Approaches to valuing IP in early stage companies

The first days of June brought together a distinguished group of IP managers to a Management Roundtable summit on valuing early stage technologies, ably led by Mike Pellegrino. BVR was there, and we are presenting a series of articles on the content.  The first dealt with why value IP, and the second on the unique challenges. Here we examine the approaches.

Mike suggested everyone focus on the objective: valuators are searching for a way to measure incremental benefits of the IP. This may be painfully difficult and laborious, pocked with informed but less-than-certain decisions, but without that metric, there can be no valuation.

Most valuation analysts agree the cost approach falls short of useful in looking at IP, as cost and value are disjointed concepts. Similar IP rights can be developed by less-efficient managers, adding to the cost without improving the incremental benefits. Costs provide no weight for future income potential.

In looking at the market approach, Mike immediately dismissed Rule of Thumb as lacking any credibility, but found other deficiencies. 

  • Price does not equal value.
  • IP, by definition, is unique, so proxies are difficult to find. (Mike did include some "props" for ktMine as the best source for royalty rate data.)
  • Most market data is retrospective, not prospective. “Do not drive the [IP] car looking in the rearview mirror.”
  • The market approach typically looks at successful deals, building in a bias.
Mike believes the income approach to be the most principled, likely to yield the best results (read most credible), and suggests using market and operational inputs to build a revenue model from the bottom up. Analysts must determine the useful life of the IP, forecast the future economic income from the IP, forecast the future residual economic value of the IP, and discount the values to the present.

Importantly, tax implications must be included in the analysis. Mike’s key dependencies are:

  1. Timing
  2. Discount rate used, and
  3. Income taxes
Prospective valuations are fraught with uncertainty, which is typically accounted for by setting up Monte Carlo-type simulations for specific drivers and real options modeling. (Real options modeling demonstrates probabilities and expected values at each option point using traditional discounted cash flow methods.)

Alas, there are problems with the income approach as well. Because of the complexity of the analyses (Mike demonstrated how a project spreadsheet can easily contain tens-of-thousands of cells), the process is subject to calculation errors. Models may be modeling the wrong behavior. There is always forecast uncertainty, and forecasters have built-in biases (“Who admits they have an ugly baby?”).

Next time: Mike offers a shortcut through the complicated process of selecting a valuation method.

Online and hard copy versions of BVR’s Guide to Intellectual Property Valuation, by Mike Pellegrino, are found here.