Intellectual Property and Divorce: An Evolving Frontier in Asset Division
September 29, 2016
“This article appeared in the September/October 2016 issue of Valuation Strategies. ©2016 Thomson Reuters/Tax & Accounting.”
While intellectual property requires special assessment in order to properly establish its value for equitable distribution purposes, a dearth of case law makes it difficult for practitioners to know what methods to employ when dividing assets.
Author: LYNNE STROBER, ELIZABETH FEATHERMAN, JENNIFER PRESTI, AND JOAN D'UVA
JOAN D'UVA, CPA, ASA, is a partner at EisnerAmper in the Forensic, Litigation and Valuation Services Group. In addition to being a CPA, she is an Accredited Senior Appraiser designated by the American Society of Appraisers (ASA) and a past President of the ASA Princeton Chapter. Her practice focuses on valuation of equity and intangible assets including intellectual property. ELIZABETH FEATHERMAN, Esq. is a counsel in the Intellectual Property practice group at Mandelbaum Salsburg. She is a registered patent attorney with mechanical engineering degrees from MIT (B.S.) and the University of Pennsylvania (M.S.). Her practice focuses on licensing and all aspects of intellectual property protection, including prosecution and enforcement of patent, trademark, and copyright rights. JENNIFER PRESTI is an associate in the family law department at Mandelbaum Salsburg. Ms. Presti is admitted to practice in New Jersey and in the U.S. District Court for the District of N.J. She is a member of the Essex County Bar Association, the Monmouth County Bar Association, and the N.J. State Bar Association's Young Lawyers' Division. LYNNE STROBER, Esq. is the chair of the family law department at Mandelbaum Salsburg. She is president of the Barry Croland Family Law Inn of Court, a fellow of the American Academy of Matrimonial Lawyers N.J. Chapter, and former chair of the N.J. State Bar Association Family Law Section.
Courts and other matrimonial tribunals across the U.S. are grappling with questions surrounding the equitable distribution of intellectual property assets-including but not limited to copyrights and patents. While these assets require special assessments to properly establish their value, it is an area has not yet been fully addressed by case law.
The types of intellectual property that may need to be distributed in a matrimonial action include:
A patent for an invention is the grant of a property right to the inventor, issued by the U.S. Patent and Trademark Office. The inventor or the patent owner has the right to use an invention or to allow others to use it via a license. A patent granted by the government allows the inventor to use or others to use the invention for a limited duration (typically 20 years) in exchange for the inventor publicly disclosing the invention. After a patent term ends, anyone is free to use the invention. In some cases, during the course of their employment, inventors are required to assign all their patent ownership rights in the invention to the company that employs them. Once the patent rights are assigned, the inventor will not retain any ownership rights.
Trademarks are brand names that enable the public to identify the source of goods or services and distinguish the goods or services of one seller or provider from those of another. A trademark can be a word, name, symbol, graphic, or other distinguishing mark, or even a sound or smell, or any combination of these. Examples of trademarks are brand names of products or services.
A copyright is a form of property that grants exclusive rights to the author of a work. The protected work must be fixed in a tangible medium of expression, such as a video, book, computer program or source code, play, painting, photograph, sculpture, architectural drawing, movie, music, or television show. Copyright protects an expression of an idea but does not protect the idea alone.
A trade secret is any confidential business information that provides an entity, person, or company a competitive edge in business. It can be a formula, practice, process, design, instrument, pattern, commercial method, or compilation of information which is not generally known or reasonably ascertainable by others, and by which a business can obtain an economic advantage over competitors or customers. A well-known example of a trade secret is the Coca-Cola soda formula.
With the dearth of case law in the matrimonial field, methodologies are needed that set forth the best way to value and divide IP assets. How can one determine the value of a piece of art, a script, or invention created by a divorcing party, and how can a plan be established for the future distribution of its value?
Laying the Foundation: State Marital Asset Distribution
Equitable distribution is the division of assets and obligations acquired during a marriage, whether individually or jointly. Equitable distribution may be effectuated either by agreement, or by a judicial decree. And, as with other types of cases, when the courts get involved in distributing marital property, they follow their own states' statutory and case law precedents. 1
In Connecticut, as a general framework for equitably distributing marital property, "[t]here are three stages of analysis regarding the equitable distribution of each resource: first, whether the resource is property within the Connecticut General Statutes § 46b-81 to be equitably distributed (classification); second, what is the appropriate method for determining the value of the property (valuation); and third, what is the most equitable distribution of the property between the parties (distribution)." (Internal quotation marks omitted.) 2
In Florida, "the court must begin with the premise that the distribution should be equal, unless there is a justification for an unequal distribution based on a number of relevant factors, such as each party's economic circumstances, contribution to the other's education and time investment in child care, among many others." 3
More examples of state law could be offered, but suffice it to say that in states that follow equitable distribution laws (as opposed to community property states), property acquired during the marriage will be divided between the spouses in a fair and equitable manner; however, there are no set rules for determining who receives what, or what the percentage distribution to each spouse shall be. In the minority of states that apply "community property" laws, when dividing a divorcing couple's assets and obligations, a judge divides the couple's joint assets and debts in half, distributing them between the parties; however, valuation remains an issue. A community property court will not attempt to divide assets based on a framework of factors, as states that follow equitable distribution laws do. There are only nine community property states:
- New Mexico
Intellectual Property Valuation Methods
Valuation analysts use numerous approaches in order to reach a reasonable indication of a defined value for the subject intangible assets on a certain date. One of the most important aspects in valuing an intellectual property asset is the ability of the asset to generate future income.
The four most common approaches to estimate the fundamental or fair value of the intellectual property are the cost approach, market approach, income approach, and relief from royalty approach.
The Cost Approach
The cost approach is based on the economic principle of substitution. This principle states that an investor will pay no more for an asset than the cost to obtain, by purchasing or constructing, a substitute asset of equal utility. This approach works best where the asset is not presently or is not expected to produce income, and is most commonly used when the intrinsic value of the asset must be reported on the books. There are several cost approach valuation methods, the most common being:
- Historical cost.
- Replacement cost.
- Replication cost.
Historical cost valuation measures the amount of money spent in the development of the intellectual property at the time it was developed. Unless the intellectual property was developed in the recent past, a historic cost measure tends to be unreliable, due to the impact of inflation and the changes that occur in technology over time. In addition, it is not always possible to provide accurate information on the resources spent for such quantification.
Replication cost valuation measures the amount of money that would need to be spent in current cost terms in order to develop the intellectual property in exactly the same way to achieve the same final state in which it currently exists. This includes costs incurred on any unsuccessful or inefficient prototypes. Technological changes and improvements to underlying technology thereafter are disregarded under this method.
Replacement cost valuation calculates the amount of money that would need to be spent in current cost terms in order to develop the intellectual property as it currently exists, but excludes the costs relating to unsuccessful or inefficient prototypes. Technological improvements to underlying technology are taken into account in the calculations under this method.
The Market Approach
The market approach is based on competition and equilibrium. Supply and demand factors will drive the price of an asset at equilibrium point in a free market. Furthermore, it provides an indication of the value by comparing the price at which similar property has exchanged between willing buyers and sellers. Data on such similar transactions may be accessed in several public sources, including specialized royalty rate databases.
For patent valuation, a market comparables approach should offer a good indication of a patent's value, as it reflects the exchange of value between two parties. However, it is often difficult to find a suitable comparable transaction in valuing patents because of the lack of disclosed sale or licensure activity and the uniqueness of each patent.
The Income Approach
The income approach analysis focuses on the economic value of the future cash flow derived from a specific collective property entity, i.e., the cash flow. This approach estimates the fair value of intellectual property by discounting the future economic benefits of ownership at an appropriate discount rate-the net present value of the discounted future cash flow. The accuracy in obtaining the discount rate of interest is critical. To determine the value of the future income stream, the following variables are required:
- A projected income stream either from product sales or license of the patent.
- An estimate of the duration of the useful life or its remaining exclusive term of the patent; the probability of success, if it is not a commercialized product.
- An understanding of risk factors, such as the risk of invalidation, superseding technology or obsolescence and incorporating those into the valuation.
- A real-world, market-appropriate discount rate.
- A determination needs to be made if there are other assets that contribute to the income stream in addition to the intellectual property.
Some of the risk factors in using the income approach, especially for patent valuation, include:
- New Patent Issuance: New patents can make existing technology obsolete or allow new competitors into the same field. If more competitors are allowed into the same field practicing their own patents, the value of the underlying technology will be diluted. To access the crowdedness in a given technology field requires research in the patent landscape in a particular technological field. It is often difficult to survey the patent landscape because we may not be able to ascertain what patent applications have been filed with the U.S. Patent and Trademark Office. Only issued patents and published patent applications are available for public viewing. Therefore it is difficult to anticipate what new patent applications are in the field.
- Patent Challenges/Declared Invalid: After a patent is issued, it still remains vulnerable and open to attack for invalidity. A challenge of invalidity comes in different forms, including for example, challenging someone other than the named inventor is the "real" inventor to the invention or the invention is "obvious" to persons skilled in the relevant technology. Formal challenges are lodged with the U.S. Patent and Trademark Office. If the challenge is successful, the patent would immediately be rendered as invalid. Any patent licenses will also be rendered invalid as well. To protect against this risk, proper due diligence should be performed to anticipate potential problems.
- Patent Infringement Suits: Defending a patent infringement suit is costly. It could include treble damages for willful infringement. To protect against such risks, due diligence should be performed prior to evaluation to survey the patent landscape and to anticipate any potential problems.
The Relief from Royalty Approach-A Hybrid of the Income and Market Approaches
Relief from royalty is based on deprival value theory and looks at the amount of income that a company would be "deprived" of, if it did not own the intellectual property in question but was required to rent it from a third party instead. The royalty represents the rental charge that would be paid to the licensor if this hypothetical arrangement were in place. The ability to determine an appropriate royalty rate is fact-dependent and requires identifying suitable comparable transactions. A reliable sales forecast is also required for estimating the income stream. There are many on-line sources that have databases of licensing transactions that can be used to determine an appropriate royalty rate.
This method is useful because the market size and expected market share are generally easy to ascertain. However, the assumption of a rental charge in the valuation may not readily materialize in reality. It must be kept in mind that some patents are of little or no economic value to warrant a rental charge.
In addition to the four main valuation methods there are others, including the real options and venture capital methods. Using the real options method would entail determining certain inputs to the Black-Scholes option pricing model. Such inputs include volatility of cash flows, and estimates of the time horizon and fixed costs invested to commercialize the product. The venture capital method is similar to the discounted cash flow model except that the discount rate is derived in a different manner. Selecting the appropriate method may be based on whether it is an asset in early stages of development (often a cost-approach or optional-pricing model would be used) or it is a mature asset where future forecasts are not so speculative (a discounted cash-flow approach or market approach would be appropriate.)
Regardless of the form of the intellectual property (e.g., patent, copyright, trademark or trade secrets) courts need to divide the assets according to how they can best be monetized and managed. While spouses may fight over the property for financial reasons, courts award the intellectual property rights to the rights-holding spouse and award some portion of the residual or royalty income from the intellectual property to the non-rights-holding spouse. This is because the rights-holding spouse is more likely to know how to further develop the intellectual property portfolio and also to maximize the value of the intellectual property assets. For example, the inventor can further develop the patent portfolio by continuing to create more inventions in his patented field and to file for more patent applications to build up the patent portfolio. Similarly, for writers who hold copyrights in their novels, screenplays, or songs, they are the most familiar with their work and can best monetize or further develop subsequent work based on their rights. In the meanwhile, the non-rights holding spouse can receive his or her interest in the form of income.
Putting the Methods to Use
Where intellectual property assets have been or are being paid out, their values are easily determinable and divisible. Other intellectual property assets may not be quantifiable at the time of divorce. A review of some available cases shows how courts throughout the U.S. have addressed the issue of valuing intellectual property in a divorce.
In Teller v. Teller, 4 the Supreme Court of Hawaii observed: "Inasmuch as intellectual property has not been the subject of equitable distribution in our courts, we have not developed a method of determining fair market value for such property." The court found that the husband's patents and trade secrets were subject to division. As part of the valuation discussion, the "cost approach" was rejected in favor of the "fair market value" methodology. The decision contains in-depth discussion of the court's analysis, including its reasoning that a trade secret is an "asset" because it has value and its misappropriation is actionable. The complex issues that may arise when an intellectual property asset becomes viable are discussed, such as whether if an asset is created before a marriage but the patent is obtained after the date of marriage, the patent is subject to division. Also, the pre-marital aspect of an IP asset may have increased in value during the marriage. These are fact-based analyses to be made. In Teller, the intellectual property had been the subject of an actual sale with a specific value attributed to the IP. As a result, the resolution of the valuation issue was easy for the court, although that is not always the case.
Jacoby v. Jacoby 5 addresses these issues as well. In this case, the IP asset at issue was not sold; the husband was going to receive a stream of income -i.e., royalties-from his invention. Once again, the court found that there was a clear basis for determining value.
In McDougal v. McDougal,6 the Michigan Supreme Court affirmed an award relating to an IP asset that provided the recipient spouse with a percentage of the stream of income and not a percentage of the IP asset itself. The high court stated: "The new judgment on remand shall provide that the patents and licensing agreements are the property of the defendant, subject to the defendant's obligation to share the funds generated from those assets, as provided in the new judgment on remand." It is interesting to note that the value of IP has also been addressed in criminal cases concerning the theft of IP assets. For instance, the loss of a trade secret has been calculated as that which a reasonably prudent investor would pay for the trade secret.
Finding a System
IP is a highly complex type of property and there are few cases that address its valuation in the context of divorce. On top of this, the emphasis on mediation and arbitration has resulted in a decreased number of court decisions addressing these complex matters. That means there is less guidance for the practitioner, as different treatments of similar facts and effective ways of addressing IP valuation remain unreported.
Lawyers and experts need a methodology for handling the valuation and division of the special assets, going forward. In that regard, the present authors propose the following: When the value of the asset is being paid out-when the value of the IP asset is being paid out-assuming it is a valid representation of value-that value should be accepted.
If an IP asset is sold, the sales price will presumptively reflect the value. This works when an IP asset is sold as part of a transaction, as when a beverage company sells the product and the drink formula (a trade secret). If a specific value is assigned to the trade secret, that value should be used, as was the case in Teller.
If payments are made by a third party for the use of the entity intellectual property, such as through royalty streams, payments net of taxes can be used to measure value. This works for recordings, television, etc.
Quantifiable IP Asset.
Where the IP asset is quantifiable, a fair market analysis may be used. This is appropriate when the asset is ripe for valuation but has not been sold or and has not yet created a stream of income, such as the payout or royalties. One example might be a computer application that addresses a novel issue. The traditional accounting analysis can be used as to cash flow, risk, possible life span, costs, characteristics of uniqueness, and whether one spouse is the sole creator. These are not marketability discounts but factors as to be weighed.
IP Asset Not Yet in Final Form.
When the IP asset is incomplete at divorce, such as a book that has been written and is under negotiation to be published, a formula needs to be in place. A hybrid model using certain aspects of the division of unvested stock options and the division of retirement assets not in payout status should be employed. A constructive trust should be imposed over the asset and a formula should be used similar to the coverture fraction establishing the marital portion of the asset. From the value of marital portion, costs should be deducted.
For example, when the husband and wife met, the wife was working on creating a unique widget. The work continued throughout the marriage and at time of the complaint she had not sold the rights to the widget. However, she sold the widget after the divorce, has received a payout over several years and has incurred marketing expenses. If the before-marriage period of work was two years, the marriage lasted for five, and the period after the filing of the dissolution complaint has been three years, one half of the total net value would be subject to distribution (5 years of marriage vs. 2 years pre-marriage and 3 years post-filing). A percentage of the half could be determined, less actual cost and taxes at the time. The percentage could be lessened as the post-complaint time increases.
All of this would be fact-sensitive. A post-divorce analysis by an expert would be necessary. The asset would be preserved and subject to the formula set forth in a judgment of divorce. The formula would not be able to be fixed until the duration for economic realization is established. There can be an annual review; after some period of time, the parties or a court may determine the distance between the award and the post-divorce success is too great and the constructive trust may be dissolved. An entity life span may be imposed on the plan, or a strict formula can be automatically imposed. The approach needs to be tailored to the case. However it is set up, this approach avoids an unanticipated windfall to only one party if the book becomes a hit. As a side-benefit, a potential legal malpractice claim may also be avoided.
Some IP assets, such as royalty streams, are easy to divide. However, other IP assets are less cooperative. The efforts of each party must be considered, such as for marketing or taking additional steps for asset creation. At the time of dissolution, a book may still need to be edited, a play produced, an invention acquired by a company, etc. Although not a complete asset, there is value.
It is risky to value an unquantifiable asset, and hard to negotiate a percentage where an unknown amount of time post-complaint will be needed to recognize the value. What about the asset that looks like it has no value, and then becomes extremely valuable post-complaint? To avoid a potential malpractice claim, rights need to be protected. Unfortunately, the case remains in part open ended. The clients remain bound to an incomplete asset. If a party waives a claim to such an asset, language needs to be included in a matrimonial settlement agreement that the value is speculative and there is a risk in waiving the claim.
The judicial decisions cited in this discussion are very fact specific, and it must be kept in mind that all options need to be considered in crafting an approach that is specific to the facts of the case. With all the burgeoning areas of IP, practitioners must be prepared to address intellectual property assets as part of equitable distribution and community property, using the guidance of case law, expert opinion, and some of the methods discussed herein. This discussion is just beginning.