This is the first entry in our series about valuing intellectual property. Check back soon for insights built on first-hand market data that dives into the real-world value of IP, but first: the basics.
Startup founders will all be familiar with the adage that ideas are worth nothing and execution is worth everything. But today, “ideas”—or, more specifically, the marketable product of them—are the backbone of the market. Increasingly, the value of today’s unicorns and deca-unicorns is built not on their tangible infrastructure, inventory, or expensive machinery, but instead on their know-how, proprietary software, network effect, and brand. None of these intangible assets are easily bought or sold, and it has made estimating the value of companies substantially more interesting.
Over the past 40 years or so, the portion of the book value of the S&P 500 that can be attributed to intangible assets has increased almost 400%. In the past, the expense of tangible assets represented a huge barrier to entry for people seeking to create massively valuable businesses. But today, companies are successfully able to make something (namely, money) from “nothing”—intangibles like thoughtwork, traction, brand, and code—instead of infrastructure.
The key difference in understanding value as a function of intangibles versus tangibles is figuring out who would buy the intangibles, and what would they would pay. For example, while Airbnb dominates a market they mostly created, their technology and software won’t have much value in and of itself (like how a building has value regardless of its owner). Airbnb is able to extract value from its technology and software as it services a specific user base in a specific market.
To make things even more interesting, many of the newer companies with massive valuations aren’t even profitable. Instead, investors believe that they have each created some form of intangible value, yet to be realized: a core technology, a cult following, a niche market
So, yes: an idea is worth nothing and execution is worth everything. But an “idea” (i.e. an intangible asset) in the right hands, and with the right resources, can be quite valuable.
What is intellectual property and why does it have value?
When an idea has moved from just being a concept to being an important element in the success of a functioning business, it’s what we call “intellectual property” (IP)—broadly, this is anything that is the product of human thought, but from a business perspective, it’s any such thoughtwork that is owned by the company. Intellectual property may or may not be protected by IP assignment agreements, patents, NDAs, or other mechanisms, and it may take many forms. Some of the most common are software (i.e. code or algorithms), a brand, a customer list, or a unique understanding of a market space or customer problems.
Many of the things a business buys or sells have obvious market value—a used Macbook might be worth $600; a lease is worth the monthly rent times the length of the agreement. These kinds of assets are tangible, in the sense that they physically exist and have an established market with buyers and sellers. IP, meanwhile, is intangible: it can’t change hands as easily and is likely unique, so it doesn’t have a readily apparent market value.
Valuing intellectual property — an attribution game
At Preferred Return, almost all of our clients are venture-backed companies, so we most often deal with IP valuation as it applies to software and technology.
Let’s take Example Company, Inc. Example has paid its team $500K to build a piece of software and spent $200K in a guerrilla marketing effort to get 10,000 customers, generating $250K a year. Example is proud of its work, especially because, aside from $20K in ongoing AWS fees and $100K in admin and support, it does not cost them any further expense to generate the recurring $250K. They make $130K in free cash flow.
Example is approached by Large Co. for a licensing deal, because Example’s software can help Large generate $10M in free cash flow over the next 5 years. The value of the technology may appear to be $500K (the cost of building it), or ( $130K * a reasonable proportion of the cost of building the tech * number of years during which it will produce said benefit ), or ( the $10M it can help Large Co generate * a reasonable portion of the software development costs ). To the untrained eye, the final value becomes a matter of negotiation. The real value of the technology, to analysts like us, becomes a matter of nuance, and the wrong answer is “let’s agree to meet in the middle.”
In startup acquisition situations, the process of estimating IP value in the larger context of the company is a little more complicated than just dividing the net profits among the independently valuable intangibles—assuming the company even has profits.
IP value requires "market participant" thinking
It’s common sense that the market value of something is only what someone will pay for it. This truth is especially self-evident when it comes to intellectual property, because what can add value for one acquirer may add none for another.
For example, Microsoft paid $26.2 billion for LinkedIn because they believed that the networking technology, the user base, and the users’ data would collectively add that much value to their existing related business, which was in an adjacent industry and could be expanded because of the intangibles. Meanwhile, had LinkedIn attempted to sell its business to Caterpillar, they would have had a hard time arguing that the same intangible assets would add $26.2 billion dollars in sales. The intellectual property’s value is not actually inherent to the intellectual property or the company—it requires a market participant to exist at all.
Because most IP only has real value in the context of a transaction, it’s extremely difficult to say what any given intangible asset (an “idea”, connections, brand, commercial contracts, software, etc) is worth in the abstract. However, because startups exist in a crowded market and compete not just with other new solutions in their space but also with incumbents who solve the problem in other ways, or who solve adjacent problems, it’s often possible to estimate the value of IP before or in the context of a transaction rather than after the fact.
It’s this specific intangible-to-use-case relationship that needs to be analyzed in order to understand the true value that intangibles create—whether you need to understand that value for tax compliance, for financial reporting, or to execute a successful transaction. If you’re trying to anticipate the value intangible assets creates for your startup, we’d love to help.