Successful Technology Licensing Chapter III: Key Terms Cluster 3: Financial Terms

1. Successful Technology LicensingChapter III: Key TermsCluster 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. 1 2 3 Revenue of Patented Product Time Growth of Technology Diffusion • Market introduction – “market penetration” • Growth phase • Saturation of maturity

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 (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 • 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 • 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.