If IP is ever to be the asset class that many believe it should be, finding a transparent, coherent, widely accepted way to value IP holdings is absolutely crucial. Over the years, there have been a number of attempts to develop generally agreed valuation principles and methods, so that it might be possible to produce more transparent, uniform and comprehensible results. As yet, though, nothing concrete has emerged.
Recently, the UK’s Royal Institution of Chartered Surveyors (RICS) published a global Guidance Note on IP Valuation, intended to build on work done in this area by International Valuation Standards. Notably, the guide emphasises the need for valuations to integrate the technical, legal and economic characteristics of IP. Such multi-disciplinary inputs, it is hoped, will help to integrate assessments of patent quality and landscapes with the discipline of corporate finance.
The guide is available for purchase via the RICS online bookstore, but we have asked Tim Heberden, IP valuation director at Australian firm Griffith Hack and the technical author of the publication, to look at the major issues it covers. This is what he has to say:
IP valuations are carried out with increasing frequency for strategy determination, to support IP transactions and financing, and for financial reporting, litigation and tax compliance. Yet many IP practitioners are wary of them. Part of the problem has been that not all valuations exhibit an understanding of (i) the functional and economic characteristics of the technology, (ii) the legal complexities of IP, (iii) the dynamics of the tech transfer market, and (iv) finance theory and established valuation standards. This is because IP valuations have traditionally been carried out either by business valuers (strong on finance, sometimes light on IP knowledge) or IP specialists who might have gaps in their finance theory.
The RICS guidance note builds on the foundation provided by International Valuation Standards (IVS), with the purpose of:
Clarifying that IP valuation is a multi-disciplinary process that requires an assessment of the asset’s legal, functional and economic characteristics.
For each category of characteristics, identifying factors that should be considered.
Describing how the asset characteristics should influence the choice of valuation approach, and be incorporated into the analysis.
Recognising the complexity of IP, the RICS guidance states that the valuer should consider whether they are competent to assess the relevant characteristics of the subject asset, or if expert opinion is required.
The guidance note refers to specific categories of IP and, to match commercial practice, separately considers technology related IP, brand related IP and artistic related IP. This note focuses on tech IP, specifically patents.
What’s being valued?
Ever read an impressive looking tech valuation report and not been certain of exactly what’s been valued? The subject of an IP valuation can be a single right or a portfolio of complementary IP rights. The guidance note stresses that unless a valuation clearly identifies the legal rights that underpin the subject asset, assesses the breadth and strength of these rights, and indicates whether ownership has been established, the remaining analysis can be compromised.
In instances where the term ‘technology’ is used to describe a subject asset, the valuation should clearly identify included patents, trade secrets, designs, copyright and any other associated intangibles.
Extent of legal protection
The legal profession long ago recognised the need for specialist IP lawyers and patent attorneys. In contrast, IP valuations are often carried out by business valuers, so the guidance note draws their attention to legal considerations that can have significant economic implications. For instance:
The claims within a granted patent define the scope of exclusive rights. The breadth, validity, enforceability and commercial relevance of the claims are pivotal to patent value.
A patent does not guarantee that the owner has the freedom to exploit the patent without infringing patents owned by other parties.
A trade secret provides no protection against independent conception of the same know-how by a third party (nor protection from inadvertent disclosure).
The legal rights protecting technology can vary by jurisdiction so it is necessary to segment the valuation by jurisdiction.
What’s the incremental utility of the technology?
A product or manufacturing process can contain multiple patents. Recognising that not all patents in a tech area are equal, the guidance note lists factors that influence earnings capability and risk. Examples of relevant functional and economic characteristics are listed below:
Although a patented invention must be novel and inventive, this does not imply than it can be profitably exploited.
The economic contribution of a patent is influenced by the relevance of its claims to the differentiating features and earnings contribution of the technology that it supports.
Patent strength and value is influenced by patent quality, claim scope, validity and enforceability.
The ease of developing alternative technology that circumvents the scope of protection has a significant impact on its useful life and value.
Patent network mapping can provide insight to the importance of the subject patent in a tech area.
To illustrate the point, the RICS guidance note indicates that a ‘blockbuster’ patent typically provides a significant increase in utility, is difficult to design around, has a long useful life and is not difficult to enforce.
Risk assessment alignment with commercial reality
The risk profile of in-progress tech includes development risk. This reflects the cumulative probability of successful commercialisiation by addressing the challenges associated with each development hurdle.
Once commercialised, the earnings of tech IP is subject to risks resulting from economic, competitive, regulatory and enforcement factors. The latter reflects the possibility that even after grant, the validity and scope of a patent can be challenged.
For these reasons the standalone risk profile of a patent family can deviate significantly from the weighted average cost of capital of a company operating in that industry. The guidance note states that if the discount rate is used to reflect development risk (as opposed to risk weighting), the probability of success should still be estimated and explicitly factored into the discount rate.
Selecting a valuation approach and method
There are only three approaches to valuing any asset category: the market approach (based on comparable sales), the income approach (based on earnings and risk expectations), and the cost approach. Within these approaches there are a variety of methods than can be used to value IP. The guidance note identifies issues that should be considered in identifying the most appropriate one, but it does not elaborate on intangible asset valuation methods identified in IVS.
(No, there aren’t as many IP valuation methods as fish in the sea. But that is another topic.)
The RICS document stresses that understanding the characteristics of the subject IP helps determine the most appropriate valuation approach. It also indicates that the heterogeneous nature of IP means that it is often necessary to use multiple methods and to carry out sensitivity analysis.
Factors influencing the appropriateness of the market approach include:
The extent of novelty or differentiation of the subject IP and the likelihood of there being other assets that are sufficiently similar to enable comparative analysis (comaparability factors are disclosed).
To the extent that there are comparable assets, whether there is sufficient relevant and publicly available data concerning arm’s length transactions.
Factors influencing the appropriateness of the income approach include the ability to:
Make reasonable earnings estimates.
Assess the likelihood of in-progress technology reaching the market.
Isolate the earnings generated by the subject IP from other contributory assets.
Factors influencing the cost approach include the strength and degree of differentiation of the IP and the likelihood of the owner of a replacement asset having freedom to operate. The guidance note stresses that there is not a linear relationship between the cost of R&D and value.
Integrating IP characteristics into valuation analysis
For the income approach, the RICS guidance note identifies factors that should be considered when assessing the asset’s useful economic life, earnings potential, sales curve and risk profile. For the market approach, it identifies characteristics that influence the extent of comparability with market benchmarks. These include:
The specific purpose of the technology, its stage of development and the ease of detecting and enforcing infringement.
Breadth and extent of available legal rights, and the remaining term of protection.
Relative market characteristics and transaction dates.
For royalty rates, terms of the respective license agreements.
However thoroughly and skilfully carried out, the valuation of any asset is an opinion rather than a factual statement. The valuation of early stage technology is clearly more reliant on the judgement of the appraiser than is the case for homogenous assets with an active market. This makes the level of disclosure in an IP valuation particularly important. Disclosure is well covered in IVS, but the RICS guidance stresses the need for the scope of an IP valuation to clearly articulate whether:
Ownership of the subject IP has been established through legal assessment, or whether this is a special assumption.
There have been any limitations to the assessment of technical matters such as patent quality, scope of claims and freedom to operate.
The document notes that the value of IP can vary significantly under different ownership and circumstances and refers to the bases of valuation described in the IVS Framework.
The RICS document provides valuers with guidance in assessing the economic potential of IP, selecting appropriate valuation methods, determining reasonable assumptions, and providing meaningful disclosure. Just as importantly, it provides the IP community with a basis for briefing a valuation, gauging the competence of a valuer and assessing the quality of a valuation report.