VALUATION of INTELLECTUAL PROPERTY

IPSI 2008
Gordon V. Smith AUS Consultants Mount Laurel, New Jersey 08054 (856) 234-1199 Telephone (856) 273-9710 Fax gsmith@ausinc.com David G. Weiler Managing Director RoyaltySource Mount Laurel, New Jersey 08054 (856) 234-1199 Telephone (856) 273-9710 Fax dweiler@royaltysource.com

COURSE OVERVIEW: Intellectual property is an increasingly important asset in the modern economy. Recent examples of infringement litigation resulting in multi-million dollar awards have only served to further emphasize this observation. The positive and negative reactions of the market to the e-commerce euphoria are a reflection on the importance of IP. Todays successful attorney or business person must be able to assist in the identification, preservation and use of valuable knowledge and information assets. One important skill needed to help meet these objectives is an ability to understand the elements that drive IP value and the business enterprise and to understand the economic impact of various IP exploitations. How You Will be Graded The class schedule is very compressed. Your grade will be based on your performance in the final examination. There will be a case study requiring some preparation between the third and fourth class sessions. The exam will include problems in which you will apply the principles introduced in class. Pre-class Requirements STUDENTS SHOULD DOWNLOAD THE SEC FORM 10-K OF THE COCA-COLA COMPANY. Go to www.thecoca-colacompany.com, then to Investors, SEC filings, Annual filings, 2/21/07 10-K, and download the pdf version. STUDENTS SHOULD DOWNLOAD THE ANNUAL REPORT and SEC FORM 10-K OF INTEL CORPORATION. Go to www.intel.com, then to Investor Relations, and download the pdf version.

STUDENTS SHOULD OBTAIN A PASSWORD TO ALLOW ACCESS TO THE IP VALUATION ONLINE TUTORIALS. THESE TUTORIALS SHOULD BE COMPLETED PRIOR TO THE START OF CLASS. Course Outline This course of study is divided into two sections: An online tutorial comprising 6 modules that will require approximately ten hours to complete. The

modules cover the following subject matter: Introduction to IP Valuation Defining a valuation, relating IP and the enterprise, and an overview of the primary valuation methods and their applicability to the valuation of IP. The Business Enterprise and its Underlying Assets Introduces the role of business enterprise value in a specific IP appraisal, examines underlying assets and their characteristics from a value point of view. Accounting, Financial Statements and Valuation Examines how GAAP affects the presentation of value information in financial statements and presents ways to extract meaningful valuation information from financials and related documents. The Cost Method Examines reproduction and replacement cost, physical, functional and economic obsolescence and the pros and cons of using this method to appraise IP. Spreadsheet examples of this method are available to download. The Market Method Presents the essential criteria for employing this valuation method. Examines the issues of comparability and methods for the adjustment of comparable data. Includes a discussion of the extraction and use of royalty rates from the marketplace. The Income Method Overview Defines and examines the inputs necessary for the income method, and includes a discussion of the investment principles that support this method. An introduction to present value principles is also provided.

Classroom lectures comprising the following material: Course overview Review of the online segment Economics of licensing Valuation case study Licensing case study Analyzing the valuation engagement Finding and working with a valuation expert

Reading The course lectures cover what you will need to know towards the course objectives. There are therefore no specific reading assignments. If you desire additional reading to strengthen your understanding, the following references would be helpful. Intellectual Property: Valuation, Exploitation, and Infringement Damages, Smith & Parr, John Wiley & Sons, Inc., Hoboken, NJ, 2005 (April). Covers all phases of this course and includes the material in several of the books that follow in this list.. Valuation of Intellectual Property and Intangible Assets, Smith & Parr, John Wiley & Sons, Inc., New York, 3rd Edition, 2000. Concentrates on IP valuation principles and practice. Trademark Valuation, Gordon V. Smith, John Wiley & Sons, Inc., New York, 1997. Focuses on the

valuation of trademarks. Dealmaking Using Real Options and Monte Carlo Analysis, Richard Razgaitis, John Wiley & Sons, Inc., New York, 2003. Introduces complex forecasting and estimation methodologies in support of valuations and royalty estimation. The Valuation of Technology, F. Peter Boer, John Wiley & Sons, Inc., New York, 1999. General treatise about the nature of technology and its valuation. Damodaran on Valuation, John Wiley & Sons, Inc., 1994. Valuation theory including the securities markets. Valuing Intangible Assets, Reilly & Schweihs, McGraw-Hill, New York, 1998. Comprehensive book including intangible asset valuation Cost of Capital, Shannon P. Pratt, John Wiley & Sons, Inc., New York, 1998. Good presentation of deriving a cost of capital, discount and capitalization rates. Intellectual Property Infringement Damages, 2nd Edition, Russell L. Parr, John Wiley & Sons, Inc., 1999. Comprehensive review of infringement damages methodologies and case law.

LECTURE / CLASSROOM SEGMENT

OVERVIEW OF THE COURSE
Why valuation? Any exploitation requires knowledge of the drivers of value The Problem Microsofts business enterprise value vs. value its book value # shares times price vs. book value of common equity The difference is what course is all about we will analyze the value elements and the accounting elements Intangible Assets & Intellectual Property Accounting Principles IP Economic Theory & Practice Economic Issues in Litigation Licensing Economics WHERE ECONOMIC ISSUES ARE IMPORTANT Transaction Support Buyer Considerations What should I pay? Seller Considerations What should I ask? Why do these questions arise? IP is in its embryonic, formative stage Mode of exploitation is questionable Is there justification for additional capital investment? Can outside capital be attracted? Fair Market Value vs. Fair Market Royalty Litigation Support Business Damages Infringement Damages Injunctions Stockholder Suits Malpractice Suits Regulatory Requirements SEC/IPO Fairness Opinions Solvency Opinion - Fraudulent Conveyance Shareholder Rights Rate-Setting Accounting Requirements Allocation of Purchase Price Economic Remaining Life Analysis Net Realizable Value Balance Sheet Cosmetics Income Taxes Federal Income Allocation of Purchase Price Transfer Pricing Holding Companies State/ Provincial Taxes Holding Companies Transfer Pricing? Estate Taxes 4

Closely-Held Stock Intellectual Property Gift Taxes Closely-Held Stock Ad Valorem Taxes Intangible Assets/Intellectual Property Financial Collateral Bankruptcy IMPORTANCE OF IP ASSETS Less dependence on bricks and mortar Large segments of world business depends on it (e.g., Microsoft, Intel, Disney, Coca-Cola)

REVIEW OF ONLINE SEGMENT

(coverage of the following topics printed here in blue - will be flexible, depending on the needs of the class and its understanding of the online materials) INTANGIBLE ASSETS DEFINED Rights Contractual receiving, providing Relationships Non-Contractual Undefined Goodwill Elements of a Going Concern INTELLECTUAL PROPERTY DEFINED Patents Trademarks Copyrights Proprietary technology / Trade secrets THE BUSINESS ENTERPRISE AND THE ASSETS THAT COMPRISE IT Business Enterprise Business Value Equation Specific Elements of the Business Enterprise Monetary Assets Tangible Assets Intangible Assets Business Asset Characteristics Important Characteristics of Risk, Financing, and Liquidity Monetary Assets Tangible Assets Intangible Assets The Critical Relationship of the Business Enterprise and its Underlying Assets

BASIC ACCOUNTING CONCEPTS THE METRICS OF THE BUSINESS ENTERPRISE Generally Accepted Accounting Principles (GAAP) IAS International Accounting Standards 5

FASB - Financial Accounting Standards Board AICPA - American Institute of CPAs Accounting for Public Companies Investors/Lenders/Regulators Example: Securities and Exchange Commission (SEC) Managed for Short-Term Profits and Minimum Taxes Accounting for Private Companies (closely-held) Private Owners Do This to Save Money and Minimize New Investment Records - None Except Tax Returns Managed for Maximum Cash Flow and Minimum Taxes Annual Reports and 10-Ks Financial and operating information presented in a positive way Selling document What can we learn about Coca-Cola Co. and Intel Corporation? Financial highlights Important elements of the business Importance of brands Selling message about common stock Strategic priorities Vanilla new brand Worldwide marketing Packaging & marketing Relationships with bottlers Company being good citizen International operations Accounting Statements Prepared by company, checked by auditor Auditor performs an attest function, or an independent check of managements reporting Do the statements conform to GAAP Includes judgement (forward-looking statements Use Coca-Cola examples Use of estimates Goodwill (see FASB adjustments Intangible assets Recoverability of Non-current assets Impairment Timing is important Accounting changes Currency translation (financial risk management) Acquisitions Not always audited Expensive, resource-consuming, may be no need May be exceptions Uncertainty about results of transactions, some transactions may not conform to GAAP Limitations in audit scope Balance Sheet A Snapshot of Past Transactions Accumulated Over Time Example of Start-Up Company Accumulation of equity and debt capital Investment in assets Assets Current Assets Cash, investments (cash equivalents) Accounts receivable 6

Inventory Raw material Work in process Finished goods Deferred Taxes, prepaid expenses Plant, Property & Equipment Its Elements Land Land improvements Buildings Leasehold Improvements Machinery and Equipment Vehicles Reserves Depreciation = Capital Recovery Loss in Value Goodwill & Other Intangibles Accounting rules Amortization Liabilities Current Liabilities Accounts payable, accrued liabilities, taxes payable, debt due within one year Long-Term Debt (e.g. Enron understatement) Deferred income taxes, other non-current liabilities (post-retirement benefits?) Common Equity (Shareholders Equity) Amounts invested since day one plus earnings retained in the business This is book value of what stockholders own Value Information from Financial Statements Current Assets How the Value of the Elements Can Vary Investments realizable? Receivables collectible? Inventory good? Usually not too bad to use book value = real value will be conservative. Plant, Property and Equipment How the Value of the Elements Can Vary Common Equity Secondary market sets the price (either by an actual market or by appraisal) Coca-Cola example What ASSETS are revalued when the market sets a price on the COMMON EQUITY liability?? Income Statement A Periods-Worth of Transactions Revenues Characteristics of Sources Volatility Cost of Goods Sold Sources Volatility Operating Expenses Characteristics of... Sources Volatility 7

Selling, General & Administrative Expenses Characteristics of... Sources Volatility Interest Other income Taxes Net Income Concept of Timing Accruals Capital Recovery / Capital vs. Expense Policy (e.g. Worldcom) Amortization Reserves (financial) International Accounting Issues Efforts at harmonization Accounting for goodwill, research and development Relationship of Accounting Amounts and Value Accounting as a Closed System of Recording Transactions Balance sheet shows costs Valuation Measures the Economic Results of Those Transactions Examples of residence - cost versus ultimate value Accounting Issues Related to IP U.K. Controversy Booking brand values FASB 141 / 142 Allocations of purchase price New SEC Considerations Should intangibles be on the balance sheet? International Accounting Harmonization Still trying getting there FINANCIAL ANALYSIS Measures the Results of Investments Internally-generated Debt/Equity Principle Analysis Tools Horizontal Analysis Comparative financial statements track year to year changes Trends in the form of index numbers Vertical Analysis Common-size financial statements Ratio Analysis Short-term Liquidity Current ratio Acid test ratio Inventory turnover Capital structure long-term solvency Debt to equity ratio (variations on calculation method) Interest coverage Return on Investment Return on total assets Return on equity Operating performance Gross margin ratio Net income to sales ratio Asset Utilization Sales to accounts receivable (variations on calculation method) Sales to inventories (variations on calculation method) 8

Sales to fixed assets (variations on calculation method) Market Measures Price-earnings ratio Earnings yield Dividend yield Dividend payout ratio Growth Rates Sales Net income Cash flow Follow the Dollars Comparables and Benchmarks Comparability - Commensurate Risks Surrogates

BASIC INVESTMENT PRINCIPLES The Investment Transaction Return of and Return on Investment Concept Example of Certificate of Deposit Investment Example of Common Stock Investment Example of R&D Investment

BASIC VALUE CONCEPTS Premise of Value Cost of Reproduction New Cost of Replacement Book Value Tax Basis Fair Market Value Valuation Valuation of the Business Enterprise Valuation of the Assets of the Business Enterprise Break-Up Values INTRODUCTION TO VALUATION METHODS Valuation Methods Three Commonly Accepted Methods Cost Approach Market Approach Income Approach Cost Approach Ingredients - General Theory The Difficulties of Obsolescence Cost Approach Applied to Intellectual Property (e.g. software) Cost Approach Cautions doesnt reflect inefficiencies, or earnings capability Market Approach Ingredients The Market Approach as a Check The Market Approach as a Measure of Economic Obsolescence 9

Market Approach for Intangibles Income Approach Ingredients Income Capitalization Theory & Mathematics Present Value Concepts

DISCOUNTED CASH FLOW ANALYSIS How it utilizes basic investment principles Income statement structure Cash flow vs. net income Elements of the calculation Forecasting methods Extrapolation techniques Single or multiple outcome techniques CAGR Real Options Decision-trees Monte Carlo Use of a growth model Use of surrogate data A TRADEMARK VALUATION Examples INCOME APPROACH PULLING IT ALL TOGETHER Class Exercise Valuation of Microsoft Microsoft business enterprise Microsoft monetary, tangible and intangible assets Microsoft intangibles workforce, trademarks, computer software, patents Illustrate how to make them fit CASE STUDY PATENT VALUATION

THE LICENSING TRANSACTION

ROYALTIES Defined Estimating Use of Present Value Principles Cost Approach Market Approach Income Approach Discounted Cash Flow CASE STUDY - LICENSING

LITIGATION DAMAGES
Patent Trademark Convergence issues Ships in the fog Dilution issues existing, actual damages vs. potential damages (but value is forward-looking)

THE VALUATION ENGAGEMENT

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Uniform Standards of Professional Appraisal Practice (USPAP) Ethical Standards Minimum Work Standards Client Relationship Minimum Reporting Standards Investigation/Data Gathering Analysis Exogenous Data Calculations Correlation Report Writing Elements of a Report As of Date Property Description Appraisal Purpose Premise of Value Information Relied Upon Valuation Methods Used and Not Used Full Exposition of Facts Relied Upon Full Exposition of Analysis/Calculations Logical Progression to Conclusion Appraiser Qualifications Draft for Factual Review Final With Limiting Conditions, Qualifications

FINDING, SELECTING AND WORKING WITH A VALUATION EXPERT

Finding an Appraiser/Witness Interviewing a Potential Appraiser/Witness Engaging a Potential Appraiser/Witness Do You Want (Need) Two Experts? Establishing an Early Warning System Who is the Client? Confidentiality Agreements Financial Arrangements Daubert considerations Monitoring the Engagement Advocacy How Much Room is There Really? Where are the Likely Soft Spots?

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