Intellectual property valuation: a finance perspective.

• Author: Samuel, Dorit
• Position: Symposium: Interdisciplinary Conference on the Impact of Technological Change on the Creation, Dissemination, and Protection of Intellectual Property

1. INTRODUCTION: FINANCE, FINANCIAL MODELING, AND THE LAW

   The close relationship between law and economics has been recognized for more than four decades. Starting with the work of the British economist and 1991 Nobel prize winner Ronald Harry Coase, in his article The Problem of Social Cost, (1) and current Judge Guido Calabresi of the United States Court of Appeals for the Second Circuit, in Some Thoughts on Risk Distribution and the Law of Torts, (2) this relationship became formalized into the field of Law and Economics. (3) Today, there are centers of Law and Economics (4) throughout the legal academy both in the United States and throughout the world, and at least ten journals are dedicated to the subject. Now, with Law and Economics as a mature discipline, accepted as a regular part of the law school curriculum, attention is focusing on the relationship between law and the related--but different--field of Finance, and how constructs from that field have important relevance to the law.

   Finance, originally a subfield of Economics, has grown exponentially, and, since the 1970s, has become increasingly sophisticated so that it has become differentiated from economics in general, and, academically, has moved from the Economics departments of universities to play a significant role as a distinct, independent field of study in business schools. Today, Finance, with its foundation in mathematical and statistical modeling, has taken on special prominence, particularly with respect to issues of asset valuation.

   The field of Finance as a whole is not easily defined. A careful analysis, however, will lead to the realization that almost all significant activity in the field is driven by one encompassing goal: to find an efficient, accurate, and palatable way to evaluate what an asset is worth at a given time, a task that requires one to grapple with serious limitations and to operate within an array of questionable assumptions. Finance professionals have long struggled with the problem of evaluating an asset in a way that accounts for the uncertainty arising from the risk inherent in the asset's performance, the overall market conditions, and their performance interrelationship within the parameters of an assumed or assumable time-period. The core of the analytic task--and the reason the field of Finance has become so mathematically sophisticated--lies in the development and application of financial models of general applicability. Two such financial models, the Capital Asset Pricing Model (CAPM) (5) and the Black Scholes Option Pricing Model (BSOPM), (6) were the basis for Nobel prizes awarded to their creators (7), and are now the most well-known and established asset valuation models, at least in part because of their extreme efficiency of use notwithstanding some theoretical limitations. Innovations such as these in the development of asset valuation models, that at the time were a dramatic departure from accepted valuation principles, had an enormous impact on the development of the field of Finance. These constructs, whether causatively or correlatively, coincided with the recognition of Finance as a field independent of Economics and of particular importance to business and business schools, and the prominence of Finance in the business curriculum over the last quarter of a century.

   Prior to the prevalence of these more sophisticated constructs, finance researchers were grappling with different approaches to the problem of evaluating an asset in a way that accounted for its various inherit risks, and quantified it originally as the standard variation of assets' returns, also known as volatility. Originally, the main concept and the initial basic building block of asset valuation was the concept of Present Value; central to this analysis is the realization that the asset value changes over time, and that change is driven by different factors. What earlier models failed to do is to evaluate how that particular change is correlated to the asset's risk and the market's risk in which this asset is traded; and integrate into their analysis the quantified risk ("volatility") in a way more comprehensive and realistic than simply consideration of statistical standard deviations. As the process evolved, CAPM theoreticians were able to quantify risk in a more sophisticated form, as the correlation of the asset's return with the market, and denominated it as beta ([beta]). With the focus on risk, Present Value analysis becomes more sophisticated, incorporating in a model not only the concept of time value, but also a measure of returns in relation to risk in evaluating an asset. The CAPM ability to quantify risk--to give it a number (albeit a shaky one)--has made it important and useful, and despite its theoretical limitations, has been applied very successfully to various financial valuation situations. Variations and enhancements on the CAPM have been developed since its inception, and today its application in models such as the NPV, EVA, and WACCs is recognized as more significant and powerful than other comparative evaluations.

   Although sophisticated financial modeling and risk analysis developed outside the lawyers' discipline, lawyers have found it increasingly necessary to incorporate some of these financial concepts and models into their work as litigators and client counselors. Problems of valuation, whether for assessing damages or structuring complex transactions, cannot be dealt with meaningfully without an understanding of financial modeling. Similarly, judges must deal with various "expert opinions" producing conflicting valuations, and must necessarily feel overwhelmed by the complexity and apparent inconsistency of these evaluations. In frustration, a judge may resort simply to a Solomonic, "cutting the baby in half' approach as the solution. (9) Despite those limitations, the important finance models are the most useful tools the courts and lawyers have, as of today, dealing with valuation issues, and use of these models in litigation is increasing significantly. With time, as more people learn to use those models and are able to consider their limitations more pragmatically, they will gain more and more overall court acceptance. The table below, a simple count of the number of reported opinions making reference to CAPM or Black and Scholes, shows the increasing judicial acceptance and understanding of these models.

   Although there has been a general increase in awareness and use of finance models by lawyers and judges in dealing with problems of asset valuation, issues of valuation of copyrighted works are particularly troublesome because of the array of circumstances in which valuation questions can arise, the different, separable components of a copyright interest, and the unique nature of individual works. (10) Theoretically, given the fact that a copyright endures for a limited term, it should be possible--even if actuarial tables need to be consulted to estimate the life of the "author" of a work--to make appropriate assumptions as to the duration of the copyright for a specific work. The "time" element of a model for projecting value on its face thus can be determinable, but a reasonable estimate of the life of a copyright on a work does not really help in determining a realistic time period for useful market exploitation of that work.

   The problem of "time" is but one element of serious uncertainty. For example, in the case of damages for infringement of copyright, section 504(a) of the Copyright Act (11) creates an alternative damages scheme. Subject to the statutory limitations, one suing for copyright infringement may elect to recover provable damages, including the infringer's profits, or to recover, without proof of actual harm, specified statutory damages. (12) As to provable damages, the Copyright Act authorizes the recovery of provable damages, attributable to the defendant's conduct, of the harm done to the copyrighted work. Such damages, of course, would include provable profits lost by the plaintiff and the nonduplicative profits received by the defendant. (13) It has been held that "Section 504(b) permits a copyright owner to recover actual damages, in appropriate circumstances, for the fair market value of a license covering the defendant's infringing use." (14) How does one determine "the fair market value of a license covering the defendant's infringing use?" (15) What model should be used to project the future (lost) profits of a given infringed work?

   Similarly, outside of the litigation/infringement problems of valuation, is the continuing matter of valuing a given work for purposes of sale or license of rights to that work. Copyright law and the various rules and limitations apply to an almost infinite array of works. Motion pictures, songs, photographs, unique individual paintings and sculptures, computer programs, choreography, and television commercials all may be protected by copyright, (16) yet there is no overall valuation scheme universally applicable. Even that complication is further complicated by the fact that valuing a work for purposes of sale or assignment of all rights to that work is necessarily different from valuing a license for a specific use of the work (or damages for infringement of specific subsets of the copyright interest). As the Copyright Act provides, copyright is not a unitary concept, but a bundle of distinct, separable rights. (17) Each of the rights exists independently of the others. Each may be exercised independently of the others and each may be transferred, assigned, divided, and subdivided independently of the others. Thus, valuing a motion picture for determining an appropriate license fee for theatrical exhibition distribution rights involves...