TECHNOLGY COST ESTIMATION
HOW MUCH DOES TECHNOLGY COST?
Technology valuation is an essential part of technology transfer. How to determine the price that will objectively reflect the value of technology? This question arises both from developer’s and buyer’s side, especially in case of intellectual property valuation. The task becomes more complicated if the technology is still in process of developing. In this case, at the present moment we need to evaluate something that will appear only in the future.
TECHNOLOGY VALUATION METHOD
There are three basic methods of technology valuation based on cost, market and income approaches. These methods are not complex investment models, and are based rather on the logical analysis of the existing information on a new technology. There are also several more sophisticated methods implying more complex mathematical calculation.
The cost approach is based on the assessment of the costs of developing a new technology.
For the developer, the value of the new technology is equal to the total amount of costs associated with its development, including indirect costs for infrastructure, utility, manpower, taxes etc.
The buyer estimates the future costs for replication of the similar technology in-house, hedging the organizational and country risks in the specific case.
This method can be potentially applied to the transfer of equipment and other tangible assets. But it is almost impossible to estimate costs for the creation of intellectual property which is purely intangible. It is obvious that the coast approach of valuation is highly subjective. For example, some of the supplier’s costs could be a result of his (her) inefficient management. So, from the buyer’s point of view these costs will be not justified. Another drawback of the coast approach is that it doesn’t reflect the future income of the new technology and its market position.
However, the cost approach can be a basis for the initial stages of negotiations. It can be helpful in understanding the other party’s position. Moreover, this method can be useful in the establishing of a joint venture, to evaluate the investments made by each party.
The market approach is based on the comparison of value of similar technologies that are already available on the market. This method is a reliable way to get the market price for which at the moment technology can be acquired.
However, in practice, the active market of new technologies doesn’t always exist. For example, in case of a breakthrough technology, it is difficult to find the comparable equivalents. Even if the market of similar technologies exists, to apply the market approach we need an open access to the information about the transactions on this market.
Besides, the market approach, as well as the cost approach doesn’t reflect the future income generated by a new technology.
The income approach is based on the expectation of future cash flows resulting from the technology implementation. This method determines the profit-creating potential of the new technology. The value of technology is considered as the difference between the cash inflows and outflows over a certain period of time.
The main drawback of the estimation of future revenues is the uncertainty of any long-term prediction. The key point of such estimation is the risk associated with each factor potentially affecting both market (future demand, regulation, exchange rate, etc.) and technology which can become obsolete.
That’s why we can find different facets of the income approach. Each of them is taking into account different aspects influencing future profits from the new technology. Among them the most widely used is the discounted cash flow method.
Discounted cash flow method (DCF) is based on the concept of the time value of money which says that a certain amount of money today has different buying power than the same amount of money in the future.
The DFC method evaluates the present value of future cash flows.
Present Value = Future value / (1+discount rate) i
Future value represents the sum of expected cash flows in a future period;
i is the year of the projection period;
Discount rate reflects different types of risks that affect the future income. For example, risks associated with inflation, taxation, changes in the cost of raw materials and energy, company and country development
The value of technology is calculated as a sum of future earnings for each year of the forecast period adjusted at the proper discount rate.
The main issue of the DCF method is the determination of the discount rate. There are various models of its calculation which are typically based on an advanced mathematical approach. The most widespread model used to calculate a discount rate is the capital asset pricing model (CAPM).
The use of mathematical calculation can be considered on the one hand as an advantage of the DCF method, which allows to accurately determine the technology value.
But on the other hand, this calculation relies heavily on the assumptions of risks and future cash flows. So, the objectivity of the technology value depends on the objectivity of the assumptions that were made. The omission or incorrect prediction of one of the parameters affecting the future value can drastically distort the final result.
Moreover, the complex mathematical calculations have high sensitivity to input parameters change. Even small errors in assumed values can exponentially change the outcome of the valuation. Consequently, two valuations of the same technology, made by two different analysts can give completely different results.
REAL OPTIONS METHOD
The real option allows to make the adjustments in the technology valuation, according to possible changes in the future.
The real options method is based on the financial theory of options. An option is a contract which gives its owner the right, but not the obligation to buy or sell a specific asset at a fixed price (called strike price) on or before a specified date. The buyer pays a premium to the seller for this right. There are various models which are used to evaluate the price of an option, among which the most widely applied, is the Black-Scholes model.
The Black–Scholes or Black–Scholes–Merton model is a mathematical model for the dynamics of a financial market containing derivative investment instruments. From the partial differential equation in the model, known as the Black–Scholes equation, one can deduce the Black–Scholes formula, which gives a theoretical estimate of the price of European-style options and shows that the option has a unique price regardless of the risk of the security and its expected return. It is widely used, although often with some adjustments, by options market participants./span>
In case of technology valuation, a real option gives to the investor the exclusive right, but not the obligation to take a decision of the further investment of the project at the specified date in the future.
The real options are often used in the valuation of research projects or other projects that consist of several parts with a high uncertainty of success.
As an example, let’s divide a research project into four phases:
2) Prototype creation
The basic options such as delay/abandon the project or expand/cut funding, will give to the investor the flexibility in the decision making taking into account the results of each stage of the project.
Consider a scientific research that leads to a breakthrough discovery that could be used in various industries. So, it could be interesting for the investor to expand the future funding. But, if the research does not lead to any result, the investor can abandon the project. Similarly, this technique is applied to all subsequent stages of the project. Success or failure in the prototype creation will determine the amount of investment in the further production. The market demand for the new product after its launching will enable the investor to make a decision about the next investment in commercialization.
The shortcomings of the real options method are first of all associated with the complex mathematical calculation which limits the quick application of this method in the real life. Moreover, it is hard to choose the right stage of the project for the options introduction. The example above was a very simplified model of a research project. In practice, the introduction of an option in the project requires considerable experience and deep knowledge in each of the areas related to research and its subsequent commercialisation.