There is a difference between the value provided by intellectual property and its fair market value. Fair market value is defined as the price intellectual property would sell for between a willing buyer and seller, with neither under obligation to transact. It requires considering a hypothetical transaction and determining what a buyer would rationally pay versus the actual value derived from the intellectual property. For example, while an invention may save a company $1 million, its fair market value would be lower since the buyer has no incentive to pay the full $1 million savings.

1. Value vs. Fair Market Value
By David Drews* – IPmetrics LLC
Before delving into the preferred methods for determining the value of intellectual property,
a topic which will take the next several months to address fully, I should first identify what it
is that one is measuring when one calculates value.
Everyone probably has some idea what the term “value” means when referring to IP. In
general, it is a measure of the benefits received from utilizing one’s intangible assets. While
value in this very general sense can be attributed to many different factors, such as
increased market share, higher prices, and synergistic increases in the effectiveness of
certain assets, in practice the perceived value will be the result of either additional revenue
or cost savings.
Is calculating value in a formal valuation exercise, then, simply a matter of identifying these
factors and tabulating the total? In most cases, the answer is no. There is a difference
between the value provided by the IP and what is known as its “fair market value.”
Anyone who has ever reviewed a formal valuation of IP may have noticed the phrase fair
market value. In most cases, this is the purported standard of value to which the analysis,
and all assumptions necessary to the analysis, has been held, and it differs in some very
important aspects from a strict calculation of the benefits derived from using the IP.
FAIR MARKET VALUE DEFINED
What does “fair market value” really mean? The definition recognized by the Internal
Revenue Service and most courts is essentially as follows: Fair market value is the price at
which an asset would change hands between a willing buyer and a willing seller, neither
being under compulsion to act and both possessing reasonable knowledge of all relevant
facts.
It follows then that to use a fair market value standard, one must conjure up a hypothetical
transaction, the price for which determines the asset’s value. What’s more, in order for this
standard to be applicable across a wide variety of assets and situations, it is imperative that
the price be determined on the basis of cash or cash equivalents. A transaction that speaks
of payment-in-kind or some kind of barter arrangement would compromise the universal
utility of the standard. Any hypothetical transaction must also take into consideration
whether the payment is made currently or is the present value of future payments to be
received.
* David Drews is president of IPmetrics LLC, an intellectual property consulting firm.
You can reach him at 858-538-1533, or ddrews@ipmetrics.net.

2. Value vs. Fair Market Value
A fair market value standard also requires that the parties in your hypothetical transaction
be willing to transact and are under no compulsion to act, i.e., that neither the buyer nor the
seller is required to enter into the transaction or is under any pressure to do so, such as
might be found with a legal ruling or bankruptcy. In other words, some of the seemingly
applicable market-price data you might otherwise consider should be ignored when it is the
result of either party being required or pressured to enter into the transaction. Also, it is
necessary to determine whether idiosyncratic behavior on the part of specific buyers or
sellers is present when utilizing data associated with them to calculate fair market value.
This will help one avoid incorporating certain driving factors that may not be present in a
typical buyer or seller.
Also encompassed within the concept of fair market value is the idea that buyers and sellers
tend to act in their own best interests. Therefore, the price paid reflects the general
economic environment in place at the time, the particular industry in which the asset is
deployed, the relative negotiating position among the parties and the type of asset in
question.
For example, a hypothetical buyer may have opportunities to obtain a higher return on its
investment by foregoing the hypothetical transaction entirely. Assuming that every buyer
wants to invest scarce resources in the most efficient manner possible, passing up a
transaction featuring a lower return on investment in favor of a deployment of assets that
would achieve the same result for a lower price, is a rational assumption.
These general comments suggest the scope of questions that come into play when applying
a fair market value standard. You would want to consider these kinds of inputs while
reviewing the applicability of market-price information or determining the scope of the
assumptions that have to be made.
There is, of course, another element of the fair market value definition: that both parties
have reasonable knowledge of all relevant facts. The first distinction that needs to be made
when applying this element is between information that is publicly available and that which
is private. In a typical transaction, however, some of the private information may be
disclosed to a potential purchaser and some of the publicly available information may not be
readily available to the average participant. These issues need to be addressed individually
in each case to determine their proper treatment. Very seldom do the participants of an
actual transaction possess knowledge of all relevant facts. The guiding term in this element
is reasonable.
The analysis performed by a hypothetical buyer and seller would also likely incorporate
reasonable estimates of relevant future activity, so this aspect typically is included as well.
In addition, valuations done to determine the fair market value of an asset at some point in
the past may need to ignore relevant information that has since come to light. When
performing historical analyses, the proper framework is to only include that which was
known or knowable at the relevant date.
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3. Value vs. Fair Market Value
A simple example will serve to illustrate the difference between value and fair market value
as outlined in this column. Suppose an inventor has developed something that would allow
a manufacturer to save $1 million when compared to the expense currently incurred during
the manufacturing process. The benefit of the technology is in the form of a cost saving and
the value of the development amounts to the $1 million in savings. But is $1 million the fair
market value? No. Fair market value is the price at which the asset would change hands.
There is no incentive for the manufacturer to pay the inventor $1 million for the development
when his benefit also equals $1 million. The fair market value, therefore, would be
somewhere between $0 and $1 million, and will be ascertained by all of the various relevant
inputs that have an impact on a true negotiation. These will include items discussed above,
such as the competitive environment and the existence of alternative methodologies.
While this simple example does not explore all of the various inputs called for in a fair
market value analysis, it does provide the basis for understanding how value and fair market
value can sometimes differ significantly. Finally, it is important to realize that fair market
value is not the appropriate standard to utilize in all cases. Sometimes the assets in
question need to be examined within a very narrow context comprised of specific
participants and inputs. Determining which standard to use is one of the first questions that
need to be answered when undertaking an IP valuation project.
This article was originally posted on corporateintelligence.com on 12-15-2000.
* David Drews is president of IPmetrics LLC, an intellectual property consulting firm.
You can reach him at 858-538-1533, or ddrews@ipmetrics.net.
© 2010 IPMETRICS LLC. All rights reserved.
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