This column is part of a series of book excerpts from Own It: The Law and Business Guide(tm) to Launching a New Business Through Innovation, Exclusivity and Relevance.
One of the more challenging aspects of developing a company based on intellectual property assets is the challenge in valuing those assets for the purpose of both lenders and investors. As a general matter, the intellectual property assets created by a company are not reflected as having value on the company’s books. As the WIPO primer on small business intellectual property business explains, “[t]he practice of extending loans secured solely by [intellectual property] assets is not very common; in fact, it is practiced more by venture capitalists than by banks.”1 Despite these accounting barriers, investors and lenders increasingly have come to value the potential of these assets.
WIPO has an extensive library of resources on valuation that can help the entrepreneur understand the complex financial models used by investors and lenders.2 By understanding the basics of intellectual property valuation, the entrepreneur can communicate the true value of these assets to those willing to finance the start-up.
The value of valuation is self-evident. As soon as an inventor can put an accurate price tag on her invention, the invention can be used as an asset to promote investment, secure loans and increase the worth of the company owning that invention. Unrealized worth does not help the inventor or the business owner — it is as if it does not exist. WIPO suggests that the ability to value the intellectual property independently from the business best establishes the commercial value of the intellectual property assets. Unfortunately, while true, this advice may be of little assistance. For the start-up, the intellectual property assets may be the only significant assets held by the company. Still, the intellectual property assets of the company add to the overall value of the business and may tip the balance for lenders or investors.
For the entrepreneur, the more one can do to formally or informally create a valuation of the intellectual property, the greater the chances that investors and lenders will recognize the value in the company. This value and valuation may not be based on the same accounting rules used for creating the corporate balance sheet that recognize or ignore asset values. Just as accounting rules depreciate property based on accounting tables rather than the attributes of the property, these rules value intellectual property in an artificial and generally unhelpful manner.
Skilled lenders and investors will look past mechanistic accounting practices to seek real worth. In his paper, “Assessment and Valuation of Inventions and Research Results for their use and Commercialization,”3 noted valuation expert Gordon Smith4 explained the meaning of value:
Value is the representation of all future benefits of ownership, compressed into a single payment. Therefore, value is continually changing as the future benefits increase or decrease, either with the passage of time or with changing perceptions of what the future will bring. Value does not exist in the abstract and must be addressed within the context of time, place, potential owners and potential uses. … Market value is defined as the present value of the future economic benefits of ownership.5
Smith is saying that the intellectual property should be valued as equal in worth to the income it will generate throughout its lifetime of use or exploitation. Such a value makes a great deal of sense, but Smith also recognizes that the passage of time and changing perceptions will always affect that lifetime of income, making such a valuation hard to calculate.
In 1926, the copyright in silent films were considered highly valuable, but within two years, the invention of the “talkie” or sound motion picture rendered them increasingly worthless. A decade later, films were generally thought to have a five-year life span as they were shown in the theatrical houses throughout the country. Many copyrights were allowed to expire because their owners did not anticipate the future revenue that would arise first from broadcast television and later, VHS tapes, DVDs and Internet downloads. In both cases, the intellectual property owners did not — and could not — fully anticipate the value of the intellectual property over its lifespan because changes in technology rendered attempts to predict the future laughable.
As a result, the estimate of present value of future economic benefits is fraught with uncertainty. The longer the lifespan one tries to predict, the less certain the prediction becomes. The practical valuation of intellectual property takes these risks into account. As Smith explains,
[w]e must … be concerned with the economic life of the intellectual property, or the period during which the intellectual property can be expected to afford its owner an economic benefit. … Technology moves on; in some sectors such as the semiconductor industry, the technology is obsolete before a patent application can be prosecuted …
We must also realize that the decline in value of most intellectual property over time is not linear, so the economic benefit may vary greatly from year to year.6
These lessons are important for the entrepreneur to understand so that the new product or service is neither oversold nor undersold. Underselling the value of the intellectual property may result in the entrepreneur giving away too much of the company’s value to investors, while overselling the intellectual property may result in discouraging any investment at all. If the entrepreneur wants to show the potential to an investor of a new product, he will increase his credibility by separating the potential for revenue over the first five years from the remainder of the lifespan of the product. While the longer lifespan may be highly valuable, the predictability is significantly lower than during the first five years.
Similarly, the investor must realize that the “cost approach” to valuing the intellectual property based on the investment in that property is largely irrelevant as a measure of anything other than the risk undertaken by the parties. As Smith points out, “[t]he cost of developing technology is seldom relevant to its value. Think of the important inventions that have been made as a result of fortuitous insight, and the costly research projects that have ended in failure.”7 The costs associated with developing the business may be important to the participants, but they do little to provide meaningful information regarding the true market value of the intellectual property.
Economic analysts point to a number of different valuation methods for placing a price tag on intellectual property and inventions. These generally reflect the cost of development, the market price for the intellectual property and the economic impact of the intellectual property.8 As noted above, the cost of development provides little useful data for new inventions or start-up businesses. The cost of development will tell the entrepreneur what is needed to get off the ground, but will say little about either the short term or long term value of the asset.
Market rates are the best predictor of a property’s worth. To assess the market value of an intellectual property asset, one merely need compare the new item to the transactions for similar items in the marketplace. Simple as this sounds, its application is highly unpredictable.
The economic benefit approach to the property is perhaps the best method available to the start-up entrepreneur. Here, the property is based on its short-term and long-term value as a revenue center. Like the market approach, the entrepreneur should be able to determine the value of licenses used in the applicable industry. If a similar copyright or patent is worth 1% or 5% or 50% of the revenue in the market for that kind of item, then the potential for the invention has a baseline.
This is not the same as knowing what the new invention is worth. It does, however, provide investors some understanding of the range of possibilities available. When Apple released the iPod, it was unlikely that the company expected a market share in excess of 90% of the music player market. Certainly Sony and the other manufacturers never anticipated the instant dominance created. But Apple could predict the profitability on its products at different levels of market share and use those predictions to base the scale of its investment.
This is part of a series of book excerpts from Own It: The Law and Business Guide(tm) to Launching a New Business Through Innovation, Exclusivity and Relevance, which provides a step-by-step guide to developing successful start-up companies using concepts of intellectual property in all aspects of business planning and financing.
* Jon M. Garon is admitted in New Hampshire and California.
1. WIPO, INTELLECTUAL PROPERTY FOR BUSINESS.
2. WIPO, List of Documents on IP Validation.
3. Gordon Smith, President, AUS Consultants, Presentation at WIPO, International Workshop on Management and Commercialization of Inventions and Technology, organized in cooperation with the Mexican Institute of Industrial Property (IMPI) and the Institute of Technology and Superior Studies of Monterrey (ITESM), Monterrey (Mexico): Assessment and Valuation of Inventions and Research Results for their use and Commercialization (April 17-19, 2002), available at WIPO, List of Documents on IP Valuation.
4. President, AUS Consultants, Moorestown, New Jersey, United States of America.
5. Smith, supra Ch. 3 note 14.
6. Id. (citations omitted).
8. Nick Bertolotti, Partner, Arthur Anderson, London, Presentation at the WIPO International Seminar on the Valuation of Industrial Property Assets, Beijing: The Valuation of Intellectual Property (1996).