As regularly occurs in business, Company A is considering acquiring Company B. The strategic perspective is very compelling: the target's patent portfolio fills numerous holes and propels the R&D program in certain key areas several years ahead of Company A's current position. A manager in Company A has been tasked with deciding whether this particular acquisition makes sense from a financial perspective. Toward that end, the manager has hired outside consultants to perform a formal valuation analysis on Company B's patent portfolio.
The manager has been in this role before and, unfortunately, has learned through experience the truth of the old maxim: garbage in, garbage out. Fortunately, she now knows to look for the mistakes and omissions that are all-too-often found in IP valuation reports. Being an educated consumer, she can rectify any errors in the valuation analysis before significant decisions involving millions of dollars are acted upon.
There are many situations in which it is important to understand the value of intellectual property. Perhaps there is a lawsuit related to the alleged infringement of a trademark and the purported loss in brand value is a key theory of damages. Another need for IP valuation may arise when a firm acquires a company with an extensive patent portfolio, as in the example above. Its due diligence efforts before, and purchase price allocation needs after the acquisition will likely require a valuation to be performed. Other contexts in which a valuation of IP may be necessary include the reorganization of a distressed company, the use of the assets as collateral when securing financing or the establishment of transfer pricing compensation.
Whether the IP valuation question is being answered internally or using outside consultants, the scope of these valuations frequently requires more than just a "gut-feeling" or "ballpark" level of analysis. It requires an in-depth analysis of the IP using accepted valuation methodologies.
This article assumes that the reader has a basic familiarity with IP valuation techniques and the reports that are associated with them. A detailed discussion of the various valuation methodologies is beyond the scope of this article and is a topic worthy of its own article.1Â In summary, there are three primary valuation methodologies: the Market Approach, the Income Approach and the Cost Approach. The Market Approach to IP valuation determines the value of the asset by comparing it to similar assets that have sold under similar circumstances at a date reasonably close to the hypothetical or proposed subject asset transaction. Using the Market Approach to value IP is similar to how real estate is appraised. The price that a three bedroom home on a corner lot recently sold for will help the appraiser determine the value of a similarly situated home in the same area.
The Income Approach to IP valuation determines the value of the asset by calculating the net present value of the projected cash flow that is forecasted to be generated via its use. The Cost Approach determines the value of the asset by aggregating the expenditures that would be necessary to replicate the current situation of either the assets in question (Reproduction Method) or assets that provide similar utility (Replacement Method). Some techniques utilize a hybrid of approaches, such as the Relief from Royalty Approach, which uses a forecast of income like the Income Approach and comparable asset royalty rates from marketplace licensing transactions as with the Market Approach. The Relief from Royalty Approach determines the value of the asset by calculating the present value of the royalty payments avoided due to the ownership of the asset.
As with most exercises of this sort, an IP valuation requires numerous inputs, some of which are hard data, some estimates based on data, and others assumptions based on past experience and a reasonable assessment of the circumstances surrounding the valuation. The valuation also requires a statement of the context of the valuation, which encompasses the standard of value against which the analysis is being conducted, the premise of value associated with the context, and the date as to when the valuation conclusion is being ascribed. Any of these inputs, if inaccurate, could lead to inaccurate conclusions of value.
As the title of this article portends, there are at least ten categories of errors, omissions or mistakes that find their way into IP valuation/damages reports. In no particular order, they are summarized as follows: