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Chapter 8
IP Valuation: Principles and Applications
in the Nanotechnology Industry
Efrat Kasznik Foresight Valuation Group LLC, 260 Sheridan Ave., Palo Alto, CA 94306, USA [email protected]
8.1 Overview of IP Valuation
8.1.1 What Is Intellectual Property (IP) Valuation?
8.1.1.1 Brief history of IP valuation in the United States
With its origins in the IP litigation of the 1980s and 1990s, the valuation of IP (primarily patents) in the United States was initially limited to damages calculations in legal cases involving claims such as patent infringement. With the introduction of tax planning involving IP, such as transfer pricing and patent donations, the valuation of intangibles became critical in non- litigation circumstances as well. Companies were required to include in their tax reporting the fair market value (FMV) of IP involved in transactions, such as the intercompany transfer of IP or the donation of a patent to a university. New accounting rules related to
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186 IP Valuation: Principles and Applications in the Nanotechnology Industry
business combinations in the United States, introduced in the early 2000s, expanded the need for IP valuations even more, as companies were now required to report the Fair Value (FV) of intangibles that were purchased with a target in a mergers & acquisitions (M&A) deal. These “compliance” situations — litigation, accounting, and tax reporting — carry with them a high degree of scrutiny by the court or regulating authorities, and require a third-party, IP valuation expert’s opinion in the form of a report or testimony. In parallel to the proliferation of tax and accounting rules, which mandated the valuation of IP in certain transactions, around the same time (late 1990s to early 2000s) the field of intellectual asset management (IAM) was starting to gain momentum with US corporations. Large companies with significant patent portfolios (like IBM, Dow, and others) were leading the way, and with the increase in sophistication of active IP portfolio management, came the need for valuation. The types of activities where a valuation became increasingly important include spin-offs, in kind contributions, licensing, patents sales, and other commercialization activities. Since many of these activities are not always subject to tax or accounting reporting, these transactions can be referred to as “non-compliance” activities. In these situations, due to the low to medium degree of scrutiny and the lack of reporting requirement, the valuation is often done in-house or between the parties, without the involvement of a third-party IP valuation expert.
8.1.1.1.1 IP valuation methodologies There are three common methods for valuing intangible assets: the market method , the income method , and the cost method. These valuation methodologies were largely borrowed from the methodologies applied in the valuation of tangible assets (like real estate, machines, inventories, etc). As a result, they are more suitable for tangible assets and some of them are challenging to implement when intangibles are involved. Each of these valuation methods is briefly described below. Market methods are useful where there is a market demand for an intangible asset and there are other similar intangibles that have traded hands under specified market conditions. In these circumstances, the market price for comparable assets may be used (with appropriate adjustments) as a measure of the market
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Technology-based intangible assets. Innovations and technologi- cal advances that are protected by contractual or legal rights. This group includes the following assets:
- Patented and unpatented technology
- Computer software and mask works
- Databases, including plants
- Trade secrets, such as secret formulae, processes, recipes, etc.
Marketing-related intangible assets. Assets that provide value to the marketing or promotion of products and services. This group includes the following assets:
- Trademarks, trade names, service marks, collective marks, certification marks
- Trade dress (unique color, shape, or package design)
- Internet domain names
- Non-competition agreements
Customer-related intangible assets. A customer relationship exists between an entity and its customer if the entity has information and regular contact with the customer, and if it stands to benefit from future contracts that are reasonably anticipated from that customer. This group includes the following assets:
- Customer lists
- Order or production backlog
- Customer contracts and relationships
8.1.1.2 IP valuation standards in the United States
8.1.1.2.1 IP valuation landscape in the United States Most IP valuations in the United States are done in compliance situations, either for financial reporting, tax compliance, or litigation damages. There is a fundamental difference between the IP valuation requirements in compliance versus non-compliance situations. In compliance situations, the valuation is mandatory, and is usually done after the deal has already been finalized. There is single point value that needs to be recorded (as opposed to a range of values that
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needs to be negotiated). On the other hand, most IP transactions today are done in non-compliance situations, where there is no mandatory reporting requirement. If an IP valuation is conducted under such circumstances, it is neither reported nor regulated under any standards. Valuations done in non-compliance situations are usually done in-house for purposes of negotiations, and therefore there would not be a single point valuation, but rather a range of values that needs to be negotiated between a buyer and a seller. In recent years, a large volume of IP transactions involving the sales of patents, were carried out through IP brokers and various kinds of IP funds (such as patent aggregators, defense funds, etc.). There are rarely any formal IP valuations done in conjunction with these transactions, as most of them rely on legal claim chart analysis, and some heuristic rules of thumb as to the discounts that should be applied to future cash flows. We turn next to discuss in more detail the IP valuation activities under the most common compliance situations: litigation damages, financial reporting (accounting), and tax reporting.
8.1.1.2.2 IP valuation for litigation damages The litigation of intellectual property in the United States has seen a sharp increase since the 1990s, both in the number of cases filed annually and in the cost of litigation. According to the American Intellectual Property Lawyers Association (AIPLA), the number of patent infringement cases has doubled in 10 years — from about 1700 in 1995, to over 3300 in 2005 [2]. The number has since leveled somewhat, but is still significantly higher than a decade ago. The cost of patent litigation has sky rocketed as well; the average cost of litigating a patent case through trial, according to the AIPLA, is estimated at $1– $3 million, depending on the amount of damages and the size of the case. The field of nanotechnology is at its early stages of patenting, and litigation activity has so far been limited. The first case filed in a potential wave of patent infringement litigations based on nanotechnology patents, DuPont Air Products Nanomaterials v. Cabot Microelectronics (filed in January 2007), represents what many feel will turn out to be a growing trend amongst companies. While it
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of the 15 factors set forth in Georgia-Pacific Corp v United States Plywood Corp , 318 F Supp 1116, 1120 (SDNY 1970). These are economic factors that increase or decrease the reasonable royalty rate that would have been the result of the hypothetical negotiations
8.1.1.2.3 Trademark, copyright, and trade secrets damages Damages in trademark, copyright, or trade secrets cases are estimated using a broader range of measures as compared with patent infringement damages. For example, the disgorgement of the defendant’s profits may be an allowable measure of damages in these types of cases (when such damages are not allowed in patent cases) Copyright infringement offers an additional approach to damages not available in other IP matters: statutory damages that are set at a fixed amount of dollar per infringement.
8.1.1.2.4 IP valuation for financial reporting According to US GAAP rules, intangible assets are only reported on the financial statements when they are paid for in a business combination transaction, such as an acquisition. As a result, “home-grown” IP assets, like patents and trademarks, are not measured or reported on the balance sheet of the company that created them. However, if that company buys another company that owns patents and trademarks, the acquired intangible assets of the target company will be valued at their fair value and reported on the acquiring company’s books. That is an interesting anomaly that is frequently pointed out by members of the IP community; however, it is unlikely that any changes to that accounting treatment will take place in the near future, primarily because of the conservative nature of GAAP rules, and the somewhat speculative nature of IP asset valuations. As long as these assets are not priced by a market transaction, their value is not certain enough for financial reporting purposes. That being the case, the valuation of IP for accounting purposes is primarily done in the context of business combinations (such as M&A deals) and is governed by GAAP pronouncements such as ASC 805 (first introduced in 2001 as Statement of Financial Accounting Standards 141). The valuation is done as part of the overall process of purchase price allocation (PPA), when the deal price paid for the acquired company is allocated among the various assets that are comprised in that company. All assets of the target company, tangible
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and intangible, as well as its liabilities, are identified and valued at their current fair value. When valuing assets at fair value, the appraisal needs to assume their “highest and best use,” which refers to the use of an asset by market participants that would maximize the value of the asset, even if the intended use of the asset by the holding entity is different. The standard of valuation applied in business combinations is “fair value,” defined as the price that would be received when selling an asset (or paid when transferring a liability) in an orderly transaction between market participants. “Market participants” are defined as buyers and seller in the principal market for the asset that have all the following characteristics:
(a) Independent and unrelated parties (b) Knowledgeable, having a reasonable understanding about the asset (or liability) and the transaction based on all available information, including information that might be obtained through normal and customary due-diligence efforts (c) Able to transact for the asset or liability (d) Willing to transact for the asset or liability, that is, are motivated but not forced or otherwise compelled to do so [4] The fair value of all assets (net of liabilities) is then compared to the acquisitions price, and the residual amount is recorded as Goodwill, which by itself is considered an intangible asset. Goodwill represents the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately valued. The results of the PPA analysis, including Goodwill, are then reported in the new, combined financial statements of the two companies. In the following years, Goodwill is tested annually for impairment, a process that involves a valuation analysis. If the test shows indication of impairment then some of the intangible assets’ fair value estimates may be revisited, and certain assets, or Goodwill, may be written off as necessary. The US GAAP valuation guidelines state a preference for market- based valuation methods, when market data is available. In reality, the markets for intangibles are very thin, the assets are uniquely different from each other, and most transactions are not publicly reported. As a result, most IP valuations done for accounting
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the intangible asset to the overall combined company’s profit margin.
- Cost-sharing methods Costsharing agreements are used to divide the cost of developing intangible assets between affiliated parties, based on their respective return from the future assets. The IRS set out a list of requirements for cost-sharing agreements’ qualification, including specific documentation and reporting rules.
8.1.1.3 IP valuation circumstances in Europe
8.1.1.3.1 Litigation damages The laws of IP damages in Europe also rely on the premise of restoring the injured party to the position it would have been in, but for the infringement of its intellectual property, although the legal procedures could vary for the United States. For example: in the United Kingdom, damages hearings constitute a separate trial, which only kicks in once liability has been established; damages hearings are therefore less frequent than in the United States as the parties have a greater motivation to settle [8]. The concept of reasonable royalty damages, based on a hy- pothetical licensing negotiation between the IP owner and the infringer, is common in Europe as well. The courts apply a range of royalty determining considerations, similar to Georgia-Pacific, although European courts have not clearly established a set of relevant criteria yet.
8.1.1.3.2 Financial reporting As a result of the international harmonization of accounting standards, the treatment of IP val- uation in business combinations is similar in Europe and in the United States. All member states of the EU are required to use the International Financial Reporting Standards (IFRS) system of accounting standards, as adopted by the EU for listed companies since 2005. The United States is expected to follow suit in the next few years, and transition into IFRS from the current US GAAP system. IFRS 3 is the standard that applies to valuation for business combinations (the counterpart of ASC 805 in the United States). Interestingly enough, it should be noted that prior to the EU adoption of IFRS standards in 2005, the United Kingdom was
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one of the only countries where home-grown intangibles (i.e., intangibles that were internally developed by the company) could be measured and presented as assets on the balance sheet. That is no longer the case as IFRS rules mostly recognize intangibles as assets for accounting purposes if they were purchased in a business combination.
8.1.1.3.3 Tax reporting Europe is a major hub of transfer pricing activity, as several European countries are favorite locations for setting up offshore IP holding companies. Currently, Switzerland and Ireland are the preferred locations for US-headquartered corporations, while EU-based corporations tend to prefer Ireland and Luxembourg. Switzerland, Ireland, and Luxembourg have good treaty networks and very advantageous tax rates. For instance, the tax rate in Switzerland is determined by negotiation with the local canton and is usually in the range of 4% to 8% [9]. The valuation of IP assets is critical at the time of transfer of the IP portfolio into the IP holding company, and needs to be done by a third party, independent valuation expert. Each IP asset should be separately assessed. The IP holding company needs to have to function as a real business; otherwise it might be treated as a “controlled foreign corporation,” in which case its accounts would have to be consolidated with those of the parent company and it would lose the benefits of operating in a low-tax jurisdiction. In order to overcome this problem in the EU, the IP holding company has to have “functionality,” which is demonstrated by a staff that actively manages the IP portfolio.
8.2 The Application of IP Valuation in the Nanotechnology Industry
8.2.1 Nanotechnology IP Landscape and Technology Development
8.2.1.1 Patent landscape overview in the United States
The field of nanotechnology is inherently interdisciplinary: a nanotechnology invention will likely have applications in multiple industries, from pharma and biotech to computer hardware.
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8.2.1.2 State of nanotechnology development around the world
Technology development is impacted by the state of research and development, and the national infrastructure that supports its commercialization. Lux Research issued a study in 2010 that ranks the status of nanotechnology ecosystems in 19 countries, based on an analytical framework that analyzes data from 2007 through 2009 [14]. The Lux Research framework maps out the nations using a two- dimensional matrix with the following axes: Nanotech activity measures the absolute level of nanotechnology development, drawing on 8 metrics including nanotech initiatives, nanotech centers, government funding, risk capital, corporate spending, nanotech publications, nanotech patents, and active companies. Technology development strength measures the robustness of technology commercialization infrastructure, drawing on 6 metrics including: high-tech manufacturing, R&D spending, intellectual capital, technology and science workforce, knowledge emigration, and technology infrastructure. The mapping on the matrix ranges from “minor league” (low on both dimensions) to “dominant” (high on both dimensions), with “ivory tower” (high on activity, but low on development) and “niche” (low on activity and high on development) in between. It is interesting to compare the US ranking on the national mappings opposed to European countries, and in particular, Italy, the Netherlands, the United Kingdom, France, and Germany. The United States earned an “Ivory Tower” ranking — with full marks in every activity metric. The United States launched the National Nanotechnology Initiative (NNI), which is well coordinated and funded, and helps support start-up and academic research. In addition, corporations and private funding invested billions of dollars and filed thousands of patents in 2009 alone. On the other hand, the United States ranked average on the Development axis. When compared to the European countries, Italy and the Netherlands are closely ranked as “minor league,” with low ranks on both dimensions. France and the United Kingdom are in the middle of the map, scoring about average on both activity and development.
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Germany seems to be faring out the best with a “dominant” ranking, scoring above average on all counts.
8.2.2 Managing an IP Portfolio in the Nanotechnology Industry
8.2.2.1 IP portfolio challenges in nanotechnology
The macro-level overview of IP landscape and national rankings leads to unique challenges at the micro level (company or research institution) when it comes to creating, managing, and commercial- izing a nanotechnology IP portfolio. While the challenges vary by company size and the specific industry in which companies operate, and while research organizations face problems that are different from those faced by corporations, there are still some common themes related to IP portfolio management than run throughout the industry. Three of these IP management topics stand out as broadly applicable to a wide range of nanotechnology IP holders around the world (in the United States and in Europe), as the industry follows the path from early stage to maturity:
- Patenting along the nanotechnology value chain
- Technology transfer from university to industry
- Mitigating litigation risk
Following is a brief discussion of each of these topics, including a discussion of the role that IP valuation can potentially play in supporting these challenges. We then conclude the chapter with some valuation case studies that demonstrate the versatility of the technologies that IP valuation experts analyze in the nanotechnology industry.
8.2.2.2 Patenting along the value chain
The concept of the nanotechnology value chain is closely related to the interdisciplinary nature of the industry. This concept is illustrated in a 2003 Intellectual Asset Management (IAM) Magazine article [15]. The authors claim that the key to a strong IP portfolio is found in patenting across the entire nanotechnology value chain, taking into consideration the following elements:
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this area began to establish entirely new technology transfer offices, building teams with legal, business, and scientific backgrounds. As a result, many new technologies have been diligently and successfully introduced into public use. Another significant result of the Bayh- Dole Act is that it provides a strong incentive for university–industry research collaborations. The technology transfer process from university to industry is primarily done in two ways: licensing and joint ventures. In both instances, there is an IP valuation analysis that needs to take place in order to facilitate the transaction. In licensing deals, the parties need to agree on the royalty rate, structure (lump sum, running royalty, or a combination of both), and other terms related to the license. In joint ventures, a university would typically contribute the IP, while the industry partner contributes the tangible components (usually cash or equipment). In order to figure out what share of the venture each side gets, the university’s “in-kind” contribution of IP needs to be valued, a task that is usually assigned to a third-party valuation expert.
8.2.2.4 Mitigating litigation risk
The biotechnology and semiconductor industries experienced ac- celerated patenting activity, followed by litigation, over the last 20 years [17]. This pattern could emerge in the nanotechnology field, especially in light of the claim overlap due to the unusually high number of patent applications covering similar technologies. Bringing a product to market involves navigating patent thickets, and facing potential litigation down the road as the industry matures seems highly likely. Legal experts following the nanotechnology industry vary in their assessment of the future of litigation in the industry. Some believe that cross-licensing is an effective tool for resolving patent thickets. The argument here is that by carefully carving the fields of use in a cross-licensing deal, each party can have an exclusive field of use that does not overlap with the other party [18]. The 2005 Lux research study goes on to predict that the nanotechnology industry will, for the most part, manage to avoid a “self-destructive IP war” through a flood of cross-licensing agreements and other types of IP licensing.
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On the other hand, other legal experts are not as optimistic as to the mitigating role of cross-licensing when it comes to future patent litigation. Their argument is that cross-licensing has worked in the semiconductor industry due to the oligopolistic nature of that industry, where there are a relatively small number of large firms with similar products and similar IP portfolios [19]. The nanotechnology industry is inherently different: there are many patent holders in a variety of different industries. Two start-ups trying to commercialize the same product in the same market are more likely to try and litigate each other out of business, as opposed to cross-license, as has been the case in the biotech industry. The role of IP valuation is fairly clear and straightforward here: if and when a wave of litigation hits the nanotechnology industry, it would give rise to a tide of economic expert who testify on damages.
8.2.3 IP Valuation Case Studies The case studies below are based on real-life valuation analyses of nanotechnology patents that were carried out in support of tax reporting for two major US corporations. Each of these organizations donated intellectual property (including patents and know-how) to a university, and the valuation was conducted to estimate the fair market value of the technologies for tax deduction. These two cases demonstrate a compliance situation (tax reporting) and are part of the technology transfer process from university to industry (even though the technologies were donated from the industry to the university, the goal with technology donations has been for the universities to further develop the technology, and then license it back into the marketplace). These cases were also selected because they represent the interdisciplinary nature of the industry, and the wide range of applications that nanotechnologies have.
8.2.3.1 Advanced thermoelectric technology
Originating industry. Aerospace. Technology description. Method for making advanced thermoelectric devices known as thermopiles. The patent involves a method for thermopile fabrication that produces advanced thermoelectric
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References 203
the raw material to the bottle. Since the patent portfolio included foreign filings as well, the analysis covered the United States and international markets in Mexico, United Kingdom, Germany, and France. Valuation standard. Fair market value for tax reporting. Valuation method. Income method based on discounted cash flow analysis (relief from royalty).
References
- Based on Ernst & Young publication, Financial Reporting Developments, Business Combinations – Accounting Standards Codification 805 , Chapter B4, Revised October 2010.
- Cost of Patent Litigation , AIPLA Mid-Winter Conference, Jan. 25, 2008. Available at http://www.aipla.org/Content/ContentGroups/Speaker Papers/Mid-Winter1/20083/Showalter-slides.pdf
- Chelton, D., Tanger, M. P., John, D., and Tony, S. Accounting for Damages in Intellectual Property Litigation, PwC, Atlanta, Washington DC, London and Sydney.
- All definitions taken from the ASC Master Glossary.
- Intangible Assets and Goodwill in the Context of Business Combinations, An Industry Study , KPMG – Corporate Finance Advisory, May 2009.
- Chelton, D., Tanger, M. P., John, D., and Tony, S., Accounting for Damages in Intellectual Property Litigation, PwC, Atlanta, Washington DC, London and Sydney.
- Based on the discussion in “Fundamentals of Intellectual Property Valuation,” Chapter 18, by Weston Anson
- Chelton, D., Tanger, M. P., John, D., and Tony, S. Accounting for Damages in intellectual Property Litigation , PwC, Atlanta, Washington DC, London and Sydney.
- Larry, C., and Sean, F. (2010) Offshoring your IP holdings , New Legal Review, May 14, 2010.
- Joff, W. (2003) Patent Challenges for Nanotech Investors , Intellectual Asset Management Magazine, September/October 2003.
- Stephen, B. M., and Leon, R. The Nanotech IP Landscape: Increasing patent Thickets Will Drive Cross-licensing , Foley & Lardner LLP.
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- Lux Research and Foley and Lardner, The Nanotech Intellectual Property Landscape , 2005.
- Nanotechnology: Thinking Small in a Big Way , JonesDay publication,
- Ranking the Nations on Nanotech Hidden haven and Fallen Threats , Lux Research, 2010.
- Joff, W. Patent Challenges for Nanotech Investors , Intellectual Asset Management Magazine, September/October 2003 (sidebar titled: “De- veloping the nanotech patent portfolio,” by Rachel E. Schwartz and John E. Cronin of the ipCapital Group, Inc.)
- University of California Office of Technology Transfer, The Bayh- Dole Act – A Guide to the law and Implementing Regulations (http://www.ucop.edu/ott/faculty/bayh.html)
- Nanotechnology: Thinking Small in a Big Way , JonesDay publication, 2008
- Stephen, B. M., and Leon, R. The Nanotech IP Landscape: Increasing Patent Thickets Will Drive Cross-licensing , Foley & Lardner LLP.
- Ruben, S., Kirk, H., and Chris, D. (2005) The nanotech intellectual property (“IP”) landscape, Nanotechnology Law and Business Journal , 2(2), Article 3.
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