Approach to Patent Valuation

I was recently awarded a patent that I was a co-inventor of. Immediately the board asked me to come up with a valuation for that patent.

Being a private, early stage company in a nascent market it did present some challenges. After much research and consultation with those who went before me I was able to structure a robust analysis of the patent value. That said, IP is worth whatever someone is willing to pay and changes on your ability to enforce it -- the market will ultimately dictate value and you must create that market.

However, there is value to the analysis when speaking to investors and strategic partners and potential licensees. So I'll walk you through the general process I used.

Methodology

we will take a purely quantitative approach to patent valuation, with an understanding that our data is imperfect and therefore using ranges and error margins to qualify our results. This analysis was done with the US market in mind as IP protection and law can vary greatly.

Please note that for the analysis below you will see the word node used frequently. This is because of the networked nature of the patent I worked on. Node can be easily replaced by "seat," "customer," "license." etc. that applies to your business and technology.

We use four approaches to quantify value, some of which may be more or less applicable to your business. We will then take a geometric mean of these methodologies to get an ultimate single number valuation for the patent.

There is a fifth approach that is popular which I will not discuss in this article. That is the Comparable Market Model. This is a widely used method and the approach is to find comparable patents in the market that have been valued or sold. This is often performed by a professional valuation firm.

Market Opportunity License Model

The market opportunity license analysis uses an approach of sizing the entire serviceable market, selecting a time period to analyze, amortizing one time income and annual income, earning a royalty percentage of that total volume, and finally providing a present value discount. The generalized approach is:

let Nodes = the number of node in the serviceable market
let OneTimeRevenue = the one time revenue generated from a node
let AnnualRevenue = the recurring revenue from each node
let Royalty = a percentage earned of total revenue
let Years = the time period of this analysis
let Discount = a discount rate to calculate the present value of future income

Market Opportunity License Model Formula

Known Company License Model

The known company license model estimates value based on royalty fees earned over a specific time period given an enumeration of the companies in the space, their business models, and an estimate of nodes and income. This is a similar analysis to the Market Opportunity License Model above, however the equation is analyzed given the size of the competitive market today. This model also accounts for present value of future income. The generalized model is:

let OneTimeRevenueTotal = the one time revenue generated from the current market
let AnnualRevenueTotal = the recurring revenue from the current market
let Royalty = a percentage earned of total revenue
let Years = the time period of this analysis
let Discount = a discount rate to calculate the present value of future income
let ErrorMargin = an percentage range to account for imperfect competitor data

Known Company License Model Formula

Operating Income Model

The operating income model provides a valuation based on a five year projection of company operating income. This model assumes the values patent carves out an opportunity to generate income and provide a barrier. The generalized model is:

let Revenue = the total annual revenue
let NetIncomePct = the average net income percentage over all years
let Years = the time period of this analysis
let Discount = a discount rate to calculate the present value of future income

Operating Income Model Formula

Reproduction Cost Model

The reproduction cost model estimates the cost to reproduce the technology claimed in the patent. This method assumes a fast ramp up time for a competitor given the detail in the publicly published patent. This method also does not include other real R&D and operational costs to implement a full solution. For example, database schema, security, billing systems, remote management, access control, analytics and reporting, operations, graphic design, hosting, and other costs of R&D and operations are not included in this analysis. There is no net present value calculation involved in this analysis. The generalized model is:
let Claims = the number of claims listed in the issued patent
let ManHours = the number of R&D hours required to build the claim
let CostPerHour = the fully loaded hourly rate for on man hour of R&D

Reproduction Cost Model Formula

Distilling The Numbers

You may determine that a single model above best represents the particulars of your company, IP, and market. However if it is difficult to find a single model that fits we can summarize the data.

Looking at the outputs of each model we can create a floor and ceiling (albeit a wide range). The reproduction cost usually will set the floor, after all if the IP addresses a market worth less than the implementation cost of the patent then the patent is not valuable. The market opportunity or the operating income model usually sets a ceiling, after all this represents the maximum projected productivity of the solution in the market.

To arrive at a single range that integrates all of the above analysis we can use two methods. First is to look at the interqartile range (the middle 50%) of each of the outputs. Next, as the each method uses different measurements, we can use a geometric mean (as apposed to a standard arithmetic mean) to calculate a single range incorporating all of the above data.

The geometric mean is the "nth root of the product of the numbers."

Here are some example numbers we can distill:

Market Opportunity License Model: $50M to $80M
Known Company License Model: $10M to $18M
Operating Income Model: $100M to $150M
Reproduction Cost Model: $4M to $6M

Given the above we can calculate the geometric mean of each end of the range which becomes:

Geometric Mean Value: $21M to $34M

In conclusion, while the final number is purely based on paper it does create an anchor point for discussions with stakeholders. Ultimately the market will decide what the IP is worth and as the valuation of your IP becomes more important I'd encourage you to work with your IP attorney.

Alexander Lowe

You will often find me with a grid line notebook and drafting pencil working through product concepts, exploring problem spaces, and toying with novel business models.

Pacifica, CA http://alexlowe.io

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