Patent Values in the Evolving I.P. MarketPLI Hot Topic TelebriefingMay 2, 2007

Fernando Torres, MScChief Economist

ftorres@ipmetrics.net

Issues

1. Role of Patent Valuation1. Role of Patent Valuation

2. Identifying & Accounting for Value2. Identifying & Accounting for Value

3. Licensing Rates, pricing M&A’s 3. Licensing Rates, pricing M&A’s

4. Values in Litigation4. Values in Litigation

Patent Value Statistics

•Patent value distributions are skewed; i.e. most of the value is represented by a minority of patents:

Patent Value Statistics

Role of Patent Valuation

• Although patents values cannot be observed directly (unlike stocks & bonds) and requires specialized analysis, the contemporary role of patent valuation cuts across most management functions:

• Strategic

• Key to deal valuation

• Throughout Strategic Planning and M&A process:• Strategy

• Target Id

• Valuation

• Initial negotiation

• Due diligence

• Closing

• Financial Reporting

Issues identifying patent values

• Internally generated intangibles are expensed or (for R&D) recorded at historical cost

• Balance sheet undervalues patents

• Acquired intangibles allocated at valuation date• Balance sheet only reflects acquired patents

• Thus, not all patent values reflected in financials, and not all patents disclosed may be core patents

• Still true in FASB No. 157

Identify patent bundles for value

• Analyze quality of patent portfolio• Relevance to current/future business

• Relative strength analysis

• Stratify IP / IA• Core v. Periphery (not only technologically)

• Peripheral portfolios may be monetized• Vertical and horizontal

• Out-licensing / Spin-off

• Potential infringement assessment

Qualitative Analysis of IA/IP

• Forward/backward patent references

• Breadth of key claims

• Challenge/infringement record

• Associated trade secrets, knowledge bases, trademarks

Standards of Value

• Fair Market Value• The price at which property would change hands

between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. (IRS.-Hypothetical)

• Fair Value• The amount at which an asset could be bought or sold

in a current transaction between willing parties, that is, other than in a forced or liquidation sale. (FASB.-Specific synergies)

Establish patent values

• Cost

• Investment value

• Reserve value

• Blocking value

• Monopoly value

• Value to licensor

• Value to (hypothetical) licensee

• Valuation of un-commercialized patents

Real Options Approach

• Adapted to patent valuation from the field of financial analysis

• Draws on a parallel between patents and stock options; the right, not obligation, during some specified time, to purchase an underlying asset whose price (value) is subject to some form of random variation (uncertainty)

• A patent gives its owner the right to exclude others from using the underlying invention, and further investment is required to exploit its commercial potential.

Real Options Valuation

• Both instruments have a direct and precise pricing relationship with an underlying asset: a company in the case of stock options, and an innovation in the case of a patent

• Either right can be transferred (license). The transfer price is less than the full value of the underlying asset. The licensee, in the case of patents, will only enter the transaction with the expectation of reaping the difference between the full value of the patent and the license price (paid-up or ongoing royalty)

• A significant difference, however, is that (until recently—Ocean Tomo Auction) there are no organized markets for patents and most intellectual property assets.

Real Option Valuation

• Key concept (Black-Scholes): the higher the volatility of returns is, the higher the value of the patent and the licensing rates

Net Payoff fromintroducingproduct

Net Payoff fromintroducingproduct

NPVCash Flows

NPVCash Flows

Cost ofIntroduction

Cost ofIntroduction

PatentValue

PatentValue

Illustration: Valuing a Patent

• A bio-technology firm with a patent on a drug called Xenova, which has FDA approval to treat multiple sclerosis.

• Estimates for use in the option pricing model:• Potential market and expected price yields a PV of cash flows

of $ 3.4 billion (S)• The initial cost of developing the drug for commercial use is

estimated to be $2.9 billion, if the drug is introduced today (K)

• The patent expires in 17 years, and the current long-term treasury bond rate is 6.0% and cost of delay is 1/17 (or 5.9%) as all excess profit is assumed to vanish upon expiration.

• Average variance in firm value for publicly traded bio-technology firms is 0.225

Illustration: Options Formula

• Value of the patent: Se-dtN(d1) - Ke-rtN(d2)• 3.4exp(-0.059)(17)(0.8720) –

2.9exp(-0.06)(17)(0.2076) = $0.9 billion

• The NPV of this project is only ½ billion:• NPV = $3.4 - $ 2.9 million = $ 0.5 billion

• The firm can benefit from the flexibility of delaying introduction until value of implemented patent equals NPV of the project

Case Study

• A “nutraceutical” company developed and licensed-in a number of patents involved in the formulation of their flagship product.

• Goals: To form an IP holding company for the patents, licenses, pending applications, and trademarks, which will receive “arms-length” royalties in a lower-tax jurisdiction

• Problem: what is the right rate to charge for the technology bundle?

Real Options Approach to Royalty Rates

• The B-S model can be adapted to yield royalty rates (based on Denton & Heald)

• Given the risk and expiration of the patent these rates will balance the risk-adjusted profit expectation of the licensor and the licensee

Where:RR is the Royalty Rate

PR is the Profit RatioN(∙) is the Normal Distribution

σ is the standard deviationT is the life span of the patent

r is the Risk-free rate

Where:RR is the Royalty Rate

PR is the Profit RatioN(∙) is the Normal Distribution

σ is the standard deviationT is the life span of the patent

r is the Risk-free rate

)]2()2([

)2()2(

TNTNe

TNTNPRRR

rT

Case Study Conclusion

• In this case, the patents involved had relatively short lives left, newer patents were about to become available, and the industry has experienced relatively high volatility

• The rates the option-pricing model allowed us to determine a royalty rate of 1.8% with a likely range of plus or minus 0.4%