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

2. 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.

3. What is IP Valuation? Benefit Risk
Valuation: The process of identifying and measuring financial benefit and risk from an asset.

4. When is IP Valuation Used?
Merger and acquisition
IP audit
Financial reporting
Financing
Investment transactions
Licensing

5. How does IP Valuation Work?

6. 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

7. 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

8. DCF Basic Approach Determine projected cash flow over time
Determine time value of money
Determine risk that projected cash flow will not be achieved

9. 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

10. 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

11. 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

12. Growth of Technology Diffusion
Market introduction – “market penetration”
Growth phase
Saturation of maturity 1 2 3
Revenue of Patented Product
Time

13. 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

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

15. 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

16. 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

18. 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

19. 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.

20. Alternative Costs Infringement suit Costs Probability of success
Impact on existing business
Legal fees
Probability of success

21. 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

22. 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

23. Forms of Payment in IP Licensing

24. Forms of Payment
Royalties
Lump sum
Installment payments

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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)

31. 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

32. 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

33. 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.

34. 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

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

36. 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

37. 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.