Valuation of IPR Presented by Deepika Maheshwari Financial

Valuation of IPR Presented by Deepika Maheshwari Financial Advisory Services Deloitte Haskins & Sells, Ahmedabad Audit. Tax. Consulting. Financial Advisory 9 th Feb 2008 This document is confidential. No part of it may be be reproduced without express approval of Deloitte. © Deloitte 2008. 1

Overview • Basics of Intellectual property rights • Importance of Intellectual property rights • Management of IPR • Valuation of IPR

Intellectual Property Rights- Basics • Increasing investment in Intangibles. • Shift in focus from Physical capital to Intellectual capital • “Value of firm= Value of physical Assets+ Value of intangible assets” Value of Intangible Assets Value of future growth opportunities that are already in place Value of future growth opportunities from new assets

Intellectual Property Rights- Importance • Source Of unexpected revenue • Increases Shareholders Value • Establishes Proprietary Market advantage • Enhances Competitiveness • Exploits new market opportunities • Reduces risk

Intellectual Property Rights- Management Identify Valuation Approaches: Design Accounting Process Residual Value Method Cost Software Market value Trade Secrets Income Know-how Real option Trademarks Brand names Formulations IP Trading Literary work M&A IPO/Fund raising Financial Reporting Patents Licensing-In Copyrights Licensing-Out Design Contract/ Royalty rates Trademarks Source: Deloitte Research Publishing rights Transfer Pricing Litigations Technology transfer To be able to reap benefits out of IP, a sound IP management programme is required

Valuation “The intangibility of a company’s most important assets makes it extremely hard to figure out what the company is really worth. ”

Valuation Parameters What Whom Why How What is the IP to be valued For whom the valuation is being done Why the firm has decided to value IP rights (Purpose) How the valuation would be done in given circumstances Patents, Copyrights, Designs, Trade secrets, Know how, Trade marks, Brand name Shareholders, Management, Licensor/Licensee, Investor, Court of Law, Acquiror , Investment banker Corporate valuation for shareholders, M&A, Management buy-out or buy-in, IPO/Fund raising, Financial Reporting, Acquisition/Licensing of IP, Litigations, , and reorganization Different approaches to valuation may be used

While valuing IP… • Understand the value chain of business and understand how profits are generated Patent Manufacturing Distribution Sales Brand • Understand Important features of IP and how it adds value to business • Obtain Adequate knowledge of trends in the industry and technology • Consider scope & Strength of IP asset • Assess the availability of competing IP in the market • Ascertain the unpredictability of future returns

Valuation- A Daunting task • No active market for trading of intangible assets • Difficult to identify the potential earnings and profits that can be generated • Uniqueness of each IPR – Non Comparability • Difficult to Segregate profits generated from tangibles and intangibles. • Difficult to ascribe appropriate economic benefit to an individual IP Asset if there are more than one IP. • Inadequate disclosure of Intangibles in financial reports • Most valuation methods ignore managerial flexibility

Valuation Methods

Valuation Methods Static valuation models Dynamic valuation models Accounting Approach Income Approach/Discounted cash flow Decision tree Analysis Cost Approach Real Option Model Market Approach Monte carlo Simulation

Accounting Approach • IPRs are subset of Intangible Assets • As per AS-26 issued by ICAI, the recognition of an item as an intangible asset requires an enterprise to demonstrate that the item meets the: • “definition of an intangible asset and • recognition criteria set out in the standard” • As per definition Intangible asset should be • Identifiable • Controllable • Able to generate economic benefits • An intangible asset should be recognized if, and only if: • it is probable that the future economic benefits that are attributable to the asset will flow to the enterprise; and • the cost of the asset can be measured reliably.

Accounting Approach- Acquisition Valuation Separate Acquisition • Cost of intangible would be the purchase consideration paid either in form of cash or in Fair value of shares or assets exchanged • Cost =Purchase consideration+ Import Duty+ Taxes+ Any direct attributable exp. Valuation As a part of Amalgamation • Allocation of purchase consideration to individual identifiable assets (including IPs) and liabilities based on their fair values at amalgamation date • Valuation method must: • Estimate Fair Value, and • Reflect current transactions and practices in industry

Accounting Approach – Valuing Internally Generated IP ECONOMIC BENEFITS Research Phase Development Phase Commercial Phase EXPENSES Direct + Indirect Expensed Capitalized 1. Technical feasibility 2. Intention to complete and use/sell 3. Ability to use/sell 4. Probable future economic benefits 5. Resource availability 6. Ability to measure Expensed Available for use • Internally generated goodwill can not be recognized as an intangible asset

Cost Approach Historical cost trending Method Value (Rs) Recreation Cost Method Assumptions : § Cost to purchase or develop new property is commensurate with the economic value of service §An investor would pay no more to purchase an asset than would be required to reproduce the asset Replacement cost method This method seeks to measure the future benefits of IP assets by calculating the amount of money that would be required to replace the future service capability of the subject intellectual property

Cost Approach- Examples Historical Cost • Example : Cost incurred on R&D to develop a new technology know-how: INR 100 for Y 1 and INR 200 for Y 2 • Inflation index: Y 1 = 100, Y 2=105, Current = 110 • Estimated Value of IP 100 x 110/100 + 200 x 110/105 = INR 320 Replacement Cost • Example : Cost incurred on R&D to develop a new technology know-how: INR 100 for Y 1 and INR 200 for Y 2 • Inflation index: Y 1 = 100, Y 2=105, Current = 110 • Chances of Success : 60% • Estimated value of IP would be (100 x 110/100 + 200 x 110/105)/0. 6 = Rs 533

Cost Approach- Pros & Cons Pros • Good for internally developed intangibles or in liquidation scenario • When comparable market data is not available • When intangible is not income producing Cons • Requires numerous adjustment to financial data • Difficult to apply if historical records are not there • No direct correlation between price and value • Risk is not factored

Market value Approach – Comparable Market value • Value of an IP = prices paid for comparable IP as part of arm’s length transactions • The transaction price, as a ratio of an asset attribute such as sales, is used to derive a market multiple • This market multiple is then applied to the attribute of the asset being valued Requirements • Active market involving comparable property • Past transactions of comparable property • Access to price information at which comparable property exchanged • Arm’s length transactions between independent parties

Market value Approach – Comparable Market value • Factors to be considered while comparing – Industry – Market Share – Profits – Impact of New Technologies – Barriers to Entry – Growth Prospects – Strength of Legal Protection – Remaining Economic Life

Market value Approach – Comparable Market value Objective: To value a trademark ‘XYZ’ of a pharma co. ‘Pharma Co. ’. • Annual sale of products with ‘XYZ’ trademark = INR 100 • Comparable transaction: Purchase of 32 medical remedy trademarks by M&J Labs for INR 5000. Annual sale of all 32 trademarked products just prior to purchase was INR 4000 Solution • Value-to-sales multiple of comparable trademark = 5000/4000 = 1. 25 • Value of ‘XYZ’ trademark = Annual sale from ‘XYZ’ trademarked products x Value-to-Sales multiple of comparable trademarked products = INR 100 x 1. 25 = INR 125

Market value Approach- Pros & Cons Pros Cons • Most of the information is not publicly available • Relatively easy to apply • Conceptually attractive • Provides evidence of value • Low Frequency of comparable transactions • Each intangible transaction is unique.

Residual Value Approach Assumption : Markets are efficient. i. e, all future economic benefits from assets (tangible and intangible) and IP of the firm are factored into the market price of firm’s equity and debt • Starts with the company’s value of equity (as measured by its stock price) plus the value of its liabilities. • From such amount, value of the company’s tangible assets, plus the value of any intangibles not transferred (Unidentifiable Intangible Assets) is reduced. The result is the lump-sum value of the intangibles being valued. • Value of IP = MC-(N+U) – Where MC= Market Capitalization N= Net Tangible Assets as shown in book (Total assets- total liabilities) U= Unidentifiable Intangible Assets Drawback: Valuation would fluctuate with market. IP assets would not be valued individually. Is the market really efficient to factor in all the benefits

Income Approach Variations Method Premium Pricing method Premium over generic product/services Excess Profit method Excess earnings over the company that does not possess intangible Royalty saving method License fee/ Royalty saved by owning the intangible Cost savings method Cost saved by owning the asset Value of IP = Present Value of expected future economic benefits from ownership of IP

Approaches Direct Capitalization • Estimate an appropriate measure of economic benefit for one period future to the valuation date and multiply it by an appropriate capitalization rate (r) r = 1/discount Rate • Where, r is a measure of economic benefit • Does not consider future economic benefits Discounted Future Economic Benefits Value of IP = Economic Benefit Period 1 (1 + k)1 Economic Benefit Period 2 (1 + k)2 Plus The terminal value of the business at the terminal year TV = Economic Benefit n (K - growth)*(1+k)^n . . Economic Benefit Period n (1 + k)n

Illustration • The book is expected to generate $150, 000 in after-tax cash flows for the first three years and $100, 000 a year for the following two years. These are the cash flows after author royalties, promotional expenses and production costs. About 40% of these cash flows are from large organizations that make bulk orders and are considered predictable and stable. The cost of capital applied to these cash flows is 7%. The remaining 60% of the cash flows are to the general public and this segment of the cash flows is considered much more volatile. The cost of capital applied to these cashflows is 10%. Year Stable Cash flows Present value @ 7% Volatile Cashflows Present value @ 10% 1 60, 000 56, 075 90, 000 81, 818 2 60, 000 52, 406 90, 000 74, 380 3 60, 000 48, 978 90, 000 67, 618 4 40, 000 30, 516 60, 000 40, 981 5 40, 000 28, 519 60, 000 37, 255 Total Source: Damodaran online 216494 302053

DCF Approach- Pros & Cons Pros • Captures economic benefit flowing due to Intangibles • Considers appropriate risk based rate of return at which to discount cash flows and estimates economic life Cons • Reliable financial projections • Estimating income attributable to intangibles, its economic life, appropriate discount rate/ cost of capital • Use of same discount rate in R&D as well as Market phase • Managerial flexibility is completely ignored • No accommodation to option like nature of investments

Matrix- Accounting for Risk & flexibility Source: Crystal ball confrence

Real option model • Investment in intangibles does not generate immediate payoff • Each intangible may have a bundle of options Source: Crystal ball confrence

Decision Tree Analysis Patent failed P = 0. 70 NPV 5= (0. 20 x NPV 1 + 0. 80 x NPV 2) Lapse P = 0. 20 Product fails P = 0. 20 Patent Application Cost NPV 10 = NPV 9 x 0. 3 - Cost Low Revenue P = 0. 40 Patent granted P = 0. 30 NPV 8= NPV 7 x 0. 8 Renew P = 0. 80 NPV 2 Status Quo P = 0. 60 NPV 3 File patent in UK P = 0. 40 NPV 4 Product Success P = 0. 80 NPV 7= NPV 5 x 0. 4 + NPV 6 x 0. 6 High Revenue P = 0. =60 NPV 6= (0. 60 x NPV 3 + 0. 40 x NPV 4) Application to Grant NPV 1 Grant to Commercialization PHASES End of first year of commercialization

Real Option Technique • Valuation under uncertainty • Use Black-Scholes (1973) Option Pricing Model • Option parameters – Value of Underlying = Present Value of Economic Benefits – Exercise Price = PV of investment in IP – Time to Expiry = Remaining economic life of IP – Standard Deviation = Standard Deviation of Economic Benefits – Risk free Rate = Riskless interest rate that corresponds to the economic life of IP – Dividend (Value Leakage) = 1/Economic Life of IP

Patent Payoff Diagram Net payoff from Patent PV of Cost of developing and commercializing the Patent Present Value of Economic Benefits from Patent

Problems • Estimation of future economic benefits • Economic benefits may not follow a continuous process • Variance may be unknown and may change over the economic life of IP • Exercise may not be instantaneous • Compound options

Categorizing Valuation Independent and Cash flow generating intangibles Not independent and cash flow generating to the firm No cash flows now but potential for cashflows in future Examples Copyrights, trademarks, licenses, franchises, professional practices (medical, dental) Brand names, Quality and Morale of work force, Technological expertise, Corporate reputation Undeveloped patents, operating or financial flexibility (to expand into new products/markets or abandon existing ones) Valuation approach Estimate expected cash flows from the product or service and discount back at appropriate discount rate. Compare DCF value of firm with intangible with firm without (if you can find one) Assume that all excess returns of firm are due to intangible. Compare multiples at which firm trades to sector averages. Option valuation Value the undeveloped patent as an option to develop the underlying product. Value expansion options as call options Value abandonment options as put options. With multiple intangibles (brand name and reputation for service), it becomes difficult to break down individual components. Need exclusivity. Difficult to replicate and arbitrage (making option pricing models dicey) Challenges Life is usually finite and terminal value may be small. Cashflows and value may be person dependent (for professional practices) Source: Damodaran website

Concluding Remarks • IP valuation calls for co-ordinated efforts from a CA, IP attorney, and a technology person • Adopt as many appropriate valuation techniques as possible, understand the pros and cons of each valuation method, and make a best estimate

Thank You Deloitte Haskins & Sells ‘Heritage’, 6 th Floor Near Gujarat Vidhyapith Off Ashram Road Ahmedabad-380 014 Gujarat Deepika Maheshwari Assistant Manager Email: dmaheshwari@deloitte. com