Valuing patents isn’t rocket science. It is actually much more difficult.
However, I developed a much simplified—and even somewhat humorous—formula that I believe captures the essence of patent valuation. Here is the formula that indicates how much sellers can expect to receive for their patents.
V = [CV + (S / 2) + (3 * C)]N
Calculated Value
The first part of the formula requires the determination of the Calculated Value of the patent. The Calculated Value can be derived by applying methodologies such as:
The Cost Method – Basically determines the present value of the investment made in producing the patent. Another component of applying the cost method consists of determining the design-around costs for a potential patent buyer. If the anticipated design-around costs exceed the cost to the inventor of producing the patented invention, there will probably be a transaction.
The Market Method – Under this method, the valuation analyst compares the prices paid for similarly situated patents. However, since there is relatively little information available relative to patent sales, most market analysis is performed using licensing terms—that similarly situated patents were able to secure—in lieu of patent sales proceeds. Then, the analyst makes adjustments to the (weighted) average consideration that the patentee receives based on issues such as stage of technological development, rights extended (exclusive vs. non-exclusive, extent of geographical coverage, and extent of field of use licensing), other consideration received beyond royalties (upfront payments and equity investments) and remaining patent life.
The Income Method – This method calls for determining the net present value that the patent generates for the commercializer of related products. If a given patented technology is incorporated into five products, the analyst would have to determine the value that such patented technology delivers to each of the five products over the lives of the products and then sum these values. This analysis is easier when it can be readily demonstrated that the patented technology allows the product to sell at a premium or that price erosion would have been more pronounced had the product not incorporated the patented technology.
In determining the value that a patented technology contributes to end products, the analyst must apportion out value associated with contributions made by tangible assets as well as other intangibles. Some of the intangibles that would need to be apportioned out of the analysis include know-how, trade secrets, trademarks, and reputation. Three other forms of intangibles that would need to be apportioned out include:
Switching Costs – For example, much of the value of a set-top cable box is a function of the high switching costs. Customers continue to pay their monthly fees to their existing cable companies, partly because they want to avoid the nuisance associated with removing and returning their set top boxes.
Network Effects – Network effects hold that some products become more valuable when more people use them. For example, network effects account for tremendous value inherent in companies such as Twitter, Facebook and LinkedIn.
Economies of Scale – Businesses that are able to operate their factories at huge levels of production can achieve low costs per unit. The significant competitive advantage delivered by producing at high volumes is separate from the value of any associated patents.
Probability Adjusted Income Method – This method is a permutation of the Income Method. The difference here is that the income projections are prepared several times to reflect scenarios such as Best Case, Expected Case and Worst Case scenarios. The final value is computer by assigning a probability of each of the scenarios occurring and then adding the product of each of these probability adjusted scenarios.
Monte Carlo Method – The Monte Carlo Analysis is the Income Method (or Probability Adjusted Income Method) on steroids. Instead of taking into account a few scenarios, Monte Carlo entails calculating thousands of scenarios and then assessing where value is most likely to lie based upon where the conclusions of value cluster.
Real Options Method – This method is designed to quantify the additional value that is captured when undertaking a research project. Sometimes this value presents itself in the form of learning what does not work. Also, there is always the possibility that researchers will discover something of tremendous value serendipitously.
Binomial Lattices – In instances when the payback from an early technology will only occur in the distant future and when calculating a NPV for such technical contribution is nearly impossible, it is better to view the technology as an option rather than as an instrument that will yield a NPV. By using sophisticated mathematics, the analyst can calculate the option value of an emerging technology.
The Power of the Story
The second component of the formula indicates that the power of the story behind one’s efforts to purchase or sell a patent is important. Suppose it is known that the CFO at the company selling the patent has demanded that there be a reduction in patent maintenance costs. It would be reasonable to assume that this directive will be accomplished by disposing of sub-optimal patents. Well, the potential buyer’s response to prices sought by the seller could well be, “You are getting rid of your lousy patents. Maybe you don’t believe that these patents are worth a few thousands of dollars in maintenance fees. So why should I pay a high price for these patents?”
On the other hand, some stories behind a patent could lead to a premium over the calculated values. For instance, a patent coming from a reputable institution or a patent with an impressive chain of title enhances the story and could receive a premium. So too, could a patent written by world-renowned inventors.
Competition for Patent
The third component of the formula indicates that the degree of competition for a patent is an important indicator of patent value. In situations, where there is only one (underfunded) potential buyer for patent, the pricing will be weaker than if there are three well-funded companies that are aggressively competing for the patent. Patents that have been on the market too long and that have been represented by a series of patent agents often loose significant value. Not only does the extended time-on-market indicate that there is little demand, possibly seller’s willingness to capitulate, and potential vulnerabilities with the patent but also that the current patent agents most likely have negotiated very high commissions for themselves.
Negotiating Ability
The final piece of the formula for calculating the value of a patent is the most important and thus, negotiating ability is the exponent. At the end of the day, patent sales and patent licensing is a matter of negotiating. All of the methodologies and metrics at the analyst’s disposal are reduced to props on the negotiating stage. An inventor can dedicate twenty years of hard work to his research project and create something with tremendous promise. He can squander half of this value in a matter of hours at the negotiating table. In the final analysis, you don’t get the deal that you deserve. Rather, you only get the deal that you negotiate.
Anyway, these are my thoughts. I would be interested in your thoughts. Please join the discussion at the Certified Patent Valuation Analyst Group on LinkedIn.
David Wanetick, Managing Director, IncreMental Advantage, LLC–a valuation firm with an expertise in valuing intangible assets and emerging technologies–based in Princeton, NJ. He teaches Valuation of Emerging Technologies which is a required course for the Certified Patent Valuation Analyst designation offered by the Business Development Academy.