Thursday, March 21, 2013

How to Value Patents

This article is extracted from a paper by Susan Chaplinsky, Professor of Business Administration at the University of Virginia (Darden School of Business). It addresses alternative methods of valuing Patents. 

This note addresses the methods used in valuing intellectual property, with particular 
emphasis on valuing patents. Additionally, the note defines intellectual property and explains its 
growing importance in the world market. Detailed descriptions of income approaches, market 
approaches, and a review of cost approaches can be found in the text. 
Defining Intellectual Property 

Intellectual property (IP) shares many of the characteristics associated with real and 
personal property. For example, intellectual property is an asset, and as such it can be bought, 
sold, licensed, exchanged, or gratuitously given away like any other form of property. Further, 
the intellectual property owner has the right to prevent the unauthorized use or sale of the 
property. The most noticeable difference between intellectual property and other forms of 
property, however, is that intellectual property is intangible. That is, it cannot be defined or 
identified by its own physical parameters. Consequently, IP must be expressed in some 
discernible way to be protectable. 

To be patentable, an invention must be novel, unique, useful, and nonobvious. A 
prerequisite to patentability is that the invention must be capable of some practical application. 
This emphasizes the importance the patent system puts on usefulness. One might say that a 
patent is a contract between society as a whole and an individual inventor. Under the terms of 
this social contract, the inventor is given the exclusive right to prevent others from making, 
using, and selling a patented invention for a fixed period of time in return for the inventor's 
disclosing the details of the invention to the public. Thus, patent systems encourage the 
disclosure of information to the public by rewarding an inventor for his or her endeavors. 
Under all patent systems, once this period has expired, people are free to use the 
invention as they wish. The benefits of an effective patent system can be partially illustrated as 
• A patent rewards the investment of time, money, and effort associated with research. It 
stimulates further research as competitors invent alternatives to patented inventions, and 
it encourages innovation and investment in patented inventions by permitting companies 
to recover their research and development costs during the period of exclusive rights. 2 UVA-F-1401 
• The limited term of a patent also furthers the public interest by encouraging quick 
commercialization of inventions, thereby making them available to the public sooner 
rather than later. Patents also allow for more latitude in the exchange of information 
between research groups, help avoid duplicative research, and, most importantly, increase 
the general pool of public knowledge. 

Intellectual Property’s Increasing Importance in Corporate America 
Intellectual property? Ten years ago, that phrase wasn't even in the vocabulary of many 
CEOs, let alone a part of their business strategies. Indeed, many chief executives still regard 
patents, trademarks, copyrights, and other forms of intellectual property as legal matters best left 
to the corporate attorneys. But the burgeoning knowledge economy has given rise to a new type 
of CEO and a new type of business competition--one in which intellectual property, not fixed 
assets, have become the principal sources of shareholder wealth and competitive advantage. 
The rise of the knowledge economy means that the intellectual property owned by a 
company is likely to determine its future economic success. Because intellectual property offers 
differentiation between products, it often holds the key to fast growth in market share and 
premium profits. Indeed, a leading product may derive its success from all seven of the major 
types of intellectual property: trade marks, design rights, copyrights, patents, know-how, 
confidential information for manufacture (so-called trade secrets), and finally databases (e.g. 
software to manage the supply chain and targeting). Exhibit 1 lists some important innovations 
of the last twenty years. 

An analysis of the Fortune 500 companies shows that in 1975, 60 percent of their market 
value was represented by their tangible assets. But twenty years later this percentage has fallen to 
just 25 percent. Since then, the proportion has fallen further and this trend looks to continue. 
Companies are increasingly looking to acquire undervalued and underused intellectual 
property. Indeed, the new millennium will see a new breed of corporate raiders, who strip-out 
and sell intellectual property, just as their predecessors did with undervalued tangible assets in 
the 1980s.

 In recent years, IP valuations have crept into a wide array of business situations, 
• Evaluating potential merger or acquisition candidates 
• Identifying and prioritizing assets that drive value 
• Strengthening positions in technology transfer negotiations 
• Making informed financial decisions on IP maintenance, commercialization 
and donation 
• Evaluating the commercial prospects for early stage Research & Development (R&D) 
• Valuing R&D efforts and prioritizing research projects 
• Supporting a valuation for loan collateral  3 UVA-F-1401 

Thus, the quality and accuracy of IP valuations have become an important focus of senior 
management. We turn now to a review of the valuation techniques frequently used to value IP. 

Methods of Valuation 

Income Approach 
Income approaches focus on the future cash flow derived from a particular piece of IP. 
As with all income valuations the need to accurately forecast future cash flow is of paramount 
importance. The following variables are needed when using an income approach: 
• An income stream either from product sales or licensure of the patent 
• An estimate of the duration of the patent’s useful life 
• An understanding of patent specific risk factors and incorporating those into the valuation 
• A discount rate 
Unlike most enterprise or fixed asset valuations, intellectual property assets have their own 
set of unique risk factors. Some of these risks are: 

• New Patent Issuance: New patents can either make existing technology obsolete or, 
more likely, allow for another competitor in the same space. If a similar patent is issued 
the value of the underlying technology will decrease. One key difficulty of the patent 
process is that it is nearly impossible to know what has been filed with the U.S. Patent 
and Trademark Office (USPTO). Only issued patents are publicly available information 
and therefore the risk posed by pending patent claims cannot be easily foreseen. Exhibit 
2 lists the number of new patent applications filed and granted by the USPTO from 1970 
to 2001. 

• Patent Challenges/Declared Invalid: An issued patent remains open to attack for 
invalidity, and it is a common defense for an alleged infringer to assert that the patent is 
invalid. Typically, patents are challenged on the grounds that someone other than the 
named inventor invented the claimed property, that the invention is “obvious” to persons 
skilled in the relevant technology, or that the patent is not unique and too similar to 
existing methods. Successful challenges can immediately invalidate the patent and 
corresponding licenses. In principle, proper due diligence should turn up these potential 

• Patent Infringement Suits: Licensees could be held liable and ultimately pay three times 
damages. Again, due diligence should reveal any potential problems of overlapping, 
uncited prior or concurrent claims.  Despite due diligence, it is estimated that over 43 percent of patent claims ultimately turn out to be not unique. (David E. Martin, “Insurable Patents? Global Metrics for Actuarial Patent Risk Management,” Conference on Growth, Prosperity and Patents, Danish E.U. Presidency, Aalborg, Denmark, October 28, 2002.)

• Trade Secrets: Some patents are virtually worthless without the necessary trade secrets. 
An example of a “worthless” patent is a pharmaceutical patent for a specific drug that did 
not reveal the exact “recipe” for formulating the drug. The inventor(s) of the patent need 
to cooperate and share those trade secrets to maximize the value of the patent. 

• Foreign Governments failure to comply with Patent Cooperation Treaties: This is a 
major issue for software patents, many of which are pirated in foreign countries and sold 
into the world market. 

Discounted Cash Flow (DCF) Method 
The discounted cash flow approach attempts to determine the value of the IP by 
computing the present value of cash flows, attributable to that piece of IP, over the useful life of 
the asset. Unlike an enterprise DCF valuation, terminal values are rarely used, as the useful life 
of a patent is typically a finite period of time. Since 1995, patents expire 17 years after issuance 
or 20 years after filing. While this does not imply that patents cannot have value after 17 years, 
it usually implies some diminution of the patent’s value beyond this point. At expiration, 
competing identical technologies can enter the marketplace. A good example of this is generic 
pharmaceuticals, there is still value in the “name brand” product after a patent has expired, but 
numerous generics typically enter the market. Valuations of patents will vary based on the 
degree of post expiration cash flows assumed. For this reason, most analysts usually begin by 
assuming no value is expected after expiration of the patent and then consider other assumptions. 

The same methodology used to forecast free cash flows and an appropriate discount rate 
in an enterprise valuation apply to an IP specific valuation. Free cash flows are forecasted for 
the useful life of the patent and the discount rate is the company’s market based rate of return, 
assuming that the company’s business risk is equivalent to the patent under consideration. The 
forecasted free cash flows should also be adjusted for the probability of a patent’s success. The 
risk factors outlined above affect the likelihood of a patent’s success 

The benefits of the DCF method are its ability to compare values among different patents, 
likely availability of many of the required inputs from the firm’s financial statements and market 
information. A drawback of DCF is that it does not capture the unique independent risks 
associated with patents. All risks are lumped together and are assumed to be appropriately 
adjusted for in the discount rate and the probability of success, rather than being broken out and 
dealt with individually (i.e., such as legal risk, technological risk, piracy, etc.) Further, often 
DCF fails to consider dependencies on properties held by others. In roughly 40 percent of cases, 
patents depend on other patents or property held in the public domain. 

Venture Capital Method 
The Venture Capital valuation technique also derives a value for a patent from the cash 
flows that arise over the asset’s life. It differs from the DCF method in that a fixed non-market 
based discount rate is used, usually 50 percent (40-60 percent range), and there is no explicit 
adjustment for the probability of success. This method does not account well for the patent 
specific risk factors outlined above. Like the DCF, cash flows are assumed to be static and  5 UVA-F-1401 
independent risk factors are lumped together. In valuing intellectual property, this simplicity is 
the method’s greatest drawback. 

Relief from Royalty Method 
Relief from royalty is based on deprival value theory and looks at the amount of income 
that a company would be “deprived” of, if it did not own the intellectual property in question but 
was required to rent it from a third-party instead. The royalty represents the rental charge, which 
would be paid to the licensor if this hypothetical arrangement were in place. The ability to 
determine an appropriate royalty rate depends upon the specific circumstances and requires the 
identification of suitable comparable transactions and prices involving third parties. 
Obtaining a royalty rate is only a first step however and a reliable sales forecast is also 
required in order to estimate the income that flows directly from the intellectual property. As 
with other income approaches, an appropriate cost of capital has to be determined. 
This method is useful because the market size and expected market share are generally 
accessible information. In addition, the method is also intuitive in that the value of a property is 
defined as a rental charge other companies would pay to use it. One significant drawback of the 
relief from royalty method is that a rental charge can always be assumed, when in reality one 
may never materialize. The plain fact is that some patents may be of little value and thus are not 
worthy of a rental charge. 

Real Options Method 
The Real Options Method (ROM) recognizes that a patent has intrinsic value based on its 
projected cash flows discounted at the opportunity cost of capital for the owner of the patent. 
Additionally, the ROM incorporates the value associated with the uncertainty inherent in a 
business and the active decision making required for a patent-based business strategy to succeed. 
The ROM values these items using the Black-Scholes option-pricing model. 
The inputs for the Black Scholes pricing model are as follows: 

  • Underlying Asset Value The present value of the property’s future cash flows  over the life of the asset 

  • Exercise Price The present value of the fixed costs that must be invested  to commercialize the product or to maintain the patent’s strength 

  • Time The time until the patent expires  NOTE: Future benefits that continue past the time of patent expiration are not considered. 

  • Volatility The standard deviation of the growth rate of the patent’s cash flows   

  • Risk-free rate The risk-free U.S. Treasury rate over the remaining life of the patent 

  • Dividends Reduction of the option’s duration due to competitive action, unforeseen delays, or other risk factors 

The primary advantage of the ROM is that it accounts for the value associated with the 
uncertainty of cash flows and the ability to manage the patent investment. Like the DCF or 
Venture Capital methods, the ROM values the stream of cash flows but it also accounts for 
acquired knowledge. This method provides a more complete evaluation than either the DCF or 
the Venture Capital method, which only capture cash flows and static fixed costs. 

The primary disadvantage of the ROM is that there is often an inexact mapping of the 
assumptions underlying option pricing theory and the real option application. For example, is 
the standard deviation of the growth rate of patent cash flows log-normally distributed? 
Likewise, the Chicago Board Option Exchange commits to pay an investor using traded options 
the exercise price of the option. No party assures that the fixed costs projected in the exercise 
price under the ROM are obtainable to the firm. The “break-through” aspect of the BlackScholes model was the observable and reliable nature of the inputs into the model. The accuracy 
of the model inputs relies on the efficient capital market assumptions that underlie the traded 
option, bond, and stock markets. 

Real investments are typically infrequently traded and  therefore their prices lack the reliability of market prices. As such, these limitations place some  doubt on the accuracy of the economic values projected under the ROM.  

Other disadvantages of using the ROM to value patents include the fact that patents  contain adverse rights, not affirmative rights which run counter to the notion of “having an  option.” Further, as noted earlier, the option value of a patent can be reduced or eliminated by a  third party filing and contesting the claim. ...

 The remaining assumptions for the ROM are fairly straightforward with the exception of 
the standard deviation or volatility of the patent cash flows. 

Other Valuation Approaches 
As with many types of valuation, other methods exist to value IP, which we touch on 
only briefly here. 

Market Comparables 
Conceptually, a market comparables approach should offer a good indication of a 
patent’s value, as it reflects the exchange of value between two parties. However, in valuing 
patents it is difficult to find a suitable comparable transaction. The two primary reasons for this 
are the lack of disclosed sale or licensure activity and by its definition, a patent must be unique. 

Historic Cost 
This valuation methodology measures the amount of money spent in the development of the 
intellectual property at the time it was developed. But unless the intellectual property was 
developed in the recent past, an historic cost measure tends to be unreliable due to the impact of 
inflation and the changes that occur in technology over time. In addition, it is not always possible 
to provide accurate information on the resources spent for such quantification. 

Replication Cost 
This measures the amount of money that would need to be spent in current cost terms in 
order to develop the intellectual property in exactly the same way and to achieve the same final 
state as it currently exists. This includes costs incurred on any unsuccessful or inefficient 

Replacement Cost
This measures the amount of money that would need to be spent in current cost terms in 
order to develop the intellectual property as it currently exists, but excludes the costs relating to 
unsuccessful or inefficient prototypes. 

As intellectual property grows in its importance, managers must understand not only the 
methods of valuing these assets, but also the unique risk factors associated with intellectual 
assets. Each valuation technique outlined has its strengths and weaknesses, but as is true with 
enterprise valuation there is no definitive right or wrong valuation approach. However, it is wise 
to use several of these methods when valuing a specific IP asset. This provides differing 
viewpoints on the underlying asset value and is a useful check for consistency in assumptions 
and human errors that may occur in relying on only one method. 

Source PDF file including appendices and detailed examples