Lost Profits and Economic Damages Analyses
The quantification of Intellectual Property (I. P.) lost profits and economic damages arises in litigation claims related to infringement, expropriation, lender liability, breach of contract, bankruptcy, and other controversial matters. In addition to damages-related controversies, there are numerous other reasons for conducting an I.P. economic analysis. These other reasons include the following:
- Transaction pricing and structuring, for either the sale, purchase, or license of the I.P.;
- Financing securitization and collateralization, for both flow-based financing and asset-based financing;
- Taxation planning and compliance, with regard to amortization, abandonment loss, and charitable contribution deductions; inter-company transfer pricing; and federal gift and estate tax compliance and estate planning;
- Management information and planning, including business value enhancement analyses, identification of licensing and other commercialization opportunities, identification of spin-off opportunities, and other long-range strategic issues;
- Bankruptcy and reorganization analysis, including the value of the bankruptcy estate, debtor-in-possession financing, traditional refinancing, restructuring, and the assessment of the impact of proposed reorganization plans; and
- Other litigation and dispute resolutions, including marital dissolution, dissipation of corporate assets, shareholder disputes, and reasonableness of owner compensation matters.
Attributes That Distinguish Intellectual Property
I.P. is a special class of intangible assets. I.P. manifests all of the economic existence and economic value attributes of other intangible assets. However, because of its special status, I.P. enjoys special legal recognition and protection. While intangible assets are often created in the normal course of business operations, I.P. is created by specific human intellectual and/or inspirational activity.
Because of this unique creation process, I.P. is generally registered under, and protected by, specific federal and state statutes. The protection of this legal registration provides economic motivation for I.P. innovators during the creative process. This legal registration also provides protection for I.P. creators during the commercialization process. It is believed that the information content of I.P. requires this special protection in order for an I.P. owner to realize economic value of these special intangible assets.
The most common methods for quantifying I.P. economic damages or lost profits are:
- the "Before and After" method
- the "But For" method, and
- the Actual/Opportunity Cost method.
Directly or indirectly, each of these damage analysis methods estimates a value by either (1) the decrease in the value of the Intellectual Property (or the I.P. owner business enterprise) related to the damage event, or (2) the value (albeit negative) of the I.P. damage event itself. In each of these methods, the damage event could be an infringement, breach of contract license joint venture agreement, breach of employment non-compete confidentiality agreement, breach of a commercialization development agreement, a business interruption or tort, a lender liability failure to perform, fraud or misrepresentation related to a sale or transfer.
Before and After
The "Before and After" method quantifies damages by comparing (1) the value of the subject I.P. before the damage event to (2) the value of the subject I.P. after the damage event. The difference, of course, is the economic effect of the damage event. This method requires a valuation of the subject copyright, patent, trademark, or trade secret just before the damage event (or series of events) occurs. Then, this method requires a valuation of the subject copyright, patent, trademark, or trade secret after the damaging event (or series of events) has occurred. Ideally, the "after" valuation is prepared as of a date after the damage event has ceased. The difference between the before and after values is one measure of the damage to the I.P.
But For Method
This difference in I.P. values between two dates may not be the only damage suffered by the I.P. owner. In addition to the decrease in I.P. value, the owner may have (1) lost profits during the period of the damage events, (2) incurred damage remediation costs during the damage event period, and (3) incurred legal/administrative costs to prosecute the party responsible for the damage event.
The "But For" method quantifies damages directly by estimating what amount of economic income would have been earned by the I.P. owner "but for" the damage event. The "But For" method typically involves (1) a backward looking projection of economic income that would have been earned from the I.P. use/ownership, "but for" the damage event, and (2) a forward looking projection of economic income that would have been earned from the I.P. use/ownership, "but for" the damage event. The backward projection starts when the first damage event occurs and continues to the date of the analysis (often trial date in a litigation matter or the date of a damage expert's report). The forward projection starts at the analysis date (for example, the trial date) and continues until both (1) the damage event stops, and (2) there is no more expected residual effect of the damage event. Typically, the result of the backward projection is future valued to the analysis date, and result of the forward projection is present valued to the analysis date. The total amount of damages is the sum of (1) the future value of the backward projection and (2) the present value of the future projection.
The "But For" method is one measure of the damages to the subject I.P. Again, the I.P. owner may have incurred other losses due to the damage event, such as legal fees, expert witness fees, and court costs.
The "Actual/Opportunity Cost" method quantifies damages to the I.P. owner by examining (1) the historical cost of developing and commercializing the I.P. through the analysis date, (2) the historical opportunity cost of not commercializing the I.P. through the analysis date, and (3) the prospective opportunity cost of not commercializing the I.P. from the analysis date. The analysis date is typically either the date of the expert's damages report or the date of the trial/arbitration hearing.
The historical cost of patent, copyright, trademark, or trade secret development includes all (1) direct costs (for example, engineering, design, market research time and expenses), (2) indirect costs (for example, management time, support staff time, overhead expenses), (3) commercialization/promotional costs (for example, advertising, promotion, marketing expenses), and (4) entrepreneurial incentive (for example, a fair rate of return on all other development costs incurred during the development process). All of these actual historical costs should be restated to current costs as of the analysis date. This restatement procedure is usually accomplished by applying price inflation trend factors to the actual historical costs.
The historical opportunity cost includes the income the I.P. owner would have earned from the use of the I.P., absent the damage event (for example, the infringement or expropriation). The historical opportunity cost is estimated from the date of the damage event through the analysis date. And, the historical opportunity cost is stated as a future value (that is, inflated to reflect current costs) as of the analysis date.
The prospective opportunity cost includes the income the I.P. owner would have earned in the future from the use of the I.P. absent the damage event. The prospective opportunity cost is estimated from the analysis date forward to the date when the damage event is no longer expected to affect the subject I.P. And, the prospective opportunity cost is stated as a present value as of the analysis date.
The total damage indication of this method is the sum of the three cost components: (1) historical cost of development, (2) historical opportunity cost, and (3) prospective opportunity cost. In addition to this damage measure, the I.P. owner may have suffered other losses due to the damage event, such as legal fees, expert witness fees, and court costs.
The three above described I.P. economic damage methods are generally analogous to the three I.P. valuation approaches. This is because I.P. economic damages are typically measured (1) indirectly-as a decrement in the value of the subject itself or, (2) directly-as the value (albeit negative) of the damage event itself. The market approach to I.P. valuation is often used in the "Before and After" damage method. The amount of the damages is the difference between (1) the "before" I.P. market value and (2) the "after" I.P. market value. The income approach is often used in the "But For" damage method. The income approach analysis estimates the present value of the economic income the I.P. owner could have earned but for the damage event. The cost approach to I.P. valuation is often used in the actual/opportunity damage method. The cost approach estimates (1) the actual cost as replacement for direct and indirect costs, (2) the historical opportunity cost as developer's profit, and (3) the prospective opportunity cost as entrepreneurial incentive.
In all three of the I.P. economic damage methods, economic income can be defined in many different ways. Economic income can be measured by increases/decreases in units (volume) sold, price per unit, market share (absolute or relative), market size, or by being/not being first to market. Economic income can be measured by increases/decreases in fixed/variable production expenses, fixed/variable selling and administrative expenses, or fixed/variable research and development expenses. And, economic income can be measured by increases/decreases in capital expenditures, working capital investments, or interest expenses. Finally, economic income can be measured by either (1) a change in the absolute dollar amount, or (2) a change (acceleration or deceleration) in the timing of any of the above economic variables.
Since (1) I.P. valuation approaches are often used in I.P. economic damages analyses, and (2) I.P. valuation approaches typically use the same measures of economic income as I.P. economic damages methods, the remainder of this discussion will illustrate the application of standard valuation approaches/methods to quantify I.P. economic damages.