Business Valuation - In Theory and Practice

Patent Valuation

Patent valuation is one of the most challenging asset valuations to conduct. Patents form part of a group of intellectual property assets that are difficult to value and account for using traditional accounting methods.

So does how patent valuation work? Simply, put there are various widely recognized methods that derive off the standard valuation approaches. These can be categorized basically into three different types: the market based approach, the cost based approach, and income approaches.

Market Based Approach

A market based approach is a simple method that has been favoured by the accounting profession. It aims to derive a multiple off a recent transaction which would include both tangible and intangible assets such as a patent. This multiple could be off sales, free cash flow, or EBITDA, and then it is applied to each asset including the intellectual property. The challenge with this approach is that tangibles and intangibles carry different levels of risk. Therefore, a dual capitalization approach may be necessary whereby different multiples or discount rates are used for the tangible assets and for the patents being valued. The free cash flow belonging to the patent is then capitalized using the higher discount rate to account for the higher level of risk. You can simplify the process and value the patent by comparing it to a similar patent used in a similar circumstance. This is similar to the market approach used for real estate where comparable sales are identified and used. However, finding true comparables can be challenging when conducting patent valuations.

Cost Method

The cost method focuses on determining what it would cost to replace the patent by either buying it or reproducing it. This is not the same as the patent’s historical cost as the future cost to recreate may very well be different than historical cost. This is a simple approach; however it is fraught with risk simply because what it costs to reproduce something may not be at all its value. For example, significant cost is spent in research and development to create drugs with patents. Yet, these drugs don’t always prove out and the value is written off to nil despite the cost to produce them.

Income Approaches

There are three primary income approaches used generally that may be more conducive to assess proper patent valuation:

  1. The incremental cash flow method - in this case, the life of the patent, the free cash flow it can generate, and the discount rate are all calculated. The life of the patent is important to estimate as generally patents expire. In this case, you are trying to do is isolate the incremental cash flow that the patent in question delivers over the business cash flow without the patent included. Therefore, you end up computing two discounted cash flows - one with the patent in and one with the patent out - to essentially isolate the incremental cash flow which is then present valued.
  2. The relief from royalty method - this method computes what it would cost a company to license the patent, and then uses the discounted cash flow method to compute the present value of this licensing relief. The PV of the royalty represents the value of the patent because this is a cost that is being saved by owning the patent. This is a challenging method to apply simply because royalty rates are seldom made public so it is important to do some due diligence into these rates and what has gone into it.
  3. The cost savings approach - this method computes the future savings that the patent will generate for the businesses (for example, a unique technology that is patented) over its life and then computes the present value by discounting these savings. It differs from the royalty method in that here what is being present valued is the estimated cost savings as a proxy for free cash flow rather than the amount it would cost the business to license the IP.

Ultimately the choice of patent valuation boils down to how the owner will use it to generate value. Sometimes, the patent generates higher revenue or reduced costs which may drive a different valuation method. If looking at mobility assets, the recent purchase of Nokia’s patents by Google may provide a great market benchmark for similar assets that may be acquired by another technology giant attempting to bolster the patent pipeline. In this case, a market approach may be the primary intellectual property valuation method rather than an income approach. However, in other more specific cases some form of discounted cash flow approach is typically more applicable to patent valuation.

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