IP Valuations: When an IP Decision Includes a Real Option

Background: Valuing IP as a Real Option

Making the decision to invest in patented technology requires a manager to map and evaluate a series of decisions and uncertainties, such as those laid out in the decision tree below.

Theoretical IP Investment Decision Tree

Following the investment decision, a manager faces a series of options, such as if and when to invest in additional product research and development. The outcomes of these options are uncertain, because they depend on other variables, including:

In light of these decisions and uncertainties, managers benefit from flexibility and choices. Patents offer this flexibility, in that they present the option, but not the obligation to pursue one of these paths, as well as the ability to block a competitor from doing the same.

Valuation in this context requires multiple approaches. Using only one approach, such as the income approach, is insufficient, because it is static, treats all decisions as “now-or-never,” and ignores the embedded management options. Without valuing the decision-making flexibility, the income approach leads to a lower bound on the IP valuation.

The income approach can be enhanced by adding the value of the choices, or real options, that a manager can make. This decision making flexibility is analogous to exercising a financial option, such as a call.

Real Options Pricing: Summary & Technique

What? Real options pricing is a valuation approach that is coupled with the income approach to account for flexibility and uncertainty.

Why? Patents behave like management options. A patent is a claim on the value of another asset. The underlying asset is the cash flow associated with the project.  

When? Scenarios characterized by a series of decisions and uncertainties, including investments in new technologies or IP in turbulent or nascent markets.

Hypothetical IP & Market Conditions

How to price? Project investment decisions are analogous to exercising a financial option, such as a call. A call option is the right to buy the underlying asset (i.e. cash flow from patented technology) at a fixed exercise price (i.e. R&D investment) before an established expiration date.

Conclusion

Real options pricing can enhance IP valuations in situations where key assumptions regarding market, financial, and technology variables are identified and estimated with reasonable accuracy. When coupled with the income and other valuation approaches, such as comparable market transactions, options thinking can guide financial and strategic decision making.