Once portfolios of intellectual properties and intangible assets have been determined, then the process of placing value on those assets can begin. At the beginning of the valuation process, it is prudent that all the different methodologies available to value the particular set of intangible assets are considered.
Four methodologies have become most important, whether for litigation or for business and other transnational reasons, although many alternatives exist. Whether in a going concern, liquidation or a post-mortem valuation in litigation, these four methods are:
- Cost Approach
- Market Approach
- Income Approach
- Relief from Royalty Approach
For this brief post, CONSOR will focus on the Cost Approach.
Whether using historical or current costs, the basic underlying principle is that of substitution. This principle states that the value of an object or piece of intellectual property is no greater than the cost to acquire that asset elsewhere, whether the cost of obtaining the asset is measured by purchasing it today or replacing it with a substitute asset of equal strength and utility.
There are several different variations to the cost approach method, and each one uses a slightly different definition of cost. For example, the difference between reproduction cost and replacement cost may seem a question of semantics, but in fact, those two terms can be very different things. Reproduction cost establishes what it would take to construct an exact replica of the intellectual property. Replacement cost establishes what it would take to create or purchase a piece of intellectual property of equal functionality or utility.
Alternative approaches to the cost methodology, historical and prospective, assess the value of the intellectual property or bundle of assets by measuring the expenditures that would be necessary to replace the assets being valued. Whether historical or future cost is being established, three general areas of cost must be examined:
1. hard costs, such as materials and acquisition of assets
2. soft costs, including engineering time, design time, and overhead
3. market costs, including costs of advertising or other costs to build a market for the intellectual property
Unless a premium is added to these costs, however, this method does not give an indication of economic benefits derived from the development, ownership, and utilization of the intellectual property. Instead, it provides a minimum value for the assets. Because the cost approach is based on the economic principle of substitution, the essential premise is that a damage calculation or valuation should be no greater than the amount a potential buyer would pay for an asset, or no greater that the cost to develop or obtain another asset of similar utility and quality.
Not all costs incurred may always be used as part of the calculation, since the obsolescence factor applies. For example, cost items relative to the development of the intellectual property may once have been proprietary but are now in the public domain.
Finally, two important thoughts: First, the costs that are included when calculating damages with this valuation methodology must be considered within the current economic and legal environment. Second, it is also important to include an allocation for opportunity costs that arises either from delayed market entry or denied market entry.
Because the cost approach does not reflect the earning potential of the assets, it is often used most effectively for embryonic technology or other assets where no specific market application or specific stream of benefits or income has yet been identified. In any event, the cost approach can often be seen as providing a floor or minimum value for the intellectual property in question, against which a second methodology may be measured.
A brief example of the cost approach to a damages calculation is shown below. In this particular case, the client had a group of technology assets that were rendered obsolete because of infringement. The chart briefly summarizes the cost approach.
CLIENT XYZ
SUMMARY OF COST APPROACH
Hard costs of development
Personnel and development costs
Market development costs
Advertising costs
Overhead costs
TOTAL COST
Multiplier for opportunity cost
Total value based in cost expressed in today’s dollars
$100,000
$25,000
$15,000
$50,000
$50,000
$240,000
160%
$384,000