Knowledge to Money – IP Valuation
HGF has been asked to include intellectual property (IP) valuation as a topic at its IP in Healthcare Conference on a few occasions now. So this article sets out to give you a high level introduction to IP valuation and what you can do to help yourself.
Why value IP?
Most commonly we tend to think about IP valuation in the contextof transactions. These may be licences, assignments, business sales – whether a sale of the whole business or the issue of shares to a new investor. The transaction might be some type of securitisation to raise finance. You may also find yourself having to value IP in the context of transfer pricing, for instance, where you license IP to an overseas affiliate. In that case you should discuss the valuation with your accountants to make sure you satisfy the transfer pricing requirements of the relevant tax authorities. IP also has to be valued where there has been litigation in relation to it. There are many cases setting out the details of how that valuation will be done. This article will focus on IP valuation for transactions.
Art or Science?
IP valuation is certainly a science to the extent that it involves financial analysis. It does not just involve numbers though. That financial analysis will be based on assumptions and use of historic data. It is true that there is a lot of uncertainty at the early stage of IP development. If you are at the latter stage of development, it can be difficult to separate IP and non-IP contributions. How precise can you be? The argument is that it is just opinion and not scientific calculation.
Is it worth doing a valuation? It is. Your aim is to bring as much science as you can to the valuation and the assumptions which go into it. You want a valuation that is as informed as you can make it. If you go into any negotiation without having made any effort to think about the valuation, then you are just waiting for the other side to tell you what number they think is appropriate. You wouldn’t do that with other provisions of the deal.
How to value IP
The type of approach you take will vary depending upon the nature of the IP involved in your transaction. Your method of valuation will be based upon the information which is available (or potentially available) to you. You will have more information about the value of your IP if, for instance, you are in Phase III clinical trials than if you are still pre-clinical. Trying to estimate the amount that might be paid for the ultimate therapy when it goes to market is much more difficult the earlier you are. The biggest constraint, however, is often your budget. If you have the money available, you can hire a professional valuer, who may be an accountant, to produce a valuation of your IP. The cost of this, however, can be prohibitive for many early stage businesses. So, you have to think about what you can do for yourself.
There are three main methods used to value IP from a quantative perspective.
This method looks at how much it would cost to replace the capability provided by your IP. This is not the same as the original cost of the IP. If, for instance, you are looking to license or assign some software, you need to know at what point the price you are asking is more than it would cost the licensee / purchaser to get someone to write a completely new programme having the same capability as your software, without copying any of the code from your software. Without anything else, it sets a notional ceiling on the amount which you can charge (and a floor below which you may not want to go). The cost method does not take account of any market factors. However, as well as the cost to replace the software, the licensee / purchaser will need to pay an amount to reflect the fact that they can have that software today, rather than having to wait for new software to be written. This method is rarely a method used to value patents because of the monopoly which a patent gives you in the market.
This method is sometimes called comparables, because you are looking for deals in the market which are comparable to the one that you are proposing to do. The big issues with this method are:
• Are there enough transactions which have been done which are similar enough to your deal? If you are buying a house, you tend to look at sales of other houses on the same street. The variables with IP deals are much more numerous though.
• If there are enough transactions, is enough of the information in the public domain? Deals often publish headline rates for licences, perhaps giving a combined figure for up front and milestone payments, but may not publicise an actual royalty rate.
• If the information is public, is it truly representative? Most of us only publicise our better deals. So, the ones that you tend to have the most information about tend to be at the top end of the market.
Even when you have found a deal or deals which are comparable, you need to remember that values can change. If a licence charges a fixed sum per product sold, that sum may have been eroded by inflation over time. It is also true that with new exciting areas of technology the amounts paid in earlier days can be higher than downstream, when those technologies become more the norm.
This method looks at the anticipated net economic returns from a bundle of IP over a given time – usually called its useful life. Here you are looking at the time value of money. An agreement to pay you a £1,000 today is worth more to you than agreement paying you a £1,000 in 12 months’ time. The money you were due to get in 12 months’ time has risk inherent in it. Its value will be eroded by inflation. There is also the possibility that you might never get the money at all. So, the income method uses the approach of discounting the future cashflow to assess its value at today’s date. In order to do this it applies a discount rate to those future sums. Ultimately you finish up with the Net Present Value (NPV) of your IP.
NPV = Cashflow − initial investment
i=Required return or discount rate
t=Number of time periods
If maths is not your strong point then the above formula can look a little challenging. In reality at a simple level you just need a spreadsheet in which you list the amount you expect to receive in each year, less the expenses you expect to incur in that particular year. You then discount that net amount per year by the chosen discount rate. The result of each of those sums for each year is then aggregated to come up with the NPV.1 There are tools available online which are already set up to do these discounted cashflow (DCF) calculations and you simply have to input the numbers.2
The discount rates will vary from deal to deal. The sort of risks which you need to be thinking about, which will feed into the size of the discount rate, are:
• Is your technology for a medicine (more risky) or a medical device (often less risky than a medicine)?
• The development stage of your product – are you near to market (less risky) or still a long way off (more risky)?
• The size of your business – the smaller you are the more risky your business is likely to be seen to be.
• Regulatory and commercial risks.
A variation of NPV is risk–adjusted NPV (rNPV). rNPV assesses success at various stages. It factors in the often significantly varying probabilities of technical and regulatory success. If you are using any professional valuer you may come across even more variations of the NPV method:
• Monte Carlo Analysis – the NPV calculation is repeated many times with different probabilities, such as a best, medium or worse case scenario. The multiple NPVs obtained are then plotted to show the most likely NPV.
• Real Options Method – the calculation takes account of the option at different stages to develop the product further or abandon it.
Rule of Thumb
This is less a method of valuation and more away of looking at how that ultimate value is shared between a licensor and licensee in a licensing deal. It emanates from the consumer electronics industry. Robert Goldscheider found that his deals generally resulted in a 25:75 split between the licensor and licensee of the licensee’s net profit from the licensed IP. This 25:75 split has varied up and down over the years and from transaction to transaction, depending upon how much work the licensee has to input compared to the licensor in order to get the product to market. The Rule of Thumb has its fans and those that decry it. It was rejected as a method of calculation some years ago in the U.S. for litigation3 but it still continues to be used to this day in many deals.
The Global Lifesciences Royalty Rates & Deal Terms survey of 2018 carried out by the Licensing Executive Society (USA and Canada), Inc.4 concluded that Comparables (Market Method) was the most frequent valuation method used in the deals that it looked at (50%) followed by rNPV (27%) and NPV (12%).
Any valuation of IP involves a mix of both quantitative and qualitative factors. You cannot look at the two types of factors in isolation. However, much you crunch the numbers, you will need to think about some more qualitative issues. As with everything else about your business, you are going to be doing a due diligence exercise on your IP – essentially carrying out a SWOT analysis.
As IP is what you are valuing, you will have to assess the strength of the IP which you have. For instance, if your IP is a patent, you may want to look at the number of forward and backward references there have been to that patent, to demonstrate the importance that others are giving to it. You will want to be able to show that your patent is directly relevant to the therapy that you are trying to bring to market. If your patent is for a new chemical entity (NCE), do you have a claim which directly claims that NCE? Do you also have claims which are broader, enabling you to protect what you have and prevent somebody else being able to work around your patent? Has your patent been subject to an opposition and were you able to withstand that threat? These are all things that you may want to weave into the story to support your valuation.
There are many other factors which can affect the value of your IP such as:
• stage of development;
• technical risk;
• regulatory risk;
• commercial risk;
• useful life;
• future competitive advances;
• transaction issues.
Identify your strengths and weaknesses in all of these areas. If they are strengths, make sure that you emphasise them in the course of your negotiations. If they are weaknesses, address what you have done to mitigate them.
You may, for instance, be a very early stage company. However, if you have already investigated the issues which will arise when going through clinical trials and submitting your application for regulatory approval and have a clear plan as to what you need to do to address those issues you will strengthen the value of your IP. Do you know what competing therapies are out there? Are there technologies coming through that may give rise to new competing therapies?
Have you factored in how you will move existing users / payers to replace the existing therapies with your therapy? Are there any costs involved with making that switch? Have they been taken into account in your calculations? Have you got a full understanding of what the useful life is of your IP? You are not just looking at the patent period, but also potential patent term extensions / supplementary protection certificates. In addition, there are the data and market exclusivity periods, which sometimes can become more valuable than the patent itself, particularly in the case of orphan drugs. With many therapies you will have created improvements to the initial technology which was developed. So, do you have any secondary patents which will further extend that useful life?
Are there other IP rights that may be relevant to your product, such as designs and/or trade marks? These can be particularly relevant in the case of medical devices. It is also important not to forget knowhow. There is often good manufacturing know-how. Sometimes it can be extremely difficult for a third party to manufacture a particular therapy even when it has come off patent.
Many things can impact a transaction. As with any deal bargaining power has an enormous role to play. If you are an early stage company, it is all too easy to see yourself as the tiny minnow. However, sometimes your technology can be critical for the large pharmaceutical or medical device company. It may even be that more than one big player would like to acquire what you have. So, then the valuation which you may have calculated may increase. You should be factoring in a premium as that bargaining power seesaw tips in your favour.
You now have the tools to develop a valuation for your IP as well as the arguments to support it. It pays to bear in mind the words of Dr Richard Razgaitis5: “Valuation requires an intermediate perspective between ignorance and certainty, involving the exercise of skill, experience and judgment.” There is no such thing as the right or wrong valuation, just the best valuation you can achieve.
1 For a simple guide to calculating NPV see https://www.mathsisfun.com/money/net-present-value.html
2 e.g. https://www.investopedia.com/calculator/netpresentvalue.aspx
3 Uniloc USA, Inc. v. Microsoft Corp. 632 F.3d 1292
4 https://cdn.ymaws.com/www.lesusacanada.org/resource/ collection/005B37B7-4F59-4978-ABC999DAFC6F6F46/2018_Life_Sciences_Royalty_Rate_Deal_Survey_-_Executive_Summary.pdf
5 An individual with over 40 years’ experience of dealing with valuation in the pharmaceutical sector who has written four books on valuation and negotiation/deal making