Introduction

To understand how to maximise the value of intellectual property rights, it is first necessary to understand the factors that affect the value of those rights.

IP Valuation Methodologies

There are numerous valuation methodologies which can be used to value intellectual property. Not one methodology is appropriate in all circumstances.

The selection of an appropriate methodology will depend upon the circumstances surrounding the valuation, including the type of IP being valued, the purpose of the valuation, and the availability of data.

In general, a primary methodology will be selected and used to value the intangible asset. The methodology selected will depend on the specific circumstances surrounding the transaction. Alternative methodologies will also be used to test the accuracy of the value obtained using the primary methodology. This will allow the valuer to assess the reliability of the value indicated by the preferred valuation methodology whilst recognising that all valuation methodologies have inherent limitations.

Three basic theories of valuation are used for valuing intellectual property: cost, market and income approaches.

Cost-based

In essence, the value of the intellectual property is the cost to replace or recreate that intellectual property. This method looks at the historical cost incurred to develop and create the intellectual property. A purchaser or licensee can avoid these costs by purchasing or licensing the intellectual property from the owner.

The relevant costs may include research and development (labour, materials and overheads), testing and regulatory approval costs, IP protection costs, equipment and other capital investments, a profit margin based on the usual profit the developer would expect to make on material, labour and overhead costs, plus a component for entrepreneurial incentive representing the amount of economic benefit required to motivate the developer to enter into the development process. The entrepreneurial incentive component is essentially a measure of the opportunity cost of undertaking the development in terms of diverted resources. Once the components of cost have been determined, it is necessary to adjust for obsolescence. The types of obsolescence relevant to intangible assets include functional obsolescence (inability to perform the function for which it was originally designed), technological obsolescence (improvements in competitive technologies) and economic obsolescence (external factors that prevent the technology from earning a fair rate of return over its useful life).

There are many inherent problems with the cost approach. The most significant is that it fails to reflect the earnings potential of the intellectual property. The value of intellectual property is derived from its earning potential, and not its cost. The cost approach assumes that the fair value of the asset will be the same as its cost, and that there is a direct relationship between cost and prospective profits. However, cost does not necessarily equate to value. Clearly there is potential for a high valuation to be placed on less successful assets on which high levels of expenditure have been directed and vice versa.

If the intellectual property offers significant economic advantage in an active market, the use of the cost method is likely to understate its value. If, on the other hand, development has been inefficient or lengthy, the use of the cost method might overstate its value. Also, for many identifiable intangible assets, it may not be possible to develop a replacement, or it may not be possible to estimate the replacement cost.

In its favour, the cost approach is useful as a readily calculated bottom-line valuation.

Market-based

Using the market approach, the value of the intellectual property is determined by the arm's length price paid in comparable transactions. T