Cluster 4: Technology Growth and Development Successful Technology Licensing Chapter III: Key Terms Cluster 3: Financial Terms Cluster 4: Technology Growth and Development

Cluster 3: Financial Terms in License Agreements Value: Total value of the licensed IP in context of the other key terms; and Form of payment: How the payments will be made.

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

How does IP Valuation Work?

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 IP in 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

NPV Formula T Ct NPV = ∑ ----------- - C0 t-1 (1+r)t

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

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 Probability of success Impact on existing business Legal fees Probability of success

Other Valuation Methods 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

Practical approach 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

Forms of Payment in IP Licensing

Forms of Payment Royalties Lump sum Installment payments

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

Form of Payment 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

Royalty Variations 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

Minimum Royalties 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

Royalty Variations 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)

Other Royalty Issues 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 Financial Terms: Warranties and Indemnities 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: Audit 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.

Cluster 4: Future Developments 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

Service and Support Teaching and Training Consulting New Versions Technical assistance limitations Consulting New Versions New Products Maintenance, telephone support Spare parts

Future developments 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

Clusters 3 and 4: Conclusion 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.