The economic valuation of trade secret assets

August 30, 2022 – The economic valuation of trade secret assets has puzzled the intellectual property bar for years. This perplexity emanates from the economic and legal aspects of a trade secret which must be validated in court.

Today, trade secret assessments are needed for strategic planning, accounting, and business transactions. But most companies do not have an internal accounting system designed to identify, classify, protect and value trade secrets. This article deals with the valuation of trade secrets.

Several recognized methods exist for the valuation of real estate: depreciated cost, replacement cost, fair market value and net present value of future cash flows. All may be acceptable assessment measures in particular circumstances.

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Amortized cost is the cost of an asset that can be depreciated. It is equal to the acquisition cost of the asset minus its estimated salvage value at the end of its useful life. Depreciation is the portion of an asset’s value that has been used. It allows a business to derive income from the assets it owns by paying for them over time. For intangible assets, including trade secrets, the amortized cost method of accounting is not acceptable. Damping requires physicality.

Replacement cost is the cost of replacing the asset. But how to replace a flash of genius? How can one calculate the amount an entity would have to pay to replace a trade secret? For patents, copyrights and trademarks, injunctive relief can be a real replacement — the restoration of exclusive use of intellectual property. But trade secrets, once lost, are lost forever. The bell cannot be interrupted. Under these circumstances, replacement cost cannot even be conceptualized, let alone determined.

Fair market value is the price at which an asset would sell in an open market. There are generally no “market commissions” for trade secrets which are, by nature, secret. The trade secret holder protects against disclosure of trade secret assets to gain economic advantage from the secrecy of trade secret information. Thus, a fair market value is often impossible for trade secret assets.

The valuation method that works best for trade secret assets is the net present value of future cash flows. It is a method of valuing a trade secret asset using the concept of the time value of money. The estimate of future cash flows is discounted to a present dollar value using a present value discount rate.

The net present value of a future cash flow requires an assessment of three factors:

(1) The total amount of future cash flows;

(2) The discounted basis of this future cash flow as present value;

(3) The probability that future cash flows will occur.

If precise values ​​can be assigned to these three factors, then the economic value of a trade secret can be calculated by multiplying these three factors together.

The first factor in the trade secrets valuation model is the total amount of revenue over time to be gained from keeping the information secret, compared to the revenue expected over time if the information were in the public domain. This is analogous to patent valuation, where the economic value of the patent is the value of the exclusive right to prevent others from making, using, offering for sale, or selling the patented invention.

The second factor in the trade secret valuation model is a valuation method used to estimate the value of an investment based on expected future cash flows. Discounted cash flow (DCF) analysis seeks to determine the value of an investment today, based on projections of the amount of cash that investment will generate in the future.

The third factor in the trade secret valuation model is the assessment of the probability of future cash flows derived from the trade secret asset, which can be calculated by evaluating the probability that the trade secret holder will prevail in a civil suit to protect the trade secret asset. .

The third factor has been the stumbling block and obstacle to calculating the economic value of a trade secret, as it has been widely (incorrectly) assumed that it is too risky to calculate the probability of validating the existence of a trade secret in a trade secret lawsuit for embezzlement. These risks include the failure of the trade secret holder to take reasonable steps to protect the trade secret asset; the risk that the trade secret will be misappropriated by a former employee or competitor; and the risk of public disclosure of the trade secret.

Everything has risks. Probability means possibility. What is the probability of something happening? In trade secret law, secrecy defines the likelihood of a trade secret. There is a low probability of misappropriation of a trade secret for a well-protected trade secret. The probability of loss is high for a poorly protected trade secret.

There is a powerful tool for validating the existence of a trade secret and predicting the likelihood of the alleged trade secret qualifying as a legal trade secret. This is the six-factor test identified by the American Law Institute in 1939 after a review of over 100 years of 19th century case law.

The six factors are:

Factor 1: The extent to which the information is known outside the company (the more the information is known outside the company, the less likely it is to be a secret protectable commercial).

Factor 2: The extent to which the information is known to employees and others involved in the business (the more employees who know the information, the less likely it is to a protectable trade secret).

Factor 3: The extent of the measures taken by the company to protect the secrecy of the information (the greater the security measures, the more likely it is to be a protectable trade secret).

Factor 4: The value of the information to the company and its competitors (the greater the value of the information to the company and its competitors, the more likely it is to be a protectable trade secret ).

Factor 5: The time, effort and money spent by the company to develop the information (the more time, effort and money spent developing the information, the more likely it is to is a protectable trade secret).

Factor 6: The ease with which the information could be properly acquired or duplicated by others (the easier it is to duplicate the information, the less likely it is to be a protectable trade secret).

The six-factor test is miraculous in its predictive abilities. The six-factor test assesses the “strength” of the alleged trade secret, ranging from a strong trade secret, to a weak trade secret, to no trade secret.

Assessing the economic value of a trade secret, using the six-factor test, provides the factual basis for the trade secret holder to identify the economic value of a trade secret. , including the calculation of the probability of future cash flows resulting from the six-factor analysis.

The economic valuation of trade secret assets is not too risky. This is a necessary requirement for trade secret accounting. Well-established valuation methods and the six-factor test provide trade secret holders with the tools to determine the economic valuation of trade secret assets.

A. Mark Halligan is a regular columnist on trade secret law for Reuters Legal News and Westlaw Today.

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The opinions expressed are those of the author. They do not reflect the views of Reuters News, which is committed to integrity, independence and freedom from bias by principles of trust. Westlaw Today is owned by Thomson Reuters and operates independently of Reuters News.

R. Mark Halligan

A. Mark Halligan is a partner at Fisher Broyles, LLP and is based in Chicago. He focuses his practice on intellectual property litigation and is recognized as a leading practitioner in the development of automated blockchain trade secret asset management systems. He teaches Advanced Trade Secrets Law in the LLM program at the University of Illinois at Chicago Law School and is lead author of the Defend Trade Secrets Act Handbook, 3rd Edition, published by Wolters Kluwer. He can be contacted at [email protected]

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