When a startup company seeks financing either through debt or new investment, one of the most important issues it faces is how to place a value on its IP portfolio. Typically for a startup company, the IP portfolio it has developed is among the largest sources of value that the company owns. Determining the value of the IP portfolio is critical as the startup company begins to seek funding which, in the case of investment finding, could have the effect of diluting the founders’ interest in the company. Accurately valuing the IP portfolio ensures that the startup company will not be leaving money on the table as it seeks investors or other funding.
Three approaches are commonly used to determine the value of intellectual property. These approaches review different factors and as a result will often produce different results. The selection of which approach to use is dependent on the purpose of the valuation and the nature of the company and its IP portfolio. Briefly, the approaches are:
- Cost Approach which examines what was spent on developing the IP portfolio and what another company might spend if it were to invent the IP portfolio from scratch.
- Market Approach which examines sales of comparable IP portfolios in sufficiently similar deals.
- Income Approach which examines anticipated economic benefits (projected incremental profits or cost savings) from using the IP portfolio.
A more detailed review of these approaches follows.
The Cost Approach assumes that a party desiring to use an IP portfolio would be willing to pay no more than the cost to replace or re-create that portfolio. Such costs include research and development (labor, materials, overhead, etc.), testing and regulatory approval costs, fees for contracted outside services, patent protection costs, equipment and other capital investments, and opportunity costs of diverted resources.
A drawback to the Cost Approach is that it does not reflect the earnings potential of the IP portfolio. Moreover, the Cost Approach assumes that the asset under review can be substituted with an equivalent. However, in the case of intellectual property, there might not be any such equivalents. Nevertheless, a cost approach may be useful for valuing the IP portfolio of start-up companies that have not yet produced meaningful cash flows and where potential future cash flows are speculative.
The Market Approach assumes that a party desiring to use an IP portfolio would be willing to pay no more than others have paid for similar portfolios. Considerations to determine whether other deals are similar include the type of intellectual property and scope of patent protection obtained for it, the nature of the market and growth opportunities.
A drawback to the Market Approach is the difficulty in finding comparable deals. Intellectual property is unique and similar deals may not exist or may not be publicly available. Moreover, the terms of the prior deals can be so different from that under review that adjustments must be made to make a meaningful comparison.
The Income Approach assumes that a party desiring to use an IP portfolio would be willing to pay a portion of its expected economic gain from using the subject portfolio. Such economic gain would be the expected incremental income stream or cash flows or cost benefits attributable to the IP portfolio.
The Income Approach requires that there be a real basis for the economic gain projections and not mere speculation. Moreover, care is needed to apportion the economic gain attributable to the IP portfolio as opposed to other factors such as existing sales networks or marketing savvy.
Which Approach Should A Startup Company Use?
The choice of which valuation approach to use depends to a large degree on the purpose of the evaluation and the maturity level of the company. For the typical startup company, the use of the Income Approach usually fails because the startup does not have a meaningful history of cash flows or expectations of future cash flows. Moreover, the use of the Market Approach usually fails because of the difficulty in identifying transactions for technology comparable to that covered by the startup company’s IP portfolio. Most often, the Cost Approach provides the most accurate value of a startup company’s IP portfolio given the early stage of the company.
To quantify the cost necessary to replace or re-create the IP portfolio, a startup company should collect and quantify the costs actually incurred to produce the portfolio. The startup company should estimate the cost of its research and development activities including time and salaries of the inventors; the materials, machinery and equipment used to develop the IP portfolio; other capital investments; third-party services contracted for; and the costs associated with patenting in the US and other countries including both legal fees and patent office fees.
Because the Cost Approach looks only at costs incurred and not at benefits expected to be achieved using the IP portfolio, the valuation will often seem low to the startup company. However, over time as the company develops a track record of cash flow and shows real potential for market penetration for its goods and services, a Market Approach or Income Approach may become more suitable allowing for higher valuations. Relying on debt financing until the cash flow of the business justifies reliance on the Income Approach will allow the founders to minimize the dilution hit associated with investment financing.