Authored by Scott J. Popma and Cory C. Bell
For science and technology-based startups, intellectual property often is a company's most valuable asset. The valuation of that intellectual property can be a challenging process, one that often lacks transparency. The newly enacted CROWDFUND Act (the Act), which legalises in the United States the sale of crowdfunded securities through authorised internet portals, requires companies to disclose how they value those securities and the assets behind them. This article explores the strengths and weaknesses of traditional patent valuation techniques and how data made public under the reporting requirements of the Act may improve the accuracy and transparency of the patent valuation process.
Crowdfunding is a method of using the Internet and social networks to raise capital. The Act, which the Security and Exchange Commission (SEC) will implement in early 2013, adds a crowdfunding exemption to Section 4 of the Securities Act of 1933, allowing the sale of securities to unaccredited investors through authorised internet portals if certain requirements are met. A recent report from Crowdsourcing.org estimates that crowdfunding will raise $2.8 bn worldwide in 2012, up from $1.5 bn in 2011. This number is expected to grow rapidly in 2013 after the sale of crowdfunded securities is permitted in the United States.
To ensure the accuracy and transparency of crowdfund offerings, the Act requires detailed disclosures regarding the business plans at the center of these offerings, including descriptions of how the securities are being valued. The Act also requires the filing of annual financial reports after successful crowdfund issuances.
There are three common approaches for valuing intellectual property assets—cost-based, market-based, and income-based. Income-based valuation tends to be the preferred approach for valuing patents, but none of these methods is ideal in the crowdfunding context. Until a better method emerges or the SEC provides guidance, the method best suited for a particular IP asset should be selected. Because crowdfund issuers are liable for material misstatements and omissions, they must be able to defend the valuation method they use.
Income-based valuation is the most widely accepted method for valuing patents, especially in mature markets where the value of the associated technology is known. This method tends not to work as well for patents covering nascent technology, however. Income-based valuations rely on comparisons of average royalty rates and market size for similar technologies to project the income for a patent over its remaining economic life (e.g., the remaining term of the patent). When nascent technology is involved—as often will be the case with innovative start-ups seeking crowdfunding—there may be no similar technology to which to compare. Another potential problem is that income-based valuations apply a discount rate to the valuation to account for risk and the time value of money. This discount rate can be higher for patent applications and unproven patents, resulting in a valuation that skews low. A company can reduce the discount rate by conducting patentability searches and obtaining patentability opinions from patent counsel.
Cost-based valuation can be appropriate for certain IP assets (e.g., trademarks and copyrights), but it is almost never the best method for valuing patent portfolios. Cost-based valuations value an asset based on the cost of creating the asset, but the cost of developing a technology often is unrelated to the actual value of the patent. For example, a patent may cover an obsolete technology and have no value, even if the cost to develop that technology was significant. A cost-based valuation of such a patent would skew high. Also, cost-based valuation fails to account for the value of the limited monopoly to practice an invention granted by a patent.
Market-based valuation historically has posed problems for patents, as finding the appropriate comparable for a patent transaction, particularly for patent applications, can be difficult. To be reliable, comparable transactions must involve the same technology, have recently occurred on the open market, and have been of the same size and structure. Because patent value is closely tied to claim scope, the claims of the patents in the comparable transactions arguably must capture similar portions of the same market. Because of this, finding a reliable transaction on which to base these valuations is often impossible.
Over time, market based valuation may become more reliable because of the reporting requirements of the Act. Comparable data will become more accessible as crowdfund issuers publically disclose their initial valuations, annual financial reports, and subsequent disposition events.
As innovative businesses prepare to launch equity-based crowdfund offerings, they should take special precautions to properly value their IP portfolios. Importantly, they must explain clearly the basis for that valuation and the potential inaccuracies of the technique. The SEC has yet to draft the implementing regulations, but it has made clear that because crowdfunding is aimed at unsophisticated investors, transparency is key. As time progresses, the Act should improve the accuracy and transparency of patent valuations. For now, the best approach is a conservative one, and crowdfund issuers should consult a patent valuation expert.
Originally printed in Financier Worldwide. Reprinted with permission. This article is for informational purposes, is not intended to constitute legal advice, and may be considered advertising under applicable state laws. This article is only the opinion of the authors and is not attributable to Finnegan, Henderson, Farabow, Garrett & Dunner, LLP, or the firm's clients.