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Valuation of IPR

Presented by Deepika MaheshwariFinancial Advisory ServicesDeloitte Haskins & Sells, Ahmedabad

Audit.Tax.Consulting.Financial AdvisoryThis document is confidential. No part of it may be be reproduced without express approval of Deloitte. © Deloitte 2008.

9th Feb 2008

Overview

•Basics of Intellectual property rights

•Importance of Intellectual property rights

•Management of IPR

•Valuation of IPR

Intellectual Property Rights- Basics

•Increasing investment in Intangibles.

• Shift in focus from Physical capital to Intellectual capital

• “Value of firm= Value of physical Assets+ Value of intangible assets”

Value of future growth opportunities that are already in place

Value of future growth opportunities from new assets

Value of Intangible Assets

Intellectual Property Rights- Importance

•Source Of unexpected revenue

•Increases Shareholders Value

•Establishes Proprietary Market advantage

•Enhances Competitiveness

•Exploits new market opportunities

•Reduces risk

Intellectual Property Rights- Management

To be able to reap benefits out of IP, a sound IP management programme is required

Identify

Design

Process

Method

Software

Trade Secrets

Know-how

Trademarks

Brand names

Formulations

Literary work

Patents

Copyrights

Design

Trademarks

Publishing rights

IP Trading

M&A

IPO/Fund raising

Financial Reporting

Licensing-In

Licensing-Out

Contract/ Royalty rates

Transfer Pricing

Litigations

Technology transfer

Valuation Approaches:

Accounting

Residual Value

Cost

Market value

Income

Real option

Source: Deloitte Research

Valuation

“The intangibility of a company’s most important assets makes it extremely hard to figure out what the company is really worth.”

Valuation Parameters

What

Whom

Why

How

What is the IP to be valued

For whom the valuation is being done

Why the firm has decided to value IP rights

(Purpose)

How the valuation would be done in given circumstances

Patents, Copyrights, Designs, Trade secrets, Know how, Trade

marks, Brand name

Shareholders, Management, Licensor/Licensee, Investor, Court

of Law, Acquiror , Investment banker

Corporate valuation for shareholders, M&A, Management

buy-out or buy-in, IPO/Fund raising, Financial Reporting, Acquisition/Licensing of IP,

Litigations,, and reorganization

Different approaches to valuation may be used

While valuing IP…

•Understand the value chain of business and understand how profits are generated

•Understand Important features of IP and how it adds value to business

•Obtain Adequate knowledge of trends in the industry and technology

•Consider scope & Strength of IP asset

•Assess the availability of competing IP in the market

•Ascertain the unpredictability of future returns

ManufacturingPatent Distribution Sales Brand

Valuation- A Daunting task

•No active market for trading of intangible assets

•Difficult to identify the potential earnings and profits that can be generated

•Uniqueness of each IPR – Non Comparability

•Difficult to Segregate profits generated from tangibles and intangibles.

•Difficult to ascribe appropriate economic benefit to an individual IP Asset if there are more than one IP.

•Inadequate disclosure of Intangibles in financial reports

•Most valuation methods ignore managerial flexibility

Valuation Methods

Valuation Methods

Static valuationmodels

Dynamic valuationmodels

Income Approach/Discounted

cash flow

Decision tree Analysis

Accounting Approach

Cost Approach

Market Approach Monte carlo Simulation

Real Option Model

Accounting Approach

•IPRs are subset of Intangible Assets

•As per AS-26 issued by ICAI, the recognition of an item as an intangible asset requires an enterprise to demonstrate that the item meets the:

• “definition of an intangible asset and• recognition criteria set out in the standard”

•As per definition Intangible asset should be• Identifiable• Controllable• Able to generate economic benefits

•An intangible asset should be recognized if, and only if:• it is probable that the future economic benefits that are attributable to the

asset will flow to the enterprise; and• the cost of the asset can be measured reliably.

Accounting Approach- Acquisition

Separate Acquisition

As a part of Amalgamation

• Cost of intangible would be the purchase consideration paid either in form of cash or in Fair value of shares or assets exchanged

• Cost =Purchase consideration+ Import Duty+ Taxes+ Any direct attributable exp.

Valuation

Valuation

• Allocation of purchase consideration to individual identifiable assets (including IPs) and liabilities based on their fair values at amalgamation date

• Valuation method must:

• Estimate Fair Value, and

• Reflect current transactions and practices in industry

Accounting Approach – Valuing Internally Generated IP

Research Phase Development Phase Commercial Phase

Expensed Capitalized Expensed

EXPENSES

ECONOMIC BENEFITS

1. Technical feasibility

2. Intention to complete and use/sell

3. Ability to use/sell

4. Probable future economic benefits

5. Resource availability

6. Ability to measure

Available for use

Direct + Indirect

• Internally generated goodwill can not be recognized as an intangible asset

Cost Approach

Value(Rs)

Value(Rs)

Historical cost

trending Method

Historical cost

trending Method

Replacement cost

method

Replacement cost

method

Recreation Cost MethodRecreation

Cost Method

Assumptions : Cost to purchase or develop new property is commensurate with the economic value of service

An investor would pay no more to purchase an asset than would be required to reproduce the asset

This method seeks to measure the future benefits of IP assets by calculating the amount of money that would be required to replace the future service capability of the subject intellectual property

Cost Approach- Examples

•Example : Cost incurred on R&D to develop a new technology know-how: INR 100 for Y1 and INR 200 for Y2

•Inflation index: Y1 = 100, Y2=105, Current = 110

•Estimated Value of IP

100 x 110/100 + 200 x 110/105 = INR 320

Historical Cost Replacement Cost •Example : Cost incurred on R&D to develop a new technology know-how: INR 100 for Y1 and INR 200 for Y2

•Inflation index: Y1 = 100, Y2=105, Current = 110

•Chances of Success : 60%

•Estimated value of IP would be (100 x 110/100 + 200 x 110/105)/0.6 = Rs 533

Cost Approach- Pros & Cons

•Good for internally developed intangibles or in liquidation scenario

•When comparable market data is not available

•When intangible is not income producing

•Requires numerous adjustment to financial data

•Difficult to apply if historical records are not there

•No direct correlation between price and value

•Risk is not factored

Pros Cons

Market value Approach – Comparable Market value

•Value of an IP = prices paid for comparable IP as part of arm’s length transactions

•The transaction price, as a ratio of an asset attribute such as sales, is used to derive a market multiple

•This market multiple is then applied to the attribute of the asset being valued

Requirements

•Active market involving comparable property

•Past transactions of comparable property

•Access to price information at which comparable property exchanged

•Arm’s length transactions between independent parties

Market value Approach – Comparable Market value

•Factors to be considered while comparing– Industry

– Market Share

– Profits

– Impact of New Technologies

– Barriers to Entry

– Growth Prospects

– Strength of Legal Protection

– Remaining Economic Life

Market value Approach – Comparable Market value

•Annual sale of products with ‘XYZ’ trademark = INR 100

•Comparable transaction: Purchase of 32 medical remedy trademarks by M&J Labs for INR 5000. Annual sale of all 32 trademarked products just prior to purchase was INR 4000

•Value-to-sales multiple of comparable trademark = 5000/4000 = 1.25

•Value of ‘XYZ’ trademark = Annual sale from ‘XYZ’ trademarked products x Value-to-Sales multiple of comparable trademarked products

= INR 100 x 1.25

= INR 125

Objective: To value a trademark ‘XYZ’ of a pharma co. ‘Pharma Co.’.

Solution

Market value Approach- Pros & Cons

Pros Cons•Most of the information is

not publicly available

•Low Frequency of comparable transactions

•Each intangible transaction is unique.

•Relatively easy to apply

•Conceptually attractive

•Provides evidence of value

Residual Value Approach

•Starts with the company’s value of equity (as measured by its stock price) plus the value of its liabilities.

•From such amount, value of the company’s tangible assets, plus the value of any intangibles not transferred (Unidentifiable Intangible Assets) is reduced. The result is the lump-sum value of the intangibles being valued.

•Value of IP = MC-(N+U)– Where MC= Market Capitalization

N= Net Tangible Assets as shown in book (Total assets- total liabilities)U= Unidentifiable Intangible Assets

Assumption : Markets are efficient. i.e, all future economic benefits from assets (tangible and intangible) and IP of the firm are factored into the market price of firm’s equity and debt

Drawback: Valuation would fluctuate with market. IP assets would not be valued individually. Is the market really efficient to factor in all the benefits

Income Approach

Value of IP = Present Value of expected future economic benefits from ownership of IP

Excess Profit method

Premium Pricing method

Royalty saving method

Cost savings method

Premium over generic product/services

Excess earnings over the company that does not possess intangible

License fee/ Royalty saved by owning the intangible

Cost saved by owning the asset

Variations Method

Approaches

• Estimate an appropriate measure of economic benefit for one period future to the valuation date and multiply it by an appropriate capitalization rate (r)

r = 1/discount Rate

•Where, r is a measure of economic benefit

• Does not consider future economic benefits

Value of IP = Economic Benefit Period 1 Economic Benefit Period 2 Economic Benefit Period n

(1 + k)1 (1 + k)2 (1 + k)n

..

Direct Capitalization

Discounted Future Economic Benefits

Plus

The terminal value of the business at the terminal year

TV = Economic Benefit n

(K - growth)*(1+k)^n

Illustration

• The book is expected to generate $150,000 in after-tax cash flows for the first three years and $100,000 a year for the following two years. These are the cash flows after author royalties, promotional expenses and production costs.

About 40% of these cash flows are from large organizations that make bulk orders and are considered predictable and stable. The cost of capital applied to these cash flows is 7%. The remaining 60% of the cash flows are to the general public and this segment of the cash flows is considered much more volatile. The cost of capital applied to these cashflows is 10%.

Year Stable Cash flows

Present value @ 7%

Volatile Cashflows

Present value @ 10%

1 60,000

56,075 90,000 81,818

2 60,000

52,406 90,000 74,380

3 60,000

48,978 90,000 67,618

4 40,000

30,516 60,000 40,981

5 40,000

28,519 60,000 37,255

Total

216494 302053

Source: Damodaran online

DCF Approach- Pros & Cons

Pros Cons

•Reliable financial projections

•Estimating income attributable to intangibles, its economic life, appropriate discount rate/ cost of capital

•Use of same discount rate in R&D as well as Market phase

•Managerial flexibility is completely ignored

•No accommodation to option like nature of investments

•Captures economic benefit flowing due to Intangibles

•Considers appropriate risk based rate of return at which to discount cash flows and estimates economic life

Matrix- Accounting for Risk & flexibility

Source:Crystal ball confrence

Real option model

•Investment in intangibles does not generate immediate payoff

•Each intangible may have a bundle of options

Source:Crystal ball confrence

Decision Tree Analysis

Patent Application

Cost

Application to Grant

Patent failedP = 0.70

Patent grantedP = 0.30

Grant to Commercialization

Product failsP = 0.20

Product SuccessP = 0.80

Low RevenueP = 0.40

High RevenueP = 0.=60

End of first year ofcommercialization

LapseP = 0.20

RenewP = 0.80

Status QuoP = 0.60

File patent in UK

P = 0.40

NPV4

NPV3

NPV2

NPV1

NPV6= (0.60 x NPV3 + 0.40 x NPV4)

NPV5= (0.20 x NPV1 + 0.80 x NPV2)

NPV7= NPV5 x0.4 + NPV6 x 0.6

NPV8= NPV7 x0.8

NPV10 = NPV9 x0.3 - Cost

PHASES

Real Option Technique

• Valuation under uncertainty

• Use Black-Scholes (1973) Option Pricing Model

• Option parameters

– Value of Underlying = Present Value of Economic Benefits

– Exercise Price = PV of investment in IP

– Time to Expiry = Remaining economic life of IP

– Standard Deviation = Standard Deviation of Economic Benefits

– Risk free Rate = Riskless interest rate that corresponds to the economic life of IP

– Dividend (Value Leakage) = 1/Economic Life of IP

PV of Cost of developing and commercializing the Patent

Present Value of Economic Benefits from Patent

Net payoff from Patent

Patent Payoff Diagram

Problems

•Estimation of future economic benefits

•Economic benefits may not follow a continuous process

•Variance may be unknown and may change over the economic life of IP

•Exercise may not be instantaneous

•Compound options

Need exclusivity.Difficult to replicate and arbitrage (making option pricing models dicey)

With multiple intangibles (brand name and reputation for service), it becomes difficult to break down individual components.

Life is usually finite and terminal value may be small.Cashflows and value may be person dependent (for professional practices)

Challenges

Option valuationValue the undeveloped patent as an option to develop the underlying product.Value expansion options as call optionsValue abandonment options as put options.

Compare DCF value of firm with intangible with firm without (if you can find one)Assume that all excess returns of firm are due to intangible.Compare multiples at which firm trades to sector averages.

Estimate expected cash flows from the product or service and discount back at appropriate discount rate.

Valuation approach

Undeveloped patents, operating or financial flexibility (to expand into new products/markets or abandon existing ones)

Brand names, Quality and Morale of work force, Technological expertise, Corporate reputation

Copyrights, trademarks, licenses, franchises, professional practices (medical, dental)

Examples

No cash flows now but potential for cashflows in future

Not independent and cash flow generating to the firm

Independent and Cash flow generating intangibles

Categorizing Valuation

Source: Damodaran website

Concluding Remarks•IP valuation calls for co-ordinated efforts from a CA, IP attorney,

and a technology person

•Adopt as many appropriate valuation techniques as possible, understand the pros and cons of each valuation method, and make a best estimate

Thank You

Deloitte Haskins & Sells‘Heritage’, 6th FloorNear Gujarat VidhyapithOff Ashram RoadAhmedabad-380 014Gujarat

Deepika MaheshwariAssistant Manager

Email: dmaheshwari@deloitte.com