How many times have we heard that Boards and Directors do not really, fully understand or appreciate the importance of intellectual property ('IP') or understand intangible asset valuations or that they often only hear about major IP litigation as an item for the Board agenda? Too often, I suspect. I have heard financiers and economists emphasise the many reasons to be skeptical about intangible asset valuations, emphasising variances and deviations of brand valuation methodologies, doubting the transparency, relevance and integrity of comparable uncontrolled transactions and eventually delegating IP to the General Counsel or Chief IP officer, often with an emphasis on managing risk as opposed to enhancing value. Many CFOs continue to undervalue IP or intangible assets despite paying significant premiums for them in M&A transactions, only to amortise them on a 3- or 5-year straightline basis despite the value contributed to the business being over 10 or more years or sometimes, contributing almost indefinitely.
There are notable exceptions, of course - and not just for internet, fintech or IT-led companies but across the chemical, manufacturing, medical, pharmaceutical and electrical fields as well as FMCG.
Another related question, given that Financial Services are the largest filers of payments and crypto patents (viz BofAML and JPMorgan) why is it that so many financial institution lenders have not yet grasped the opportunity to lend against intangible asset valuations.
Is it just a question of time or a deeper question of understanding? Studies show that the default rate against such lending to IP-rich firms is significantly lower than defaults in traditional lending scenarios. This concept is echoed in a paper by Mark Lemley, which suggests that companies, especially startups, obtain patents as a financing tool. The paper goes on to state that venture capitalists use patents as “evidence that the company is well managed, is at a certain stage in development, and has defined and carved out a market niche.” (Ref. 1)
What is IP Valuation?
Monetary or financial valuation is the process of determining or measuring reliably the value or worth of an asset in certain circumstances, the cost or price of an asset may be a good indicator of its value. The value of an IP asset derives, in essence, from its ability to exclude competitors from a particular market.
Why Valuation Is Important
'For most high tech startup businesses, the value of the entire business or enterprise is easy to determine once the value of the IP is determined. This is typically true because the IP constitutes the vast majority of the business value and because the IP is generally the most challenging asset class to value. Consequently, the following sections concentrate on valuing a company’s relevant IP rather than the entire business'. (Ref. 2)
Investors are driven by the goal of maximizing returns while keeping risks as low as possible. Risks associated with a startup’s technology —including its technical viability, uncertainty regarding the size of the achievable markets, the legal viability of the IP protections and a lack of history for the company or data from comparable companies/technologies to provide a precedent— make the valuation of IP for 'early stage' technology firms a very challenging task.
Ultimately, the board of directors is responsible for the valuation, strategy and risk management of any and all issues that could be sufficiently material to investors that they may be required to be disclosed in public securities filings. What is sufficiently material will depend on local laws and regulations but to take a leaf from the SEC's book, information is material if it ‘limits the information required to those matters to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security registered’.
Outside the US, the standards are notably higher in some sense. In the Hague, the court held that directors and officers are responsible for a company's copyright and trademark infringement (Ref 3).
So what can Directors and Officers do?
The first step is to raise awareness at the Board level and for key executives to become more educated on intellectual property issues relative to other material Board issues and engage in an IP audit in order to develop informed strategies:
- Identify what IP that the company owns and uses;
- Determine whether the IP is valid and enforceable and whether it conflicts with any third party IP rights
- Determine how aligned that IP is with business strategy and how close to the core of the business is that IP;
- Conduct an IP valuation - or at least a valuation of the core IP assets which may include trade secrets, patents, methodologies and know-how, copyright (eg software), registered or unregistered designs, trademarks and associated goodwill or even critical data the company uses to monetise its insights.
Valuation methodologies and drivers
Whilst Sarbanes-Oxley and other international regulations set no specific requirements for CPAs valuing intellectual property, it does put greater emphasis on accurate valuation of all assets and imposes punishments on CEOs and CFOs for failure to do so.
Intangible assets of all kinds, including patents, trade marks/brand names, in-process research and similar assets, have become increasingly important to the economic value of a business.This makes it critical to accurately disclose the facts about intellectual property.
That is not the only development affecting IP valuation. FASB Statement nos. 141 (intangible asset identification upon acquisition) and 142 (annual intangible asset fair value measurement) require companies to measure and report on the financial performance of acquired intangible assets.
Valuing IP assets also raises competition issues over divulging asset values companies might prefer to keep secret. Companies must balance their need to protect proprietary information with disclosure requirements.
CPAs can help companies choose from several methods for valuing IP assets. These include the market, cost and income approaches:
- With the market approach, a company compares its IP assets with similar assets in the marketplace that have a known value.
- The cost approach values IP based on the cost to obtain it;
- the income approach values assets based on the present value of the future income streams expected from the asset being considered. It considers the amount and timing of the expected cash flows attributabel to the asset(s) in question and the risk associated with realising those cash flows.
Valuations benefit Investors and shareholders alike
An IP valuation report will help to identify valuable opportunities that might not have been highlighted without the valuation.
- Provides insights to legal, technical, and business due diligence.
- IP valuation experts have access to data sources not generally available to any but the largest and most sophisticated venture capital firms.
- IP value changes with time. Valuations at different points in the life cycle allow investors to make informed decisions regarding whether and when to invest.
- A valuation may identify additional IP revenue streams outside of the owning company’s core business. If the IP is being infringed, the net value associated with potential infringement actions can also be estimated.
- Permits quantification of the contribution that IP assets to company value.
This is merely an indicative list of potential benefits.
It would be simplistic to say that IP and IA valuations are easy. They are a science, and an art, applying both quantitative and qualitative methodologies to complex data sets and comparable uncontrolled transactions. Expertise exists, however, to assist Boards and responsible officers to discharge their responsibilities in an increasingly IP-led IOT economy.
What's more, an alignment of IP strategy with firmwide corporate strategy will best serve customers and shareholders alike.
Reference 1: Mark Lemley - Stanford U. Numerous papers on ResearchGate.
Reference 2: https://www.stout.com/en/insights/article/have-ip-assets-need-money-role-intellectual-property-valuation-startup-investment/
Reference 3: 10Novomatic cs v. Bluemay Enterprises NV. 27 June 2018 (ECLI: NL:RBDHA: 2018:7746).