Peter Zura’s Two-Seventy-One Patent Blog has an interesting note about the valuation (or, overvaluation, as the case may be) of Biotech patents. Zura points to an article from Dominique Patton, questioning whether the current onslaught of high profile patent litigation is causing excessive valuations of the Intellectual Property Rights (IPRs) of technology companies. But, one of the biggest problems with intangible assets is that there are few fundamental accounting norms for actually calculating a patent’s value.

Pointing to high-profile, high-value lawsuits, Patton believes this only increases the urge to count every patent as a winner. But, as she notes, “not all patents are valuable, and very many are worthless” and unless companies differentiate the wheat from the chaff, the currently excessive valuation of intellectual property could turn out to be the bubble of this decade.

Currently, intangible assets make up about two-thirds of corporate market value in the US with biotech firms typically showing IP as 60% of their market value. Yet, intangible assets can evaporate into thin air – witness that Enron’s intangibles were once estimated to be worth $60 billion.

Patton writes:

Experts have long warned about the inadequacy of existing accounting norms in capturing the monetary worth of patents. Those that are generating licensing revenue and royalties can be valued on a discounted cash-flow basis. A further slice is deemed valuable because of the competitive threat it prevents.

In the food, pharmaceutical and biotech industries, for instance, where it is now commonplace to seek to block out an entire market space with a patent barricade, some 11 per cent of the patents filed are subsequently contested. A patent battle, alone, is the first mark of real value, according to some commentators.

Elsewhere, within some companies, the monetary value of patents is deduced by looking at what it would cost to license in the same notional technology. This provides a theoretical basis, but little real data to work with.

Yet the most striking fundamental of patent valuation, overall, is how few fundamentals there are. Companies themselves struggle to evaluate their own intellectual property.

For those managing both patent applications and granted patents it is essential to know the value of each sufficiently accurately if one is to make well-founded decisions about their management. Since only a small proportion of patents turn out to be of extraordinary value, methods which lead to a better understanding of the value of given patent applications or patents are necessary.

The problem in the case of patents is particularly complex due to the, sometimes lengthy and certainly complex, application process involving initial uncertainties about both the technical and commercial success in competitive markets of the underlying technology as well as uncertainties about the legal challenges which can occur both during the application and subsequent enforcement.

Several methods for valuing patents are in common use. Among the most popular are the cost method, the income method, the design around method, the comparable transactions method, and the discounted cash flows method. There are also some less popular methods of patent valuation, including relief from royalties, real options, and various rules of thumb. However, these methods are less popular because they tend to be complex and unreliable.

The cost method values a patent at the cost of developing the patented technology. The cost method may place a lower limit on the valuation, since the patent owner generally wants to at least recoup development costs. However, it does not account for the ability of a patent to generate profit. However, valuation methods based on the historic costs of acquisition make no allowance for the future benefits which might accrue from the patent. They are of no help other than in historical cost based accounting systems or where taxation methods dictate their use and not useful for making business decisions.

The income method involves some element of forecasting the future cash flows. However, it is only with the addition of trying to account for the elements of time and uncertainty in future cash flows that these valuation methods gain a solid foundation. The key issue in these methods is how the forecast cash flow is derived.

The design around method values a patent at the cost of designing around the claims of the patent. The design around method may place an upper limit on the valuation, since it usually doesn’t make sense to pay more for a patent than it would cost to develop an alternative product.

The comparable transactions method uses the sale of a comparable patent as a basis for valuation. However, this is only useful when comparable patents exist. It can be very difficult to find comparable patents. Even if there are benchmarks, there is no assurance that the purchase price of the comparable patent properly took into account an appropriate value (i.e., it the comparable transaction may have been over- or undervalued).

The discounted cash flows method attempts to account for the profit that a patent can generate and is the method most often used for patent valuation. However, this method relies upon company specific profit projections and the use of a risk premium, which make the valuation far too subjective.

As you can see, a patent is not a simple investment project involving initial costs and near certain future returns but a complex series of possibilities each involving costs and actual benefits or potential future benefits. These factors only are revealed over time with considerable uncertainty as to the final outcome.

Just be careful out there in case the bubble bursts.

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