CLAYTON G. SHULTZ, FCBV, FCA
APRIL 12, 2002
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little paper is directed at providing guidance to lawyers
whose clients are selling or acquiring rights to intellectual
property or other intangible assets. These transactions
frequently involve the granting of a license to market
or use the property for a specific or indefinite period.
The principal focus of my comments is on those properties
that have yet to prove their commercial viability.
Valuation issues, with respect to mature technologies
with established track records that demonstrate a capacity
to contribute cash flows, are usually able to be valued
using the conventional techniques of discounted cash
flows or market capitalization.
Lawyers do not (and should not) prepare the valuation
calculations nor do they always advise their clients
on the business aspect of the transaction. This paper
will suggest that an important value-added service could
be provided to most clients, whether they be vendor
or purchaser, by lawyers who understand the valuation
underpinnings of the transaction on which they are advising.
The motivation for doing so is not only to improve service
to the client; it is also in the lawyer's financial
interest. These transactions tend to be complex and
time consuming; if they are not supported by proper
valuation and business imperatives, fee difficulties
At the end of this paper I have included a cursory overview
of the valuation techniques currently applied by professional
business valuators. A useful, in depth analysis of this
topic is to be found in the book by Mr. John T. Ramsay,
QC, Technology Transfers and LICENCING, Butterworths,
Toronto. The focus of this paper, however, is to alert
the lawyer to the subjective underpinnings of value
as opposed to providing a series of models for quantifying
that value. In my experience this critical, common sense
evaluation of the business and economic underpinnings
of the property being bought or sold is, almost without
exception, short changed. Otherwise reasonable projects
are thereby doomed to failure by the rush to access
When valuing an intangible asset it is essential, at
the outset, to distinguish between commercial and non-commercial
value. The latter concept embraces those transactions
that once may have no future, continuing financial consequences.
Examples are consumption expenditures for apparel and
entertainment, and even luxury items such as automobiles
and boats, where the ultimate resale value is subsumed
to the initial consumption benefit. The characteristics
of intellectual property must be examined to ensure
that there is indeed economic consequences to its possession.
Non-commercial goodwill is irrelevant to the valuation
of intellectual property licenses.
The classical definition of value is that of "fair market
value". This concept is summarized as "the highest cash
price at which informed willing parties will transact
in an open marketplace on a particular date". It has
been said that this definition of value is "preferred
by some judges all of the time and all of the judges
some of the time". Interestingly, it is a concept that
tends to be studied more at the end of a business relationship
than at the beginning. Much of the learned valuation
writings are based on judicial pronouncements, inevitably
made after the business has ceased when there is either
a dispute to be settled, taxes to pay or other problems.
Nevertheless, the classical definition provides useful
insights into the valuation of an intellectual property
transaction. First, the concept is one of an exchange
of cash. This concept is important to bear in mind when
valuing a property exchanged for shares or other non-cash
property. When the consideration is non-cash, the parties
are usually excessively casual about value issues.
A second essential element of the fair market value
determination of intellectual property rights is that
the rights must be actually transferable from one party
to the other: the recipient organization has to be able
to commercially benefit from them. In this sense, the
classical concept of an open and unrestricted marketplace
as being fundamental to the fair market value determination
must, in the case of the transfer of intellectual property
rights, be modified. Such rights, without exception,
dictate the need for certain characteristics in the
acquirer. For instance, the code to automate stock trading
is valueless in the hands of anyone but another stock
exchange that wishes to automate.
The determination of fair market value is a notional
concept: it does not require the identification of specific
purchasers. The valuation of intellectual property rights,
particularly in the context of this paper, represent
real world transactions. If the vendor has failed to
identify, in a very specific way, who the purchasers
and, if different, the end users are, it is possible
that the rights will have little or no value.
There must be a discernable economic advantage to the
acquirer of the property. Although seemingly trite,
this obvious requirement is frequently overlooked by
Examination of the economic advantages start with the
net cash projected to be received by the LICENCEE. That
advantage, measured either by its ultimate expected
sale proceeds or by the periodic income net of expenses
generated from its regular use, is compared with the
upfront or periodic royalty cost to the acquirer. This
understanding is just as important to the LICENCOR-vendor
as it is to the LICENCEE-purchaser because it should
prove impossible to market a non-viable business proposition.
The second aspect of the economic advantage is the timing
of revenue receipts. Some products, particularly bio-technology
properties may take many years before they produce sales,
let alone recovery of the costs of researching, developing
and marketing the product. The value of the property
is dramatically affected by the timing of periodic cash
Finally, a skilled assessment must be made of the risk
that the cash in-flows predicted for a particular intellectual
property will in fact occur. The multiplicity of factors
included in that decision go far beyond the quality
of the technology itself or, even, its apparent utility
to the intended marketplace.
The final issue under the value imperatives section
is that of exclusivity. Paradoxically, this factor is
of limited concern at the outset of the development
of a new product or service. Many vendors in that position
secretly wish for some competition to demonstrate the
viability of the concept. If, however, the intellectual
property does in fact demonstrate its commercial viability
then its owner will wish to do all possible things to
preserve that exclusive ownership in order to, among
other things, license it to others. Accordingly, competent
legal advice is critical to setting things up at the
outset rather than awaiting the immergence of a competitor
and attempting to resolve the matter through expensive
Legal advisors should be aware that, by the time that
the entrepreneurs-LICENCORs come to their offices for
the purposes of "papering the deal" will, by that time,
have become addicted to the concept and will, long ago,
have ceased to question its acceptability, marketability
and profitability. The time that a legal advisor spends
reviewing the subjective fundamentals of the property
that is the subject of the transaction will be richly
rewarded by either introducing some reality into the
hopes of the LICENCOR or, more positively, suggesting
additional prerequisites to be performed by the LICENCOR.
All too frequently, the lawyers and other advisors are
engaged after critical financing deadlines have been
set and the entire thrust of the engagement is to produce
reports, documents and exchange filings. The fundamentals
are skipped over.
There are numerous indicia which, when present, indicate
the probability of asset value or otherwise. These include
Cash Spent by the Vendor
Although it is true that the fact that a vendor has
spent a lot of money developing an intellectual property
does not necessarily equate to its having value: the
concept might be unworkable or nobody else might see
the use of it. But the opposite is almost universally
true: if there has not been a material investment in
the property, then it is likely that the intellectual
property has minimal value. One reason for this phenomenon
is that, absent the necessity of making substantial
hard dollar investments in the project, the acquisitor
could merely hire the people to develop those projects
within his own organization and thereby avoid the initial
capital costs. Actual expenditures continue to be of
significant interest to stock exchanges: CDNX currently
requires evidence of expenditures in excess of $1 million
as a threshold for listing on that Exchange. Obviously,
"expenditures" include only those external to the organization
and will exclude "deemed" remuneration for personal
time and effort spent by inventors and others.
In short, it is the presence of external expenditures
that indicates value is there, although it may not be
the determinant of that value.
Capacity to Exploit the Technology
It is critical that the organization acquiring the technology
has the ability to use it to economic advantage. A technology
that is compatible with existing business and technological
structures and that can be seen to enhance those pre-existing
entities will be more valuable than obtains in a situation
where the vendor is hoping that new organizations will
come into being for the purpose of using the technology
at a profit.
One of the most dramatic examples of this phenomenon
is the relationship between IBM and Microsoft. Although
not always friendly, the corporate cultures of those
two massive organizations have become very inter-dependent.
The vendor of intellectual property must identify not
only potential purchasers but also the end users when
they are not the same. This aspect of the plan is especially
important in situations where the end user is a consumer
requiring a huge investment in marketing and distribution.
The valuation of the technology must be set at a figure
that gives not only the vendor a return but the intermediary
an adequate reward after all of the costs and risks
of marketing and distribution.
Supplier - Labour Reliability
The transition of the utility from vendor to purchaser
inevitably requires some support from the vendor, both
initially and, perhaps again at the retooling stage.
The organizational stability of the vendor is of paramount
importance to the purchaser and the lack of same will
seriously impact the value.
Again, Microsoft provides a useful example of the importance
of customer support. That company has invested millions
of dollars in providing technical support for all of
its products. If one has the patience and money, Microsoft
technicians will eventually solve almost all consumer
A critical component of the valuation issue is market
research and feasibility studies. These can be quite
expensive and LICENCORs frequently ignore them or try
to do them on their own in an amateurish fashion. Quite
simply, such studies can provide essential insights
into whether the end users want the product or not and
what their expenditure thresholds will be.
Such studies are necessary even when the LICENCOR hopes
to market his intellectual property through intermediaries
or wholesalers. To be convinced that they should commit
resources to the marketing and distribution of the product,
wholesalers need to be convinced of the existence of
a marketplace. This aspect of the matter becomes especially
important when "worldwide rights" are being touted as
providing the basis for an optimistic reception.
In examining many such products I have seen minimal
attention paid to this very important topic. Amusingly,
in one of the few cases where a feasibility study was
done, its results were ignored!
The post-development survival costs of intellectual
property start-ups are huge. If the party in whose hands
the intellectual property is being valued does not have
access to significant amounts of cash, it is probable
that the property has little value. Although it is true
that some projects which wither due to lack of financing
can become resuscitated in the hands of others, I have
found this result to be rare indeed.
A startup organization that is counting on sales to
fund research and development, marketing and distribution
efforts, is virtually certain to fail. Projected sales,
costs and collections are notoriously optimistic in
The business plan, if credible, will be specific as
to the amounts needed, and the source of those amounts.
The methodologies applicable to valuing intellectual
property rights are little different, in principle,
than assigning a value to other business interests.
It involves three components:
estimation of the future cash flows (or savings)
expected from the property rights;
Determining the risk of not receiving all of the
projected cash flows and expressing that risk in
terms of a discount or capitalization rate; and
Calculating the actual expenditures incurred in
the development of the property.
Discounted cash flow ("DCF") is the technique of calculating
the up front consideration for a specified number of
future receipts. For example, if the appropriate interest
rate is 10% per year, you would pay $90 today for the
right to receive $100 in one year's time.
When the future income streams are relatively stable
and certain, and when they will continue for a specified
time period, then a discounted cash flow approach is
entirely appropriate. Property leases are typically
valued using this approach.
Discounted cash flow techniques, however, are seldom
very useful in assigning a value to startup situations.
Typically the early stage forecasts are optimistic due
to financing and operational delays and projections
beyond a two or three-year period are so uncertain as
to be meaningless.
The cost method of valuing intellectual property is
obviously suspect as a determinant of value. It does,
however, have a couple of useful elements. First, stock
exchanges give considerable weight to the cost factor.
Second, it provides insights to the buy-or-build decision.
And, as noted above, in the absense of material cash
investment, the property is very unlikely to have a
In order to have any utility, the cost calculation must
be restricted to actual cash outlays; payments to inventors
and principles must either be excluded or segregated.
Valuation by the capitalized earnings approach is accomplished
by applying the reciprocal of the interest rate appropriate
to the business interests being valued to the annual
after-tax earnings of the interest or enterprise. If,
for instance the appropriate interest rate is 10%, the
reciprocal, called the earnings multiple, is 10 times.
If the earrings are $50,000 the application of a 10
times multiple yields a (present cash) value of $500,00.
It is analogous to the familiar Price/Earnings ratio
reported by publicly traded companies.
This valuation method is inappropriate in the absense
of a sustained historical earnings stream; it will seldom
be encountered in start-up situations.
The importance of this technique is frequently under
utilized in the valuation of intellectual property rights.
Although comparison with other organizations would appear
to be irrelevant in circumstances where the property
is unique and proprietary, useful insights obtain from
examine the revenue potential or cost savings obtainable
from competing properties. If the economic advantages
are not clear and unequivocal, then it is likely that
there is no value to the property. And, when the advantages
can be reliably calculated, the results give a reasonable
indication of the maximum value of the property.
The comparative market approach is also critical when
valuing a product where the end users are consumers.
It is doubtful that Linux would enjoy the popularity
that it does among geeks if its licence cost was higher
RUNNING ROYALTY AND STRATEGIC PARTNERSHIPS
This approach involves a pay-as-you go arrangement.
The parties negotiate a basis for the royalty: typically
a percentage of the product selling value or the pre-agreed
cost savings and payment flows from LICENCEE to LICENCOR
after the fact.
The arrangement has the very considerable merit of removing
most of the risk assumed by the purchaser, a circumstance
that should reasonably be expected to reward the vendor
with a somewhat higher return.