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Valuation of Intellectual Property

Japanese Patent Attorneys Association

Tokyo, Japan

October 30 and 31, 2016

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Presenter’s Contact Information

Raymond Rath, ASA, CFAManaging DirectorGlobalview Advisors LLC19900 MacArthur Boulevard, Suite 810Irvine, CA 92612949-475-2808rrath@globalviewadvisors.com

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Overview of Presentation

Day 1 – October 30, 2016— Section 1 - Introduction and Overview— Section 2 - General IP Insights— Section 3 - Importance of IP Rights— Section 4 – IP Litigation Overview— Section 5 - General Valuation — Section 6 - Cost and Market Method OverviewTotal

Day 2 – October 31, 2016— Section 7 - Income Approach Overview— Section 8 – Royalty Rate Estimation— Section 9 – Technology Valuation— Section 10 - Case StudiesTotal

4Globalview Advisors LLC

Section 1:Introduction and Overview

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Introduction

This course provides an overview on intellectual property related develops and valuation

Selected guidance from financial reporting valuation pertaining to intangible asset valuation is incorporated in the course. This relates to the focus of accounting standards setters and other parties on developing accurate intangible asset valuations.

The process for developing accounting and valuation guidance pertaining to intangible assets benefits from:— Transparency— Public vetting of guidance— Detailed review by qualified experts— Involvement of a wide range of interested parties

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Importance of Intangibles – Competitive Advantageof Firms is Increasingly Driven by Intangibles

“Wealth and growth in today's economy are driven primarily by intangible (intellectual) assets. Physical and financial assets are rapidly becoming commodities, yielding at best an average return on investment. Abnormal profits, dominant competitive positions, and sometimes even temporary monopolies are achieved by the sound deployment of intangibles, along with other types of assets.”— Intangibles Management, Measurement and Reporting,

Baruch Lev Brookings Institution Press, Washington D.C. 2001, p. 9.

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Importance of Intangibles – Intangible Assets Can Have Unlimited Scale “Physical, human, and financial assets are rival assets in the sense

that alternative uses compete for the services of these assets. In particular, a specific deployment of rival assets precludes them from simultaneously being used elsewhere.”

“In contrast, intangible assets are, in general, nonrival; they can be deployed at the same time in multiple uses, where a given deployment does not detract from the usefulness of the asset in other deployments.”

“A major contributor to the nonrivalry of intangibles is the fact that these assets are generally characterized by large fixed (sunk) cost and negligible marginal (incremental) cost.”

“Intangibles are often characterized by increasing returns to scale. The usefulness of the ideas, knowledge, and research embedded in a new drug or a computer operating system is not limited by the diminishing returns to scale typical of physical assets.”— Intangibles Management, Measurement and Reporting, Baruch

Lev Brookings Institution Press, Washington D.C. 2001, p. 22.

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Importance of Intangibles – Intangible Assets Can Have Unlimited Scale (cont’d)

“Knowledge is cumulative, with each idea building on the last, whereas machines deteriorate and must be replaced. In that sense, every knowledge-oriented dollar makes a productivity contribution on the margin, while perhaps three-quarters of private investment in machinery and equipment is simply to replace depreciation.” Grossman and Helpman (1994, p.31)— Intangibles Management, Measurement and Reporting,

Baruch Lev Brookings Institution Press, Washington D.C. 2001, p. 25.

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Increased Emphasis on Intangibles – Relative Values of Tangible and Intangible Assets

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Importance of Intangibles – Purchase Allocation of Wyeth, Inc. (Pfizer, Inc. 10K – 10/5/2009 - $ in millions)

Working capital, excluding inventories $16,342

Inventories 8,388

Property, plant and equipment 10,054

Identifiable intangible assets, excluding in-process research and development

37,595

In-process research and development 14,918

Other noncurrent assets 2,394

Long-term debt (11,187)

Benefit obligations (3,211)

Net tax accounts (24,773)

Other noncurrent liabilities (1,980)

Total identifiable net assets 48,612

Goodwill 19,954

Net assets acquired 68,566

Less: Amounts attributable to non-controlling interests (330)

Total consideration transferred 68,236

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Importance of Intangibles – US Economy Has Increased Focus on Intangibles

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Importance of Intangibles – US Economy Has Changed Markedly Over Time

Labor force – by occupation (2011)− Farming, forestry, and fishing - 0.7%− Manufacturing, extraction, transportation and crafts -

20.3%− Managerial, professional and technical – 37.3%− Sales and office – 24.2%− Other services – 17.6%

Note: Figures exclude the unemployed Source: The World Factbook, 2011

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Increased Emphasis on Intangibles – Changing Mix of Business Value Over Time

Under current accounting rules, many internally created intangible assets are not included on the balance sheet of the owner. Hence, the book value of the firm often does not reflect the true value. Balance sheets are no longer a full measure of the financial position of many firms.

As intangible assets assume increasing importance in the economy, Price to Book Value Multiples are increasing as represented by the S&P 500. Increasing multiples reflect increasing recognition of the importance of intangibles.

— 1977 1.2 to 1.0— 1980 1.3 to 1.0— 1985 1.6 to 1.0— 1990 1.8 to 1.0— 1995 3.0 to 1.0— 2000 4.2 to 1.0— 2005 2.9 to 1.0 (Post ASC 805)— 2011 2.3 to 1.0— 11/2014 2.8 to 1.0

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Increased Emphasis on Intangibles – Market Value and Book Value Relationship Over Time

2.73

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2.76 2.81 2.77

22.17 2.17

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Price to Book Value

Dates

31‐Dec‐02

31‐Dec‐03

31‐Dec‐04

31‐Dec‐05

31‐Dec‐06

31‐Dec‐07

31‐Dec‐08

31‐Dec‐09

31‐Dec‐10

30‐Dec‐11

31‐Dec‐12

31‐Dec‐13

18‐Nov‐14

Series1 2.85 2.58 2.14 2.05 2.17 2.17 2 2.77 2.81 2.76 2.92 3.03 2.73

S&P 500 Price to Book Value December 31, 2002 ‐ November 18, 2014

Series1

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Importance of Intangibles – Direct Example of Market Value to Book Value Relationship

Importance of Intangible AssetsComparison of Market Cap to Book Value for Selected CompaniesAs of November 17, 2014$ in billions

Market Book Value Ratio ofChina Business Capitalization of Equity MC to BVETencent Holdings, Inc. Internet Software and Services 154.54 9.66 16.0Baidu Internet Software and Services 85.63 6.30 13.6Lenovo Computers and Peripherals 14.30 3.02 4.7

JapanSony Corporation Household Durables 22.16 21.93 1.0Toyota Motor Corp. Automobiles 188.13 140.50 1.3NTT Telecommunications 61.83 82.65 0.7

France (EUR $Billion)Compagnie Generale DES Etablissements Michelin SCA Auto Components 13.36 9.26 1.4LVMH Moet Hennessy Louis Vuitton Textiles, Apparel and Luxury Goods 86.69 38.18 2.3Danone Food Products 40.76 14.74 2.8

GermanyDaimler AG Automobiles 81.99 59.72 1.4Allianz SE Insurance 59.86 57.81 1.0Bayer AG Pharmaceuticals 113.25 28.72 3.9

United KingdomBAE Systems plc Aerospace and Defense 14.65 2.78 5.3HSBC Holdings plc Commercial Banks 202.03 275.97 0.7GlaxoSmithKline plc Pharmaceuticals 110.30 11.59 9.5

United StatesApple Inc. Computers and Peripherals 668.53 111.55 6.0The Coca-Cola Company Beverages 187.99 33.43 5.6McDonald's Corp. Hotels, Restaurants and Leisure 93.40 13.63 6.9

Book value of equity as of latest quarter end.Market cap as of November 2014.

Source: Capital IQ

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Increased Emphasis on Intangibles – Market Value to Book Value at January 5, 2016 – Key Industry Sectors

Source: Aswath Damodaran, NYU Finance Professor As of January 5, 2016

Industry Name Number of firms PBV ROE EV/ Invested Capital ROICAdvertising 44 6.81 25.96% 7.47 59.68%Aerospace/Defense 92 4.39 20.19% 4.96 30.15%Air Transport 20 3.48 44.13% 2.11 18.57%Apparel 63 3.73 14.51% 2.91 15.99%Auto & Truck 19 2.26 14.70% 1.14 5.06%Auto Parts 65 2.56 21.81% 2.08 18.38%Bank (Money Center) 9 0.96 9.92% 1.05 ‐0.01%Banks (Regional) 644 1.16 9.23% 1.24 ‐0.02%Beverage (Alcoholic) 22 4.43 13.03% 4.43 15.85%Beverage (Soft) 43 8.13 21.98% 5.16 22.42%Broadcasting 29 2.39 11.73% 2.70 19.38%Brokerage & Investment Banking 42 1.16 7.98% 1.07 0.00%Building Materials 39 4.06 12.64% 3.05 15.91%Business & Consumer Services 159 3.88 10.00% 4.48 22.41%Cable TV 19 4.57 19.57% 2.58 16.04%Chemical (Basic) 42 1.59 ‐6.25% 1.40 12.57%Chemical (Diversified) 9 3.10 17.72% 2.36 12.75%Chemical (Specialty) 104 3.71 21.79% 3.00 20.20%Coal & Related Energy 38 0.75 ‐31.49% 0.93 0.22%Computer Services 118 4.43 32.23% 4.14 30.10%Computers/Peripherals 64 3.22 27.53% 2.94 35.70%Construction Supplies 52 2.47 14.62% 1.80 12.18%Diversified 26 1.86 5.67% 1.75 7.71%Drugs (Biotechnology) 411 7.50 22.35% 4.08 20.33%Drugs (Pharmaceutical) 157 4.05 15.21% 3.16 15.19%Education 40 1.79 0.79% 2.14 9.63%Electrical Equipment 120 3.45 15.43% 3.70 24.35%Electronics (Consumer & Office) 25 2.72 17.74% 2.29 20.18%Electronics (General) 167 2.01 10.42% 1.98 12.50%Engineering/Construction 51 1.48 1.74% 2.37 15.20%

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Increased Emphasis on Intangibles – MV to BV

Industry Name Number of firms PBV ROE EV/ Invested Capital ROICEntertainment 84 3.20 21.92% 4.13 33.00%Environmental & Waste Services 97 3.15 8.21% 3.76 18.31%Farming/Agriculture 37 1.73 10.46% 1.32 7.43%Financial Svcs. (Non‐bank & Insurance) 272 1.73 ‐1.20% 1.04 0.15%Food Processing 89 2.71 17.57% 3.61 23.13%Food Wholesalers 14 3.28 11.14% 2.94 17.94%Furn/Home Furnishings 30 2.84 13.56% 2.55 15.07%Green & Renewable Energy 28 0.73 ‐4.06% 0.84 2.81%Healthcare Products 254 3.84 10.33% 3.64 16.75%Healthcare Support Services 127 3.09 14.57% 5.53 41.50%Heathcare Information and Technology 126 4.24 11.79% 4.55 14.34%Homebuilding 34 1.60 16.01% 1.36 8.45%Hospitals/Healthcare Facilities 58 2.20 9.98% 1.66 9.50%Hotel/Gaming 73 3.13 20.35% 2.12 9.41%Household Products 134 5.37 13.46% 5.21 29.01%Information Services 70 5.76 23.78% 7.68 37.61%Insurance (General) 20 0.91 4.67% 0.99 6.26%Insurance (Life) 25 0.95 8.68% 1.02 8.56%Insurance (Prop/Cas.) 53 1.38 11.91% 1.38 11.69%Investments & Asset Management 145 1.11 11.18% 1.21 6.23%Machinery 130 3.00 12.76% 3.45 22.54%Metals & Mining 114 1.21 ‐23.49% 1.18 8.29%Office Equipment & Services 24 3.81 29.36% 2.89 23.02%Oil/Gas (Integrated) 7 1.49 5.84% 1.41 2.95%Oil/Gas (Production and Exploration) 351 1.14 ‐27.53% 1.10 ‐3.93%Oil/Gas Distribution 79 1.19 7.52% 1.23 9.21%Oilfield Svcs/Equip. 143 1.42 8.26% 1.48 16.19%Packaging & Container 25 3.31 16.99% 2.69 17.10%Paper/Forest Products 20 3.26 6.34% 1.88 11.92%

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Increased Emphasis on Intangibles – MV to BV

Industry Name Number of firms PBV ROE EV/ Invested Capital ROICPower 73 1.60 8.55% 1.37 7.20%Precious Metals 113 0.73 ‐4.40% 0.76 9.34%Publshing & Newspapers 39 1.75 4.18% 2.60 13.24%R.E.I.T. 221 2.06 7.48% 1.41 2.73%Real Estate (Development) 21 1.37 ‐1.29% 1.23 ‐0.85%Real Estate (General/Diversified) 12 1.69 1.70% 1.56 3.13%Real Estate (Operations & Services) 55 2.22 13.66% 1.99 10.52%Recreation 65 3.76 11.21% 2.73 14.80%Reinsurance 3 0.95 6.99% 0.96 7.88%Restaurant/Dining 83 10.48 31.92% 4.42 15.87%Retail (Automotive) 26 5.90 33.90% 2.49 12.57%Retail (Building Supply) 5 14.32 45.64% 5.08 21.62%Retail (Distributors) 83 2.80 14.96% 2.09 13.74%Retail (General) 19 3.02 15.15% 2.24 12.46%Retail (Grocery and Food) 17 4.92 26.76% 2.51 9.62%Retail (Online) 39 12.74 15.96% 11.16 20.81%Retail (Special Lines) 124 3.51 19.73% 2.61 12.91%Rubber& Tires 4 1.92 0.49% 1.39 20.05%Semiconductor 87 2.98 15.81% 2.10 13.35%Semiconductor Equip 46 2.27 6.23% 1.69 9.98%Shipbuilding & Marine 11 1.05 26.48% 1.16 6.42%Shoe 11 6.59 25.95% 5.95 22.41%Software (Entertainment) 17 4.05 12.30% 5.95 24.52%Software (Internet) 308 4.59 9.12% 4.35 13.47%Software (System & Application) 241 5.17 11.72% 4.16 18.95%Steel 36 1.34 ‐14.11% 1.34 ‐8.18%Telecom (Wireless) 19 1.47 ‐3.16% 1.24 1.52%Telecom. Equipment 121 2.56 12.40% 2.11 14.01%Telecom. Services 65 2.70 12.21% 2.32 12.81%Tobacco 20 29.94 ‐17.22% 9.51 77.34%Transportation 21 5.65 20.32% 3.69 20.14%Transportation (Railroads) 12 2.53 18.55% 1.90 17.19%Trucking 26 3.03 22.26% 1.63 12.42%Unclassified 3 1.21 0.70% 1.12 ‐3.01%Utility (General) 20 1.83 9.17% 1.45 6.96%Utility (Water) 18 2.29 9.68% 1.74 8.77%Total Market 7480 2.48 10.77% 1.74 6.55%

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Definition of Technology

Technology is the application of knowledge to useful objectives.It is usually built on previous technology by adding new technology inputs or new scientific knowledge.

Technology may even involve little or no science, as scientists define the term. New financial software is surely technology, but creating it requires virtually no new science.

New technology is also created through the combination of two or more technologies without much true scientific intervention.

The criterion for successful technology is usefulness, as defined in commercial, military, social or medical terms. Usefulness does not, in many cases, require that the user understand the technology or what makes it work.

Technology differs from science in the fact that it becomes obsolete.

Source: The Valuation of Technology, F. Peter Boer, John Wiley & Sons, 1999.

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Definition of Product

The noun product is defined as a "thing produced by labor or effort“ [1] or the "result of an act or a process“ [2], and stems from the verb produce, (to) lead or bring forth. Since 1575, the word "product" has referred to anything produced [3]. Since 1695, the word has referred to "thing or things produced". The economic or commercial meaning of product was first used by political economist Adam Smith.

In marketing, a product is anything that can be offered to a market that might satisfy a want or need. In retailing, products are called merchandize. In manufacturing, products are purchased as raw materials and sold as finished goods. Commodities are usually raw materials such as metals and agricultural products, but a commodity can also be anything widely available in the open market. In project management, products are the formal definition of the project deliverables that make up or contribute to delivering the objectives of the project.

In general usage, product may refer to a single item or unit, a group of equivalent products, a grouping of goods or services, or an industrial classification for the goods or services.

Source: Wikipedia, May 2009

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Products Often Include a Variety of Assets

Products can be viewed as a collection of different assets including technology(s), trade name, design and other elements (service and warranty policy, as additional examples). If all of these elements are complementary and have a similar useful life, it is possible to value a product. − For example, a Nike shoe product may be a collection of

intangible assets such as: trade name, design, technology, patent(s), and trade secrets.

The composition and contribution of intangible assets can change over a product’s life.

As the lives of the different component parts frequently vary, we rarely observe the valuation of a product.

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Definitions – Intangible Assets

International Accounting Standard 38, paragraph 8 defines intangible assets as “identifiable non-monetary asset without physical substance.”

ASC 350, Intangibles-Goodwill and Other defines intangible assets as “Assets (not including financial assets) that lack physical substance. (The term intangible assets is used in this Statement to refer to intangible assets other than goodwill.)”

IVSC GN 4 Valuation of Intangible Assets paragraph 3 defines an intangible asset as “A non-monetary asset that manifests itself by its economic properties. It does not have physical substance but grants rights and economic benefits to its owner or the holder of an interest.

The International Glossary of Business Valuation Terms (IGBVT)1 defines intangible assets as “non-physical assets such as franchises, trademarks, patents, copyrights, goodwill, equities, mineral rights2, securities and contracts (as distinguished from physical assets) that grant rights and privileges, and have value for the owner.”

Note difference in treatment of goodwill between ASC 350 and IGBVT.– 1 IGBVT 2001 is a glossary of business valuation terms prepared jointly by the

AICPA, ASA, CICBV, IBA, and NACVA.– 2 EITF 04-02 states that mineral rights are a tangible asset.

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Definition of Intellectual Property

Intellectual property is a subset of intangible assets. The term intellectual property refers broadly to the

creations of the human mind. Intellectual property relates to items of information or

knowledge, which can be incorporated in tangible objectsat the same time in an unlimited number of copies at different locations anywhere in the world. The property is not in those copies but in the information or knowledge reflected in them. Intellectual property rights are also characterized by certain limitations, such as limited duration in the case of copyright and patents.

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Definitions – Intellectual Property

Four ways to protect intellectual property include:

— Patent,

— Trademark,

— Copyright, or

— Trade secret.

Intellectual property falls into two broad groupings:— Industrial IP – Patents, industrial designs, trademarks,

service marks, layout-designs of integrated circuits, commercial names and designations, others

— Artistic IP - Copyrights and related artistic creations, such as poems, novels, music, paintings, and cinematographic works

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Important Elements of an IP Asset

Prerequisites for Undertaking IP Valuation - To be able to value an IP asset, the IP asset must be separately identifiable.a. IP must be subject to specific identification and a recognizable description.b. There should be some tangible evidence or manifestation of the existence

of the IP asset (e.g., a contract, a license, a registration document, a computer diskette, a set of procedural documentation, listing of customers, recorded on a set of financial statements, other)

c. It should have been created or have come into existence at an identifiable time (or time period) or as the result of an identifiable event.

d. It should be capable of being legally enforced and legally transferred.e. It should be capable of having its income stream separately identifiable

and isolated from the contribution of other assets employed in the business.

f. It should be capable of being sold, without selling the other business assets of the enterprise to the same buyer.

g. It should be subject to being destroyed or to termination of existence at an identifiable time (or time period) or as the result of an identifiable event.

Source: World Intellectual Property Organization (WIPO)

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Potential IP Elements for Biotechnology

IP products in biotechnology, genetic engineering and chemistry are technologically complex and incorporate many inputs.

As a result, IP inputs from third parties may be required. For these industries, examples could include:— Research tools— Recombinant techniques— DNA sequences— Transformation vectors— Cell lines— Adjuvants— Delivery devices

Source: Problems with Royalty Rates, Royalty Stacking and Royalty Packing Issues, Jones, Whitman and Handler, Intellectual Property Management in Health and Agricultural Innovation, 2007.

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Identification of Intangible Assets – Primary Groups

An understanding of the range of intangible assets will increase the understanding of the role of IP at different entities

There are many types of intangible assets. Accounting standards under IFRS and US GAAP provide

detailed information on types of intangibles. IFRS 3 and ASC 805, Business Combinations, include five

groups of intangible assets. These include:− Technology-based intangibles (Industrial IP)− Marketing-related intangibles (some Intellectual

Property)− Contract-based intangibles (probably not IP)− Customer-related intangibles (probably not IP)− Artistic-related intangibles (Artistic IP)

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Identification of Intangible Assets – Technology-Based Intangible Assets

Technology-based intangible assets protect or support technology and include:

a. Patented technologyb. Computer software and mask worksc. Unpatented technologyd. Databases, including title plantse. Trade secrets, such as secret formulas, processes,

recipesSource: IFRS 3 and ASC 805 (non-exhaustive list).

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Identification of Intangible Assets – Marketing Related Intangible Assets

Marketing-related intangible assets are primarily used in the marketing or promotion of products or services. The non-exhaustive listing includes:

a. Trademarks, trade names, service marks, collective marks, certification marks

b. Trade dress (unique color, shape, or package design)

c. Newspaper mastheadsd. Internet domain namese. Non-competition agreements

Source: ASC 805 and IFRS 3 (non-exhaustive list).

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Identification of Intangible Assets – Customer-Related Intangible Assets

Customer-related intangible assets related directly to the customer including:

a. Customer listsb. Order or production backlogc. Customer contracts and related customer

relationshipsd. Noncontractual customer relationships

Source: ASC 805 and IFRS 3 (non-exhaustive list).

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Identification of Intangible Assets – Artistic-Related Intangible Assets

Artistic-related intangible assets are those intangible assets of an artistic nature reflecting the creativity of the creator. These can include such items as:

a. Plays, operas, balletsb. Books, magazines, newspapers, other literary worksc. Musical works such as compositions, song lyrics,

advertising jinglesd. Pictures, photographse. Video and audiovisual material, including motion

pictures, music videos, television programsSource: ASC 805 and IFRS 3 (non-exhaustive list).

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Identification of Intangible Assets – Contract-Based Intangible Assets

Contract-based intangible assets are established by contracts and include:

a. Licensing, royalty, standstill agreementsb. Advertising, construction, management, service or supply

contractsc. Lease agreementsd. Construction permitse. Franchise agreementsf. Operating and broadcast rightsg. Servicing contracts such as mortgage servicing contractsh. Employment contractsi. Use rights such as drilling, water, air, timber cutting, and

route authoritiesSource: ASC 805 and IFRS 3 (non-exhaustive list).

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Identification of Intangible Assets – Definitions and Characteristics of an Asset

FASB Concepts Statement No. 6, Elements of Financial Statements, paragraph 25 defines an asset as follows:— Assets are probable future economic benefits obtained or

controlled by a particular entity as a result of past transactions or events.

An asset has three essential characteristics:— It embodies a probable future benefit that involves a capacity,

singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows.

— A particular entity can obtain the benefit and control others' access to it.

— The transaction or other event giving rise to the entity's right to or control of the benefit has already occurred.

To identify an asset, ask yourself the following:— Is there a future economic benefit? If so, to which entity does it

belong? What made it an asset of that entity?

34Globalview Advisors LLC

Section 2:General IP Insights

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Means of Generating Value from IP Holdings

How to derive value from an IP asset?— Direct Cash Flow Generation

• Direct exploitation of the IP• Sale or licensing of the IP

— Defensive Value - Even by not exploiting an IP asset (i.e., by merely owning it), it may be possible to add value, for example, by:• Minimizing the negotiating power of customers,• Offsetting supplier power,• Mitigating rivalry,• Raising barriers to entry by competitors,• Reducing the threat of substitutes.

- Source: WIPO, IP Valuation Module 11

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IP Related Business Models

With the increasing importance of IP, there are a variety of different business models that involve IP including:— Traditional IP (patent and technology) development

companies— Non-Practicing Entities (hold IP to license)

• Licensing agents• Litigation finance and investment firms

— Patent pools – formed by operating companies to reduce risk of patent litigation

— Intermediaries• Patent brokers and auction houses• Online patent and technology exchanges• Royalty stream securitization firms• Patent-based M&A advisory firms

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Non-Practicing Entities (NPE) - Introduction

Non-Practicing Entities (NPEs) are entities that primarily hold IP portfolio in order to generate licensing or litigation revenues.

Publicly-traded NPEs in the U. S. include:− Acacia Research Interdigital Vringo VirnetX− Wi-LAN Unwired Planet Tessera Rambus− RPX Marathon Parkervision Pendrell − Neonode AS NPEs hold IP but do not “operate” similar to many business

enterprises, they can provide useful insights on IP related developments.

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NPE – Overview of Sovereign Patent Funds (SPF) -Overview

Sovereign patent funds represent another fairly recent development in the world of IP. SPFs are patent aggregation entities set up with government funding with an intent to further national economic goals. Like NPEs, SPFs have also been subject to criticism by certain parties.

Examples include:— Industrial Technology Research Institute (ITRI) in Taiwan— Innovation Network Corporation of Japan (INCJ)— France Brevets – France— Ruichuan IPR Funds - China

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Non-Practicing Entities – Recent Developments

The stock market value of NPEs is down by 50% over past 5 years (Source Bloomberg 6/20/2016). Contributing factors include:— Increased willingness to fight suits by those being sued by NPEs— Courts less sympathetic to NPE lawsuits

• Why isn’t much software obvious?• Less likelihood of an injunction to step selling product with

alleged infringement• Potential requirement to reimburse expenses of alleged

infringing party ( Conversant (a private NPE) lost a case against Apple in the Eastern District of Texas and was ordered by the court to pay costs of just over $736,000.)

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NPEs – Recent Developments – Supreme Court Developments Court cases and legislative developments are focused on IP related

issues. Two significant cases include:

— eBay Inc. v. MercExchange, L.L.C. – U.S. Supreme Court holds that district courts have the power to deny injunctions in appropriate cases. Reduces risk of an injunction that would stop product sales. eBay Inc. v. MercExchange, L.L.C, 126 S. Ct. 1837, 1841 (2006).

— Supreme Court’s 2014 ruling in Alice Corp. v. CLS Bank International, which has made it significantly more difficult to defend the validity of software patents, and the administrative fast track to challenge, and often invalidate, patents at the Patent Trial and Appeal Board established by the 2011 Leahy-Smith America Invents Act.

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IP Damages - Blackberry

In 2006, Research-in-Motion agreed to a settlement of $612.5mm for patent infringement pertaining to the Blackberry smart phone.

The settlement amount was very high given concern of a permanent injunction for a product in of an early stage firm with exceptionally high future growth potential

In current legal environment, this amount of settlement would not be expected

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IP Portfolio Sales Transactions - Introduction

Operating companies are increasingly recognizing the benefits of holding broad IP portfolios:— Licensing income— Reduce risk of lawsuits (by owning reduce risk of legal action

by NPEs)— Defensive value

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IP Portfolio Sales Transactions - Examples

Around mid-2011, Nortel Networks Corp., the defunct Canadian telecommunications giant, auctioned off its portfolio of six thousand patents and drew an astonishing winning bid of $4.5 billion from a group of companies that included both Apple Inc. and Microsoft Corp.

Google purchase of Motorola Mobility for $12.5 billion. Transaction included 17,000 patents and 7,500 applications plus phone business

In January 2013, Eastman Kodak sold its digital imaging patent portfolio for $525mm

Acacia Research Corp January 2012 acquisition of ADAPTIX, Inc. and its 4G mobile technology patent assets for $160mm

Microsoft’s April 2012 purchase of 800 patents and non-exclusive license to 300 more from AOL Inc. for over $1.0 billion

Intel – three acquisitions in 2012. Over $500mm paid Numerous other

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Notable IP Acquisition Failures or Areas of Concern

VW acquisition of Rolls-Royce Motor Cars, Ltd. from Rolls-Royce, PLC – VW got Bentley trade name. BMW wound up with Rolls Royce trade name. Inadequate due diligence.

1990 Acquisition of Pine-Sol by Clorox Apple trademark usage in China

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IP Litigation in the US

In the U.S., there is significant and increasing litigation regarding infringement of IP rights. — The total number of patent infringement cases filed in U.S.

District Courts jumped to 5,219 in 2015 after declining the year before, according to an RPX study. NPEs filed more than 3,600 of those cases, roughly two-thirds of the total. Companies with less than $100 million in annual revenue, which are less able to weather large legal bills, made up more than 60 percent of defendants in those cases.

The strength of IP will reduce the risk of IP and increase value

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Increasing Importance of IP Licensing

Firms are increasingly recognizing the value from their IP portfolios IBM increased patent licensing royalties from $30 million in 1990 to

$1 billion in 2000 — One ninth of IBM’s annual pretax profit— Based on IBM profit margins, that would require $20 billion of

incremental revenue (25% of existing global revenues)— In 2011, IBM announced it was its 19th year of leading the US

in the number of patent grants From 2008 to 2012, Forbes magazine reported annual licensing

revenues of $1.1 to $1.2 billion 2014 revenues of $742 million

– Decline may relate to lower royalty rates– Reduced utilization

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Example of IP Licensing Operations – AT&T

AT&T's Intellectual Property arm is the often unheralded, but important organization working behind the scenes to protect and preserve innovations on new-generation applications and enhanced services for businesses and consumers. And, it may be the industry's best kept secret.

AT&T Intellectual Property is one of the world's largest intellectual property operations, with a heritage of innovation that dates back more than a century to Alexander Graham Bell. AT&T owns one of the strongest patent portfolios in the telecommunications industry and consistently ranks in the top 25 companies each year in obtaining new U.S. patents.

In addition to building and protecting our large portfolio of intellectual property assets, AT&T Intellectual Property manages a vigorous intellectual property licensing and sales program. Learn about AT&T patent sales, patent licensing, technology licensing and brand licensing.

AT&T's philosophy is that strong, fair management of intellectual property is critical to fostering continual innovation. Our licensing program is focused on maximizing access to AT&T innovations, while also ensuring that investments in research and innovation are valued fairly and appropriately.

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Section 3:Importance of IP Rights

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IP Insights – Reasons for Obtaining Patents

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IP Insights – Unused Patents

A survey by the firm BTG of 150 technology-intensive firms and research universities in the United States, Western Europe and Japan found that 24% had more than 100 unused patents, 12% had more than 1,000 unused patents and only 15% reported had no unused patents. Approximately 30% of Japanese firms reported having more than 2,000 unused patents (BTG, 1998).

A survey of EPO patent applicants (about 700 total responses) showed that the average share of licensed patents in a respondent’s patent portfolio in 2003 was 8% among Japanese firms, 11% among European firms and 15% among US firms (Roland Berger, 2005).

A large scale, comprehensive survey conducted by the Japan Patent Office (JPO) (about 6,700 total responses) found that only 30% of Japanese patents were being exploited internally, less than 10% were being licensed out to other parties, and more than 60% of Japanese patents were not being used at all (JPO, 2004).

Source: Valuation and Exploitation of Intellectual Property OECD, STI Working Paper 2006/5

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Reasons for Valuing IP / Intangibles – Partial List

Transactions / Planning— Purchase / Sale / Spinoff— Licensing— Financing— Transaction Support— Investment Strategy / Support

Litigation— Infringement / enforcement of rights— Bankruptcy— Marital Dissolution

Compliance— Financial Reporting— Taxation

• Transfer Pricing• Ad Valorem (Property Tax Assessments)• Estate and Gift• Other

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IP Rights Assessment

The valuation of IP rights is not simply a mathematical, accounting, economic or financial process

The extent of IP rights is a significant determinant of their value Important Attributes of IP Rights include:

— Validity— Enforceability— Freedom to use

Key tasks in confirming IP rights that are actually held include:— Catalog and verify ownership— Assess scope and validity of patent / other claims— Freedom to make, use or sell technology without impeding

rights of other patent holders

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IP Rights Assessment and Valuation – Skills Required for a Valuation

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Importance of IP Rights

Strong IP portfolio gives you a competitive advantage by excluding competitors from features that make your products attractive to customers

Strength is a function of scope and enforceability Potential investors want to know whether the IP portfolio:

— Excludes competitors from the market— Can be enforced against competitors

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Importance of IP Rights – Value Enhancement

IP strategic valuation enhancement steps:1. Resolve any freedom to operate issues2. Build a strong IP portfolio3. Clean up title to the IP4. Negotiate solid licenses5. Get the IP portfolio organized

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IP Rights Assessment

Steps1. Asset investigation (patents or applications in place)2. Contract investigation (contracts / licenses)3. Litigation investigation

Five common problems1. Target doesn’t hold rights (title update, employee transfer,

developed by independent contractor2. Prior agreements limit rights3. Pending / threatened infringement claims4. Significant barriers to exploitation – third parties have blocking

IP rights (freedom to operate)5. IP rights are encumbered by liens

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IP Rights Impact and Type of Transaction

The form of a transaction where IP is a significant component can have a significant impact of the procedures required to confirm IP rights held

Types of transactions include:— Asset purchase –

Greater risk of failing to acquire all IP Potential to trigger anti-assignment clauses in any license or

other agreements— Carve-out transactions— Acquisition of the stock of the parent entity that ultimately holds

the IP

NCA and type of transaction— Strategic— Financial

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Measures of IP Importance

Revenue and cash flow generation tied to IP Royalties or license fees received Availability of commercially viable alternative Replacement cost of IP including time, expense and level of effort

Knowledgeable parties— Outside IP counsel— Internal counsel— CIO

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Trade Name Rights Assessment

Trade Name Rights Considerations— Goods and services availability— Countries / geographic availability

Relative to Industrial IP, artistic IP rights assessment would be relatively more straightforward in many situations

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Patent Ranking for Large Portfolios

As noted in prior slides, many firms will hold hundreds or even thousands of patents and patent applications. This creates a need to focus IP procedures on most important IP elements. Key considerations include:— Patent life— Priority date of the patents— Litigation history— International coverage— How often a patent is cited— Coverage and breadth of the claims— Size of the potential market covered— Ease of design around— Threat of patents ending up being owned by a competitor— Potential issues related to patent exhaustion

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IP Due Diligence Overview

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Freedom to Operate

Freedom To Operate is the essential to the value of Intellectual Property— Lack of patents can impair competitive advantage

Areas suggesting risk: — Threatening letters from third parties— Prior lawsuit(s) for infringement

Conduct thorough freedom to operate searches for the product as a whole— Include issued patents and pending patent applications

US and major markets Evaluate the results:

— Patents that require action now— Patent applications you need to follow

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Resolving Freedom to Operate Issues

Develop an action plan:— Consider how long until the patent expires— Design around troublesome patents— Obtain licenses on patents that cannot easily be

designed around— Obtain opinion letters— Get ready for litigation

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Power to Exclude

Develop and implement a patent strategy that is market oriented rather than invention oriented

Focus on getting patent claims that exclude competitors from selling competitive products— Rather than covering an “invention”

Show Investors how your patents will stop competitors from entering your market— This is more compelling than showing how your patents

cover specific technical aspects of your products

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Patent Enforceability

Strong chain of title— unbroken chain of title from the inventors to the Company— Title to IP is held, initially, by the Inventors

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Licensing Strategies and IP Value

Licenses may be required to enhance IP portfolio value— Exclusivity:

• Your Company needs to have an exclusive license on foundational technology– Non-exclusive licenses are just freedom to operate

licenses— Field of Use:

• The field of use should be broad enough to cover all uses contemplated by the business plan

— Restrictions on license transfer:• Restrictions on transfer can handicap “exits” such as M&A • You should limit such restrictions to the “noise” level

– For example, payment for transfer rather than prohibition

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Primary Phases in IP “Audit”

1. Gather IP Data2. Organize IP Assets3. Confirm / Clarify IP Ownership4. Assess IP Legal Protection and Compliance5. Develop IP Policies / Procedures6. Develop IP Leveraging Strategies7. Maintain IP Enforcement Strategies

Source: Intellectual Asset Management and Harvesting, Andrew J. Sherman, Business Law Brief.

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IP Asset Due Diligence

Patent Attorney1. File history review2. Maintenance fees3. Prior art search4. Freedom to operate5. Litigation search6. Docket review7. Claim evaluation

• Enforceability, coverage, etc.8. Check ownership (assignments, employment agreements, etc.)

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Section 4:IP Litigation Overview

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Seminal IP Civil Court Cases

In the U.S., there are several IP related court cases that have received relatively significant attention. These cases include:— Panduit Corp. v. Stahlin Bros. Fibre Works, Inc.— Georgia-Pacific Corp. v. U.S. Plywood Corp.— Grain Processing v. American Maize Products Co.— Microsoft v. Uniloc

The cases reinforce a variety of the IP concepts previously discussed

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Panduit Corp. v. Stahlin Bros. Fibre Works, Inc.

To win award for patent infringement, the Patentee must establish:— Demand for the patented product— There aren’t any non-infringing substitutes— Amount of profit the patentee would have made absent the

infringing conduct

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Georgia-Pacific Corp. v. U.S. Plywood Corp.

Cases suggests use of a royalty model to value IP and/or establish financial damages

Provides guidance on royalty damages calculations assumed— Parties agree to negotiate— Parties agree that the IP is valid and enforceable

Cases set forth 15 factors to assist in developing a hypothetical negotiation between parties. Key considerations include:— Significance of the IP to the product and to market demand— Royalty rates paid for similar IP— Expert testimony as to value of IP

Factors in areas including:— Licensing— Competition— Profitability— Alternatives

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Grain Processing v. American Maize Products Co.

Must show demand related to products incorporating the IP Even if a competing process has not been developed, the subject

process has not been infringed if:— Materials available— Technical process known— Defendant had necessary equipment, know-how and

experience Consider actual alternatives at time of infringement that were

available to defendant Burden on proof is on the infringer to demonstrate ability to

implement

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Microsoft v. Uniloc

This case provided a detailed discussion of the “Profit Split Method” (“PSM”) to determine a reasonable royalty rate. The case determined the use of a 25% profit split as a starting point for a reasonable royalty rate has no basis in fact and disallowed its use.

This case will be discussed in much greater detail later in this course.

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IP Litigation – Legal Developments – Fee Shifting

The payment of legal fees by parties to a civil suit may vary in different legal jurisdictions. Under the “American Rule”, each party to a litigated matter is often responsible for their legal fees. In other jurisdictions the “English Rule” provides the losing party will generally be required to pay the legal fees of the winning party.

In 1946, U.S. Congress enacted Section 70 of the Patent Act which granted courts broad discretion to award attorneys” fees. Provision intended to deter infringement and protect accused infringers from frivolous litigation.

In 2005, the legal discretion to award fees was made significantly more different as a result of the Brooks Furniture case requiring “material inappropriate conduct”, a case that is “objectively baseless” and is “brought in subjective bad faith”.

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IP Litigation – Legal Developments – Fee Shifting

In April 2014, the Octane Fitness v. Icon Health & Fitness and Highmark v. Allcare Health Management System, the U.S. Supreme Court vested greater discretion in trial courts. Discretion to award fees in a particular case was returned to the court that is most familiar with the matter. Results in less risk of overturn of fee award on appeal.

These cases suggest increased risk of “fee shifting” so that the loser of the case may be responsible for the legal fees of both parties. This action would presumably reduce the risk of lawsuits for infringement. As many (but not all lawsuits) are brought by NPEs, the general expectation is that this increased risk would reduce the value of IP held by NPEs and increase the value of IP held by operating entities.

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Fee Shifting – Octane Fitness Case

Holding: Section 285 of the Patent Act authorizes a district court to award attorney's fees in patent litigation in "exceptional cases" – that is, cases which stand out from the others with respect to the substantive strength of a party’s litigating position or the unreasonable manner in which the case was litigated. District courts should determine whether a case is exceptional “in the case-by-case exercise of their discretion, considering the totality of the circumstances.” The Federal Circuit’s Brooks Furniture Mfg. v. Dutailier framework, pursuant to which a case is “exceptional” only if the district court finds either litigation-related misconduct of an independently sanctionable magnitude or determines that the litigation was both “brought in subjective bad faith” and “objectively baseless,” superimposes an inflexible framework onto statutory text that is inherently flexible.

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Fee Shifting – Court Awards

Studies of fee awards provide some early insights on the impact of fee shifting changes resulting from Octane and Highmark cases.

Observations cover a short period with a modest number of cases— Increase in fee shifting awards from prior years— 76 cases over twenty month period involved fee shifting awards— A modest number of cases involve attorney sanction and/or

joint and several liability for the attorneys— Range of fees of $675,000 to $10,300,000 with average award

of $1,300,000— 76% of wards to the accused infringers

Source: Two years after Octane – fee shifting in patent litigation, IAM blog, Katharine Wolanyk of Gerchen Keller Capital, LLC in Chicago, Illinois.

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Patent Trials and Appeals Board

The Patent Trial and Appeal Board (PTAB) conducts trials, including inter partes, post-grant, and covered business method patent reviews and derivation proceedings, hears appeals from adverse examiner decisions in patent applications and reexamination proceedings, and renders decisions in interferences

The Patent Trial and Appeal Board is created by statute, and includes statutory members and Administrative Patent Judges. The PTAB is charged with rendering decisions on: appeals from adverse examiner decisions, post-issuance challenges to patents, and interferences.

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IP Legal Developments

Lexmark International Inc. v. Impression Products Inc. (2016 WL 559042 (Fed Cir Feb 12, 2016 ((en Banc)). Finding – sales of patented products abroad by the patent owner or a licensee do not exhaust the patent rights in those products.

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IP Legal Developments – Cuozzo v. Lee

SCOTUS declined to overhaul two key tenets of the post-issuance review procedures

1. Broadest reasonable claim interpretation intact2. Review decisions are not appealable

Holding: The Leahy-Smith America Invents Act creates an agency procedure called “inter partes review” that allows a third party to ask the U.S. Patent and Trademark Office to re-examine the claims in an already-issued patent and to cancel any claim that the agency finds to be unpatentable in light of prior art; the act also provides that the PTO’s decision whether to institute an inter partes review is “final and unappealable.” This provision bars a court from considering whether the PTO was correct in instituting an inter partes review when it did so on grounds not specifically mentioned in a third party’s review request. Moreover, the PTO has authority to issue a regulation stating that the agency, in inter partes review, shall construe a patent claim according to its broadest reasonable construction in light of the specification of the patent in which it appears. (Justices voted 8 – 0).

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IP Legal Developments – Prior Art

Prior art is constituted by all information that has been made available to the public in any form before a given date that might be relevant to a patent's claims of originality. If an invention has been described in the prior art, a patent on that invention is not valid.

Information kept secret, for instance, as a trade secret, is not usually prior art, provided that employees and others with access to the information are under a non-disclosure obligation. With such an obligation, the information is typically not regarded as prior art. Therefore, a patent may be granted on an invention, even though someone else already knew of the invention. A person who used an invention in secret may in some jurisdictions be able to claim "prior user rights" and thereby gain the right to continue using the invention. As a special exception, earlier-filed and unpublished patent applications do qualify as prior art as of their filing date in certain circumstances.

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IP Legal Developments – Prior Art

Arguments claiming prior art are used in defending and attacking patent validity. In one U.S. case on the issue, the court said:

"One attacking the validity of a patent must present clear and convincing evidence establishing facts that lead to the legal conclusion of invalidity. 35 U.S.C. § 282. To establish invalidity under 35 U.S.C. § 103, certain factual predicates are required before the legal conclusion of obviousness or nonobviousness can be reached. The underlying factual determinations to be made are

1. Scope and content of the prior art;2. Differences between the claimed invention and the prior art;3. Level of ordinary skill in the art; and4. Objective evidence of non-obviousness, such as commercial

success, long-felt but unsolved need, failure of others, copying, and unexpected results."

Graham v. John Deere Co., 383 U.S. 1, 17, 148 USPQ 459, 467 (1966).

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IP Defensive Alliances

Defensive alliances are another development in efforts to reduce the risk of litigation from NPEs.

Strategies of defensive alliances may vary somewhat. Members of defensive alliances pledge to grant a license to all other members anytime they transfer a patent to a third party.

Examples include:— License On Transfer (LOT) Network – Members include Ford,

Toyota, Nissan, Hyundai and Kia— Open Invention Network - Set up to protect Linux and other

open-source software technologies. Toyota joins on June 6, 2016.

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IP Infringement Consultations by Type for Japan

Source 2015 Annual Report, Office of IP Protection, MITI, June 2015

Mix of IP infringement cases in Japan for which IP right was identified

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Section 5:General Valuation Observations

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Introduction to Valuation Concepts

There are three primary approaches to valuation— Cost – Value based on costs incurred to “build” the asset— Market – Value based on sales prices for similar assets— Income – Value based on present value of future cash flows

Market transactions involving IP occur frequently. However, the ability to use this data for valuation purposes is frequently limited— Portfolios of IP— No disclosure (private transactions)

Given this, the Cost and Income Approaches are most frequently used.

The Cost Approach reflects the amounts incurred to build an asset The Income Approach reflects the income from holding an asset In many cases, valuation using both the Cost and Income

Approaches should be employed if “building” or creating an asset is viable (i.e., existing patent protection doesn’t preclude)

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Valuation Challenges – Charitable Contributions of IP

Many U.S corporations had donated IP to charitable organizations in order to obtain tax deductions. Donors would receive tax deductions based on the fair market value of the donated IP.

Transfers were frequently to universities and in many cases the IP was not used nor did it provide any economic benefit

Valuation of the donated IP was also challenging and subject to significant uncertainty.

IRS ultimately revised rules pertaining to these transfers and significantly limited ability to take charitable contribution— Prior rules allowed deduction based on FMV— Revised rule limits deduction to the lower of tax basis or FMV

of the IP As IP investment is frequently expensed, there would be no tax

basis and the tax basis and amount of the contribution would be $0

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Introduction - Industrial vs. Artistic IP Valuation

Contrast valuation of industrial vs. artistic IP— Industrial IP often more difficult to value

• Cash flow segregation challenges– Multiple technologies in place for products in many

industries– Multiple assets – customers and/or trade names– Life of cash flows is frequently related to company and

competitor factors— Artistic IP valuation – less challenging once commercially

exploited• Often assumes that the IP completely creates demand – no

customer or trade name intangibles may be present to complicate matters

• Life of cash flows may be less uncertain

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Business Valuation vs. Asset Valuation - Comparison

RUL = Remaining Useful Life

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Definitions – Fair Value in a Financial Reporting Context

Fair Value (Accounting Definition under IFRS 13 and ASC 820): — “Fair value is the price that would be received to sell an asset or paid to

transfer a liability in an orderly transaction between market participants at the measurement date.” (IFRS 13 and ASC 820).

— “An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities . . .” (IFRS 13 and ASC 820)

— “The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the objective of a fair value measurement is to determine the price that would be received to sell the asset or transfer the liability at the measurement date (an exit price).” (IFRS 13 and ASC 820)

— Fair value was previously thought to be an entry price (buy-side); what a company would pay to acquire an asset or pay to settle a liability.

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Definitions – Fair Value in a Financial Reporting Context (cont’d)

— A fair value measurement is for a particular asset or liability. Therefore, the measurement should consider attributes specific to the asset or liability, for example, the condition and/or location of the asset or liability and restrictions, if any, on the sale or use of the asset at the measurement date. (IFRS 13 and ASC 820)

— “The asset or liability might be a standalone asset or liability (for example, a financial instrument or an operating asset) or a group of assets and/or liabilities (for example, an asset group, a reporting unit, or a business).” (IFRS 13 and ASC 820)

— It is essential to view fair value from the point of view of market participants rather than a specific entity. Market participants are unrelated parties, knowledgeable of the asset or liability given due diligence, willing and able to transact for the asset/liability, and may be hypothetical. (IFRS 13 and ASC 820)

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Definitions – Fair Value in a Legal Context

Fair Value (Legal Definition): — In a legal setting in the United States, fair value determinations for

intangible assets are limited. Celebrity goodwill is one area of legal dispute. Personal or professional goodwill of a business is another area.

— Often used in dissenting stockholder actions and shareholder oppression cases.

— The definition varies from jurisdiction to jurisdiction as specified in state statutes and developed in the state’s case law precedents.

— In some jurisdictions, the fair value of a stock interest may exclude valuation discounts that might be appropriate in estimating the FMV of the interest. The exclusion of these discounts may reflect “just” compensation to the party bringing the suit for the oppression of the controlling shareholders rather than the FMV of the interest. As such, this “standard” of value is legal community-based, not economically-based.

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Definitions – Fair Market Value

Fair Market Value: Fair market value (FMV) is the most common standard of value used in business appraisals today, particularly for U.S. tax-related appraisals. Two definitions are classically given to this standard: — The price at which the property would change hands between a

willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell; both parties having reasonable knowledge of relevant facts. [Revenue Ruling 59-60]

— The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller acting at arm’s-length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. (Note: In Canada, the term “price” should be replaced with the term “highest price.”) [IGBVT]

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Definitions – Intrinsic Value and Investment Value

Intrinsic Value

— The value that a prudent investor considers, on the basis of an evaluation or available facts, to be the "true" or "real" value that will become the market value when other investors reach the same conclusion. [IGBVT]

— What the value should be based on analysis of all the fundamental factors inherent in the business or the investment. Intrinsic value does not consider extreme aspects of market conditions and behavior (such as observed during the peak of the 1998-2001 bubble).

— Does NOT reflect current market but expectation of what the market will eventually realize as value.

Investment Value - The value to a particular investor based on individual investment requirements and expectations. [Note: in Canada, the term used is "Value to the Owner."] [IGBVT]

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Definitions – Premise of Value

Premise of Value – an assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation; e.g., going concern, liquidation. [IGBVT]

There are two basic premises of value:

− (1) going concern value and

− (2) liquidation value.

− Under each premise of value, there exist certain other assumptions regarding the purpose of the valuation that affect the choice of the standard of value.

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Definitions – Liquidation Value

Liquidation Value – The net amount that would be realized if the business is terminated and the assets are sold piecemeal. Liquidation can be either "orderly" or "forced.” [IGBVT]

Orderly Liquidation Value – Liquidation value at which the asset or assets are sold over a reasonable period of time to maximize proceeds received. [IGBVT]

Forced Liquidation Value – Liquidation value, at which the asset or assets are sold as quickly as possible, such as at an auction. [IGBVT]

The liquidation value and going concern value of specific intangible assets may differ dramatically depending on the characteristics of the intangible asset and the facts and circumstances unique to the business. For a going concern, the liquidation value of an intangible asset would often be significantly reduced (or $0) as the value of intangibles can often best be recognized as a part of a ongoing business enterprise.

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Definitions – Replacement and Reproduction Cost (Cost Approach Definitions)

Replacement Cost New – the current cost of a similar new property having the nearest equivalent utility to the property being valued [IGBVT]

Reproduction Cost New – the current cost of an identical new property [IGBVT]

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Public Company Financial Statistics on Intangible Assets

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Importance of IP – Publicly Available Data on Relative Values of Different Assets in Business Acquisitions

Public companies in the United States and countries operating under International Financial Reporting Standards (IFRS) are required to disclose the fair values of the underlying assets of firms they acquire.

These studies provide insights on the importance of different types of intangible assets to different types of firms.

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2014 Houlihan Lokey Survey of Purchase Price Allocations by US Firms in 2013

Numerous firms perform and publish studies of the characteristics of different acquisitions. Studies by Houlihan Lokey are presented below and in the following slides.

2014 study of 422 transactions with sufficient disclosure Intangible assets include:

— Developed technology— In-process research & development— Customer-related assets— Trademark and trade name— Other (including non-compete, licenses and core

deposits) Source: Houlihan Lokey, 13th Annual Purchase Price

Allocation Study, October 2014

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2014 Houlihan Lokey Survey of Purchase Price Allocations -Goodwill vs. Intangible Values

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Frequently Identified Intangible Assets – 2008 to 2010

Source: Houlihan Lokey Purchase Price Allocation StudyPC = Purchase Consideration (Total Purchase Price)

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Allocation to Developed Technology – By Industry

Source: Houlihan Lokey Purchase Price Allocation Study

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Allocation to Developed Technology – 2011 to 2013

Source: Houlihan Lokey Purchase Price Allocation Study

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Allocation to IPR&D – 2011 to 2013

Source: Houlihan Lokey Purchase Price Allocation Study

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Allocation to IPR&D – By Industry

Source: Houlihan Lokey Purchase Price Allocation Study

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Allocation to Customer Related Intangibles – 2011 to 2013

Source: Houlihan Lokey Purchase Price Allocation Study

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Allocation to Customer Related Intangibles – By Industry

Source: Houlihan Lokey Purchase Price Allocation Study

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Allocation to Trade Names – 2011 to 2013

Source: Houlihan Lokey Purchase Price Allocation Study

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Allocation to Trade Names – By Industry

Source: Houlihan Lokey Purchase Price Allocation Study

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Section 6:Overview of Cost and Market Approaches to Valuation

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Overview of Cost Approach – Considerations for Use

Asset not directly associated with income generation of the business.− Readily replaceable workforce compared to complex FDA approval.− Internally-used software.

When the cost of reconstructing or replacing an asset with a sufficiently comparable asset can be reasonably determined.

Asset not readily valued using market or income approach. Economic obsolescence should be considered, but is difficult to

quantify:− Does not consider amount of future economic benefits− Does not consider timing and duration of future economic

benefits− Does not consider risk

Depending on nature of asset, there can be subjectivity in developing cost estimates. Software development would have less subjectivity, creation of a cure for a type of cancer would have a high degree of uncertainty on costs.

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Overview of the Cost Approach – Elements of Labor, Material and Overhead

Labor – Fully-burdened direct labor including all related payroll benefits (primarily taxes, pension, and insurance).

Material – All materials directly consumed in the development of the intangible asset development process. (Rare for most intangibles.)

Overhead – Facility costs, management and administrative support, and other unallocated expenses.

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Overview of the Cost Approach – Inclusion of Entrepreneurial Profit

For real estate assets, a provision for profit or incentive on the costs associated with the development of an asset is regularly included and is a specific element of the description of the valuation approach.

For intangible assets, many valuation professionals do not include a provision for any profit or incentive on the costs associated with the development of an asset which is valued using the Cost Approach.

An asset acquired from a third party would presumably reflect their costs associated with creating the asset as well as some form of profit mark-up required to provide a return on investment.

There is limited current guidance on this issue in the financial valuation literature related to the valuation of intangible assets.

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Cost Approach – Inclusion of Opportunity Costs –SEC Perspective

SEC Speech on December 10, 2007 by Sandie E. Kim — Some of the question to keep in mind include, but are not

limited to, the following:• Is the asset difficult to obtain or create?• Is there a long period of time required to obtain or

create the asset?• Is the asset scarce?• Is the asset critical to the business operations?

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Overview of the Cost Approach – Internally Development Costs vs. Third Party Cost Estimates

The estimated cost of an asset could differ depending on whether costs are based on internal or third party cost estimates.

Cost estimates for intangible development from a third party would be expected to include compensation for:—Labor,—Material,—Overhead, and—Profit required to compensate the seller for their efforts.

Historical practice for valuation of internally created intangibles may include differing assumptions regarding these amounts –especially allocation of overhead and inclusion of a profit element.

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Overview of the Cost Approach – Internal Development Costs vs. Third Party Cost Estimates – Example

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Overview of the Cost Approach – Limitations

The Cost Approach does not incorporate information about the amount of economic benefits associated with the asset (i.e., it does not consider economic obsolescence).

It does not consider the duration of time over which the economic benefits will be enjoyed.

The Cost Approach does not capture the risk associated with receiving the expected economic benefits.

Adjustments that are necessary to reflect the effects of obsolescence must be separately calculated and are often difficult to quantify.

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Overview of the Cost Approach – Challenges with Relationship between Cost and Income Approach Value Indications

A development stage drug requires valuation for ASC 805. Key information developed by the valuation professional includes:—Estimated costs incurred of $10,000,000 at valuation date. —Estimated costs to complete of $100,000,000 with 3 years until

expected revenue and income generation (if viable). —Valuation professional has estimated a fair value of the

development stage drug of $200,000,000 using a discounted cash flow analysis.

—What questions does this difference between cost and income indications raise? (E.g., does this difference imply a risk that someone can beat them to market?)

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Obsolescence – Estimation of Economic Obsolescence

Economic obsolescence is the loss in value of a property caused by factors external to the property.

External factors may impact the value of many assets of a business enterprise (cash and certain assets are not impacted by external obsolescence).

To measure economic obsolescence at a business enterprise level, compare: —Fair value of the total invested capital (TIC) of the business

enterprise (appraised as a going concern) to —Fair value of total individual estimates for WC, FA and IA

(summation of all individual appraised asset values less current liabilities). (Remember TIC is equal to WC plus FA plus IA.)

If the FV of TIC is less than the total of WC, FA and IA, there is obsolescence that should be allocated to underlying assets of the enterprise.

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Cost Method is Useful When

Subject IP assets can be easily reproduced, for example, software The income stream or other economic benefits associated with the

asset being valued cannot be reasonably and/or accurately quantified

There is no economic activity to review, such as early-stage technology that is not yet producing revenue

There is no direct cash flow being generated from use of the subject IP assets

The IP forms part of a larger group of assets when other valuation methods are not appropriate;

Calculating a floor or minimum value/price for an IP asset however, the floor so calculated may be inaccurate when the cost includes elements that do not add value to the IP asset

Establishing a maximum price for buying an IP asset when many candidates for substitution are available.

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Cost Method is Less Meaningful When

Cost method does not account for wasted costs- often vast amounts sums spent on pharmaceutical research projects result in no benefit.

It does not consider the unique and novel characteristics of IP. Therefore, it usually does not incorporate the expected economic benefits or the income generating potential of the IP asset.

It does not take into account the factors of risk and uncertainty associated with realizing the economic benefits associated with the IP asset.

It does not directly incorporate the trend in benefits associated with the IP. An IP asset that provides economic benefits with an increasing growth rate can be far more valuable that which displays a downward trend.

The duration over which the economic benefits will be enjoyed is yet another element not considered in this method, as the remaining Economic or Useful Life (RUL) of the IP is a vital component in valuation.

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Cost Method is Less Meaningful When (cont’d)

It may not provide an indication of the "highest price obtainable" in the open market, in the context of the "fair market value" standard.

This is because potential purchasers, may be willing to pay a premium over the cost they would incur in attempting to replicate the property, to become the proprietor of a novel product on a timely basis.

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Market Approach

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Overview of Market Approach – Considerations for Use To conduct a Market Approach, the appraiser needs to identify

arm’s-length transactions of guideline assets, disclosure of pricing information and reasonable knowledge of relevant facts.

Market data is frequently not available for intangible assets.— Intangible assets are very unique.— When intangibles are sold, they are typically sold with other

components of a business enterprise.— If sold individually, transactions are not often subject to public

disclosure. Aside from the use of market royalty rates, the Market Approach

is rarely used for valuing intangibles. Examples where Market Approach for an intangible asset are

relatively limited. A few include:— Domain Names— Operating Rights - FCC Licenses and telecom operating

spectrums

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Market Approach – Considerations for Comparability1. Circumstances in which a previous license was agreed can be

significant2. Product of willing negotiations or a court-imposed solution3. Cross-licensing4. Profitability5. Risks6. Industry7. Market size and characteristics8. Growth outlook for relevant products9. Channels of distribution10. Other barriers to entry and exit11. Company structure12. Management matters (transparency; bounded rationality)

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Market Approach – Considerations for Comparability (cont’d)

13. Timing of transaction14. Nature of IP asset (e. g., patent or trademark)15. Scope and status of legal protection16. Strength of the IP rights; uncertainty re validity of IP rights17. Duration18. Exclusivity19. Territory20. Geographical coverage of the IP asset21. Extent to which the IP asset contributes to market demand for the

final product22. Availability of substitutes23. Licensor's anticipated profitability from use of the IP24. State of development of the IP asset

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Market Approach - Royalty Rate Estimation – Key Factors

The factors to consider in the royalty rate selection process include:— Type of intellectual property— Single property or multiple properties— De novo or seasoned property— In-process, developed, or commercialized property— New vs. seasoned territory of licensor/licensee— New vs. seasoned products/services covered— Length of the license term— Sale, license, or other type of transfer— Transfer between independent parties— Type of license compensation:

• royalty rate - profit split - cost plus— Type of royalty rate formula:

• % of revenue - % of gross profit - % of net profit

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Section 7Overview of the Income Approach to Valuation

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Overview of Income Approach – Definition of Income Approach per IFRS 13 and ASC 820 B10 The income approach uses valuation techniques to convert

future amounts (eg cash flows or income and expenses) to a single present (discounted) amount. The fair value measurement is determined on the basis of the value indicated by current market expectations about those future amounts. Those valuation techniques include the following:

a. present value techniques (see paragraphs B4–B22)

b. option pricing models, such as the Black-Scholes-Merton formula (a closed form model) and a binomial model (a lattice model), which incorporate present value techniques and reflect both the time value and the intrinsic value of an option

c. the multi-period excess earnings method, which is used to measure the fair value of some intangible assets.

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Valuation Methods

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Overview of Income Approach – Alternative Methods

The derivation of income estimates is the key difference in the valuation of intangibles using the different methods.— Multi-period Excess Earnings Method (MPEEM)

• Value is based on excess income (residual income of the business after deducting returns from all other assets).

— Relief-from-Royalty Method (RFR)• Value is based on avoided third party license payment for

right to use an asset (assumes asset is not owned).— Income Increment / Cost Decrement Methods

• Value based on differential cash flows with and without an asset.

— Build-Out (Greenfield) Method• Assumes the only asset in place is the appraised asset. All

other assets will be acquired and “ramped-up” in the Build-Out Method DCF Model

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Multi-Period Excess Earnings Method - Primary Steps1. Assess business operations and the appropriate asset(s) to be valued

using the MPEEM. (Key Issue)2. Estimate future revenues driven by the intangible asset(s). (Key Issue) 3. Estimate expenses (COGS and Operating Expenses). (Key Issue) 4. Adjust the above expenses as appropriate for any unrelated expenses.

(Key Issue)5. Determine the fair values of the assets needed to support the

generation of profits (Key Issue). 6. Estimate the rate of return (discount rate) for each contributory asset.

(Key Issue)7. Calculate the excess earnings (residual income) associated with the

primary intangible asset.8. Estimate the discount rate for the intangible asset being valued. (Key

Issue)9. Calculate present value of the projected economic benefits.10. Add the additional value associated with amortizing the value of the

asset for income tax purposes to reach conclusion of fair value.

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MPEEM (Technology) – Pharma Acquisition Example

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10Revenue (1) 10,000$ 50,000$ 100,000$ 150,000$ 165,000$ 165,000$ 123,750$ 61,875$ 30,938$ 15,469$

Growth N/A 400.0% 100.0% 50.0% 10.0% 0.0% -25.0% -50.0% -50.0% -50.0%Cost of Goods Sold 10.0% 1,000 5,000 10,000 15,000 16,500 16,500 12,375 6,188 3,094 1,547 Gross Profit 9,000 45,000 90,000 135,000 148,500 148,500 111,375 55,688 27,844 13,922SG&A Expenses 30.0% 3,000 15,000 30,000 45,000 49,500 49,500 37,125 18,563 9,281 4,641 Total R & D 1,000 Less: Development R & D (2) 800 Maintenance R & D (3) 200 200 200 200 200 200 200 200 200 200Operating Income 5,800 29,800 59,800 89,800 98,800 98,800 74,050 36,925 18,363 9,081Less: Royalty on Trade Name (4) 4.0% 400 2,000 4,000 6,000 6,600 6,600 4,950 2,475 1,238 619Pretax Income 5,400 27,800 55,800 83,800 92,200 92,200 69,100 34,450 17,125 8,463Income Taxes 40.0% 2,160 11,120 22,320 33,520 36,880 36,880 27,640 13,780 6,850 3,385After-Tax Earnings 3,240 16,680 33,480 50,280 55,320 55,320 41,460 20,670 10,275 5,078

After-Tax Capital Charges (5) % of RevenueNet Working Capital (Excl. Excess Cash) 0.50% 50 250 500 750 825 825 619 309 155 77Fixed Assets 0.75% 75 375 750 1,125 1,238 1,238 928 464 232 116Internal Technology 0.25% 25 125 250 375 413 413 309 155 77 39Assembled Workforce 0.50% 50 250 500 750 825 825 619 309 155 77

Total Capital Charges 2.00% 200 1,000 2,000 3,000 3,300 3,300 2,475 1,238 619 309

Income from Technology 3,040 15,680 31,480 47,280 52,020 52,020 38,985 19,433 9,656 4,768

Partial Period Factor 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000Mid-Year Convention Discount Rate 0.5000 1.5000 2.5000 3.5000 4.5000 5.5000 6.5000 7.5000 8.5000 9.5000Present Value Factor 25.0% 0.8944 0.7155 0.5724 0.4579 0.3664 0.2931 0.2345 0.1876 0.1501 0.1200Present Value 2,719 11,220 18,020 21,652 19,058 15,246 9,141 3,645 1,449 572

Sum of Present Values 103,188$ Plus: Tax Amortization Benefit (6) 13,417 Fair Value of Technology 116,605$ Fair Value of Technology, Rounded 120,000$

Notes:(1) Financials based on Management projections.(2) Development R & D expense excluded in calculation of maintenance R & D.(3) Future levels of maintenance R & D estimated based on year 1 estimate.(4) See Market Comparable Royalty Rate exhibit.(5) See Capital Charge Analysis exhibit.(6) TAB calculated using discount rate of 25 percent.

December 31

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Overview of Relief from Royalty Method – Definition from Glossary of CAC Best Practices Guide

As provided in the Glossary of the Contributory Asset Charges best practices guide, the RFR Method is defined as:

– “A valuation method used to value certain intangible assets (for example, trademarks and trade names) based on the premise that the only value a purchaser of the assets receives is the exemption from paying a royalty for its use. Application of this method usually involves estimating the fair market value of an intangible asset by quantifying the present value of the stream of market-derived royalty payments that the owner of the intangible asset is exempted or “relieved” from paying.”

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Overview of RFR Method - IPR&D Guide Comments

1.22 A relief from royalty method is often appropriate for certain types of intangible assets. For instance, trademarks and trade names, patents, and developed product technology are examples of intangible assets that frequently are licensed in exchange for a royalty payment. A critical element of this method is the development of a royalty rate that is comparable to ownership of the specific asset (for example, a rate that equates to worldwide, exclusive rights to use that asset in perpetuity in any manner desired). Therefore, if a properly supportable royalty rate that corresponds to the rights and responsibilities represented by the asset being licensed cannot be obtained due to the nature of the asset, then the relief from royalty method should not be used, and other, more appropriate methodologies should be considered instead.

1.23 Generally, the relief from royalty method is applied in situations in which— the importance of the intangible asset to a business or product is similar to that of a

comparable, licensed asset (for example, pharmaceutical compounds that are licensed).

— the intangible asset can be reasonably separated from other assets, and it is practical and possible to license it separately.

— the rights of ownership can be compared to the rights under a license (for example, similar geographic market coverage, duration, exclusivity, limitation, technology, and type of customer).

— royalty rates can be observed, including rates for agreements that confirm comparable economic rights for similar intellectual property.

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Overview of RFR Method - IPR&D Guide Comments

1.24 Typically, the best source of royalty rate information would be other licensing agreements for comparable technologies made by one of the companies in a transaction. When such information is not available, it may be appropriate to use industry average rates or other broad benchmarks with reasonable justification. Royalty rates would also need to consider the qualitative drivers of comparability. Truly comparable rates may be difficult to find for most IPR&D assets and, therefore, simulated or adjusted royalty rates taking into consideration qualitative value drivers of the subject intangible asset could be used.

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Overview of Relief from Royalty Method -Preferred Application of RFR Method

2.20 Generally, the relief-from-royalty method is applied in cases where:

—The importance of the intangible asset to a business or product is similar to that of a comparable, licensed asset (for example, pharmaceutical compounds that are licensed).

—The intangible asset can be reasonably separated from other assets and it is practical and possible to license it separately.

—The rights of ownership can be compared to the rights under a license (for example, similar geographic market coverage, duration, exclusivity, limitation, technology, and type of customer).

—Royalty rates can be observed, including rates for agreements that confirm comparable economic rights for similar intellectual property.Source: CAC Best Practices Guide

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Overview of Income Approach – RFR Method and Income Incremental/Cost Decrement Methods

The RFR Method or Income Increment/Cost Decrement Method are often used to value assets with indirect income benefits (e.g., create cost savings).

Examples of indirect income benefits (i.e., does not directly produce revenue): — Cost savings to intangible asset owner due to a relief from

having to pay a third party for the licensing of a similar asset— Cost savings leading to increased income – avoided marketing

expenses due to a recognized trade name — Protection from competition from a covenant not to compete

leading to increased income due to reduced competition for a period of time

— Other cash flow benefit If an asset or assets are valued using a RFR Method, it is likely that

another asset (customer or technology related intangible asset) would be valued using the MPEEM.

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RFR Method - Valuation of Trade Name Example

$ in 000's ResidualYear 1 Year 2 Year 3 Year 4 Year 5 Year

Revenue $42,000 $43,260 $44,558 $45,895 $47,271 $48,690Growth 3.0% 3.0% 3.0% 3.0% 3.0%

Total Revenue 42,000$ 43,260$ 44,558$ 45,895$ 47,271$ 48,690$ Less: Unbranded Product Revenues 15.0% 6,300 6,489 6,684 6,884 7,091 7,303 Revenues Subject to Royalty 35,700 36,771 37,874 39,010 40,181 41,386

Royalty Rate 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0%Pre-Tax Royalties 1,785 1,839 1,894 1,951 2,009 2,069Less: Maintenance Expense 100 100 100 100 100 100Pre-Tax Royalties after Maintenance Expense 1,685 1,739 1,794 1,851 1,909 1,969Income Taxes 40.0% 674 695 717 740 764 788After-Tax Royalties 1,011 1,043 1,076 1,110 1,145 1,182 Capitalized Residual Value (CF / (k - g)) 10,742 Partial Period Factor 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000Mid-Year Convention Discount Rate 0.5000 1.5000 2.5000 3.5000 4.5000 4.5000Present Value Factor 14.0% 0.9366 0.8216 0.7207 0.6322 0.5545 0.5545Present Value of Cash Flow 947 857 776 702 635 5,957

Sum of Present Values of Cash Flows 9,873Plus: Tax Amortization Benefit 2,093 Indicated Fair Value of Trade Name 11,966 Indicated Fair Value of Trade Name, Rounded 12,000$

Note:(1) Financials based on Management projections.

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RFR Method - Valuation of Internal Use Technology – Example

$ in 000'sYear 1 Year 2 Year 3 Year 4 Year 5

Revenue Allocable to Technology 100,000$ 103,000$ 106,090$ 109,273$ 112,551$ [1] Growth N/A 3.0% 3.0% 3.0% 3.0%

Beginning Percentage Useful 100.0% 90.0% 70.0% 50.0% 30.0%[2] Technology Replacement Rate 20% 20.0% 20.0% 20.0% 20.0% 20.0%[3] Annual Retention Factor 90.0% 70.0% 50.0% 30.0% 10.0%[4] Revenue Dependent on Technology 90,000$ 72,100$ 53,045$ 32,782$ 11,255$ [5] Royalty Rate 1.0% 1.0% 1.0% 1.0% 1.0% 1.0%

Pre-Tax Royalties 900 721 530 328 113[6] Less: Maintenance Expense 0.0% 0 0 0 0 0

Adjusted Pre-tax Royalties 900 721 530 328 113Income Taxes 40.0% 360 288 212 131 45Adjusted After-Tax Royalties 540 433 318 197 68

Partial Period Factor 1.0 1.0 1.0 1.0 1.0Mid-Year Convention Discount Rate 0.5 1.5 2.5 3.5 4.5Present Value Factor 16.0% 0.9285 0.8004 0.6900 0.5948 0.5128Present Value of Cash Flow 501 346 220 117 35

Sum of Present Values of Cash Flows 1,219Plus: Tax Amortization Benefit 232 Fair Value of Internal Use Technology 1,451$ Fair Value of Technology, Rounded 1,450$

Notes:[1] Stable revenue growth estimate provided by Management.[2] Technology assumed to have a five year life with components phased-out periodically.[3] Initial period reflects partial year adjustment for phase-out.[4] Pro forma revenue reflects phase-out of existing, internal use technology.[5] Estimated based on costs savings from use of patented production process on internal production process.[6] Due to phase-out, no maintenance expense was included.

Fiscal Year Ending December 31,

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Application of RFR Method – Key Assumptions

While the RFR Method is an apparently simple approach to apply, its simplicity may mask complex assumptions embedded in the data used. Failure to properly address the appropriate selection and use of the method and the development of appropriate estimates for these key assumptions may lead to erroneous valuations.

Key assumptions in the RFR Method include:— Future revenues — Royalty rate— Possible expenses— Discount rate

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Application of RFR Method – Primary Steps

1. Develop projected revenue streams associated with the intangible asset being valued. (Key issue)

2. Develop royalty rate estimate for the intangible asset. (Key issue)3. Multiply projected revenue by the royalty rate estimate for the asset.4. Estimate any expenses (maintenance, administrative, regeneration,

other) that might be associated with the asset. (Key issue)5. Calculate pretax royalty savings stream and tax effect to determine

after tax contribution.6. Develop a discount rate appropriate for the intangible asset. (Key

issue)7. Apply discount or capitalization rate to after-tax royalty savings

stream and total the present value of the future royalty savings, including terminal period.

8. Add amortization tax benefit to reach value indication.Note: Unlike the EEM, the RFR Method does not include charges for contributory assets.

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Application of RFR Method – Challenges of the RFR Method – Financial Impact of the Intangible

Possible impacts of an asset on an enterprise include:—Increased revenue

− Higher price per unit and/or − More units sold

—Avoided/reduced expenses− Reduced advertising/marketing or other expenses− Avoid licensing fee

—If an asset only results in a reduction of expenses, estimation of the value using RFR Method would seem to be more reasonable.

—If an asset (such as a trade name) leads to both higher unit volumes and a lower cost per unit, does the royalty rate account for both of these factors? If not, what method(s) of valuation might be appropriate? Is the RFR Method appropriate for valuing the Coca Cola trademark?

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Valuation Assumptions

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Cash Flow Estimation - Market Participant vs. Entity Specific Assumptions

Valuations prepared for financial reporting should incorporate market participant rather than buyer specific assumptions.

Valuations for litigation, transaction or other purposes should reflect buyer specific assumptions

Values from market assumptions and buyer specific assumptions should be assessed and compared

Process for normalizing market participant projections:— Start with projections of buyer.— Extract any elements that relate solely to buyer specific

synergies.— Include any market participant synergies not included.

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Cash Flow Estimation - Market Participant vs. Entity Specific Assumptions - Example

The following example will clarify this concept.− Cash flows to seller $100− Cash flows to financial buyers $120 (higher cash flows

expected due to enhanced mgmt.)− Cash flows to strategic buyers $140 to $150 (various

strategic buyers) with cost synergies − Cash flows to strategic buyers $170 to $175 (various

strategic buyers) with revenue and cost synergies − Cash flows to optimal buyer $200 (greatest revenue/cost

synergies)

Market participant cash flows would be from $170 to $175. Optimal buyer would not pay seller for synergies that only buyer will realize.

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Cash Flow Estimation - Market Participant vs. Entity Specific Assumptions –Types of Synergies

Revenue— Increased revenue from cross selling to customers— Increased revenue from product/service bundling

Cost— Selling costs reduction from sales force redundancies— Reduced manufacturing costs from production consolidation— Reduced distribution costs from consolidation of distribution

facilities Cost of Capital

— Combined entity may have better access to capital— Reduced customer concentration resulting in lower borrowing

rate Other

− Tax

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Revenue Estimation – Partial List of Factors to be Considered

Correct estimation of product revenues which include a specific technology

Functional and economic obsolescence in a technology Prior experience – Frequency of upgrades or next generation

technology launches (“carryover” of core technology) Legal protection – Does the existence of a patent impact

technology life and value? Expected competitor actions Subject company actions /assumptions vs. ”market-

participant” assumptions Replacement of a related component Actively employed vs. defensive asset

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IP Valuation – Cash Flows and Discount Rates

Expected Cash Flow Method— Free cash flows are forecasted for the useful life of the patent

and the discount rate is the company’s market based rate of return, assuming that the company’s business risk is equivalent to the patent under consideration. The forecasted free cash flows should also be adjusted for the probability of a patent’s success.

Venture Capital Method— The Venture Capital valuation technique also derives a value

for a patent from the cash flows that arise over the asset’s life. It differs from the DCF method in that a fixed non-market based discount rate is used, usually 50 percent (40-60 percent range), and there is no explicit adjustment for the probability of success. This method does not account well for the patent specific risk factors outlined above.

— Methods of IP Valuation, University of Virginia, UVA-F-1401

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Discount Rate Estimates Reconciliation - Weighted Average Cost of Capital

Fair Value of Long Term Interest Bearing Debt+

Fair Value of Equity

Market Value of Invested Capital

= =

WACC - Capital Based WARA - Asset Based

Fair Value of Intangible Assets

Fair Value of Tangible Assets

Fair Value of Net Working Capital

Fair Value of Goodwill

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Assets in a business enterprise have different risk and return characteristics Rate of return of a particular asset is commensurate with its risk Assets typically have different liquidity and return characteristics

Investment Return Requirement

Low High

High

Low

Degree of Risk

Inventory

Cash

Receivables

Tangible Assets

Intangible Assets

Discount Rate Estimates – Risk and Rate of Return

Liquidity

Low

High

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Discount Rate Estimates – Sample Calculation for Returns on Specific Assets

Working Fixed Customer Current AssembledBEV Capital Assets Trade Name Relationships Technology Workforce IPR&D Goodwill

Weighted Average Cost of CapitalDebt-to-Capital 16.0% 100.0% 70.0% 16.0% 0.0% 0.0% 0.0% 0.0% 0.0%Cost of Debt (After-tax) 3.9% 3.9% 3.9% 3.9% 3.9% 3.9% 3.9% 3.9% 3.9%Pro Rata Amount 0.6% 3.9% 2.7% 0.6% 0.0% 0.0% 0.0% 0.0% 0.0%

Equity-to-Capital 84.0% 0.0% 30.0% 84.0% 100.0% 100.0% 100.0% 100.0% 100.0%Cost of Equity 16.2% 16.2% 16.2% 16.2% 16.2% 16.2% 16.2% 16.2% 16.2%Asset Specific Risk Premium 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 4.0% 7.0%Cost of Equity 16.2% 16.2% 16.2% 16.2% 16.2% 16.2% 16.2% 20.2% 23.2%Pro Rata Amount 13.6% 0.0% 4.8% 13.6% 16.2% 16.2% 16.2% 20.2% 23.2%Weighted Average Cost of Capital 14.2% 3.9% 7.6% 14.2% 16.2% 16.2% 16.2% 20.2% 23.2%Rounded 14.0% 4.0% 8.0% 14.0% 16.0% 16.0% 16.0% 20.0% 23.0%

Notes:(a)

will assist tn making these estimates.

Estimates of capital type percentages are somewhat judgmental.Reconciliation with the WACC and IRR and a detailed understanding of appraised entity

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Application of RFR Method – Revenues

The selection of the appropriate revenue stream is a critical first step. Key elements of the revenue estimate include:— Level of revenues: A royalty rate may be applied to the entire revenue

base of a firm. In other cases, a subset of the total revenues may be appropriate. A firm sells both trademarked and private label products.

Trademarked product sales would likely be used in the valuation of the trade name, but private label sales would not.

— Duration: Revenues may be projected into perpetuity or projected over a finite period of time.

Revenues for the valuation of a trade name would include all future revenues for which the trade name would be expected to be applied and would contribute to the generation of income. Future revenues should consider:— Existing customers and/or technology— Future customers and/or technology

As it relates to revenue level selection and duration, there are numerous and complex distinctions between valuing company versus product trade names, which are outside the scope of this course.

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Section 8Royalty Rate Estimation

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Royalty Rates – Introduction

A royalty rate estimate is a critical input in the valuation of certain intangible assets such as technology and trademarks.

While the assets are valued using the Income Approach (more specifically a Relief from Royalty Method), the estimation of a royalty rate may be based on reliance on royalty rates from market transactions. Given the limited number of market transactions frequently observed, other means of estimating a royalty rate will also be discussed.

Selection of royalty rates begins with understanding the economic benefits provided by the IP:

—Increased prices—Increased unit sales—Decreased costs—Combination of any or all of the above

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Royalty Rates – Types of Royalty Rate Payments

Types of Royalties:— Lump sum payment— Annual payment (a.k.a., Running Royalties)

• Revenue• Per unit • Gross margin• Other

— Combination of lump sum payment and running royalty Georgia-Pacific Corp. v. United States Plywood Corp., 318 F. Supp.

1116, 166 U.S.P.Q. (BNA) 235 (S.D.N.Y. 1970) established a key precedent for royalty rate selection criteria. (Primarily used for Patents)

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Royalty Rates – Factors Influencing Royalty Rates

Factors influencing royalty rates include:— Strength and scope of intellectual property rights— Territorial extent of rights— Market drivers — Royalty stacking— Exclusivity of rights— Level of innovation— Durability of the technology— Degree of competition / availability of other technologies— Inherent risk— Strategic need / portfolio fit— Stage of development— Therapeutic field— Availability of finances— Deal structure / reward structure

Source: Royalty Rates: Current Issues and Trends, Sharon Fitch, Medius Publications, www.medius-publications.com

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Methods for Estimating a Royalty Rate

There are several different methods for estimating a royalty rate. These include:— Transaction Based Royalty Rate – royalty rate based on

market transaction• Existing licenses of subject • Guideline licenses

— Return on Assets Method – Royalty rate based on a residual income analysis similar to that applied in applying the MPEEM

— Profit Split Method - Profitability of subject operations relative to competitors – e.g., Chanel perfume compared to private label perfume

Estimate of royalty rate from a meaningful market transaction is preferred, if feasible.

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Royalty Rate Estimate – Market Based vs. Return on Assets vs. Profit Split Method

When guideline royalties (comparables) provide limited or no meaningful insights to the estimation of a royalty rate, a Return on Assets Method (“ROAM”) or a Profit Split Method (“PSM”) may be employed.

Even if relevant market data is available, comparison of royalty rate from guideline market data to the ROAM and/or PSM can provide useful insights.

Each of these three methods will be discussed in significant detail in subsequent slides.

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Royalty Rates – Market Transactions - Challenges

Establishing a reasonable royalty rate based on market transactions is challenging. A partial list of concerns includes:— Limited number of transactions— Frequent lack of comparability

– Profit potential– Functions and risks born by licensor and licensee – Exclusivity and restrictions in license– Territory and field of use– Duration– Rights to receive updates and modifications– Terms of license

— Differences between a partial license vs. full ownership— Complexities of royalty payment structures can increase

challenges in determining an effective royalty rate

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Royalty Rates – Market Transactions -Commercial Databases Royalty Source – www.royaltysource.com Royaltystat – www.royaltystat.com – full documents, good search

capability Licensing Executives Society surveys Licensing Economic Review (Smith & Parr) – www.ausinc.com Financial Valuation Group – www.fvginternational.com PLX Systems – www.pl-x.com Consor Intellectual Asset Management (Wes Anson) –

www.consor.com IPRA, Inc. – Intellectual Property Research Associates –

www.ipresearch.com ktMINE – www.ktmine.com Licensing Royalty Rates 2008 Edition, Gregory Battersby, Charles

Grimes Lexis Nexis – SEC Filings

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Royalty Rates – Market Transactions - Licensed-Out Royalty Rates as Determined by a Voluntary Survey

0-2% 2-5% 5-10% 10-15% 15-20% 20-25% Over 25%Primary Industry

Aerospace 40.0% 55.0% 5.0%Automotive 35.0% 45.0% 20.0%Chemical 18.0% 57.4% 23.9% 0.5% 0.1%Computer 42.5% 57.5%Electronics 50.0% 45.0% 5.0%Energy 50.0% 15.0% 10.0% 25.0%Food/Consumer 12.5% 62.5% 25.0%

General Mfg. 21.3% 51.5% 20.3% 2.6% 0.8% 0.8% 2.6%Gov't/University 7.9% 38.9% 36.4% 16.2% 0.4% 0.6%Health Care Equip. 10.0% 10.0% 80.0%Pharmaceuticals 1.3% 20.7% 67.0% 8.7% 1.3% 0.7% 0.3%

Telecommunications 100.0%Other 11.2% 41.2% 28.7% 16.2% 0.9% 0.9% 0.9%

Source: McGavock, et. al., "Factors Affecting Royalty Rates." les Nouvelles , June 1992, p. 107.

Royalty Rate Category

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Profit Split Method – Introduction

The Profit Split Method (PSM) was used before advent of databases with licensing data – advances in research technology led to a shift away from the PSM.

PSM may be useful as a reasonableness check or when no better data is available (transfer pricing regulations include a variety of approaches and the PSM is not a preferred method).

Careful assessment required to confirm the intangible asset merits a material share of profit. In the US, Internal Revenue Code Section 482 transfer pricing requires a detailed assessment (functional analysis) when valuing intangibles using the PSM.

The PSM is broad and encompasses a Rule of Thumb known as the 25 percent rule (“25% Rule”). While many use the 25% Rule, there appears to be limited empirical market evidence to support the range for the profit split and the resulting royalty rate for an intangible. Use of the 25% Rule was recently rejected in the Microsoft v. Uniloc civil court case. Key insights from this case will be presented later in this module.

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Profit Split Method – Introduction - Functional Analysis

For transfer pricing projects, a “functional analysis” might be performed to assess which elements of the value chain are driving the profitability. The royalty rate is basically derived by allocating the overall profit of the business amongst the different profit generating business functions.

In a transfer pricing setting, a functional analysis looks at the functions, risks and assets of the controlled (related) entities. In setting a royalty rate, the functional analysis would look at the relative contributions of the subject asset and the remaining assets and functions of the entity.

Depending on the form of calculation performed, a functional analysis can be viewed as a robust form of the Profit Split Method.

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Profit Split Method – Description

This method suggests that a licensee pay a royalty rate that essentially allocates (splits) the profit between the licensor and the licensee. Most frequently cited profit split range has been 25 to 33 percent of expected operating profits for a product that incorporates intellectual property.

The Profit Split Method has been used in valuing patents, trademarks, trade secrets, and know-how.

Studies of profit splits relate to the licenses involving technology related intangibles. Despite limited anecdotal evidence for marketing related intangibles such as trade names and trademarks, the Profit Split Method is occasionally used to estimate a royalty rate for trade names and trademarks.

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Profit Split Method – Determined From Empirical Analysis

A royalty may be calculated using the price differences between products:

— A branded product and its generic product equivalents (trade name), or

— A product incorporating proprietary technology versus a substitute using technology that is general (technology).

Similarly, a reasonable royalty can be assessed by comparing operating margin differences (typically EBIT) between entities:

— EBIT % for selling generic products versus branded products, or

— EBIT % of a manufacturing outsourcer vs. a manufacturer that also owns the technology.

“Pure plays” for comparison are rare – a manufacturer may also outsource to fill excess capacity. Margins will include both operations.

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Profit Split Method – 25 Percent Rule

Application is as follows:— Estimate the expected operating profits applicable to the

IP divided by the net sales over the same time period to derive a profit margin.

— Multiply that profit margin by 25 to 33 percent to derive a running royalty rate.

— Adjust up or down for relevant factors.

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Profit Split Method – Origins of 25 Percent Rule

A 1938 Sixth Circuit Court of Appeals case (Horvath v. McCord Radiator and Mfg. Co. et al., 100F.2d 326, 335 (6th Cir. 1938)) noted:— “Ordinarily royalty rights to the inventor should bear a certain

portion of the profits made by the manufacturer and that the inventor was entitled to a 'portion ranging from probably ten percent of the net profits to as high as thirty percent,' which should be graduated by the competitive situation.”

Often attributed to research by Robert Goldscheider in the late 1950s.— Based on 18 exclusive licenses for territories around the world by a

Swiss subsidiary of a large American company.— Each related product was number 1 or 2 in its market. (This

may suggest very strong asset that was licensed.)— IP rights licensed included a patent portfolio, a continual flow of

know-how, trademarks, and copyrighted marketing and product materials.

— Found royalty rates at approximately 25 percent of EBIT.

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Profit Split Method – Uniloc USA, Inc. v. Microsoft Corp.– Overview and Key Findings

A 2011 United States civil court case, Uniloc USA, Inc. and Uniloc Singapore Private Limited v. Microsoft Corporation, No. 2010-1035 (Fed. Cir. January 4, 2011), provides important insights on the use of the PSM to determine a royalty rate for the valuation of technology using the Relief from Royalty Method.

Findings of the court case include:— Relief from Royalty Method accepted as a reasonable

means of valuation of a technology— Use of the 25% Rule is a “fundamentally flawed tool for

determining a baseline royalty rate in a hypothetical negotiation”

The following slides will summarize some of the observations of the court regarding the PSM.

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Profit Split Method – Uniloc USA, Inc. v. Microsoft Corp.– Specific Comments from the Case

The Federal Circuit panel of judges held that— “the 25 percent rule of thumb is a fundamentally flawed tool for

determining a baseline royalty rate in a hypothetical negotiation. Evidence relying on the 25 percent rule of thumb is thus inadmissible under Daubert and the Federal Rules of Evidence, because it fails to tie a reasonable royalty base to the facts of the case at issue.”

— “. . . there must be a basis in fact to associate the royalty rates used in prior licenses to the particular hypothetical negotiation at issue in the case. The 25 percent rule of thumb as an abstract and largely theoretical construct fails to satisfy this fundamental requirement. The rule does not say anything about a particular hypothetical negotiation or reasonable royalty involving any particular technology, industry, or party. Relying on the 25 percent rule of thumb in a reasonable royalty calculation is far more unreliable and irrelevant than reliance on parties’ unrelated licenses, which we rejected in ResQNet and Lucent Technologies.”

— (ResQNet and Lucent are cases cited in the Uniloc case decision.)

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Profit Split Method – Microsoft v. Uniloc - Specific Comments from the Case (cont’d)

“. . . this court has passively tolerated its use where its acceptability has not been the focus of the case, or where the parties disputed only the percentage to be applied (i.e. one-quarter to one-third), but agreed as to the rule’s appropriateness.“ However, the court recognized that it never squarely addressed the use of the rule.

The Federal Circuit noted that it “has sanctioned the use of the Georgia-Pacific factors to frame the reasonable royalty inquiry” and that those “factors properly tie the reasonable royalty calculation to the facts of the hypothetical negotiation at issue.” However, use of the 25% rule as a starting point is not acceptable, because “beginning from a fundamentally flawed premise and adjusting it based on legitimate considerations specific to the facts of the case nevertheless results in a fundamentally flawed conclusion.”

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Profit Split Method – Microsoft v. Uniloc - Specific Comments from the Case (cont’d)

Three areas of challenge for the 25 percent rule:1. Does not account for the unique relationship between the patent and the

product or service. “[The 25 percent rule] takes no account of the importance of the patent to the profits of the product sold, the potential availability of close substitutes or equally non infringing alternatives, or any of the other idiosyncrasies of the patent at issue that would have affected a real-world negotiation. ”. . . fails to “distinguish between monopoly and normal profit. . . . Thus for narrow patents, the rule may be overly generous to the patentee, and for broad patents it may be overly stingy”)

2. Does not account for the unique relationship between the parties. . . . the rule should not be used in isolation because it fails to “account for the different levels of risk assumed by a licensor and licensee”) (“[T]he rule is unlikely to have any basis in the accused infringer’s industry, in the technology involved in either the patent or the accused product or service, or in the claimed invention’s contribution to the infringing product or service.”)

3. The rule is essentially arbitrary and does not fit within the model of the hypothetical negotiation within which it is based. (“[The 25% and the 5%] rules of thumb are best understood as special cases that may be appropriate to a given situation only by chance.”) . . . the 25% rule “shortcut” “is essentially arbitrary. Because it is based on ex post results, it does not necessarily relate to the results of a negotiation that took place prior to the infringement”).

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Profit Split Method – Microsoft v. Uniloc - Specific Comments from the Case (cont’d)

“ . . .the 25 percent rule of thumb would predict that the same 25%/75% royalty split would begin royalty discussions between, for example, (a) TinyCo and IBM over a strong patent portfolio of twelve patents covering various aspects of a pioneering hard drive, and (b) Kodak and Fuji over a single patent to a tiny improvement in a specialty film emulsion.”

“It is of no moment that the 25 percent rule of thumb is offered merely as a starting point to which the Georgia-Pacific factors are then applied to bring the rate up or down. Beginning from a fundamentally flawed premise and adjusting it based on legitimate considerations specific to the facts of the case nevertheless results in a fundamentally flawed conclusion.”

“This court’s rejection of the 25 percent rule of thumb is not intended to limit the application of any of the Georgia-Pacific factors. In particular, factors 1 and 2—looking at royalties paid or received in licenses for the patent in suit or in comparable licenses—and factor 12—looking at the portion of profit that may be customarily allowed in the particular business for the use of the invention or similar inventions—remain valid and important factors in the determination of a reasonable royalty rate. However, evidence purporting to apply to these, and any other factors, must be tied to the relevant facts and circumstances of the particular case at issue and the hypothetical negotiations that would have taken place in light of those facts and circumstances at the relevant time.”

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Royalty Stacking - Introduction

The Uniloc case essentially recognizes the challenge of developing royalty rates when products incorporate an ever larger number of features that each contribute to the overall product value

Value (selling price) of product = $100 Value of patented feature = $2 The value of all patented features presumably would need to be less

than $100 in order to provide a return for business functions including marketing, manufacturing, distribution and others and also profits on these functions

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Royalty Stacking Challenges

Assume a product has 1,000 features which are subject to patented IP

A study of market royalty rates suggests a wide range of royalty rates of say 1% to 5%

Using the low royalty rate of 1%, if all of the features receive a 1% royalty (low end of the range), they combined royalties would be 1,000% of revenues - this clearly is not economically feasible

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IP for Biotechnology – Royalty Example

Vaccine Component Royalty Rate− Antigen A, Proprietary to Company A 2%− Antigen B, Discovered using proprietary tool

of Company B 2%− Antigen C, Nonproprietary 0%− Proprietary Assembly Technique of Company C 2%− Proprietary adjuvant 2%

Total Royalty 8%

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Royalty Stacking – Potential Solutions

Establish royalty ceiling - Pro rate royalties to not exceed an established amount

Establish royalty floor (protect and incentivize licensor)

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Challenges with Royalty Rates

A detailed research paper, Patent Holdup and Royalty Stacking,provides important insights on royalty rates for IP.

Paper concludes that royalty rates associated with subsets of IP for complex, multi-technology products may overstate the true economic value of the IP component— Risk of permanent injunction increases risk to licensee

dramatically— Risk of having to switch technologies midstream can drive

royalty rates higher than expected

Source: Patent Holdup and Royalty Stacking, Mark A. Lemley and Carl Shapiro, © 2007.

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Challenges with Royalty Rates

Non-litigated transaction data often not available Royalty rate data from federal securities law filings has a significant

selection bias— Only material items are required to be presented (values above

a certain $ threshold). Lower royalty rate agreements would more likely not be materials and might not be presented in filings

Ability to separate value of a component from value of a total product. — Royalty rates will often be presented as a percentage of the

total product, whereas, the appropriate base is that of the component. As the mix of components and their relative contributions will vary, this dramatically reduces the meaningfulness of any royalty findings. Again, selection bias would suggest that only more material IP situations will be presented given materiality.

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Challenges with Royalty Rates (cont’d)

— Theoretically correct approach would involve consumer surveys to determine the value of a component to a product.

Survey found the royalty rate of 10.0% of total price for components and 14.7% for integrated product claims.

While directionally reasonable, the difference is surprisingly small— Expectation of many components in many products – result

above suggests very small number of components Royalty rate as % of gross sales should decrease as the number of

items contributing increases

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Royalty Rates – Court Established vs. Negotiated Royalty Rates

If court cases establish a royalty assuming parties agree IP is enforceable, conceptually, market negotiated royalties would be lower as there is some risk this is not the case.

Patents are “probabilistic rights”— Nearly half of all litigated patents are invalidated. Many more

found not to be infringed— Despite due diligence, it is estimated that over 43 percent of

patent claims ultimately turn out to be not unique.• David E. Martin, “Insurable Patents? Global Metrics for

Actuarial Patent Risk Management,” Conference on Growth, Prosperity and Patents, Danish E.U. Presidency, Aalborg, Denmark, October 28, 2002.

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Return on Assets Method - Introduction

The Return on Assets Method is similar to performing a common-size multi-period excess earnings model (“MPEEM”). Required returns (contributory asset charges) for a company’s asset base are deducted from the total earnings stream. The remaining income as a percentage of revenue is the basis for the royalty rate.

Returns on working capital, fixed assets, and workforce are deducted from earnings (EBITA) to determine the excess income available for remaining intangible assets. This represents the “return-on” for all intangible assets.

Determine the proportion of the residual return allocable to the subject asset. The remaining excess earnings (as a percent of revenue) are those “returns-on” which are attributable specifically to the subject asset.— The determination of the residual portion of the return may be

challenging if there are several important intangible assets. It is difficult to value multiple intangible assets using residual earnings concepts.

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Return on Assets Method – Alternative Approach to “Basic” Profit Split (cont’d)

1. Develop EBIT estimate for the business enterprise.2. Estimate returns for categories of tangible assets including

working capital, net fixed assets and any other assets required. 3. Subtract estimated returns for working capital and fixed assets

from EBIT.4. Equals: EBIT allocable to all intangibles. 5. Subtract estimated returns (contributory asset charges) for any

intangible assets that are readily valued (assembled work force, internal use software as examples.

6. Estimate share of EBIT margin for the remaining intangibles that is allocable to subject intangible (typically trade name or technology).

7. Multiply share of EBIT margin allocable to intangibles by estimated share for specific intangible asset.

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Return on Assets Method – Example

Valuation of Enabling Brand - Relief from Royalty MethodRoyalty Rate Based on Return on Assets Method

Year 1 Year 2 Year 3 Year 4 ResidualTotal Revenues 100,000$ 103,000$ 106,090$ 109,273$ 112,551$ Growth N/A 3.0% 3.0% 3.0% 3.0%Unbranded Revenues 5.0% 5,000 5,150 5,305 5,464 5,628 Revenues Dependent on Brand 95,000 97,850 100,786 103,809 106,923 Royalty Rate (ROA Method - see below) 9.0% 9.0% 9.0% 9.0% 9.0% 9.0%Pre-Tax Income Attributable to Brand 8,550 8,807 9,071 9,343 9,623Income Taxes 40.0% 3,420 3,523 3,628 3,737 3,849Adjusted After-Tax Royalties 5,130 5,284 5,442 5,606 48,116Present Value Factor 15.0% 0.9325 0.8109 0.7051 0.6131 0.6131Present Value of Cash Flow 4,784 4,285 3,837 3,437 29,501

Sum of Present Values of Cash Flows 45,844Plus: Tax Amortization Benefit 8,741 Fair Value of Enabling Brand 54,585 Fair Value of Brand, Rounded 55,000$

% ofCalculation of Royalty Rate for Enabling Brand TotalEBIT Margin (Branded Product Sales) 20.0% 100.0%Less: Contributory Asset Charges - Working Capital 2.0% 10.0% - Fixed Assets 2.0% 10.0% - All Intangible Assets (Other than brand) 7.0% 35.0%Indicated Royalty Rate for Brand 9.0% 45.0%

Note(s):(1) - Other models included a provision for possible maintenance / other expense. When using ROA Method,starting point for royalty rate calculation is EBIT. Hence, maintenance expense is already captured.

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Royalty Factors – Georgia Pacific Factors

1. Existing license(s) - The royalties received by the patentee for the licensing of the patent in suit, proving or tending to prove an established royalty

2. Similar licenses - The rates paid by the licensee for the use of other patents comparable to the patent in suit

3. Terms of license - The nature and scope of the license, as exclusive or non-exclusive; or as restricted or non-restricted in terms of territory or with respect to whom the manufactured product may be sold

4. The licensor's established policy and marketing program to maintain his patent monopoly by not licensing others to use the invention or by granting licenses under special conditions designed to preserve that monopoly

5. The commercial relationship between the licensor and licensee, such as, whether they are competitors in the same territory in the same line of business; or whether they are inventor and promoter

6. The effect of selling the patented specialty in promoting sales of other products of the licensee; that existing value of the invention to the licensor as a generator of sales of his non-patented items; and the extent of such derivative or convoyed sales

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Royalty Factors – Georgia Pacific Factors (cont'd)

7. Time Period - The duration of the patent and the term of the license

8. The established profitability of the product made under the patent; its commercial success; and its current popularity

9. The utility and advantages of the patent property over the old modes or devices, if any, that had been used for working out similar results

10. The nature of the patented invention; the character of the commercial embodiment of it as owned and produced by the licensor; and the benefits to those who have used the invention

11. The extent to which the infringer has made use of the invention; and any evidence probative of the value of that use

12. The portion of the profit or of the selling price that may be customary in the particular business or in comparable businesses to allow for the use of the invention or analogous inventions

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Royalty Factors – Georgia Pacific Factors (cont'd)

13. The portion of the realizable profit that should be credited to the invention as distinguished from non-patented elements, the manufacturing process, business risks, or significant features or improvements added by the infringer

14. The opinion testimony of qualified experts15. The amount that a licensor (such as the patentee) and a licensee

(such as the infringer) would have agree upon (at the time the infringement began) if both had been reasonably and voluntarily trying to reach an agreement; that is, the amount which a prudent licensee – who desired, as a business proposition, to obtain a license to manufacture and sell a particular article embodying the patented invention – would have been willing to pay as a royalty and yet be able to make a profit and which amount would have been acceptable by a prudent patentee who was willing to grant a licenseSource: Georgia-Pacific Corp. v. United States Plywood Corp., 318 FSupp 1116, 6 USPQ 235 (SD NY 1970).

190Globalview Advisors LLC

Section 9Technology Valuation

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Technology Lifecycle Estimation – Different Stages of Technology

Technology life cycles vary and technology replacement is a key success factor for many company. Stages of technology include:

1. Developed Product Technology – Technology as it exists in a current product(s) offering.

2. In-Process Technology (“IPR&D”) - In-Process Technology represents internally developed or purchased intellectual capital which has not reached technological or economic feasibility, however, when feasible, is expected to provide a future stream of profits through commercialization.

3. Future Technology (Next Generation) – Future generation technology that is expected to change so significantly from existing and in-process technology that it must be considered new technology.

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Technology Lifecycle Estimation – Different Stages of Technology – Sample Revenue Map - Graphic

Revenues

Year

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Revenue Estimation – Inherent Risks

1) Intellectual Property Specific Risks− Uncertainty of competitive strength− Scope of claims− Freedom to practice− Ability to detect infringers− Enforceability of Intellectual Property Rights

2) Technology Specific Risks− New innovations− Changes in user needs / desires− Increase supplier costs− Change in economic environment

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Revenue Estimation – Inherent Risks (cont’d)

3) Commercialization Risks

− Ability to produce or distribute the related product

− Ability to scale to production volumes

− Customer acceptance

− Market adoption rates

− Pricing and profitability

4) Regulation Risks

Source: Intellectual Asset Deals And Decisions: Are You Building Or Destroying Value, Tony Hadjiloucas and Mark W. Haller, PricewaterhouseCoopers LLP.

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Revenue Estimation - Risks – Technical, Commercial and Financial Feasibility

Another way to look at risk associated with a technology is through consideration of risks in three broad groupings. These include:− Technical feasibility – The technology “works”− Commercial feasibility – There is a market for the technology− Financial feasibility – Success in the market will provide an

adequate return on investment A financial successful technology will need to be viable in each of

these areas. Viability at an initial level is required to reach viability at the remaining levels.

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Revenue Estimation – Lifecycle Analysis

Future revenues for technology assets can often be estimated based on lifecycle analysis (remaining life based on expected future financial viability) as a means to derive the remaining economic life of an asset. Lifecycle analysis is often used for existing and IPR&D technology.—The estimation of future revenues using lifecycle analysis

will vary on a case by case basis. The factors outlined in Paragraph 11 of ASC 350 provide general considerations for this complex task.

—Even with a management lifecycle estimate, valuation professionals must perform sufficient procedures to be comfortable with management-provided inputs.

—Must ensure that above estimations are in line with a “market-participant” point of view.

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Revenue Estimation – Lifecycle Analysis – Scenario 1

Scenario 1: Analysis of two years of upgrades at approximate replacement rate of 10% per year might suggest a remaining economic life of 10 years. Based on more thorough discussions with Management, coupled with industry research, suggest that a major industry shift to a new generation technology occurs approximately every five to seven years.

—Based on the above, the remaining economic life of the existing technology may be tied closer to the expectation of the next shift to a new generation technology platform, as opposed to historical erosion/decay rates for the existing technology.

—From a revenue forecasting and mapping standpoint, this might result in a gradual short-term decline in technology revenue, followed by a more rapid decline (“cliff-effect”), as the technology reaches the point of exposure to new generation technology.

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Revenue Estimation – Lifecycle Analysis – Scenario 2

Scenario 2: Software development company launches a new major release of its product once per year (Version 1.0 to Version 2.0 release). Each annual introduction of a new version of the technology does not result in a “decay” of (or erosion to) the predecessor technology, but rather, a “dilution” of it, by virtue of “adding” new technology components (not “replacing” prior version technology).

—This may indicate the presence of core technology if the underlying code (in case of a software company) has been the base for all technology version launches of the product since its inception

—The remaining economic life of the core technology (base code in this example) would most likely be expected to exceed that of the existing technology based on it.

—“Minor” releases typically not considered IPR&D (Version 1.11 to 1.12)

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Products with Multiple Technologies - Introduction

Many companies typically track revenues by product lines (name) rather than by technology categories (or classifications).

For financial reporting purposes, we must recognize that we are not valuing a product as an asset, but rather, the technology inherent in the product line.

In “allocating” each product line revenue to underlying technology classification revenue, it must be recognized that each of the technologies acquired/owned would experience various levels of content erosion over time due to: — Changing functionality of the technology in relation to

the advancements in the successive designs— Necessity to add new or replace old architecture.

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Products with Multiple Technologies - Introduction

Business Unit

Product Line I Product Line II

Product A Product B Product C Product D

Tech 1 Tech 2 Tech 3 Tech 4 Tech 5 Tech 6

Inventory of Technology-based Intangible Assets (“Tech”)

Core Technology I Core Technology II

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Products with Multiple Technologies – Issues to Consider

Products, such as the iPhone, may have numerous distinct technologies (technology-based intangible assets) embedded in the product.

Potential for complementary technology assets. Identify the various identifiable technology-based intangible assets

(including existing and base/core technologies) inherent in the product (refer to ASC 805, paragraph A51 for sample list of assets).

Some technologies may continue for future generations (core technology), whereas, others may be included only in the existing product lifecycle.

Are all the technology components within the product owned or are they licensed-in?

Can the contribution of each distinct technology component (to the overall product line) be isolated and reliably quantified? Can the estimated product line revenue allocation (to each underlying technology component or group) be supported through discrete financial metrics (such as R&D expenses)?

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Products with Multiple Technologies – Issues to Consider (cont’d)

May consider grouping technology components if comparable in terms of functionality and identical in terms of remaining economic life

Are any of the technology components of a product covered by patents?

For those technologies covered by patents, should the remaining economic life of the technology by tied close to the remaining legal life of the patents or the remaining economic life of the technology covered by their claims?

Can any of the technology components be classified as primary (vs. contributory)?

Potential for some technology components being employed by multiple product lines owned by the business.

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Non-Technology Offerings - Introduction

• Many sales in the software sector (and other industries) may involve bundled offerings of technology and non-technology components. A contract could include a perpetual license to software and payments for services such as customer support. Accounting guidance has recognized these challenges.

• Although non-technology offerings, such as contractual service and maintenance, are often tied closely to existing (installed) technology products, the economic benefit associated with such offerings might constitute (existing) customer relationship value rather than technology value.

• As such, any revenue associated with “non-technology” offerings should most likely be excluded from the technology revenue allocation.

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Non-Technology Offerings – Example

These bundled offerings occur in more traditional industries (see industrial cranes example below). As such, any revenue associated with “non-technology” offerings might be excluded from the technology revenue allocation.

The chart below relates to all of the Company’s revenues, including existing, IPR&D, and future.

Industrial CranesYear 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Cranes $70,000,000 $84,000,000 $97,000,000 $109,000,000 $120,000,000 $130,000,000 $138,000,000Assembly / Installation $2,800,000 $3,360,000 $3,880,000 $4,360,000 $4,800,000 $5,200,000 $5,520,000Training $1,400,000 $1,680,000 $1,940,000 $2,180,000 $2,400,000 $2,600,000 $2,760,000Service & Maintenance $4,900,000 $5,880,000 $6,790,000 $7,630,000 $8,400,000 $9,100,000 $9,660,000Spare Parts (after-market) $4,410,000 $5,292,000 $6,111,000 $6,867,000 $7,560,000 $8,190,000 $8,694,000

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Non-Technology Offerings – Sample Questions / Solutions

Based on the revenue classifications/categories on the previous slide, what are the anticipated intangible assets of target company?

How would these assets be valued? Since Assembly/Installation services are offered in

conjunction with the sale of the actual crane units, and are inseparable, the revenue stemming from this combined product/service offering should be the source for the technology valuation model. This would include both existing and IPR&D technology. —Given that technology is a primary income generating asset

for the Company, the Multi-Period Excess Earnings Method (“MPEEM”) should be used to value the technology.

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Base Technology – Introduction

Some technology may have a long useful life. As it result, it may be incorporated into a variety of existing as well as in-process and possibly future technologies / products

The following slide provides an example of a long-lived “base” technology

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Base Technology - Valuation Methodology - Example

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Royalty from Existing Technology (Product X) 315$ 400$ 455$ 480$ 475$ 440$ 375$ 280$ -$ -$ Royalty from IPR&D (Product X2) 50 248 545 746 671 537 322 193 96 - Royalty from Future Technology - 12 113 320 615 1,120 1,581 1,796 1,881 1,869 Total Royalty Paid to Core Technology 365 660 1,113 1,546 1,761 2,097 2,278 2,269 1,977 1,869

Income Tax Expense @ 40% 146 264 445 618 704 839 911 908 791 747 Net Royalty Income 219 396 668 927 1,057 1,258 1,367 1,362 1,186 1,121

Partial Period Adjustment 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000Discount Rate @ 15% 0.9634 0.8654 0.7525 0.6544 0.5690 0.4948 0.4303 0.3741 0.3253 0.2829

Present Value of Net Royalty Income 211$ 343$ 503$ 607$ 601$ 623$ 588$ 509$ 386$ 317$

Sum of Present Value of Net Royalty Income 4,687 Plus Tax Benefit of Amortization 941

Fair Value of Core Technology (Rounded) 5,600$

Existing Technology (Core Technology)

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Multi-Scenario Models – Introduction

Multi-scenario valuation models consider different cash flow, discount rate and probability estimates associated with each scenario considered.

At present time, the use of multi-scenario models is relatively infrequent in the valuation of intangible assets.

Some/many technologies may not require valuation using a multi-scenario model.

Unproven technology might be valued using a multi-scenario or decision-tree model given the wider range of possible scenarios.

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Multi-Scenario Models - Value of an Investment Without an Option

Source: Valuation and Pricing of Valuation and Pricing of Technology-Based Intellectual Property Presented to the Sault Ste. Marie Innovation Centre Sault Ste. Marie Workshop on Intellectual Property by Michael M. Avedesian, December 11, 2007.

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Multi-Scenario Models - Value of Investment With an Option

Source: Valuation and Pricing of Valuation and Pricing of Technology-Based Intellectual Property Presented to the Sault Ste. Marie Innovation Centre Sault Ste. Marie Workshop on Intellectual Property by Michael M. Avedesian, December 11, 2007.

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Multi-Scenario Models - Sample Decision Tree for Development Stage Pharmaceutical

212Globalview Advisors LLC

Technology Lifecycle

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Technology Lifecycle Progression - Conceptualization

Idea Development Product Product feasibility Development Preproductionconcept definition

Conceptualization Applied Research

• Includes: (a) ideas, thoughts, new knowledge, or plans for a new product, service, or process; (b) significant improvement to an existing product, service or process; or (c) decision by company to focus its research activities within certain core competencies.

• Management activities: initial assessment of the potential market, cost, and technical issues for ideas, thoughts, or plans to determine whether the ideas can be developed to produce an economic benefit.

IPR&DFuture Technology Existing Technology

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Technology Lifecycle Progression - Applied Research

Idea Development Product Product feasibility Development Preproductionconcept definition

Conceptualization Applied Research

Includes: Planned search or investigation aimed at discovery of additional knowledge in hopes that it will be useful in defining a new product, service, or process that will yield economic benefits.

Management activities: Feasibility assessment of successful project completion and commercial viability of the resulting product, service, or process.

Future Technology Existing TechnologyIPR&D

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Technology Lifecycle Progression - Development and Preproduction

Idea Development Product Product feasibility Development Preproductionconcept definition

Conceptualization Applied Research

DevelopmentTranslation of research findings or other knowledge into a detailed plan or

design and carrying out the development efforts pursuant to a plan.

Preproduction Represents business activities necessary to commercialize the asset

resulting from R&D activities for economic benefit.

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Technology Lifecycle Estimation - Lifecycle Progression - Drug Approval Process

– The chart below depicts the R&D process in the pharmaceutical industry.

Source: ‘www.innovation.org’

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Technology Lifecycle Estimation - Lifecycle Progression - Risk vs. Value Correlation of a Drug

Source: Valuation and Pricing of Valuation and Pricing of Technology-Based Intellectual Property Presented to the Sault Ste. Marie Innovation Centre Sault Ste. Marie Workshop on Intellectual Property by Michael M. Avedesian, December 11, 2007.

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Technology Lifecycle Estimation - Lifecycle Progression - Drug Approval Process

Pre-discovery – First step is understanding the disease and its underlying cause. How are genes altered? How does this affect encoding of proteins and their interaction with other cells? How do cell change the tissue they are in, and how the disease affects the patient.

Target Identification and Validation – Once cause is understood, researchers select a target, a single molecule such as a gene or a protein involved in a disease, for a potential medicine. Researchers must validate the target is involved in the disease and can be acted upon by a drug through experiments on living cells and animal models.

Drug Discovery – Search for a molecule or a lead compound that may act on the target to alter the course of the disease.

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Technology Lifecycle Estimation - Lifecycle Progression - Drug Approval Process (cont’d)

— Manufacturing: Once approved by the FDA, the process of going from small-scale to large-scale manufacturing begins. Any manufacturing facility must meet the FDA’s guidelines for Good Manufacturing Practices.

— Ongoing Studies and Phase IV Trials: Research on the approved drug continues even after commercialization, as a larger number of patients begin to use the drug. Companies must continue to monitor the performance of drug and submit periodic reports to the FDA. In some cases, the FDA requires a company to conduct additional studies on an approved drug in Phase IV studies to evaluate long-term safety or how the new drug affects a specific subgroup of patients.

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Technology Lifecycle Estimation - Lifecycle Progression -Drug Approval Process (cont’d)

Early Safety Test – Lead compounds are tested to assess safety in living cell, animals or computational models. These studies test— Absorption in the bloodstream— Distribution to the correct site of action in the body— Metabolism is effective and efficient— Excretion from the body is successful— Toxicity level of the drug is demonstrated to not be toxic

Lead Optimization – Alternative lead compounds are tested to try and increase safety and effectiveness. Final result is the candidate drug.

Preclinical Testing - Preclinical testing involves lab and animal tests to determine if the candidate drug is safe for human testing.

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Technology Lifecycle Estimation - Lifecycle Progression -Drug Approval Process (cont’d)

Investigation New Drug (“IND”) Application and Safety File- Before clinical testing can begin an IND must be submitted to the U.S. Food and Drug Administration (“FDA”). The application contains results from the preclinical testing, the candidate drug’s chemical structure and how it is thought to work in the human body, a listing of any side effects, and manufacturing information.

Phase I Clinical Trial – Once the IND has been approved by the FDA, the candidate drug is tested in people for the first time, with about 20 to 100 healthy volunteers. The main goal of this phase of clinical trials is to understand if the drug is safe for humans.

Phase II Clinical Trial - In Phase II clinical trials the drug’s effectiveness is evaluated in about 100 to 500 patients with the disease or condition that the drug is targeted to treat.

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Technology Lifecycle Estimation - Lifecycle Progression - Drug Approval Process (cont’d)

— Phase IIa and IIb Trials: Sometimes combined with a Phase I trial, a Phase IIa trial helps understand the safety and efficacy of the candidate drug, and the dosage in a small group of volunteers. Phase IIb trials build on the results that have been collected with a larger group of patients in preparation for a rigorous Phase III trial.

— Phase III Clinical Trial: Researchers study the drug in about 1,000 to 5,000 patients to generate statistically meaningful data about safety, efficacy, and overall benefit-risk relationship. Provides a basis for the labeling instructions to ensure proper use of the drug. Phase III trials are the longest and costliest of all the clinical trials with hundreds of sites in the US and the world participating in the study to get a large and diverse group of patients.

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Technology Lifecycle Estimation - Lifecycle Progression - Drug Approval Process (cont’d)

— New Drug Application (“NDA”) - Once all three phases of the clinical trials are complete, the sponsor analyzes the data. If the results show that the drug is safe and effective, the sponsor files for an NDA with the FDA requesting approval to commercialize the drug. The NDA, which can be more than 100,000 pages, includes all the information from prior years of work, and proposals for manufacturing and labeling information.

— FDA Review of NDA - The FDA reviews the NDA to address: (i) do benefits outweigh the risks, (ii) information the package insert should contain to guide physicians in the use, and (iii) whether the manufacturing methods ensure its quality and preserve the drug’s identity, strength, and purity. The FDA can either approve, request for further information or studies, or deny approval.

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Conclusion

There is an increasing emphasis on intellectual property assets.

There are multiple reasons why IP is valued, including for compliance, transaction, and litigation purposes.

Many assumptions require significant informed judgment by the appraiser, such as estimating discount rates and contributory asset charges.

Intellectual property valuation is an art and a science.

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Questions

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Presenter’s Bio—Raymond Rath

Managing Director at Globalview Advisors LLC. Valuation firm with offices in Irvine, Los Angeles, Boston and London.

Organize and moderate eleven annual one-day conferences for the American Society of Appraisers on fair value issues including presentations by staff of the SEC, PCAOB, FASB and IASB.

Led development of two three-day valuation courses for the ASA -Valuation of Intangible Assets and Special Topics in the Valuation of Intangible Assets. Led efforts resulting in certification program for an Intangible Assets valuation specialty designation.

Member, AICPA Investment Companies Task Force for AICPA Accounting and Valuation Guide, Determining Fair Value of Portfolio Company Investments of Venture Capital and Private Equity Firms and other Investment Companies. Guide is in development.

Author, Private Company Valuation chapter in the CFA Institute text Equity Asset Valuation. Chapter is a required reading for CFA level 2 candidates globally.

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END