Patent Valuation Methods

For businesses, innovation is the most important means of staying competitive in the marketplace, and the only way to keep that competitive advantage is to protect innovative ideas and prevent other companies from using them. Patents provide a way for businesses to keep their ideas safe from other users, at least for a period of time. Since patents are assets to companies, it is important for investors to know how to calculate a patent's value and account for it.

Key Takeaways

  • A patent provides an inventor with exclusive rights to the patented process, design, or invention for a certain period of time.
  • For a business, patents are classified as intellectual property, a form of intangible asset.
  • Being intangible, patents are difficult to value properly, but they still must be accounted for on a firm's balance sheet.
  • Patents can be valued using a variety of methodologies depending on the type of patent and whether the patent is likely to produce future cash flows or not.

What Is a Patent?

A patent is an exclusive right granted to an inventor for a fixed time period. A patent excludes others from making, using or selling the item in question for the duration of the patent's life. Once a patent has been granted to an inventor, they have the legal authority to prohibit others from making or selling the invention in the country where the patent was granted.

Patent law was enacted by Congress, but to create a patent, inventions have to meet certain requirements.

Subject Criterion

This criterion requires that inventions not fall into three different categories:

  • Laws of nature
  • Natural phenomena
  • Abstract ideas

It also requires that inventions that seek to be patented fall within one of three categories:

  • Machines
  • Human-made products
  • Processing methods

Innovation Criterion

This criterion requires that the invention must be unknown. In other words, the invention cannot be one that has been shown to the public before or be one that is already included in an existing patent approved by the U.S. Patent and Trademark Office.

For this criterion, it also states that an invention will not be patented if the invention only differs from a previously patented invention by making obvious modifications.

Description Criterion

This criterion requires that the inventor adequately describe the invention in a manner that will enable a person with ordinary skills (in other words, a layman) to understand the invention.

Types of Patents:

Plant Patent

A plant patent is granted by the government to an inventor who has invented or discovered a new variety of plant. This patent lasts 20 years from the date of filing and prevents anyone else from selling or using the plant.

Utility Patent

Utility patents are granted to inventors who invent or discover any new and useful process, software or machine, or any new functional improvement to an existing invention. A utility patent usually lasts 20 years from the filing date.

Design Patent

A design patent protects an invention's ornamental design, improved decorative appearance or shape. This patent is appropriate when the fundamental product already exists and is not being improved upon in function but only in style. This patent lasts 14 years from the date the patent is granted.

Valuing a Patent

It is very important for businesses to account for a patent's value in their books. This value is especially important to businesses in transactions involving mergers and acquisitions, business dissolution, bankruptcy, and infringement analysis.

A key part of valuing a patent is to obtain a value of the invention in question. It does not make good business sense to obtain a patent on an invention that will not result in a suitable return for the inventor. Because patents are intangible assets, it is often difficult to assign a monetary value to them. The most common patent-valuation method is the economic-analysis method.

The Economic Analysis Method

The economic-analysis valuation method has three approaches: cost, income, and market.

Cost Approach

This approach states that a patent's value is the replacement cost or the amount that would be necessary to replace the protection right on the invention. The replacement cost of an item refers to the amount of money that would be paid, at the present time, to replace the item. If an inventor has an item that they have patented, the patent's value would be the amount of money required to replace that invention. A prospective client would not be willing to pay more for a patent than the amount they would have to pay to obtain an equivalent protection right.

Income Approach

This method looks to future cash flows in determining valuation. It states that a patent's value is the present value of the incremental cash flows or cost savings it will help provide. When a company or individual develops a product that has the potential to be patented, the underlying hope is that the patented product will cause an increase in sales, or at least be a cost-saving measure in the company. This approach states that the patent's value is the current cash value of these future benefits.

Market Approach

This methodology involves determining what a willing buyer would pay for similar property. In other words, the patent's value is approximately equal to the value of similar patents or patented products that have been sold and purchased before.

Two things must be in place for this approach to be used for patent valuation:

  • Existence of an active market for the patent, or a similar one
  • Past transactions of comparable property

Look for similar values for the following items when looking for comparable patents:

  • Industry characteristics
  • Market share or market share potential
  • Growth prospects

Getting a Patent

In many cases, it can take about two years for applications received in the U.S. Patent and Trademark Office to be processed. Applications are usually numbered in sequential order, and applicants who apply by mail are usually informed within eight weeks of the application number and official filing date. If filed electronically, the application number is available within minutes. While waiting for the application to get approved, the inventor may make products with a "patent pending" designation. The cost associated with obtaining a patent usually includes legal fees, filing fees, prosecution fees, translation costs, and maintenance fees.

To learn more about costs associated with filing patents, see the fee information on the United States Patents and Trademark Office (USPTO) website.

The Bottom Line

Both businesses and investors must be able to account for a patent's value. After all, new inventions and innovations often keep companies on top. As intangible assets, patents present a challenge in terms of valuation, but they can be pivotal in determining a company's success – and the success of investors who buy these companies' stocks.

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