Mike Pellegrino in BVR’s Guide to Intellectual Property Valuation explains how analysts and financial advisors should view IP value obsolescence. Physical deterioration generally has no tangible impacts on IP value because IP is generally intangible, however, functional, technological, and economic obsolescence do affect the value of intellectual property more directly.
Functional obsolescence occurs when the IP user must incur excess operational costs to use the IP versus current alternatives, which may be state of the art. For example, manufacturing Company A uses a patent under license from Company B and pays Company B a royalty of 5% of gross revenues for use of the patent. However, Company A determines that new technology would allow it to sell equivalent functionality in the market with new technology that it has developed for lower cost. Thus, Company A is experiencing functional obsolescence using the patent under license from Company B, as there is newer technology that can provide the same utility for lower cost.
Technological obsolescence occurs when technological forces render the intellectual property worthless. For example, patents for a next-generation computer floppy disk drive may likely be very effective and have the fastest seek time and greatest data recovery rate ever known to man. Yet the technology is largely worthless because there are better technological options already on the market, such as high-capacity flash memory, which provides more utility in a much more efficient and superior manner.
Economic obsolescence occurs when the use of the intellectual property in its highest and best form cannot provide an adequate return on investment (ROI). This can occur easily because intellectual property is generally unique and may have little utility outside of a particular function. This tends to limit the value of the IP economically, especially compared to newer IP.