Valuation of IP based on a royalty stream
This article originally appeared on the Lawyer’s Daily website, published by LexisNexis Canada Inc.
Challenges arise in the valuation of intellectual property (IP) due to a number of factors, including: difficulties in estimation of cash flows to be generated from the IP’s use or licensing, particularly for early-stage or disruptive IP; tax considerations due to the ease of migration of IP; and selection of an appropriate discount rate and the quantification of risk.
One common approach to value IP is the relief from royalty method. The relief from royalty method determines the value of IP as the present value of the royalty or licence fees that would have been paid, had the asset had been licensed in an arm’s length transaction.
At the core of this approach is the question of the expected cash flows from the subject IP, applicable royalty rate and the risk associated with generating these cash flows (e.g. financial, operational and market-based).
Forecasting 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.
Royalty rates vary widely; often they consist of a payment of a specified percentage of a predetermined financing metric (e.g., revenue or profit earned by the licensee on sales associated with the IP) or production (e.g., units produced using the subject IP).
If the subject IP has not been licensed previously, determining the royalty rate that ought to apply is more challenging. The valuation principle of fair market value is instructive in this context and contemplates establishing a royalty rate that maximizes the price for the subject IP in the notional situation of informed parties acting at arm’s length under no compulsion. Similar reasoning underlies the determination of a reasonable royalty in the Georgia-Pacific Corp. v. United States Plywood Corp. 318 F Supp 116 (SDNY 1970) case known as “Georgia Pacific Factors”; the Georgia Pacific Factors require that the royalty rate (in the context of determining damages in IP litigation) be determined by considering the factors that would influence a hypothetical reasonable and voluntary negotiation.
A variety of public and paid resources exist to benchmark an appropriate royalty rate for a subject IP. Proprietary databases such as RoyaltySource and ktMINE, reported case decisions, SEC filings, business periodicals and valuation books contain many examples. Each of these market-based inputs must be adjusted for specific differences between the subject IP and the licensing agreements for comparable IP. This valuation method requires that licensing agreements for similar assets can be observed and transmitted which is often not possible for novel IP. Whatever the source for the royalty rate, it is essential that it reflects the economic contribution of the subject IP and the future economic benefit to be derived from its use.
In addition, there are several “rules of thumb” which can be utilized in determining an appropriate royalty rate. On such rule is the “25 per cent profit split valuation method” which determines a royalty rate in order to allocate 25 per cent of the licensee’s profits to the licensor. Although this may serve as a useful starting point to begin consideration of the value of IP, courts have been reluctant to accept this methodology.
Given the ease with which IP can be migrated between jurisdictions, relevant tax considerations are significant. For example, the after-tax royalty payments and therefore the calculated value of the subject IP would be significantly higher if the licensor’s royalty payments were taxed in Barbados at a marginal rate of 2.5 per cent, as compared to Canada at a potential marginal rate of 26.5 per cent.
Forecast cash flows from the licensing of the subject IP are discounted to present value using a risk-adjusted measure of return. Discount rates vary widely, as early-stage and disruptive IP would be discounted at much higher rates when compared to established markets due to the uncertainty surrounding the forecast cash flows. Discount rates may also be relatively lower if the royalty rate is based on revenue vs. profit, as the risk of receiving revenue-based royalties is generally lower than those dependent on profit.
Significant judgment exists in the valuation of IP using the relief from royalty method due to the uncertainty surrounding the selection of the royalty rate to apply to the cash flows generated by IP, and the selection of the discount rate to apply to the royalty stream. IP valuation may be subject to expert critique during litigation. It is therefore important to provide thorough justification for approaches used and how conclusions were drawn.