The key challenge when acquiring a technology asset is determining a fair value for the asset. While there are many approaches to valuing technology and Intellectual Property (IP) assets, one of the most important methods is creating a business model that reflects the value of the asset to your organization based upon its intended use. The key to locking in on a rational value is to adjust the full revenue potential based upon intended use with risk factors that take into account technology and commercialization risk for the acquired asset.
Risk factors include anything that could materially affect projected income, including market growth, market penetration, technology, commercialization, and IP risks. In order to effectively account for these, you must identify all of the potential risks that could materially affect the return achieved over time, determine which of those risks are already accounted for in the valuation, estimate the likelihood of occurrence of each of the additional risk factors, and estimate the effect each risk could have on revenue. You then add up the product of the likelihood of the risks and the effect of each risk to calculate an overall risk factor.
Recently, a client came to us asking us to evaluate a valuation model for acquiring patents to see if it made sense. The patent owner had developed the model showing potential value of $250 million in licensing revenue assuming a successful outcome of litigation with a company infringing on the patent. Because the patent owner had not accounted for any risks within the model, the valuation was unrealistically high.
The most basic risk factor to apply to an estimated value of an asset is a weighted average cost of capital (WACC) on future revenues. The weighted average cost of capital reflects the company's overall costs of capital used to finance business operations or acquisition. A firm's WACC is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm. In our case, we estimated the WACC at 9%, which in turn reduced the estimated valuation by $20M.
WACC is only one of many risks to account for when estimating valuation. The initial model estimated both the historical and future value of the patent based upon a licensing royalty stream from an infringing company for use of the patents. For the future value, we needed to add the risk of the infringer redesigning its product to avoid the need to pay a license fee. Additionally, we needed to incorporate risks of future revenue growth for the infringing product as a result of pricing pressure in the market. Finally, we needed to include the largest risk - that the patent owner would lose the infringement court case. Once we factored in all of the risks, the risk-adjusted value was reduced significantly - from the $250M estimate of the patent owner, to just $10M. Because litigating an infringement case may cost several million dollars in legal fees, we recommended that our client reconsider purchasing the patent.
Not accounting properly for risks is the most common (and most costly) mistake we see in valuation modeling. If you are acquiring a patent, technology, or company, it is critical to review a seller's valuation to understand how it has accounted for risk. This is most typically done through a weighted average cost of capital or discount rate, but you need to be clear on which risks are included in that calculation. Then you need to assess what other significant risks not accounted for, and add additional risk multiples as needed to arrive at a rational valuation.
Here are the most common risk factors we apply to valuation models:
Market Growth includes any risk that could affect the growth rate of a market. Such a risk could be macroeconomic, such as the risk of recession. A luxury product would be highly affected by this, while a non-luxury product would be less affected. Another market growth risk might also be regulatory, reflecting regulatory changes that would affect a product launch date. This factor would be relevant for products within highly regulated markets such as pharmaceuticals, food, and energy. Finally, market growth risks include anything that could affect the adoption rate or use curve of a technology, such as the market relevance based upon changing population demographics, or the risk of technology obsolescence.
Market Penetration includes any risk that could prevent the technology from achieving the estimated market penetration rate. Such risks are typically competitive threats, and may include a disruptive competitive technology entering the market that would materially affect the market relevance of a product.
Technology Risk includes risks that the technology will not work or will be late to market, or that the technology development costs will be significantly higher than expected. Technology risk is a major factor in early-stage technologies and in pharmaceutical or biotech deals.
Commercialization Risk includes risks related to the company's ability to commercialize the product effectively. These risks may include factors related to the company's ability to develop new channels of distribution, or reach new consumer segments not currently served by existing products.
IP Risk includes risks that could affect the value of the Intellectual Property. For example, the risk that key patent applications will not be issued, or that a patent will not issue with strong claims, that a key patent will lose a reexamination, or that a patent may face litigation. Other risks might include or that a trade secret is revealed.
The art of risk-adjusting valuation models effectively comes through quantifying the likelihood and estimating the potential effect of that risk factor. These estimates can range from a “gut feel” factor, to factors derived through complex modeling based on the effect of past events on similar industries or technologies.
The pie chart illustrates that, while an initial value may be large, once risks are factored in, the value may reduce to a fraction of the original value. In the example cited earlier the initial value was $250M. But when we factored in the time value of money (WACC) we reduced the value by 8% to $230M. We then factored in the market risk, reducing the value by 40% (to $129M). We then factored in the IP risk, reducing it by 8% (to $108M). Finally, we factored in the litigation risk which, in this case was the risk of reduced value due to settlement, reducing the value by 40% to $10M. The final risk-adjusted value was just 4% of the original value.
Risk factoring is critical to developing valuation models that work. By investing the time needed to develop thorough and effective risk adjusted valuation models, you significantly increase the potential that you will actually achieve the projected return on investment for your technology acquisition and make better, more informed business decisions.
For an in-depth look at how to value IP for an acquisition, read Rachael Schwartz' article on the subject published in the February, 2011 issue of IPM Magazine.ipCapital Group, Inc. (ipCG) specializes in working with companies around the strategic use of Intellectual Property and technology innovations. Our valuation experts combine their expert knowledge in IP and technology and financial valuation acumen to quickly develop valuations and business modeling to guide business decisions. If you'd like to learn more about risk adjusting or general IP valuation, click here or contact Adam Bulakowski at 802-859-7800 x261 or email@example.com.