Bachelor’s thesis in Business Administration · Web viewA major study by Arthur Andersen (1992) found that patents where separable from the underlying business and from a number

Bachelor’s thesis in Business Administration 1998School of BusinessStockholm University

Valuation of Intellectual Property

How Should a Large Corporation Estimate the Value of an Externally Produced Patent?

Max OlofssonKati Öhman

Tutor: Lars Ehrengren


Abstract

Valuation of intellectual property is important for different reasons and the purpose of this paper is to find a practical method for patent valuation. Examples of situations when the value of a patent needs to be estimated are: in license agreements, when patents are bought or sold, in merger & acquisitions, when rewards for inventors need to be calculated or when patents are used as securities for loans. Especially the situation when a large corporation is offered to buy an externally produced patent is considered.

By doing literature searches and interviewing some large companies, a number of different theoretical and practical methods for valuing patents (intangible assets) have been found. An elaborated version of the net present value (NPV) approach is recommended as the most practical method.

Keywords: patent, intangible asset, intellectual property, IPR, valuation, value, investment, model, method

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Table of contents

1 INTRODUCTION.................................................................................................................................3

1.1 Background..................................................................................................................................41.2 Problem........................................................................................................................................51.3 Purpose........................................................................................................................................51.4 Suggested method........................................................................................................................6

2 EARLIER STUDIES......................................................................................................................7

2.1 Literature studies.........................................................................................................................72.1.1 The value of prior art citations..........................................................................................72.1.2 Accountant methods for tax purposes................................................................................82.1.3 General valuation methods of IPR and Intangible Assets.................................................92.1.4 The Technology factor method.........................................................................................122.1.5 Valuation of patents.........................................................................................................142.1.6 Market coverage method..................................................................................................152.1.7 Auction valuation methods...............................................................................................162.1.8 Option Pricing Theory methods.......................................................................................16

2.2 Company interviews..................................................................................................................172.3 Analysis of earlier studies..........................................................................................................18

3 PROPOSED MODEL..................................................................................................................21

3.1 Net present value approach........................................................................................................213.2 Customized model.....................................................................................................................22

4 PRACTICAL METHOD.............................................................................................................23

4.1 Procedure for handling proposals..............................................................................................234.2 How to make the business interested.........................................................................................24

5 CONCLUSION.............................................................................................................................25

5.1 Future studies.............................................................................................................................255.2 Future scenarios in the patent business......................................................................................25

6 REFERENCES.............................................................................................................................27

6.1 Further literature........................................................................................................................28

7 APPENDIX...................................................................................................................................29

7.1 Estimation of utility issues........................................................................................................297.2 Estimation of competitive advantage issues..............................................................................31

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1 Introduction

Intellectual property rights (IPR) or intangible assets are, as the terms suggest, the hidden resources of a company and they are part of what is called intellectual capital, which also includes human resources etc. Copyrights, trademarks, brand names and patents are the best known intellectual property rights. This paper will focus on patents.

Earlier, patents have often been overlooked as valuable assets and licensing activity has been considered to be a non-core activity, seen as means of generating marginal income. A major study by Arthur Andersen (1992) found that patents where separable from the underlying business and from a number of other forms of intellectual property rights. It also concluded that the valuation of patents might be subjective, but no more than the valuation of unquoted companies, businesses in emerging markets, or pension funds.

Patents have become more and more important over the last decades and they provide one of the few legal ways of blocking trade in the European Union. The accelerating deregulation of industries worldwide and the elimination of tariffs in the spirit of the World Trade Organization only contribute to that fact. The GATT agreement has strengthened the patent rights and the respect of intellectual property rights in many countries.

A patent can be seen as a temporary agreement between an inventor and the society. By granting a patent, the society permits the inventor to monopolistically exploit his invention in the jurisdiction of the patent granting authority for a maximum of twenty years1 from the date of filing2 of the patent application. The inventor, on the other hand, reveals his invention to the public, which can subsequently improve it for the benefit of mankind (people do not have to “reinvent the wheel”). This arrangement gives the inventor a chance to recover the money he spent on the research and development, and the society’s overall knowledge will also increase, since expensive R&D would not be conducted if it could not also be properly protected. A developed intellectual property legislation could be seen as one of the most important criteria of a modern state.

Patents are used for different purposes. One obvious way of use is to achieve freedom of action, i. e. to assure that a corporation’s products and services do not infringe patents of competitors. If they do, this could mean that the company would have to pay heavy license fees or that it’s products or services will be shut out from an important market.

1 Due to extensive and time-consuming control of pharmaceuticals by public authorities, these patents usually get extended protection by five years at the most.2 US legislation differs from that of the rest of the world. The concept first to invent rather than first to file is what matters there. US patents expire after a maximum of 17 years after the date of issue or 20 years from the earliest claimed date of priority.

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Other ways to use patents are of course in more aggressive manners, where for instance royalties, one-off payments or cross-licenses are demanded. There are also suggestions that patents could be used as securities for loans3, which naturally requires reliable methods for patent valuation. Other examples when proper values for the patents are needed are when rewards for inventors need to be calculated or in merger & acquisitions situations.

The true power of a patent, however, is derived from the fact that it permits its owner the right to exclude others from using, selling or manufacturing the patented invention. Asserting this right is in the extreme case done in court. But filing a lawsuit, due to a detected patent infringement, may have some drawbacks, included therein are:

the direct expense (lawyer consultation etc) the business disruption (human resources have to focus on the litigation and

matters relating to it) the risk that the patent of the plaintiff may be invalidated by the court the probability that the defendant will file a counter suit and leave the battle as the

net winner

Many companies monitor their competitor’s behavior closely when it comes to how aggressively and well they protect their intellectual property rights. A company cannot ignore every patent infringement that occurs and must therefore file a law suit against a flagrant infringement by a competitor. Otherwise other competitors would also infringe the company’s patents without facing the risk of being sued. Thus, the value of the whole patent portfolio of a company can be severely compromised unless the owner actually exercises the above-mentioned right.

Finally, it is important to stress the difference between the invention, which is the underlying asset, and the patent, which grants exclusive rights over the invention as defined by the patent claims4. The importance becomes even more crucial when one has to decide what is being valued. The word patent is occasionally used in a somewhat unclear sense, meaning either the underlying invention alone, the IPR alone or sometimes both – including the entire project of commercializing the invention! In some cases, the invention refers to one of several embodiments or in other cases something within the scope of the patent claims. Projects comprising the commercialization of an invention and the corresponding patent protecting such an invention are two different entities, even though closely related.

1.1 Background

The preceding chapter illustrates some reasons for why a proper value has to be given to this strategic asset, but our attention to the matter is attracted by another reason.

3 Bertolotti, N and Bezant, M, The Valuation of Patents, Patent World, March, 1997.4 A patent normally consists of a first page (including bibliographical data), a background (where the state-of-the-art, as known to the inventor, and the problem is cited), a summary, a description of the invention (with a number of embodiments) and the patent claims (which define the legal scope of the patent).

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Often independent inventors or smaller innovation companies propose to sell their patents to a multinational corporation like for instance Telefonaktiebolaget L M Ericsson5. This is often hindered due to the lack of proper evaluation methods for those patents. Ericsson, and many other companies, has so far been using ad hoc-methods, which have not been successful enough.

1.2 Problem

How should a large company handle this kind of proposals or more specifically, how much should it be prepared to pay for a patent that an outside inventor offers?

A patent will have a different value depending on which company that will exploit it, since timing, technology and patent knowledge within the company have an impact on how the patent’s value can be maximized.

The problem for an arbitrary company when a patent is offered for sale is to subjectively estimate the value of it, with respect to its own business. But are there, from an objective point of view, any criteria that influence the value of a patent and can they be incorporated in an economic model which is practically useful?

It can be argued that the value of a patent can be fully estimated by standard investment decision methods. But since a patent offers an exclusive right to its owner, there should be some factors that would take this exclusive right into consideration and affect the standard investment decision analysis. So the key issue would be to focus on these special factors and try to fit them into an investment decision analysis.

We are focusing the attention to a complete sale of a patent, i.e. not a license agreement, in which only a part of the ownership would be transacted between the buyer and the seller. There are of course many factors that are common to both kinds of problems, but we will focus on the complete sales transaction.

To give a general answer to this question is probably an extremely difficult task, and the proper way to do it will certainly vary from case to case.

1.3 Purpose

The purpose of this paper is to find a useful procedure for valuing a patent that is offered for sale. In order to do that, a couple of issues need to be investigated:

What should the company do with these proposals? What should be investigated and by whom?

What is the business worth of a patent and how can this be found out?

What would be the best way to inform and motivate the business (internally within the company) to buy the patent for starting a money making business case?

5 NASDAQ:ERICY

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Find a procedure for how to deal with these proposals (checklists etc).

The most important and difficult task is to find out what the business value of the patent is, and the focus of this paper is to investigate this. The result will be incorporated in a context that deals with the other questions stated above.

1.4 Suggested method

We will use the following method to reach a practical solution:

1. Make literature studies and web-searches to find out what others have investigated and accomplished in this area.

2. Interview IPR managers in some large companies to learn if they are using any formalized methods for cooperating with inventors or if they have any models for valuing a patent.

3. Develop an adequate method based on the gathered information.

The scope of this paper is limited to the sale of one or several patents that are offered for sale from an external inventor to a large company. We are hence not interested in for example royalty agreements between large companies or the valuation of a whole patent portfolio.

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2 Earlier studies

We realize that extensive studies and analyzes have already been made in this area previous to this paper, although with a slightly different focus and purpose. It is therefore natural to investigate what others have achieved in different articles, papers, reports and books. This is done in order to incorporate the most important and interesting results, with respect to our specific goal, so that we can stress what is lacking and fill out the blank spots, if there are any.

Since we are professionally active in the field of patents, we understand that theory and practice are two different issues. To make this paper more complete and useful, we have decided to contact a few large corporations to find out if any methods are actually used to value patents.

2.1 Literature studies

To find out what others have published in this field, we have performed searches on the Internet, where all major Swedish, British and American University registers have been searched explicitly (the countries with the oldest patent activity are the US and the UK). Moreover, we have also conducted a number of database searches of all business magazines that are stored electronically by the commercial database host Dialog (http://www.dialogweb.com/). A few books have also been consulted and the findings are listed and analyzed below.

2.1.1 The value of prior art citations

When a patent application is finally treated by a patent office the scope of the claims that define the legal protection of an invention are normally narrowed down by the examiner. This is done by citing earlier scientific articles, product brochures, and of course previously known patents. Thus, an extensive public document is created, which contains detailed information about the invention, the inventor, the organization to which the inventor assigns the intellectual property right and the technological predecessors of the invention – the citations.

By identifying the prior art, the citations that appear in a patent serve the important legal function of delimiting the property right of the granted patent. This means that the citations contained within a patent convey information about the technological predecessors of the invention embodied in the patent document.

Hall et al. (1998) have focused on the information contained in citations and have found that citation-weighted patent stocks are more highly correlated with market value than patent stocks themselves and that this effect is mainly due to the high valuation placed on firms that hold very highly cited patents. This suggests that there

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is a connection between the number of citations ultimately received by a patent and the economic significance of the associated invention.

The way in which citations can indicate quality is obvious: if a particular innovation is truly technologically valuable, then it should lead to more subsequent citations. The idea of using subsequent citations to a patent as a measure of the patent’s value rests on the argument that valuable technological knowledge within a firm tends to generate patents that future researchers build on (and therefore cite) when doing their own innovations.

Hall et al. have in their study found that an increase of one citation per patent is associated with a three to four percent increase in market value at the firm level.

2.1.2 Accountant methods for tax purposes

Rabe and Reilly (1994) discuss different methods that accountants use in the valuation of taxpayers’ intangible assets for property tax purposes. Three different approaches to estimate the market value for intangible assets are explained, namely:

1. The market approach, which is based on an analysis of actual sales or license transactions regarding comparative intangible assets.

Objective criteria for determining the comparability between these “bench mark” intangibles and the subjective intangible may include the type of intangible (e.g. a patent), use of the intangible, industry, size of firm, term of the license agreement, etc. The appraiser then surveys the appropriate secondary market (using the aforementioned criteria) and selects a sample for analysis. These agreements should all be transactions between independent parties, involving transactions of assets or license agreements comparable to the intangible asset in question. Finally, a value for the intangible asset is estimated.

2. The income approach is quite straightforward and is based on a measure of the economic income earned by the company directly associated with the use of the intangible asset. There are several measures of economic income, but one should choose one that is relevant for the type of asset (in our case a patent), the type of firm and the nature of the industry. The selected measure of economic income is subsequently capitalized by an appropriate rate of capitalization to conclude the estimate of the value of the intangible asset.

3. The cost approach quantifies the costs to generate an equal intangible asset in terms of functionality, utility, usefulness and remaining life. Methodologies include depreciated replacement cost, depreciated reproduction cost, recreation cost, creation cost and cost savings/avoidance.

They argue that ideally, the intangible asset value finally derived will be based on a synthesis of two or even three of the aforementioned valuation approaches. However, depending on the quantity and quality of available data, it may be acceptable to rely on one valuation approach in the final determination of the intangible asset value for property tax purposes.

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The determination of the expected remaining useful life of an intangible asset will obviously affect the results of any of the three valuation approaches. For example, an intangible with an expected remaining life of three years will have a lower depreciated replacement cost than the same intangible with an expected remaining life of fifteen years, all other factors held equal. The shorter-lived asset will also generally fetch a lower market-derived transaction sale price or royalty rate and produce economic income for a shorter period of time.

There are numerous ways to estimate the expected remaining life of intangible assets. According to Rabe and Reilly some of these measures include:

Physical life Functional life Technological life Economic life Contract life Statutory/judicial life Legal/regulatory life Actuarial mortality life

Generally speaking, the shortest of these remaining useful life measures is used to estimate the value of intangible assets for property taxation purposes.

Taylor’s (1996) case study is focused on some tax peculiarities that non-citizens residing in the US will face. Among other things, he generally mentions four methods for valuing a patent, but he does not give an in-depth analysis of the valuation techniques, which are:

Compare the sales prices of patented and comparable non-patented products and then calculate the value of this difference over the patent’s useful life. This approach assumes that patent protected products commands a higher sales price.

The savings in manufacturing expenses attributable to the use of a patented process over its useful life could be estimated.

Capitalize expected royalty incomes.

Project the invention’s future earning capacity.

Even though all of these methods are not mutually exclusive, some precaution must be taken. For instance, one cannot expect to both license a patent to a competitor and simultaneously charge more for the product protected by the patent in question.

2.1.3 General valuation methods of IPR and Intangible Assets

Smith and Parr (1994) have written a whole book on the valuation of intellectual property and intangible assets. They describe a lot of general valuation methods and techniques for the whole scope of intangible assets, where the valuation of patents is

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just one out of many intangible assets. But the methods are of course general and some specific techniques and ideas can be used for the valuation of one single patent.

They point out some important and useful ideas and methods:

It is important to emphasize the relationship between value and earnings. The highest and best use of a patent is that which provides the highest net return. Quite obvious, but this net return varies depending on how the intellectual property is exploited, when it is exploited and by whom it is exploited.

They stress that a careful definition of value is most important in appraisals of certain types of intellectual property. The more a property is designed, constructed or suited for a special purpose, the more difference there will be in the value measured by different premises.

One could estimate the value by using the fair market value that is defined as: “Fair market value is the amount at which a property would exchange between a willing buyer and a willing seller, neither being under compulsion, each having full knowledge of all relevant facts and with equity to both.”There is a second definition of fair market value that is useful in the valuation process; “Fair market value is equal to the present value of the future economic benefits of ownership.”

Cost of reproduction (the cost that would be incurred to construct a replica of the property) is a useful starting point to develop other measures of value.Cost of replacement (the cost to obtain a property with equivalent utility) is used in budgeting for property replacement or additions, as a starting point in determining other measures of value and to determine insurance coverage.

Another way of expressing the value of a patent is to calculate the present value of all earnings that will be lost due to the entrance of competition (this also shows that a lost patent indicates value).

The different valuation methodologies that are described are the commonly used cost, income and market approaches. These are also briefly described earlier in chapter 2.1.2.

Transactions of single patents are rather rare events, and when they occur, the terms of exchange are not often disclosed to the public. Thus, the most difficult aspect of the market approach is comparability. Even if pricing information for a specific exchange of a patent would be available, the price at which the property exchanged will most likely have no bearing on the value of other patents unless positive comparability exists. Some of the most important factors that should be considered for intellectual property comparability are: industry, market share, profits, new technology, barriers to entry, growth prospects, legal protection and remaining economic life.

Cost does not equal value. A failure of the cost approach is that direct consideration of the economic benefits and the period over which they might be enjoyed is not accurately captured in the value. The cost approach is not as comprehensive as the other two generally accepted valuation approaches (market and income). Many of the

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most important factors that drive value are not directly reflected in the methodology and must be considered apart from the basic cost approach process. These factors are:

The cost approach does not directly incorporate information about the amount of economic benefits associated with the property.

Information about the trend of the economic benefits is missing from consideration.

The remaining life of the property is not directly considered. The risk associated with the expected economic benefits is not directly

incorporated in the model. Adjustments to reflect the affects of obsolescence must be separately calculated

and are often difficult to quantify.

It is important to consider the value of intellectual property from the viewpoint of current and potential exploitation. Areas in which the property can be used to enhance economic benefits that are not currently being pursued should be considered. When using the income approach the cash flows should address possible extensions and the associated risks.

Another way to estimate the value of intellectual property is to look at license royalties. The contribution to cash flow from intellectual property is estimated as the amount that the business would have to pay a third party to license similar property. The amount saved in licensing royalties is considered to represent the profit contribution of the intellectual property. But this procedure has errors; rarely do royalty rates associated with licensing negotiations represent the full amount of economic benefit derived from the intellectual property. Mostly the royalty rate represents a sharing between the licensor and the licensee of the intellectual property economic benefits. The licensee uses the property and pays a portion of the enjoyed benefits to the licensor as a royalty but keeps some of the benefits derived from the property. The royalty therefore rarely represents the total economic benefits derived from using the intellectual property.

Contribution to earnings: an analysis that ends after studying only the profit margins can be incorrect. A more proper method must study the total earnings of a business enterprise relative to the investment in monetary, fixed assets and other complementary assets.

Smith and Parr also discuss the analytical approach, which is another method for deriving a reasonable royalty that originated in the field of infringement litigation. It identifies the economic contribution of intellectual property as the difference between profits expected from infringing sales and a normal industry profit level.

Expected profit margin – normal profit margin = royalty rate

The problem with this approach is to find out what the normal profit is and if it is appropriate for application to the specific case. The approach can provide an order of magnitude indication of a reasonable attribution of intellectual property economic contribution, but the method could be improved. What is missing is consideration of the specific amount of complementary assets required for exploitation of the subject intellectual property.

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Of all the valuation methods described above, the preferred methods for patents and technology are ranked in the following order: income approach, market approach and cost approach.

The amount of income associated with the intellectual property reflects: the value of the intellectual property assets as part of the enterprise the relative risk associated with the intellectual property

Intangible assets and intellectual property are often considered the highest risk asset components of the overall business enterprise. Patents can be made obsolete by the advancing technology of competitors. These assets may have little liquidity and poor versatility for redeployment elsewhere in the business, thus increasing their risk. A higher rate of return on these assets is therefore required.

There is a difference of licensing a patent versus owning it to 100%. Owning the whole intellectual property include having the responsibility to provide financial support for initiating and pursuing infringement lawsuits and continuing research and development to enhance the property.

The authors also warn about using rule-of-thumb methods and industry norm methods when discussing licensing agreements.

It is also important when considering a reasonable royalty that looking at the money spent on development for the intellectual property is misleading. The issue is to provide a fair rate of return on the value of the intellectual property asset and the amount spent on R&D is rarely equal to the value of the property. The underlying value of intellectual property is founded upon the amount of future economic benefits, which are based on the amount of potential income, the risk of achieving it and its possible duration. The development costs do not reflect any of these factors and should therefore not be used for obtaining a fair return on a valuable asset.

Using discounted cash flow analysis (DCF) is considered to be a fundamental and reliable method. In order to determine the value for the business the present value of cash flows and the residual value should be considered.

2.1.4 The Technology factor method

The consultant firm Arthur D. Little, Inc. has developed a method called Technology Factor Valuation (1994) together with The Dow Chemical Company for practical valuation of intellectual property.

It is intended to be flexible, cost efficient and easy to implement. It allows a multidisciplinary business team to develop a first estimation of a specific technology’s contribution to a business case. Using this method, members of an assigned technology evaluation team employ a detailed and systematic qualitative assessment of the attributes of a technology (e.g. a patent) and its impact on the business. In addition to a quantitative numerical result, one of the benefits of the technology factor

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methodology is to arrive at a consensus among the different management functions within the business.

The value of a technology is based on the cash flows generated by the utility and the competitive advantage that a company derives from ownership and/or use of the underlying intellectual property (e.g. a patent). The technology factor is an expression of the expected incremental cash flow derived from the practice of a specific technology within the business. It is expressed as a percentage of the expected incremental net present value (NPV) of the business as a whole:

Technology Value = Technology Factor Incremental Business NPV

where 0 Technology Factor 100 %, and the NPV is the sum of several factors including tangible, intellectual and complementary assets.

The resulting competitive advantage can manifest itself as market differentiating (increased market share) or cost saving. The technology factor for a net cost saving technology equals 100%, since the entire NPV of the incremental cash flow due to usage of that technology is equal to the value of the technology. For a technology that contributes to market differentiation, the use of the technology factor method requires a qualitative assessment of how the practiced technology contributes to the competitive advantage, when other tangible and intangible assets have been filtered out.

The success of the valuation is highly dependent on the composition of the evaluation team and its contributions. Dow6 recommends the following functions to be represented:

Function ContributionBusiness Strategic fit of technology with long-term business planAttorney Defines the exact boundaries of the intellectual propertyR & D Competitive R&D and its impact on the considered technologyTechnology center Scale up hurdles and competitive manufacturing processesMarketing Product attributes, market applications and competitive responseBusiness analyst Economic impact (change of market share and price). Calculates

incremental cash flow and NPV of the related productsEvaluator/Appraiser Facilitates the generation of the Technology Factor and

determines the value of the technology

The same information used by the evaluation team to determine the NPV of the incremental cash flow is also applied to determine the technology factor, which is composed of all the attributes of a technology that affect the potential for the technology to create value. These attributes can be organized in two general categories of utility issues and competitive advantage issues7, reflecting its usefulness for a particular purpose or its expected success on the market respectively.

6The Dow Chemical Company, Valuing Intellectual Properties, September 1994.7 See Appendix.

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Now, the team has to decide if a specific attribute creates value, destroys value or has no impact on the business. The two categories of attributes are evaluated in two separate tables containing the qualitative notes (+, - or 0) that corresponds to each type of impact. When all the attributes are discussed, the evaluation team determines if the total impacts of utility and competitive advantage respectively are low, medium or high8. Finally, the absolute technology factor is determined by the combined impact of the two categories. This absolute technology factor is then multiplied with the calculated NPV to determine the value of the technology in question.

Consultant Paul Strassmann stresses the importance of the use of this method9: Regardless of the approach they take to understand and use the information effectively, executives should understand that it is a long-term effort. He also says: “The information productivity you have today is the result of years of effort - of things you have done with human beings and technology and software.” Remaking that information environment will also take years - and it will have to be done in an increasingly complex, fast moving environment. Executives should embark on that journey sooner, rather than later, says Dow's global director of intangible assets and capital management Gordon Petrash in the same article. “This is all moving very quickly from the realm of opportunity to the realm of necessity. I think there are companies focusing on this in very clever, very good ways, and they will have a significant opportunity versus those that are just scratching their heads and figuring out what to do. I just don't think a lot of head-scratching time is left.”

2.1.5 Valuation of patents

Arthur Andersen completed a major study in 1992 concerning the valuation of intellectual property. They concluded that patents are separable from the underlying business and from a number of other forms of intellectual property and that the valuation of patents may be subjective, but not more than the valuation of emerging companies and other similar issues.

Intellectual property is often subject to pricing and royalty disputes, because of its uniqueness and high value relative to tangible property.

It is important to understand and identify the purpose of the valuation. The most common valuation bases are: existing use value (present value to the owner) market value (amount that would be paid by a buyer) liquidation value (when the asset will be sold in a forced sale situation)

The value of a patent depends on the expected future cash flow derived from its use.

value = quantity (price-cost) capitalization factor

The capitalization factor represents the risk and the potential rewards of the cash flows and converts the annual cash flow into an absolute value for the patent. A patent 8 In the specific case of the chemical and plastics industry, these three notes have the following ranges: Low (0-30 %), Medium (30-50 %), High (50-75 %). These ranges must be adjusted for each industry.9 Anonymous Chief Executive, Is it working?, CEO Brief Supplement, p. 10, October 1996.

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can lower the risk of the future cash flows, since it offers protection and reduces competition. But at an early stage in the technology development the risk could be high.

There are three main valuation methods that could be used: cost methods market value methods economic bases methods

It is important to choose a method that suits the purpose best, and to check the result with other acceptable methods.

The cost methods are called historical cost (measures the actual cost to create the patent) and replacement cost (the cost to recreate the patent). None of these methods give any good result in estimating the value, since they do not estimate the future benefits associated with the patent. But they may need to be considered if it is very difficult to separately identify the cash flows associated with the patent.

The market valuation methods determine the value by comparing patents in recent transactions and royalty rate agreements. But the number of transactions is still limited and it could be difficult to find patents that are easily comparable.

Economic based methods are superior to the other methods, since they address all components of value; the identification, separation and quantification of the cash flows and the capitalization of these cash flows. Net cash flow and discounted cash flow methods should be used. The discounted cash flow method should include considering the degree of leadership of the patent in its market, the stability of the cash flows from the patent in previous years, the remaining patent life, pricing and regulatory issues and the cost of developing competing technology. These factors will provide a risk profile for the patent and an associated discount factor can be calculated. Royalty rate methods can also be used to value patents, but they often require that previous similar license agreements have been conducted. The difficulty in using economic based methods lies in that a detailed and reliable cash flow analysis is needed.

The best method for valuing a patent is considered to be the capitalization of net cash flows or royalties attributable to the patent using the discounted cash flow method. Since there are many issues to be considered when valuing a patent, it is important to choose the appropriate method and check all relevant factors carefully.

2.1.6 Market coverage method

Bednarek (1994) stresses the importance of having a patent on the adequate markets, i.e. filing the patent application in the most important countries. He uses two different measures of market importance. First, he calculates the cost of covering the market of a population of one million in different countries (large population covered with one patent). Secondly, he calculates the cost of covering a market of one billion dollars GDP (gross domestic product) in various countries.

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These two measures are combined into one patent value index. The first measure is more important for a low tech-product, while the second measure is more important for an expensive product.

The most important markets according to his results are:

1. USA2. India3. UK4. Canada5. Japan, Germany, Brazil8. France9. South Africa10. Australia

2.1.7 Auction valuation methods

The value of intellectual property could also be given a market value by using a sealed bid auction process where different interested buyers meet. But this requires numerous interested buyers to give a fair value of the sold property. This method is probably most interesting to the seller.

2.1.8 Option Pricing Theory methods

Patents could also be seen as real options and there are some articles written about option pricing theory methods (OPT) for valuing patents and similar assets or opportunities - see for example Mitchell and Hamilton (1988), Copeland et al. (1990), Trigeorgis (1996) or Wilmott et al. (1997).

From these articles it can be noticed that an R&D project could be seen as a series of compounded options (Copeland et al.) or as a call option (Mitchell and Hamilton). In the latter case the cost of an R&D project was identified with the cost of a call option on the future commercialization of the project, whereas the future investment needed to capitalize on the R&D program was identified with the exercise price of the option. The present value of the returns that the company will receive from the investment was likened to the value of the share subject to the call option. However, they did not discuss in practice how one might go about calculating the value of the considered options!

An attempt to illustrate the equivalence between the inputs required valuing financial and real options are shown below:

Financial option Real optionS Price of the underlying asset Present value of project cash flowsX Exercise price of the option Investment cost of the project

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t Time to expiry Time left to invest inr Risk free interest rate Risk free interest rate Standard deviation of underlying asset return Standard deviation of the project value

Furthermore, real options have been categorized as:

Proprietary or shared Simple or compound (the latter involves a number of successive options) Expiring or deferrable (the latter allows an investment/decision to be postponed)

Thus, patent related options are considered to be of the type proprietary, compound and deferrable, since they are by definition exclusive to the patentee, involve a number of successive stages as well as decisions that can often be postponed (next deadline in the application process, renewal fee date or expiration of license agreement).

Even though these approaches look serious and advanced, there are a few aspects of option pricing theory methods for patents that make them dubious. For example, patents (real option) and the corresponding underlying asset are not continuously traded, could the use of geometric Brownian motion processes to model the price of the underlying asset be justified when considering patents?

2.2 Company interviews

To find out if and how other companies handle this problem, we have chosen to contact a number of large corporations about their procedures in this matter.

We have talked with the patent managers, since they will almost always be part of the process of valuing the patent together with many other people in the organization (engineers, product managers and business people). The patent managers have the knowledge to analyze if the offered patent is a strong patent or if a patent application have the possibility to become an important patent.

The companies that have been contacted are:

ABB Corporate Research Robert Bosch, GmbH Electrolux AB Ericsson Radio Systems AB Sandvik Scania Telia Research AB Tetra Pak AB Volvo AB

A few questions were put together in order to treat all companies in the same manner.

The questions were:

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Has any external inventors proposed to sell their inventions or patents to you? If that happens, what do you do about it? If you decide to buy/license the patent, do you have some kind of formal valuation

method or process that gives you an idea of how much you need to pay for it? Do you value your whole patent portfolio by using any method?

We will not disclose the particular answers that each of the companies has given, but instead we will give a summary on what they have answered in general.

The conclusions are:All companies have experienced that external inventors propose to sell their inventions, patent applications or granted patents to them. Some companies are offered a few dozen proposals to buy patents from external inventors every year, others only a few. When this happens, the patent managers usually contact the people responsible for the concerned product, i.e. product managers. So a number of people will be involved in the decision making whether to buy the patent or not. None of the contacted companies have any formalized method for dealing with this issue and thus it is mostly done on an ad hoc-basis.

Often the lack of resources, both in the patent department and in the technical development organizations, results in a few numbers of patent transactions. It was revealed that it is important that the offered patent fits well into the technical development phase of the company and the market as a whole, thereby showing that timing is crucial. Most companies have not had the time or seen the need to create any general model or method for these kinds of evaluations. The majority of the companies preferred to evaluate a granted patent to eliminate the risk of being accused of theft. Some firms however, thought that a filed application was OK, since it was then possible to influence the subsequent prosecution of it.

None of the companies value their patent portfolios (except for tax depreciation purposes). This is probably also due to the lack of resources and knowledge. This will most certainly change in the future, since a lot of other intangibles in the companies are starting to become evaluated, like intellectual capital.

2.3 Analysis of earlier studies

This section will summarize the different methodologies that have been found in the articles and through the company interviews. The advantages (+) and disadvantages (-) with the methods will also be listed.

The following methods are most commonly used for valuing patents:

Income approach (NPV, DCF)+ Considers future cash flow streams from all revenues and costs+ Is the most accepted method+ Can be used at any stage of the process- Detailed knowledge of business and market plan is required- Time consuming to get accurate data

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Market approach+ Credible technique if useful transactions have been conducted- Low probability that similar patent trades will occur (lack of trade markets)- Does not consider future cash flows- Indirect approach of valuation (the valuation is completely done by others)

Cost approach + Relatively simple- Does not consider future cash flows- Does not consider remaining life time- Risk is neglected

Technology factor method+ Considers all factors (future cash flows, risk etc)+ Methodical and systematical+ Gains internal consensus within the business- Requires lot of skilful people who will do the assessment- Requires significant knowledge of own business/competitors/customers

Royalty rate methods+ Credible technique if useful transactions have been conducted- Gives a static and out-of-date value

Auction method+ Direct determination of a willing buyer+ No calculation is necessary- Requires many buyers to give a fair value

Option method+ Takes the changing risk into account+ Takes all factors into consideration (though only in theory)- Very complex in practice- Hard to convince people that it really works, not reliable for the moment, but

could perhaps be that in the future?

It could be necessary to use different adjusted valuation methods for different kinds of technology. It is for example easier to value medical compounds in terms of market size and customer interest since a value could be put on every sold pill (see for example Astra’s compound Losec which is sold worldwide). It is not as easy to put a market value on an improved algorithm in a radio channel allocation method or on a service provided in a telecommunication’s system. On the other hand a standard blocking method in a telecommunication system could be very valuable since it enforces all other companies in the business to adopt the method covered by the patent, which yields license money or a strong negotiation position to the patent owner.

By analysis of the different approaches we have concluded that the most useful methods for valuing a patent should be the income method or even better, the more

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elaborated technology factor method. The market approach could also be used in some specific cases.

The other methods described (cost, market, royalty, auction) are not appropriate enough for valuing a patent, since they do not take future benefits nor risks into account. They are also static methods and not dynamic. The option method is only interesting in theory for the moment, but could be very useful in the future if more research and analysis of the method is performed within industries and the financial markets. Further development will definitely be required to make this method useful in practice.

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3 Proposed model

Basically, the value of a patent could be calculated by standard investment methods. These methods are used by investors, accountants, banks etc even if they are not entirely accurate. They are known and commonly used methods, but what does the exclusive right offered by a patent add to these valuation methods? Exactly put, what is the value of the exclusive right? What are the impacts on standard investment decision models when also taking into account the exclusive rights provided by a patent? Valuing a patent is not easy, and could not really entirely be valued by standard investment methods, since they do not consider all patent specific factors. But it is also important when valuing a patent to use the “common language” of investors and other people involved in the investment decisions, so that they feel familiar with the situation.

Remember that we are interested in buying the patent and owning the legal rights by 100%, instead of just buying a license that only provides a shared part of the rights.

3.1 Net present value approach

The net present value (NPV) is probably the most realistic method for valuing a patent.

NPV = net present valueC0 = the investment cost to buy the patentCFt = positive and negative cash flows (income and costs that are related to the project)r = the discount rate, which is the internal cost of capital used for similar projects.t = the number of years to discount the cash flow (the life of the project)

The NPV should be positive, which implies that the project is profitable. The factor C0

is the investment cost in a project, and this investment cost should be less than the sum of the discounted positive and negative cash flows during the projects lifetime. When considering a patent purchase, the C0 could be seen as the payment.

You could at the NPV from two different angles, from both the seller’s and the buyer’s point of view. We are of course interested in the buyer’s perspective and to keep the investment cost as low as possible. The seller’s perspective is of course the opposite and the C0 should incur both the costs that the seller has had for obtaining the patent and the cash flows should comprise some reasonable profit that reflects the value of the patent.

Patent specific factors that influence the NPV, both positively and negatively, are:

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1. Technical factors

Is the patent potentially standard blocking? What are the probable technical advances in this field in the future (how soon will

the patent be obsolete?) What are the possibility and interest in the industry to design around the patent?

2. Legal factors

Is it a granted patent or just an application that will be valued? Has the opposition period expired (low risk that the patent will be withdrawn)? What is the remaining lifetime of the patent? How many countries has the patent been filed in and is there a possibility to file in

more countries within the priority year? What kind of countries is the patent filed in (respecting intellectual property

rights, pirate copies, developed/developing countries)? What are the scope and quality of the patent claims (novelty of the invention,

broad/narrow, what do they really cover, independent claims, apparatus/method)? Is it easy or difficult to detect infringement (uniqueness of the technology)? Is there a need to apply for further patents that will cover further developed

technology related to the subject patent?

3. Economical factors

What is the type of the patent – standard blocking (extremely important within telecom industry), market differentiating (will the customer pay a higher price for the product?) or cost reducing?

Which countries is the patent filed in – market size for the monopoly? Is there a possibility to license or sell the patent further to other companies?

Except for the factors considered in standard investment decisions, all the above stated factors have to be taken into account when valuing a patent. The risk situation is different in a patent investment decision, since a patent could for instance be invalidated in court. On the other hand, the benefit of getting a monopoly can definitely not be ignored.

3.2 Customized model

In order to use the NPV model in real investment situations, an adjusted and customized version of the technology factor method is chosen. It has been customized with respect to the telecom/infocom industry.

It can be hard to evaluate the result from this model in the beginning and therefore, we suggest that it be compared to the outcome from some well-known model, for example the market method.

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4 Practical method

In order to be able to use all these rather theoretical approaches and ideas in a practical way in a business, it would be suitable to have some kind of checklist that could be consulted when a proposal to buy a patent is offered. Therefore we will try to propose a practical action list which could be used by the persons in charge for taking the decision whether to buy the offered patent or not. This would help these persons to remember all the numerous factors and considerations that need to be analyzed.

The checklist is also valuable since it provides a model or method that could be improved in the future. It is always good to have some kind of model, even though it is not perfect or complete, but when you have a “skeleton”, it is easy to continue to develop it while using it, so that you do not have to start from scratch every time the problem occurs. You also formalize the procedure and it facilitates comparisons with earlier cases.

A list, or rather a work sheet, of relevant factors for the investment decision analysis can be found in the appendix. It includes both patent specific as well as standard investment factors. Apart from that, it also consists of instructions of who should estimate what.

4.1 Procedure for handling proposals

To be able to make a decision whether to buy the patent or not, a group of carefully selected people should meet and discuss the issue. They will be provided with the proposal and the checklist in advance, so that everyone is familiar with the offer and the questions that will be discussed during the meeting. The duration of the meeting should probably not exceed more than a few hours and a decision should be made during this time.

The following functions that attend in the decision process should have knowledge corresponding to:

Patent engineer or patent attorney Technical experts (R&D, production technology, standardization etc) Marketing expert Strategic business manager

The people involved should discuss and analyze the different issues in the checklist to be able to reach a unanimous conclusion whether each factor contributes positively, or negatively to the technology’s value creating potential. This will be marked with a plus, minus or zero in the column on the right hand side. When all issues have been treated, each of the two categories is summarized as having a low, medium or high technology factor. These two estimates are then merged into a total technology factor with an “exact” value, which the evaluation group reaches in consensus. This

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technology factor multiplied with the NPV, which value also depends on the listed issues, gives a value on the patent according to:

Absolute technology factor (%) NPV ($) = Value of Patent ($)

Item to be valued

Utility Competitive advantage

Range of technology factor

Absolute technology factor

Patent No. Decide the impact on value creation from the utility attributes:LowMediumHigh

Decide the impact on value creation from the comp. advantage attributes:LowMediumHigh

Combine the utility and competitive advantage factors to decide the technology factor range and narrow it down to a high- or low-end value of that range.

Revisit the attributes again and give an explicit value to the technology factor (i.e. 45%).

4.2 How to make the business interested

If it can be shown that the value to buy the patent is significant, the business and the persons in charge should be interested in looking closer at the offer. Since they should participate in the analysis and decision making, due to the intrinsic consensus characteristic of the method, they will rather quickly find out if it would be interesting to buy the patent or not.

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5 Conclusion

As can be concluded by consulting the numerous articles cited, there are a lot of different proposed valuation methods and techniques. Some of them are interesting in theory, but when it comes to practice, most of them are difficult to use, mainly due to the lack of proper input values for the different variables to take into consideration. This is of course not surprising, since most advanced decisions include many unknown factors and ad hoc values for the input variables. Others are just too simple and do not consider future cash flows that are crucial in patent valuation.

For many situations the technology factor method provides a good tool for valuing a patent. It has several advantages and includes many of the benefits from different methods, and it spreads knowledge and consensus within the organization. This facilitates the subsequent step after the valuation of a patent, namely the part of convincing business managers to buy and exploit it optimally. But the valuation of patents is difficult and depends from situation to situation so it is also necessary to use other methods in many cases.

5.1 Future studies

There are still some issues that have to be solved before the technology factor method can be used for an arbitrary company. Other issues concerning the valuation of intellectual property are also interesting to investigate further. The following topics are suggested for future studies:

The appropriate rate of return (cost of capital) in a patent project should be investigated.

The technology factor ranges must be adjusted to fit the company’s industry. Expand or improve the list in the appendix to include further issues? Contact other companies in for instance the U.S., the U.K. or Germany, where the

valuation of patents is probably more elaborated. Contact patent attorneys that deal with damage valuation, i.e. when someone has

infringed on a patent (post valuation).

5.2 Future scenarios in the patent business

Patents will play a much larger importance for all companies in the future. This can be concluded by following the “cold war” fought within industry. This can be observed at the different patent offices around the world (for example PRV in Sweden, the European Patent Office EPO and the American Patent Office UPSTO), since the number of filed patent applications in all technical fields has increased substantially during the last decade.

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More law suits for infringement and license negotiations will follow when the companies start to use their patents more aggressively than they do today. There already exist companies that make more money on their licensing income than on their core business profits.

The United States, the UK and Germany are probably the countriesin which the patent maturity in the companies as to using patents professionally in their business is most developed. The immaturity of using patents as the real business tools that they are will most certainly change during the next decade in most countries. Even for companies only trying to use patents defensively in protecting their R&D the scenario will change. They will have to start using them more aggressively, both as a necessity invoked by other companies doing the same and also for profitability reasons, license royalties can give large income to the company.

Patent portfolio valuation will certainly become a much more important and necessary task within the companies, both for internal reasons and demands from the financial markets. Now the value of patents is mostly merged with R&D and the whole know-how of technology in the company. But the isolation of value of patents can be seen in the light of other recently developed methods for valuation of for example intellectual capital, i.e. the know-how and competence of the companies’ employees.

Patents could potentially be used as collateral for loans, especially if they are a company’s principal assets. Therefore it is important that it is possible to put a fair value on the patents. But many financial institutions are reluctant to use patents as security, both due to the unawareness of the possibility and the lack of proper evaluation methods.

Why not start a new derivative-market: patents as options!There already exist option markets for gold, wheat, coal and other unsophisticated commodities. This new patent option market would attract the financial markets, especially since the technology covered by the patents could often be interesting and exciting to people. The patents could for instance be valued by different option valuation methods. This would be a risky derivative market, but the riskier the market - the higher returns if you bet on the right patent! This could maybe be possible within the next decade!

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6 ReferencesBednarek D. M., Global Patent Strategy, Managing Intellectual Property, Vol. 9, No. 44, pp. 12-22, Nov 1994.

Bertolotti N. and Bezant M., The Valuation of Patents, Patent World, March 1997.

Copeland T., Koller T. et al, Valuation - Measuring and Managing the value of companies, New York, John Wiley & Sons Inc, 1990

Hall H. B., Jaffe A. and Trajtenberg M., Market Value and Patent Citations: A first Look, Conference on Intangibles and Capital Markets, New York University, May 15-16, 1998 and Conference on the Economics of Science and Technology, University of Urbino, Italy, June 5-6, 1998.

Mitchell, G. R., Hamilton W. F., Managing R&D as a Strategic Option, Research Technology Management (May-July), 1988

Pakes, A., Patent as Options: Some Estimates of the Value of Holding European Patent Stocks, Econometrica 54:755-784.

Rabe J. G. and Reilly R. F., Valuation of Intangible Assets for Property Tax Reasons, National Public Accountant, Vol. 39, No. 4, pp. 26-30, April 1994.

Smith G. V. and Parr R. L., Valuation of Intellectual Property and Intangible Assets, second edition, John Wiley & Sons, Inc. 1994

Taylor N. B., Estate and Asset Protection for the Resident Alien: A Case Study, Journal of Financial Planning, Vol. 9, No. 3, pp. 68-77, June 1996.

Trigeorgis L., Real Options: Managerial Flexibility and Strategy in Resource Allocation, Cambridge, Mass. MIT Press, 1996

Wilmott P., Epstein D., Mayor N., Schonbucher P. and Whalley E., The value of market research when a firm is learning: real option pricing and optimal filtering, Mathematical Institute, Oxford University, October 1997

Arthur Andersen/The Economic Intelligence Unit, The Valuation of Intangible Assets, 1992.

The Dow Chemical Company, Valuing Intellectual Properties, September 1994.

Anonymous Chief Executive, Is it working?, CEO Brief Supplement, p. 10, October 1996.

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6.1 Further literature

Pitkethly R., The valuation of patents (A review of patent valuation methods with consideration of option-based methods and the potential for further research), Judge Institute of Management Studies, University of Cambridge, Research papers in management studies 21/97

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7 Appendix

7.1 Estimation of utility issues

Effect on value creationFunction Issue Explanation of issue - 0 +

Strategic Usefulness to the company

Does the technology fit with current or future business strategy? Vertical or horizontal integration?

Strategic/Marketing

Usefulness to others

Is the intellectual property useful to other companies (indicates value)? How many competitors use the technology? Are the competitors willing to pay to get the patent or spend money to design around it?

Technology/Strategic

Capital required for implementation

How much will it cost to implement this new technology? New technological processes, increased marketing activity, education?

Technology/Marketing

Useful life of the technology

Depends on industry and the customer interest.

Technology Pioneering processing technology

Does the patent represent a pioneering technology with respect to manufacturing? Is it an incremental improvement?

Technology Cost saving Does the innovation reduce cost?Technology/Marketing

Time required for implementation of technology

Generally, it takes 3 years to develop new technology or design around existing patents. The risk factor increases with time.

Marketing/Strategic

Expected revenue

Steady stream, cyclical or seasonal?

Technology Further development of technology

Is research continued and are any future developments needed?

Strategic Business expectations

High, medium, low

Technology Spin-off effects Significant, acceptable, negligibleTechnology Stage of the

technologyGrowth, mature, decline

Technology Internal competence

Do we have the technical competence in the organization to implement this?

Legal/ strategic

Licensing opportunities

Possibility and willingness to license the patent to others

Legal/Technology

Further filing Is it necessary to apply for more patents in order to protect further developed technology related to the subject patent?

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Legal/Strategic

Maintaining and supporting costs for the IPR

Maintenance of patent (administrative), competitive monitoring

Legal Insurance value Could the patent be used as collateral for loans?Does the implemented patented process yield extra insurance costs?

Appraiser Other The appraiser needs to determine if there any other attributes that are specific for the evaluated technology.

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7.2 Estimation of competitive advantage issues

Effect on value creationFunction Issue Explanation of issue - 0 +

Marketing Anticipated competitive response

Will the competitors reduce the price, add service or fight for market positioning? Will competitors try to invalidate the patent?

Marketing/Strategic

Differentiation Will the customer pay more for the product? Will the technology increase market share?

Marketing Alternative technology

Are there any substitutes in the market? Different products or processes?

Legal Standard blocking

Does the patent block any relevant standards?

Strategic/Marketing

Commercial lifetime

Duration of customer interest

Strategic Strategic positioning

Does the technology give leadership position for the company? Will the company’s competitive position deteriorate if the technology is not protected?

Technology Pioneering technology

Does the patent represent a pioneering technology regarding a product/service?

Marketing Competitor impact

Which customers are influenced and what market share do they represent?

Marketing Customer impact Which customers are influenced and what market share do they represent?

Legal Countries Number of countries the patent application is filed in. Possibility to file in more countries within the priority year? Kind of country – is IP-law respected?

Legal Legal status Granted patent or just an application? Has the opposition period expired?

Legal Scope and quality of the patent claims

The broader the claims are and the more novel an innovation is, the higher the probability to extract value

Legal/Technology

Detection of infringement

Can infringement be detected by analysis of the product? Is the technology unique enough that the patent covers the only process that could be used?

Legal Remaining time to expiration

Usually, if a patent has less than 2 years to expiration, the business is negatively impacted.

Strategic Environmental effects

Can goodwill/badwill be generated?

Technology Complexity of technology

How high is the entry barrier due to the complexity of the technology?

Marketing Geographic area Is the interest in leveraging the technology regional or global? Market size/type?

Technology/Strategic

Credential technology

Will the technology mark you as the industry leader?

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Technology Spin-off effects Significant, acceptable, negligibleLegal/Marketing

Impact of IPR on other products within the company or on customers

Will the technology render other IPR:s, products or processes obsolete?

Technology/Marketing

Design around possibilities?

Is it easy and are competitors willing to design around?

Legal/ Technology

Teaching value of patent

Does the patent increase the know-how of the company?

Legal/Strategic

Right to use the technology

Are the patents totally free of use for the business? Is the technology tied to an exclusive agreement?

Appraiser Other The appraiser needs to determine if there any other attributes that are specific for the evaluated technology.

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Documents

Bachelor’s thesis in Business Administration · Web viewA major study by Arthur Andersen (1992) found that patents where separable from the underlying business and from a number