Valuation of Confidential Information
It is a business adage that what gets measured gets done. The corollary is that you have to identify Confidential Information in order to know how it is used, and therefore of how much business value it is.
Confidential Information is essentially the glue that holds a company’s work processes and assets together. As such, on its face, Confidential Information is extremely valuable to a company. That said, this information is often tacit versus explicit, and whenever documented, is done so poorly.
Nonetheless, to address valuation it is first necessary to tie the five business needs of the company to the corresponding intellectual property need, of which Confidential Information will be a subset. These relationships are best expressed in a priority related to the Maslow hierarchy of business needs. The Maslow relationship between business and IP needs is shown in the figure.
With respect to Confidential Information, the most fundamental business need of not having any surprises revolves around the IP requirement that the business have freedom to operate. The intellectual property class that most frequently interferes with this freedom is patent infringement. For Confidential Information, is it is not a legally protected asset in most jurisdictions, so it’s value at this rung in the Maslow hierarchy is minimal. Exceptions to the statement are noted in the Territorial Considerations of Confidential Information blog of this site.
It is at the second Maslow level, the business needs for sustained advantaged market position, where Confidential Information is most valuable. The work processes that define how employees, customers, suppliers, and physical assets work together smoothly are indispensable to a successful business. A good way to visualize this is to visit a franchise retail operation like a fast-food restaurant or coffee shop. In such an environment the optimized placement of counters, food preparation equipment, payment devices, customer tables, restrooms, and cleaning supplies are most apparent. The cost-effective delivery of high-quality products is enhanced by such an environment. The Confidential Information about how this environment is working together is critical to the success of the business. However, it rarely protected by trade secret or other formal intellectual property class. Just because the information is in plain view doesn’t mean the average person can really see it. It would take a really carefully trained observer, and even then such a person wouldn’t have physical access to all areas needing observation.
At the third Maslow level where the business needs to fully exploit the technology and business model of the organization, out-licensing programs provide additional value to an organization. To build on the fast-food restaurant or coffee shop example, these operations are often a franchise. It is part of the franchising process that the Confidential Information is shared with the franchisee. From a valuation standpoint it is the price that a franchisee is willing to pay for a fast-food restaurant vis-à-vis a restaurant of their own design that indicates the value of the Confidential Information (notwithstanding the value of the trademarks and bulk purchased supplies and services to the franchisee).
At the fourth and fifth Maslow levels the role of Confidential Information in meeting these higher business needs is minimal in the aggregate. There is of course specific Confidential Information it has sporadic time value.
Three Valuation Methods: Cost, Cash Flow or Income Methods, and Market Methods for Confidential Information
A great deal has been written on the valuation of intellectual property. The best resources are available from the World Intellectual Property Organization (WIPO) and the Licensing Executives Society International. The focus is on three primary means to determine how much intellectual property is worth. These are cost approach, and income approach, and the market approach. Within each of these generalized approaches there are variety of tools and techniques well documented in the LESI and WIPO literature that address the specific unique characteristics of the asset to be evaluated.
The value of intellectual property, intellectual assets, and human capital is always dependent upon the context of the evaluation. In addition to the Maslow Business Need perspective, the three overall environments or contexts for IP valuation are traditionally: 1. Is the evaluation being done as a final stage of a legal action or lawsuit; 2. Is the reason for the evaluation to determine the fair value for an arm’s length friendly licensing negotiation; or 3. Is the evaluation being done to satisfy the requirements of tax authorities or business regulators? Each of these requires slightly different valuation methods.
When it comes to Undisclosed Confidential Information, it is the second environment relating to friendly business negotiations that is of most importance. For this situation, three issues or questions become relevant. 1. How much can the company afford to pay for the right to use the Confidential Information? 2. In what way should the licensee pay the licensor? 3. How much should the licensee pay the licensor?
The first of these issues is important because of prudent licensee cannot base decisions on the theoretical value of technology but rather on whether or not it will enhance his ability to gain revenues. If the price of the Confidential Information, when added to the cost of the product, results in a cost of goods that is higher than what the market will bear, the licensee will lose money and the licensed negotiation will of been a wasted exercise. In win-win negotiations both licensee and licensor discuss and share the data related to this issue so that the ceiling for the value of the technology is established. Then below the ceiling, the value according to the cost approach, income approach, and market approach is established by a variety of methods.
The Retail franchise model is a good example of how valuable and how difficult it is to address Confidential Information. This is probably the most widely used means to transfer the Confidential Information. That said, the value of Confidential Information as part of such contract is rarely if ever split out. Behind the scenes, the franchisee is thinking that the almost unsurmountable hurdle of trying to reverse engineer such an operation at a reasonable price point. This knocks the cost approach out as an option right from the start. Cash flow and income method often show a franchisee how they will be more profitable than other standalone restaurants they could create or buy in an area. The difficulty here of course is that the Confidential Information portion of that income analysis is almost impossible to obtain. The glue example of the introduction is perhaps the best way to visualize this. The glue is everywhere, providing benefits and value in a multitude of different ways. It is simply not cost-effective from an analytical technique standpoint trying quantify this for an income approach. This leaves the market value approach for setting the value of the franchise. However, this to doesn’t really get to the crux of the Confidential Information’s value. Such is rarely split out in the market comparable data.
A very sophisticated Four-leaf model of intellectual capital valuation does exist. However, analysis of the 77 categories of intellectual capital identified in this model is both time consuming and expensive. The benefit of knowing the value of just the Confidential Information of a business would outweigh the cost of obtaining it.
Confidential Information is very valuable and indispensable to an organization. Because of its ubiquitous nature is a clue holding all elements of a business together it is almost impossible to set a value for this in isolation. Valuation is often done in the context of a franchise, wherein the mixture of intellectual assets is valued as a whole rather than the separate elements.