Why calculating cost is all in the mind
There are many factors in determining the correct value of intellectual property
GENERALLY, the reason for an intellectual property (IP) valuation gives some idea of the context in which the IP is to be valued and this is the most important determinant of value.
For example, in some industries an IP portfolio is likely to be worth more to a large manufacturer than to a small business entrepreneur due to the existence of complementary competencies such as a skilled sales force, effective marketing programme and established distribution channels.
Because these factors vary from one situation to the next, the same IP may have a different value when considered in the context of two or more different enterprises. So, the value of IP must be conducted with a view to the “hands” in which the IP is to be exploited, the prevailing market conditions and other circumstances which may have an effect on the ability of the IP to generate revenues or increase profits.
A formal valuation of IP will refer to a standard of fair market value. In theory, this is the price at which the IP asset exchanges between a willing buyer and a willing seller, both having reasonable knowledge of all relevant facts and neither being under compulsion to act. With this standard, it is assumed that a hypothetical transaction takes place. However, there may be a marked difference between the price at which the seller is prepared to sell the IP and the price at which a particular purchaser is prepared to buy it. There may also be a marked difference between what two different purchasers would be prepared to pay for it. So with no real information on the notional purchaser, can a realistic value be determined?
The effect of context on the determination of a purchase price isn’t all that surprising since the same principle applies to tangible assets — there may be a market difference between what a commercial office space developer and a boutique hotel chain may be prepared to pay for the same building — and these prices will be determined by the ability of that building to generate future revenue and profit for the respective purchasers.
In some circumstances, a company or tax authority may wish to establish the value of IP where no particular transaction is envisaged, that is a value of the IP in the context of the owner’s ongoing business. In these circumstances, the IP is typically valued in the hands of the existing owner, using a relief-from-royalty method. This method computes a value for the IP based on the present value of the amount that the owner would pay in royalties over the useful life span of the IP to licence in its use from a third party, if it did not own the IP. In this context, the IP is valued having regard to the factors (such as market share, forecast revenue, advertisement spend, competition, competencies, infrastructure and distribution channels) which are relevant to the owner itself.
So clearly a distinction must be drawn between the “value of an IP portfolio” and the answer to a specific question, such as: “What would Company X be prepared to pay to Company Y to purchase the IP portfolio?” These may be different amounts. It is critical to understand what is being valued.
Consider a situation where a proprietor of a trademark portfolio has granted a wide, fully paid-up perpetual licence to another party to use the trademarks in its business. The trademark proprietor, although it owns the trademarks, has divested itself of most of the rights associated with the trademark — it cannot even use the trademarks in the course of trade and retains ownership only of the “bare domini- um” of the marks.
In the immediate term, the trademark owner has no ability to derive any revenue from the mark, unless the terms of the licence agreement entitle it to sell the mark or the licence terminates at some later time (due to breach, for example) and the marks have not yet outlived their usefulness.
The licensee of the marks would probably not be prepared to pay very much to take assignment of them from the proprietor, since it already enjoys almost all of the benefits associated with ownership of the marks. Does that mean that the licence under the marks is not valuable? Not necessarily — the marks may be well known, distinctive and have established a high degree of trust among consumers, making it important for the licensee to have ongoing use rights under the marks.
In some cases, the ability of the IP to generate future revenue and increase profits is dependent on the occurrence of other factors.
Since we don’t have a crystal ball, an intellectual property valuation method that takes future contingent events into account, must be adopted. Several valuation techniques, such as binomial models and Monte Carlo simulations, are based on a decision tree analysis where conditional events required for the intellectual property to generate revenue or increase profits (and the contribution which the IP makes to these) is modelled explicitly.
Modelling the effect of future events on the value of IP requires a two-step approach: establishing the probability of a certain event occurring that will make the IP valuable and, second, computing the value of the IP if this event takes place.
If you lose sight of what you are valuing and why you are valuing it, you might be calculating the answer to a different question.