There is no disputing the ever growing importance of intellectual property portfolios to business. In the world of today there exist many industries where Intellectual Property (IP) accounts for 80% to 90% of the average company's value. That is a world of difference from just 30 years ago where IP assets tended to account for roughly about 20% of assets for the average company in those industries. As a consequence of the importance of Intellectual Property to many companies, it is often necessary to have patent valuations done. Patent valuations are required by companies for a variety of reasons including for business agreements, acquisitions and mergers, capital financing, taxation purposes, and for calculating damages in legal disputes.

There exist various methods of calculating the value of patents. Classical (âPopularâ) approaches to patent valuation include the cost approach, the design around approach, the comparable transaction approach, and the discounted cash flows approach. There also exist new emerging approaches to patent valuation such as the maximum achievable profit approach, venture capital approach, relief from royalty approach and real options approach. In this blog I will focus on discussing the classical approaches to patent valuations.

Cost Approach
The cost approach values a patent based on the cost of the patented technology. Under the cost approach, the value of a patent is calculated through historical cost trending or by estimating the cost of recreation. There do exist variations to the cost approach such as discounting the calculated costs based on variables like inflation. One short coming of the cost approach is that it does not take into account the profits that a patent can generate which is often the primary reason that a patent is acquired in the first place.

Design Around Approach
The design around approach values a patent based on the cost of designing around the claims of a patented technology. The basis of the design around approach is the presumption that one should never pay more for a patent than it would cost to produce an alternative product of equivalent value. Like the cost approach, the drawback to the design around approach to patent valuation is that it does not take into account the profits that a patent can generate.

Comparable Transaction Approach
The comparable transaction approach bases the value of a patented technology upon the evaluation of sales of a comparable patent. The comparable transaction approach (otherwise called the market approach) presumes that a patents value is equivalent to what a buyer would pay a seller for a similar patent. One short coming of the comparable transaction approach is that there may exist difficulties in finding comparable patents. Another short coming is that the purchase price of a comparable patent may not reflect the ability of that comparable patent to create profit.

Discounted Cash Flows Approach
Presently this is the most popular method of patent valuation. The discounted cash flows approach (otherwise popularly known as the income approach) estimates the overall profit that the patent can generate. Typically this approach calculates the value of a patent based on company specific profit projections and the use of a risk premium. Under the discounted cash flows approach, the projected future revenues of the patented technology is discounted by a risk premium (and other variables) to provide a present value for a patent. The resultant present value is then considered to be the market value of the patent. The primary drawback to this approach is that the value can be inaccurate because the processes of determining company specific profit projections and calculating a risk premium are susceptible to subjective bias and to manipulation.

While no approach to patent valuation can predict the value of a patent with a 100% degree of certainty, companies nonetheless will continue to find it necessary to have their patents valuated. The patent valuation approach that a company adopts should be based on the purpose for the valuation. For example, if your company is trying to determine whether to license a patented technology to incorporate into a product, then the design around approach may be most appropriate. The design around approach would allow your company to evaluate whether it would be cheaper to invest in developing alternative technology rather than licensing the patented technology. Or suppose your company wants to attract investment capital, then perhaps the discounted cash flows approach would provide the information sought by prospective investors. Depending on the purpose for the patent valuation, certain approaches will be more appropriate then others.