Income based IP valuation

In the last article we have discussed why a company needs to be aware of IP valuation methods and
different methods and their advantages, used for IP valuation. In this blog we will discuss about the first
method that is Income based Method for Intellectual Property valuation in details.

To use income based methods one needs to accurately calculate the income which can potentially be
generated by IP under consideration. It includes estimation of

• Potential income to be generated by the IP
• Duration of the revenue
• Potential growth/ decline of the revenue
• Risk associated with the revenue generated by the IP

In typical IP business practice IP owner earns revenue by licensing the IP to its customer. The licensing typically has two components namely license fee and royalty. The license fee is a fixed amount which the customer agrees to pay to the IP owner. Customer may pay it at a time or stagger the payment in few terms. The royalty is an amount which customer pays to IP owner on each of his product, which has used the IP, gets sold. Royalty can be a % of the product price or a definite amount for each unit sold.

Besides estimation of revenue generated by Intellectual Property, the IP owner needs to estimate the cost associated with that revenue flow. The cost may be linked to each customer acquisition or it may be a fixed cost irrespective of number of customer acquired. The fixed cost part may contain the cost of regular maintenance and upgrading of IP, marketing expense etc. The customer specific cost part includes IP customization needed for each customer, sales cost directly associated to the customer etc.

Once the revenue and cost are calculated the IP owner can calculate the profit he can makes out of the IP for the IP lifetime. Few of the points should be taken care in the calculation are

• Revenue from license fee starts immediately after the customer license the IP and will not in general depend on success of customer product
• Revenue from royalty will start only after the customer’s product gets launched in the market, but will last for the complete life cycle of the customer’s product. This revenue depends on the success of customer’s product
• In several scenario part of the customization done for an IP for a customer can be defined as generic enhancement and can be attributed to all future customers. Hence it is important to amortize the cost of the customization for several customer
• Availability of competitive product or change is business environment (like imposition of new regulation, change in standard) can severely affect sales potential of an IP and hence that needs to be taken care

Once the profit is calculated IP owner can use discounted cash flow method to calculate the present value of the IP

Now let us see how one can use discounted cash flow method to calculate value of an IP. In discounted cash flow model present value of an asset is calculated by discounting future value of money. The discount rate is equal to the summation of risk free interest rate and premium the investor demand for the risk associated of non materialization of the income

Where CF_i = cash flow at the year i
r = risk free rate + risk premium

Now for IP valuation
CF_i = income from license fee + income from royalty – cost for IP enhancement, customization etc – cost
for sales and marketing

The IP owner should not take 100% of the license fee in the first year if he gives free warranty more than a year. In that case he should take part of license fee as future income (typically 20% is taken)

n = economic life of the IP in terms of year. Economic life is the number of years for which one can
expect income from the IP. This can be governed by

• Life of the patent if the IP is patentable
• Possibility of obsolescence of IP due to change in standard etc

Risk premium will depend on

• Market and industry risk
• Risk of development of products by competitors
• Litigation risk

Also the risk premium depends the stage of technology for which the IP has been developed. For IP for upcoming technology the risk premium is quite high as there is uncertainty on the success of the technology. But IP for a matured technology will have lesser risk and lower risk premium

For areas like pharmaceutical, electronics where success of IP development also cannot be guaranteed the income is adjusted with a probability factor. The probability factor can vary every year, in which case the income from every year can be multiplied by corresponding probability factor. Or, the present value can be multiplied by the probability factor at the end

When the probability of income varies every year the Modified cash flow in year ‘i’ mCF_i = CF_i x p_i where p_i is the probability of getting the income at year ‘i’

For examples, the income from pharmaceutical patent depends heavily of the success of clinical trial. At the first clinical trial the rate of success is quite low and hence the probability of cash flow will be low. As the number of clinical trial increases the probability also increases

When the probability is constant

IP value = PV x p

That’s it for today, I will be back next week with the next part in the series. If you are interested in learning more, subscribe to our newsletter and blog updates at the top of this page. Leave a comment, if you have something to say or if you need any clarification. Till then, CIAO.