Patent Values in the Evolving IP Market

Patent Values in the Evolving I.P. Market PLI Hot Topic Telebriefing May 2, 2007 Fernando Torres, MSc Chief 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 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

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

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

Qualitative Analysis of IA/IP
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)

Establish patent values
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.

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.

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

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

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

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?

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

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%

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Patent Values in the Evolving IP Market

by Fernando Torres, MSc on Jul 12, 2010

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Patent Values in the Evolving IP Market — Presentation Transcript