RICS draft guidance note - Valuation of Intellectual Property Rights, Guidance Note, 2nd ed

RICS draft guidance note - Valuation of IP Rights, 2nd edition

The cost approach

Paragraph 70.1 of IVS 210 states:

'Under the cost approach, the value of an intangible asset is determined based on the replacement cost of a similar asset or an asset providing similar service potential or utility.'

In addition, the cost approach may be used when the subject intangible asset or IP does not have an identifiable income stream or when no other approach can be applied.

In situations where the cost approach is considered appropriate, the factors that should be considered include:

the stage of development of the subject IP and, if not yet commercialised, the remaining development stages and timeline

the complexity and novelty of the subject IP and the degree of difficulty in creating an asset of similar utility

the extent of obsolescence in the subject IP

the relevance of the historic development process to the reproduction of the IP or production of a replacement asset and

the estimated time required to develop an alternative asset, the opportunity cost and the probability of success.

  • Appendix A: Valuations supporting IP debt financing

This appendix identifies characteristics of IP that are of specific relevance to valuations supporting IP financing.

When scoping an IP valuation that has been commissioned by a debt provider, the valuer should ascertain the nature of the loan, which can range between:

asset-backed financing where the IP is used as collateral and

business loans where the IP is not used as collateral, but the lender wishes to assess the extent to which the IP can be expected to support a company's competitive advantage and ability to service the debt.

The nature of the loan can influence appropriate bases and premises of value; for instance, where the IP is used as collateral, the debt provider may wish the valuer to consider the premise of liquidation value.

Economic characteristics of IP that are particularly relevant to IP financing are described below, along with relevant valuation considerations.

Tech, brand, artistic and data assets can consist of a variety of IP, which can vary by jurisdiction. Furthermore, the interest of debt providers might be restricted to a specific jurisdiction. This has important implications for the scope of an IP valuation and the definition of the subject asset. The valuer should:

clarify the geographic scope and segmentation of the engagement prior to commencement and disclose this in the valuation report

in describing the subject asset, identify the specific rights within each relevant jurisdiction

disclose within the valuation report:

  • whether legal opinion has been provided regarding factors including ownership, status (to ensure that registered IP has not expired), freedom to operate and encumbrances and
    • whether technical and market factors have been assessed by an appropriate expert, or if they are covered by special instructions.

The value of IP can be highly sensitive to bases and premises of value, including assumptions made, because their commercial utility can rely on access to other assets and due to the fact that IP markets are neither efficient nor liquid.

IVS 104 identifies alternative bases of value (for example market value and equitable value) together with premises of value, which relate to the assumed use of the subject asset (such as highest and best use, current use, orderly liquidation and forced sale). When establishing the scope of work (see IVS 101) the appropriate premise(s) of value consistent with the basis and purpose (see IVS 104) must be agreed, along with whether alternative valuation estimates are required for differing premises or assumptions. For instance, if the purpose of a valuation is to inform an asset-backed financing decision, it may be appropriate to use the premise of current use and also the premise of orderly liquidation.

By way of illustration, the value of a patent portfolio protecting an early stage product may vary as follows:

low value in current use due to high risk during the development and commercialisation stages

higher value under the premise of highest and best use, due to access to complementary assets and adequate funding and

no value if marketed on a stand-alone basis in an orderly liquidation, due to an extremely low probability of sale.

The risk profile of IP assets varies considerably depending on their utility relative to competing assets, their stage of development and the strength of the associated legal rights. Chapters 3 and 4 identify factors that should be used to assess the functional, economic and legal characteristics of IP assets.

These factors are relevant whatever the purpose of the valuation and whatever methodology is applied. However, under the premises of orderly liquidation and forced sale, the commercial and legal strength of the IP may have magnified importance due to the fact that IP markets tend not to be efficient nor liquid.

Factors that contribute to the standalone value of IP include:

whether or not it has an established commercial utility and

the existence of licensees and other stakeholders.

Chapter 5 identifies characteristics of the subject IP that influence the choice of valuation approaches and methods. The most appropriate method of valuation may vary for alternative premises of value. For instance, the income approach might be appropriate to estimate value in use for IP of moderate strength that is expected to generate cash flow when used in combination with complementary assets. However, if the subject IP is not capable of being licensed on a stand-alone basis, an alternative valuation approach is likely to be more appropriate.

For tech-IP and data-IP that is in the early stage of commercialisation, there can be a range of potential earnings and risk scenarios. Within the selected valuation methods, valuers should use their judgement, sometimes supported by sensitivity analysis, to express their opinion on an appropriate value range. When conducting an IP valuation for debt funding, it is important for the valuer to ensure that the 'most likely' value range does not obscure potential outcomes that might result in the subject IP being unable to service the debt.

  • Appendix B: Determining IP royalty rates

This appendix identifies characteristics of IP that are relevant to the determination of notional royalty rates. It is beyond the scope of this document to provide in-depth guidance to royalty analysis. The appendix has been included due to the common use of the relief from royalty method of valuation, but the principles are also relevant to the determination of royalty rates as a basis for licensing negotiations or transfer pricing.

Royalties are a profit-sharing mechanism between IP owners and licensees. Parties to an arm's length licence are free to select any basis of royalty calculation that they believe results in an equitable split of IP earnings, including:

a single up-front payment or set of payments at designated milestones

a predetermined amount that is paid periodically

a percentage of revenue earned by the product or service to which the IP relates

a percentage of profit

a charge based on units of manufacture or sales and

a combination of the above.

Arm's length royalties result from negotiations between the licensee and licensor, and are informed by a range of commercial factors, including:

the commercial utility of the licensed IP relative to alternatives

the strength of legal protection of important features of the IP

the characteristics of the market in which the IP asset is used

the extent of the IP's reliance on complementary assets owned by the licensee and

other terms of the licence that determine how the risks and rewards are shared between licensor and licensee.

The same factors are relevant to the determination of notional royalty rates for the purpose of IP valuations and transfer pricing. It is beyond the scope of this appendix to describe and assess alternative methodologies to estimate royalties, but three broad approaches are:

  1. estimating a royalty through benchmarking relative to arm's length royalties for similar IP. This is sometimes referred to as the comparative uncontrolled pricing method
  2. earnings-based methods, which use financial analysis to estimate the incremental revenue, or cost savings, generated by the subject IP and
  3. cost-based methods, which make reference to an appropriate return on the cost of the subject IP. These methods are generally not appropriate for highly differentiated IP with strong legal protection, but can be used for IP assets that are replicable.

All approaches to royalty determination should include:

a clear definition of the subject IP within the relevant jurisdiction(s), as described in chapter 2 of this guidance note and

an assessment of the strength of the subject IP asset in terms of its functional, legal and economic characteristics, as described in chapters 2 and 4 of this guidance note.

When estimating an IP royalty based on benchmarking relative to arm's length royalty rates, careful consideration should be given to:

similarities and differences between the subject IP and the benchmarked transactions in terms of legal characteristics. For instance, within the same area of technology, there is little comparability between tech-IP consisting of a portfolio of granted patents with broad claim scope and a technology that is reliant on a single patent application

similarities and differences between the subject IP and the benchmarked transactions in terms of functional and economic characteristics. Due to the intrinsic nature of IP assets, the earnings differential between average and exceptional assets is pronounced; hence, a benchmarking exercise that does not properly reflect functional differences can be misleading

the comparability of the royalty base, i.e. for the same product, the royalty rate will vary depending on whether it is calculated as a percentage of wholesale revenue or retail revenue

differences in market conditions and economic circumstances between different markets and transaction dates

the economic circumstances of the parties, or other business dealings, that might influence the licensing terms and

the terms of the licence, i.e. the royalty might differ substantially depending on how other commercial risks and rewards are apportioned between the licensor and licensee.

When conducting statistical analysis of royalty databases, the analysis should take due account of the following:

Royalty databases exclude IP assets that lack the earnings capability to be licensed. This can be a significant portion of the IP population within an industry, so the median royalty rate within the database is likely to be materially higher than the median royalty for the IP population as a whole.

It can be erroneous to infer a linear relationship between IP strength and royalty potential. For instance, within a particular industry, the strongest IP typically commands a significantly higher royalty than the upper-quartile.

For patents that are deemed to be essential to practice a technical standard, valuers should be aware of fair, reasonable and non-discriminatory (FRAND) licensing and royalty terms.

The most appropriate method of royalty determination is influenced by the characteristics of the IP and the availability of information.

Due to the complexities of IP assets, it is sometimes appropriate to use a corroborating as well as a primary method of royalty determination, or to integrate the findings of several analyses in order to support a royalty assumption.