Example of the Income Method Using Relief from Royalty

The following section provides a rough outline for a valuation using the relief from royalty methodology of the Income method. For these sections, assume that the appraiser has already gathered and reviewed the pertinent background information, understands the context for the valuation, and has already qualitatively studied the intellectual asset to be valued.

The estimated royalty base may be based on the projected revenue of the prospective acquirer from launching a product/service that uses the Intellectual Assets being valued. The appraiser will need to consider, however, whether the proposed agreement is exclusive or non-exclusive. If the proposed agreement is non-exclusive, then the appraiser should note that the results of the valuation using this approach will be based on the value of the Intellectual Assets to just the proposed acquirer and not necessarily to its entire market.

To estimate the potential Acquirer’s product revenue, the appraiser establishes a selling price and number of units expected to be sold by the Acquirer. This estimate can be derived in a number of ways. Among other things, during negotiations with the potential acquirer, the owner may ask how much a prospective unit will sell for. Of course, the acquirer might not actually know the unit’s sales price or be willing to disclose it accurately. The appraiser can use as a proxy, for example, the price of related products. Similarly, the appraiser also estimates how many units will be sold in the first year of deployment. This estimate can be prepared using a number of variables, such as a percentage of the volume of related products that are sold. Assume, for example that the sales price estimate is 150 euro and the sales volume for the first year is 20,000 units. Thus, the estimated revenue for the first year is 3 million euro (150 euro x 20,000 units).

The appraiser next estimates the unit sales throughout the effective remaining lifetime of the Intellectual Asset being appraised. For some Intellectual Assets with legally defined terms, this may be relatively easy to determine. For others, the effective remaining lifetime may be difficult to estimate. Other factors need to be considered such as obsolescence, as previously mentioned. In many instances, the appraiser may be forced to select a term that seems “reasonable” based on the information at hand.

Year	Revenue (millions €)	Calculation
1	3.0	€150 x 20,000 units
2	6.0	€150 x 40,000 units
3	12.0	€150 x 80,000 units
4	24.0	€150 x 160,000 units
5	48.0	€150 x 320,000 units
6	52.8	€150 x 352,000 units
7	58.1	€150 x 387,000 units
8	63.9	€150 x 425,920 units
9	70.3	€150 x 468,512 units
10	77.3	€150 x 515,363 units

To test the reasonableness of the royalty base, the Appraiser researches sales of similar devices. While sales for many items will not generally available in the public domain as manufacturers typically keep this information confidential, the Appraiser can likely find additional data points that permit testing of the reasonableness of the Appraiser’s projected sales levels.

There are various resources for obtaining comparable license agreements and royalty rates that can be used as the starting point in identifying appropriate comparables. Many of these resources are fee based or subscription services; however, public information can also be obtained. Some of these resources are listed in Appendix C.

After quantifying the royalty base described above, it is necessary to determine a reasonable royalty rate, i.e., one at which the university would license the subject Intellectual Asset. The appraiser begins his/her analysis by examining quantitative royalty indicators using techniques such as the Market Approach and the Profit Apportionment Approach.

Assume that the appraiser is not aware of any licenses of the subject Intellectual Asset to any third party. Therefore, the appraiser attempts to identify transactions between unrelated parties for intellectual property assets similar to the subject Intellectual Asset. This is one application of the Market Approach. To identify potentially comparable transactions, the appraiser reviews publicly-available information from sources, such as the RoyaltyStat LLC database and U.S. Securities and Exchange Commission filings. While the appraiser reviews all of the aforementioned sources, he/she is unable to identify specific transactions that relate to the subject intellectual asset. However, the appraiser identifies historical industry royalty rates that are applicable to the subject intellectual asset from a royalty rate guidebook. For example, in certain electronics technologies, the appraiser may find a mean royalty rate of 4.5%. If a license does exist from the existing documents collected, this rate could act as a foundation and be adjusted accordingly.

The appraiser can also consider as a comparable some form of profit apportionment. But the appraiser must employ something more sophisticated than the 25% rule if he expects the other party to accept his approach. Whatever profit apportionment the appraiser proposes should have a rational and defensible empirical basis.

One of the most common questions in intellectual asset valuation profession is how one finds comparable royalty rates for the subject assets/royalty agreements. It is also common to question what clauses or terms in an agreement impact the royalty rate selection. IP valuation specialists sometimes misunderstand the need for proper due diligence when selecting royalty rates. While there is never a perfect comparable due to the inherent unique nature of IP and the multitude of licensing structures available, market data on royalty rates can serve as an appropriate benchmark for these types of analysis. In the tables below, we have chosen the royalty rate of 4% purely for illustrative purposes.

Assume for this example that future sales of the prospective Acquirer’s products could be characterized as having low to moderate risk. Accordingly, based on the information at the appraiser’s disposal, the appraiser selects a 30% discount rate for his/her analysis. The appraiser may also need to find information related to applicable tax rates that will apply to sales of the product. Here, a tax rate of 20% was chosen purely for illustrative purposes.

3.3.8.3 Results from the Income Approach

The Relief from Royalty approach provides one estimate of the fair market value of the Subject Assets as shown below. This estimate can be used in negotiating a transaction price with the Acquirer.

In the example shown above, a single value was reached through the application of a single approach. Given the previous discussion about the lack of market comparables typically encountered by the IP appraiser, there are typically few independent benchmarks, or “rules of thumb,” against which to measure or test results. Therefore, the appraiser must first draw on his/her experience and common sense to estimate whether the conclusion is well reasoned. For example, it is difficult to rationalize that a very early stage technology could be worth hundreds of millions of dollars if a fully functioning prototype does not exist, and there are no commercialization plans. It can certainly be the case that a groundbreaking technology with global demand could have a potentially large royalty base; however, the combination of the estimate of market penetration timing and rates, and the proper discount rate in these instances will have a material impact on value.

Another manner in which to analyze the result is to consider the value of the intellectual asset in relation to the estimated value of the entire business enterprise. Intellectual Assets are but one of the components of an asset base that make up the value of an entire enterprise. Basic valuation principles hold that the fair market value of one of the asset categories cannot be worth more than the entire business enterprise. For this reason, it is critical that the practitioner review all key inputs and assumptions for reasonableness and accuracy and review the work as dispassionately as possible.

3.4 Other Valuation Methods

We have focused thus far on three classical valuation methods and their associated methodologies. There are other valuation methods. We will discuss a few of them here. The interested reader is welcome to find others, but should be advised that there is likely not a “silver bullet” methodology that solves all problems, is highly accurate, and is easy to apply. As noted above, the main problem in valuation is the absence of recent and representative comparative data. This problem is not likely to be solved by simply using another method.

Monte Carlo simulations have been used for many years to study a variety of topics. The general premises behind Monte Carlo simulations may be applied to a valuation exercise.

The Monte Carlo valuation approach is a refinement of Income method. In the Monte Carlo approach, the appraiser assigns a value range to various variables in the equation, such as the price and cost variables used to calculate the net present value (NPV). The appraiser assigns a probability to individual values within a range. The appraiser calculates NPV repeatedly using a random selection of the probability weighting values assigned to each variable. The appraiser next plots multiple NPVs by frequency of occurrence, which serves to indicate which NPV is the most likely to occur.

If the appraiser performs these equations for a suitable number of iterations, then the resulting NPV should converge to a range that might be somewhat more accurate than the appraiser’s calculation of a single instance. Unfortunately, the accuracy of the NPE values cannot be better than the accuracy of the value ranges and probabilities that the appraiser assigned to various individual values. Nevertheless, the approach may be helpful in uncovering ranges and conditions that were not readily apparent to the appraiser, and in some instances, the simulation may effectively point out errors to the appraiser that allows him to improve the equations he is using.

The Black-Scholes methodology may also be applied to valuation. The method is based on the famous Black-Scholes formula for valuing stock options. Here, the option value arises from the right to wait and see what happens to the stock price where the IP “investment” is viewed as an “option” to develop the IP further depending on future technology and market developments.

The Black-Scholes formula may employ variables such as: (1) development cost to commercialize; (2) mean market value of products embodying similar patents; (3) time before commercial utilization; (4) product value volatility; (5) risk-free rate of return; and (6) patent expiration. This approach recognizes that risk is not uniform over time but decreases as additional information becomes available.

As with many other methods, the methodology of Black-Scholes is sound, but the trouble in applying this method to intellectual asset valuation is that most of the numbers being used as inputs are estimates and very uncertain estimates at that. Thus, the resulting answers may have the appearance of computational certainty while simply being a composition of guesses.

The appraiser must also understand how small adjustments to any of the variables may impact the valuation results. Key considerations in the relief from royalty method include the selection of the royalty base, royalty rate, tax rate, and risk factor/discount rate. Any adjustments to these factors, or any combination thereof, can have a very material impact on the valuation result. This fact emphasizes the importance in the selection and reasonable values for each variable.

To illustrate this fact, review the figures in the sensitivity table presented below (unrelated to the example thus far) where the results from sixteen calculations are shown based upon four different discount rate and royalty rate combinations (values presented in millions of dollars). Utilizing the lowest royalty rate (.10%) and highest discount rate (16%) produces a valuation of $279 million dollars (rounded). Utilizing the highest royalty rate (1%) and the lowest discount rate produces a valuation of $5.3 billion dollars (rounded). The difference between the two valuations is greater than 1,800%. If you look at each vertical column, you will see that the valuation increases by 1000% in each case as the discount rate increases from 0.1% to 1.00%. In summary, this table highlights the care that must be taken in the analysis and selection of each critical variable in the process. This is especially true for royalty rates. The practitioner must be careful not to include or exclude a particular rate due to poor due diligence, and must take special care when a comparable agreement includes multiple rates as the use of minimums/maximums, averages or medians can produce wildly inaccurate figures.

	Discount Rate
		9.0%	10.0%	12.0%	16.0%
Royalty Rate	0.10%	$531.8	$480.7	$396.50	$278.9
	0.30%	$1,595.3	$1,442.0	$1,189.6	$836.6
	0.50%	$2,658.9	$2,403.4	$1,982.7	$1,394.4
	1.00%	$5,317.7	$4,806.8	$3,965.40	$2,788.8