Valuation of Trade Secrets
With rapid advances in technology coupled with the increasingly advanced state of reverse engineering, companies are under greater pressure than ever to protect their intellectual property. Among the intangible assets, intellectual property is arguably the most diverse, ranging from tradenames, copyrights, and patents to know-how and trade secrets. Despite being commonly defined as exclusive rights to creations of the mind, not all intellectual property is afforded the same legal protection. To be afforded legal protection, the attributes of intellectual property must be disclosed to the public.
However, in order to serve their economic purpose, characteristics of know-how and trade secrets cannot be made available to the public and therefore have little protection outside of non-disclosure agreements. Know-how is a form of trade secret and is much more frequently seen in the valuation profession than trade secrets. In practice, know-how is combined with a patented technology and valued as what is commonly referred to as developed technology. Trade secrets, on the other hand, are usually seen on a standalone basis, and given the critical attributes that must be disclosed, valuations are seldom seen outside of litigation. Per the Uniform Trade Secret Act, the defining criteria of trade secret intellectual property are as follows:
- The information is not generally known in the industry or trade,
- Appropriate steps have been taken to protect the secrecy of the information, and
- There is an actual quantifiable competitive advantage derived from the secrecy of the information.
With the inherent confidentiality in trade secrets and their lack of legal protection, choosing an appropriate methodology presents some challenges. Given that once a trade secret is in the public domain any competitive advantage is eliminated, the replacement cost approach is a non-starter. Using a market approach to value a trade secret is also challenging given the absence of a market for trade secrets and the shortage of disclosed information even if there were one. To properly conclude the value of trade secrets, the “with and without” and relief from royalty applications of the income approach are logically the most appropriate methodologies to use.
The calculation of the “with and without” method requires the evaluation of the following two factors:
- Estimating the timing and amount of future incremental cash flows, and
- Applying an appropriate discount rate.
The first factor is calculated through the difference between the income generated from keeping the trade secret undisclosed and the income generated if the trade secret were in the public domain.
The second factor would be discounting the above calculated cash flows to present value at a rate appropriate to capture the riskiness of the cash flows. With the considerable challenges to sustaining any competitive advantage, this discount rate should be higher than the cost of capital for the overall business enterprise.
The calculation of a relief from royalty method is similar to the above methodology; however, the future cash flows calculated are attributable to the entire enterprise. The cash flows are then applied a royalty rate, which calculates the amount to be saved by owning the trade secret as opposed to licensing it from a third party. These adjusted cash flows are then discounted to present value at the same rate as determined in the “with and without” methodology.
While both of these methodologies can be used to quantify the competitive advantage of a trade secret, both fail to capture the other two criteria of a trade secret: a) the information is not generally known in the trade, and b) appropriate steps have been taken to protect the secrecy of the information. Put another way, conclusions drawn from the two methodologies must be adjusted for the probability that a reasonable person would agree to the existence of a trade secret. While showing that the information contained in the trade secret is not of general knowledge to the trade could involve the testimony of industry experts, the second criteria is much more subjective. The plaintiff has the burden of proof to show that “reasonable” measures were taken to properly secure the trade secret. These measures can range from diligent paper shredding and minimization of employee exposure in some instances to creation of complex IT firewalls and implementation of physical security in others.
With the increasing importance of intellectual property to maintain a competitive advantage, we are almost certain to see an increase in litigation and in valuations involving trade secrets going forward.