Willamette Management Associates White Paper: INTELLECTUAL PROPERTY VALUATION CONSIDERATIONS

Willamette Management Associates White Paper: INTELLECTUAL PROPERTY VALUATION CONSIDERATIONS by Robert F. Reilly, CPA INTRODUCTION AND OVERVIEW There are numerous reasons why Willamette Management Associates analysts are asked to value an owner/operator s intellectual property assets. All of these individual owner/operator reasons are generally grouped into the following categories of motivations: transactions, financings, taxation, regulatory compliance, bankruptcy, financial accounting, litigation, and strategic planning. Willamette Management Associates analysts are frequently asked to value intellectual property for all of these categories of reasons. The owner/operator s legal counsel are often involved in the intellectual property valuation process. This is because the legal counsel are involved in assisting their owner/operator clients with respect to structuring transactions, performing due diligence, complying with taxation and regulatory requirements, negotiating and arranging financings, prosecuting and defending claims, and defending and commercializing the intellectual property. In our experience, legal counsel are often involved in the process of: identifying the client s intellectual property, performing the related due diligence, interviewing and selecting the intellectual property valuation analyst, defining the valuation analyst s assignment, assisting the owner/operator to assemble valuation-related data and documents, providing legal instructions to the valuation analyst, reviewing and questioning the valuation work product, interpreting and relying on the valuation report, and defending the valuation during any administrative, regulatory, or judicial challenge. At Willamette Management Associates, our analysts often value general commercial intangible assets without the advice from, or the assistance of, the owner/operator s legal counsel. This is because general intangible assets (e.g., customer relationships, assembled workforce, goodwill, etc.) typically have no special legal definition or statutory protection. Also, the valuations of such commercial intangible assets are usually performed for financial accounting and other non-legal purposes. In contrast, due to the special statutory status of intellectual property assets (i.e., of patents, copyrights, trademarks, and trade secrets), our valuation analysts and the client s legal counsel often work together in several phases of the intellectual property valuation assignment. First, this white paper summarizes the valuation implications of the 2011 America Invents Act. Second, this white paper summarizes (1) many of the reasons to conduct the intellectual property valuation, (2) the elements of the intellectual property valuation assignment, and (3) the data gathering

Intellectual Property Valuation Considerations Page 2 and due diligence process. Third, this white paper describes and illustrates the three generally accepted intellectual property valuation approaches, specifically: cost approach valuation methods, market approach valuation methods, and income approach valuation methods. Finally, this white paper comments on (1) the valuation synthesis and conclusion process, (2) the attributes of an effective intellectual property valuation report, and (3) what type of professional should perform the intellectual property valuation. VALUATION IMPLICATIONS OF THE AMERICA INVENTS ACT The Leahy-Smith America Invents Act (AIA) was signed by President Obama on September 16, 2011. The AIA represents long-awaited and long-debated patent reform legislation. The AIA includes significant changes to patent filing, patent administration, and patent challenge procedures. However, the final version of the AIA excludes numerous procedures that were incorporated in earlier drafts of the bill, particularly procedures related to patent valuation and economic damages measurement. The following discussion summarizes many of the provisions of the AIA. And, this discussion mentions several of the provisions that were not included in the final AIA legislation. An Introduction to the AIA One of the most significant changes in the 2011 legislation is that the AIA adopts a first-to-file (versus the prior law first-to-invent) procedure for the granting of a patent. The AIA includes provisions addressing post-grant review proceedings and inter partes review proceedings. The AIA provides for significant changes in product patent marking (and in eliminating certain false patent marking claims). And, the AIA allows the U.S. Patent and Trademark Office (PTO) to establish a new fee structure. In terms of patent litigation, the AIA includes a provision that the failure to obtain the advice of legal counsel can no longer be used to prove that an accused infringer (1) willfully infringed the patent or (2) intended to induce infringement of the patent. However, the most significant impact of the AIA on patent legislation relates to what the legislation ultimately did not include. Early versions of the legislation included a valuation calculation provision that required the court to conduct an analysis to ensure that a reasonable royalty is applied only to the portion of economic value of the infringing product or process properly attributable to the claimed invention s specific contribution over the prior art. However, none of these valuation or economic damages provisions ultimately made it into the final AIA legislation.

Intellectual Property Valuation Considerations Page 3 The New First-to-File Patent Application System Unlike most of the rest of the world, the United States historically operated under a first-to-invent system of determining the priority of an invention that is, what party is entitled to receive a patent on the invention. Typically, the first inventor was considered to be whoever could demonstrate the earlier conception and diligence related to reducing the invention to practice. Under the AIA, the priority of an invention is determined by the earliest date that the patent application was filed with the PTO. This first-to-file patent application system should eliminate costly and time-consuming interference proceedings. Such interference proceedings are conducted to determine which inventor is entitled to the grant of the patent. Under the new AIA legislation, derivation proceedings may replace interference proceedings to determine whether an earlier filer improperly copied, or derived, the invention from a later filer. This new first-to-file patent application provision will not go into effect until 18 months after the enactment of the AIA. Scaling Back of the Patent Application Grace Period Before the AIA, the patent applicant enjoyed a one-year grace period under which a prior disclosure of the invention (by the patent applicant or by any other party) up to one year prior to the applicant s filing date did not count as prior art. This grace period was applicable provided that the patent applicant could show (1) a conception date prior to the disclosure and (2) diligence in either (a) reducing the invention to practice or (b) filing a patent application for the invention. The AIA replaces this absolute one-year grace period with a personal grace period. Under the AIA, the patent applicant s own prior disclosures (or disclosures derived from the patent applicant) within one year prior to the applicant filing date are exempt as invalidating prior art. However, other disclosures of the invention by third parties do constitute invalidating prior art. These applicant grace period changes will take effect 18 months from the date of enactment of the AIA. New Procedures for Challenging a Patent The AIA provides many different mechanisms for challenging a patent, both post-issuance and preissuance. The AIA post-issuance challenge provisions are intended to make the PTO a more viable venue for challenging patents. These new provisions should result in faster, lower-cost, and more rational decisions on patent viability. The AIA replaces the previous inter partes reexamination procedure with

Intellectual Property Valuation Considerations Page 4 two similar but unique provisions for challenging the patentability of an issued patent: (1) an inter partes review and (2) a post-grant review. The inter-partes review procedure parallels the prior inter partes reexamination procedures. The AIA removes the threshold requirement that an alleged basis of unpatentability be new. This new procedure begins one year after the date of the AIA enactment. However, the new standard for declaring an inter partes review (i.e., the reasonable likelihood that the requester will prevail instead of the previous substantial new question of patentability ) takes effect immediately. A post-grant review will be available to challenge an issued patent within the first nine months after the patent issuance. This review does expand the available legal theories that may be used to challenge patentability. However, the current reexamination procedures may only challenge an issued patent based on (1) prior art patents and (2) printed publications. The post-grant review provisions also require that the PTO resolve the patent challenge entirely within a year of the review request (with a six month extension period available). This procedure will be available one year after the date of the AIA enactment. In addition to the provisions for a post-grant challenge, the AIA pre-issuance challenge provisions allow a third party to submit a patent application, patent, published patent application, or any other relevant printed publication for consideration by the patent examiner during the examination of a patent application. However, such a submission must be made in writing. And, the submission must be submitted before the earlier of: (1) the date that the notice of allowance is given or mailed or (2) the later of (a) six months after the patent application is published or (b) the date of the first patent rejection. A Supplemental Examination of the Patent The AIA also contains provisions to reduce the litigation burden on patent owners who are planning to assert their patents. In these legislative provisions, the AIA takes aim at the common litigation charges of inequitable conduct. A finding of inequitable conduct can block the enforcement of an entire patent. This occurs even when the accused conduct by the patent owner is unrelated to the validity of any asserted claims. Therefore, charges that a patent holder failed to candidly deal with the PTO are often made in patent litigation. Under the AIA, a charge of inequitable conduct cannot be based on information presented or corrected in a supplemental examination that was timely requested by the patent owner. The PTO may elect to reexamine the patent if the presented information does affect the validity of any claim. Therefore, the safe harbor provided by supplemental examination procedure may make this provision a valuable tool for the pre-assertion scrub of a patent.

Intellectual Property Valuation Considerations Page 5 Significant Changes Related to Patent Product Marking Claims A patented product (or the associated packaging) may now be marked with the word patent or pat. followed by an address of a posting on the Internet. That Internet address will be accessible to the public without charge. That Internet address will list the patent number(s) that cover the patented product. Before the AIA, in order to give public notice, a patented product needed to be marked with the actual number(s) of the patent(s) that covered the patented product. In addition, the marking of a potential product with an expired patent number that is, the patent number that previously covered that product is no longer actionable as a false marking. Finally, the AIA amends the prior false marking statute in two ways. First, the AIA grants only the US government the standing to sue for per-article fines. Second, the AIA only permits those parties who have suffered competitive injury as a result of false marking standing to sue for compensatory damages. These AIA changes apply to false marking cases pending on or after September 16, 2011. The New Prioritized Examination Procedures Under the AIA, the PTO is required to implement a prioritized examination procedure for utility patents and plant patents. This new procedure will allow patent applicants to file a request with the PTO for prioritized examination. That request must include the payment of a fee (in addition to other filing fees) of $4,800 (or $2,400 for a small entity). The patent application for which the request is made should have (1) no more than four independent claims and (2) no more than 30 total claims. The PTO may not accept more than 10,000 such requests per year. Additional PTO Patent Application Fees Under the AIA, all patent fees charged by the PTO were increased by 15 percent effective on September 26, 2011. Also, to encourage patent applicants to use electronic filing procedures, an additional $400 fee (or $200 for a small entity) was instituted for all patent applications that are not filed electronically after November 15, 2011. Summary of the AIA The AIA legislation changes affect many aspects of patent prosecution and litigation. And, these AIA changes could impact the value of an owner/operator s individual patents. This is particularly the case (1)

Intellectual Property Valuation Considerations Page 6 for pending (as of 2011) patent applications and (2) for patents involved in the reexamination process (as of 2011). Accordingly, the patent owner/operator and the legal counsel (1) should reevaluate the patent application or prosecution strategies and (2) should consider the impact of the AIA of individual patents. In particular, the patent owner/operator and the legal counsel should consider the impact of the AIA enactment on (1) the managing and protecting of the client s intellectual property and (2) the monitoring and challenging of third-party patents. However, only time will tell the impact of the AIA (1) on patent valuations and (2) on patent litigation economic damages analyses or judicial damages awards. Since all of the AIA provisions have not been fully implemented, the market for patent sales and/or licenses has not yet incorporated the impact of the AIA on patent transactions. In addition, the legislative changes that would most directly affect patent valuation and economic damages analyses were excluded from the final (executed) version of the AIA. REASONS WHY ANALYSTS ARE ASKED TO CONDUCT THE INTELLECTUAL PROPERTY VALUATION Table 1 summarizes many of the common reasons why Willamette Management Associates analysts are asked to value an owner/operator s intellectual property. In some valuation engagements, we are retained directly by the owner/operator. More commonly in intellectual property valuation engagements, we are retained by the legal counsel for the owner/operator. Many of the individual client reasons to value intellectual property are listed in Table 1. Table 1 Common Reasons to Value the Owner/Operator Intellectual Property 1. Transaction pricing and structuring: Pricing the sale of an individual property or a portfolio (bundle) of two or more intellectual property assets. Pricing the license of an individual intellectual property or a portfolio (bundle) of two or more intellectual property assets. Concluding an appropriate exchange ratio when owner/operators exchange use rights to two portfolios (bundles) of intellectual property Opining on the fairness (from a financial perspective) of a sale or license of intellectual property (for the benefit of a minority investor, joint venture partner, etc.) Quantifying the equity allocations in the formation of a new business enterprise or joint venture, based on relative values when one or more parties contribute intellectual property assets.

Intellectual Property Valuation Considerations Page 7 Quantifying the asset distributions in a business enterprise or joint venture liquidation, based on relative values when one or more parties receive intellectual property assets. Pricing the transfer (either ownership or use) of intellectual property between (1) two wholly owned subsidiaries of a party business entity or (2) two less than wholly owned subsidiaries of a parent business entity. 2. Financings collateralization and securitization: Estimating the value of intellectual property used as collateral in either cash flow-based or assetbased corporate debt financings. Estimating the value (current value or residual value) of the commercial intellectual property transfer in a sale/licenseback financing Identifying sale, license, or other cash flow generation opportunities for an owner/operator attempting to raise business financing Estimating the value of intellectual property in the process of quantifying debtor entity solvency (in order to avoid a fraudulent transfer claim) in any corporate financing transaction. 3. Taxation planning and compliance: Supporting the tax basis purchase price allocation (among the acquired tangible assets and intangible assets) in a going concern business acquisition. Supporting the amortization deductions for the tax basis (i.e., fair market value) of purchased intellectual property. Supporting the charitable contribution deduction for donated intellectual property. Calculating the arm s-length transfer price (ALP) for the cross border use or other transfer of a multinational corporation s intellectual property. Measuring the state and local ad valorem property tax impact of either taxable intellectual property or tax exempt intellectual property. Creating an intellectual property holding company subsidiary (e.g., a Delaware holding company) and designing interstate use license agreements for the internal licenses of a multistate owner/operator Performing a fair market valuation of intellectual property transferred between the foreign/foreign subsidiaries or the foreign/domestic subsidiaries of a multinational owner/operator 4. Regulatory compliance and corporate governance: Performing a custodial inventory of owned and licensed intellectual property. Assessing the insurance coverage requirements for owned and licensed intellectual property. Estimating values to assist legal counsel with the owner/operator s defense against infringement, tort, breach of contract, and other wrongful acts. Estimating values to assist legal counsel with the owner/operator s defense against an allegation of the dissipation of corporate assets. Providing proof of a fair market value price for sale or license of intellectual property between a for-profit entity and a not-for-profit entity (to avoid claims of excess benefit or private inurement)

Intellectual Property Valuation Considerations Page 8 5. Bankruptcy and reorganization: Estimating the value of intellectual property used as a secured creditor s debt collateral. Estimating the value of intellectual property used as debtor in possession (DIP) secured debt financing collateral. Providing evidence of the fairness of sale or license of debtor intellectual property (particularly with regard to a Bankruptcy Code Section 363 sale) as a DIP cash generation spinoff opportunity. Estimating the value of intellectual property in the assessment of the debtor corporation solvency or insolvency with respect to fraudulent transfers and preference actions. Calculating the impact of the use or license of intellectual property on the bankrupt owner/operator s plan of reorganization. Performing a fresh-start accounting fair value valuation of intellectual property of the debtor owner/operator emerging from bankruptcy protection 6. Financial reporting and fair value accounting: Performing the business acquisition fair value accounting in order to allocate the purchase price among the acquired tangible assets and intangible assets. Performing fair value valuations for goodwill and intellectual property periodic impairment testing. Preparing post-bankruptcy fresh-start accounting fair value valuations for emerging entity tangible assets and intangible assets. Preparing fair value valuations of intellectual property contributed to a business in exchange for an equity ownership 7. Forensic analysis and dispute resolution: Measuring a fair royalty rate or other economic damages analysis in intellectual property infringement claims. Measuring lost profits or other economic damages in intellectual property breach of contract, license, or noncompete/nondisclosure agreement damages claims. Calculating the value of intellectual property included in condemnation, expropriation, eminent domain, or dissipation of corporate assets claims. 8. Owner/operator management strategic planning information: Estimating the value of contributed intellectual property in the formation of joint venture, joint development, or joint commercialization agreements. Assisting in the negotiation of inbound or outbound intellectual property use, development, commercialization, or exploitation agreements. Assisting in the identification and negotiation of intellectual property license, spin-off, joint venture, and other commercialization opportunities. Concluding the fairness of any transaction between an inventor/shareholder and the related business when the inventor/shareholder has fiduciary duty (e.g., to minority stockholders, ESOP participants, etc.)

Intellectual Property Valuation Considerations Page 9 Performing the valuation of (non-income-producing) defensive use intellectual property In addition to understanding the reason for the intellectual property valuation, the valuation analyst should also understand the objective of the analysis. The owner/operator or the legal counsel should specifically define which one (or ones) of the following intellectual property opinions the valuation analyst is being asked: 1. to estimate a specifically defined value for the subject intellectual property; 2. to measure lost profits, lost value, or some other type of economic damages to the intellectual property; 3. to conclude an arm s-length price (ALP) for the intercompany transfer of intellectual property between controlled foreign corporations (i.e., in compliance with Internal Revenue Code Section 482); 4. to estimate a license agreement fair royalty rate between independent arm s-length parties (but not related to Section 482); 5. to opine on the fairness of an intellectual property sale, license, or other transfer transaction from a financial perspective; 6. to estimate the intellectual property remaining useful life (RUL); 7. to estimate a relative exchange ratio for two bundles of intellectual property; and 8. to analyze the development or commercialization potential of an intellectual property. The valuation analyst s engagement objective should be specified as one of the elements of the intellectual property assignment. Typically, this analysis purpose and objective is documented in an engagement letter between the analyst and the owner/operator (or between the analyst and the legal counsel). Such an engagement letter provides useful assignment (and sometimes legal) instructions to the valuation analyst. In addition, such a written engagement letter helps to reduce any future misunderstandings between the valuation analyst and the owner/operator (or the legal counsel). COMMON ELEMENTS OF THE INTELLECTUAL PROPERTY VALUATION ASSIGNMENT In our experience, the first element of the valuation assignment is a complete definition of the subject intellectual property. That definition statement should specify what patent, copyright, trademark, or trade secret is the valuation subject. This definition should include the registration number and country for the patent, copyright, or trademark (if registered). This definition statement should also describe any commercial intangible assets that should be considered along with the subject intellectual property. For

Intellectual Property Valuation Considerations Page 10 example, should the trademark analysis include advertising materials, trade dress, and domain names? Should the patent analysis include product/process engineering drawings, other technical documentation, and related proprietary technology? The second element of the valuation assignment is a description of the bundle of legal rights subject to analysis. The assignment statement should specify which of the following (or which other) bundles of legal rights the analyst should include in the intellectual property valuation: 1. fee simple interest 2. term/reversion interest 3. life/residual interest 4. licensor/licensee interest 5. territory (domestic/international) interest 6. product line/industry interest 7. sublicense rights 8. use rights 9. development rights 10. commercialization/exploitation rights 11. rights to enhancements, research and development efforts, new developments, etc. 12. rights to legal protection, promotional activities, advertising expenditures, etc. The third element of the valuation assignment is a description of any intellectual property license or contract that is in effect. If there is a license or agreement (contested or otherwise) associated with the subject intellectual property, then the valuation analyst should be made aware of the contract terms. Some common intellectual property contract terms are listed in Table 2. Table 2 Common Intellectual Property Contract Terms 1. Licensor/licensee responsibility common contract terms: identity of the licensor and the licensee term of the agreement (including any renewal options) the intellectual property legal protection requirements amount and responsibility for research and development expenditures amount and responsibility for marketing, advertising, or other promotional expenditures responsibility to obtain and maintain any licenses, permits, or other regulatory approvals

Intellectual Property Valuation Considerations Page 11 milestone dates for regulatory approvals, commercialization, sales levels, etc. 2. Other common contract terms: minimum use, production, or sales requirements minimum marketing, promotion, or commercialization expense requirements research and development technology development payments, development completion payments party responsible to obtain the required regulatory approvals milestone license payments rights to any future developments rights to sub-license The fourth element in the valuation assignment is the standard (or definition) of value that the analyst is being asked to conclude. The standard of value typically relates to the question: Value to whom? The different standards of value often correspond to different reasons to conduct the intellectual property valuation. Often, the standard of value is determined by a statutory, regulatory, or administrative requirement. Therefore, the owner/operator (or, commonly, the legal counsel) will instruct the analyst as to the appropriate standard of value to use in the assignment. Some of the common alternative standards of value include the following: fair value fair market value use value user value owner value investment value acquisition value contributory value defensive value collateral value intrinsic value residual value

Intellectual Property Valuation Considerations Page 12 The fifth element in the valuation assignment is the premise of value that the valuation analyst should assume. The premise of value considers the assumed set of circumstances under which the intellectual property transaction (sale or license) will take place. In other words, under what set of circumstances will the parties identified in the standard of value get together to complete the transaction? Some of the more common alternative premises of value include the following: value in continued use value in place (but not in use) value in exchange orderly disposition basis value in exchange voluntary liquidation basis value in exchange involuntary liquidation basis The selected premise of value is typically an assignment instruction from the owner/operator (or from the legal counsel). If the client (or legal counsel) does not provide an instruction as to the appropriate premise of value, then the valuation analyst will typically select the premise of value that concludes the highest and best use (HABU) for the subject intellectual property. In selecting the intellectual property HABU, the valuation analyst may consider the following alternatives: the current owner/operator HABU a new owner/operator (i.e., the marketplace) HABU licensor/licensee HABU The sixth element of the valuation assignment is the valuation date. The owner/operator (or the legal counsel) will instruct the analyst as to the appropriate as of date on which to conclude the defined value. There is typically a transaction, legal, or regulatory reason to select a particular analysis as of date. The above-listed elements describe the objective of the valuation. In our experience, the valuation analyst also needs to know the purpose of the valuation. The purpose of the valuation typically considers the following elements: 1. What will the intellectual property valuation be used for? 2. Who will rely on (or receive a copy of) the valuation? 3. What form and format of an intellectual property valuation report is required? 4. Are there any legal instructions (e.g., specific statutory definitions, judicial precedent, or reporting requirements) that the analyst should consider?

Intellectual Property Valuation Considerations Page 13 In order to serve the information needs of the owner/operator or the legal counsel, the valuation analyst should have a clear understanding of the intellectual property assignment. The legal counsel is often responsible for ensuring that the valuation analyst develops that clear understanding. THE VALUATION PROCESS DATA GATHERING AND DUE DILIGENCE Before the analyst selects and applies the valuation approaches, methods, and procedures, he or she should perform a due diligence with respect to the owner/operator s intellectual property. In our experience, the legal counsel may participate in this due diligence process. This is particularly the case if the intellectual property valuation relates to a transaction, financing, or litigation matter. However, these analyst due diligence procedures relate to identifying and obtaining information for the valuation, economic damages, or transfer price analysis. Therefore, the analyst s due diligence process is a supplement to and not a substitute for the lawyer s legal due diligence process. First, the valuation analyst will typically gather and analyze information related to the intellectual property current owner/operator. The information will typically relate to both the historical development and the current use of the intellectual property. Such information will typically include the following: 1. the owner/operator s historical and prospective financial statements (related to the line of business or business unit that operates the intellectual property) 2. the owner/operator s historical and prospective intellectual property development and maintenance costs 3. any current and expected owner/operator resource/capacity constraints (e.g., with consideration of raw materials, production, storage, distribution, sales, etc.) 4. a description and an estimate of the intellectual property economic benefits to the current owner/operator, including the following economic benefit components: any associated revenue increase (e.g., related product unit price/volume, market size/position) any associated expense decrease (e.g., expenses related to product returns, COGS, SG&A, R&D) any associated investment decrease (e.g., inventory, capital expenditures) any associated risk decrease (e.g., the existence of any intellectual property contracts, a decrease of cost of capital components, the defensive use of intellectual property) any assessment of the impact of the intellectual property on the owner/operator s strategic/competitive strengths, weaknesses, opportunities, and threats (i.e., a SWOT analysis)

Intellectual Property Valuation Considerations Page 14 The analyst may consider the market potential of the intellectual property outside of the current owner/operator. For example, the analyst may consider the following factors from the perspective of an alternative (e.g., hypothetical willing buyer) owner/operator: 1. a change in the market definition or in the market size for an alternative owner/user 2. a change in alternative/competitive uses of the intellectual property to an alternative owner/user 3. the ability of the intellectual property to create inbound/outbound license opportunities to an alternative owner/user 4. whether the current owner can operate the intellectual property and also outbound license the intellectual property (in different products, different markets, different territories, etc.) The analyst should also review and challenge (1) any owner/operator-prepared financial projections and (2) any owner/operator-prepared measures of intellectual property economic benefits. In particular, the analyst may test the achievability of such projections and the reasonableness of such economic benefit measures against industry, guideline company, and other benchmark comparisons. For example, the analyst may perform the following benchmark comparative analyses: 1. compare any owner/operator prior-prepared projections to the owner/operator prior actual results of operations 2. compare any owner/operator current management projections to the owner/operator current capacity constraints 3. compare any owner/operator current financial projections to the current total market size (i.e., demand, capacity, etc.) 4. consider any published industry average comparable profit margin (CPM) data for the industry in which owner/operator competes 5. consider selected guideline publicly traded company comparable profit margin (CPM) data for the industry in which owner/operator compacts 6. consider the quality and quantity of available guideline or comparable intellectual property license data for the industry in which owner/operator competes 7. perform an RUL analysis for the subject intellectual property, with consideration of the following life measurements: legal/statutory life contract/license life technology obsolescence life economic obsolescence life lives of prior generations of the subject intellectual property

Intellectual Property Valuation Considerations Page 15 position of the subject intellectual property in its current life cycle In addition to comparing the owner/operator historical and projected results to the selected guideline public companies (described below), the analyst may also compare the owner/operator results to published industry data sources. Table 3 presents some of the common published industry data sources that valuation analysts often use for these benchmark comparative intellectual property analyses. Table 3 Common Industry Financial Ratio Data Sources Used in the Intellectual Property Due Diligence The Risk Management Association Annual Statement Studies: Financial Ratio Benchmarks BizMiner (The Brandow Company) Industry Financial Profiles CCH, Inc. Almanac of Business and Industrial Ratios Fintel, LLC Fintel Industry Metrics Reports MicroBilt Corporation (formerly IntegraInfo) Integra Financial Benchmarking Data ValueSource IRS Corporate Ratios Schonfeld & Associates, Inc. IRS Corporate Financial Ratios The data sources included in Table 3 allow the valuation analyst to compare to owner/operator financial results to benchmark industry expense ratios, profit margins, returns on investment, and so forth. Such a comparison assists the valuation analyst to assess the reasonableness of the owner/operator s financial projections and/or the owner/operator s assessment of any intellectual property economic benefits. GENERALLY ACCEPTED INTELLECTUAL PROPERTY VALUATION APPROACHES AND METHODS There are three generally accepted intellectual property valuation approaches: the cost approach, the market approach, and the income approach. The valuation analyst will typically consider, and attempt to apply, all three approaches in the intellectual property valuation. This is because the application of multiple approaches provides the analyst with multiple value indications. These multiple value indications often reconcile into a reasonable range of intellectual property values (e.g., with the analyst considering the mean, median, modes, interquartile measures, and other measures). Ideally, the multiple intellectual property value indications provide mutually supportive evidence of the analyst s final value conclusion.

Intellectual Property Valuation Considerations Page 16 However, most intellectual property valuations are primarily based on only one valuation approach. For each intellectual property valuation, the analyst will select the approach (or approaches): 1. for which there are the greatest quantity and quality of available data, 2. that best reflect the actual transactional negotiations of market participants in the owner/operator industry, 3. that best fit the characteristics (e.g., use, age, etc.) of the specific intellectual property, and 4. that are most consistent with the practical experience and professional judgment of the individual analyst. Within each valuation approach, there are several valuation methods that the analyst can select and apply. And, within each method, there are also numerous procedures that the analyst can perform. Therefore, valuation procedures are performed within a valuation method to conclude a value indication. And, valuation methods are applied within a valuation approach to conclude a value indication. The analyst may perform two or more valuation methods within a single approach. For example, the analyst may perform three different income approach methods and then reconcile the three value indications to conclude a single income approach value indication. At this point in the process, the analyst will reconcile the various valuation approach indications (if more than one approach is used). This synthesis of the various valuation approach value indications will result in the analyst s final value conclusion for the owner/operator s intellectual property. All of the cost approach methods are based on the economics principle of substitution. That is, the value of intellectual property Alpha is influenced by the cost to create a new substitute intellectual property Bravo. As will be discussed, all cost approach methods apply a comprehensive definition of intellectual property cost, including consideration of an opportunity cost during the intellectual property development stage. In addition, the cost of the new substitute intellectual property should be reduced (or depreciated) in order to make the hypothetical new Bravo intellectual property comparable to the actual old Alpha intellectual property. Unlike many commercial intangible assets, intellectual property assets are not fungible. That is, the marketplace cannot actually replace the Alpha intellectual property with an actual replacement Bravo intellectual property. This is because Alpha is a legally protected intellectual property. For example, an FCC license is an example of a fungible commercial intangible asset. A buyer may refuse to accept the seller s asking price for, say, an FCC broadcast license. Instead, the buyer can go to the marketplace (or to the FCC) and buy a perfectly identical substitute license. In this case, the cost of the alternative license is relevant to the valuation of the FCC license intangible asset.

Intellectual Property Valuation Considerations Page 17 However, a patent is not a fungible intangible asset. Rather, a patent (by definition) is a unique intellectual property. A buyer cannot go to the marketplace and buy a perfectly identical substitute patent. There is only one subject patent, and it is registered with the U.S. Patent and Trademark Office (PTO). The buyer may buy a functionally similar patent. Or, the buyer can develop a new noninfringing invention. However, a perfectly identical substitute patent would, by definition, infringe on the subject patent. Therefore, although the cost approach is used in intellectual property valuation, it may have certain application limitations. All market approach methods are based on the two economics principles of efficient markets and of supply and demand. That is, the value of the subject intellectual property may be estimated by reference to prices paid in the marketplace for the arm s-length sale or license of a comparable (or a guideline) intellectual property. A comparable intellectual property is very similar to the subject property. The comparable intellectual property is approximately the same age, is at approximately the same place in its life cycle, and is used about the same way that the subject intellectual property is used. The comparable property may be used in the same industry, performing about the same function, at about the same size company as the subject property. Sales or licensees of comparable intellectual property provide direct pricing evidence to the analyst about the subject intellectual property. Accordingly, the analyst may be able to apply mean or median pricing metrics to the subject intellectual property. In contrast, a guideline intellectual property is generally similar (but not identical to) the subject property. The guideline intellectual property should be subject to the same general risk and expected return) investment elements as the subject intellectual property. However, compared to the owner/operator intellectual property, the guideline intellectual property may be operated in a different industry, at a different size company, with a different function, etc. Nonetheless, sales or licenses of guideline intellectual property still provide meaningful (albeit indirect) pricing evidence to the analyst about the subject intellectual property. In order to obtain pricing evidence from the guideline intellectual property transactions, the analyst will compare the guideline properties to the subject intellectual property. This comparison is often based on such measures as relative growth rates, relative profit margins, relative returns on investment, etc. These comparative analyses will allow the analyst to select subject-specific valuation pricing metrics. The analyst will consider comparable uncontrolled transaction (CUT) pricing data related to comparable property and to guideline property sales or licenses. The analyst will consider the CUT data in order to extract pricing multiples or capitalization rates that can be applied to the owner/operator intellectual property.

Intellectual Property Valuation Considerations Page 18 All income approach methods are based on the economics principle of anticipation. That is, the value of any investment is the present value of the income that the owner expects to receive from owning that investment. All income approach methods involve a projection of some measure of owner/operator income over the intellectual property RUL. This income measure may relate to (1) the income earned from operating the intellectual property in the owner/operator business enterprise (i.e., operating income) and/or (2) the income earned from outbound licensing of the intellectual property from the owner/licensor to an operator licensee that will pay a royalty (or some other payment) for the use of the intellectual property (i.e., ownership income). This intellectual property-related income projection is converted to a present value by the use of a risk-adjusted discount rate (or an annuity period direct capitalization rate). In summary, cost approach methods are particularly applicable to the valuation of recently developed intellectual property. In the case of a relatively new intellectual property, the owner/operator development cost and effort data may still be available (or may be more subject to an accurate estimation). In addition, cost approach methods are also applicable to the valuation of in-process intellectual property and to noncommercialized intellectual property. An example of a noncommercialized intellectual property is a patent or trademark that is held primarily for its strategic defensive use (i.e., so a competitor cannot own or operate the subject intellectual property). However, in all cases, the valuation analyst should realize that the intellectual property value is not derived from the current cost measure alone. Rather, the intellectual property value is derived from the current cost measure (however defined) less appropriate allowances for all forms of depreciation and obsolescence. Market approach methods are particularly applicable when there are a sufficient quantity of comparable (almost identical) intellectual property transaction data or guideline (similar from a risk and expected return perspective) intellectual property transaction data. These transactions may relate to either sale or license transactions. Such arm s-length, third party transactions are typically called CUT sales or licenses. The valuation analyst will attempt to extract market-derived valuation pricing metrics (e.g., pricing multiples or capitalization rates) from these CUT data to apply to the corresponding metrics of the subject intellectual property. Finally, income approach methods are particularly applicable to situations in which the subject intellectual property is used to generate a measurable amount of income. That income can either be (1) operating income (when the intellectual property is used in the owner s business operations to increase revenue or decrease costs) or (2) ownership income (when the intellectual property is licensed from the owner/licensor to an operator/licensee in order to produce royalty income). Income approach methods may also be used when the owner/operator has elected not to commercialize the intellectual property. Rather, the owner/operator may have elected to develop and

Intellectual Property Valuation Considerations Page 19 maintain the intellectual property for defensive purposes. This situation would be the case when this deliberate forbearance of use is for the purpose of protecting the income that is produced by the owner/operator s other intellectual property. The applicable measure of income in this analysis would be the opportunity cost related to the alternative intellectual property. That opportunity cost is often measured as (1) the actual income generated by the protected intellectual property less (2) the income that the protected property would generate but for the defensive protection of the subject intellectual property. COST APPROACH VALUATION METHODS There are several intellectual property valuation methods encompassed in the cost approach. Each valuation method uses a particular definition (or measurement metric) of cost. The two most common cost definitions are: 1. reproduction cost new and 2. replacement cost new. Reproduction cost new measures the total cost, in current prices, to develop an exact duplicate of the subject intellectual property. Replacement cost new measures the total cost, in current prices, to develop a new intellectual property having the same functionality or utility as the subject intellectual property. Functionality is an engineering concept that means the ability of the intellectual property to perform the task for which it was designed. Utility is an economics concept that means the ability of the intellectual property to provide an equivalent amount of satisfaction to the owner/operator. There are other cost definitions that are also applicable to a cost approach valuation. Some valuation analysts consider a measure of cost avoidance as a cost approach method. This method quantifies either historical or prospective development costs that are avoided because the owner/operator already owns the subject intellectual property. Some valuation analysts consider trended historical costs as a cost approach measure. In this method, the intellectual property historical development costs are identified and trended to the valuation date by the use of an inflation-based index factor. This trended historical cost method is particularly applicable when (1) the subject intellectual property is relatively new or (2) the owner/operator has fairly complete records related to the historical development costs and efforts. In addition, the inflation-based trend index should be appropriate to the type of costs that are being indexed to current costs. Regardless of the specific cost definition that is used in the cost analysis, all cost measurement methods (including reproduction cost, replacement cost, or some other cost measurement) should consider a comprehensive cost analysis.

Intellectual Property Valuation Considerations Page 20 Any cost measurement considers includes the following four cost components: (1) direct costs (e.g., materials and supplies), (2) indirect costs (e.g., engineering and design expenses, legal fees), (3) an intellectual property developer s profit (e.g., a profit margin percent applied to the direct cost and indirect cost investment), and (4) an opportunity cost/entrepreneurial incentive (e.g., a measure of lost income opportunity cost during the intellectual property development period adequate to motivate the development process). Usually, the intellectual property development material, labor, and overhead costs are easy to identify and quantify. The developer s profit component can be estimated using several generally accepted procedures. This cost component is often estimated as a percentage rate of return (or profit margin) on the developer s investment in the material, labor, and overhead costs. The entrepreneurial incentive component is often measured as the lost income that the developer would experience during the replacement intellectual property development period. The lost income concept of entrepreneurial incentive is often considered in the context of a make versus buy decision. For example, let s assume that it would require a two-year period for a potential buyer to develop a replacement patent. If the buyer buys the seller s actual patent, then the buyer can start earning income (either operating income or ownership license income) immediately. In contrast, if the buyer makes its own hypothetical replacement patent, then the buyer will not earn any income (either operating income or ownership license income) during the two-year development period. The two years of lost income during the hypothetical patent development period represents the opportunity cost of making (i.e., developing) a de novo replacement patent compared to buying the actual seasoned patent. All four cost components that is, direct costs, indirect costs, developer s profit, and entrepreneurial incentive should be considered in the intellectual property cost approach valuation. Therefore, while the cost approach represents a different set of analyses than the income approach, there are certain economic analyses included in the cost approach. These economic analyses provide indications of either of these two related cost approach components: (1) the appropriate amount of lost income opportunity cost (if any) or (2) the appropriate amount of economic obsolescence (if any). The intellectual property cost new (however measured) should be adjusted for any decreases in the subject intellectual property value due to: 1. physical deterioration, 2. functional obsolescence, and 3. economic obsolescence.

Intellectual Property Valuation Considerations Page 21 Physical deterioration is the reduction in asset value due to physical wear and tear. It is unlikely that an intellectual property will experience physical deterioration. Functional obsolescence is the reduction in asset value due to the inability of the subject intellectual property to perform the function (or yield the periodic utility) for which it was originally designed. The technological component of functional obsolescence is a decrease in asset value due to improvements in technology that make the subject intellectual property less than the ideal replacement for itself. Economic obsolescence is a reduction in asset value due to the effects, events, or conditions that are external to and not controlled by the current use or condition of the intellectual property. The impact of economic obsolescence is typically beyond the control of the intellectual property owner/operator. Economic obsolescence is often analyzed with respect to the ability of the owner/operator to earn a fair rate of return on investment (ROI) related to the actual intellectual property. In any cost approach analysis, the valuation analyst should estimate the amounts (if any) of intellectual property physical deterioration, functional obsolescence, and economic obsolescence. In this estimation, the valuation analyst may consider the intellectual property expected RUL and the intellectual property actual ROI. Figure 1 illustrates the consideration of direct and indirect costs (e.g., material and direct labor) and developer s profit and entrepreneurial income in the cost approach valuation of an intellectual property. Figure 1 also considers the comparison of historical costs to current (valuation date) costs. In Figure 1, the total historical direct and indirect costs are illustrated to equal $100 when the intellectual property was developed in 2000. The total replacement direct and indirect costs are illustrated at $125, as of a 2012 valuation date. Figure 1 also illustrates how the owner/operator does not typically consider the developer s profit or entrepreneurial incentive cost components even if the owner/operator did keep track of the historical (e.g., year 2000) direct material and labor development costs. The year 2012 developer s profit and entrepreneurial incentive cost components (illustrated at $75) are then added to the year 2012 direct and indirect cost components (illustrated at $125). The sum of all of these cost components (illustrated at $200) is the year 2012 replacement cost new (RCN) for the subject intellectual property.

Intellectual Property Valuation Considerations Page 22 Figure 1 Cost Approach Comparison of Historical Cost to Replacement Cost New in the Intellectual Property Development Process Figure 2 illustrates the relationships between replacement cost new (RCN) and replacement cost new less depreciation (RCNLD) in the intellectual property cost approach valuation. In Figure 2, the intellectual property RCN is illustrated at $200; this is the same RCN estimate concluded in Figure 1. In a cost approach analysis, depreciation is subtracted from the RCN in order to estimate the intellectual property current value (or RCNLD). As illustrated in Figure 2, the three depreciation components include physical depreciation (typically a de minimus consideration for intellectual property), functional obsolescence, and economic obsolescence. In Figure 2, these three depreciation components are illustrated to be approximately $60. Therefore, the intellectual property RCNLD is calculated as follows:

Intellectual Property Valuation Considerations Page 23 $200 replacement cost new (RCN) 60 less depreciation (LD) = $140 replacement cost new less depreciation (RCNLD) In Figure 2, the current value (or the RCNLD) of the subject intellectual property is illustrated to be approximately $140. As illustrated in Figure 2, it is noteworthy that RCNLD (and not RCN) provides the intellectual property cost approach value indication. Figure 2 Cost Approach Comparison of Replacement Cost New to Current Value in the Intellectual Property Development Process A common cost approach formula for quantifying intellectual property replacement cost new is: reproduction cost new curable functional obsolescence = replacement cost new. To estimate the