Not always an easy task

The valuation of the licensed property

Robert Michelin, lawyer

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NDLR - The Canadian Institute recently held its "Licensing of Intellectual Property" conference. This is a summary of the presentation given by Ronald W. Scott, a Toronto-based specialist in the valuation of intellectual property.

In any licensing transaction, one of the key steps is to determine of the value of the licensed property in order for the licensor and the licensee to have a frame of reference for their activities. In licensing situations involving intellectual property this is not always an easy task. Intellectual property frequently defies attempts at identification or classification. Determining the value of such property thus constitutes an even more challenging responsibility.

Different notions of value

Mr. Scott defined "value" as the amount of one resource that a party is prepared to exchange for an amount of another resource. He proposed that the two most common ways to consider the value of intellectual property in a licensing context are income consideration and capital consideration.

The former (income value) he defined as the annual value of the yield of the licensed intellectual property. The latter (capital value) he defined as the current value of the revenue stream that might be derived from the licensed property. The use of the word «current» is not a contradiction; it refers to the present value of the anticipated revenue. The suggestion was made that in a licensing context the capital value is often a more useful indicator because the parties are involved in a continuous, long-term relationship. Accordingly, they will in most instances look to the future value or potential value of the licensed intellectual property in establishing the price to be paid by the licensee, generally in the form of a royalty rate.

Mr. Scott suggested several criteria which should be verified by intellectual property valuators in the framework of a licensing transaction in order to determine most accurately the value of the licensed property or technology. The extent to which the licensing arrangement provides competitive value to the licensee was identified as an important indicator as to the value of the intellectual property. So too was the cost saving to the licensee from not having to develop its own alternative to the licensed technology or property. What these factors have in common is that they will effect the value derived from the intellectual property by the licensee, once the licensee has secured the rights to it. In other words, in determining the value of the intellectual property, it is necessary to look at the factors that make it attractive to the licensee.

Other indicators of this nature include the type and level of the support commitments offered by the licensor, the legal protection (copyrights, patents, trademarks, etc.) attached to the intellectual property, the newness and originality of the licensed technology (as well as the possibility of commercially viable improvements) and any evidence of previous commercial success. Mr. Scott stressed the importance to both parties of asking questions of this nature. Both sides must know about the potential value of the licensed technology/product before concluding a license agreement. For the valuator engaged by the licensee, this information will come in large part from the licensee's own due diligence. Accordingly, the valuator must work hand in hand with the attorney overseeing the due diligence.

For licensors, the information will result from their understanding of their own technology. Although, this seems obvious, Mr. Scott emphasized that in many instances the licensor is not familiar with the potential of his or her own technology from the perspective of the licensee. He suggested that the valuator engaged by the licensor should focus on the value of the licensed technology for the licensee, based on the theory that knowing why the licensee wants the technology and what the licensee hopes to gain by licensing it is the optimal way for the licensor to negotiate a favourable royalty rate.

Establishing the royalty rate

Mr. Scott stressed the importance, from the valuator's point of view, of not losing sight of the central role of the valuation exercise: establishing a favourable royalty rate or any other form of payment that the licensor is or should be asked to pay. To this effect, it was suggested that the essential feature in calculating the value of the intellectual property to be licensed is the economic value added: the difference in value between the licensee's business without the licensed technology and its value with the licensed technology included.

No matter what technique is employed by the valuator - cost method (focusing on the replacement cost to the license of the intellectual property), market method (focusing on alternatives of the licensed intellectual property) or income method (as previously discussed, focusing on what is produced by the intellectual property) - the objective of the valuator, irrespective of which party has engaged him or her, is to determine how much the licensee is willing to pay for the right to use the intellectual property in question. Until this determination has been made, any royalty negotiation will progress no further than the preliminary stages.

The cost approach estimates value by examining what resources must be consumed or sacrificed to replace the licensed property. Although generally a fundamental method in most valuation situations, where intellectual property is concerned this approach may not always be useful for the simple reason that much intellectual property is unique and therefore impossible or at least very difficult to replace. In addition, the intellectual property may be the subject of a licensing transaction before it has reached full development stage. Biotechnology assets, for example, may be unproven assets whose replacement costs are impossible to determine. A valuation method that relies on such an indicator may thus not be the most efficient means of determining the actual value of such assets.

The market method calculates value by referring to information on purchase and sale transactions where similar property was involved. The principle is relatively uncomplicated; prospective buyers should not pay more for given property than they would pay for alternative property that would suit their needs. In intellectual property situations, however, the same problem is present as with the cost approach. Where the licensed property is a unique intangible, there may not be similar property transactions available for comparison. The licensed property may be so one-0f-a-kind that the licensee does not have an alternative. In such a scenario, a comparison method of value determination may not be very effective.

The income method is based on the notion that the value of an asset is determined from the income it generates or can be expected to generate. According to Mr. Scott, this is perhaps the most useful method for establishing the value of intellectual property, because there is more information available on which to base the determination of value. Through careful investigation, both parties to the transaction develop some idea of the income that the licensed product or technology will be capable of producing. They are therefore able to more easily attach a value to the property in question.

Royalty rate scenarios

In discussing the various techniques available to valuators of intellectual property, Mr. Scott suggested that the context in which the license arrangement is being negotiated will play a significant role in determining the valuation method used. Examples of different scenarios include situations in which an item already established in one market is licensed for development in a new market, a completely untried but patented product is introduced, a licensor seeks a royalty on a product or idea that is a comparatively minor but necessary element of a more elaborate system or technology, and the license agreement is for the «spin-off» of a successful idea or another form of intellectual property. The point that Mr. Scott was making was that every licensing situation has its own information requirements and availability and the valuator's choice of technique will be a reflection of those requirements and that availability.

Conclusion

Mr. Scott's presentation was one of the most useful of the series because it provided helpful insight into an aspect of licensing situations which may not be uppermost in the minds of the attorneys involved in preparing license arrangements. Mr. Scott suggested that the preparation of a licensing arrangement should be regarded as a process incorporating many elements which must work harmoniously if the client, whether licensee or licensor, is to receive the best advice. Determination of the value of the licensed intellectual property should be considered an essential step in this process. Attorneys who keep this in mind and pay careful attention to the manner and techniques of an intellectual property valuation, as well as to the results of such an exercise, will be more able to provide thorough advice to their clients.

 

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