The Challenge of Valuing Intellectual Property:
the Process is More Important than the Sticker Price
By, David Gauthier, Ph.D., MBA
Vice-President, Central Region
Foragen Technologies Management Inc.
Introduction
One of the most important things I learned in business school was how to cope with making decisions based on ambiguous and incomplete data. This lesson was driven home during a marathon case analysis exercise for a finance class. Armed with our arsenal of equations, theorems, spreadsheets and calculators, our workgroup was determined to find the “correct” solution to the case. The problem was that the data in the case did not lead strongly toward any particular answer. Despite numerous mathematically correct calculations, we still could not decide which way to go. Ultimately, we chose a solution, used our calculations to back it up, and submitted our paper. We received a high grade-as did some other groups in the class-even though they made completely different recommendations from ours. Of course, the whole point of the case was that there was no correct answer. Our series of assumptions were as logical as those made by the other groups, but they took us in a different direction. It wasn’t the specific answer that achieved a high grade, it was the thought process behind it that mattered.
The same is true for intellectual property (IP) valuation exercises. No matter how diligent each party is, the value a vendor attributes to its IP will likely be different than the value attributed to it by the purchaser. These differences should not be surprising, since the ultimate value of IP is largely dependent on future events. Some future events are more controllable than others, but uncertainty regarding how the future will unfold leads to an uncertain estimate of the IP’s present value.
IP For Sale
In most cases, the vendor’s view of the future is rosier than the purchaser’s. Consequently, the vendor’s asking price for the IP today is usually somewhat higher than the purchaser’s estimate of its worth. To a great extent, the degree to which their respective price estimates differs reflects how similarly or differently they view the future. Sometimes, these views are so dramatically different that a deal is impossible, and no further discussions are necessary. However, if both parties have done a reasonable job during the process of evaluating the technology, then the asking and bidding prices are usually within a reasonable range, and negotiation of the final price can begin.
The goal of the valuation exercise for the vendor, then, is to ensure that the price asked for the IP is close enough to the purchaser’s estimated price so that negotiations can continue. The final price paid will depend on how well each party can defend its vision of the future. Therefore, it is not the sticker price per se that is important, it is the assumptions, data and arguments that each party compiles to defend or dispute it that will determine what the buyer will ultimately pay for the IP.
Some industry sectors have a long history, and have generated sufficient data to make the task of estimating value somewhat easier. In these cases, past performance of products and services generated from similar IP could be a good predictor of value, and the application of tools such as comparative analysis or benchmarking can be relatively effective and straightforward. However, many high technology industries are so new that data is almost impossible to find, and estimates about the value of IP essentially boil down to guesses. The key is to ensure that the long series of sequential guesses is logical, and that each can be rationalized. As difficult as the process might be, it is far superior to nonsensical methods, such as cost-based valuation, where the price has nothing to do with the actual value of the technology, but only with what has been spent on its development to date plus some profit.
A Valuation Model
For new or ambiguous industries, valuation is usually based on some variation of a discounted cash flow model-a set of financial statements that predict revenues, costs, income and cash flow for a company several years into the future, discounted by a certain rate to account for risk. At first glance, it might seem a difficult task to generate such a model for a new or non-existent market, but under closer inspection, it can be seen that its key elements are the same as those considered in any business plan. These are:
1. the market potential for the IP in the future (revenues);
2. the resources and costs needed to achieve that value (resources and costs); and
3. the risk associated with 1 and 2.
Consequently, the valuation model or projected financial statements should not be thought of as distinct from the business plan, but as a summary of the plan. They are merely devices that distill a plan into a statement of potential economic value. By building a sound plan, a sound valuation model should follow.
In the process of assessing the future revenue stream generated by IP, the marketing plan, sales plan, competitive analysis, and business strategy components of the business plan are being built. Basic questions must be asked, such as:
- What are the general dynamics of the market served?
- Why does this market need the IP in question?
- What features of this IP make it better than other competitors serving this industry?
- Who are the customers?
- What will they be sold?
- How much will they pay for it?
- What method of sales will be used (direct, distributors, retail)?
These questions can be straightforward when asked about tangible products or services, since the purchaser can examine or experience them, market surveys can be conducted, and consumer trials can be carried out. Unfortunately, much IP is merely conceptual, and requires extensive development before a product or service can be sold. Furthermore, it could serve a new, undeveloped market, or even create a new one, making a comprehensive market analysis nearly impossible.
In this case, the concept has to be made as tangible as possible by describing what the product or service will ultimately be. The task is not always easy, but during the process market issues that impact IP, and market needs must be considered. Various products/service alternatives should be evaluated and rank ordered to determine when they should be pursued. The key is to use a liberal dose of imagination, while maintaining a firm reality check on assumptions. The easier it is to visualize the product/service concept, the easier it will be to estimate how much revenue it could generate.
Having estimated the revenue potential of the IP, the resource requirements that will be necessary to achieve this revenue should be considered. Typically, these are the technology development plan, operations plan, and human resources plan sections of the business plan. Questions to be posed should include:
- What are the key steps and timelines needed to develop the IP into a marketable product/service?
- What skill sets are needed to achieve these steps?
- Who needs to be hired?
- What equipment, supplies, facilities are required?
- What administrative capabilities are needed?
- What is it going to cost to do all of this?
The more specific the description of the product/service concept and market projections, the easier it should be to generate answers to the resource-related questions.
About Risk
Armed with estimates of revenue and costs, assembling financial projections is a relatively straightforward exercise. Estimates of future cash flow can be generated. To turn the projections into a revenue model, the only thing left to do is to discount these cash flows by the appropriate amount to account for risk. Unfortunately, this step is probably the most ambiguous part of the entire valuation exercise.
To illustrate how risk leads to a discounted value, we just need to take a look at interest rates. Investments like bonds and GIC’s return a guaranteed amount of interest in the range of 5% per year. Riskier investments, such as a mutual fund might return 12%-15% per year over a long enough time frame, but these returns are not certain, and an investor could just as easily lose 10% to 15% over a given time period. The higher potential earnings are the reward for taking a greater risk. Investing in IP is an even riskier venture, meaning that the purchaser will anticipate an annual return rate of 35%, 50% or more.
To account for this risk, the value of the cash flow for a particular year in the financial projections is discounted by this rate for every year back to the present. For example, the cash flow projected for year 1 would be discounted by 50%, the cash flow year 2 would be discounted by 50% twice sequentially, the cash flow for year 3 would be discounted by 50% three times sequentially, and so on. The totals of all of these discounted cash flows are added to generate the approximate value of the IP today, which is called the net present value (NPV).
Given that cash flow projections are often for the next 3 to 10 years, small differences in the discount rate can generate substantial differences in NPV, making them one of the most contentious issues in any negotiation. A well-prepared vendor will have built risk mitigation strategies into the business plan (highly skilled, flexible management, multiple product opportunities, back-up plans, etc.), but should still be prepared to apply a fairly high discount rate to account for uncontrollable risks and the uncertainty of the future.
The Brave Vendor
Vendor acknowledgment of uncontrollable risks and discounting of the IP’s sticker price accordingly can actually increase its value to the purchaser. It demonstrates that the vendor has been brave enough to think through an uncertain future and is aware of the purchaser’s requirement for a higher return on investment. A purchaser’s opinion of the vendor is a vital variable in risk assessment, so the more prepared and accommodating the vendor is, the more the risk is reduced, and the higher the value of the IP becomes.
In summary, demonstrating that you have gone through a well-planned valuation process adds value in and of itself, even if it leads to an uncertain answer.
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