Good afternoon…For this section of the briefing there are four major topic areas I would like to cover: No. 1 is the question of what patent values are and what role does a “patent valuation” appraisal play in your companies and/or your practices No. 2 then drills down into the key step of actually identifying the patents from an analysis of a company’s public financial information Third, I’ll touch on another critical component of a valuation analysis, and that is the determination of royalty rates, with particular attention to the due diligence surrounding business transactions involving patents, and finally… In fourth place I’ll talk a little bit about the valuation of patents in a litigation environment
At first glance, it seems clear that everyone involved in business and patent law would have an intuitive understanding of what is meant by “patent value”. However, some may emphasize value from a technical perspective, others may be thinking of the validity and legal value of a patent, while financial folks will clearly be thinking about the economic value of a patent. Technical value and legal value actually have very specific goals and, although they may be necessary components of an evaluation of a patent portfolio, are substantially subjective and not enough to be the basis of financial decision making. The economic value of a patent, which is the sense of value we want to talk about today, is meant to be a somewhat objective value, the current value of the economic profit that a patent can generate during its statutory life span if put into practice commercially. Obviously, if patent values where that simple, you wouldn’t have paid good money to listen today…right? Let’s leave the nitty-gritty of how a patent’s economic value is calculated for later, and get a sense first of how much patents are typically worth. [Ray has already talked about the values reached in the recent auctions…but] in most, if not all, studies of patent values around the world, the most striking and common finding seems to be the fact that valuable patents are the minority, and that most are not worth very much. For instance, around the turn of the century, the 21 st century that is, a survey of patent value studies found that, in the USA and Germany (specifically) the top 10% of patents represented over 80% of the value. What’s more, For US universities in particular, the top 10% of institutions represented over 90% of patent values. If we picture a bell-curve distribution, like the one teachers use to bump-up grades, patent values are really not distributed in a nice normal symmetric way, rather, their distribution is skewed to one side, so that most of the value is concentrated in a few very valuable patents, and tapers off toward most patents having lesser values.
A more recent study by the European Union in 2005 found that for Germany, Spain, France, Italy, the Netherlands, and the United Kingdom, the same concentration applies. In the UK for example, more than 50% (53%) of patents are worth less than 1 million Euros (just under $1.4 million USD), another 25% are worth between 1 and 3 million euro (1.4 – 4.2), and only 10% are worth more than 100 million Euros (136 milion dollars). This is all the more remarkable if you consider how much pharmaceutical R&D costs, billions, how many drugs don’t pan-out, and how important pharmaceutical patents are generally considered to be.
Now, patents are generally recognized as a business asset, and many characteristics of a patent are paralleled by other relatively intangible assets (like financial assets in particular promises-claims) , a big problem is that patent values cannot be observed directly, we can’t look them up on the wall street journal like stocks and bonds. It requires a specialized study. But, even if it can be easily observed, the value of a company's patent portfolio plays an important role is many decision making functions: Strategy, where to invest in the future, what to acquire, what to spin off. Throughout the planning and m&a process, an idea of the value of what the company owns, what it can acquire, what it can sell in terms of businesses. Even outside of biotech, where patents are sometimes the only product of a company, how can one advise a company on how much to pay for an acquisition…not only do we have to do the due diligence to check on what the target actually owns, and how valid it may be,…in the end the deal is closed based on an amount of money. And after a transaction, there’s the financial reporting requirements, and with FASB 141, 142, 144 you don’t want to overestimate the value of patents that have been acquired based on what the seller though about them, and then deal with disclosing impairment charges. SO…patent values play a central role in linking patenting activity into business strategy and transactions.
Now, on to the second topic area…identifying patents for valuation… The first obstacle to determine the value of patents is the reality of GAAP: internally generated intangibles, like patents, are recorded as expenses (although there are special rules for R&D in process) and are not recorded as assets on the balance sheet. Even if we were to get all the expense related to a company’s patents, conventional accounting practice would only be recording their historical cost. A key economic principle is that historical cost is not economic value. You need to account for inflation, market changes, technical obsolescence, new applications, waste (excessive cost) to reflect the current value of the potential profit obtainable from the patent but, there’s more…Even if the patent is not practiced, it may well have a “blocking value” by keeping the competition from improving their products or methods.... The situation is, of course a little more complicated by the fact that, since at least 2001, acquired IP is now recorded at their allocated acquisition value, so company’s that grow by M&As have more itemized intangible value in their books, than company’s that develop their own technology. So…no all of the value of patents is reflected or reported in company financials, and even when they are reported, they may still not be the core technologies of a company, nor implemented. (this is still going to be true once FASB 157 comes into effect at the end of this year). One of the most striking things about this is that, according to some studies the overwhelming majority of the S&P500’s market value has to be attributed to intangibles (trademarks & patents mainly), in other words the book-to-market multiples are historically very high, not because stocks are overvalued, but because intangibles are not recorded in the books!
What to do then, to identify patent values. One step is to take time to analyze patent quality from an economic or financial perspective, to check which patents are actually relevant to the company’s current business, to the future strategy, and which support the company’s competitive position better. We typically have to segregate core and peripheral patents, to concentrate the valuation only on the core (the concentrated distribution is also present intra-company to some extent), and strategically, doing this also helps identify some patents that are non-core and can be monetized in some way (although this is a very difficult task). There is, of course an economic and financial aspect to the potential infringement of a patent portfolio, as long as the company can afford to enforce its rights of course… __________________________________ Anecdotes: C&A had car model by car model patents, very specific,…with limited use in a way because no one else would be manufacturing the same model/year and, contractually, if reassigned, the IP would travel with the contract to the new manufacturer. So only broader (eg, technique manufacturing processes) would have real economic value, or when coupled with trademarks (invisitec, acro-edge) etc. Others, motorola, malden mills metro one
AS far as quality indicators, which have a role in defining patent value, its important to review references back/forth and their assignements as they are good indicators of the market place where the invention or method can sell and, therefore, where it can be valued.
Now before getting bogged down in details, a valuation has to have clearly defined the concept of value that is going to be used, what is usually called the “std of value” There are many variations of standards but two stand out as central ones, what the IRS considers Fair market value, and what the FASB considers Fair Value. = definitions= The first one is obviously a “hypothetical” value, and it emphasizes full information on both sides…this can be very important in M&As and it’s the basis for tax purposes of course…The FASB definition implies a specific transaction, and will consider the synergies of the acquired and existing patent portfolios, and this is the basis for financial reporting. In a specific transaction however, buyer and seller may operate from a different point of view and knowledge about the patent, and value it very differently…
So…depending on the particular purpose of the analysis, the stage of the management process where it is used, and the destination of the result (CEO, IRS or SEC), the actual amount of value may reflect different considerations, building on cost, value if acquired, the value of reserving a technology for exclusive use, the value of blocking competitors, the value of first-to-market advantages, the value if licensed (actual license or opportunity cost). In any case, it is important that patents have economic value even if not in commercial use. All of the preceding considerations boil down to possibility of applying conventional asset-valuation methods cost / market / income which use a discounted cash flow approach to value. But, it’s important to recognize that there are many situations when those conventional methods may not be sufficient, particularly when: It is not yet commercialized When most of the investment expense has not happened, and is still being decided When the litigation value is important, or strategic blocking When the cost of maintaining the patents is a consideration (You don’t want to let a key patent lapse for “cost cutting”’s sake and then have a need for it…
The latest approach to those situations is to adapt the valuation of stock options to value patents. This approach seems to be more advanced in Europe than in the US, and there are opposing points of view about some key questions, but the general direction of valuation practice is that its use is more likely to be insightful than the traditional methods. This approach treats a patent not strictly as a financial asset, but as an intellectual property right.
IN this approach, a key concept about patent values is this:… Thus patent values can be expected to be higher in new technology industry segments, such as biotech, nanotech, and much less in stodgy traditional industries, which seems to underlie the valuation multiples of publicly traded companies in these industries, higher multiples for “growth” sticks, and lower ones for “value” companies. Another conclusion in these new methodologies is that patents seldom are worthless, until they approach the end of their lives, there is still a probability that the NPV of the implementation/litigation will be higher than the NPV of the investment that is still needed… In the downloadable materials I included some sample applications of this analysis, but here we just need to turn to two last areas to remark: Setting royalty rates Values in Litigation RRates, what is new in this area is the possibility of applying the real options approach to determine the proper rates fro a transaction, or even for transfer pricing. Briefly, we can use the same approach to value a license balancing the probability that, if the rate is too high, the licensee and the license will fail, and if its too low the licensor loses a lot of value. In litigation, the latest methods cannot be used, at least not until there is sufficient recognition of them. Valuation of patent infringement damages still maintains the use of the conventional discounted cash flow analysis, but sometimes the calculations of a reasonable royalty are greatly exaggerated, as in the recent Lucent Technologies et al. v. Gateway Inc. et al., (MP3 audio patent) decision of the district court for California’s southern district, which ordered Microsoft to pay $1.5 billion in damages based on a reasonable (sic) royalty of 0.5% of the value of the computers which had Windows installed! This is much more than those partial patents would reasonably be worth in the market ($1 to $3 milion) So a good valuation in litigation is worth, literally, billions !!! Thanks
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 <ul><li>Patent value distributions are skewed; i.e. most of the value is represented by a minority of patents: </li></ul>
Role of Patent Valuation <ul><li>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: </li></ul><ul><ul><ul><li>Strategic </li></ul></ul></ul><ul><ul><ul><li>Key to deal valuation </li></ul></ul></ul><ul><ul><ul><li>Throughout Strategic Planning and M&A process: </li></ul></ul></ul><ul><ul><ul><ul><li>Strategy </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Target Id </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Valuation </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Initial negotiation </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Due diligence </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Closing </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Financial Reporting </li></ul></ul></ul></ul>
Issues identifying patent values <ul><li>Internally generated intangibles are expensed or (for R&D) recorded at historical cost </li></ul><ul><ul><ul><li>Balance sheet undervalues patents </li></ul></ul></ul><ul><li>Acquired intangibles allocated at valuation date </li></ul><ul><ul><ul><li>Balance sheet only reflects acquired patents </li></ul></ul></ul><ul><li>Thus, not all patent values reflected in financials, and not all patents disclosed may be core patents </li></ul><ul><ul><ul><li>Still true in FASB No. 157 </li></ul></ul></ul>
Identify patent bundles for value <ul><li>Analyze quality of patent portfolio </li></ul><ul><ul><li>Relevance to current/future business </li></ul></ul><ul><ul><li>Relative strength analysis </li></ul></ul><ul><li>Stratify IP / IA </li></ul><ul><ul><li>Core v. Periphery (not only technologically) </li></ul></ul><ul><li>Peripheral portfolios may be monetized </li></ul><ul><ul><li>Vertical and horizontal </li></ul></ul><ul><ul><li>Out-licensing / Spin-off </li></ul></ul><ul><li>Potential infringement assessment </li></ul>
Qualitative Analysis of IA/IP <ul><li>Forward/backward patent references </li></ul><ul><li>Breadth of key claims </li></ul><ul><li>Challenge/infringement record </li></ul><ul><li>Associated trade secrets, knowledge bases, trademarks </li></ul>
Standards of Value <ul><li>Fair Market Value </li></ul><ul><ul><li>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) </li></ul></ul><ul><li>Fair Value </li></ul><ul><ul><li>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) </li></ul></ul>
Establish patent values <ul><li>Cost </li></ul><ul><li>Investment value </li></ul><ul><li>Reserve value </li></ul><ul><li>Blocking value </li></ul><ul><li>Monopoly value </li></ul><ul><li>Value to licensor </li></ul><ul><li>Value to (hypothetical) licensee </li></ul><ul><li>Valuation of un-commercialized patents </li></ul>
Real Options Approach <ul><li>Adapted to patent valuation from the field of financial analysis </li></ul><ul><li>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) </li></ul><ul><li>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. </li></ul>
Real Options Valuation <ul><li>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 </li></ul><ul><li>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) </li></ul><ul><li>A significant difference, however, is that (until recently — Ocean Tomo Auction) there are no organized markets for patents and most intellectual property assets. </li></ul>
Real Option Valuation <ul><li>Key concept (Black-Scholes): the higher the volatility of returns is, the higher the value of the patent and the licensing rates </li></ul>Net Payoff from introducing product NPV Cash Flows Cost of Introduction Patent Value
Illustration: Valuing a Patent <ul><li>A bio-technology firm with a patent on a drug called Xenova, which has FDA approval to treat multiple sclerosis. </li></ul><ul><li>Estimates for use in the option pricing model: </li></ul><ul><ul><li>Potential market and expected price yields a PV of cash flows of $ 3.4 billion (S) </li></ul></ul><ul><ul><li>The initial cost of developing the drug for commercial use is estimated to be $2.9 billion, if the drug is introduced today (K) </li></ul></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>Average variance in firm value for publicly traded bio-technology firms is 0.225 </li></ul></ul>
Illustration: Options Formula <ul><li>Value of the patent: Se -dt N(d1) - Ke -rt N(d2) </li></ul><ul><ul><li>3.4exp(-0.059)(17)(0.8720) – 2.9exp(-0.06)(17)(0.2076) = $0.9 billion </li></ul></ul><ul><li>The NPV of this project is only ½ billion: </li></ul><ul><ul><li>NPV = $3.4 - $ 2.9 million = $ 0.5 billion </li></ul></ul><ul><li>The firm can benefit from the flexibility of delaying introduction until value of implemented patent equals NPV of the project </li></ul>
Case Study <ul><li>A “nutraceutical” company developed and licensed-in a number of patents involved in the formulation of their flagship product. </li></ul><ul><li>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 </li></ul><ul><li>Problem: what is the right rate to charge for the technology bundle? </li></ul>
Real Options Approach to Royalty Rates <ul><li>The B-S model can be adapted to yield royalty rates (based on Denton & Heald) </li></ul><ul><li>Given the risk and expiration of the patent these rates will balance the risk-adjusted profit expectation of the licensor and the licensee </li></ul>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 <ul><li>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 </li></ul><ul><li>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% </li></ul>