les Nouvelles July 2016 Article of the Month
Ten Common Mistakes In IP Valuation/Damages Reports
San Diego, CA, USA
As regularly occurs in business, Company A is considering acquiring Company B. The strategic perspective is very compelling: the target's patent portfolio fills numerous holes and propels the R&D program in certain key areas several years ahead of Company A's current position. A manager in Company A has been tasked with deciding whether this particular acquisition makes sense from a financial perspective. Toward that end, the manager has hired outside consultants to perform a formal valuation analysis on Company B's patent portfolio.
The manager has been in this role before and, unfortunately, has learned through experience the truth of the old maxim: garbage in, garbage out. Fortunately, she now knows to look for the mistakes and omissions that are all-too-often found in IP valuation reports. Being an educated consumer, she can rectify any errors in the valuation analysis before significant decisions involving millions of dollars are acted upon.
There are many situations in which it is important to understand the value of intellectual property. Perhaps there is a lawsuit related to the alleged infringement of a trademark and the purported loss in brand value is a key theory of damages. Another need for IP valuation may arise when a firm acquires a company with an extensive patent portfolio, as in the example above. Its due diligence efforts before, and purchase price allocation needs after the acquisition will likely require a valuation to be performed. Other contexts in which a valuation of IP may be necessary include the reorganization of a distressed company, the use of the assets as collateral when securing financing or the establishment of transfer pricing compensation.
Whether the IP valuation question is being answered internally or using outside consultants, the scope of these valuations frequently requires more than just a "gut-feeling" or "ballpark" level of analysis. It requires an in-depth analysis of the IP using accepted valuation methodologies.
This article assumes that the reader has a basic familiarity with IP valuation techniques and the reports that are associated with them. A detailed discussion of the various valuation methodologies is beyond the scope of this article and is a topic worthy of its own article.1 In summary, there are three primary valuation methodologies: the Market Approach, the Income Approach and the Cost Approach. The Market Approach to IP valuation determines the value of the asset by comparing it to similar assets that have sold under similar circumstances at a date reasonably close to the hypothetical or proposed subject asset transaction. Using the Market Approach to value IP is similar to how real estate is appraised. The price that a three bedroom home on a corner lot recently sold for will help the appraiser determine the value of a similarly situated home in the same area.
The Income Approach to IP valuation determines the value of the asset by calculating the net present value of the projected cash flow that is forecasted to be generated via its use. The Cost Approach determines the value of the asset by aggregating the expenditures that would be necessary to replicate the current situation of either the assets in question (Reproduction Method) or assets that provide similar utility (Replacement Method). Some techniques utilize a hybrid of approaches, such as the Relief from Royalty Approach, which uses a forecast of income like the Income Approach and comparable asset royalty rates from marketplace licensing transactions as with the Market Approach. The Relief from Royalty Approach determines the value of the asset by calculating the present value of the royalty payments avoided due to the ownership of the asset.
As with most exercises of this sort, an IP valuation requires numerous inputs, some of which are hard data, some estimates based on data, and others assumptions based on past experience and a reasonable assessment of the circumstances surrounding the valuation. The valuation also requires a statement of the context of the valuation, which encompasses the standard of value against which the analysis is being conducted, the premise of value associated with the context, and the date as to when the valuation conclusion is being ascribed. Any of these inputs, if inaccurate, could lead to inaccurate conclusions of value.
As the title of this article portends, there are at least ten categories of errors, omissions or mistakes that find their way into IP valuation/damages reports. In no particular order, they are summarized as follows:
|Figure 1. Ten Common Mistakes in IP
||Incorrect Standard of Value
||Incorrect Tax Treatment
||Cherry Picking Data
||Business Value v. IP Value
||Inaccurate Risk Profiles
||Incorrect Expense Treatment
#1 – Incorrect Standard of Value
One of the first things set forth in a valuation report is the standard of value against which the analysis has been conducted. Probably the most frequently used standard is Fair Market Value ("FMV"). FMV is the price at which an asset would exchange "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."2
Some elements of that definition need further explaining. The primary aspect of the willing buyer and willing seller is that they be a "typical" actor, one that does not mirror any one particular entity. In other words, the unique characteristics and idiosyncrasies associated with a particular company or organization should not influence the selection of inputs or analysis of data. With IP, the identity of the seller is oftentimes common knowledge, so the FMV requirement for a typical actor may only apply to the hypothetical buyer.
Not being under compulsion to act means that the asset is not being bought or sold due to a distressed situation, a court order, or some other requirement or outside obligation. The asset is the subject of the hypothetical transaction contemplated by the parties described in the definition of FMV because it is in both parties' interest for that transaction to take place.
Another standard of value that may be used is Fair Value. In a Fair Value assessment, the FMV definition is altered slightly to incorporate specific actors. In that case, the unique characteristics of the parties involved should inform the selection of inputs and analysis of the data. One may also come across the designation Historical Value, although Historical Value is not really a "standard" of value on its own. With Historical Value, either the FMV or Fair Value parameters are analyzed as of a particular date in the past. The important difference with Historical Value is that events and information that are subsequent to the "as of" date of the analysis should generally not be incorporated unless they were reasonably foreseeable or determinable at that time.
As can probably be surmised, the errors associated with this category occur when an incorrect standard of value is selected, or when the analysis includes inappropriate data or influences. Without completely recreating the analysis, it is oftentimes difficult to back out the effects of this kind of error since it may not be readily apparent which inputs, estimates and assumptions were impacted by it. It is also important to recognize that the unique elements surrounding the construction of a "But For" scenario in litigation may require a different or altered standard than would otherwise be the case in a more typical IP valuation analysis.
#2 – Incorrect Tax Treatment
The inclusion or exclusion of the effects of taxation can have a significant impact on the calculated value of IP. In general, the value of IP should be calculated on an after-tax basis, unless it is related to damages in litigation or arbitration. The reason for the difference in treatment is that awards resulting from successful litigations are generally taxable. If the damages are calculated on an after-tax basis, the effect is that the successful plaintiff is essentially taxed twice on the award.3 To put the plaintiff in the same financial position it would have been in had the infringement not occurred,4 it is necessary to calculate the damages on a pretax basis.
The opposite is true for regular valuation analyses. It is done on an after-tax basis for a reason that is similar to why damages reports are performed on a pretax basis: the investor is interested in the amount of value that is available to him, which necessarily incorporates the level of taxation to which he will be subjected. In valuation analyses, it is important to include a tax shield analysis, which incorporates the impact of the buyer amortizing the cost of the purchase. The purchase price amortization will usually influence the negotiated price.
|Figure 2. Effect of Tax Treatment on Value
|Patent Portfolio Value (Pretax)
|Patent Portfolio Value (After-Tax)
Figure 2 illustrates the effect that tax treatment can have on the calculated value of a patent portfolio. Assuming a discount rate of 20.0%, the after-tax value of a patent portfolio that has a $100.00 pretax value is $73.82 after the tax rate and amortization benefits have been applied. Representative errors in this category include using the wrong tax premise for a particular situation, using an incorrect tax rate, or omitting the tax shield analysis. For a typical valuation, the tax analysis should incorporate information related to the buyer. In a U.S. based FMV scenario, this will usually be generalized to only include federal taxes that are applicable to any potential purchaser. As a demonstration of an error that touches on multiple error categories, ascertaining the tax implications in a FMV analysis based on the characteristics associated with a specific party may lead to an incorrect conclusion of value. This error is related to both an incorrect standard of value and an incorrect tax treatment.
Correcting the impact of an incorrect tax treatment is generally straightforward since it is typically one of the last components of the value calculation. In most cases, if the valuation is pretax and should have been after-tax, simply apply the correct tax treatment according to the context parameters of the situation. If the valuation is after-tax and should have been pretax, back out the tax treatment calculations to get to the correct value conclusion. Whether the analysis was performed on a pretax or after-tax basis should be disclosed in the report.
#3 – Double Counting
Double counting occurs when the same data is used in multiple inputs or mutually exclusive analyses. In litigation, for example, if the same block of sales is used to calculate a reasonable royalty and defendant's profits, the two damages conclusions are not additive. Failure to recognize the mutually exclusive nature of the analyses under those circumstances may lead to a double counting of damages. Similarly, competing prospective analyses, such as lost future profits and corrective advertising damages, should not be added together.
|Figure 3. Alternative Damages Calculations on Same Block of Sales
|Reasonable Royalty Damages Calculation
|Defendant’s Profits Damages Calculation
|Incorrect Damages Conclusion
|Correct Damages Conclusion
Double counting may also be a problem in a valuation context. It is most often related to incorporating the same risk in multiple inputs. When the same risk is handled via multiple inputs, such as adjusting the growth rate estimate, the royalty rate and the discount factor to acknowledge an increased competitive response or some other risk, the resulting analysis may overweight that particular risk and cause the valuation conclusion to be too low as a result.
The opposite effect typically ensues when a royalty stacking situation is improperly handled. Using a comparable license royalty rate to value a particular patent when that royalty rate covers numerous technologies overstates the contribution of the subject patent to the resulting cash flow. This kind of error may also be categorized as ignoring reality, which is discussed in more detail below.
#4 – Cherry Picking Data
Probably the most common error found in IP valuation and damages reports, "cherry picking" of data occurs when perfectly valid data is ignored or under-weighted relative to other data that better supports the desired outcome. In other words, cherry picking often skews the results of a valuation analysis in favor of the client's position. Unfortunately, this does not provide an accurate assessment of the value of the IP and could subject the client to nasty surprises in the future, when actual results ultimately do not match up with those forecasted with the cherry-picked data. Also, when it becomes obvious that an expert witness has cherry-picked data to reach a damages conclusion, that expert's credibility will be impacted and the client may find itself subject to the opposition's damages presentation with no chance for rebuttal.
The cherry picking of data oftentimes shows up in the analysis and determination of a comparable royalty rate. If the range of possible comparable rates is from 2% to 10%, there should be a comprehensive discussion as to why the analyst's opinion is that the appropriate rate is in the 9% to 10% (or 2% to 3%) range. This is not to say that all valuation reports need to use the mean or median in a range of comparable royalty rates. The concluded rate simply needs to be justified by the data and circumstances, whether it is at the high end, low end or middle of the range. Cherry picking can also be evident in the selection and use of estimated growth rates, industry research reports or competitive patents.
As with the Incorrect Standard of Value error category, backing out the effect of this kind of error can be difficult without completely reconstructing the analysis, at least the portion associated with the suspected cherry-picked data. Once that adjusted analysis has been completed, the use of corrected data in the calculation should be fairly straightforward, whether it impacts a royalty rate, revenue growth or some other input.
#5 – Business Value vs. IP Value
Failure to distinguish between the value of the business and the value of the IP utilized by the business can have one of the largest relative effects on the accuracy of the valuation. Depending on the industry, this could increase the concluded value of the subject assets by several orders of magnitude.
|Figure 4 - Differentiating Between Enterprise Value and IP Value
|Total Enterprise Value
|Value of All Intangible Assets
|Value of Subject Patents
Some valuation techniques, such as the Relief from Royalty Approach, make this distinction between business value and IP value via the key inputs and how they are used. When the comparable royalty rates are specific to licensing a trademark, for example, they already distinguish between the IP and the overall business. On the other hand, other Income Approach related analyses may need to be adjusted or apportioned to differentiate between the two.
Overstating or understating the presence or impact of various intangible assets may also skew the results. For example, it needs to be recognized and incorporated into the analysis if the company has an extensive portfolio of trade secrets and know-how to go along with its large patent portfolio, or if it has decades-long relationships with key customers. These assets may enhance the value of key IP components or have tremendous value in their own right.
#6 – Ignoring Reality
In essence, the Ignoring Reality error category may encompass all of the others. However, there are specific instances of these kinds of errors that occur often enough so that their illumination is worth undertaking.
One of the primary instances of this kind of error is ignoring or failing to properly analyze the presence or absence of necessary complementary assets. If the IP valuation features a forecast of sales, does the company (or industry) have enough manufacturing capacity to support that level of activity? Is the forecasted activity consistent with the actual distribution capabilities that would be needed to achieve it? Would the entity need to add workers to be able to produce that volume of product and, if so, does the available workforce have the level of experience and education necessary? Finally, is there enough working capital in place or available to support the level of operations indicated by the forecast? If any complementary assets such as these are insufficient, the forecast may not be realistic and the resulting valuation conclusion may be too high. Oftentimes, the presence or availability of these complementary assets may be part of the underlying assumptions. As long as the reader of the valuation report understands that is the case, they can assess the accuracy and validity of the analysis and conclusions for themselves.
Other elements that may be covered by this error category are external to the parties involved in the hypothetical transaction rather than internal. Does the analysis acknowledge the state of the industry or economy at the relevant "as of" date? Is the competitive environment accurately portrayed and accounted for? For example, if a new product has been recently introduced by a key competitor, does the analysis reflect this? Similarly, have there been recent regulatory changes that impact the product or service associated with the subject IP? These and other elements, such as whether the subject IP is associated with a distressed operation or a going concern, should be captured by the construct of the analysis and the underlying context for the valuation. The assessment of the claims of a patent relative to competitive patents and product offerings may also be an area where the reality of the situation has not been accurately captured.
While some of these may only be differences of opinion and not true errors, these are all items of which the reader of the report needs to be aware. Correcting for these errors/differences of opinion may be as simple as adjusting an input or two, or it may require re-calculating everything.
#7 – Incomparable 'Comparables'
When an analysis utilizes comparable asset transactions, such as license agreements that feature similar trademarks or patents, the closer those agreements are to the set of circumstances encountered in the subject asset analysis, the better indicator of compensation or pricing they are likely to be. Some of the aspects of those license agreements that may be important, and therefore need to be understood, include the time-frame for the license (when it was negotiated and its duration), the geographic coverage of the license and underlying IP, the product categories covered by the license, the compensation structures found in the license (magnitude, timing and construct), any exclusivity or sub-licensing aspects of the license, any distribution channel requirements or restrictions and whether the license covers multiple assets or a single asset, among other things.5
If these elements in the comparable agreements do not closely match the parameters surrounding the IP being valued, adjustments may be necessary. For example, if the comparable agreements all pre-date the hypothetical transaction by several years, the terms of those agreements may be adjusted if there is an understanding of the changes/trends that have taken place during the interim.
Similar problems may crop up with the use of company proxies for inputs such as market share characteristics, operational aspects or product life cycles. The better and more comprehensive the disclosure of the terms associated with the comparables, the better positioned the report reader is to understand the accuracy and validity of the analysis and concluded values.
|Figure 5 - Important Elements In Comparable License Agreements
|• Date of Agreement
|• Assets Covered
||• Product Categories
|• Distribution Channels
||• Milestone Payments
|• Marketing Requirements
||• Guaranteed Amounts
|• Upfront Payments
||• Royalty Base
#8 – Duration Mismatch
Duration matching problems typically manifest themselves in remaining useful life assumptions and discount rate determinations. The remaining useful life assumption may ignore the impact of potential obsolescence or the limiting effects of product life cycles, in which case it would be too long. Similarly, it may disregard the heritage, awareness and longevity of a well-known trademark or the full term of a relevant license, in which case it may be too short. The selection of the remaining useful life should be consistent with these important data.
The inputs used to determine the discount rate should also be consistent with these factors. When assessing the risk of achieving the projected cash flows, the yield associated with a two-year Treasury note does not capture the time-value-of-money risk component for a ten-year cash flow projection. Likewise, a 20-year Treasury bond is too long when the IP is associated with a product that has a two-year life cycle.
Correcting for these kinds of errors simply requires substituting the correct information for the incorrect information. One needs to make sure that all downstream calculations are reworked as well.
#9 – Inaccurate Risk Profiles
The time-value-of-money component is not the only part of the risk assessment that analysts get wrong when conducting IP valuations. They may miscalculate specific inputs such as the premiums associated with the size of the subject organization or the asset class. They may also fail to correctly ascertain the proper capital structure. Any of these errors may yield a discount rate that is too high or too low, thereby misconstruing the level of risk associated with achieving the forecasted cash flows and understating or overstating the value of the IP, respectively.
There may also be risks that are specific to the subject asset or the products and services for which it is associated. For example, new competitive products may be entering the market (a recent example: music downloads versus CDs) or changes in the economy may impact the desirability of certain products that feature a particular patent or trademark (e.g., the impact of higher gasoline prices on the sale of large SUVs).
Unless these risk aspects have been properly analyzed and accurately incorporated into the calculations, the resulting value conclusions may be off the mark.
#10 – Incorrect Expense Treatment
Finally, the proper treatment of expenses may have a significant impact on the calculation of IP values or damages. Typical problems include using a fully-loaded expense profile in a situation that requires an incremental expense profile, or vice versa, or a failure to include relevant expenses in situations such as a licensing operation.
Generally, incremental expenses are used when the products or services that are related to the subject IP only account for a relatively small fraction of the entity's operation. With exceptions, incremental expenses are also typically called for when ascertaining the lost profits associated with a patent or trademark infringement. However, if the fixed expenses are allocated by the company to the level of specificity needed in the analysis, whether that is the operating division or SKU, then that information should be utilized.
There are numerous instances in which a valuation has been conducted that utilizes royalty cash flows, but the corresponding expenses associated with the projected licensing operation are ignored. These expenses may include maintenance fees for keeping the registrations current; management and administrative expenses for dedicated personnel; legal expenses for registration applications, prosecutions and rights enforcement; and marketing expenses borne by the licensor.
Here again, correcting for this kind of error may be as simple as substituting the correct information for the incorrect information and revising the calculations accordingly.
|Figure 6 - Effect of Different Expense Treatments
|Applicable Cash Flow
With the knowledge that these kinds of errors and omissions often find their way into IP valuation and damages reports, the consumer of these analyses is better prepared to keep an eye out for them and understand how they impact the concluded value. Hopefully, this list of potential errors may also help analysts avoid making these kinds of mistakes in the first place. With both the analyst and the client aware of potential pitfalls, perhaps Company A's ultimate decision will be based on accurate information, and costly mistakes such as overpaying for the assets or needlessly passing on the deal will be circumvented.
- For example, see Intellectual Property Valuation Techniques at www.ipmetrics.com/IPVT.pdf.
- One of the primary sources for this definition is Revenue Ruling 59-60 from the Internal Revenue Service.
- Schweihs, Robert P., "Measuring Lost Profits Economic Damages on a Pretax Basis," Summer 2010 Insights, pages 10–11.
- For example, as is presented in the Federal Circuit Bar Association Model Patent Jury Instructions. (www.fedcirbar.org), page 60.
- Oftentimes, patents and trademarks are covered by the same license. There may also be several patents or trademarks covered within a single license.