Tips for applying art and science to intellectual property valuations

Valuing intellectual property depends on a broad range of expertise and requires a valuation professional to have more than a cursory understanding of marketing, accounting, finance, scientific and/or applied science, the applicable intellectual property law, statistics, financial modeling, and report writing. “Is that all!?” you may be thinking.

While continual changes in each of these fields present a high barrier for a valuator seeking to perform these engagements, in the end, intellectual property valuation is similar to other valuation forms. It is part science and part art. And it’s important that a valuator maintain a mastery of both to generate credible and repeatable results.

In BVR’s publication, Guide to Intellectual Property Valuation, 2nd edition, author and valuation expert Michael Pellegrino outlines the best approaches to apply both the science and art to your next intellectual property valuation. In this blog post, we cover some of the most important takeaways. For a deeper dive into the topic, be sure to download the complete chapter from this must-read guide.

Applying the Science

The science in intellectual property valuation relates to the fundamental mathematics that surrounds the quantification and distillation of the value proposition into dollars and cents. It includes things such as financial formulas and the ability to perform quantitative analysis. Proper knowledge of basic math, discounting, calculating revenues, calcu­lating profits, and calculating cash flows are all important.

Quantitative analysis also requires the valuator to perform meaningful statistical analysis to support an engagement. The science results are unequivocal and should be exactly repeatable, regardless of the valuation professional. Further, the science is independent of the valuator’s background, certifications, education level, schooling, or other factors.

The Art and Science of Intellectual Property

For example, a $100 cash flow received one year from today is worth $80 today with a 25% discount rate. Every valuator should come to the same conclusion given these inputs. It does not matter where the valuator went to school or whether he or she has an accounting certification, a finance certification, or even no certification. That said, a valuator’s improper use of the science could lead to erroneous valuation conclusions.

So how does one reasonably defend against seemingly innocent errors that nonetheless generate catastrophic results? A valuator typically can employ several defensive measures to reduce the risk of such errors:

  • Keep it simple: Contemporary modeling tools can be remarkably powerful. With this power comes responsibility to use the tools properly. Keeping the models simple reduces error potential.

  • Implement automated checks: To protect against possible math errors, develop automatic dashboards to verify proper model calculation. A sophisticated valuation model may include a dashboard that tests hundreds of different value conclusions to ensure internal model consistency.

  • Use style guides: Ralph Waldo Emerson wrote, “A foolish consistency is the hobgoblin of little minds.” While Emerson’s point may have been that the mundane is boring, the mundane can be the savior of a valuation professional.

  • Utilize a peer review process: Regardless of how good a valuator may be, he or she is still human, and humans make mistakes. The ideal solution is to have an independent party perform an objective peer review of the valuation model.

Practicing the Art

The art in intellectual property valuation relates to the qualitative judgments a valuator renders to generate a final result. It is not a “gut” feeling relied upon to render a conclusion in a valuation engagement. Frankly, clients would likely find little solace knowing their value opinion depends on what the valuator had for lunch that day. Further, “gut” feelings do not stand up well to cross-examination.

The Art and Science of Intellectual Property

Thus, the artful application of valuation principles becomes crucial to generating a credible valua­tion report. Several important principles include the following:

  • Understanding and Scoping the Valuation Engagement Correctly

    While a seemingly simple thing to “get right” in a valuation engagement, coming to a mutual understanding of what exactly constitutes the valuation engagement between the client and the valuator is not necessarily as simple as it seems.

    The client and the valuator need to understand and agree on several factors to scope the intellectual property valuation engagement correctly. This is where generic business valuation and intellectual property valuation engagements diverge.

    Business valuation engagements typically constitute consideration of the entire enterprise, including all historical and reason­ably prospective value propositions. For intellectual property valuation, the specification of the engagement can be more difficult. One who can appropriately apply the art of intellectual property valuation will avoid misunderstandings that lead to an erroneous value conclusion or to a value conclusion that does not match the client’s understanding of the engagement, project timing, or budget.

  • Selecting Appropriate Valuation Methods

    Selecting the appropriate valuation method for an intellectual property engagement is not necessar­ily as easy as it is with other types of valuation engagements. Intellectual property generally belongs in a class of its own for several reasons, one of which is it’s an intangible and has no intrinsic value in a fixed form like other assets, which negates the applicability of asset- or cost-based approaches.

  • Performing Credible Due Diligence

    The art of performing due diligence for an intellectual property valuation engagement is crucial to generating a credible work product. Yet, a preponderance of the education and analysis common to these valuation reports focuses on performing forensic analysis of the historical income-generating ability of the intellectual property. In doing so, the valuator misses many of the key value-creating considerations for the intellectual property. This can lead a valuation professional to the wrong conclusion.

  • Properly Constructing the Valuation Models
    Constructing an appropriate valuation model is as much an artistic creation as a painting by Van Gogh or a book by Mark Twain. Constructed properly, a valuation model will reflect a reasonable and probable reality of value for the value standard and premise for the engagement. An improperly constructed valuation model will be as much a work of fiction as Moby Dick.

The Science-Art Continuum

When it comes to valuing intellectual property, the question is: Which is more important: the science or the art? One may argue that both are equally important. If the science is wrong, then the ending value indication will not be correct. However, applying the science in an artful manner is not easy. Seemingly innocuous items or oversights can have a material value impact. So the art of rendering qualitative judgments to arrive at an appropriate valuation demands—as with any art— imagination and skill.

For more on this fascinating and complex topic, be sure to download the complete chapter from intellectual property expert Michael Pellegrino.

Free IP guide chapter