1. Valuation of IPR 9th Feb 2008 Audit.Tax.Consulting.Financial Advisory
Presented by Deepika Maheshwari
Financial Advisory Services
Deloitte Haskins & Sells, Ahmedabad
9th Feb 2008
Audit.Tax.Consulting.Financial Advisory
This document is confidential. No part of it may be be reproduced without express approval of Deloitte. © Deloitte 2008.

2. Overview
Basics of Intellectual property rights
Importance of Intellectual property rights
Management of IPR
Valuation of IPR

3. Intellectual Property Rights- Basics
Increasing investment in Intangibles.
Shift in focus from Physical capital to Intellectual capital
“Value of firm= Value of physical Assets+ Value of intangible assets”
Value of Intangible Assets
Value of future growth opportunities that are already in place
Value of future growth opportunities from new assets
Only a fraction of worldwide R&D spending is commercialized ; enormous pool of innovation lies unused
Many great ideas never see the light of day. Despite substantial resources in R&D, yet many of their best innovations are never sold.
The untapped technologies and know-how could be turned into substantial revenue.
An example of second componet would be a patent resulted from R&d invetemnt already made.
Example of third component would be a product that may be discovered or developed from future investments that may be made.
Assets already in existence enable the firm to compete for the world as it exists.
Future investments in assets can create growth opportunities which enable a firm to compete for the future.

4. Intellectual Property Rights- Importance
Source Of unexpected revenue
Increases Shareholders Value
Establishes Proprietary Market advantage
Enhances Competitiveness
Exploits new market opportunities
Reduces risk

5. Intellectual Property Rights- Management
Valuation Approaches:
Accounting
Residual Value
Cost
Market value
Income
Real option
Identify
Design
Process
Method
Software
Trade Secrets
Know-how
Trademarks
Brand names
Formulations
Literary work
IP Trading
M&A
IPO/Fund raising
Financial Reporting
Licensing-In
Licensing-Out
Contract/ Royalty rates
Transfer Pricing
Litigations
Technology transfer
Patents
Copyrights
Design
Trademarks
Publishing rights
Source: Deloitte Research
To be able to reap benefits out of IP, a sound IP management programme is required

6. Valuation
“The intangibility of a company’s most important assets makes it extremely hard to figure out what the company is really worth.”

7. Valuation Parameters What
Patents, Copyrights, Designs, Trade secrets, Know how, Trade marks, Brand name
What is the IP to be valued
Shareholders, Management, Licensor/Licensee, Investor, Court of Law, Acquiror , Investment banker
Whom
For whom the valuation is being done
Corporate valuation for shareholders, M&A, Management buy-out or buy-in, IPO/Fund raising, Financial Reporting, Acquisition/Licensing of IP, Litigations,, and reorganization
Why
Why the firm has decided to value IP rights (Purpose)
For the valuer, this process of understanding is not usually a problem when these rights have been formally protected through trademarks, patents or copyright.  This is not the case with intangibles such as know how, (which can include the talents, skill and knowledge of the workforce), training systems and methods, designs, technical processes, customer lists, distribution networks etc.  These assets are equally valuable but more difficult to identify in terms of the earnings and profits they generate.  With many intangibles a very careful initial due-diligence process needs to be undertaken together with IP lawyers and in-house accountants. 
How
How the valuation would be done in given circumstances
Different approaches to valuation may be used

8. Understand Important features of IP and how it adds value to business
While valuing IP…
Understand the value chain of business and understand how profits are generated
Understand Important features of IP and how it adds value to business
Obtain Adequate knowledge of trends in the industry and technology
Consider scope & Strength of IP asset
Assess the availability of competing IP in the market
Ascertain the unpredictability of future returns
Manufacturing
Patent
Distribution
Sales
Brand
Scope of legal rights protecting the asset
Level of codification: How effectively the codified information may be used
Level of difficulty in infringing the Products IP rights

9. Valuation- A Daunting task
No active market for trading of intangible assets
Difficult to identify the potential earnings and profits that can be generated
Uniqueness of each IPR – Non Comparability
Difficult to Segregate profits generated from tangibles and intangibles.
Difficult to ascribe appropriate economic benefit to an individual IP Asset if there are more than one IP.
Inadequate disclosure of Intangibles in financial reports
Most valuation methods ignore managerial flexibility
For the valuer, this process of understanding is not usually a problem when these rights have been formally protected through trademarks, patents or copyright.  This is not the case with intangibles such as know how, (which can include the talents, skill and knowledge of the workforce), training systems and methods, designs, technical processes, customer lists, distribution networks etc.  These assets are equally valuable but more difficult to identify in terms of the earnings and profits they generate.  With many intangibles a very careful initial due-diligence process needs to be undertaken together with IP lawyers and in-house accountants. 

10. Valuation Methods

11. Valuation Methods Static valuation models Dynamic valuation models
Accounting Approach
Income Approach/Discounted cash flow
Decision tree Analysis
Cost Approach
For the valuer, this process of understanding is not usually a problem when these rights have been formally protected through trademarks, patents or copyright.  This is not the case with intangibles such as know how, (which can include the talents, skill and knowledge of the workforce), training systems and methods, designs, technical processes, customer lists, distribution networks etc.  These assets are equally valuable but more difficult to identify in terms of the earnings and profits they generate.  With many intangibles a very careful initial due-diligence process needs to be undertaken together with IP lawyers and in-house accountants. 
Real Option Model
Market Approach
Monte carlo Simulation

12. Accounting Approach IPRs are subset of Intangible Assets
As per AS-26 issued by ICAI, the recognition of an item as an intangible asset requires an enterprise to demonstrate that the item meets the:
“definition of an intangible asset and
recognition criteria set out in the standard”
As per definition Intangible asset should be
Identifiable
Controllable
Able to generate economic benefits
An intangible asset should be recognized if, and only if:
it is probable that the future economic benefits that are attributable to the asset will flow to the enterprise; and
the cost of the asset can be measured reliably.
definition of Intangible asset is as follows:
“An intangible asset is an identifiable non-monetary asset, without physical substance, held for use in the production or supply of goods or services, for rental to others, or for administrative purposes.”
Identifiability
11. The definition of an intangible asset requires that an intangible asset be
identifiable. To be identifiable, it is necessary that the intangible asset is
clearly distinguished fromgoodwill. Goodwill arising on an amalgamation inthe nature of purchase represents a payment made by the acquirer in
anticipation of future economic benefits. The future economic benefitsmay
result from synergy between the identifiable assets acquired or from assets
which, individually, do not qualify for recognition in the financial statements
but for which the acquirer is prepared to make a payment in the
amalgamation.
12. An intangible asset can be clearly distinguished from goodwill if the
asset is separable. An asset is separable if the enterprise could rent, sell,
exchange or distribute the specific future economic benefits attributable to
the asset without also disposing of future economic benefits that flow from
other assets used in the same revenue earning activity.
13. Separability is not a necessary condition for identifiability since an
enterprise may be able to identify an asset in some other way. For example,
if an intangible asset is acquired with a group of assets, the transaction may
involve the transfer of legal rights that enable an enterprise to identify the
intangible asset. Similarly, if an internal project aims to create legal rights for
the enterprise, the nature of these rights may assist the enterprise
in identifying an underlying internally generated intangible asset. Also,
even if an asset generates future economic benefits only in combination
with other assets, the asset is identifiable if the enterprise can identify
the future economic benefits that will flow
Control
14. An enterprise controls an asset if the enterprise has the power to obtain
the future economic benefits flowing from the underlying resource and also
can restrict the access of others to those benefits. The capacity of an
enterprise to control the future economic benefits from an intangible asset
would normally stem from legal rights that are enforceable in a court of law.
In the absence of legal rights, it is more difficult to demonstrate control.
However, legal enforceability of a right is not a necessary condition for
control since an enterprise may be able to control the future economic
benefits in some other way.
15. Market and technical knowledge may give rise to future economic
benefits. An enterprise controls those benefits if, for example, the
knowledge is protected by legal rights such as copyrights, a restraint of trade
agreement (where permitted) or by a legal duty on employees to maintain
confidentiality.
An enterprise may have a team of skilled staff and may be able to
identify incremental staff skills leading to future economic benefits from
training. The enterprise may also expect that the staff will continue to make
their skills available to the enterprise. However, usually an enterprise has
insufficient control over the expected future economic benefits arising from
a team of skilled staff and from training to consider that these items meet the
definition of an intangible asset. For a similar reason, specific management
or technical talent is unlikely to meet the definition of an intangible asset,
unless it is protected by legal rights to use it and to obtain the future
economic benefits expected from it, and it also meets the other parts of the
definition.
17. An enterprise may have a portfolio of customers or a market share
and expect that, due to its efforts in building customer relationships and
loyalty, the customerswill continue to tradewith the enterprise. However, in
the absence of legal rights to protect, or other ways to control, the
relationshipswith customers or the loyalty of the customers to the enterprise,
the enterprise usually has insufficient control over the economic benefits
fromcustomer relationships and loyalty to consider that such items (portfolio
of customers, market shares, customer relationships, customer loyalty) meet
the definition of intangible assets.
Future Economic Benefits
18. The future economic benefits flowing from an intangible asset may
include revenue from the sale of products or services, cost savings, or other
benefits resulting from the use of the asset by the enterprise. For example,
the use of intellectual property in a production process may reduce future
production costs rather than increase future revenues.

13. Accounting Approach- Acquisition
Valuation
Cost of intangible would be the purchase consideration paid either in form of cash or in Fair value of shares or assets exchanged
Cost =Purchase consideration+ Import Duty+ Taxes+ Any direct attributable exp.
Separate Acquisition
Valuation
Allocation of purchase consideration to individual identifiable assets (including IPs) and liabilities based on their fair values at amalgamation date
Valuation method must:
Estimate Fair Value, and
Reflect current transactions and practices in industry
As a part of Amalgamation
Internally Generated Goodwill
35. Internally generated goodwill should not be recognised as an
asset.
36. In some cases, expenditure is incurred to generate future economic
benefits, but it does not result in the creation of an intangible asset thatmeets the recognition criteria in this Statement. Such expenditure is
often described as contributing to internally generated goodwill.
Internally generated goodwill is not recognised as an asset because
it is not an identifiable resource controlled by the enterprise that can
be measured reliably at cost.
37. Differences between the market value of an enterprise and the
carrying amount of its identifiable net assets at any point in time may be due
to a range of factors that affect the value of the enterprise. However, such
differences cannot be considered to represent the cost of intangible assets
controlled by the enterprise.
Judgement is required to determine whether the cost (i.e. fair value) of
an intangible asset acquired in an amalgamation can be measured with
sufficient reliability for the purpose of separate recognition. Quoted market
prices in an active market provide the most reliable measurement of fair
value. The appropriate market price is usually the current bid price. If
current bid prices are unavailable, the price of the most recent similar
transaction may provide a basis from which to estimate fair value, provided
that there has not been a significant change in economic circumstances
between the transaction date and the date at which the asset's fair value is
estimated.
29. If no active market exists for an asset, its cost reflects the amount that
the enterprise would have paid, at the date of the acquisition, for the asset in
an arm's length transaction between knowledgeable and willing
parties, based on the best information available. In determining this
amount, an enterprise considers the outcome of recent transactions for
similar assets.
30. Certain enterprises that are regularly involved in the purchase and sale
of unique intangible assets have developed techniques for estimating their
fair values indirectly. These techniques may be used for initialmeasurement
of an intangible asset acquired in an amalgamation in the nature of purchase
if their objective is to estimate fair value as defined in this Statement and if
they reflect current transactions and practices in the industry to which the
asset belongs. These techniques include, where appropriate,
applying multiples reflecting current market transactions to certain
indicators driving the profitability of the asset (such as revenue, market
shares, operating profit, etc.) or discounting estimated future net cash
flows from the asset.

14. Accounting Approach – Valuing Internally Generated IP
ECONOMIC BENEFITS
Research Phase
Development Phase
Commercial Phase
EXPENSES
Direct + Indirect
Expensed
Capitalized
Expensed
Technical feasibility
Intention to complete and use/sell
Ability to use/sell
Probable future economic benefits
Resource availability
Ability to measure
Available for use
Internally generated goodwill can not be recognized as an intangible asset

15. Cost Approach Historical cost trending Method Assumptions :
Cost to purchase or develop new property is commensurate with the economic value of service
An investor would pay no more to purchase an asset than would be required to reproduce the asset
Recreation Cost Method
Value
(Rs)
Helpful information:
Scientists and engineers who worked on the product development effort
Salaries and benefits of people involved in the project
Overhead costs for utilities and research space
Overhead costs for clerical support and technicians
Cost of inputs used in the development process
Prototype construction and testing expenses
Outside services for independent evaluation and certifications
Lack of accurate record keeping often requires this approach
Technical risk: If the buyer chooses to develop an IP alternative, there is no certainty that the alternative would work as successfully or enjoy the same level of IP protection as the IP asset in question
Factoring Technical Risk: probability of failure = 40%
Risk Premium = 100/(100 – 40) = 1.67
Replacement cost method
This method seeks to measure the future benefits of IP assets by calculating the amount of money that would be required to replace the future service capability of the subject intellectual property

16. Cost Approach- Examples
Historical Cost
Replacement Cost
Example : Cost incurred on R&D to develop a new technology know-how: INR 100 for Y1 and INR 200 for Y2
Inflation index: Y1 = 100, Y2=105, Current = 110
Estimated Value of IP
100 x 110/ x 110/105 = INR 320
Example : Cost incurred on R&D to develop a new technology know-how: INR 100 for Y1 and INR 200 for Y2
Inflation index: Y1 = 100, Y2=105, Current = 110
Chances of Success : 60%
Estimated value of IP would be (100 x 110/ x 110/105)/0.6 = Rs 533
Historical cost is the actual cost incurred in creating and developing an intellectual property . Funds invested to be factored with “time cost” of money
It provides a guide for minimum return needed to justify an investment in an IP asset but it should not be the sole basis for valuing an IP asset

17. Cost Approach- Pros & Cons
Good for internally developed intangibles or in liquidation scenario
When comparable market data is not available
When intangible is not income producing
Requires numerous adjustment to financial data
Difficult to apply if historical records are not there
No direct correlation between price and value
Risk is not factored
No direct correlation between expenditure and economic benefit e.g
Early stage R&D and patenting can be very costly, but the process or product may never be commercialized.
Minimal investment in IP, but sudden market growth leads to increase in revenues.
No emphasis on duration over which the economic benefits would be utilized
Lesser the economic life, lesser the valuation
Risk associated with receiving the expected economic benefits is not directly factored
More the risk, lesser the valuation
Information about trend of economic benefits
More valuation of an IP with increasing growth trend and vice versa

18. Market value Approach – Comparable Market value
Value of an IP = prices paid for comparable IP as part of arm’s length transactions
The transaction price, as a ratio of an asset attribute such as sales, is used to derive a market multiple
This market multiple is then applied to the attribute of the asset being valued
Requirements
Active market involving comparable property
Past transactions of comparable property
Access to price information at which comparable property exchanged
Arm’s length transactions between independent parties

19. Market value Approach – Comparable Market value
Factors to be considered while comparing
Industry
Market Share
Profits
Impact of New Technologies
Barriers to Entry
Growth Prospects
Strength of Legal Protection
Remaining Economic Life

20. Market value Approach – Comparable Market value
Annual sale of products with ‘XYZ’ trademark = INR 100
Comparable transaction: Purchase of 32 medical remedy trademarks by M&J Labs for INR Annual sale of all 32 trademarked products just prior to purchase was INR 4000
Value-to-sales multiple of comparable trademark = 5000/4000 = 1.25
Value of ‘XYZ’ trademark = Annual sale from ‘XYZ’ trademarked products x Value-to-Sales multiple of comparable trademarked products
= INR 100 x 1.25
= INR 125
Objective: To value a trademark ‘XYZ’ of a pharma co. ‘Pharma Co.’.
Solution

21. Market value Approach- Pros & Cons
Relatively easy to apply
Conceptually attractive
Provides evidence of value
Most of the information is not publicly available
Low Frequency of comparable transactions
Each intangible transaction is unique.
Frequency of transactions
Evidence of an active market?
Comparability of “market” transactions
Transactions of specific IP are scarce
licenses, more often than sale/assignment of IP
circumstances of transaction (e.g. cross-license, license agreed in settlement of litigation)
Headline data only?
Summary royalty terms, but what about the rights and obligations under the license?
Summary transaction terms, but what about manufacturing and distribution contracts?

22. Residual Value Approach
Starts with the company’s value of equity (as measured by its stock price) plus the value of its liabilities.
From such amount, value of the company’s tangible assets, plus the value of any intangibles not transferred (Unidentifiable Intangible Assets) is reduced. The result is the lump-sum value of the intangibles being valued.
Value of IP = MC-(N+U)
Where MC= Market Capitalization
N= Net Tangible Assets as shown in book (Total assets- total liabilities)
U= Unidentifiable Intangible Assets
Assumption : Markets are efficient. i.e, all future economic benefits from assets (tangible and intangible) and IP of the firm are factored into the market price of firm’s equity and debt
Drawback: Valuation would fluctuate with market. IP assets would not be valued individually. Is the market really efficient to factor in all the benefits

23. Income Approach Variations Method Premium Pricing method
Premium over generic product/services
Excess earnings over the company that does not possess intangible
Excess Profit method
License fee/ Royalty saved by owning the intangible
Royalty saving method
Key parameters:
Economic benefits
Discount rate
Economic life
This component measures the compensation of investor for commitment of capital. Must be commensurate with the risk of economic benefits
Factors that affect this component include inflation, liquidity, real interest rates and measures of relative risk.
K = r + u + a
Where r = risk-free rate (time value)
u = firm specific risk
a = risk differential between IP and firm risk
As per Dividend Growth model
K = Div/P + g
As per CAPM model
E(r) = Rf + ß (Rm – Rf)
Factors affecting economic life:
Technological breakthroughs
Government regulations
Changes in market dynamics
Cost saved by owning the asset
Cost savings method
Value of IP = Present Value of expected future economic benefits from ownership of IP

24. Approaches Direct Capitalization Discounted Future Economic Benefits
Estimate an appropriate measure of economic benefit for one period future to the valuation date and multiply it by an appropriate capitalization rate (r)
r = 1/discount Rate
Where, r is a measure of economic benefit
Does not consider future economic benefits
Discounted Future Economic Benefits
Value of IP =
Economic Benefit Period 1
Economic Benefit Period 2
Economic Benefit Period n
(1 + k)1
(1 + k)2
(1 + k)n ..
Plus
The terminal value of the business at the terminal year
TV = Economic Benefit n
(K - growth)*(1+k)^n

25. Source: Damodaran online
Illustration
Year
Stable Cash flows
Present 7%
Volatile Cashflows
Present 10% 1
60,000
56,075
90,000
81,818 2
52,406
74,380 3
48,978
67,618 4
40,000
30,516
40,981 5
28,519
37,255
Total
216494
302053
The book is expected to generate $150,000 in after-tax cash flows for the first three years and $100,000 a year for the following two years. These are the cash flows after author royalties, promotional expenses and production costs.
About 40% of these cash flows are from large organizations that make bulk orders and are considered predictable and stable. The cost of capital applied to these cash flows is 7%. The remaining 60% of the cash flows are to the general public and this segment of the cash flows is considered much more volatile. The cost of capital applied to these cashflows is 10%.
Source: Damodaran online

26. DCF Approach- Pros & Cons
Captures economic benefit flowing due to Intangibles
Considers appropriate risk based rate of return at which to discount cash flows and estimates economic life
Reliable financial projections
Estimating income attributable to intangibles, its economic life, appropriate discount rate/ cost of capital
Use of same discount rate in R&D as well as Market phase
Managerial flexibility is completely ignored
No accommodation to option like nature of investments
Reliable financial projections
Estimating income attributable to intangibles, its economic life, appropriate discount rate/ cost of capital
Using of same discount rate in R&D as well as Market phase
Managerial flexibility is completely ignored
No accommodation to option like nature of investments
Valuation process:
Forecast income and costs associated with using the property over the life of the property
Compute Net Present Value of future cash flows (use appropriate discount rate reflecting risk of investment)

27. Matrix- Accounting for Risk & flexibility
Valuation process:
Forecast income and costs associated with using the property over the life of the property
Compute Net Present Value of future cash flows (use appropriate discount rate reflecting risk of investment)
Source:Crystal ball confrence

28. Source:Crystal ball confrence
Real option model
Investment in intangibles does not generate immediate payoff
Each intangible may have a bundle of options
Valuation process:
Forecast income and costs associated with using the property over the life of the property
Compute Net Present Value of future cash flows (use appropriate discount rate reflecting risk of investment)
Source:Crystal ball confrence

29. Decision Tree Analysis
Patent failed
P = 0.70
NPV5= (0.20 x NPV x NPV2)
Lapse
P = 0.20
NPV1
Patent
Application
Cost
Product fails
P = 0.20
Low
Revenue
P = 0.40
NPV10 = NPV9 x0.3 - Cost
Patent
granted
P = 0.30
Renew
P = 0.80
NPV2
Product
Success
P = 0.80
NPV8= NPV7 x0.8
Status Quo
P = 0.60
NPV3
High
Revenue
P = 0.=60
NPV7= NPV5 x0.4 + NPV6 x 0.6
File patent
in UK
P = 0.40
NPV4
NPV6= (0.60 x NPV x NPV4)
Application to Grant
Grant to
Commercialization
End of first year of
commercialization
PHASES

30. Real Option Technique Valuation under uncertainty
Use Black-Scholes (1973) Option Pricing Model
Option parameters
Value of Underlying = Present Value of Economic Benefits
Exercise Price = PV of investment in IP
Time to Expiry = Remaining economic life of IP
Standard Deviation = Standard Deviation of Economic Benefits
Risk free Rate = Riskless interest rate that corresponds to the economic life of IP
Dividend (Value Leakage) = 1/Economic Life of IP

31. Patent Payoff Diagram Net payoff from Patent
PV of Cost of developing and commercializing the Patent
Present Value of Economic Benefits from Patent

32. Problems
Estimation of future economic benefits
Economic benefits may not follow a continuous process
Variance may be unknown and may change over the economic life of IP
Exercise may not be instantaneous
Compound options

33. Source: Damodaran website
Categorizing Valuation
Independent and Cash flow generating intangibles
Not independent and cash flow generating to the firm
No cash flows now but potential for cashflows in future
Examples
Copyrights, trademarks, licenses, franchises, professional practices (medical, dental)
Brand names, Quality and Morale of work force, Technological expertise, Corporate reputation
Undeveloped patents, operating or financial flexibility (to expand into new products/markets or abandon existing ones)
Valuation approach
Estimate expected cash flows from the product or service and discount back at appropriate discount rate.
Compare DCF value of firm with intangible with firm without (if you can find one)
Assume that all excess returns of firm are due to intangible.
Compare multiples at which firm trades to sector averages.
Option valuation
Value the undeveloped patent as an option to develop the underlying product.
Value expansion options as call options
Value abandonment options as put options.
Challenges
Life is usually finite and terminal value may be small.
Cashflows and value may be person dependent (for professional practices)
With multiple intangibles (brand name and reputation for service), it becomes difficult to break down individual components.
Need exclusivity.
Difficult to replicate and arbitrage (making option pricing models dicey)
Source: Damodaran website

34. Concluding Remarks
IP valuation calls for co-ordinated efforts from a CA, IP attorney, and a technology person
Adopt as many appropriate valuation techniques as possible, understand the pros and cons of each valuation method, and make a best estimate

35. Thank You Deloitte Haskins & Sells ‘Heritage’, 6th Floor
Near Gujarat Vidhyapith
Off Ashram Road
Ahmedabad
Gujarat
Deepika Maheshwari
Assistant Manager