Is your company sitting on a hidden goldmine of intellectual property? Have you cultivated and adequately protected it? If you decide to sell your business, do you know the value of your IP assets? Read on to identify and increase your IP’s value.
WHAT ME CARE?
Some think the subject of IP is dry, even boring.
About as boring as trillions of dollars.
in 2019, IP-intensive companies in America (those with more IP registrations per employee than the average) accounted for one-third of national employment and about $8 trillion or 40% of GNP.
Slightly more than half of this IP value was in the form of patents, 40% in trademarks and 8% in copyrights. Understandably, trade secrets are by their nature hard to track but they’re estimated to be worth trillions too.
Today it’s the rare company that doesn’t bring at least some IP weaponry to the battle for customers.
There’s a clue to which ones have lots of it – fat gross margins (and usually, skinny balance sheets too). If that describes your company, do you know what IP is driving those gross margins and why?
We’ve broken this article down into three parts:
- A mercifully brief description of IP and its four main types;
- How the presence or quality of IP contributes to the value of a business.
- How to quantify your IP’s value.
IP is defined as “intangible creations of the human intellect.” But if it’s intangible – meaning you can’t see, feel, hear or smell it — how can you know it exists?
Stepping back, the implication is that whatever process or thing we’re talking about, it has an existence independent of the physical medium that happens to embody it.
As a result, the registered trademark for root beer soda maker Barq’s® may be embossed on a glass bottle, carved in bas relief on a bar of soap, or spray-painted on a billboard. Doesn’t matter — it’s still a single unit of IP and one trademark.
But not all IP exists on some ethereal plane separate from how it’s expressed. Utility patents can cover the material composition of an object as well. One example is proprietary drugs.
Stormy IP Weather Ahead?
Because it’s typically intangible, people already find it challenging to identify and manage. But now developments in the field of AI are raising questions about whether only humans can create it.
Courts have said yes, refusing to protect AI-generated works. That strikes us as narrow-minded. If IP must be created by humans, then we suppose there’d be no protection for AI-created drugs.
And since AI uses lots of other people’s IP as its raw material, like copyrighted text, that raises another set of questions. Do AI apps like ChatGPT owe compensation to the owners of said IP?
The Four Types of IP
Putting these looming issues aside, we list below the four types of IP recognized in the US. We’ve organized them in order of cost to register, most expensive first. (We do not address here the cost of securing protection for IP embedded in products and services sold outside US jurisdiction.)
Unlike trademarks and copyrights, patented items don’t get their own special symbol. Rather they’re identified either by the words “patent pending” or “patent applied for,” or the word “patented” or “pat.” followed by the item’s patent number.
The Utility Patent
Utility patents protect IP in the form of processes, machines, and manufactured products. Examples: software, 3D printers, a Slinky™, etc. And as we mentioned above, utility patents can even cover what material a product is made of, like the recipe for radar-absorbing paint.
Filing a utility patent is complex and time-consuming. Costs range from $4,000 to $10,000 and more, most of that accrued by patent attorney research and application materials.
(These costs exclude those associated with filing a “provisional” patent which establishes the priority of your claim before you’ve had a chance to complete the full application.)
If you’re granted a utility patent, you can also expect to pay about $750/year to maintain it. Doing so assures the right of exclusive use for 20 years following your initial application.
The Design Patent
For 25 years from the time a design patent is granted, it protects the appearance of a manufactured product — shape, surface ornamentation or configuration, etc. You could cover some products with both a utility and design patent. Preparing and filing design patent applications cost from $2,000 to $6,500, again with most of that generated by patent attorneys. Design patents require no maintenance fees.
The Plant Patent
Applications for plant patents are rare and cover unique plants either invented or discovered in a “cultivated area.” The patent grants exclusive use for 20 years from initial application filing date but willy-nilly the USPO make the application public 18 months after it’s filed.
For complete protection, some plant patent applicants may file for utility and design patents as well. So you could patent a plant three ways. To prepare and file a stand-alone plant application costs between $1,000 (DIY) and $10,000.
Trademarks distinctly identify who or what made a product or service. Sometimes marks that identify a service as opposed to a product are called “service marks.”
You’re looking at a registered trademark when you see ®. Trademarks and service marks that have been applied for but not registered look like: this:
For a trademark example see Coca Cola™ versus generic cola. For a service mark, see Stanley Steemer™, a carpet cleaning service.
Both types of marks identify the source of their creation by using insignia, phrases, words, symbols (logos) or overall look and feel, e.g., “trade dress.” So today even a distinctively-designed website can qualify for trademark protection.
Costs to obtain a mark vary widely depending on:
- How many product or service “classes” you seek protection in;
- Whether or not you can describe the mark with the use of a standard application form. If you must go freehand instead, it’ll cost you more;
- Whether you file electronically or by mail;
- Your “filing basis” (see USPTO’s definition of this term);
- How much research you must do to assert convincingly that your mark is unique.
But in general, expect to spend $250 to $1,000 or more per application. Your trademark registration is generally good for 10 years and you may renew it indefinitely at a cost of about $600 for the cheapest “filing basis” on a single class. If you fail to renew timely or “abandon” your trademark, you can lose it. For more on the subject, see this useful Forbes piece.
Copyrights grant the authors of artistic works rights of exclusive ownership in literature, movies, graphical images, sounds, etc. These rights last a lengthy 95 years from when the work was first released to the public, or 125 years from when it was created, whichever is less.
While authors’ rights are protected simply by creating a work, you can and should further document those rights by attaching to the work a copyright symbol and notice. Example: © 2023 Kuhn Capital, Inc. All Rights Reserved. Doing that makes the job of proving ownership easier should you later be challenged or infringed. Weirdly, there’s a special symbol for sound copyrights — ℗. It stands for”phonogram” though people often mistake it for a patent notice.
Authors who seek the strongest possible proof of copyright ownership may electronically register one with the USCO for about $50.
Trade secrets are “proprietary processes, instruments, patterns, designs, formulas, recipes, methods, or practices” that are known only to those inside a company and that give it a competitive edge.Inventors often elect to protect their IP by treating it as a trade secret rather than reveal its “special sauce” to the public as they must when granted a patent.If challenged, the owners of a trade secret must show that it has value and that they’ve taken commercially reasonable efforts to protect it. A famous trade secret example is the immensely valuable Coke™ formula supposedly guarded under heavy 24/7 security.Three examples of convincing efforts to safeguard a trade secret:
- Requiring those you may have hired to help create it to acknowledge that they have no claim of ownership on it;
- Requiring those accessing it to sign an NDA;
- Securing the secret by storing it in a locked safe and/or encrypting it if feasible.
A DIY Generic Form of IP Protection
In fact, when compensating others to create IP of any type, obtain in advance their written agreement that you’re paying them both for their contribution to it and for their acknowledgment that you own all rights.
IP’s ROLE IN M&A
While you need to know the four types of IP in order to develop and preserve them, what’s more important to someone who buys or sells a business is whether or not the IP has material value.
And whether it’s “organic.”
- Organic IP is integrated with ongoing company operations. You can’t separate it from the processes and products that make up ongoing sales without doing economic damage. It’s often the main reason why a company’s gross margins are high (or not). Imagine the Coca Cola™ company’s value without its syrup formula.
- On the other hand, inorganic IP has independent value unrelated to company operations. You could sell it off without affecting operations. For the same reason, acquirers of a business are less likely to bother valuing inorganic IP fairly.
Therefore, if you’re selling a company you may want to market its inorganic IP to other buyers beforehand, or simply exclude it from the company’s sale.
Acquirers of a company pay attention to organic IP because it can impact present value three ways:
- It lowers the risk that the company won’t achieve projected cash flows. That is, it reduces the cash flow’s “discount” or “hurdle” rate;
- It increases the volume of projected cash flows;
- Or conversely, by its absence it increases the discount rate and/or reduces cash flow volume.
And for a definition of what “financial” buyers are, see our WHICH ACQUIRER FITS YOUR COMPANY BEST?
HOW TO PUT A NUMBER ON IP VALUE
Before we address this topic, a warning to the wise: valuing any kind of IP is complex and time-consuming. If you’re a business owner or CEO you have to ask yourself the question, do you feel lucky?
Do you have the time to take away from running your business and the expertise to complete these valuation techniques quickly and accurately? Few founders can — or should — say yes. Since most of them answer no, that’s one reason why investment bankers and IP attorneys exist. Yet as a manager, you ought to know in general how IP valuation works. So read on.
About Organic IP
The Case for Comparables
Since you can’t physically separate organic IP from a business without repercussions, how do you value it?
The same two ways you’d value a company – by looking at both the cash flow it generates and the value of comparable transactions. After doing that you hope that the values those two techniques produce tend to agree.
Let’s take comparables analysis first.
It’s true that you’ll have more problems extracting the value of IP using comparable transactions than when you use them to value an entire enterprise. That’s because:
- IP is by definition unique. That sometimes makes the search for comparables quixotic.
- Assuming that you do find comparable deals, info on their inner workings can be vanishingly scarce. After all, you need two things:
- A value (specifically, a net present value that considers earn-outs, seller paper, etc.);
- A relationship between that value and some other variable like annual IP revenue or cash flow. You need those multiples to calculate your own IP’s value.
The Case for Present Value
As for examining future cash flows, how do you identify what part of it was generated by IP? One way to do that is to investigate the royalties that someone would pay to “rent” rights to the IP. That someone could be a competitor. Analysts call this approach “relief from royalties.”
While potentially useful, once again this technique relies on the availability of convincing comparables. For that reason, we prefer to rely on a more quantitative method of our own making. We call it the Incremental Gross Margin approach.
Gross Margins, Anyone?
Gross margin (GM) is of course the difference between what you sell something for and what it cost you to make. Incremental GM is the degree by which a company’s gross margin is greater than the average of its competitors.
Yes, incremental GM may not be entirely due to the contributions of IP. Depending on the industry, other factors like proximity to raw materials, cheap labor, market trends, etc., can also play a role. But you can often subtract out those other factors statistically to isolate what’s left. That can only be IP.
Or you can select a group of competitors with skinny margins and determine which of those clearly appear to lack IP. Then compare their average or median GM to yours.
Some Organic IP Examples
A Hypothetical One
Consider the income statements of 15 logistics software vendors where the average GM is 55%. In this industry, cost of goods is mostly payroll for software development and maintenance.
For some reason Company A’s is 70%. Digging in, you find that the company has a trade secret, a software app (process IP) that produces quicker, cheaper, more accurate shipping schedules.
Outside of this trade secret, you don’t see any other reason for the company’s comparatively rich cash flow. You check with Company A management and they agree.
After you review the competition (you find they’re old-school low-tech players all), you finally conclude that Company A’s trade secret is largely responsible for its 15% higher GM and that this IP is good for another 10 years.
By running a present value calculation on this incremental cash flow, and the degree by which it reduces the cash flow discount rate for those 10 years, voila — you have the trade secret’s value.
Two Real-World Ones
Nvidia has a GM of 65%. The GM of fellow chipmaker Intel is 38%. Analysts agree that the 27% difference is largely due to the value of Nvidia’s collection of proprietary graphics and AI chip processing IP.
In another real-world example, we created the exhibits below for a sellside client in the tech services industry. We wanted to illustrate the value of the company’s trade secret, a process that automatically identified service quality and delivery problems. It even suggested solutions.
We knew the company had an above-average GM and company management felt this was mostly due to how the IP cut down on client turnover. This lower turnover led to lower service costs because company consultants spent less time acquainting themselves with new client circumstances and needs. The company’s IP contribution to GM is evident from the extraordinary customer loyalty shown in these two charts:
These charts and others supported our argument that the seller’s IP had created an increased margin of 10% in low-risk cash flows for a likely eight years.
About Inorganic IP
Since inorganic IP by definition isn’t integrated into ongoing operations, you can’t use Incremental Gross Margin to estimate the present value of its cash flow. So you’re limited to various types of comparables analyses like IP transactions and relief from royalties.
But if you find these approaches to be impractical or insufficiently reliable, you might simply go the old-school route of testing the market by hiring an investment banker to approach likely buyers or royalty payers under NDA.
ALL TOGETHER NOW
Is your IP operating behind the scenes to contribute a big chunk of the cash flow your company enjoys? Have you taken steps to secure it, to grow it, and when the time comes, to quantify and defend its value? Doing these things will likely return far more than the time and expense you spend on them.