Valuing a Patent License - Overview

Copyright © 2005, William H. Black

This discussion paper provides an introduction to some of the concepts underlying the establishment of a value for a patent license. It is intended to stimulate thinking on the topics included, and does not constitute legal or accounting advice. Your comments are welcome: contact whb@billblackcpa.com .

What is a patent license worth?.

Developing an estimate of value

What if they won’t negotiate?

Strategies for capturing value

Caveats

What is a patent license worth?

Pragmatically, a license is worth what someone is willing to pay for it. And for them to be willing to pay for the license, it has to represent a way for them to make more money, even after paying for the license, than they would be able to make without the advantages covered by the license. The evaluation of how much a license is worth involves estimates about future costs and benefits, tempered with an assessment of the risk that actual future conditions will vary adversely from the estimates.

Investing in IP that matters is the most cost-effective investment many companies can make. IP assets, particularly patents, are at their core, marketing tools. They can help establish a market niche, prevent someone else from invading a niche, or preserve a marketing position that otherwise would erode[1].

Rules of thumb, typical industry percentage royalties, and the like can prove misleading, for they address other innovations and the benefits from them; not the benefits from your innovation. It makes little difference whether many licenses in the industry set license fees at 2-3% if your innovation results in a benefit several orders of magnitude greater than the benefits of the typical innovation. Negotiation based upon a clear understanding of the costs and benefits is a productive strategy. Both the innovator and the licensee should make a fair return on investment (including intellectual capital), reflecting the risks borne by each side.

If your innovation represents something entirely new, for example a way do doing something that cannot be done at all currently, you might think it would be worth more than something which merely improves existing processes. Paradoxically, demonstrating the value for something entirely new is likely to be far more difficult, for you must demonstrate:

a)                  The innovation does what you say it can do;

b)                  There is a market demand for what it can do;

c)                  That market can be reached at a reasonable cost (distribution, promotion, etc.);

d)                  The innovation can be made and implemented at a reasonable cost;

e)                  It can be sold at a price which yields an attractive profit;

f)                    Other factors, like competition or other innovations, are not likely to disrupt the expected profit stream.

If the innovation merely improves upon the familiar, then your potential licensee is likely to have an independent understanding of market demand and cost factors, which will make your required educational efforts less extensive. In such cases, the requirements for detailed market analysis by the innovator may be reduced. With something entirely new, additional support is likely to be needed to buttress your estimates of profitability. In either case, valuation is a data-intensive process, drawing upon cost accounting information, economic data, engineering studies, market research and analysis, and many other disciplines.

Developing an estimate of value

First, understand the nature of your innovation. What advantages does it offer? Those advantages can be cost reduction (if your innovation covers process improvements or a better way of making what the manufacturer is making already), revenue enhancement (if it makes the product more attractive and the manufacturer can sell more of it or sell it at a higher price), or market penetration (a way of doing something that they aren’t doing now or can’t be done without the innovation). For each of these types of advantages, you need to make an estimate of the cost reduction or revenue enhancement stemming from the use of your patent. This estimate needs to consider fixed and variable cost behavior over the relevant range of likely sales, coupled with the likely selling prices and related sales volumes. Also remember to reflect the mechanics of compound interest – future benefits need to be reduced by the time value of money when calculating value at the present time.

Keep in mind that the licensee is also contributing resources to the process, for example production capacity and facilities, distribution networks, market presence and credibility, technical and development skills, or financial support. Without the resources of the licensee, you might not be able to get into that market at all (or not at a level permitting significant economies of scale). Conversely, without a license to use your patent the licensee would not be able to penetrate the market as effectively. Therefore, there needs to be an apportionment of the benefits and profits according to the resources contributed by each side and the risks assumed by each side.  There is no such thing as a free lunch. The profits you hope to realize by licensing your innovation will only happen if your licensing arrangement makes it possible for the licensee to profit as well.

The strength of your patent also needs to be evaluated by a competent professional. If your innovation is easy to design around, or similar results can be obtained by other non-patented processes, your bargaining position is weakened. If your innovation is critical to the functioning of broader processes, or alternative non-infringing methods are not cost-effective, you have a stronger position in negotiations. While narrowly-defined patents may be easier to defend, they may also be easier to design around, while broad patents may cover more area but may also be more vulnerable to attack. Evaluation of the strength of a patent or potential patent is not an accounting or economic exercise, and thankfully is beyond the scope of this discussion paper.

To make matters even more complicated than they already are, you may need to consider the effects of your patented product on the sales of related (non-patented) items. If the item of which your patent is a part can demonstrably enhance sales and profits of another product, those convoyed sales represent an additional benefit which should be considered in the licensing negotiations.

Based on an understanding of the benefits from your innovation and the profitability it can be expected to produce, you can begin to negotiate a license which fairly shares the profits according to resources (including intellectual capital) and risks. When preparing for negotiation, the more you know about the industry, the competition, and the market, the better. While most people think of the typical licensing arrangement as a straight percentage of revenues deal, there are many other possible ways to structure the arrangement. Those include lump-sum payments, fixed amount per unit sold, sliding scale of percentages based on volume, reciprocal licensing arrangements (of other products), and variations and permutations of those themes.

What if they won’t negotiate?

Of course, if your “deep pockets” competitor believes it will be cheaper for them to litigate than to license the patented advantages, you may not be able to reach a good-faith agreement. When considering litigation to defend your patent, you need to understand the underlying value of your innovation as well.  While it may not make sense to spend $200K or more litigating a patent which might bring in $250-300K in royalties over its useful life, it almost certainly would make sense to spend that much to defend a likely $10 million royalty stream. Also, bear in mind that the royalty determined by the court will be “reasonable”, not necessarily the royalty you would have agreed to at the outset had you been able to avoid the costs and risks of litigation.

The scope of damages in patent litigation expands beyond the licensing arrangements discussed above, and can extend to lost profits on sales made and sales lost by the patent holder as well. While a full discussion of lost profits from patent damages would require a substantial amount of space, in summary areas for recovery of damages could include lost profits from lost sales, price erosion on actual sales, lost profits from lost growth opportunities, and damages from lost sales of convoyed (related) products.

Cost effective litigation is somewhat of an oxymoron, but if the pot of gold at the end of your rainbow is big enough and your claim strong enough, somehow you should be able to pull together a team to be taken seriously. Patent expertise is clearly necessary to prove the validity of your patent, but litigation experience is also necessary when attempting to prove damages to a jury or court.

Strategies for capturing value

In fact, some companies exist only to pursue licensing royalties, litigation and settlements for their patent portfolios: Acacia is one current example.

Acacia's sole business practice is licensing IP that it didn't invent. The company purchases someone else's patents and enforces them by threatening litigation. Thanks to a public stock offering and a successful licensing program covering different patents, Acacia has money in the bank and a readiness to spend it on patent enforcement.[2]

Acacia (and others) have adopted a business model based on the perception that aggressively pursuing licensing revenues, backed up by the threat of enforcing patent rights through litigation, will generate a positive earnings stream for the company.

There are other approaches to capturing the value of intellectual property without litigation. IP Auctions describes itself as follows:

ipAuctions Inc. was formed to provide a professional auction process for the sale of Intellectual Property assets. The site is designed for the corporate and business professional, as well as, U.S. Bankruptcy Court trustees, attorneys and other individuals who wish to auction valuable intangible assets.

We specialize in handling property such as patents, trademarks, product and software licenses, copyrights, databases and customer files.  Our goal is to maximize the value of each transaction to our buyer base through full disclosure of the property offered, including links to the U.S. Patent and Trademark Office, and contact information about the seller.[3]

Caveats

This discussion is necessarily abstract, since it does not include any consideration of specific products, specific industries, or specific advantages provided by a particular innovation. Cost / benefit analysis is always situation-specific, but the general principles described above should give you some additional perspective. This discussion paper does not constitute legal or accounting advice, and competent professional help should be sought when appropriate.