TECHNOLOGY VALUATIONA VIEW ON THE DIFFERENT METHODS FOR VALUATION Valuation is a difficult exercise and often a prejudiced one.

An owner of an asset, a potential purchaser and an insurer, will each value a fixed asset differently, even though it is an exclusive asset which is calculated in a common currency. Conventionally, the valuation of assets reflected their historical cost, with adjustments related to depreciation, and their value used to be directly linked to their expected profitability. However, in recent years, this linking is no longer mechanically applicable, as current economy companies produce revenue seemingly not linked to their fixed assets. This is happening mainly because of their growing importance of intangible assets and, in particular, technological advancement. It can be concluded that valuing intangible assets is very difficult & significant, and even more subjective! Even so, numerable methods can be used to value technology1. Given that valuation may be data dependent & subjective to other criteria, the valuations derived from each of the criteria will not be the same. However, they should provide some assistance by instituting certain parameters within which the financial deals could be negotiated, including not only the total amount, but also the ways in which payments are to be made. Below are the approaches used to value the technology. Cost Approach The cost approach is basically used to estimate all the costs that would be incurred if the licensee were to obtain, from a different source, technology that could deliver an identified process or product. This might most likely be through a third party with competing but non-infringing technology. The cost approach is used to ascertain the costs that would be involved in the creation
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Intellectual Property of Biotech Companies: A Valuation Perspective, Deborah Hylton and David Bradin, April 2002, http://faculty.fuqua.duke.edu/courses/mba/2001-2002/term4/hlthmgmt491/Files/DUKE_LECTURE.doc, Jeffrey H. Matsuura, An Overview of Intellectual Property and Intangible Asset Valuation Models

of similar technology considering the prices and rates of payment on the date of valuation (cost of technology reproduction/reinstatement). The time involved in bringing out such a technology is also of prime importance along with the costs incurred. The licensee will most likely refer to similar technologies, and this, where possible, can be a useful measure of the importance and value of the licensors technology while being acquired by the licensee. This involves less of valuation/ calculation and more a negotiation strategy related to what options the potential licensee has for alternative business partners if the potential licensor will not negotiate favorably on the financial terms. The licensors investment in the technology is represented by those expenditures associated with developing, shielding and commercializing the technology. These expenditures are known only to the licensor who has borne the costs and can be somewhat practically be estimated by the potential licensee. The license cost will usually include the base, or the minimum value that the licensor will want to recover, including the interest. If however, for example, the license is non-exclusive(more than one licensee), the licensee could argue that the recovering of the licensors investment should be borne equally by all the parties. The potential licensee might bargain that all the costs incurred were not productive and that there were some unproductive research expenditures, which should not be taken into account. The potential licensee may even argue that he is concerned only about commercializing & earning profits from the license & the cost incurred by the licensor is irrelevant to him. He is only interested in the value of the technology to his business, not its cost to an unrelated party. Almost always the licensor will not often reveal the true cost of the technology development and the potential licensee has no way to confirm that cost. In the end, the goal should be for both parties to have a realistic understanding of the licensors expenditure & investment and the payments to be made to the licensor by the licensee. Income Approach The licensee through successful technology licensing achieves increased profits because of the use of the intellectual property protected technology.

The income approach to valuation involves making guesses, as to the amount of income that the new technology will generate. The issue then is to determine the respective shares the parties should each have of the benefits and find a royalty formula that matches that calculation. Some licensing professionals start their valuation calculations with a rule of thumb, according to which the licensor should receive around one quarter to one third of the benefits accruing to the licensee, often referred to as the 25% rule 2. This rule has the advantage of being well known and widely quoted, and so is a common starting point for many licensors and licensees. It can then be varied by the parties in negotiation for any number of equitable and logical reasons. Often these will include the issue of risk and such factors as the technologys stage of development (embryonic to fully developed), the capital investment required, the content and strength of the intellectual property package and an analysis of the market. By way of illustration, if a new product is expected to sell for US$1,500, and all costs total US$750, there will be an operating profit of US$750. Of this, 25% is US$187.50. This is the amount, according to the rule, the licensor should receive, and could be a starting point for further negotiation having regard to the above risks and royalty variables and any other relevant factors. It may be that one party does not wish to pay or receive running royalties for the term of the agreement, but wants only a lump sum (perhaps in time-based or event-based installments), and therefore a fully-paid-up license. In this event, the next step would be to prepare a statement identifying for each year all the cash inflows and outflows, for the term of the agreement (n), and to then apply the formula 1 / (1 + r/100)n and calculate the lump sum or Net Present Value (NPV). This calculation requires the selection of a discount rate, r, which is the cost of capital adjusted for risk and so effectively incorporates or reflects all the risks. The NPV establishes the present value of
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Use of the 25 Per Cent Rule in Valuing IP, Robert Goldscheider, John Jarosz and Carla Mulhern, Les Nouvelles, December 2002, page 123

future income streams expected from the use of the technology under consideration. Obviously, this method is only as good as the precision of the data that is put into it. In some negotiations, one or both parties will hire accountants to run various scenarios of possible return and discount depending on certain scenarios. This may be simple or complex, involving more elaborate valuation technologies such as real options or Monte Carlo simulations. In many cases, however, the parties who are in business will have a welldeveloped practical sense of the risk and possible returns from the licensed-in technology. It should be noted that the NPV (also termed the Discounted Cash Flow or DCF) analysis is relevant to any issue where time and money are relevant factors. It can thus be a tool of wide application. Market Approach Sellers and purchasers of real estate and used cars know, or can readily ascertain, what other parties have agreed for similar houses in the same area, or for the same make and year of car. It follows that comparable market transactions are a convenient and useful way of determining the value of an asset in anticipation of negotiating a purchase or sale. The same approach is beneficial in licensing, though perhaps not as useful because there will seldom be identical technology and intellectual property packages. In addition, the commercial details of an agreement will not be ascertainable where they are considered by the parties to be competitorsensitive. This is more likely to be a problem where there is an exclusive worldwide license. Where it is non-exclusive, or is exclusive in different geographical territories, subsequent licensees will often know of, or at least have a good idea of, other licensees terms and conditions. Furthermore, nonexclusive licensees sometimes require that details of subsequent licenses be provided, or might require, through a Most Favored Licensee right, that a more favorable subsequent deal be made available to them as the earlier

licensee. In practice, these may be hard to use and enforce as agreements are often confidential. To some extent, it is useful to look at existing royalty ranges in certain types of licensing transactions. These may provide evidence in arguing for a particular rate in a negotiation, and may also provide useful guidelines. However, licenses are notoriously difficult to compare because the nature of the technology and the scope of the license will have a significant effect on the value of the license. A very broad exclusive license to make, use and sell all the rights to all patents in a certain technology will have a very different value than a limited non-exclusive license to exploit a technology in a narrow field of use. Still, information on other license royalties can be interesting and shows a wide range of royalty rates. An early survey by the Biotechnology Licensing Committee of the Licensing Executives Society (LES) reported that the following royalty ranges for nonexclusive licenses were considered representative for: Research reagents (e.g. expression vector, cell culture), 1 - 5% of net sales. Diagnostic products (e.g. monoclonal antibodies, DNA probes), 1 - 5% of net sales. Therapeutic products (e.g. monoclonal antibodies), 5 - 10% of net sales. Vaccines, 5 - 10% of net sales. Animal health products, 3 - 6% of net sales. Plant/agriculture products, 3 - 5% of net sales. The Licensing Economic Review of September 1990 reported that, for early-stage recombinant pharmaceuticals, royalty rates of 7-10% applied for exclusive arrangements and 3-4% for non-exclusive. Following regulatory approval, the rates for exclusive licenses were 12-15% and for non-exclusive licenses they were 5-8% of net sales.

M.Yamasaki in les Nouvelles, September, 1996, reported on average royalty rates reflecting both the R&D stage at the time the license is signed and the situation of the parties to the agreement. Thus, where a small biotech company licensed-in from a research institution or a university and, after further development, licensed-out to a major pharmaceutical company the added value was reflected in increased royalty rates:

These figures alone, however, do not show the full picture of the economic value of the deals and it is a frequent licensing pitfall to think only in terms of percentages and numbers. Most often, the actual terms of license agreements, including what may have been paid in the form of lump sum payments and other incentives that may have been agreed to, are unknown. Yet, they affect substantially the royalty rates agreed to. It is, therefore, difficult to assess what a given percentage royalty actually means. In summary, the usefulness of the market approach is often very limited. Generalizations, surveys and industry norms at least provide a starting point. What can be much more useful, however, is knowledge of a comparable licensing arrangement in the same industry which could provide another basis or check for a particular valuation of a particular technology. Other Criteria Tom Arnold and Tim Headley, in Factors in Pricing License in les Nouvelles, March, 1987, compiled a checklist of 100 important considerations in setting the value of technology licenses. These are listed under the following nine headings: Intrinsic Quality (e.g., significance of technology and stage of development) Protection (e.g., scope and enforceability) Market Considerations (e.g., size and share)

 Competitive Considerations (e.g., third party) Licensee Values (e.g., capital, research and marketing) Financial Considerations (e.g., profit margins, costs of enforcement and warranty service) Risk (e.g., product liability and patent suits) Legal Considerations (e.g., duration of the license rights) Government (e.g., local laws on royalty terms and currency movement). Royalties have been discussed in patent infringement lawsuits where courts engage in the task of determining what a correct royalty would have been in order to determine damages from infringements. The courts look at many factors and these are useful to consider as a sort of checklist when examining the value of intellectual property in a non-infringement situation: 1. The royalties received by the patentee for the licensing of the patent in suit, proving or tending to provide an established royalty. 2. The rates paid by the licensee for the use of the other patents comparable to the patent in suit. 3. The nature and scope of the license as exclusive or nonexclusive; or as restricted or non-restricted in terms of territory or with respect to whom the manufactured product may be sold. 4. The licensors established policy and marketing program to maintain his patent monopoly by not licensing others to use the invention or by granting licenses under special conditions designed to preserve that monopoly. 5. The commercial relationship between the licensor and licensee, such as, whether they are competitors in the same territory in the same line of business; or whether they are inventor and promoter. 6. The effect of selling the patented specialty in promoting sales of other products of the licensee; the existing value of the invention to the licensor as a generator of sales of his non-patented items; and the extent of such derivative or convoyed sales. 7. The duration of the patent and the term of the license. 8. The established profitability of the product made under the patent; its commercial success; and its current popularity.

9. The utility and advantages of the patent property over the old modes or devices, if any, that had been used for working out similar results. 10. The nature of the patented invention; the character of the commercial embodiment of it as owned and produced by the licensor; and the benefits to those who have used the invention. 11. The extent to which the infringer has made use of the invention; and any evidence probative of the value of that use. 12. The portion of the profit or of the selling price that may be customary in the particular business or in comparable businesses to allow for the use of the invention or analogous inventions. 13. The portion of the realizable profit that should be credited to the invention as distinguished from the non-patented elements, the manufacturing process, business risks, or significant features or improvements added by the infringer. 14. The opinion testimony of qualified experts. 15. The amount that a licensor (such as the patentee) and a licensee (such as the infringer) would have agreed upon (at the time the infringement began) if both had been reasonably and voluntarily trying to reach an agreement; that is, the amount which a prudent licensee - who desired, as a business proposition, to obtain a license to manufacture and sell a particular article embodying the patented invention - would have been willing to pay as a royalty and yet be able to make a reasonable profit and which amount would have been acceptable by a prudent patentee who was willing to grant a license. There is, thus, no limit to the factors that may be relevant to the valuation of a particular technology. Of course, with so many factors, many of them will not be important or decisive depending on the situation. What is important will depend on each partys strategic objectives and business needs. Thus, if a licensees need, for example, is to manufacture successfully the licensed product in the territory, and, rather than export, to sub-license other manufacturers in neighboring territories, it will be very important for the licensee to have exclusivity for the geographic areas of interest and to have the right to grant sub-licenses. The strategic objectives, and the necessary

rights, will impact on the valuation and the accompanying negotiations, for both parties. Concluding Comments The principal approaches to valuation of technology all have their limitations, which need to be borne in mind when valuing intangible assets. Each licensing negotiation is unique and it is difficult to apply the experiences of others or theoretical rules to the distinct situation at hand. However, the rules discussed above should provide some guidance in approaching the question of valuation. Further, it is advisable that the parties rely on the assistance of experienced valuation professionals and/or accountants to guide them through the complexities of a valuation exercise. Finally, a valuation is for the purpose of negotiating terms and conditions that would be acceptable to both parties and, as the Chapter on Negotiating Guidelines and Tips makes clear, while it would be nice to get the deal you deserve, you actually get the deal you negotiate.3

http://www.royepstein.com/epstein_aipla_2003_article_website.pdf and Roy J. Epstein and Alan J. Marcus, Economic Analysis of the Reasonable Royalty: Simplification and Extension of the Georgia-Pacific Factors,