Customers & Industries: Pellegrino & Associates

From Boardroom to Courtroom: Using @RISK to Value Early-Stage Companies

  • Industry: Legal
  • Product(s): @RISK
  • Application: Intellectual Property Valuation

Summary

One of the challenges faced by early-stage companies with no assets other than untested technology is how to determine a fair market value for their intellectual property (IP) should they face a civil lawsuit. Pellegrino & Associates uses @RISK risk analysis software to calculate fair IP values, based on discounted future incomes.

With @RISK, we were able to increase confidence in our conclusion by presenting clear and convincing evidence that was easy to defend. I use @RISK for every court case.
Michael Pellegrino

Pellegrino & Associates, LLC is a boutique valuation company with a specialty in software and intellectual property (IP) valuations that include patents, copyrights, trademarks and trade secrets. The firm focuses on building credible valuations for a wide range of companies, from privately-owned businesses to Fortune 500 organizations. These valuations are used for a variety of purposes including internal budgeting and planning, property tax reporting, raising investment capital and economic feasibility analysis.

One of the challenges faced by early-stage companies with no assets other than untested technology is how to determine a fair market value for their intellectual property (IP) should they face a civil lawsuit. Pellegrino & Associates uses @RISK risk analysis software to calculate fair IP values, based on discounted future incomes. The method is detailed in the book BVR’s Guide to Intellectual Property Valuation, by Michael Pellegrino, a leading expert in IP valuation.

Intellectual property (IP) makes a huge contribution to local, national and global economies. Businesses rely on the enforcement of their IP, e.g. patents, trademarks and copyrights, while consumers use IP to ensure they are purchasing safe, guaranteed products. This is why it is important for organizations to understand the value and protect intellectual property.

Determining the value of IP is a significant challenge, especially for early-stage companies with no IP assets other than untested technology. Many variables need to be considered, including estimated market share and adoption, taxes, risks, regulation, and IP protections, operating budgets and capital requirements. One of the key problems relating to the uncertainty of these variables: If a company faces a civil lawsuit, how should the financial value for the IP be determined so that any awarded damages are equitable, regardless of whether the IP proves to be highly valuable or fails to be adopted in the future.

According to Michael Pellegrino, owner of Pellegrino & Associates and chair of the Licensing Executives Society (LES) IP Valuation Standards Committee, "Uncertainty is a fundamental characteristic of all IP valuation, as there are many unknown drivers and it's impossible for anyone to forecast what will happen in the future and their related interdependencies." These drivers can include taxes, timing, margins, quantities sold, staffing costs, revenue per unit, risks, market adoption rates, and development timelines. With so many uncertainties, IP experts either don't model at all, or tend to rely on three main ways to create valuations: model discrete outcomes on certain value drivers (e.g. best case, worst case, expected case), use of functional math models (e.g. Black-Scholes), and use of Monte Carlo simulation.

Pellegrino & Associates uses Palisade's @RISK software to run Monte Carlo simulations for their risk analysis. "We've used it on more than 300 client engagements in every major sector of the economy, from software and semiconductors to chemical coatings and consumer electronics," said Pellegrino. "We apply it to a range of damages models including the assessed value of a product, reasonable royalty payments, total cost of product reproduction, as well as the potential for lost profits – and in all the cases that went to court where we used Monte Carlo simulation, our results were accepted every time."

Building the Model

In one civil case between the founders of a small, private company that specialized in lubrication technologies for pharmaceutical containers, such as prefilled syringes and insulin pumps, Pellegrino & Associates needed to determine the value of two different products. One product was a syringe lubricant, which was based on seven patents and several pending patents; the other product was a scratch-resistant coating, which was based on two patents and also had several pending patents. Neither product was generating significant revenue, but needed to be valued for potential compensatory damages in a court case.

While both products tested well in the lab, they were very early stage and not yet proven in the market. This made it difficult to forecast the future market response or easily assign a credible value. An additional level of complexity was generated by the parties involved in the court case. The plaintiffs wanted the valuation as high as possible, while the defendants wanted it as low as possible. This meant that at least one of the parties would be unhappy with the valuation, so the model would need to be easy to understand and defend.

The Pellegrino team built a valuation model based on a total of 35 simulated inputs: 27 inputs for the syringe lubricant and 8 inputs for the scratch-resistant coating. "With the possibility of each input having up to 10 potential values, we were looking at 1035 possible value permutations – that's a pretty big number," explained Pellegrino. "What made the situation even more difficult was the fact that we didn’t have much discrete, numerical data. It was mostly continuous, which meant the inputs could have had hundreds of possible values." The model would have been unmanageable without computer assistance, so the Pellegrino team used Palisade's risk analysis software to build an integrated decision tree and discounted free cash flow model.

The team used Palisade's @RISK software to build statistical models based on simulation algorithms and Monte Carlo simulations, which calculated fair value based on discounted future income. While neither party in the civil court case contested the valuation model – or the simulated inputs – Pellegrino & Associates was required to explain and defend the variances, distributions, and final outputs. For this case, they needed to distill these complex statistical concepts into common analogies and easy-to-understand visual representations. "While Monte Carlo simulation can be complicated, how you present it doesn’t have to be," said Pellegrino. "In addition to using life insurance actuaries as an analogy, we also used @RISK to create graphics that helped us easily illustrate the variances and final outputs."

Pellegrino & Associates primarily used discrete distributions to show the probability of occurrence of discrete random variables, and triangular distributions to determine the minimum, maximum and peak probability of continuous variables. Of the 35 different inputs that were measured, only 4 had great statistical significance: per-syringe royalty rates, discount rate variance, the first two companies that might license the patents, and when these companies might license the patents.

In the end, the court felt that Pellegrino & Associates' analysis was competent and ruled that their valuation report set forth clearly and in layman's terms the factors, limitations, assumptions, and methodologies used to determine fair value.

"With @RISK, we were able to increase confidence in our conclusion by presenting clear and convincing evidence that was easy to defend. I use @RISK for every court case," concluded Pellegrino.

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