Cutting through the complexity of IP valuation
This article originally appeared in the March 10, 2017, issue of The Lawyers Weekly published by LexisNexis Canada Inc.
There are many challenges that arise in the valuation of intellectual property due to a number of factors, including: difficulties in estimation of potential market and market share (particularly for early-stage or disruptive IP); quantifying and accounting for synergies; selection of an appropriate discount rate (and the quantification of risk); tax considerations; and use of market data. This article discusses a number of these issues as highlighted by recent examples of litigation involving complex IP valuation issues, including:
- Recent cases involving Apple and Samsung illustrate that damages for infringement in the technology space can be significant. The pharmaceutical industry has many examples of damages arising from infringement which are dealt with under s. 8 of the patent medicines notice of compliance (NOC) regulations. Recent cases (including Sanofi against Canada’s Apotex) highlight the significant damages that can arise in the case of generic drug competition;
- IP is a significant component of the value of many acquisitions. If the benefits of the transaction do not materialize, the allocation may be subject to regulatory or shareholder actions;
- Tax structures involving the migration and cross-border licensing transactions of intellectual property. Due to the concern surrounding the shifting of profits from high-tax to low-tax jurisdictions, such structures have come under increased scrutiny by tax authorities and multinational organizations. See, for example, the recent case of Cameco, a Canadian-based uranium company which is involved in a dispute with Canada Revenue Agency.
At the core of each of these issues is the question of the expected cash flows that might have been generated by the subject IP and the risk (e.g. financial, operational and market based) associated with generating these cash flows. There is no single overriding methodology to value IP. Accordingly, valuators consider subjective factors and the merits of multiple approaches.
Common valuation approaches include: the discounted cash flow (DCF) approach where forecast cash flows generated by the subject IP are discounted to a present value using a risk-adjusted measure of return; precedent transactions and comparable public company analysis where market multiples are used to calculate a value of IP (market approach); and replacement cost approach which represents the cost that a purchaser would incur to develop an asset with the same utility as the subject IP.
Issues arise in applying the DCF approach based on the relevance and reliability of forecast cash flows. Developing a forecast requires detailed consideration of, among other factors: expected market size, the subject IP’s market share, competitive dynamics, time to market and costs to reach the market. Each of these elements is uncertain (particularly for early-stage or disruptive IP) but can be corroborated with an analysis of comparable products’ market adoption as well as preparation of scenarios or probabilistic simulations.
The quantification of synergies is also a significant issue in many cases of IP as the prospective value depends on the market of buyers. There are two types of purchasers: financial and strategic. Financial buyers are interested in cash flow prior to the exit from the investment whereas strategic buyers are interested in gaining synergies from vertical integration, horizontal integration, or economies of scale. A strategic buyer may attribute a higher value to IP than a financial buyer. The assumption to be made with regard to the type of purchaser is specific to each case.
Underlying all valuation approaches is the quantification of the discount rate which considers asset, business and industry risk, and is subjective. Discount rates for early stage and disruptive IP are the most difficult to quantify. Industry surveys may be used as a test of required return but judgment must be exercised. Industry surveys typically measure actual return while valuation is dependent on required returns. Moreover, investors in early-stage IP often consider the overall portfolio return not the return on a specific IP asset.
Given the ease with which IP can be migrated between jurisdictions, relevant tax considerations are significant. For example, consider an IP asset that generates $10 million in pre-tax cash flow which we would value using a capitalization multiple of 4.0x. If the company is taxed in Canada, it could pay tax at a marginal rate of 26.5 per cent, while if it is domiciled in Barbados, it could be taxed at a 2.5 per cent marginal rate. In this example, the capitalized value would differ by more than $10 million ($29.4 million capitalized value in Canada, $39.0 million in Barbados). Relevant considerations are the timing of and tax rates on repatriation of profits.
IP valuation is highly specific to the subject asset. Adjustments to observed market data may be required based on factors such as size, geographic area, historic and projected growth, access to financing, product lifecycle and whether or not the company is public.
Overall, significant judgment exists in the valuation of any IP due to the uncertainty surrounding the cash flows generated by IP and the complexities of the market. IP valuation and damage quantification issues often arise which may be subject to expert critique during litigation. It is therefore important to provide thorough justification on approaches used and how conclusions were drawn.