How To Do Valuation Analysis
This is a reproduction of Investing in Patents by Russ Krajec. For the complete book, get it on Amazon.
Valuation analysis of patents can be very involved, and every analysis has very big assumptions.
The value of a patent to a startup cannot always be quantified in dollars. For example, the deterrence factor of keeping competitors at bay because the company has a patent can never be quantified or even estimated.
Patents have values based on use scenarios. The patent may have one valuation in an outbound licensing scenario but a different value if the patent were sold outright.
The most common valuation method revolves around a reasonable expected royalty. This method is used most often by the courts to assess penalties for infringement.
The easiest method is the 25% rule. This rule of thumb is that a reasonable royalty rate for a patent would be 25% of the gross margins of a product protected by the patent. These is still debate on whether it is 25% of the entire gross margins of the product or 25% of the contribution of the invention to the gross margins of the product.
For example, a reasonable royalty rate for an intermittent windshield wiper patent might be 25% of the gross margins of the windshield wiper, but sometimes the courts have awarded 25% of the gross margins of the entire car. One could argue either way, and there would be endless lawsuits to decide this.
There are many more sophisticated methods for determining valuation, but each one has one or two assumptions on which the valuation hinges. Most of the work is to uncover data that supports those assumptions, or to try and bracket the assumptions to give a reasonable range.
One key element of valuation: remember to consider the patent life. A patent with 15 years of life can have a very significant value when evaluating the licensing revenues on a discounted cash flow basis.
After all the analysis, the patent is worth what someone is willing to pay. The valuation procedures are a way to find good order-of-magnitude numbers for valuation.