Creating Exponential Value, Part II: What is Your Idea Worth?

In the previous article of this series, Stuart Lindquist touched on a point that is critical to physician inventors to consider: namely, how far to take your idea down the path of development on your own before trying to sell it off to a company. While it may be enticing to look for possible suitors soon after inception of your idea, chances are that the full value of that idea has not yet been realized. Could you have garnered interest from multiple companies if you had prototyped and tested it? What would it have been worth if you had gained regulatory approval first?

Throughout the series, the following notion holds true: your best chances of creating exponential value are found when you invest your own resources to more fully develop the idea before shopping it around. This is primarily due to two drivers – timing and risk. These two factors will be more fully explored in this article.

Today, we carry the discussion further by diving deeper into assessing the value of your idea. While the term “value” can be broad in its application, in this article we will focus solely on economic value. We will provide the reader with tools for estimating, communicating and supporting value. And we will use the word product rather than idea, because we will make the assumption that you have already thought your idea through and taken it at least part of the way down the path of development to the point of being ready to sell to a company for future commercialization.

Know the Inherent Benefit of Your Technology

Let’s assume that you have developed your product enough to have generated something of significant economic value. You are at the point of looking for a potential acquirer. Your idea is close to being a viable product. The first step is to fully understand the potential benefits of your product as seen by an acquiring company. Hopefully, you already have some idea of its worth because you’ve assessed the market potential of the product as part of a feasibility study.

In order to create value, your product must have the capacity to generate income (technically, free cash flows) for an acquiring company by either filling a gap in their portfolio, thus allowing them to win market share, or by generating a cost savings over what they are currently doing. Simply put, they must be able to sell more, reduce their costs or both. As one of my business school professors used to say, you need to find someone’s pain and come up with a product or service to alleviate that pain. Perhaps the “pain” that a potential acquirer is feeling is related to being out of the market in a particularly hot area. This could be a golden opportunity for you. Knowing the features or benefits that your product offers will lead to negotiating leverage for you down the road.

What Determines Value?

Here is where we get back to two of the major drivers of value – timing and risk. Timing has several facets. Every product takes time to develop. The longer a company takes to develop a product (i.e. the longer they are out of the market), the more potential revenue is lost. Lost revenue is an opportunity cost that is very painful to medical device companies, especially if they are trying to compete with their peers to have a full product portfolio. This is especially true in a growing market or new market segment. Not only is it important for the company to start generating revenues, but given a typical product adoption curve, there is a compounding factor which magnifies the effect of being earlier rather than later to market. That is why, fully developed and close to commercialization, your product may be worth millions today and a year ago you may have been ignored. It’s all timing.

But there is more to the equation than just timing. Risk is also a crucial factor. The more risk you can remove from the equation or the more risk you take off of the shoulders of a potential acquirer, generally, the higher the value. Risk comes in many forms: technical, market, regulatory and legal, just to name a few.

You have the ability to mitigate much of the risk of new product development. From an engineering perspective, you and your team can design, prototype and test various features in order to come up with the optimal combination that reduces risk of future product failures. Or you can explore new materials that make your device function better or reduce the cost to manufacture.

Regulatory risk is reduced once the product has gained approval from your local regulatory body. In the U.S., this is most typically a 510(k) clearance that allows a company to start selling a device. This 510(k) can be seen as an asset, a very valuable asset in today’s world. In fact, I have had more than one device company executive tell me that a 510(k) is more valuable than a patent for certain products. Why? Because for all of their benefits, patents can take three to five years or more to issue after submitting your final application. This may represent a major portion of the useful life of the product. So the reality is that you will often be selling your product to a company, and the company will be selling the device to the market, prior to earning an issued patent. More than likely, you will negotiate the value of your product based on the assumption that a patent will issue, not necessarily after it issues.

That is not to say that the intellectual property process is not valuable. On the contrary, two of the major parts of intellectual property work – non-infringement and patentability – can be extremely valuable. A well thought out (and well documented) non-infringement search, sometimes called a “freedom to operate” or FTO, is indispensable to realizing the maximum value of your product. An acquiring company wants to know that their legal risk of infringing on another company’s property is mitigated as much as reasonably possible. And if your product idea is unique enough to patent, this can significantly reduce the market risk of entering a crowded and competitive business climate.

Valuation Methods

So, let’s say that you have a good idea of the inherent benefits that your product offers to a potential acquirer. You have mitigated as much as possible the many forms of risk, and you offer a company an immediate opportunity to enter a particular market segment. How much is it worth to them? This is the million dollar question (literally!).

The difficulty in estimating the economic value of your product is related to the following:

• You cannot directly measure it (economic benefit for the company comes in the future)
• Much of the value is market driven (see the earlier note on timing)
• It is a one-of-a-kind opportunity (at least if its patentable)

All of these factors contribute to making technology valuation part art and part science. The more you know about different methods of valuation, the better off you will be to negotiate the best possible outcome.

The first approach, and arguably the least helpful, is a cost-based approach. This essentially places the value of your product equal to what a company would reasonably expect to spend in order to replicate what you have done. Be careful – this could mean to knock off what you have done, which is one argument for a strong confidentiality agreement. Companies are routinely making make-vs.-buy decisions. Note that I am using the term “buy” loosely. In reality, companies may buy outright, license or just distribute products. These options are very different and offer a range of benefits to you as the inventor. The argument goes like this, “If we can buy a product from you cheaper or faster than we can make it on our own, we will buy it.”

They may ask you what it took for you to bring the product to where it is today. Be careful with this approach, as it doesn’t take into account the future value of your product opportunity. Using a simple analogy, this is like selling a house in a rapidly appreciating market for exactly what you paid for it. This is obviously not the best way to value your product, although it may represent the bottom of a range of possible valuations and therefore it is helpful to know. In certain situations, smaller companies (i.e. those with limited cash for acquisition activity) may limit your value to what they can afford to pay, and then argue the point based on the cost method. Since you may have no idea of how much they can develop a product for, you have little negotiating leverage once you head down this path.

A second valuation method, and one that is most widely used, is a market approach. Using the example of selling a house, this approach seeks to pin a value to your product based on what others have paid by finding comparable examples.

Companies will try to use market comps to determine the value of your product. After all, who can argue with the market? Everyone assumes that the market is right…even when it’s wrong. It is easy to defend and takes the burden off of the company to find a more appropriate valuation for your specific situation. One problem with this approach is that it inherently assumes that your product is much like others. In other words, it has similarities to existing products on the market in terms of useful life, economic potential, risk profile and features and benefits. This of course is not entirely true, especially if your product is unique enough to be patentable.

In addition, most technology transactions are private and therefore not reportable. It is very hard, even for the companies, to get a solid historical example. The results may be skewed because data exists for only a portion of the overall transactions that occur. And when numbers are reported, often they are for transactions on whole companies, not single technologies.

Despite the drawbacks, the market approach is an improvement upon the cost approach and is widely used as the most reasonable way to value a transaction. It is also easier to generate than our third method, described next.

The third way to value your product is to analyze future potential. This approach is less widely used than the others and presumes some financial modeling knowledge, but may also give the most accurate representation of what your product is worth. It is done quite often within companies to set the course for their own product development efforts, and therefore it is worth an introduction.

Analyzing future potential is essentially an estimation of the opportunity to generate income. Recall that we spoke earlier of the need for a product to generate income in the form of free cash flows for a company in order for it to have economic value to them, and hence a payout worthy of your investment.

In a simplified manner, cash flows may be estimated using the following methodology.

1. Determine the time horizon for your analysis. Although you may argue that extending the analysis all the way out through the life of your patent is justified, that is far too long into the future to make reasonable assumptions. More often a shorter time period is used; for example, five years.
2. Forecast cash flows. This can be as simple or as complicated as you want to make it. At a minimum, you’ll want to have some estimate of a reasonable average selling price in the market of similar devices, and a ballpark cost to manufacture your product. You may also want to know other costs related to selling the product in the market, like sales rep commissions. Recognizing that this information is difficult to obtain for many surgeon inventors, companies exist to partner with you in order to help find relevant information upon which to base your analysis.
3. Discount the cash flows. Using a discount factor allows you to model the effect of timing and risk. Generally, companies will discount value more heavily for projects in the early stages of development due to the fact that much of the risk has yet to be mitigated. Discounting also takes into account the time value of money – a dollar today is worth more than a dollar tomorrow. Companies will also discount the cash flows to account for the opportunity cost of using funds for acquiring your technology instead of using them for some other purpose, like developing more products.
4. Determine net present value. This can be calculated very simply given the factors noted above. The net present value, or NPV, is the summation of all of the individual discounted cash flows. It is something you can calculate using Microsoft Excel or another spreadsheet program.

While the above methodology can get complicated quickly, it is worth knowing how a company views the opportunity for your product as you begin to negotiate a value. After all, the process will inevitably come down to a negotiation, and the more you know, the better off you will be in standing your ground.

Conclusion

As a surgeon inventor, you will at some point find yourself in the position of trying to sell your product to a larger company for commercialization. This is one of the last steps in what was most likely a long and sometimes painful journey. Maximize the potential by gaining a solid understanding of the inherent value that your product offers, especially to those companies that feel the pain of not having a product like yours in their portfolio. Understand the impact of timing and risk. And familiarize yourself with the various methods of valuation. While there is no one right method, all of them may be useful to some extent.

Better yet, use all three to help you “triangulate” on a value. Doing your homework will put you in a position to best determine, communicate and defend the proper valuation for your product idea.