This article has been written by Gaurangi Kapoor, pursuing a Certificate Course in Intellectual Property Law and Prosecution from LawSikho.
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‘Valuation’ of intellectual property, is a recent development, still in its nascent stage, especially in developing nations such as India.
A business enterprise may be defined as a portfolio of assets, assembled together for the purpose of serving the needs of a specific marketplace, and in that process, to provide an investment return on the funds expected to create it. Today, the share of IP within that portfolio, on average, accounts for almost double the net worth of tangible assets, implying that effective exploitation of IP has become a key factor in businesses’ success. Exploitation invariably increases the need for risk assessment, and the importance of establishing proper structure(s) and method(s) for evaluating its monetary facet is greater today than ever.
To understand IP valuation, it is necessary to first understand the definition of an IP asset. An intellectual property asset is a form of an intangible asset (that cannot be touched) which is a creation of the mind, controlled by an entity and accrues economic benefit to it through licensing, self-creation or related events. It can be legally enforced, protected and transferred and owns a legal, economic as well as a business profile. However, for valuation the useful economic life of an IP asset is crucial for its valuation.
What is meant by Valuation of IP
The valuation of an asset integrates the legality of that property with the economic concept of its value. Now, one of the prerequisites of (commercial) valuation is context. An asset’s value cannot be determined without context; it is always in reference to place, time, and other relevant variables. With regard to tangible assets there exist well-developed methods for the same.
IP applications and stakeholders constitute diverse categories, with each field having its own legal and regulatory framework. Even within one category, such as patents, there’s heterogeneity with regards to their nature, purpose, time frame, etc. The terms and conditions of intellectual property exchanges vary widely. Moreover, there are no established markets for the exchange of intellectual property assets. Further, the details of intellectual property exchanges, especially prices, are rarely available to the public. Therefore, IP valuation requires a more specialized approach, more advanced methods. These methods consume substantial amounts of time and capital; thus, their continued growth indicates some very real, economic benefits arising out of valuation, a realization that has dawned only gradually.
In fact, one of the major hurdles in the expansion of this concept has been lack of awareness regarding these benefits, a problem that persists in developing economies (e.g. India), especially in rural or low capital sectors, such as small enterprises and agriculture. Those who could benefit the most from these modern-day structures are the ones most stuck within their traditional ways and approaches. Major focus of this paper is to contribute towards bridging this gap.
Why we need IP Valuation
Some of the key reasons for IP valuation are – facilitating transactions like M&A or licensing, financial reporting on public statements, litigation, bankruptcy, tax planning, et al. One of the fastest growing areas of activity though, is the financing of IP assets. This can be achieved through a number of ways, including borrowing against the license stream (similar to factoring) or securitization of IP.
Methods of Valuation
Different reasons or purposes require different valuation strategies, and these, along with the nature of subject IP, premise, functional status of asset(s) in question, etc. become key determinants in choosing the method(s) for valuation, which may be qualitative or quantitative.
Qualitative valuation methods
They are capable of accommodating a multitude of factors but do not give us an answer in monetary terms, and their uses are often restricted to internal patent management. Qualitative valuation is espoused by countries like Japan and Denmark, and is not particularly relevant to our study.
Quantitative valuation Methods
They provide the (contextual) monetary value of an IP asset or a cluster of assets, and even though certain terminologies and combinations may seem ambiguous or confusing, there are only three categories within which these methods fall – cost based, market based, and income based, an alternate perspective to which can be past, present and future value respectively.
This establishes the value of an asset by determining the cost of its recreation. This approach must include certain additional factors such as opportunity cost, depreciation, deterioration due to functional or economic obsolescence, etc. to calculate a fair value. There are two methods through which the same is reached – reproduction cost (also known as historical cost) which seeks to measure the cost of creating an identical asset, and replacement cost, which measures the cost of creating an asset with the same utility. Replacement cost method is based on the principle of substitution – an investor would not pay more for an asset than the cost to obtain similar benefits from another asset. Both methods have certain flaws, yet they are the only viable options in many circumstances.
Cost approach is not very popular, and is rarely used as a sole method in IP valuation, since the uniqueness of IP and its unexpected income generating capacity or risk and uncertainty is not factored in. Trends and growth rates, which greatly impact value, are not considered either. In fact, many commentators and practitioners believe that it has little role in IP valuation because:
a) the legal protection of IP makes recreation difficult; and
b) without the legal protection such cost for many IP assets is effectively zero.
Nevertheless, it is useful when recreation of subject IP is easy when the subject IP is economically dormant or in nascent stages of production, thus not generating income, when determining the floor value (or the maximum value while comparing with the alternatives) of an asset, etc.
Reproduction cost approach
This is inherently flawed since there is often very little correlation between the cost incurred on the creation and its subsequent utility or value, especially in the case of IP. For example, the creation of a certain phone application may have been a costly affair but if at present there exist resources that can create an alternative at a much cheaper cost, the creator of the asset in question would probably not find any buyer if its value is based on this method. But there may exist scenarios where no functional alternatives are present to set a benchmark, wherein the same may be used, although it is quite uncommon.
The replacement cost approach tackles the flaws present in the former. It takes into consideration the current availability of resources and their present cost. A drawback to this is that it may allow for an excess of subjectivity in the absence of comparable benchmarks in the market. Yet, generally speaking, replacement cost is closer to the fair market value than reproduction cost.
This is based on the premise that market transactions of intellectual property indicate value. Also known as the transactional method, it is basically the price paid by a willing buyer to purchase a similar asset in similar circumstances, which, if carried out with adequate data in hand, should establish the fair market value of the subject IP. In fact, ‘fair market value,’ and ‘arm’s length standard’, which are two of the most common valuation standards, have been derived from this approach.
But again, the peculiar nature or uniqueness of IP creates certain problems such as difficulty in finding comparable assets; more often than not the reference transactions need to be corrected for the dissimilarities, which inevitably attract subjectivity. Moreover, the exchange of IP in the marketplace typically is completed as part of the exchange of an entire company or division and even then, the price is rarely disclosed separately for the intellectual property component. Nonetheless, it is one of the simpler methods, and with the availability of sufficient market-derived sale or licence transactional data, can provide meaningful pricing guidance.
Tax authorities usually favour this approach for deals with affiliates and it is also used for deriving inputs for the income approach. Although market-based valuation methods can be extremely useful, they are seldom comprehensive enough to provide the basis for a satisfactory conclusion of value on their own.
This is probably the most fundamental approach with regard to valuation since the inherent value of an asset can be best defined as its income-generating capacity. This approach values an asset based on the present value of the cash flows that the asset is capable of generating in the future. There are three components to this approach – projected cash flows (which is the future income attributable to the asset), the economic life of the IP, which gives an estimate for the duration of income, since the economic life of an IP asset is distinct from and usually much shorter than its legal life (e.g. patents), and the discount rate, i.e. the cost of financing the subject IP. The discount rate takes into account the time taken to receive the amount of income, and the associated risk(s) of such an undertaking.
Despite this approach’s intrinsic strength, it is also one that involves alarmingly high levels of subjectivity because of the projections which are to be estimated. Moreover, rather than a holistic view of the risk(s) involved, only its systematic component, i.e. market determined discount rate is accounted for. This approach also fails to deal with separate risks (such as legal, technological, etc.) individually, which may result in the incorrect adjustment in the discount rate. Nevertheless, in cases where the income generated through the asset is positive and its future estimation can accurately be done, the income approach is preferred. Financing or securitization of assets is one of the foremost reasons for the valuation of IP, and the income-based approach is the most widely accepted set of methods for that purpose.
Valuation of IP is an extremely important subject area in modern-day commerce. Not only does it help in effectively exploiting the intellectual property (through licensing, securitization, etc.) and raising money for future investments, which is a boon for start-ups, low cash sectors and small enterprises, it also solidifies the relevance and economic strength of IP in this age. Valuation re-establishes IP’s status as a proper class of assets/property. This acts as a deterrent for possible violation(s).
Despite having various purposes and benefits, the growth of this concept and its usage have been disappointingly low in India, especially in MSMEs and the agricultural sector, two groups that could immensely benefit from the valuation of their IP, and gain a much stronger position in the market, as far as bargaining power is concerned. There are several reasons for this lacklustre pace.
There is a serious lack of awareness amongst these two groups regarding IP as a class of assets, and its capability to potentially generate revenue through modern methodologies such as securitization. Even though, as logical beings, they may appreciate the intrinsic value of IP, the absence of vocabulary and exposure curbs that appreciation before it takes the shape of realization, regarding the monetary value of these assets. Those who exploit this lack of knowledge have no incentive to spread awareness, and the ignorance continues.
There is a lack of legislation and/or guidelines governing valuation, which means uniformity of the process is jeopardized, and since it is a new area, India doesn’t have experts in this field. This, along with the reluctance of people to move away from traditional means of raising capital has resulted in an extremely slow progression of valuation in this country. Thus, one of the key focuses, moving forward must be to educate and change the mindset of (at least) the target groups on the monetary relevance of IP and IP valuation.
Students of Lawsikho courses regularly produce writing assignments and work on practical exercises as a part of their coursework and develop themselves in real-life practical skill.