IP value and risk is contextual. Differing uses of IP may present differing levels of monetization risk as relevant to the determination of a discount rate.
As an owner, assignor, assignee, licensor, licensee, or infringer, IP monetization and related risks are viewed in different ways. Exhibit 4 summarizes typical ways IP is monetized. While this exhibit is intended to address the topic of monetization broadly, it applies most directly to patents, particularly as related to defensive uses that involve the right to exclude, blocking, and counterclaims. Notwithstanding these nuances, this general framework provides a helpful economic backdrop for discussion related to all types of IP.
As indicated in Exhibit 4, IP can be monetized directly or indirectly. Indirect monetization through direct use and blocking is generally pursued with the intent of capitalizing upon sources of proprietary competitive advantage enabled by the IP that lead to greater revenues and profits. In contrast, direct asset monetization is pursued in an attempt to obtain payments from IP users by selling, licensing or asserting the IP. Since direct asset monetization relies upon IP use and payment by others, monetization risks associated with royalty reporting, litigation and collection are introduced that don’t exist with direct use or blocking where no external payment is required.

1. Direct Use
Direct use occurs when owned IP is embodied in a company’s products or services with the hope of selling more units, selling at higher prices, and/or enjoying lower costs than would have occurred without the IP.
When valuing an established business, value is often assessed under the premise of a going concern and the assumption that business cash flows will continue in a manner consistent with past performance. Logically, cash flows and value ascribed to IP embodied in established products and services reflect common business risks. In this setting, IP risk is tightly coupled with overall business risk.
But IP may also be new and part of a planned offering being developed with the hope of penetrating a new or existing market. In this setting, whether the business using the IP is established or not, unknowns associated with development costs, commercialization challenges, regulatory approval, competition, market acceptance and other factors may present risks consistent with those encountered by venture capital firms that invest in early-stage ventures.
Contrasting the above examples, we see less IP monetization risks in the established business setting than in the setting of a new product or venture. Discount rates should reflect these differences. IP-related discount rates in the established business/product setting might reasonably be at or around the company’s cost of equity while an early-stage venture capital rate might be more applicable to the IP being deployed in the setting of a new product or new venture.
2. Blocking
Economic value through blocking is created by preventing competitive entry or causing a competitor to exit the market.
The benefits of blocking may apply to existing products and services that embody the blocking IP or other offerings that don’t. If existing offerings embody the IP, blocking can limit competition and, accordingly, may allow for higher prices and greater market share. In this setting, where both internal use and blocking occur simultaneously, the monopoly value of the IP is demonstrated. If the IP is not embodied in existing offerings, it may be used to prevent competitive entry considered threatening to existing offerings—such as profitable incumbent technology with dominant market share that could be rendered obsolete by new technology that embodies the blocking IP. In this setting, the blocking IP insulates legacy products from competition.
Under the premise that blocking value arises from the preservation of existing cash flows, the discount rate may be properly based on the cost of capital for the company overall or the legacy business segment specifically.
3. Licensing
A licensee faces the same types of risks that occur under internal use, thus leading to similar risk considerations. If a licensee is non-exclusive, it may face additional competitive risk from others in the market using the same IP. This risk may have been reflected in the royalty rate, but may also be reflected in estimated future cash flows and/or the discount rate.
With IP that has generated historic royalties and is expected to continue doing so, the riskiness of the activity that underlies these royalty payments—such as the sale of products that embody the licensed IP—is a primary risk driver for both licensee and licensor. However, additional risks associated with royalty reporting, disputes and collection can exist that may justify higher discount rates for the licensor.
To demonstrate this last point, consider a multinational licensing arrangement where licensees in different countries have various sub-licensees. More realization and collection risk may exist among certain licensees than others due to economic, cultural and political factors that differ across countries. Varying business risks and enforcement challenges may also exist. In this setting, it may be appropriate to use different discount rates in discounting expected cash flows from differing sources.17
4. Assertion
Under an assertion-driven business model, the ability to monetize IP is based on a variety of factors which may include the strength of the IP rights and the utility of the IP in its unauthorized use. To the extent that an assertion action could go to trial, IP strength and utility factors become relevant to the issue of damages and likelihood of recovery.
With asserted patents, we encounter three discrete legal factors that influence value: validity, enforceability, and infringement. Each may have their own relevant probability. In addition, appeal and recovery trends should also be a consideration.
While non-practicing entities may only recover economic damages through a reasonable royalty in patent cases, practicing entities may be able to recover damages through a reasonable royalty or lost profits.18 Since 2000, approximately 80 percent of patent cases with damage awards have included an award of reasonable royalties, while only 30-40 percent included an award of lost profits. Additionally, around 70 percent of district court decisions get appealed to the Federal Circuit.19
In assessing the assertion value of a patent or other IP, factors related to the time, expense, and probability of recovery should be considered in assessing value and the cost of capital associated with funding the assertion effort. Specialized litigation finance firms exist to fund litigation projects. Recovery fees charged by these firms—net of the market value for professional services provided under the arrangement—would provide direct market-based evidence for the cost of capital related to an assertion effort.20
5. Defensive Pools
Defensive pools are a relatively new form of patent monetization by which companies pay to gain access to patents which they can use as the basis of counterclaims in assertion actions brought against them. Companies such as RPX and Intellectual Ventures make their patent arsenals available to customers for this purpose.21 The success of this business model is based on the ability to acquire patents considered helpful in defending against assertion actions while pricing access in a manner that makes economic sense for customers and provides sufficient returns to the provider.
In acquiring new patents, the pool provider might reasonably use its existing WACC as the basis for discounting related cash flows. However, risk premiums may be appropriate due to expected legislative changes, forthcoming judicial opinions, uncertainty associated with a new technological area, or weaknesses associated with specific patents under consideration (see the Alice discussion below).
6. Buy or Sell
A buyer of IP may make a purchase with the intent of monetizing the IP using one or more of the approaches noted thus far. Such a purchase could range from a single piece of IP for a very specific purpose or a portfolio of IP underpinning an entire business. With the purchase of a single piece of IP, the selection of an appropriate discount rate would be influenced by the anticipated means of monetization. With the purchase of a large IP portfolio, the discount rate might be more appropriately considered within the broader context of the overall business relative to other assets acquired.
A seller may want to consider the value of the IP based on their current use and also estimate the value of the IP to a prospective buyer as a means of calculating a potential range of negotiation for the sale. This analysis could involve any or all of the monetization approaches and discount rate considerations noted thus far.
7. Infringe or Misappropriate
Finally, IP can be monetized through infringement or misappropriation. While some IP users may be unaware of their wrongful use, others use IP with some knowledge that their use may be considered wrongful. Once an IP user becomes aware of its potentially wrongful use, it is faced with the decision of whether or not to continue using the IP. If the decision is made to continue, then the future benefits of use may be considered relative to potential costs associated with legal fees and damages on a probability-adjusted basis.
Teva Pharmaceuticals is a company that makes rational business decisions to risk infringement. Teva has launched generic drugs “at risk” after filing a Paragraph IV certification under the Hatch-Waxman act indicating that they consider patents of a branded drug producer to be invalid, unenforceable, or not infringed. Based on this filing and having obtained necessary FDA approvals, Teva has launched products before the issue of infringement has been settled by the court.
Financial analysis in this setting may involve probability adjusted scenarios that consider the cost and likelihood of an infringement finding in court versus the benefits associated with continued royalty-free use. In this setting, the analyst should consider risk in the discount rate that is not already considered in probability adjustments.
Monetization Approaches Based on Unauthorized Use
In Exhibit 4, the monetization approaches associated with Infringement and Misappropriation (7), Assertion (4), and Defensive Pools (5) are specifically identified as a sub-group because they share common vulnerabilities and risks.
On June 19, 2014 the Supreme Court issued its unanimous decision in Alice Corp. v. CLS Bank International. In Alice, the Supreme Court considered the issue of patentable subject matter by specifically weighing in on software patents. In the wake of the Supreme Court’s decision to invalidate the patents at issue, Alice has been applied by district courts and the USPTO to invalidate many other software-related patents. The decision in Alice along with changes at the USPTO allowing new post-issuance validity challenges are but two examples of increased patent monetization risks that will impact probability adjustments and discount rates used in patent valuations.
The cumulative economic impact of various legislative, regulatory and judicial actions, many of which targeted non-practicing entities, was being felt by the end of 2014. Patent wars involving Apple, Samsung, Google and other big players were also cooling down during this period. As a result, some businesses based upon unauthorized patent use lost value. For instance, between early July 2014 and year-end, RPX lost 30 percent of its market value. This slide in value occurred shortly after the Alice decision.
Risks such as those created by Alice and other changes in the market can be reflected through decreases in forecasted revenue, increases in costs, reduced success probabilities or increased discount rates in financial modeling.