for Distressed Asset Sales
By: Fernando Torres, MSc
In the context of a corporate bankruptcy, creditors naturally focus on the short-term viability and liquidity of the business. In many cases, pursuing financing to continue operations involves selling assets outside the ordinary course of the core business. Two central concerns in these situations are whether all possible assets have been identified, and if they been accurately valued. Increasingly, the types of assets that are uncovered are intellectual property, such as patents, copyrights, and trademarks.
Depending upon the specific history, industry, and other characteristics of the business, there may be patents and patent applications that refer to technology not critical to the core business. It has been our experience that substantial value can be found in these technology assets if, and only if, an accurate valuation can support a sale.
Frequently, the challenge in valuing these assets is the lack of a reliable secondary market and that their application, outside of the original business, may be unproven or uncertain. The consequence of these characteristics is that the most often used valuation techniques (market-based or discounted cash flow) cannot be reliably applied. In this article, we present an alternative valuation approach that captures the value of the potential these technologies have and provides reliable values for these increasingly prevalent types of assets.
Patent Values as Options
A patent is a right to exclude others from applying the technology described through the claims, and does not constitute the obligation of the patent owner to put the technology to use. This right has a finite lifespan, typically less than 20 years. At this level of generality, a patent it shares the key characteristics with a financial stock option, specifically a “call” option; the right, but not the obligation, to buy a stock for a set price during a specific time frame.
As an example, suppose a patent has only two years remaining and that, if implemented, there is a 30% chance that it will generate a profit of $10 million within one year, and a 70% chance that it will lose $1 million. By the second year, the probabilities and profits are assumed to be the same. These premises generate three possible scenarios at the expiration of the patent’s statutory lifespan:
- A 9% chance of $20 million in profits (0.3 x 0.3)
- A 2% chance of $9 million in profits (0.7 x 0.3 + 0.3 x 0.7)
- A 49% chance of $2 million on losses (0.7 x 0.7)
Assuming an interest rate of 5%, a potential buyer could borrow funds to buy the patent and repay the loan, after two years, including compound interest (At $1.025 per dollar borrowed). The solution can be illustrated considering the following two possibilities:
If the buyer pays $5 million for the patent, the probability-weighted outcome in two years will be $4.6 million in profits, but $5.51 has to be repaid for the use of the funds for two years, so there would be a loss of $0.91 million.
If the buyer pays $4 million for the patent, the probability-weighted outcome in two years will be the same $4.6 million profit, and $4.41 has to be repaid for the use of the funds for two years, so there would be a net gain of $0.19 million.
The maximum amount a buyer with a 5% cost of capital would pay would be $4.17 million, that is the amount that equates the outcome with the cost of the funds; it measures the maximum value of the technology. Naturally, in a bankruptcy or reorganization, actual pricing would be lower.
This simplistic example illustrates that, depending on how high the interest rate is, the value of the patent is less than the expected value of the profits. Additionally, it highlights that the necessary inputs are the cost of capital, the term of the patent, its profit possibilities, and the associated probabilities of the scenarios.
In practical applications, the well-known Black-Scholes model allows for the generalization of this approach to a continuous time (rather than discrete “years”), and represents the various scenarios as a probability distribution, mathematically identified by a single risk parameter (the statistical variance). The value of the option or the patent depends then upon the difference between the current value of the patent and the cost of capital, as well as the variance and the time left before the patent expires.
 For instance, the yield on a 2-year U.S. Treasury note.
 The sum of $20 million x 9%, minus $2 x 49%, plus $9 million x 42%.
 The exact solution is: 2 x (0.3x$10 – 0.7x$1) / (1.05)2 = $4.172 million.
 Given the foreseeable applications and alternative outcomes noted.