L38 Valuation Methods

The thing that is so suprising about IP valuation methods is their relative lack of sophistication relative to valuation methods used in financial markets. This may be due to a lack of research in the field and a mutual acceptance of existing methods by those using them but it may also reflect the unique nature of IP and the inherent difficulty of valuing any IP, especially early on in its life.

The mechanics of payments for licences are dealt with later (L52). Here the issue discussed is how the underlying IP might be valued. It is important to note that one must be aware not only of what the theoretically correct valuation of the IP is, but also what valuation the other party might put on it. Both these will be important in negotiating an agreed price.

 

  • The patent or IPR value is often confused with the total business project value.
    In most licensing cases one is concerned with the total value. For a patented invention if :

    A = The value of fully commercializing the underlying Invention in the presence of a patent
    B= The value of fully commercializing the underlying Invention in the absence of a patent

    Then the value of the Patent per se is A less B for all embodiments. This represents the value of the potential extra profits obtainable from fully exploiting the invention in the patent’s presence compared with those obtainable without patent protection.

    In most cases involving licensing we are concerned with A

  • Valuation Methods have varying degrees of sophistication
    in increasing order of sophistication they include :
    • Cost based methods accounting for the cost of obtaining IP
      Cost based methods based on the cost to obtain IP are theoretically flawed. Valuations should be based on forward looking measures.The past is irrelevant.
    • Market based methods accounting for Market conditions
      Market based methods where values are based on industry average royalty rates (Going Rate Methods). These may not be theoretically sound but may be of practical tactical use if others are using them.
    • Income based methods accounting for Projected cashflows
      • Discounted Cashflow (DCF) Methods allowing for:
        • the time value of money and the uncertainty of cashflows
          Income based methods using DCF analysis of cashflows are theoretically the best compromise between theory and practice. These work best where there are well established cashflows. For example, towards the end of a successful patent's life.
    • Option Pricing based methods accounting for the above and flexibility.
      Option values are a more important aspect of IP value early in the life of a project when great uncertainty still exists. Option pricing methods based on financial derivative pricing methods are sophisticated but rarely used to value IP at present. One exception is the valuation of early day licensing of pharmaceuticals which specifically include options1 to invest in further development.

    Other ways of discussing the calculation of royalty payments include :

    • Profit sharing method
      This calculates the extra profit due to use of the patented invention and divides this between the licensor and licensee.
    • Investment risk factor method
      A variant on the above where the split of the profit is weighted to reflect the risk and investment put into the project by the licensor and licensee.

  • Many factors largely connected with the precise terms of the agreement can be taken into account in deciding final royalty payments in a licence. Lists of these can be found in many books dealing with licensing. In general there is little attempt to show the precise relationship between these factors and any rational calculation of a royalty rate. In some cases this is because none exists and in others because it is too complex for anyone to discern and the factors are used merely to guide negotiators.

1 For a working paper on the valuation of patents including a discussion of such methods see: Pitkethly, R.H. "The Valuation of Patents : A review of patent valuation methods with consideration of option based methods and the potential for further research", WP 05/99, Oxford Electronic Journal of Intellectual Property Rights, <http://www.oiprc.ox.ac.uk/EJWP0599.html>