JOURNAL OF THE LICENSING EXECUTIVES SOCIETY. Volume XXXVII No. 4 December 2002

Transcription

1 les Nouvelles JOURNAL OF THE LICENSING EXECUTIVES SOCIETY Volume XXXVII No. 4 December 2002 Use Of The 25 Per Cent Rule In Valuing IP ROBERT GOLDSCHEIDER, JOHN JAROSZ & CARLA MULHERN Page 123 Brain Power Use It Or Lose It BENNY BROWNE Page 134 New Guidelines For Valuing In Process R & D TERRY ALLEN, JIM RIGBY & RIZVANA ZAMEERUDDIN Page 139 Technolgy Transfer In Brazil: A Guide To Licensing Foreign Technology In Brazil CLARISSE ESCOREL & TARA PENNINGTON Page 143 Managing Intellectual Assets For Shareholder Value BRIAN NAPPER & SHELLY IRVINE Page 148 Licensing Of New Products: Determinants Of Royalty Structure TRICHY V. KRISHNAN & MURALI SANTHANAM Page 155 Negotiation Strategies For Technology Acquistion Contracts JEFFREY J. BLATT Page 173 Recent Decisions In The United States BRIAN BRUNSVOLD & JOHN PAUL Page 176 Open Book From Ideas To Assets Investing Wisely In Intellectual Property JOHN RAMSAY Page 179

2 Use Of The 25 Per Cent Rule In Valuing IP BY ROBERT GOLDSCHEIDER, JOHN JAROSZ AND CARLA MULHERN* Introduction As the importance of intellectual property ( IP ) protection has grown, so has the sophistication of tools used to value it. Discounted cash flow, 1 capitalization of earnings, 2 return on investment, 3 Monte Carlo simulation 4 and modified Black-Scholes option valuation methods 5 have been of great value. Nonetheless, the fairly simple 25 Per Cent Rule ( Rule ) is over 40 years old and its use continues. Richard Razgaitis has called it the most famous heuristic, or rule of thumb, for licensing valuation. 6 The Rule suggests that the licensee pay a royalty rate equivalent to 25 per cent of its expected profits for the product that incorporates the IP at issue. The Rule has been primarily used in valuing patents, but has been useful (and applied) 1. D.J. Neil, Realistic Valuation of Your IP, 32 les Nouvelles 182 (December 1997); Stephen A. Degnan, Using Financial Models to Get Royalty Rates, 33 les Nouvelles 59 (June 1998); Daniel Burns, DCF Analyses in Determining Royalty, 30 les Nouvelles 165 (September 1995); Russell L. Parr & Patrick H. Sullivan, Technology Licensing: Corporate Strategies For Maximizing Value (1996); Richard Razgaitis, Early-Stage Technologies: Valuation and Pricing (1999). 2. Robert Reilly & Robert Schweihs, Valuing Intangible Assets (1999). 3. Parr and Sullivan, pp V. Walt Bratic et al., Monte Carlo Analyses Aid Negotiation, 33 les Nouvelles 47 (June 1998); Razgaitis, pp Dr. Nir Kossovsky & Dr. Alex Arrow, TRRU Metrics: Measuring The Value and Risk of Intangible Assets, 35 les Nouvelles 139 (September 2000); F. Peter Boer, The Valuation of Technology: Business and Financial Issues In R&D, (1999). 6. Razgaitis, p See, e.g., Richard S. Toikka, In Patent Infringement Cases, the 25 Per Cent Rule Offers a Simpler Way to Calculate Reasonable Royalties. After Kumho Tire, Chances are the Rule Faces Challenges to its Daubert Reliability, Legal Times 34 (August 16, 1999). 8. Robert Goldscheider, Litigation Backgrounder for Licensing 29 les Nouvelles 20, 25 (March 1994); Robert Goldscheider, Royalties as Measure of Damages 31 les Nouvelles 115, 119 (September 1996). in copyright, trademark, trade secret and know-how contexts as well. Since the Rule came into fairly common usage decades ago, times, of course, have changed. Questions have been raised on whether the factual underpinnings for the Rule still exist (i.e., whether the Rule has much positive strength) such that it can and should continue to be used as a valid pricing tool (i.e., whether the Rule has much normative strength). In this paper, we describe the Rule, address some of the misconceptions about it and test its factual underpinnings. To undertake the latter, we have examined the relationship between real-world royalty rates and real-world industry and company profit data. In general, we have found that the Rule is a valuable tool (rough as it is), particularly when more complete data on incremental IP benefits are unavailable. The Rule continues to have a fair degree of both positive and normative strength. History of the Rule One of the authors Robert Goldscheider 7 did, in fact, undertake an empirical study of a series of commercial licenses in the late 1950s. 8 This involved one of his clients, the Swiss subsidiary of a large American company, with 18 licensees around the world, each having an exclusive territory. The term of each of these licenses was for three years, with the expectation of renewals if things continued to go well. Thus, if any licensee turned sour, it could promptly be replaced. In fact, however, even though all of them faced strong competition, they were either first or second in sales volume, and probably profitability, in their respective markets. These licenses therefore constituted the proverbial win-win situation. In those licenses, the intellectual property rights transferred included: a portfolio of valuable patents; a continual flow of know-how; trademarks developed by the licensor; and copyrighted marketing and product description materials. For those licenses, the licensees tended to generate profits of approximately 20 per cent of sales on which they paid royalties of 5 per cent of sales. Thus, the royalty rates were found to be 25 per cent of the licensee s profits on products embodying the patented technology. 9 *Robert Goldscheider, Chairman, International Licensing Network. John Jarosz and Carla Mulhern, Principals, Analysis Group/Economics. We would like to thank the following individuals for their hard work and useful comments on earlier drafts of this paper: Jaime Baim, Laura Boothman, Jeff Kinrich, Jennifer Price, Chris Vellturo and Robert Vigil. The views expressed here are ours and do not necessarily represent those of others at the International Licensing Network or Analysis Group/Economics. les Nouvelles December

3 Mr. Goldscheider first wrote about the Rule in He noted, however, that in some form it had been utilized by valuation experts prior to that. 11 For example, in 1958, Albert S. Davis, the General Counsel of Research Corporation, the pioneer company in licensing university-generated technology, wrote: If the patents protect the Licensee from competition and appear to be valid the royalty should represent about 25% of the anticipated profit for the use of the patents. 12 A form of the Rule, however, existed even decades before that. In 1938, the 6th Circuit Court of Appeals, in struggling with the problem of determining a reasonable royalty, heard expert testimony to the affect that: ordinarily royalty rights to the inventor should bear a certain proportion to the profits made by the manufacturer and that the inventor was entitled to a proportion ranging from probably ten per cent of the net profits to as high as thirty per cent, which should be graduated by the competitive situation. 13 Regardless of its origins and author(s), the concept has aided IP valuators for many years. Explanation of the Rule In its pure form, the Rule is as follows. An estimate is made of the licensee s expected profits for the product that embodies the IP at issue. Those profits are divided by the expected net sales over that same period to arrive at a profit rate. That resulting profit rate, say 16 per cent, 9. Robert Goldscheider, Technology Management: Law/Tactics/Forms (1991). 10. Robert Goldscheider & James T. Marshall, The Art of Licensing From the Consultant s Point of View, 2 The Law and Business of Licensing 645 (1980). 11. Robert Goldscheider, Technology Management: Law/Tactics/Forms (1991). 12. Albert S. Davis, Jr., Basic Factors to be Considered in Fixing Royalties, Patent Licensing, Practicing Law Institute, Horvath v. McCord Radiator and Mfg. Co. et al., 100 F.2d 326, 335 (6th Cir. 1938). 14. In the reasonable royalty determination in Standard Manufacturing Co., Inc. and DBP, Ltd. v. United States, both sides experts focused on the patent holder s profit rate. The Court took exception noting that defendant s profits were a more realistic and reliable estimation of profits which were to [the plaintiff] by the infringement since they are derived from the actual sale of [the infringing product]. Standard Manufacturing Co., Inc. and DBP, Ltd. v. United States, 42 Fed. C1. 748, 767 (1999). The Court noted that a variety of federal courts held the same, citing Mahurkar v. C.R. Bard, Inc., Davol Inc. and Bard Access System, Inc. 79 F.3d 1572, 1580 (Fed. Cir. 1996) (district court did not err in calculating portion of award when it initially used infringer s profit rate); TWM Manufacturing Co., Inc. v. Dura Corp. and Kidde, Inc. 789 F.2d 895, 899 (Fed. Cir. 1986) (affirming district court s computation of damages based on infringer s profits); Trans-World Manufacturing Corp. v. Al Nyman & Sons, Inc. and Al-Site Corporation, 750 F.2d 1552, 1568 (among factors considered in determining reasonable royalty was the infringer s anticipated profit from invention s use, and evidence of infringer s actual profits probative of anticipated profit.) is then multiplied by 25 per cent to arrive at a running royalty rate. In this example, the resulting royalty rate would be 4 per cent. Going forward (or calculating backwards, in the case of litigation), the 4 per cent royalty rate is applied to net sales to arrive at royalty payments due to the IP owner. The licensee/user receives access to the IP, yet the price (i.e., royalty) it pays will still allow it to generate positive product returns. The theory underlying this rule of thumb is that the licensor and licensee should share in the profitability of products embodying the patented technology. The a priori assumption is that the licensee should retain a majority (i.e., 75 per cent) of the profits because it has undertaken substantial development, operational and commercialization risks, contributed other technology/ip and/or brought to bear its own development, operational and commercialization contributions. Focus of the Rule is placed on the licensee s profits because it is the licensee who will be using the IP. 14 The value of IP is, for the most part, dependent upon factors specific to the user (e.g., organizational infrastructure). 15 IP, like any other asset, derives its value from the use to which it will be put. 16 Focus also is placed on expected profits because the license negotiation is meant to cover forthcoming and on-going use of the IP. 17 It is the expected benefits from use of the IP that will form the basis for the licensee s payment of an access fee. Past, or sunk costs, typically should be ignored because a decision is being made about the future. 18 That is, what going-forward price results in the product being a sound investment? Any product in which the projected marginal benefits exceed the projected marginal costs should be undertaken. Focus is placed on long-run profits because access to IP often will afford the user more than just immediate benefits. 19 Focusing on a single month or single year typically will not properly represent the forthcoming and on-going benefits of the IP. In many occasions, it takes some period of time for a new company or new product to obtain its operational efficiencies and a steady state. Furthermore, up-front investments often need to be amortized over the economic life of a product (not just its starting years) in order to evaluate properly the economic returns to the product. 15. Baruch Lev, Rethinking Accounting, Financial Executive Online Edition, March/ April 2002 Cover Story, maggable/articles/ coverstory.cfm. 16. In some circumstances, the licensor s profits may provide some guidance. That is, those profits may, in part, reflect his/her appetite for a license and those profits may serve as a surrogate for missing or unknown licensee profits. 17. Razgaitis, p Fonar Corporation and Dr. Raymone V. Damadian v. General Electric Company and Drucker & Genuth, MDS, P.C. d/b/a South Shore Imaging Associates, 107 F. 3d 1543 (Fed. Cir. 1997). Hanson v. Alpine Valley Ski Area, Inc., 718 F.2d 1075 (Fed. Cir. 1983). 18. Richard Brealey & Stewart C. Myers, Principles of Corporate Finance, 123 (6th Ed. 2000). 19. Razgaitis, p December 2002 les Nouvelles

4 Finally, the Rule places focus on fully-loaded profits because they measure the (accounting) returns on a product. Gross profits represent the difference between revenues and manufacturing costs. Gross profits, however, do not account for all of the operating expenses associated with product activity. Those costs include marketing and selling ( M&S ), general and administrative ( G&A ) and research and development ( R&D ) expenses. Some of those costs are directly associated with product activity, others are common across product lines. Fully-loaded profits account for the fact that a variety of non-manufacturing overhead expenses are undertaken to support the product activity, even though they may not be directly linked to certain volume or activity levels. And such costs are often driven by product activity. Failure to take into account these operating expenses may lead to an overstatement of the returns associated with the sales of a product. According to Smith and Parr: Omission of any of these [overhead] expenses overstates the amount of economic benefits that can be allocated to the intellectual property. In a comparison of two items of intellectual property, the property that generates sales, captures market share, and grows, while using less selling and/or support efforts, is more valuable than the one that requires extensive advertising, sales personnel, and administrative support. The economic benefits generated by the property are most accurately measured after considering these expenses. 20 According to Parr: The operating profit level, after consideration of the nonmanufacturing operating expenses, is a far more accurate determinant of the contribution of the intellectual property. The royalty for specific intellectual property must reflect the industry and economic environment in which the property is used. Revenues Cost of Sales Gross Margin 21. Parr, pp Figure 1 25 Per Cent Rule Illustration - Revenue Side Operating Expenses Operating Profits Revenues Cost of Sales No Patent $100 $40 $60 $30 $30 Revenue Enhancing Patent $110 $40 $70 $30 $40 25 Per Cent Rule ($40*25%)/ $110=9.1% Some environments are competitive and require a lot of support costs which reduce net profits. Intellectual property that is used in this type of environment is not as valuable as intellectual property in a high-profit environment where fewer support costs are required. A proper royalty must reflect this aspect of the economic environment in which it is to be used. A royalty based on gross profits alone cannot reflect this reality. 21 Fully-loaded profits may refer to either pretax profits or operating profits. Pretax profits are calculated as revenues minus: 1) cost of goods, 2) non-manufacturing overhead expenses and 3) other income and expenses. The historical relationships underlying the 25 Per Cent Rule, however, have in fact been between royalty rates and operating profits. 22 The latter is revenues minus: 1) cost of goods sold and 2) non-manufacturing overhead. Not subtracted out is other income and expenses. In many cases, these two measures of profit are quite similar; in other cases, they are not. Given that the value of intellectual property is independent of the way in which a firm (or project) is financed, 23 from a theoretical point of view, the operating profit margin is the correct measure to use. Suppose that firm A and firm B each have one piece of identical intellectual property and each manufactures and sells one product that embodies that intellectual property. The only difference between the firms is that firm A is heavily financed by debt and firm B is not. Firm A would then have significant 22. Robert Goldscheider, Technology Management: Law/Tactics/Forms (1991), Razgaitis, p Brealey & Myers, Chapters 2 & 6. Figure 2 25 Per Cent Rule Illustration - Cost Side No Patent $100 $40 Cost Reducing Patent $100 $30 25 Per Cent Rule Gross Margin $60 $ Gordon V. Smith & Russell L. Parr, Valuation of Intellectual Property and Intangible Assets, 362 (2nd Ed. 1994). Operating Expenses Operating Profits $30 $30 $30 $40 ($40*25%)/ $100=10% les Nouvelles December

5 interest expenses to deduct from its operating profits resulting in pretax profit levels below operating profit levels. Firm B does not have any interest expense to deduct. Thus, on an operating profits basis, firm A and firm B would have equivalent profit margins; but, on a pretax basis, firm B would be considerably more profitable. Application of the 25 Per Cent Rule to operating profits would result in the same royalty rate in the case of firm A and firm B; whereas, application of the Rule to pretax profits would result in a lower royalty rate for firm A. Since the underlying intellectual property and the products embodying it are identical for both firms, one would expect to obtain the same resulting royalty rate. Thus, application of the Rule to operating profits would yield the appropriate results. Illustration of the Rule IP, like any asset, can be (and is) valued using three sets of tools. They are often referred to as the Income Approach, the Market Approach and the Cost Approach. 24 The Income Approach focuses on the returns generated by the user owing to the asset at issue. The Market Approach focuses on the terms of technology transfers covering comparable assets. The Cost Approach focuses on the ability (and cost) to develop an alternative asset that generates the same benefits. The 25 Per Cent Rule is a form of the Income Approach. It is particularly useful when: 1) the IP at issue comprises a significant portion of product value and/or 2) the incremental benefits of the IP are otherwise difficult to measure. IP is often priced based on the enhanced revenues and/or reduced 24. Shannon P. Pratt et al., Valuing a Business: The Analysis and Appraisal of Closely Held Companies, (3rd Ed. 1996); Shannon P. Pratt et al., Valuing Small Businesses and Professional Practices, (2nd Ed. 1993); Gordon V. Smith & Russell L. Parr, Valuation of Intellectual Property and Intangible Assets, (2nd Ed. 1994); Robert Reilly & Robert Schweihs, Valuing Intangible Assets (1999). costs that it generates versus the next best alternative. 25 The extent of that excess (or incremental value), holding all else constant, may form the upper bound for the appropriate price. 26 The 25 Per Cent Rule can be (and is) applied when the licensee reports product line revenue and operating profit data for the product encompassing the IP. It need not be the case that the IP at issue be the only feature driving product value. (In fact, underlying the Rule is the understanding that a variety of factors drive such value.) That is why only a portion of the profits 25 per cent is paid in a license fee. And that is why the appropriate profit split may be much less than 25 per cent of product profit. The Rule also can be (and is) applied when the licensee does not report profits at the operating profit level. (In fact, there are very few instances in which firms report product profits at such a level.) As long as product revenues and costs of goods sold are reported (i.e., gross margins are available), the accountant or economist can (and does) allocate common (or non-manufacturing overhead) costs to the product line in order to derive operating profits. The illustration in Figure 1 shows how the Rule is applied. A patent may enhance or improve product revenues through increased prices (though that may occur with a reduction in volume 27 ) or through increased volume. The second column in Figure 1 illustrates the impact of a revenue-enhancing patent. Applying the 25 Per Cent Rule to the expected operating profits results in a royalty rate of 9.1 per cent. A patent may also reduce product costs. Figure 2 illustrates that by 25. Paul E. Schaafsma, An Economic Overview of Patients, 79 Journal of the Patent Trademark Office Society 251, 253 (April 1997). 26. Jon Paulsen, Determining Damages for Infringements, 32 les Nouvelles 64 (June 1997). applying the 25 Per Cent Rule to such expected operating profits results in a royalty rate of 10 per cent. Valuators (and courts) who use the 25 Per Cent Rule occasionally split the expected or actual cost (i.e., incremental) savings associated with the IP at issue. 28 According to Degnan and Horton s survey of licensing organizations who base a royalty payment on projected cost savings, almost all of them provide for the licensee paying 50 per cent or less of the projected savings. 29 The apparent reasoning is that such incremental benefits should be shared. Splitting the cost savings by 75/ 25, however, may not be consistent with the 25 Per Cent Rule. In Figure 2, the incremental (or additional) cost savings are $10. Splitting that amount ($10) by 25 per cent, results in a running royalty rate of 2.5 per cent ($10 x 25%/$100), which is 1/16 of the new product profits, rather than 1/4. Applying the Rule to incremental savings (or benefits) results in a running royalty that is lower than that dictated by the 25 Per Cent Rule. It may under compensate the IP owner. The 25 Per Cent Rule, in its pure sense, should be applied to fully loaded operating profits, not to already computed incremental benefits. Several courts have (implicitly) recognized the problem of splitting incremental benefits. In Ajinomoto, the district court wrote: Although the licensing rule of 27. Paul A. Samuelson & William D. Nordhaus, Economics 47 (17th ed. 2001). Crystal Semiconductor v. Tritech Microelectronics International, Inc., 246 F. 3d 1336 (Fed. Cir. 2001). 28. Standard Manufacturing Co., Inc. and DBP, Ltd. v. United States, 42 Fed. C1 748, (1999). Ajinomoto Inc. v. Archer-Daniels- Midland Co., No SLR, 1998 U.S. Dist. LEXIS 3833, (D. Del. March 13, 1998). Tights, Inc. v. Kayser-Roth Corp. 442 F. Supp. 159 (M.D.N.C. 1977). Dow Chemical Co. v. United States, 226 F. 3d 1334 (Fed. Cir. 2000) Razgaitis, pp Stephen A. Degnan & Corwin Horton, A Survey of Licensed Royalties, 32 les Nouvelles 91, 95 (June 1997). 126 December 2002 les Nouvelles

6 thumb dictates that only one-quarter to one-third of the benefit should go to the owner of the technology given [defendant s] relatively low production costs and its belief that the sale of [the product] would increase [convoyed sales], the court concludes that [defendant] would have been willing to share all of the benefit with [plaintiff] and that [plaintiff] would have settled for nothing less. 30 Furthermore, in Odetics, the Federal Circuit wrote that one expects [an infringer] would pay as much as it would cost to shift to a non-infringing product. 31 And in Grain Processing, the Federal Circuit adopted the lower court s reasoning that an infringer would not have paid more than a 3% royalty rate. The court reasoned that this rate would reflect the cost difference between (infringement and non-infringement). 32 To the extent that incremental benefits (i.e., cost savings) have already been calculated, any profit split applied to those may not be consistent with the 25 Per Cent Rule. In theory, the licensee should be willing to accept a royalty that is close to 100 per cent (not 25 per cent) of the cost savings. Application of the Rule The 25 Per Cent Rule is used in actual licensing settings and litigation settings. Over the past three decades, a variety of commentators have noted its widespread use. 33 In their survey of licensing executives, which was published in 1997, Degnan and Horton found that roughly 25 per cent (as a sheer coincidence) of licensing organizations used the 25 Per Cent Rule as a starting point in negotiations. 34 They also found that roughly 50 per cent of the organizations used a profit sharing analysis (of which 30. Ajinomoto Inc. v. Archer-Daniels-Midland Co., No SLR, 1998 U.S. Dist. LEXIS 3833, at 44 n.46 (D. Del. March 13, 1998). 31. Odetics, Inc. v. Storage Technology Corp. 185 F. 3d 1259, 1261 (Fed. Cir. 1999). 32. Grain Processing Corp. v. American Maize- Products Co., 185 F. 3d 1341, 1345 (Fed. Cir. 1999). 33. Robert E. Bayes, Pricing the Technology, in Current Trends In Domestic and International Licensing 369, 381 (1977). Marcus B. Finnegan & Herbert H. Mintz, Determination of a Reasonable Royalty in Negotiating a License Agreement: Practical pricing for Successful Technology Transfer, 1 Licensing Law and Business Report 1, 19 (June-July 1978). Lawrence Gilbert, Establishing a University Program, 1 The Law and Business of Licensing (1980). Robert Goldscheider & James T. Marshall, The Art of Licensing-From the Consultants Point of View, 2 The Law and Business of Licensing 645 (1980). H.A. Hashbarger, Maximizing Profits as a Licensee, 2 The Law and Business of Licensing 637 (1980). Alan C. Rose, Licensing a Package Lawfully in the Antitrust Climate of 1972, 1 The Law and Business of Licensing 267 (1980). Yoshio Matsunaga, Determining Reasonable Royalty Rates, les Nouvelles 216, 218 (December 1983). The Basics of Licensing: Including International License Negotiating Thesaurus, les 13 (1988). Edward P White, Licensing: A Strategy For Profits, 104 (1990). Martin S. Landis, Pricing and Presenting Licensed Technology, 3 The Journal of Proprietary Rights 18, (August 1991). Wm. Marshall Lee, Determining Reasonable Royalty, les Nouvelles 124 (September 1992). David C. Munson, Licensing Technology: A Financial Look at the Negotiational Process, 78 J.P.T.O.S. 31, 42 n.21 (January 1996). Schaafsma, p Munson, Figuring the Dollars in Negotiations, 33 les Nouvelles 88 (June 1998). Robert Reilly & Robert Schweihs, Valuing Intangible Assets , 503 (1999). 34. Degnan and Horton, p Degnan and Horton, p. 92. the 25 Per Cent Rule is a variant) in determining royalties. 35 A dramatic employment of the Rule occurred in the early 1990 s in the course of negotiations between two major petrochemical companies, respectively referred to as A and B. A was a leading manufacturer of a basic polymer product ( X ), with annual sales of over $1 billion. Its process ( P-1 ) required the purchase from B of an intermediate compound ( Y ) in annual volumes of over $400 million. A owned a patent on its P-1 process to manufacture X, which would expire in 7 years. A developed a new process to make X ( P-2 ) to which it decided to switch all its production of the polymer concerned, essentially for cost reasons, but also because P-2 was more flexible in producing different grades of X. P-2 did not involve the need to purchase Y from B. Rather than simply abandon P-1, however, A decided to offer B the opportunity to become the exclusive worldwide licensee of P-1. The argument was that such a license could be profitable to B because it was a basic producer of Y (which A had been purchasing at a price containing a profit to B), and B could thus manufacture X on a cost-effective basis. Another attraction of such a license would be that it could compensate B for the loss of its sales of Y to A. B was interested to take such a license to P-1, and offered to pay a 5 per cent running royalty on its sales of polymer made in accordance with P-1. A decided to test the reasonableness of this offer by applying the 25 Per Cent Rule, a good portion of which analysis could employ hindsight. A understood the market for X, past and present, and had what it considered to be realistic projections for the future. A had made such a study because it intended to remain in the market for X, utilizing P-2. A was also able to calculate pro-forma profitability to B by subtracting B s margin on its sales of Y to A for use in P-1. This analysis revealed that B should be able to operate as a licensee under A s P-1 patent at an operating profit of 44 per cent. A shared its fully documented analysis with B and asked please tell us if we are wrong. If not, A would expect to receive an 11 per cent royalty based on B s sales of X using A s patented P-1 process, based on the 25 Per Cent Rule, rather than the 5 per cent that was offered. Following study of A s work product, B (somewhat surprised and reluctantly) agreed with A s conclusion. B accepted these terms because B would still make a 33 per cent operating profit under the license, which was higher than B s normal corporate operating profit rate. Over the remaining life of its P-1 patent, this additional 6 per cent royalty amounted to added profit, les Nouvelles December

7 in fact, of several hundred million dollars to A. In Standard Manufacturing Co., Inc. and DBP, Ltd. v. United States, 36 the U.S. Court of Claims employed a two-step approach to determining a litigated reasonable royalty. The first step involved an estimation of an initial or baseline rate. The second step entailed an adjustment upward or downward depending on the relative bargaining strengths of the two parties with respect to each of the (15) factors described in Georgia-Pacific Corp. v. United States Plywood Corporation. 37 The Standard Manufacturing Court found the application of the 25 Per Cent Rule to be an appropriate method for determining the baseline royalty rate. And in support of its use of the 25 Per Cent Rule, it cited defendant s expert s (Robert Goldscheider s) considerable practical experience with the Rule. 38 The Court also noted that a number of other federal courts had recognized that the 25 Per Cent Rule is a rule of thumb typical in the licensing field. 39 For example, the 25 Per Cent Rule has been useful in situations where a party analyzes its own IP for management or tax reasons, or as part of a merger, acquisition or divestiture. The Rule has been employed 36. Standard Manufacturing Co., Inc. and DBP, Ltd. v. United States, 42 Fed. C (1999 U.S. Claims LEXIS 11). 37. Georgia-Pacific Corp. v. United States Plywood Corporation, 318 F. Supp (S.D.N.Y. 1970) modified and aff d, 446 F.2d 295 (2d Cir. 1971). 38. Standard Manufacturing Co., Inc. and DBP, Ltd. v. United States, 42 Fed. Cl. 748, (1999 U.S. claims LEXIS 11). 39. Ajinomoto Co., Inc. v. Archer-Daniels- Midland Co., No SLR, 1998 U.S. Dist. LEXIS 3833, at 052 n.46 (D. Del. March 13, 1998); W.L. Gore & Associates, Inc. v. International Medical Prosthetics Research Associates, Inc., 16 USPQ 2d (D. Ariz. 1990); Fonar Corporation and Dr. Raymond V. Damadian v. General Electric Company and Drucker & Genuth MDS, P.C. d/b/a/ South Shore Imaging Associates, 107 F.3d 1543 (Fed. Cir. 1997). See also, Donald S. Chisum, Chisum On Patents, [3] [iv], , (1993 and Supp. 1997). Fromson v. Western Litho Plate & Supply Co., 853 F. 2d 1568 (Fed. Cir. 1988). Industry Automotive Chemicals Computers Consumer Goods Total Figure 3 Licensed Royalty Rates (Late 1980 s ) No. of Licenses ,533 Minimum Royalty Rate 1.0% 0.5% 0.2% 0.0% 0.0% Maximum Royalty Rate 15.0% 25.0% 15.0% 17.0% 77.0% Median Royalty Rate 4.0% 3.6% 4.0% 5.0% Electronics % 15.0% 4.0% Energy & Environment % 20.0% 5.0% Food % 7.0% 2.8% Healthcare Products % 77.0% 4.8% Internet % 40.0% 7.5% Machine/Tools % 25.0% 4.5% Media & Entertainment % 50.0% 8.0% Pharma & Biotech % 40.0% 5.1% Semiconductors % 30.0% 3.2% Software % 70.0% 6.8% Telecom % 25.0% 4.7% Industry Automotive Chemicals Computers Consumer Goods Figure 4 Industry Profit Rates ( ) No. of Companies Wtd. Avg. Operating Margin 5.0% 11.1% 6.9% 11.0% Electronics % Energy & Environment % Food % Healthcare Products % Internet % Machine/Tools % Media & Entertainment % Pharma & Biotech % Semiconductors % Software % Telecom % Total 6, % 128 December 2002 les Nouvelles

8 as follows: the remaining economic life of the property being valued, which may be shorter than the remaining legal life of any patents that may be part of the analysis, is estimated; the operating profit rate expected during each of such years is projected and 25 per cent (or another rate considered appropriate in accordance with the Rule) is applied to each of the annual figures; a discounted cash flow analysis is performed, using an appropriate discount rate to convert future flows into a current year lump sum amount. The rationale for this appraisal methodology is that the plus or minus 25 per cent apportionment is the price of a reasonable royalty that the appraising party would be willing to pay for a license for this property, at that point in time, assuming that it did not own it. The Rule, whether used in litigation or non-litigation settings, provides a fairly rough tool to be augmented by a more complete royalty analysis. The precise split of profits should be adjusted up or down depending on the circumstances of each case and relative bargaining positions of the two parties. 40 If a licensor comes to the bargaining table armed with a relatively strong arsenal of assets, it may be entitled to 25 per cent, or perhaps more, of the pie. Correspondingly, a weak arsenal of assets supports a lower split. In determining the appropriate split of profits, the factors established in the Georgia-Pacific case are quite helpful. 41 In fact, many of the courts that have used the Rule in litigation 40. Robert Goldscheider, Litigation Backgrounder for Licensing, 29 les Nouvelles 20, 25 (March 1994). 41. Georgia Pacific v. United States Plywood Corp., 318 F. Supp (S.D.N.Y. 1970) modified and aff d, 446 F.2d (2d Cir. 1971), the court set forth 15 factors that should be considered in determining a reasonable royalty. See also, Stephen A. Degnan, Using Financial Models to Get Royalty Rates, 33 les Nouvelles 59, 60 (June 1998). Industry Automotive Chemicals Computers Consumer Goods Figure 5 Licensee Profits ( ) No. of Companies Licensee Wtd. Avg. Operating Margin 6.3% 11.6% 8.0% 16.2% Electronics % Energy & Environment % Food 6 7.9% Healthcare Products % Internet % Machine/Tools 8 9.4% Media & Entertainment % Pharma & Biotech % Semiconductors % Software % Telecom % Total % Industry Automotive Chemicals Computers Consumer Goods Total Figure 6 Royalty Rates and Licensee Profits Median Royalty Rate 5.0% 3.0% 2.8% 5.0% 4.3% Average Operating Profits 6.3%* 11.6% 8.0% 16.2% 15.9% Royalty as % of Profit Rate 79.7% 25.9% 34.4% 30.8% Electronics 4.5% 8.8% 51.3% Energy & Environment 3.5% 6.6% 52.9% Food 2.3% 7.9% 28.7% Healthcare Products 4.0% 17.8% 22.4% Internet 5.0% 1.0% 492.6% Machine/Tools 3.4% 9.4% 35.8% Media & Entertainment 9.0% %* -3.0% Pharma & Biotech 4.5% 24.5% 17.7% Semiconductors 2.5% 29.3% 8.5% Software 7.5% 33.2% 22.6% Telecom 5.0% 14.1% 35.5% * Fewer than 5 observations in data set. 26.7% les Nouvelles December

9 have done so in the context of evaluating Georgia-Pacific factor #13 the portion of the realizable profit that should be credited to the invention as distinguished from non-patented elements, the manufacturing process, business risks, or significant features or improvement added by the infringer. Justification for the Rule The Rule, based on historical observations, provides useful guidance for how a licensor and licensee should consider apportioning the benefits flowing from use of the IP. Somewhat untenable (and unrealistic) is guidance that either the licensor or licensee is entitled to all of the returns. No bargain would be reached. Though a 50:50 starting split has a ring of a win-win situation, in fact, the evidence suggests otherwise. Richard Razgaitis has identified 6 reasons for why a 25/75 (starting) split makes sense. 42 First, that s the way it is. Numerous licensors and licensees have agreed to a 25/75 split. It is, according to him, the industry norm. Second, typically 75 per cent of the work needed to develop and commercialize a product must be done by the licensee. Third, he who has the gold makes the rules. Licensees have considerable leverage because of the numerous investment alternatives open to them. Fourth, a 3-times payback ratio is common. Such is obtained by a licensee retaining 75 per cent of the return by investing 25 per cent. Fifth, technology is the first of the 4 required steps of commercialization. The others are making the product manufacturable, actually manufacturing it and selling it. Finally, the ratio of R&D to profits is often in the range of 25 to 33 per cent. Criticisms of the Rule Despite (or perhaps because of) its widespread use, the 25 Per Cent Rule has been criticized in several ways. First, it has been characterized as a crude tool and as arbitrary. According to Paul Schaafsma: 42. Razgaitis, pp Number of Industries Figure 7 Distribution of Profit Splits - Licensee Profits <0% 0%-20% 21%-40% 41%-60% 61%-80% >80% Figure 8 Royalty Rates and Successful Licensee Profits Automotive Chemicals Computers Consumer Goods Number of Industries Industry Total Median Royalty Rate 5.0% 3.0% 2.8% 5.0% 4.3% Average Operating Profits 11.3%* 12.0% 8.3% 18.4% 18.8% Royalty as % of Profit Rate 44.1% 25.0% 33.3% 27.1% Electronics 4.5% 13.1% 34.3% Energy & Environment 3.5% 9.2% 38.1% Food 2.3% 14.2% 15.8% Healthcare Products 4.0% 18.5% 21.6% Internet 5.0% 10.4% 48.0% Machine/Tools 3.4% 9.6% 35.0% Media & Entertainment 9.0% -13.5%* -66.7% Pharma & Biotech 4.5% 25.8% 17.4% Semiconductors 2.5% 31.9% 7.8% Software 7.5% 25.1% 21.4% Telecom 5.0% 14.5% 34.5% * Fewer than 5 observations in data set. 26.6% Figure 9 Distribution of Profit Split - Successful Licensee Profits <0% 0%-20% 21%-40% 41%-60% 61%-80% 130 December 2002 les Nouvelles

10 A typical rule of thumb is for the licensor to command 25% of the profit. While this attempts to link the value of the patent to the profitability of commercial exploitation, because it does not relate to the value and degree to which the patent can exclude substitute products and therefore command a patent profit, it is little better than [an] industry norm. Patented products add to [ ] economic profit the patent profit tied into the ability of the patent to further exclude substitutes. the portion of the total profit can vary greatly even within a given industry. Adding these values together, and multiplying by an arbitrary fraction to derive the value of a patent is an exercise in arbitrary business analysis. 43 According to Mark Berkman: [The 25 Per Cent Rule does] not take into account specific circumstances that will determine the actual value of the patent at issue. No consideration is given to the number or value of economic alternatives or the incremental value of using the patented technology over other viable alternatives. 44 And Richard Toikka has questioned whether, in litigation contexts, the Rule is reliable under Daubert v. Merrill Dow Pharmaceuticals 45 and Kumho Tire Co. v. Carmichael. 46 The Rule, however, is one of many tools. Ultimate royalty rates often are higher or lower than 25 per cent of fully-loaded product profits, depending upon a host of quantitative and qualitative factors that can and should affect a negotiation (or litigation). Even critics of the Rule have conceded that, despite its crudeness, it retains widespread endorsement and use. 47 Part of that is due to its simplicity and part of that is due to self-fulfilling prophecy (because of its simplicity, it has become a norm and, because it is a norm, it is used over and over 43. Schaafsma, pp Mark Berkman, Valuing Intellectual Property Assets for Licensing Transactions, 22 The Licensing Journal 16 (April 2002) U.S. 579 (1993) U.S. 137 (1999). 47. Schaafsma, p Russell L. Parr, Intellectual Property Infringement Damages: A Litigation Support Handbook 171 (1993). 49. Robert Goldscheider, Litigation Backgrounder for Licensing, 29 les Nouvelles 20, 25 (March 1994). 50. Parr, p Berkman, p. 16. Gregory J. Battersby & Charles W. Grimes, Licensing Royalty Rates: 2002 Edition 4-5 (2002). again). Moreover, the Rule is not intended to be used in isolation. There are a variety of other tools that should be employed in any valuation assignment. A second criticism is that the Rule is indefinite. That is, should 25 per cent be applied to gross profits, operating profits, or some other measure of profits? According to William Lee: The 25% rule is sometimes a little indeterminate as to whether it refers to 25% of net profit or 25% of gross profit (if you represent the prospective licensor, then of course you apply the 25% against anticipated gross profit; if you represent the prospective licensee, you contend that the 25% applies to net profit!). Note that the indefiniteness as to whether the 25% rule speaks to net profit or gross profit brings it somewhat in line with the rule of thumb of 1/3 to 1/4 of profit as a reasonable royalty as expressed in [some publications]. 48 In fact, there is no indefiniteness. The Rule is based on historical observations of the relationships between royalty rates and operating margins. 49 That is, rates often are 25 per cent of operating margins. And it is anticipated operating margins, according to the Rule, against which the profit split figure should be applied. Applying it to another level of profits may be valid and useful in certain contexts, but such an application is not grounded in the concepts and facts surrounding the 25 Per Cent Rule. Third, some analysts believe that there is no indefiniteness and that, in fact, 25 per cent is meant to be applied to a licensee s gross profits. 50 (Gross profits, again, represents the difference between revenues and cost of goods sold. No deduction for non-manufacturing overhead costs is included.) They criticize that application because gross margin ignores a host of other relevant costs. Such analysts have concluded that while the 25 Per Cent Rule is simple, popular and easy to understand, it should be avoided. 51 Focusing on gross profits ignores too many important factors. 52 This criticism is specious, however, because the 25 Per Cent Rule is an allocation (or splitting) of operating profits. Explicit consideration is given to all of the costs, including non-manufacturing overhead, that are needed to support a product or are driven by the product. The Rule is not a split of gross profits. Furthermore, in their survey of licensing executives, Degnan and Horton found that royalty rates tend to be 10 to 15 per cent of gross profits. 53 In other words, royalty rates divided by gross margin is substantially lower than 25 per cent. In P&G Co. v. Paragon Trade Brands, 54 the court cited testimony that the Rule is not really even useful as a general guide for deriving an appropriate royalty rate. 55 In part because of that, the court wrote that it will consider the [25%] Rule-of- Thumb analysis in determining the royalty rate, [but] this approach will not receive substantial weight. 56 Nonetheless, in its final royalty analysis, the court did write that the [25%] Rule-of-Thumb analysis provides an additional confirmation of the reasonableness of a royalty rate of 2.0% Parr, p Parr, pp Degnan and Horton, p The Procter & Gamble Company v. Paragon Trade Brands, 989 F. Supp. 547 (D. Del. 1997). 55. The Procter & Gamble Company v. Paragon Trade Brands, 989 F. Supp. 547, 595 (D. Del. 1997). 56. The Procter & Gamble Company v. Paragon Trade Brands, 989 F. Supp. 547, 595 (D. Del. 1997). 57. The Procter & Gamble Company v. Paragon Trade Brands, 989 F. Supp. 547, 596 (D. Del. 1997). The expert s Rule-of- Thumb analysis obtained a range of Per cent to 2.6 Per cent. les Nouvelles December

11 Fourth, it has been asserted that the Rule is inappropriate to use in those instances in which the IP at issue represents a small fraction of the value residing in a product. The authors are sympathetic to the criticism. However, both the concepts underlying the Rule as well as the empirics supporting it recognize the flexibility of the Rule. The precise split should be adjusted up or down depending on a host of factors, including the relative contribution of the IP at issue. Relatively minor IP often should (and does) command a split of profits lower than relatively important IP. A final criticism of the Rule is that it provides a rough or imprecise measure of incremental benefits. A complete (and accurate) incremental analysis is preferred. None of the authors disagree. The Rule often is an adjunct to other valuation methods. And it is particularly useful when helpful data on incremental value are unavailable or limited. The 25 Per Cent Rule is a starting point to apportioning the profits. William Lee, both a critic and proponent of the Rule, has noted: in most instances the rule-ofthumb of approximately 1/4 to 1/3 of the licensee s anticipated profit to go to the licensor is a good starting place for negotiations. Whether or not anticipated profit is expressed during negotiations, the effect of royalty on profitability should certainly be in the minds of the negotiators on both sides. My experience, and apparently the experience of others, tends to show that most successful licensing arrangements end with royalty levels in this range. However, like all rules-of-thumb, circumstances alter cases. 58 Empirical Test of the Rule To test the validity of the 25 Per Cent Rule, we attempted to compare royalty rates from actual licensing transactions with the expected long-run profit margins of the products that embody the subject IP. We were able to gather royalty rate data 58. Lee, p from thousands of actual licensing transactions. 59 Because of the confidentiality of these licenses, along with a lack of access to expected (or actual) product profit rates, we were unable to undertake a direct comparison of product profit and royalty rates. We, therefore, examined profit data for two surrogates licensee profits and successful licensee profits. With the first proxy, we examined the profits for those firms in each industry that were involved in licensing transactions. We used those profit rates as a proxy for expected long-run product profits. With the second proxy, we examined successful licensee profits. We defined as successful those licensees in the top quartile in their respective industries in terms of profitability. Presumably, these may more accurately reflect the kind of profit rates that are generated by products that embody valuable IP. For both proxies, we compared median (or middle of the range) industry royalty rates to weighted average profit rates. Although we considered comparing median royalty rates to median profit rates, for some industries, median profit rates differed substantially from weighted average profit rates due, at least in part, to the presence of a significant number of small, startup firms earning negative profit margins. Given that the negative margins earned by start-ups may not be indicative of expected longrun profits, we examined weighted average profit margins (which gives these negative profit margins relatively less weight). Royalty Rates To obtain information regarding royalty rates observed in actual licensing transactions, we used 59. We were unable to gather (or evaluate) information from proposed transactions that were never consummated. Presumably, in those instances, IP sellers were asking for more than IP buyers were willing to pay. We have no a priori reason to think, however, that exclusion of such data biases our results. information provided by Royalty- Source.com, a searchable database of intellectual property sale and licensing transactions, containing information spanning the late 1980s to the present. From RoyaltySource, we obtained summaries of all available licensing transactions involving the following fifteen industries: Automotive Chemicals Computers Consumer Goods Electronics Energy and Environment Food Healthcare Products Internet Machines/Tools Media and Entertainment; Pharmaceuticals and Biotechnology Semiconductors Software and Telecom 60 These licenses involved a variety of payment terms lump-sum, fee per unit and running royalties on sales. For ease of comparison, we confined our analysis to the 1,533 licenses that involved running royalties on sales. 61 Figure 3 shows on an industry-byindustry basis, the information we obtained from RoyaltySource. We have reported minimum, maximum and median royalty rates. The median royalty rate across all industries was 4.5 per cent, though median rates ranged from a low of 2.8 per cent to a high of 8.0 per cent. Industry Profits We obtained financial information for the fifteen industries included 60. RoyaltySource database tracks licensing transactions for other industries as well. The industry categories used here were developed by the authors and are somewhat different than the internal classification system used by RoyaltySource. 61. Data available to us from RoyaltySource.com did not allow us to easily convert lump-sum or the per unit royalties into royalties per dollar, which terms were needed for testing our hypothesis. As a result, we excluded those observations from our analysis. We have no a priori reason to think, however, that exclusion of such data biases our results. 132 December 2002 les Nouvelles

12 in our analysis from Bloomberg. The Bloomberg database provided financial data for the period 1990 through 2000 for 6,309 companies included in the fifteen industries under consideration. Figure 4 reports both the average operating profit margin for each of the industries. Licensee Profits Because total industry profits are not a particularly close match to royalty rates covering a limited number of companies, for our first analysis, we examined profitability data for only those companies that were identified as licensees in the licensing transactions database. Figure 5 reports weighted average operating profit margins for each of the industries. Royalty Rates and Licensee Profits A comparison of royalty rates and licensee profits provides some support for use of the 25 Per Cent Rule as a tool of analysis. Across all (15) industries, the median royalty rate as a percentage of average licensee operating profit margins, as shown in Figure 6, was 26.7 per cent. Excluding the media & entertainment and internet industries, the range among the remaining industries varies from 8.5 per cent for semiconductors to 79.7 per cent for the automotive industry. In spite of the variation across industries, the majority of industries had ratios of royalty rates to licensee profit margins of 21 to 40 per cent. Figure 7 shows a distribution of the ratios across industries. Successful Licensee Profits We also examined profitability data for successful licensees. We defined those to be licensees with profit rates in the top quartile for each industry. We used these profit rates as a further-refined surrogate for projected product profit rates. Royalty Rates and Successful Licensee Profits A comparison of royalty rates and successful licensee profits appears to, again, provide some support for use of the 25 Per Cent Rule. As shown in Figure 8, across all industries, the median royalty rate as a percentage of average operating profits was 22.6 per cent. Excluding the media and entertainment industry, for which only limited data were available, the ratios range from a low of 7.8 per cent for the semiconductor industry to a high of 48.0 per cent for the internet industry. Figure 9 reports the ratio distribution across industries and shows that, again, the majority of industries have ratios of royalty rates to successful licensee profit margins in the 21 to 40 per cent range. Conclusions An apportionment of 25 per cent of a licensee s expected profits has become one, of many, useful pricing tools in IP contexts. 62 And our empirical analysis provides some support for its use. A comparison of royalty rates with two proxies for expected long-run product profits (namely, licensee profits and successful licensee profits) yields royalty to profit ratios of 27 per cent and 23 per cent, respectively. Although the data support the Rule generally, there is quite a variation in results for specific industries. As this variation makes clear, the Rule is best used as one pricing tool and should be considered in conjunction with other (quantitative and qualitative) factors that can and do affect royalty rates. 62. Razgaitis, p les Nouvelles December

13 Brain-Power Use It Or Lose It! BY BENNY BROWNE* Based on a speech given by Benny Browne at the LESI Conference, Osaka, Japan, on April 7th, This paper looks at brain power and human relations and how we can effectively capture the brain power and how we can use it for the benefit of mankind. So brain power, use it or lose it. Over the last ten years we have seen an enormous shift in importance from tangible assets to intangible assets. For example, you ve seen people like Microsoft with a market capitalization of many billions of dollars, but when you actually look at their hard tangible assets they are around 30% of the total so you ve seen a moving from tangible to intangible assets. There s been a move from domestic to international focus through to global focus and from tangible asset backed economies through to information economies and that s about where we are now. So how do we work with this and what do we do about it? Everybody knows that you can identify and protect the traditional intangible assets such as patents and trademarks and copyrights to a certain extent, but it s much more difficult to protect what is in the head of the knowledge workers, as they are called. I d like to have a look at effective ways of protecting the knowledge and ensuring that the investment in the workers heads is not lost to competitors. A great Australian, Rupert Murdoch, the Executive Chairman of News Corporation, in October last year, gave the Inaugural Keith Murdoch oration in Melbourne. His speech was entitled, Brain Power Shake Up Urged. You may think that this applies to Australia alone, but it doesn t. It really applies across the board. This is what he said: Australia is steadily slipping in the current race to create and attract human capital. We must realize that the financial assets of any country comprise less than 30% of the national balance sheet. According to the world s foremost social scientists, 70% of the real value of any society lies in its human capital. The key to the future of any country is not in its physical resources or industrial capital, rather it is the human capital which will fund the health and growth of nations in the next 100 years. So having become very philosophical, let s have a look at what I d like to cover. I want to have a look at: What brain power is, or what I call brain power. Why it s important today. How best to manage it. Employer/employee loyalty. The problems that we have today with accounting standards which don t allow us to capture brain power in balance sheets are: How you actually harness it, How you protect it; and Some emerging Australian trends in the law as far as protection is concerned. Intellectual capital is what we are talking about and it s made up really of four elements. They are: Brain power (which some people call human capital), Structural capital - for example, patents, trade marks, Customer capital, and Other capital. To emphasize the importance of Intellectual Capital I will relate what was told to me by the Chairman of a public company, Geoff Brash, many years ago: The four most important things in a successful company are the shareholders, the customers, the suppliers and the staff. In order to maintain the success of the company, equal attention must be paid to all four. What Geoff was saying, in essence, is that without people a company could not be successful. Brain Power consists of: Competencies (your staff competencies), skills; Knowledge and experience and in particular how they have been applied to create value for others; What s in the mind of the knowledge workers. Some years ago I was invited to go to the Toyota factory in Melbourne which is an enormous factory. It takes about 3 hours to get around the whole factory. The man who was going to take us around the factory was a retired employee and had been with the company for something like over 40 years. He had never had any position of extreme management responsibility, he had been somebody who had worked his way up but had never got to the very top. And his job now was to take international and other visitors around the Toyota factory. I asked *Benny Browne is a partner in Griffith Hack, Melbourne, Victoria, Australia. 134 December 2002 les Nouvelles

14 my host, Why is this man doing this job? and he said, Because he has been around for 40 years, he knows everything there is to know about this factory. This is corporate knowledge at its best. It s something which is being used in the best way possible because this man can tell you everything that s happened in the factory, how it has grown, what they do there, the introduction of robotics, etc. It s really something very important and Toyota saw it and picked it up and worked with it. Structural capital encapsulates methods that have been developed, systems and processes and personal networks. Karl Sveiby, a famous writer in this area, describes structural capital as that which is left after the employees go home for the night. So when the factory is empty, what s left is the structural capital. One of the biggest industries in the world today, franchising, makes extensive use of structural capital. It is based around the licensing of systems, trade secrets and trade marks. But its principal focus is in the licensing of systems. Customer capital comprises the number and depth of personal customer relationships. These give rise to an organization s reputation. A reference written by a customer of an organization is always more valuable than a reference written by the organization itself. Shakespeare, in the play Othello, puts these words into the mouth of the character Othello: He who steals my purse takes nothing. Twas mine, tis his and has been slave to thousands. Yet he who robs me of my good name takes that which not enriches him but makes me the poorer indeed. And then there is other capital such as things which we can t touch but we can identify them and see in the form of patents, etc. Question: So why is brain power important? Answer: Because it delivers results and the results are what you see around you in your office. If your offices were stripped of people there wouldn t be one iota of worth in the chairs and all the other things. What s in your office is extremely important. There is a Columbian university which has conducted a study and they say that the spending on intangible assets like R & D and employee education results in a return of 800% greater than an equal investment in new plants and equipment. Why? Well, new machinery only allows incremental improvements but R & D and employee education leads to innovation that creates revolutionary ideas. There s a body called the Conference Board which has conducted a survey of 200 senior executives, and this survey shows that 80% of companies have some knowledge management efforts under way. 60% of these senior executives use knowledge management enterprise wide and 60% expect to in five years, so it s an increasing trend. Twenty five percent have a Chief Knowledge Officer or a Chief Learning Officer and 21% have a communicated knowledge management strategy. They have also reported the following gains from Knowledge Management. Buckman Labs has increased its new product sales by 50%, Dow Chemical has saved 40 million dollars a year in the re-use of patents - they did a huge patent audit and brought about this enormous amount of revenue saving. Ford Motor Company and BP Amoco saved more than US$600 million in the past three years by employing knowledge management techniques. Hewlett Packard reduced its cost per call by 50%. Rank Xerox reduced its dispatches by 15%. Roche can send out its products for FDA approval six months faster and Sequent registered 10% higher sales for new sales reps after 6 months. You ll see adverts in the papers these days, Knowledge Officer Sought. I saw one last year for a very big research and development corporation in Australia called the CSIRO - they were advertising for a Knowledge Officer. There is a body called Best Practices LLC in the United States. They say that this is what ought to be happening: formally define the role of knowledge in your business and in your industry. All of us know it s there, but nobody has defined it. Understanding what knowledge in the company is will allow you to focus on finding and capturing intellectual capital and that will allow the company to excel above others. Divide the intellectual capital into the strategic areas, for example: Brain Power, Structural capital, Customer capital, and Other capital. Develop management systems to assist in benchmarking efforts. You need to be able to measure things because what gets measured gets managed. Turning next to the employer/employee relationship. Employees are the key to success to a company s exponential growth. 1 It is absolutely essential to have employee/employer loyalty. Some years ago I was listening to an audio tape of David Suzuki who, most of you know, is the famous environmentalist and philosopher based in Canada. He said a striking thing, and I thought, this guy is good. He said, Why is it that in our universities we teach mathematics, we teach science, we teach arithmetic, reading and writing and yet nobody teaches relationships? In our lives we have constant relationship interactions with our families, with our outer families and with other people, but nobody teaches anybody how to relate. And as a result, my bet is that there would be a lot less dispute and war and so on in the world if relationships were better taught. Bad employees, as everybody knows, can cause a business to fail. Choosing an employee is somewhat like choosing a house. When one chooses an employee, the interview lasts perhaps an hour. When one chooses a house, the inspection lasts 1. Deal Consulting, Creating Employee Loyalty. les Nouvelles December

15 perhaps an hour. After that hour, on both occasions, we make up our minds as to whether to proceed or not. People get employed it s like buying a house. Yes, in the employment situation, there are things like six months probation, but if there were a better strategy to assess what you are taking on, the end result would be much better. It s like a marriage, you need to know with what you are getting involved. Bad employees obviously can cause businesses to fail and we ve seen that. I won t mention any names, but a very large accounting firm in America springs to mind. Mediocre employees. Well, there are lots of people who fall into this category. As Spike Milligan once said, In the army all you have to do is walk around with a broom in one hand and a piece of paper in the other and nobody will ask you what you are doing because you seem to be employed. Good employees can really make a business go through the roof. Now how do you keep the best employees in your business? Well, pay is something which is very important, but it is not always the most important. One of our employees in our law firm was working from home, he had a wife and a very small child and he wanted to spend time with them. His productivity, when measured against his work at the office, was much higher than it had been before. He was at home in the morning to play with his child. At ten in the morning, when the child went back to sleep, he started work. Through a staggered working hour day it turned out that he was working many more hours and much more productively from home than he had been when working all day at the office. So pay isn t always the most important thing. It s only a benchmark to value an employee s worth. It is important to note, however, that wages below market rate result in bad employees. You get the worst employees out of the pool. Benefits provided by a company operate in a similar way to wages. Some years ago I visited a company in Australia called Southern Dental Technologies. I was being shown around the plant and talking to the Managing Director and asked him, How do you keep the people in your R & D section, you know you are in a very competitive business, what do you do to keep these people? And he said to me, You know we sign confidentiality agreements, but they re as good as the paper they are written on. If somebody really wants to get out there and break up your business, they will. And I said, What do you do? And he said, We treat our employees very well. In this respect the benefits provided by a company to its employees forms part of this question: How do you treat your employees? You ll have to match your competitors, that s obvious. If you don t, you re not going to keep the people. Training. Training today is very important because things are changing so fast in the world, we ve got to have continuous training which is dynamic and is exponential and allows employees to feel as though they are climbing the career ladder. The training shouldn t be limited to just technical sorts of job skills, but it should be wider. It should include items such as like foreign languages, computers and other types of courses, which in a wider life sense will make the employees better employees. A learning environment where people feel mentored. In a lot of the law firms, and I can really speak about law firms because, as I said before, I am a lawyer. There are employees who, when you talk to them, will say, I really feel great about working here because I, as a junior person, get to work with a partner and I really feel great about being in this company because I am involved in what s going on. I get to work with the managers. Career plans. Obviously there are some places where they ve got career plans for their lowliest workers right the way through. Evaluations and reviews. Now these are very sensitive issues and sometimes they can cause a lot of damage, but they must focus on the individual and how they fit into the company and not so much on what they are doing wrong. It s not another one of those OK, lets bash her/him sessions. The reviews should be used as a method to keep good employees and not to weed out bad ones. Regular business meetings. I know of some firms which have meetings where every one of the legal secretaries are brought into the meetings as well because they have a lot to contribute - they are important people. I have always maintained that the garbage man who comes around the streets early in the morning removing the garbage is one of the most important people, because without him we would have this garbage stacked up everywhere. Everybody in the whole chain is very important and they need to know that, and they need to feel that they are very important. And obviously if you recognize and reward good work, your employees are certainly going to appreciate what you are doing for them and with them. You ve got to provide good working conditions because without good working conditions people will see the green on the other side of the fence and will leave. Now, I was talking about the accountancy problem before. There has been a move worldwide, globally to allow human capital to be recorded on balance sheets of companies. I know a chap called Sam Khoury, he is a LES member. He was working with Dow Chemical and he did his doctorate on the valuation of what is in people s heads. Being able to value what is in people s heads is one thing, however, unless that valuation can appear on the balance sheet as an asset, it is worthless from a financial point of view. Global accounting standards are trying to get to grips with this but I don t believe it will happen in my lifetime. There are too many things which will mitigate against it. In Canada there has been the strongest push to try and 136 December 2002 les Nouvelles

16 have this happen but even they have struck a blank wall. Why have Brain Power valued on the balance sheet? Because you can go to the bank and say, I ve got this asset, I want a leverage against it. Or, I m selling my company, I have this asset and you will get the employees, you will get the people to go with it. Harnessing it? Well, you heard it said before that intellectual property audits are valuable in identifying and harnessing brain power. However anecdotally, corporations and government bodies pay very little attention to what the people do within the organization. By using the intellectual property audit it can be pointed out to management what the corporation or government body has in the form of brain power, that it is an important asset and that it must be nurtured. If a company develops a knowledge management system, it will certainly help in harnessing it and bringing it to account. Obviously, if we could introduce new global accounting standards, that would be great, but that s on the wish list and it s not something which is going to happen over night. Protecting it. One of the ways of protecting it can be in the form of restraint of trade. Now restraint of trade will be a term familiar to the lawyers. All it means is that you say to an employee you may not go out and work with a competitor for a period of time in a certain area. Those restraints are, in the western world at least, illegal and they can only be made legal if they are reasonable in relation to how long, what geographic area and what type of restraint it is. So there is a way of protecting brain power, but it is still limited. Restraining know-how. Now this is a new phenomenon which has come about over the last ten years. People in drafting contracts will try and restrain know-how, and I must say that you will see later that there is a trend where restraint of knowhow is gaining some acceptance. Garden leave. This is a really new concept. For those of you who think that it is something akin to garden gnomes in a garden, you are quite right. It is paying an employee a very large sum of money to sit in his or her garden and do nothing for a certain period of time. You will see later that the Australian courts are warming to this idea but it still has not met with total acceptance by the Courts. These trends through the cases show the following: In 1972 there was a British case 2 where a man was paid ten pounds, not to go out and compete. Without any hesitation the court just said, no, you can t do it, you cannot try and restrain a person from earning a living even though you have paid him some money, it doesn t wash with us, it is something you are not allowed to do. And the real irony in this case was that the employee, after the court ruled that he couldn t be restrained, sued the company for his ten pounds because he said that it still owed him the money even though he couldn t be restrained. There was a case in Australia in which involved a company which was dealing with Taiwan. The company had an employee whom they had signed up on an agreement that he wasn t going to be allowed to disclose the customer lists. Well the usual happened, and it happens all the time - he left the company and within a short time he joined the competition and he had all the information at his fingertips. His previous employer sued him and the company who was employing him, alleging that the employee had breached confidentiality. The Court held that it would allow a restraint but for reasons which are not important here. There was an Act of Parliament in New South Wales which hadn t been complied with properly, so they didn t enforce the restraint, but they were coming to the view that this was a reasonable type of thing to do, to protect the company s goodwill. 2. Howard Hudson, Wright v. Gasweld, In 1997 you had a similar type of case of Kone Elevators 4 where a person who was a sales person within the company moved to another company. Just before he left Kone, Kone scheduled the release of brand new products which was attended by the employee. Kone alleged that the employee knew exactly what those products were, having been involved in the briefings. Furthermore, the employee s employment with a competitor would result in damage being suffered by Kone, were the ex-employee to divulge all the new product information to the new employer. The court held that, but for the fact that Kone had failed to comply with the New South Wales Restraint of Trade legislation, it would have granted a restraining order. So the court there was saying if you had complied, we would have allowed you to restrain him in those circumstances. The next case was one of Arnotts Biscuits. 5 Arnotts is a very big biscuits manufacturer in Australia. The Managing Director of Arnotts had left and he had been paid something like one and a half times his annual salary not to go and work for a competitor. He left and, within the restraint period, joined Weston Biscuits. Within days of him joining Weston, Arnotts went to court seeking an injunction on the basis that they had paid a significant amount of money so that the former managing director would not join a competitor. The court wouldn t stop the man from going to Weston for reasons which are not important, but obiter the court commented that the concept of garden leave was not a bad idea. If somebody has been paid a lot of money not to go and work then that person oughtn t go and work, and the court stated that it would have enforced this particular contract against the employee if the conditions in question had been complied with. Apparently he had signed up 4. Kone Elevators, Arnotts v. Weston, les Nouvelles December

17 for this deal with Arnotts during his employment rather than after his employment, so it seemed to be part of his employment contract and therefore didn t fall within the reasonable restraint. The very last case is one which is a very recent case in Australia. 6 It was a decision of the full Federal Court. A confidentiality agreement was challenged in the court as a restraint of trade. Earlier we were talking about trying to protect know- how by confidentiality agreements. This confidentiality agreement had no ending date and was completely disallowed by the Court as an unreasonable restraint of trade. When the confidentiality agreement was read in a broader sense, the employee was to be restrained from working at any time and the court disallowed this. Yet the Court indicated that restraints which are reasonable will be allowed, and really what s reasonable is what is reasonable in the community at any given time. The emerging trend in Australia seems to be that the courts are coming to the view that garden leave may well be an acceptable practice and that know-how is not able to be restrained indefinitely through the medium of a confidentiality agreement. In my view, however, it is still going to take a long time before we get to some decision which actually points to garden leave and concludes that it, in itself, is satisfactory So, in conclusion let me say that I ve taken you through some philosophy, taken you through a bit of law, and taken you through some advice. In the end, if you don t use your brain power you will lose it. 6. Maggbury v. Hafele, December 2002 les Nouvelles

18 New Guidelines For Valuing In Process R&D BY TERRY ALLEN, JIM RIGBY AND RIZVANA ZAMEERUDDIN* The world of licensing pro fessionals is changing, with more documentation and analysis being required to arrive at the values of intellectual property, especially for In Process R&D. This article will highlight some of the key points from the American Institute of CPA s (AICPA s) Practice Aid, Assets Acquired in a Business Combination to be used in Research and Development Activities: A Focus in Software, Electronic Devices, and Pharmaceutical Industries. Since the Enron scandal broke, auditors have been exercising extreme care when auditing a client s financial statements. In particular, auditors are examining off-balance sheet liabilities and the fair value measurement of assets included in the financial statements more scrupulously. Although the fallout from the Enron scandal highlighted problems in financial reporting, other developments have contributed to the perceived need for greater scrutiny in the financial reporting process. These other developments include: Changes in generally accepted accounting principles (GAAP) approved in June 2001 the Statement of Financial Accounting Standards (SFAS) 141, Business Combinations and SFAS 142, Goodwill and Intangible Asset Impairment; Changes reflected in SFAS 144, Accounting for the Impairment of Long- Lived Assets and for Long-Lived Assets to be Disposed of; The current Financial Accounting Standards Board (FASB) project concerning the application of SFAS 141 and 142 to non-profit organizations; and The release of the AICPA s Auditing Standards Board exposure draft of new auditing standards re- lated to fair value measurement. The FASB is working on the application of SFAS 141 and 142 principles to non-profit organizations. Research institutions, such as hospitals and universities, create and license intellectual property. Complicated issues arise from transactions involving licenses for this intellectual property. The goal of this FASB project is to clarify these complicated issues. In January 2002, the AICPA s Auditing Standards Board released an exposure draft of new auditing standards related to Auditing Fair Value Measurements and Disclosures. This exposure draft provides guidance for auditing fair value measurements and financial statement disclosures. Fair value measurement is the technical accounting term for the valuation of intangible and tangible assets for financial reporting purposes. On December 17, 2001, the AICPA, in conjunction with the Securities and Exchange Commission (SEC), released the AICPA s Practice Aid, Assets Acquired in a Business Combination to Be Used in Research and Development Activities: A Focus in Software, Electronic Devices, and Pharmaceutical Industries. This Practice Aid devotes one chapter to valuing In Process R&D and, more importantly, one chapter to auditing the valuation of In Process R&D. Previously, auditors only had to examine the credentials of the valuation expert. Now, this Practice Aid requires auditors to audit the valuation of the purchased R&D before they issue an opinion on the company s financial statements. Non-U.S. based readers are mistaken if they believe that these changes do not affect them as well. The AICPA s exposure draft Auditing Fair Value Measurements and Disclosures issued on January 15, 2002 incorporated the International Federation of Auditors exposure draft on Auditing Fair Value Measurement issued in October A final draft of the international statement on fair value measurement will be issued by the end of this year and will probably be adopted by the Economic Union in Fair value measurement will clearly be an important international issue in the immediate future. What does all this mean to management? First, management must have a better understanding of value in various situations, such as buy/sell agreements, litigation, and financial reporting. Management also must have a better understanding of who will be using the fair value measurements and what their different needs are. The users of this information will include buyers, licensees, litigants, investors, regulators, and others. Second, when research assets are valued for financial reporting purposes, management can expect thorough analysis of internal financial records, memorandums, reports, projections, and other company representations. Furthermore, the valuer and auditor will have extensive information requests (see Practice Aid, Exhibit 1 Patent Information Request List). *Terry Allen, CPA/ABV, ASA and Jim Rigby, CPA/ABV, ASA are both Managing Directors of The Financial Valuation Group and are located in Kansas City, MO, and Los Angeles, CA, respectively. Rizvana Zameeruddin, MST, JD is a CPA, currently working on her LLM in tax, and teaches part time at DePaul University's School of Accountancy. les Nouvelles December

19 Consequently, management will be required to provide documentation of their assumptions and claims. Financial record keeping will be more extensive and the quality of these records will have to improve. Management will need to ensure that their articles, presentations, reports, and revenue and cost projections are consistent when presented to different parties. They will have to review the assumptions and projections of external valuation experts thoroughly. The AICPA s Practice Aid will affect the way management and research staff carry out their normal work activities. Designed to be a best practices publication, the Practice Aid will affect valuation procedures and methodology regardless of how value is defined. The biggest change dictated by the Practice Aid is the requirement that auditors audit the valuation work, supporting values appearing in the financial statements. Previously, under SFAS 73, The Use of Experts, the auditor was merely required to examine the valuation expert s qualifications and experience. Now auditors will be required to do more research when engaging experts. This additional work will almost certainly result in higher standards. The Practice Aid discusses the various documents to be examined when the In Process R&D is valued. It also includes a sample valuation report that company management can compare with the reports provided by valuation experts. The Practice Aid highlights various valuation methods for In Process R&D, particularly, the relief-from-royalty method, the multi-period excess earnings method, and real option methods. The relief-from-royalty method discounts to a present value, the payments which would be required if the R&D we re licensed from an outside party. Because the company owns the R&D asset, it has the right to manufacture and to sell products that incorporate the R&D without having to pay a royalty fee to the developer. Avoiding a stream of royalty payments represents future cash savings, which have value 1. AICPA Practice Aid, P Ibid, P Ibid. to the company. A relief-from-royalty method may be appropriate for certain categories of intangible assets. Trademarks and trade names, patents, developed product technology, and base (or core) technology are all categories of identifiable intangible assets that frequently are licensed in exchange for a royalty payment. 1 The Practice Aid indicates that the relief-from-royalty method would rarely be appropriate in the valuation of specific In Process R&D projects because royalty rates on similar projects are seldom available. 2 The method would be appropriate in certain cases, such as the following: When the identifiable intangible asset makes a contribution to the company s cash flows that is comparable to that made by a comparable licensed asset; When the identifiable asset can be separated from other assets and it is practical and possible to license it separately; When the rights of ownership can be reasonably compared to the rights under a license; and When the verifiable objective information regarding royalty rates can be obtained. The second valuation method specifically discussed in the Practice Aid is the multi-period excess earnings method. The multi-period excess earnings method is a specific application of the discounted cash flow method under the income method. 3 It is known by various other names including the discounted incremental earnings method. This method is the most common method used by valuation experts in determining the fair value of intangible assets. The principle behind the multiperiod excess earnings method is that the value of an identifiable intangible asset is equal to the present value of the incremental after-tax cash flows attributable to that intangible asset. 4 The net cash flows attributable to the subject asset are those in excess of fair returns on all the other assets that are necessary to the realization of the cash flows (the contributory assets). These assets include not only assets purchased in the subject transaction, but also all assets required to realize the cash flows. The acquiring company may already own some of these assets or may need to purchase them in separate transactions, if they are necessary to generate the expected future cash flows. 5 The real option method is the third method discussed in the Practice Aid. Although this method has not yet become widely accepted and applications have not been standardized, interest is growing. The Practice Aid indicates that real option methods are expected to supplement the multi-period excess earnings method in the future. 6 Real option methods have begun to achieve acceptance as a superior method for evaluating income streams subject to both uncertainty and choice. In the discounted cash flow method, for example, when using very high discount rates (usually with early stage research project cash flows), the negative cash outflows occur at the beginning of the estimation period (in which the present value interest factor is still relatively significant), and the positive cash flows occur at the end of the estimation period (in which the present value interest factor has become exponentially lower), thus often resulting in negative present values. Management often will still invest in those projects because they have the choice either to stop investing or to continue investing based on either failing to reach, or reaching and exceeding certain targets at certain time-based milestones. They are still willing, however, to invest small amounts in a portfolio of projects (which can be discontinued midstream) in anticipation of the 4. Ibid. 5. AICPA Practice Aid, P Ibid, P December 2002 les Nouvelles

20 occasional large return. A traditionbased observer might conclude that management has acted irrationally to invest in a project with negative net present value, while emerging theory might suggest that the discounted cash flow method is accurate or incomplete when used in a circumstance of high risk and multiple choice-points in the future. 7 The use of real option methods has yet to be embraced as a valuation tool, and although it deserves a mention, the level of standardization among practitioners has not yet reached a point for inclusion in the Practice Aid. The Practice Aid takes the position that intangible asset fair values should include the present value of the expected tax payments made by the asset s owner and the tax benefits resulting from the amortization of that intangible asset for income tax purposes. This position is in stark contrast to the common belief by many professionals that the fair value of the intangible asset does not include the amortization benefit. The inclusion of the tax effects in the valuation is common in the income and cost approaches, but not the market approach. 8 Guidelines for Rates of Return to be used in the valuation process are also provided in tabular form in the Practice Aid on page 92. The Task Force believes that venture capital rates are the most appropriate rates to use for In Process R&D valuations and as such, venture capital continues to be an important source of R&D funding. The task force identified two publications that provide guidance about the rates of return commanded by venture capital investors at various stages of an entity s development. Those two publications are: Plummer, James L., QED Report on Venture Capital Financial Analysis (Palo Alto: QED Research, Inc., 1987). Scherlis, Daniel R. and William A. Sahlman, A Method for Valuing High-Risk, Long Term Investments: The Venture Capital Method (Boston: Harvard Business School Publishing, (1987). The Practice Aid also focuses on the analysis of Prospective Financial Information (PFI). An auditor is required to obtain an understanding of the business purposes for an acquisition sufficient to enable him or her to evaluate whether the accounting is consistent with the business purpose. In order to obtain this type of information, the auditor usually talks to the company s CEO and CFO, however, the auditor should consider further discussions with the marketing personnel familiar with the acquiree s products and markets, and also the R&D, production, and business development personnel who are familiar with the products and product development plans related to the acquired technology in order to gain additional insight. The auditor s inquiries of the marketing and business development personnel should provide information about: base (or core) technology, historical and existing product lifecycles and changes in volumes and average selling prices over those lifecycles, future products and dependency of future products on base (or core) technology, management s technology development plans, capabilities of personnel to conduct R&D, markets served by the company and those it would like to serve, competitive conditions, and regulatory requirements. 9 This list, although extensive, is not fully comprehensive; it is intended only as a guideline for auditors to help achieve the level of understanding of a company s business and to help design effective substantive auditing procedures. The very nature of acquired In Process R&D estimate is such that virtually every scenario will be unique to each company and each industry. The elements of the PFI that require verification will likely contain a lot of estimates and assumptions made by management. The information to be verified includes, but is not limited to revenue, cost of sales, sales and marketing expenses, general and administrative expenses, technical support expense, R&D expense, tax expense, required levels of tangible assets, and required levels of intangible assets. If the valuation specialist does not feel that he or she has received enough support for a particular PFI assumption, then 7. AICPA Practice Aid, P Ibid, P AICPA Practice Aid, P Guidelines for Rates of Return Stage of Development Start-Up First Stage or Early Development Second Stage or Expansion Bridge/IPO Plummer 50% - 70% 40% - 60% 35% - 50% 25% - 35% Scherlis and Sahlman 50% - 70% 50% - 70% 30% - 50% 20% - 35% les Nouvelles December

21 he or she should review other client records as well as external sources to support each material assumption underlying the specific elements of prospective financial information. 10 In preparing their PFI, a fundamental point for corporate management is to not include synergies for valuation of In Process R&D. The Practice Aid states that synergies unique to the combined enterprise should not be used in estimating the fair value of any asset (individual) acquired. Adjustments to the selected PFI can be accomplished by revising the revenue growth or cost savings rates from those used in the selected PFI to those of market participants. 11 Of the synergies that need to be eliminated, there are three main types: cost synergies, revenue synergies, and income tax synergies. Since synergies should not be included in the valuation of In Process R&D, the Practice Aid provides examples of how to eliminate such synergies when making a valuation. 12 Example Eliminating Cost Synergies. Company A acquired Company X in a purchase business combination. Selling costs for Company X are 40% of revenues, and the rate representative of performance of market participants is 30% of revenues. Due to the unique size and efficiency of its distribution channel, selling costs for Company A are 20% (also the rate used by Company A in its PFI alternative that was used to negotiate the final purchase price). Selling costs in the PFI would be adjusted up to 30%, the rate representative of market participants, to eliminate a synergy specific to the acquiring company. Example Eliminating Revenue Synergies. Company A acquired Company X in a purchase business combination. Company X s product complements Company A s product. Upon acquisition, Company A s combined product offering will be unique in the market, and Company A believes that it can derive 10% more in revenues from both products than it or market participants could if they were to sell either product on a separate stand-alone basis. The PFI should exclude all revenues attributable to Company A s preexisting product, and the incremental 10% increase in revenues derived from Company X s product, which resulted from having a combined product offering. Example Eliminating Income Tax Synergies. Company A acquired Company X in a purchase business combination. Company A currently does not pay income taxes because of large net operating loss carryforwards. Company A does not expect to pay income taxes in the foreseeable future due to the size of the net operating loss carryforwards. In the PFI that Company A provides to the valuation specialist for use in valuing certain assets acquired to be used in R&D activities, management of Company A does not include any expected income tax payments resulting from the cash flows attributable to the acquired assets. In other words, in the PFI prepared by Company A s management, the present value of the expected future cash flows attributed to the acquired assets is the same on a pretax basis as on an after-tax basis because no income tax payments are expected. The Practice Aid goes on to list information that would be useful in evaluating the PFI assumptions. Such information includes knowledge of the business, due diligence studies, research report of analysts, market research studies, historical experience with new product development activities of the acquiring company, offering memoranda, board of director materials prepared in support of the acquisition, development progress subsequent to the acquisition, and forecasts provided to lenders. 13 The Practice Aid advises that management s expectations should be tested based upon internal budgets, technology development plans, materials presented to the board of directors in support of the acquisition and other corporate documents, including website content and press releases. 14 Even with all the information gathered and analyzed, additional analytic procedures may still be required, therefore, the information developed in performing the preliminary procedures set forth above should be used to tailor further substantive procedures and evaluate the reasonableness of the results. 15 As the auditors responsibilities increase, they will require more information from the owners or buyers and sellers of the In Process or completed R&D. The auditor should consider whether the preliminary valuation is unreasonable considering the knowledge of the acquiring company s business and the business purpose of the acquisition. That consideration includes an assessment of whether the key assumptions appear reasonable based on the auditor s knowledge of the business and the In Process R&D projects. There are newer, and more stringent requirements of licensing professionals including a trend towards more documentation and analysis to arrive at the values of Intellectual Property especially In Process R&D. The AICPA Practice Aid helps assist the licensing professional in better understanding these requirements as they pertain to the valuation of In Process R&D. It is intended only as a guide however, and an in depth review of the Practice Aid is highly recommended AICPA Practice Aid, P Ibid, P Ibid. 13. AICPA Practice Aid, P Ibid, P AICPA Practice Aid, P The Practice Aid can be purchased on the website AICPA s joint venture. 142 December 2002 les Nouvelles

22 Technology Transfer In Brazil: A Guide To Licensing Foreign Technology In Brazil BY CLARISSE ESCOREL AND TARA PENNINGTON* Introduction In the modern economy tecnology has undoubtedly become an essential tool to enable a country to achieve a certain level of development. Investment in technology not only enhances and encourages scientific research but also makes the country a more attractive market for foreign investments. In addition, technology development improves the quality and speed of industrial production constituting a vital element for an emerging country like Brazil, enabling it properly to supply its internal market and to face its international competitors. In this perspective, the selling, transfer or even rental of a specific technology through the so-called Technology Transfer Agreements is seen in Brazil as an important economic and commercial negotiation which must both observe the applicable laws and be registered at the Brazilian Patent and Trademark Office (BPTO). In Brazil, the acquisition of technology from developed countries is commonly used by national companies to make themselves more competitive and better able to face the international market. According to BPTO data base, in 2001 its Technology Transfer Board has registered 2,020 technology agreements, representing 20 per cent more than the previous year. The total amount of royalty remittances abroad for technology transfer was 11 percent higher in the year 2000 than in 1999 when they reached the equivalent of US$1.987 billion. According to the Brazilian Central Bank US$ billion was remitted abroad in 2000 as a result of trademarks, patents, franchise and *Clarisse Escorel (cescorel@leonardos.com.br) is an associate attorney with Momsen, Leonardos & Cia, in Rio de Janeiro, Brazil. Tara Pennington is a law student from University of San Francisco School of Law, and spent a five-week internship with Momsen, Leonardos & Cia during May and June, This article takes into consideration changes in the law up to August 31st, The authors would like to express their gratitude to Gabriel F. Leonardos, partner of Momsen, Leonardos & Cia, for his support in the conception and realization of this article. other kinds of technology transfer agreements. The majority of agreements recorded at the BPTO in the year 2000 were technical assistance agreements basically in the fields of chemical products manufacture (11%), metallurgic (10%) and automotive (8%). In 1998 and 1999 the scenario was not very different. The growth of remittances for technical assistance during the last decade can be explained by the privatization trend that took place in Brazil and the opening of the internal market for foreign investments mainly in the telecommunication, transportation, electricity and fuel sectors. It is reasonable that the foreign investor wants to bring technicians from overseas in order to implement properly new methods and equipment. Nevertheless, it would not be accurate to consider that in such case Brazil was acquiring technology from abroad. The genuine transfer of technology may be verified in agreements like a trademark and patent license agreements as well as technology supply and franchise agreements wherein there is a training and learning process by local technicians. The BPTO has 32,000 registrations of technology agreements since However, it should be noted that the effective technology transfer character of such agreements is not necessarily as huge as it seems. As mentioned herein above the great majority of agreements recorded at the BPTO are technical assistance and related ones wherein the technology transfer content must be carefully examined. The real technology transfer can be found in patent license and technology (know-how) supply agreements and is extremely valuable for Brazil not only because it provides technology modernization for the local industry but also in view of the corresponding payment of royalties. The royalties are calculated with basis on the net sales of the goods produced by the licensee utilizing the technology and, therefore, if there are no sales, which add to the gross domestic product, there are no remittances abroad, establishing a mechanism in which any amount paid to the licensor is the result of licensee income that would not exist if there were no technology license. In view of the above introductory scenario, the purpose of this article is to provide a general overview of licensing in Brazil and to offer advice on how to minimize unnecessary delays or rejection of the corresponding technology transfer agreements. Law nº 9,279/96, which took effect in 1997, is the intellectual property law that governs trademarks, patents and licensing, that is, the registration of technology transles Nouvelles December

23 1. Franchising is regulated in Brazil by Law nº 8,955 of fer agreements in Brazil. Even though this law constructed a framework for technology transfer, foreign parties planning to license technology in Brazil should be aware that in order to update and to respond to first world countries developments in this field the country is constantly improving its intellectual property system. The effect of this rapid change is that the BPTO often creates new rules, sometimes even non-written ones. As a result, registering technology transfer agreements in Brazil can sometimes be an unpredictable and frustrating experience. However, as Brazil gains momentum and power as a developing nation, it is crucial for parties seeking to license technology on a global scale to understand the Brazilian approach to technology transfer. The Brazilian Patent and Trademark Office ( BPTO ), known in Brazil as the National Institute of Industrial Property ( INPI ), is the largest intellectual property office in Latin America. The BPTO is responsible for registering all patents, trademarks and technology transfer agreements. Royalty-bearing technology transfer agreements should be submitted for review to the BPTO. The BPTO may request additional information or clarification on the filing, and, in some cases, may reject the filing entirely. Except in the latter situation, the agreement will eventually be recorded with the BPTO, the effect of which is to permit it to be enforceable against third parties, accrue royalties and receive beneficial tax treatment. Following the agreement registration before the BPTO, the certificate of recordal issued by such office must be filed at the Brazilian Central Bank (BCB) for the royalty payments to be authorized. Part I of this article sets forth the five different types of technology transfer agreements recognized by the BPTO and the documents required for each filing. Part II provides an in-depth explanation of the different types of agreements, accrual and payment of royalties as well as tax implications for licensing foreign technology. Part III is a case study that illustrates a typical foreign technology licensing transaction between a Brazilian party and a foreign party and discusses the registration of the resulting technology transfer agreements with the BPTO. I. Technology Transfer Agreements Recognized by the BPTO and General Filing Requirements The BPTO recognizes five types of technology transfer agreements: patent license agreements, trademark license agreements, technology supply (know-how) agreements, technical assistance agreements and franchise 1 agreements. Parties interested in licensing foreign technology in Brazil, whether they are Brazilian or foreign, must file a technology transfer agreement for registration with the BPTO. On average, it takes the BPTO 40 days to review and record an agreement. Once the agreement is recorded at the BPTO, it is enforceable against third parties, royalty payments are remissible (as long as the procedure at the BCB is successful) and the Brazilian party becomes eligible to claim the royalty payments as tax-deductible items. All technology transfer agreements and accompanying documents must comply with the BPTO registration requirements. The rules indicate that: (i) representatives of each party must initial all pages of the agreement and sign the final page; (ii) foreign parties should have the agreement notarized by an official Notary Public; (iii) the signature of the Notary Public must be legalized by the nearest Brazilian Consulate; (iv) two witnesses of any nationality or domicile must sign the last page of the agreement; and (v) each witness must list their full name, address and nationality. Apart from submitting the agreement for review by the BPTO, the parties must file several other documents. If the agreement is between a Brazilian party and a foreign party or between two Brazilian parties, they must submit: (i) a simple Portuguese translation of the agreement a translation by a public sworn translator is not required; (ii) the forms entitled Requerimento de Averbação and Ficha Cadastro de Entidade completed by the Licensee/Recipient or by their attorneys; (iii) a receipt verifying payment of the official filing fee; (iv) a power of attorney signed by the legal representative of either Licensor/Provider or Licensee/Recipient; (v) a copy of the bylaws of the Licensee/ Recipient; and (vi) a letter addressed to the Technology Transfer Department of the BPTO briefly explaining why the parties entered into the agreement. In the event that both parties to the technology transfer agreement are foreign, the parties should submit: (i) the original version of the technology transfer agreement; (ii) a notarized copy thereof; (iii) its translation into Portuguese; (iv) the receipt verifying payment of the official filing fee; (v) a power of attorney and; (vi) a petition to be prepared by its attorneys. In many cases, the parties will need to file more than one type of technology transfer agreement. Depending on the type of technology that is being transferred, the BPTO may only approve limited payment of royalties. Parties who file a patent and a trademark license agreement (when the trademark identifies the patent), a trademark and a knowhow agreement (when the trademark identifies the know-how), a patent and a know-how agreement (when the know-how is necessary in order to effectively use the patent) or all three agreements may not be able to request separate royalty payments for each agreement. The BPTO views the above pairs of agreements as dependent, meaning that one agreement is considered to be a consequence of the other. From BPTO perspective, it would be unfair for the licensee to have to make separately royalty payments for each portion of an overarching business operation. Therefore, royalties 144 December 2002 les Nouvelles

24 paid on one type of technology provide consideration for use of the other. For example, a franchise agreement incorporates the corresponding trademark because the trademark is considered to be included in the agreement as a necessary tool for the franchiser. Brazilian Franchising Law includes trademark use into franchise agreements because it would be unfair to require the licensee to pay separately for the use of the trademark when a franchise and the corresponding trademark are inextricably linked. An exception to this rule is when a party files a know-how agreement in conjunction with a technical assistance agreement. In that situation, royalties are payable on both agreements despite the fact that they relate to the same subject matter because technical assistance and know-how have separate functions and are considered as not dependent on each other. Another exception is if a party can demonstrate that a patent and a know-how can work well separately and are not necessarily connected to each other, in which case it may be possible to collect royalties for each agreement, subject to approval by the BPTO. II. Explanation of the Five Types of Technology Transfer Agreements The five types of technology transfer agreements have some differences in terms of filing requirements, tax treatment and royalties. Parties interested in prompt registration with the BPTO should take careful note of these differences to expedite the approval process. A. Patent License Agreements Parties who wish to license a patent issued by or pending with the BPTO must file a patent license agreement. The agreement should clearly set forth the application or registration numbers of the patent or patents and their respective titles. Brazilian law permits accrual of patent royalties if the patent to be licensed is still pending with the BPTO. However, royalty payments may not be remitted until the patent registration process with the BPTO is complete, that is, when the corresponding patent certificate is issued. While the application is pending with the BPTO, royalty payments may be deposited in an escrow account until the patent registration process is finalized and the BCB authorizes the remittance. After receiving approval from both institutions, the payments can be remitted to the Licensor. The Licensor can continue to collect royalties as long as the patent and, therefore the agreement, is in force. The expiration term of a patent in Brazil is 20 years. The Brazilian tax ordinance, nº 436 of 1958 of the Treasury Ministry, governing technology transfer agreements, established deductibility ceilings for payments flowing between companies that have a parent/subsidiary relationship. The ceilings are a designated percentage of the net sales made by the Licensee of the products or services using the licensed patent, trademark or technology. For related parties, the maximum amount that may be paid by the Brazilian party to the foreign licensor is exactly the tax deductibility ceiling which ranges between 1% and 5% for patent license agreements. On the other hand, if no ownership interest exists between the parties, there is no tax deductibility ceiling imposed on the royalty payments owed by Licensee to Licensor. It should be noted that this policy creates a disincentive for both Brazilian and foreign parties considering a technology transfer transaction because of the negative tax implications for the Brazilian company and the payment caps the foreign company will have to accept. The tax ordinance, in effect since 1958, reflects a quite old protectionist mentality being a clear example of the Brazilian government s resistance to totally embrace the globalization of business. B. Trademark License Agreements Trademark license agreements stating the trademark application or registration number should be filed with the BPTO. The approximate length of time between the filing of a trademark application and the issuance of a trademark registration is two years. There is an important difference in the treatment of royalties for trademarks and patents in Brazil. Whereas a patent license agreement may accrue royalties as soon as the patent application is filed with the BPTO, a trademark must be registered with the BPTO for royalties to accrue. This difference is explained by the attributive principle, a legal concept embraced by Brazilian law. Brazil follows the first to file system which dictates that priority rights to a trademark are given to the first individual to file the trademark with the BPTO. This system is different from the first to use system adopted by the United States, whereby trademark rights are given to the first party to use the trademark, regardless of which party initiates the registration process. In Brazil, an applicant has no property rights over a trademark until it is officially registered, that is, when the corresponding certificate is issued by the BPTO. In contrast, a patent affords the inventor an immediate property interest. Trademark royalty payments may begin only after the registration process is complete, and payments may continue as long as the trademark registration is in force. Trademarks are valid in Brazil for a period of 10 years and are renewable by the trademark owner for subsequent 10-year periods. Trademark license agreements are subject to lower deductibility ceilings than patent license agreements, as the tax deductibility ceiling on trademark license agreements is always 1 per cent. C. Technology Supply Agreements (Know-How Agreements) Technology supply agreements cover the acquisition of know-how destined to the manufacture of industrial products and services. This type of agreement differs from patent license agreements insofar as the recipient has, in principle, the right to use the know-how royaltyles Nouvelles December

25 free upon expiration of a term that is usually of five or ten years, depending on whether the agreement is renewed. The reason behind this difference is that the BPTO views technology supply agreements as equivalent to a sale of technology while patent and trademark license agreements are considered agreements for rental of technology. Know-how licenses trigger payments for a term of no more than five years, after which time renewal for an additional five-year period is conditional upon a showing that the technology has been updated enough to merit continued payment of royalties for a second five-year term. Thus, upon expiration of a term of either five or ten years, the BPTO considers that the recipient owns the technology for which he had paid. Know-how agreements receive the same tax treatment as do patent license agreements, and the deductibility ceiling ranges between 1 per cent to 5 per cent of the net sales. D. Technical Services (Assistance) Agreements Parties supplying and executing specialized services for which payment is to be received should file a technical services agreement with the BPTO. Typical activities covered by this type of agreement are transfer of technical information, planning and programming methods as well as searches, studies and specialized projects on how to perform the services and operate the technology. In evaluating this type of agreement, the BPTO requires submission of a detailed schedule setting forth the qualifications of the technicians, their hourly labor rates, and total number of hours worked. The payment term under this type of agreement may be fixed either as a lump sum or as a series of payments as long as the BPTO receives a schedule explaining the breakdown of fees. In addition, the BPTO should be notified of the time period during which the services will be rendered. In the event that the services are performed before the agreement and a schedule is filed with the BPTO, the parties should include the starting and ending dates of the services. If a technical services agreement is filed in connection with a patent or trademark license agreement, the tax deductibility ceiling applies, limiting the royalty payments remissible to the foreign party. However, if the technical services agreement is the only agreement to be filed pertaining to the foreign technology, Brazilian law does not impose a tax deductibility ceiling on the payments. E. Franchise Agreements The sole franchise agreement recognized by Brazilian Franchising Law nº 8955 of December 15, 1998 is the business format franchise. This type of agreement covers the temporary acquisition of rights which involve the licensing of a business method that usually includes the license of trademarks and the supply of technical assistance services in combination with some other related technology transfer. This type of agreement is subject to the same tax regulations as the other agreements, but the deductibility ceilings may be more flexible regardless of whether the parties maintain a parent/subsidiary relationship. III. Case Study The following example demonstrates a business transaction that would necessitate multiple filings with the BPTO. A new American company ( Licensor ) launches a business manufacturing and selling widgets in the United States. It immediately decides to expand its market to Latin America, specifically to manufacture and sell the widgets in Brazil. After consulting with its attorneys and some Brazilian business connections, it locates a Brazilian party ( Licensee ) that is interested in manufacturing the widgets. The Licensor agrees to transfer its technology to the Brazilian company in exchange for royalty payments. Not only does the Licensor need to file a know-how agreement to cover the technology it supplies, it also must file a technical assistance agreement to cover the process of teaching the Brazilian workers on the manufacture of the widgets through the knowledge of foreign technicians. In addition, the Licensor files patent and trademark license agreements authorizing and regulating the Licensee s use of the patent and trademark. Because all of the agreements relate to the same operation, royalty payments for the use of each piece of technology will probably not be approved by the BPTO. The Licensor should first contact counsel that is either located in Brazil or is extremely familiar with the BPTO and its licensing procedure. In order for the patent and trademark to be enforceable in Brazil against potential infringers, the Licensor should file patent and trademark applications with the BPTO. The applications should be filed as soon as possible after the widget business first begins in Brazil since royalties related to a patent license agreement may begin to accrue as of that date. If the patent application process runs smoothly, the patent certificate should be issued in approximately two years. Since the Licensee will be using the patent during that time, the Licensor may request that the Licensee deposit the patent royalty payments in an escrow account for remittance following registration of the patent. Royalties do not accrue regarding the trademark until the corresponding trademark registration has been granted. While the patent and trademark applications are pending, the parties can execute and file the technology transfer agreements so that the Licensor or Licensee, depending on which party has rights of enforcement, can enforce the patent and trademark against any third parties, royalties can be payable to the Licensor and the Licensee can receive tax benefits. The BPTO would probably refuse to approve royalties for each agreement because the entire transaction relates to the manufacture and sale of the same widgets covered by the patent application. For example, the BPTO may only approve royalties on the patent, and 146 December 2002 les Nouvelles

26 those royalties will be calculated based on a percentage of the net sales of widgets made by the Licensee. Because the parties do not have a parent/subsidiary relationship, there is no tax deductibility ceiling imposed by the government. The Licensor has more flexibility to designate the percentage of sales it wishes to collect as royalties, and, subject to BPTO approval, the Licensee can claim that entire amount as tax-deductible. After the BPTO approves the patent and patent licensing agreement, the BCB will authorize the proposed royalty payments. The BCB normally requires approximately two weeks to authorize the remittance of royalties. After this process is complete, the parties should be sure to notify the BPTO of any name, address or ownership changes. Conclusion While Brazil has not yet perfected its intellectual property system, tremendous progress has been made in recent years, especially with the new Intellectual Property Law, Law nº 9,279/96. As one of the most important developing countries, certainly the most relevant economy in South America and together with Mexico the most important in Latin America, effective technology transfer is paramount to Brazil s upward mobility in the international intellectual property arena and to global expansion of businesses. les Nouvelles December

27 Managing Intellectual Assets For Shareholder Value BY BRIAN NAPPER AND SHELLY IRVINE* A History of the Intellectual Asset Management ( IAM ) Movement The evolving technologybased economy of the 1990s, characterized by shorter product cycles, rapid infiltration of e-commerce and an increase in patenting activity, brought forth a shift in strategic thinking for many companies. In 1982, only 32% of the average company s asset base was comprised of intangible assets. Today, this figure is over 70% and growing. 1 Realizing this trend, and seeking competitive advantage during this time of change, firms began to focus on how to generate addi- 1. Harvard Business Review, Jan-Feb Intellectual Property Intellectual Assets tional value from these intellectual assets. The focus of this article is to illustrate the short-term financial benefits and long term strategic and competitive advantages that a firm will realize from having an integrated and focused IAM program. It will provide the reader with a basic understanding of IAM and offer tools to begin company-wide implementation of an IAM program. A company s intellectual assets include not only its intellectual property ( IP ) patents, copyrights, trademarks and trade secrets but also other codified or intangible knowledge such as know-how, contracts, processes and procedures, licenses and non-compete agreements. More broadly defined, intellectual assets include a company s branding, human capital, such as a skilled workforce, and the Patents Trademarks Trade Secrets Trade Names Copyrights Codified Knowledge & Know-How Contracts Permits Licenses Non-Competes Human Capital Organizational Capital Customer Capital Distributor Supplier relationships it has with customers, suppliers and distributors, widely called intellectual capital. The focus on intellectual assets evolved not only from a changing economy, but also from a changing legal environment. In 1982, the Court of Appeals for the Federal Circuit ( CAFC ) was created in the United States and had an immediate and positive impact on owners of intellectual property. Statistics show that prior to the CAFC s creation, approximately 70% of patents challenged in the U.S. federal courts were overturned, compared to approximately 20% after its creation. 2 Further, in 1998, the CAFC ruled that business processes are patentable, a move that generated significant patenting activity within industries such as banking and financial services, which rely on proprietary methods and processes for competitive advantage. Coupled with the favorable legal environment for intellectual property owners was the exploding rate at which patents were being applied for and granted in the 1980s and 1990s. With the focus on intellectual property in the legal and technical community, many companies such as Dow Chemical, Hewlett-Packard and IBM became pioneers in intellectual asset management with well-run and highly publicized pro- 2. North Carolina State University Study, 1%20PPT%20Notes/504.01%20Ch.%208.ppt. Intellectual Capital *Brian Napper, Partner, Deloitte & Touche Shelly Irvine, Senior Manager, Deloitte & Touche 148 December 2002 les Nouvelles

28 Patent Number 1,000,000 2,000,000 5,000,000 6,000,000 pharmaceutical, aerospace, information technology, consumer goods and biomedical sectors will implement systems to better manage their intellectual assets. 4 Revenue Enhancement IAM facilitates revenue enhancement through licensing income, focused and maximized research and development ( R&D ) expenditures and strategic alliances/joint ventures, among others. Worldwide patent licensing grew to well over $100 billion in 1998 and is expected to reach half a trillion dollars annually by 2005 as companies search for new revenue streams by expanding licensing programs. 5 Companies such as IBM and Rambus have turned their patent portfolios into profit centers through strategic licensing of their intellectual propgrams. Each of these companies has experienced the benefits of IAM in terms of revenue, cost savings and strategic advantage. For example, IBM, with its immense patent portfolio and focus on out-licensing, has reportedly managed to generate annual revenues in excess of $1.2 billion from licensing. Dow Chemical has integrated IAM into every facet of its business, using its intellectual assets not only to generate revenue and cost savings, but also to guide the company into strategic markets, protect its position in certain markets and generate more focused and efficient patenting. IAM can benefit not only large companies with wellestablished intellectual assert portfolios, but companies of any size, industry or stage of development. An increase in companies alliance activity throughout the 1990s has also created a demand for IAM. Intellectual assets have become the currency of choice in connection with strategic and joint venture alliances between companies within the same industry, or often within multiple industries. It is estimated that businesses conducted through alliances accounted for 3-5% of an average company s revenues in That figure stands at 20% in 2000 and is expected to reach 40% by IAM is critical to maximizing a company s position within these increasingly important alliances, as well defined, protected and valuable intellectual property often forms the basis and business justification for such endeavors. Benefits of an Effective IAM 3. EIU Global Executive Survey. Granted Elapsed Time 122 years after first patent 24 years after patent 1,000, years after patent 4,000,000 8 years after patent 5,000,000 System Intellectual assets shape every part of an organization. As illustrated below, each division or discipline within a company plays a key role in IAM, and as such, efforts to implement an IAM program must be coordinated on all fronts. Whether used as a defensive or offensive tool, IAM provides significant benefits to a company in terms of revenue enhancement, cost reduction and strategic advantage. The benefits to be gained from IAM are not going unnoticed in the marketplace. Between now and 2005, more than 50% of companies in the Personnel People are a key intellectual asset. A firm must provide the tools and incentives to maximize their value. Legal Ensures that valuable assets are identified developed and protected. R & D Innovation meets market needs. 4. Gartner Group. 5. The Basics of Financing Intellectual Property Royalties, Part III: What is the Market by Licent Capital, July 2, 2001 at / =3&id=412. Marketing Brands, trade names and trademarks provide competitive advantage. Finance/ Accounting Maximize intellectual asset value through capital budgeting, R&D allocation, financial risk analysis and measurement and reporting tools. les Nouvelles December