Patent Values in the Evolving I.P. Market PLI Hot Topic Telebriefing May 2, 2007 Fernando Torres, MSc Senior Economist [email_address]

Issues 1. Role of Patent Valuation 2. Identifying & Accounting for Value 3. Licensing Rates, pricing M&A’s 4. Values in Litigation

Patent Value Statistics Patent value distributions are skewed; i.e. most of the value is represented by a minority of patents:

Patent value distributions are skewed; i.e. most of the value is represented by a minority of patents:

Patent Value Statistics

Role of Patent Valuation Although patents values cannot be observed directly (unlike stocks & bonds) and requires specialized analysis, the contemporary role of patent valuation cuts across most management functions: Strategic Key to deal valuation Throughout Strategic Planning and M&A process: Strategy Target Id Valuation Initial negotiation Due diligence Closing Financial Reporting

Although patents values cannot be observed directly (unlike stocks & bonds) and requires specialized analysis, the contemporary role of patent valuation cuts across most management functions:

Strategic

Key to deal valuation

Throughout Strategic Planning and M&A process:

Strategy

Target Id

Valuation

Initial negotiation

Due diligence

Closing

Financial Reporting

Issues identifying patent values Internally generated intangibles are expensed or (for R&D) recorded at historical cost Balance sheet undervalues patents Acquired intangibles allocated at valuation date Balance sheet only reflects acquired patents Thus, not all patent values reflected in financials, and not all patents disclosed may be core patents Still true in FASB No. 157

Internally generated intangibles are expensed or (for R&D) recorded at historical cost

Balance sheet undervalues patents

Acquired intangibles allocated at valuation date

Balance sheet only reflects acquired patents

Thus, not all patent values reflected in financials, and not all patents disclosed may be core patents

Still true in FASB No. 157

Identify patent bundles for value Analyze quality of patent portfolio Relevance to current/future business Relative strength analysis Stratify IP / IA Core v. Periphery (not only technologically) Peripheral portfolios may be monetized Vertical and horizontal Out-licensing / Spin-off Potential infringement assessment

Analyze quality of patent portfolio

Relevance to current/future business

Relative strength analysis

Stratify IP / IA

Core v. Periphery (not only technologically)

Peripheral portfolios may be monetized

Vertical and horizontal

Out-licensing / Spin-off

Potential infringement assessment

Qualitative Analysis of IA/IP Forward/backward patent references Breadth of key claims Challenge/infringement record Associated trade secrets, knowledge bases, trademarks

Forward/backward patent references

Breadth of key claims

Challenge/infringement record

Associated trade secrets, knowledge bases, trademarks

Standards of Value Fair Market Value The price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. (IRS.-Hypothetical) Fair Value The amount at which an asset could be bought or sold in a current transaction between willing parties, that is, other than in a forced or liquidation sale. (FASB.-Specific synergies)

Fair Market Value

The price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. (IRS.-Hypothetical)

Fair Value

The amount at which an asset could be bought or sold in a current transaction between willing parties, that is, other than in a forced or liquidation sale. (FASB.-Specific synergies)

Establish patent values Cost Investment value Reserve value Blocking value Monopoly value Value to licensor Value to (hypothetical) licensee Valuation of un-commercialized patents

Cost

Investment value

Reserve value

Blocking value

Monopoly value

Value to licensor

Value to (hypothetical) licensee

Valuation of un-commercialized patents

Real Options Approach Adapted to patent valuation from the field of financial analysis Draws on a parallel between patents and stock options; the right , not obligation, during some specified time , to purchase an underlying asset whose price (value) is subject to some form of random variation (uncertainty) A patent gives its owner the right to exclude others from using the underlying invention, and further investment is required to exploit its commercial potential.

Adapted to patent valuation from the field of financial analysis

Draws on a parallel between patents and stock options; the right , not obligation, during some specified time , to purchase an underlying asset whose price (value) is subject to some form of random variation (uncertainty)

A patent gives its owner the right to exclude others from using the underlying invention, and further investment is required to exploit its commercial potential.

Real Options Valuation Both instruments have a direct and precise pricing relationship with an underlying asset: a company in the case of stock options, and an innovation in the case of a patent Either right can be transferred (license). The transfer price is less than the full value of the underlying asset. The licensee, in the case of patents, will only enter the transaction with the expectation of reaping the difference between the full value of the patent and the license price (paid-up or ongoing royalty) A significant difference, however, is that (until recently—Ocean Tomo Auction) there are no organized markets for patents and most intellectual property assets.

Both instruments have a direct and precise pricing relationship with an underlying asset: a company in the case of stock options, and an innovation in the case of a patent

Either right can be transferred (license). The transfer price is less than the full value of the underlying asset. The licensee, in the case of patents, will only enter the transaction with the expectation of reaping the difference between the full value of the patent and the license price (paid-up or ongoing royalty)

A significant difference, however, is that (until recently—Ocean Tomo Auction) there are no organized markets for patents and most intellectual property assets.

Real Option Valuation Key concept (Black-Scholes): the higher the volatility of returns is, the higher the value of the patent and the licensing rates Net Payoff from introducing product NPV Cash Flows Cost of Introduction Patent Value

Key concept (Black-Scholes): the higher the volatility of returns is, the higher the value of the patent and the licensing rates

Illustration: Valuing a Patent A bio-technology firm with a patent on a drug called Xenova, which has FDA approval to treat multiple sclerosis. Estimates for use in the option pricing model: Potential market and expected price yields a PV of cash flows of $ 3.4 billion (S) The initial cost of developing the drug for commercial use is estimated to be $2.9 billion, if the drug is introduced today (K) The patent expires in 17 years, and the current long-term treasury bond rate is 6.0% and cost of delay is 1/17 (or 5.9%) as all excess profit is assumed to vanish upon expiration. Average variance in firm value for publicly traded bio-technology firms is 0.225

A bio-technology firm with a patent on a drug called Xenova, which has FDA approval to treat multiple sclerosis.

Estimates for use in the option pricing model:

Potential market and expected price yields a PV of cash flows of $ 3.4 billion (S)

The initial cost of developing the drug for commercial use is estimated to be $2.9 billion, if the drug is introduced today (K)

The patent expires in 17 years, and the current long-term treasury bond rate is 6.0% and cost of delay is 1/17 (or 5.9%) as all excess profit is assumed to vanish upon expiration.

Average variance in firm value for publicly traded bio-technology firms is 0.225

Illustration: Options Formula Value of the patent: Se -dt N(d1) - Ke -rt N(d2) 3.4exp(-0.059)(17)(0.8720) – 2.9exp(-0.06)(17)(0.2076) = $0.9 billion The NPV of this project is only ½ billion: NPV = $3.4 - $ 2.9 million = $ 0.5 billion The firm can benefit from the flexibility of delaying introduction until value of implemented patent equals NPV of the project

Value of the patent: Se -dt N(d1) - Ke -rt N(d2)

3.4exp(-0.059)(17)(0.8720) – 2.9exp(-0.06)(17)(0.2076) = $0.9 billion

The NPV of this project is only ½ billion:

NPV = $3.4 - $ 2.9 million = $ 0.5 billion

The firm can benefit from the flexibility of delaying introduction until value of implemented patent equals NPV of the project

Case Study A “nutraceutical” company developed and licensed-in a number of patents involved in the formulation of their flagship product. Goals: To form an IP holding company for the patents, licenses, pending applications, and trademarks, which will receive “arms-length” royalties in a lower-tax jurisdiction Problem: what is the right rate to charge for the technology bundle?

A “nutraceutical” company developed and licensed-in a number of patents involved in the formulation of their flagship product.

Goals: To form an IP holding company for the patents, licenses, pending applications, and trademarks, which will receive “arms-length” royalties in a lower-tax jurisdiction

Problem: what is the right rate to charge for the technology bundle?

Real Options Approach to Royalty Rates The B-S model can be adapted to yield royalty rates (based on Denton & Heald) Given the risk and expiration of the patent these rates will balance the risk-adjusted profit expectation of the licensor and the licensee Where: RR is the Royalty Rate PR is the Profit Ratio N(∙) is the Normal Distribution σ is the standard deviation T is the life span of the patent r is the Risk-free rate

The B-S model can be adapted to yield royalty rates (based on Denton & Heald)

Given the risk and expiration of the patent these rates will balance the risk-adjusted profit expectation of the licensor and the licensee

Case Study Conclusion In this case, the patents involved had relatively short lives left, newer patents were about to become available, and the industry has experienced relatively high volatility The rates the option-pricing model allowed us to determine a royalty rate of 1.8% with a likely range of plus or minus 0.4%

In this case, the patents involved had relatively short lives left, newer patents were about to become available, and the industry has experienced relatively high volatility

The rates the option-pricing model allowed us to determine a royalty rate of 1.8% with a likely range of plus or minus 0.4%