An Analyst’s View of Methods for Valuing Patents - August 15, 2011

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With all the recent press surrounding the purchasing of patents I thought it would be useful to summarize the methods for calculating the value of these transactions and attempt to show a framework around rational valuations. Of course, in reality, the market for patent purchases doesn’t always work rationally.  But by leveraging the market and financial research techniques and the fundamental valuation techniques I applied as an analyst in the investment banking industry as well as my experience through the boom and bust years of the dot com era, I hope to provide not only some pragmatic insight, but also a perspective on when valuations leave the rational framework.  Ultimately each patent valuation analysis is unique and, similar to corporate valuations must typically include detailed market and financial research beyond the summaries presented below.

Patents, in particular, are but a subset type of intellectual property that also includes copyrights, trademarks, and trade secrets.  Intellectual property is generally categorized as an intangible asset, in that it has no inherent value by itself, but is valuable in what it can do, i.e. protect inventions that may represent a differentiating market advantage and thus realize increased profitability, or be licensed and realize royalty revenue, etc.  So, the base case for analyzing the value of a patent focuses on analyzing a cash flow stream resulting from what the patent enables.  A cash flow stream analysis must also, at a minimum, incorporate a discount interest rate, which takes into account the time value of money and computes the present value of the future cash received.  This is called a discounted cash flow (DCF) analysis. In addition, any time there’s an analysis of future cash flows, market environment factors such as competing technologies, regulatory changes, and economic issues need to be considered to determine downside risks and/or upside potential for those future cash flows.  This, in turn, can alter the present value of the patent.  This present value calculation is the current net valuation of the patent. 

Of course, there are a variety of situations that can arise in reality.  The simplest case, for example, would be a patent that’s licensed to say five different market competitors.  Each competitor has agreed to pay $100 per month over the lifetime of the products in which the patent is used.  The lifetime of those products is estimated, based on various market factors, to be 36 months.  The value of that patent via a present value calculation (using a 5% discount rate) of these future cash flows would be $16,732.  Another relatively simple case could be where a patent protects a technological innovation that is used in a product and, as a result, that product is able to realize a profit margin of 40% versus the closest competing product profit margin of 30%.  The value of this patent can be represented as the present value calculation over the lifetime of the product of the 10% profit margin difference.  Of course various future market factors could be encountered that could changes these profit dynamics, which is why fundamental market research is typically needed in these analyses. Some patent situations may not involve revenue or profit at all.  For example a patent could be issued on a money saving technique for a certain process.  In this case the value of the patent would be derived off the DCF analysis of the amount of the savings.  In addition, patents can be used simply to prevent other competitors from even entering a certain market segment.  In this case a more complex DCF analysis might examine the profitability difference of the patented product as the sole market offering versus the hypothetical profit profile if multiple competitors offered similar products.  Ultimately, specific cases can be combinations of the situations above and thus involve present value calculations of various modified DCF analyses.

All of these present value calculations attempt to factor in the numerical facts about the patent situation and can be used as a basis in patent valuations and patent purchase situations.  However, valuations can certainly leave the realm of these rational calculations in open market and auction purchase situations.  Like the overly optimistic market bubble of the dot com era, these situations often involve over-inflated values spurred by such issues as the lost opportunity cost if a competitor acquires the patent(s), the company’s ability to defend itself against a competitor’s patent litigation, and pure speculation as to the future value.  In these situations, while it’s still useful to understand the base value calculations, valuations may clearly rise above the computations.

Jim Moeller, Managing Partner
Moeller Ventures, LLC