Intellectual Property and the Valuation Pyramid

Valuing intellectual property is the process of determining the worth of anything that was created by the human mind and has the same legal rights as actual physical property. Such intellectual property, or IP, can often be a company’s most valuable asset. Determining this value then is of the utmost importance, and a common way to do so is by viewing an IP through what is called a valuation pyramid.

The Foundation of the Valuation Pyramid

The foundation of the valuation pyramid is made from four building blocks, which are:

  • Purpose. Why is the asset being valued?
  • Description. What qualities give the asset value?
  • Premise. What is the asset’s use?
  • Standard. Who do we think will want the asset?

These blocks and their associated questions form the basis of how value is assessed, including the depth, completeness, focus, and working parameters of analysis. Understanding these questions ensures that value is assigned within acceptable standards of the associated IP’s field and that the valuation addresses all the relevant concerns related to the IP.

The Profile of the Valuation Pyramid

The next level of the pyramid is the profile, which refers to the financial, business/strategic, and legal characteristics of the IP that define the asset’s ability to generate value, with said ability being evaluated by the following three profiles:

  • Financial profile. This refers to the IP’s fiscal impact on the greater value chain into which it fits. Considerations in defining this include costs, revenues, and investments associated with the IP; price premiums; saved or excess capital; and the time it will take to commercialize the IP.
  • Business profile. This refers to the IP’s ability to make money. This can be determined by such factors as the IP’s market lifecycle, its barriers to exploitation, what other assets or services may be bundled with it, what its competition is, supplier and customer dynamics, new technologies, and government regulation. A good evaluation of an IP’s business profile will take into account all relevant factors, as well as how the IP may be used in conjunction with other IPs.
  • Legal profile. This refers to the legal issues that might come with owning the IP. IP’s do not have such issues as tangible assets may have, like air and water rights, workforce intangibles, and customer relationships, but there may be other issues unique to each individual IP.

The Methodology of the Valuation Pyramid

This level of the pyramid deals with the methods by which value is to be assigned to an IP. Methodologies used to assign value to an IP include:

  • The cost approach. This approach determines value by considering the cost to use an IP and operating off the principle that the value therein cannot be greater than the cost of obtaining a substitute asset elsewhere. Such a method is useful when an IP does not currently produce income, the technology driving it is well known, or it has weak legal protection.
  • The market approach. This approach determines value by comparing the IP to similar IPs and the value they have achieved through recent transactions in similar markets. This approach is most useful when a market for similar IPs is already thriving.
  • The income approach. This approach determines value by focusing on an IP’s ability to generate income, which is determined by its projected cash flow, economic life, and rate of discount. Basically, value is assessed by weighing the price of the IP against the cost of putting it to market and the length of time it can be marketed competitively. This valuation method is the most direct, but it can still be highly subjective.

The Solution of the Valuation Pyramid

The solution level is the top level of the pyramid, and its purpose is to determine what actions are to be taken to extract an IP’s potential value. Three categories of action to be considered within this level are:

  • Planning recommendation. The question to be answered here is whether there is more value in a license transaction or in a direct IP sale. The potential benefits and costs of each option should be thoroughly explored.
  • Compliance. This refers to making sure use and sale of the IP complies with all government regulatory requirements. Compliance with tax and FASB requirements are the most important considerations here.
  • Dispute resolution. This refers to any infringement or settlement claims related to the IP that must be dealt with or may be dealt with. Expert testimony will often be used to determine this.

Taken together, these three issues, in conjunction with the rest of the pyramid, will help you determine how to extract the most value from your IP. If you need further help understanding how valuing intellectual property works, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale and average 14 years of legal experience, including work with or on behalf of companies like Google, Stripe, and Twilio.