Successful Technology LicensingChapter III: Key Terms Cluster 3: Financial Terms
Cluster 4: Technology Growth and Development
• Value: Total value of the licensed IP in context of the other key terms; and
• Form of payment: How the payments will be made.
• Value: Total value of the licensed IP in context of the other key terms; and
• Form of payment: How the payments will be made.
Cluster 3: Financial Terms in License Agreements
• What is IP Valuation?
• Benefit
• Risk
Valuation: The process of identifying and measuring financial benefit and risk from an asset.
When is IP Valuation Used?
• Merger and acquisition
• IP audit
• Financial reporting
• Financing
• Investment transactions
• Licensing
The Three Classic Methods
• Income– value over time discounted for
• risk• time value of money
• Market comparables– Competing technology
• Cost of alternatives– Invent around– Law suit
The Income Method• Most popular method: Discounted Cash Flow
(DCF) is the technique commonly used to calculate.
• Income over time/risk• Advantages: projects income based on clear
factual assumptions • Disadvantages:
– Assumptions about income vary greatly– Assumptions about risk are difficult– Both disadvantages are worse with new
technologies
DCF Basic Approach
• Determine projected cash flow over time
• Determine time value of money
• Determine risk that projected cash flow will not be achieved
Cash Flow - Income Method
• “Top Down”Approach• Starts with overall earnings of a business that
owns intangible asset;• Reductions - for the value of the tangible assets;• “Left Over” is the intangible value.
• Only works when there business has only one intangible asset
Cash Flow - Income Method
• “Bottom up” Approach• Base - income (earnings) specifically
attributable to the intangible asset or patented technology under review
• Variables:– expected growth rate of those earnings, – the economic life of the asset, – discount rate to reflect time value of money and
risk.
• Works best where intangible asset already commercialized
How Cash Flow Calculation Works
1. Determine current cash flow from the particular asset -- distinguish the IP from other elements of value in the product.
2. Subtract any costs (cash outflows) that are required to generate the income (>Net Cash Flow)
3. Estimate net cash flow (expected growth) --over the economic life of the asset
in many cases shorter than life of IPin pharma/bio may be longer than IP
--identify the market for this technology
Growth of Technology Diffusion
• Market introduction – “market penetration”• Growth phase• Saturation of maturity
•1 •2 •3
•Revenue of Patented Product
•Time
How DCF Calculation Works
4. Discount projected future net cash flow to a lump sum that is the present value.
5. To do this, you make a judgment to determine a “discount rate” based on:
• Real interest rate – cost of capital• Expected inflation rate• Risk premium – probability of success• Apply discount rate on the projected net
cash flow over the economic life of the asset = PRESENT VALUE AMOUNT
Example
• Cash flow is $US20 billion per year
• Net cash flow $US2billion (app. 10% of total annual revenues)
• Penetration rate of the new technology in the first year is 10% of the total market ($US200 million) and is expected to grow 5% over 5 years
• Discount rate is 8% - sum of interest, inflation and risk impact
Example• Value of $1 in the period of 5 years discounted by the rate of
8%– 0,9259– 0,857– 0,794– 0,735– 0,681
• Discounted cash flow in this example– $185 M– $180 M– $175 M– $170 M– $165,5M
• Net present value - $875,5
Year 1 2 3 4 5 6 $244 $232 $220 $210 $200
(1) Expected economic benefit
(2) Discount factor
(NPV Formula)
1 1 (1.08)
1 _ (1.08)2
1 _ (1.08)3
1 _ (1.08)4
1 (1.08)5
0
(3) Discount factor
.925 .857 .794 .735 .681
(4) Discount benefit stream a
= $185 $180 $175 $170 $165,5
(5) Present Value
$875,5 = 185 + 180 + 175 + 170 + 165,5
*a Note: (4)=(2) X (1)
Market Comparables• Advantage--simple, if there are appropriate data
• Difficulties • IP market is not developed• Difficult to find pertinent data (contracts are
confidential usually)• Sector databases might have useful information-
variations and complexity of each case have to be taken into consideration
• Geographical and market differences• Other terms in contract have to be taken into
account
Alternative Costs• Replacement (creation) cost--cost of R&D +
cost of IP protection + probability of success; • Advantages: useful to estimate a
competitor’s invent-around costs and understand licensor’s perspective;
• Disadvantages– lost time
– difficult to determine
– cost of creation is not always representative of the value of the protected technology.
Alternative Costs
• Infringement suit– Costs
• Impact on existing business
• Legal fees
– Probability of success
• 25% Rule of Thumb
- Licensor gets 25% of profit
• Real options
• Monte Carlo simulation - a form of income analysis
• Qualitative valuation - subjective valuation used taking into account the strength or quality of the IP
• Many other variations
Other Valuation Methods
• Licensee perspective: how much can it afford to add to its cost of goods sold?
• Licensor perspective: – What rate of return on R&D investment does it
expect? • Misleading if R&D investment sunk cost• Misleading if technology is spin off
– What is cost of granting license• Competition• Warranites, guarantees. liabilities• Administration, enforcement
Practical approach
Royalties
• Royalty rate times royalty base
• Base is critical– Related to use of licensed IP– Kept in ordinary course of licensee’s business– Not subject to “creative accounting”– Not subject to unexpected fluctuations
Royalty Base
• Anything related to use of IP– Number of patented products made– Cycles of patented machine– Sale price of patented product– Sale price of product made using patented
method
• Price inflation sensitive, otherwise consider escalation provision
• The basis for royalty calculation:– Net Sales (must be defined -- gross sales net of
freight, shipping, rebates, insurance). – May be better to fix a % of gross sales in order
to avoid disputes or fix % of deductions.– What is the product on which the royalty is
measured--the whole device, only a part? Affects rate, not base
– Royalties on product that does not contain the licensed IP—possible problem
Form of Payment
• Increasing royalty rate as volume decreases– Keeps income to licensor constant
• Increasing royalty rate as volume increases– Restrain production– Reflect higher profits in pharmaceutical licenses
• Decrease royalty rate as volume increases– where value of technology is declining– incentive to produce more
Royalty Variations
• Based on business plan
• Important in exclusive licenses as security for licensor, incentive
• Absolute payment obligations? Risky for the licensee--can run it into insolvency, restrictions on sales– Licensee should have right to terminate
• Trigger for termination/ modification
Minimum Royalties
• Capped royalties
– Cap royalties over term of agreement to a fixed amount/avoids windfall
– Licensor doesn‘t like as it limits upside
• Vary royalty rate based on profit margin– 4 cylinder vs 8 cylinder auto
• Advances against royalties (where licensor needs up front cash to fund operations)
Royalty Variations
• Tax– Needs to be clear who will pay– If there is a double taxation agreement, the
problem may not arise• Withholding issue
• Non profit, no benefit
• Separate royalties for patents and know how in case patent is invalidated
Other Royalty Issues
• Product warranty– Product defects– Failure to perform to specification
• Indemnification – Third party claims of infringement– Product liability, malfunction, personal injury
• Indemnity should be capped at a fixed sum
• Indemnity by small party not worth much
Other Financial Terms: Warranties and Indemnities
• Provide for audit in case of royalty disputes
• Specify record keeping and report obligations
• Establish range of error that triggers audit cost shift
• Access to records needs to be practicable
• Penalties for licensee who avoids royalties by developing alternative technologies.
Other Financial Terms: Audit
• Improvements by Licensor• Improvements by Licensee• Joint Improvements• Must define improvements• Grant backs
– In Europe, no exclusive licensee or assignment of grant backs and permitted only if mutual
Cluster 4: Future Developments
• Teaching and Training– Technical assistance limitations
• Consulting• New Versions• New Products• Maintenance, telephone support• Spare parts
Service and Support
• Avoid any commitments that limit options to develop new products
• Options to acquire new IP--but on what terms
• Rights of first refusal can be illusory and hold up deals
• Licensee will generally want access to the latest, but freedom to stay with the old
Future developments
• Financial Terms are always related to Clusters 1, 2 and 4.
• Look at total value
• Use flexibility in deciding how to pay
• Give both sides financial incentives to continue to work together.
Clusters 3 and 4: Conclusion