Funding — the lifeblood of any startup — can rise or fall on how a company is valued. But for many early stage companies, their most valuable (and often only) significant asset is their intellectual property (IP). Indeed, many companies are founded based on little more than an invention or even just a novel idea. But how do you put a sticker price on something intangible like an invention or an idea? And are some forms of IP worth more than others to potential inventors or funding sources?
Some entrepreneurs might assume that the best option for presenting a bright outlook for their company is to file as many patent applications as possible. They may believe that the best way to obtain funding based on intangible assets is to be able to wave a stack of patents or patent applications in front of a potential investor. Or, they may think that simply being able to use the term “patent pending” is a sign of a soon-to-be successful product. In reality, however, valuing a patent portfolio has very little to do with how prolific the company is in filing applications.
Moreover, by putting too much emphasis on patents and patent applications, a startup may be neglecting the value of trade secrets. Trade secrets may not have the same cache as patents to a startup because they do not come with a ribbon-affixed certificate, are not subjected to any examination process, and are often harder to define. But trade secrets can be just as valuable — and in some instances more valuable — than patents.
It is important, therefore, for a startup to understand how both patents and trade secrets can be valued as assets, the positive and negative factors that go into valuing both, and how potential investors really view these assets.
Determining the Value of Patents and Trade Secrets
Any intangible asset can be valued so long as it is (1) identifiable, (2) controlled, and (3) imparts future economic benefit (such as revenue or reduced future costs). For a patent or patent application, determining if it qualifies is usually straightforward. For a trade secret, these questions may be more difficult to answer.
Namely, a trade secret is defined by the U.S. Patent and Trademark Office as:
[I]nformation that has either actual or potential independent economic value by virtue of not being generally known, has value to others who cannot legitimately obtain the information, and is subject to reasonable efforts to maintain its secrecy.”
For instance, a trade secret can include a proprietary formulation, processing method, method of manufacture, computer algorithm, or other type of information that is valuable because it is secret as well as other types of proprietary information, such as a database of consumer preferences, customer lists, or contact lists.
As a result, the biggest hurdle in being able to value a trade secret often involves simply whether it is “identifiable.” A company’s most valuable and most important trade secrets should, for example, be listed, documented, and specifically protected from disclosure. Once a trade secret can be identified and characterized, its value can then be analyzed just as with a patent.
Intellectual property valuations involve ascertaining a fair market value — the price a hypothetical arms-length buyer would pay for the intangible asset. This can be done a number of ways, such as through:
- An income approach: measuring the value of the IP by determining the present value of the economic benefit it is expected to provide over the life of the IP.
- A market approach: analyzing what purchasers of similar assets in the market have paid.
- A cost approach: measuring the cost invested in developing the IP.
One commonly used method is the relief from royalty method, which combines both the market and income approaches. By owning the IP, the company does not have to pay a third party to license the IP, thereby realizing a “relief from royalty” payments. By analyzing market transactions, a market royalty rate is applied to forecasted economic benefits (either sales or cost savings) related to the IP and converted into present value by accounting for risks associated with the economic benefits.
Ultimately, the characteristics of each subject patent or trade secret will determine the appropriate methodology to determine its fair market value.
Factors Considered in Patent and Trade Secret Valuations
Regardless of the specific valuation methodology, the factors that go into the valuation can vary significantly between patents versus trade secrets. That is because patents and trade secrets have several fundamental differences that affect their relative value.
Namely, the primary value of a patent lies in the ability to potentially use it to exclude others from making, selling, using, offering for sale, or importing a competing product. Some key elements of a patent that can be considered in a valuation analysis include:
- That it has a limited term (typically 20 years from the filing of an application).
- That it cannot be lost through later reverse engineering or independent development.
- That it can be found invalid in view of prior art.
- That it requires disclosure via a patent application and runs the risk that others may use that disclosure to flout the patent.
- That it can be used to preclude even innocent infringers and maintain exclusivity.
- That it requires little expense to maintain (such as periodic maintenance fees).
- That it is limited geographically to where the patent protection was obtained.
The primary value of a trade secret, on the other hand, is in preventing others from even knowing how to make that competing product in the first place. Some key elements of a trade secret that can be considered in a valuation analysis include:
- That it has no expiration and can last forever if maintained (like the Coca-Cola recipe).
- That it can be lost if reverse engineered or independently developed (even if not intentionally misappropriated).
- That there is no mechanism for a third party to force disclosure of a trade secret.
- That it is kept secret: Competitors are kept unaware of its specifics.
- That it has little offensive ability to preclude competitors.
- The costs to maintain secrecy over time.
- That secrecy is maintained worldwide and enforceable in any jurisdiction with trade secret misappropriation laws.
Each of these competing considerations affects the relative value of a patent versus a trade secret. However, a certain amount of subjective analysis is required in considering these factors and their impact on the value of the IP. For instance, to assign value to a patent portfolio, an analysis must be undertaken regarding the strength, scope, and potential exclusionary ability of the patents.
Similarly, valuing a trade secret involves analyzing the benefit that the company realizes by keeping the information secret, such as the exclusivity, greater sales, price premiums, or cost reduction.
Objective Valuation Does Not Necessarily Equal Value to a Given Investor
The objective valuation of an IP asset, of course, may not be the same as the “value” that a given investor or funding source sees in that asset. For example, while security interests can legally be recorded for both patents and trade secrets, a financial institution may be unwilling to accept a trade secret as security for a loan, since trade secrets are not as easily transferable as patents. Or, a company may have a large portfolio of potentially valuable patent applications, but an investor may be concerned that the ongoing cost to prosecute those applications may not be the best use of capital for an early stage company.
At the end of the day, most importantly, a company’s IP strategy should be aligned with its overall business model, as valuable IP alone does not indicate a valuable or successful startup.
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Christopher M. Scharff is a shareholder at McAndrews, Held & Malloy, Ltd. Henry Kaskov is president of Kaskov Valuations, Inc.
The opinions expressed here are the opinions of the authors and may not reflect the opinions of McAndrews, Held & Malloy, Kaskov Valuations, Inc., their clients, or any individual attorney or employee. This is for general information purposes and is not intended to be, and should not be taken as, legal advice.
