For this article I turned to my friend Andy Scott, a repeat-repeat entrepreneur who co-founded a patent strategy and brokerage firm and was named ‘Top 300 World’s Leading IP Strategists’ at one point. Andy is currently a partner at Advantary.co, which provides outsourced CxO executives. Ping the folks at Advantary if your company needs to augment its management team! Advantary also organizes CEO Roundtables in case you want to apply at https://www.ceo.advantary.co/.
At a lot of tech companies, their portfolio of Intellectual Assets (IA), also called Intellectual Property (IP), could be the most valuable corporate asset. When buyers seek to acquire a target company, their due diligence includes identifying its IA/IP, assigning a value to that IA/IP, and evaluating the transferability risk of that IA/IP in the overall M&A valuation.
TL;DR
– 84% of the collective valuation of the S&P 500 companies is attributed to Intellectual Assets;
– When an M&A buyer does their due diligence on your company, they want to be able to assign a value to the IA/IP that you legally and defensibly hold. Companies with IA/IP that is documented and legally strong can receive a higher valuation during financings and exits;
– When developing a patent portfolio for optimal valuation in an M&A exit scenario, it’s important to have patent assets that not only cover your company’s own innovations but also current and future innovations of your competitors;
– Part of an IA/IP risk strategy is understanding who might sue you for IP infringement. Entering a market where competitors have significant patent portfolios should not be taken lightly, and patent litigation risk can come even from non-practicing entities (aka Patent Trolls);
– Purchasing patents is a tactic for building a patent portfolio and for counter assertion when threatened by a competitor;
– Company founders often assume incorrectly that M&A buyers (or even their own investment bankers) will automatically recognize the value of their intellectual assets during due diligence; it’s incumbent on you to highlight IA/IP contributions to strategic valuation.
Your IA/IP strategy will evolve over time with changes in market dynamics and technological advances. Company founders feel pressure to grow market share quickly and sometimes cut corners on developing an intellectual asset strategy in the early days — which can undermine valuation upon M&A exit.
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What’s Going On Here
Setting up an Intellectual Assets strategy from the earliest days of the company is critically important for tech companies. According to a risk management report from Aon, Intellectual Assets, also known as Intangible assets, comprise approximately 84% of the collective value of the S&P 500 companies. Depending on what sector your company competes in, your Intellectual Assets could be one the largest value components in an M&A transaction or IPO event, and therefore these assets need to be properly managed and optimized.
But many company founders assume incorrectly that M&A buyers (and even their own investment bankers) will automatically recognize the value of their intellectual assets during due diligence. Many investment bankers do not have the skills needed to evaluate and market intellectual assets. Their lack of IA knowledge coupled with your lack of an IA strategy can lead to mistakes that could lose significant value for you, the seller. The work that you do up front to demonstrate IA value can multiply your company’s valuation during a transaction.
A recent example of how IP can drive value is Intel’s December 2019 sale of its wireless modem business to Apple for $1 Billion. To help establish the value of its business unit ahead of the sale, in June 2019 Intel organized an auction of the over 8,000 patents held by this business which could have been acquired by multiple competitive businesses or a non-practicing entity that could have acquired and litigated the patents. The auction revealed the value of the patent portfolio vs. the economics of the modem manufacturing operations, and Apple paid substantially more for the entire wireless modem business given this exercise to separate and market the patent assets.
What Counts as Intellectual Assets?
The emergence of the commercial Internet in the 1990s and the dawn of the ‘new economy’ of knowledge work created the need to account for intangible assets separately from physical assets. Today, intangible assets comprise codified knowledge such as specific code, know-how, business processes, customer databases, and customer relationships. Other terms include “intellectual capital” and “intellectual assets,” which technically mean different things but it’s not important for this post.
The term Intellectual Property (IP) refers specifically to knowledge that can be legally protected. Examples of IP include:
- Trademarks are symbols or words that legally represent a company or product.
- Copyrights gives the owner of a work (for example, a book, movie, picture, song or software) the right to say how other people can use it.
- A patent gives its owner the legal right to exclude others from making, using, selling and importing an invention for a limited period of years.
- And trade secrets are the crown jewels of codified knowledge that are a significant value driver for the business.
In this post, we’ll refer to all intellectual assets collectively as IA/IP.
Why You Need an IA/IP Strategy
When an M&A buyer does their due diligence on your company, they want to be able to assign a value to the IA/IP that you legally and defensibly hold. Companies with valuable IA/IP that is documented and legally strong increase their chance of funding and can receive a higher valuation during financings and exits. An IA/IP strategy is simply a systematic process for creating, protecting, and growing intellectual assets within the company, and it is the responsibility of a company’s CEO and the broader leadership team.
IA/IP strategies can vary depending on the stage and particular industry of a company. In general, startups want to establish guidelines for creating IA/IP, analyzing its competitive position in its market, setting policies for third-party interactions, and continually auditing its IA/IP position.
At a high level, having an IA/IP strategy in place can help many areas of your business:
- Competitive advantage
- Improved product definition
- Protection & justification for R&D investments
- More effective marketing (e.g.patent-pending status)
- Increased revenue and profitability by being able to legally exclude competitors
How Risky is your IA/IP?
M&A buyers also need to feel confident that the IA/IP they are buying will legally transfer to them and hold up in court if a dispute arises. Failing to be thoughtful about IA/IP strategy can bring significant risks to startup companies, and can potentially kill an M&A deal during due diligence. For example, engaging with 3rd party developers or potential corporate partners without the proper NDAs and assignment of IP rights can lead to loss of innovations, and/or future litigation.
Questions that you want to anticipate in your IA/IP strategy include: Did you build your code base on top of Open Source? How do you define and optimize the value of your IP contribution? Can you prove that you actually own your IP? Did you file all your documentation properly, and can you produce that documentation during M&A due diligence? Did you ever pledge your code as loan collateral? Are there any other liens or encumbrances on your IA/IP ownership? Et cetera. Insurance markets are beginning to offer transaction liability insurance specific to IP which can mitigate some of these risks.
A final important piece of an IA/IP risk strategy is understanding who might sue you for IP infringement. Entering a market with large and small competitors with significant patent portfolios should not be taken lightly. A common source of patent litigation risk can come even from non-practicing entities (a.k.a. NPEs or Patent Trolls) that do not have an operating business but hold patents for licensing and litigation purposes. Founders can get very emotional when hit with an NPE lawsuit and overspend on legal costs. A better strategy is to mitigate this risk using insurance and rational negotiation techniques.
Optimizing IA/IP Value
Most companies will hire an outside lawyer to make their IP filings. However, company founders and boards should understand the broader legal concepts.
When developing a patent portfolio for optimal valuation in an M&A exit scenario, it can be important to have patent assets that not only cover your company’s own innovations but also current and future innovations of your competitors. To save money and time, some earlier-stage companies file provisional patents, which buys them 12 months of patent-pending status. They can then decide to file a more expensive non-provisional application and keep the earlier priority date.
In general, the highest value patents have claims with broad applicability; however, overly broad claims run the risk of later being ruled invalid. Claims should also be drafted with future assertion in mind, versus simply protection. Many capital-constrained startups decide to file one broad patent with many claims, and then over time build out a family of related assets. International patent applications can be costly, thus it is important to prioritize filings based on near and long term market opportunities for the company.
Purchasing patents is yet another tactic for building a patent portfolio. Depending on available capital, a company can build a quality portfolio quickly. Companies purchase patents for various purposes including for counter assertion when threatened by a competitor, or to ensure freedom to operate when entering a new market.
Conclusion
It is critical to have a deliberate approach to building an IA/IP portfolio that will stand up to scrutiny during due diligence, and create strategic valuation in your M&A negotiations. Your IA/IP strategies will evolve over time with changes in market dynamics and technological advances.
Innovation and proprietary technology are the cornerstones of successful companies in competitive global markets. Company founders feel pressure to grow market share quickly, but sometimes cut corners on developing an intellectual asset strategy in the early days — which can undermine valuation upon M&A exit. To establish market leadership, it is critical to protect and leverage your core intellectual assets. A good first step for any company is to build an inventory of its intellectual assets, which will be the basis for a broader IA/IP strategy.
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If you are considering an M&A exit in a 1-2 year time frame, now is a perfect time to contact XROCKET to help you optimize your exit valuation: m.addison@xrocket.io
