceutical intellectual property the stages of clinical research and regulatory approval represent clearly defined phases. Some other industries have guidelines or generally accepted development milestones, such as:

• unproven concept;
• model validation;
• proven small-scale prototype;
• proven commercial-scale prototype; and
• commercial launch.

The development path provides a framework for estimating the probability of successfully reaching the market, the expected time to market and remaining R&D costs. Where there is significant development uncertainty, the valuer should consider using risk-weighted scenarios or real options methods of valuation.

As a ‘most likely’ probability of success can mask the breadth of possible outcomes, valuation reports should disclose the development path and probability assumptions.

Market and asset risk
It is highly unlikely that the standalone risk profile of technology-related intellectual property is equal to the systematic risk of the enterprise that owns it. So corporate cost of capital is unlikely to be a suitable discount rate for technology-related intellectual property. The build-up method can be used to incorporate asset-specific risks, which should include the risk of technical obsolescence and risks that are intrinsic to patents and trade secrets.

Cross-checks
IP valuations benefit from the use of more than one method and from commercial-sense checks and sensitivity analysis. The valuer should ‘kick the tyres’ of each valuation assumption and the findings. Valuation reports should enable the user to do the same – for example:

• the intellectual property’s contribution to product earnings should assess comparable royalty rates and profit split analysis;
• where possible, the intellectual property’s contribution to enterprise value and total intangible value should be assessed;
• if the income approach has been used, comparison should be made to any available IP transactions – even if not directly comparable; and
• the cost of developing new intellectual property of similar utility, should be considered as this represents the value ceiling (subject to freedom to operate).