Fraserburgh

What VC and PE practitioners need to know about IP

When considering intellectual property as • funding costs; an asset class, investors must approach • competitive landscape; due diligence and post-deal management • industry comparators; and a little differently to reap the benefits • obvious exit routes.

By Chris Donegan, Fraserburgh In this context, it is perhaps unsurprising that VC/PE-backed companies such as Google, There are about 240 venture capital (VC) funds Facebook and Groupon were built without a active today which finance around 1,500 new bedrock of valuable patents, although Google companies each year. Approximately 20% of these has subsequently backfilled its portfolio companies generate 80% of VC fund returns. with its $12.5 billion acquisition of Motorola VC funds are a subset of the much larger Mobility’s intellectual property. private equity (PE) universe, in which more However, this situation may be changing. than 75% of the 3,500-plus funds focus The VC/PE industries are cyclical and in 2013 the on buy-out, growth capital or later-stage investment horizon is unfavourable for classic investments in relatively small size. Of the VC/PE strategies that require large amounts 11,000 deals concluded annually, most are of debt. Banks are not funding leveraged buy- valued at less than $100 million, which will outs and it is politically difficult to generate not make the front page of the Wall Street operational cost savings through lay-offs during Journal. a recession. VC/PE firms are thus refocusing on Advocates of VC/PE believe that since improving the fundamentals of the companies private companies are not obliged to meet that they buy by driving sales, protecting quarterly analysts’ earnings targets, they will margins and exploiting intellectual property. be managed more strategically, enabling them Furthermore, some key industry sectors that to focus on innovations that generate long- are attracting capital are IP rich. These include term equity value. While multiple studies have smartphones, software, music publishing, film, confirmed that, on average, VC/PE-backed biotech and medical devices. It is in this respect companies outperform their non-VC/PE- that a better understanding of intellectual backed peers, these studies do not reveal the property and a coherent IP management strategy expected correlation in terms of innovation, can bring significant value. based on number of patents filed or cited. Given this context, and after seven years Intellectual property is rarely the primary working with VC/PE investors in IP-related driver for a VC/PE transaction. Common transactions, I would like to dispel some factors that determine ‘go’ or ‘no-go’ for myths and provide food for thought for VC/PE investors include: investors considering intellectual property as • management track record; a business asset. • valuation; • complexity/technology risk; Intellectual property confers legitimacy, • downside protection; which has economic value • market size; Rights holders have legitimacy. Legitimacy is a

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soft benefit most of the time, but is important against a large number of public to companies which care about projecting transactions to generate an average value a certain image to their investors (often per patent. major institutions) and analysts. Intellectual property provides an underpinning fact Aside from the difficulty in conclusively base that supports a brand proposition. proving the value of an intangible asset, whose Innovative companies patent and protect their value may be significantly different depending inventions. Brand quality and product quality on the rights holder, there are also VC/PE- are synonymous in the eyes of customers. specific factors. One of the most common The halo effect is powerful if strategically relates to the desire for funds to demonstrate managed and marketed. Owning IP rights valuation uplifts within relatively short positions a company and its investors on timeframes following investment. high ground competitively, legally and from The VC/PE investment paradigm is based a brand perspective. The net effect is better around investors’ ability to demonstrate added and clearer product or service differentiation, value to the business that they are buying. favourable perceptual positioning and the Historically, a large part of this has derived ability to charge a premium for the product or from the discount to fair value at which the service offering. assets are acquired. However, calculating fair value for intellectual property can be IP value can be determined within a VC/PE tricky. For patent portfolios, one approach investor framework is to sell some patents to provide an average VC/PE investors often have difficulty proving price per patent and thus rebase the entire a priori the monetary value of intellectual portfolio. This can be misleading, since patent property. There are many reasons for this, portfolios behave like options with skewed including litigation history, cash flow and value distribution and the benchmark price is availability of comparative benchmarks. For therefore unlikely to be representative. Monte example, royalty-generating copyrights are Carlo analysis may be used on large portfolios intuitively easier to value than patents that to provide a more objective valuation, but this may confer strategic advantage, but produce can lead to false precision, since qualitative no direct income. The methodology used to analysis drives the input variables. The value intellectual property may be unfamiliar default position is often to value according to to the investor, or may fail to provide the level the cash generated by the portfolio over its of objective certainty that is the industry life, which results in volatile valuations, as norm for buyers of tangible assets. portfolios pass revenue milestones. All valuation methodologies commonly used for intellectual property use discounted Licensing revenues are pure earnings cash-flow analysis of actual or assumed The value to investors of a properly structured royalty streams, where the discount takes into licensing and litigation strategy to defend consideration the duration of the effective life and support intellectual property cannot be of the product. However, discounted cash flow overstated. However, few companies excel is helpful only where royalty data is available. in this area. Historically, companies such More often than not, some approximation of as Lucent, IBM, Nokia and Qualcomm have value is necessary. This may be based on: generated hundred of millions of dollars • market valuation – namely, the actual from such activities as part of their day-to- price offered for the intellectual property day operations. More recently, specialist IP in the secondary market; companies such as Round Rock Research have • evidence of use, where an imputed value is demonstrated the value of this as a pure-play given to a patent based on its contribution business model. to the sales revenues of products that In the creative industries, a properly incorporate it; or structured IP protection (litigation) strategy is • market comparability, where the indispensable, and a well-established industry intellectual property is benchmarked architecture exists to support this. For

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example, the network of collection societies critical, establishing a dominant brand position in the music business enables copyright and barriers to entry for competitive products holders to register and audit their rights on a is a primary driver of success. The best way cost-effective basis. Litigation – or the threat to gain and retain market share is to exclude thereof – is essential for this process to work. a competitor from the market entirely. Only There are a variety of approaches through ownership of intellectual property provides this which to get a licensing or enforcement option. programme underway, including using an IP In certain situations, intellectual property professional or outsource partner, whereby is essential for the product or service being the costs of the programme can be mitigated offer and the uniqueness of the intellectual through contingency-based work. Some property gives the rights holder unparalleled investors may be uncomfortable with this negotiating power. This can create either a strategy, as they often have other portfolio premium-priced product or a utility-type companies that may be litigation targets for business model. For example, when making an independent enforcer. Notwithstanding a biopic about a famous musician, the right this complication, earnings from licensing to play his or her music is fundamental to directly hit the bottom line and the boost to the project and therefore the primary price earnings before interest, taxes, depreciation driver. In contrast, Qualcomm develops and and amortisation and internal rate of return licenses fundamental wireless technologies to (IRR) is immediate and significant. all mobile communications companies, billing them much as a utility company would charge The easiest way to gather market share is for water. to have a monopoly Rarely does a VC/PE investor buy a company Intellectual property provides optionality without competitors. The strength of a properly and different paths to value realisation constituted and managed IP portfolio is that There is ample evidence that no matter how it provides the investor with exactly this – great your business model is, market reality the right to exclude others. In this respect, almost always requires changes. These may intellectual property may be used as both sword be minor or substantial. In this respect, and shield. This is increasingly important in intellectual property often provides the highly competitive and cannibalistic technology substance that allows this flexibility. markets (eg, smartphones). For a company in Intellectual property can turn competitors the technology sector, where market share is into customers with no net margin

The ‘staircase effect’ of platform intellectual property

Each subsequent application of Fourth operating the platform IP benefits from the company successful prior implementation, as the IP is ‘proven’ Third operating company

Second operating company

First operating company

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Buyers which can work in harmony with sellers to carve out a win-win result will find themselves with a competitive edge – willing sellers at their disposal in a supply- constrained auction market reduction. This is a well-trodden path in the Intellectual property may be managed across pharmaceutical and medical device sectors, the entire portfolio to enhance fund IRR where the costs to market are huge for Most PE/VC firms leave the management of regulatory and competitive reasons. Once the intellectual property in each portfolio a small VC-backed company has proven company to the individual management teams its technology, the most common route to of each company. This approach mirrors that market is not an initial public offering, but an of some multinational companies (eg, GE), exclusive licensing transaction with a major which drive IP management into operating firm. This leverages the economies of scale in businesses in order to make intellectual sales and marketing that big pharma possesses property accountable and a profit-and-loss- and provides investors with risk reduction in relevant item. However, this approach creates execution. diseconomies of scale. An alternative approach Similar cooperative strategies are is to create a group IP management function emerging in the cloud computing arena, where (eg, Nokia) that fosters synergies and manages expert providers of secure communications intellectual property strategically. For a large are providing incumbents with a wholesale PE firm with say, more than 40 portfolio utility product, rather than competing head to companies, the synergy and value from head for end client contracts. managing intellectual property in this manner could be significant on a fund IRR basis, while Platform intellectual property is more aligning IP strategy with the firm’s objectives. valuable than product intellectual property Litigation and licensing will not damage Platform intellectual property may be your reputation expressed through various different operating VC/PE funds often shy away from litigation as companies and thus effectively monetised a legitimate revenue line item. The frequently multiple times. Good examples include drug- cited reason for this is that the ‘reputational delivery systems that may apply equally to the risks’ are considered too high. This is arguably oncology and dermatology fields, where each a misunderstanding of the purpose that operating company licenses the technology litigation serves in the day-to-day IP world, for its specific sector, but leaves the investor compared to the activity of a troll or corporate owning the parent intellectual property to activist. In this context, it is not so much monetise in a different sector in the future. what you do that has impact, as how and Such IP platforms benefit from each where you do it. successive monetisation, which incrementally My observation is that legacy plays a role increases the value of the platform from here. Some VC/PE investors have been the royalty streams and the value of each new victims of prior bad press that precludes them operating company by virtue of the platform’s from normal enforcement activity on behalf of track record. The effect is a staircase or ladder, portfolio companies. where the second application has value at time Simply put, if you own intellectual zero simply because of platform brand. property it is legitimate to defend and assert

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it. For operating companies, the greater quality buyers. Buyers which can work in reputational risk lies in failing to protect your harmony with sellers to carve out a win-win intellectual property, which could lead to result will find themselves with a competitive unfettered brand dilution and erosion of your edge – willing sellers at their disposal in a margin protection. supply-constrained auction market.

Obey the Fortune 500 rule Conclusion A few years ago, a successful PE firm The notion of intellectual property as an explained to me that the value of investments asset class that can generate value for VC/PE in companies that it had acquired showed no transactions has greater merit today than at correlation to the calibre of the management any other time in the past decade. However, team, the price that it paid for the assets, in considering intellectual property in this the product market, sector or geography. manner, VC/PE investors must approach due However, what did correlate with returns was diligence and post-deal management a little the identity of the seller. This drove them to differently. Those able to do this will reap the deal only with Fortune 500 companies. considerable benefits available from intellectual The rationalisation of this observation property and position themselves as preferred is that blue-chip originators of intellectual buyers in the minds of the creators and rights property have superior compliance, filing and holders of this unique asset class. documentation procedures, leading to fewer nasty surprises post-acquisition. If you are going to buy trademarks, copyrights, patents or brands, the rights holder that you buy them from is important. An exception to this Fortune 500 rule may be in highly creative industries where intellectual property may be owned wholly or partially by its creator. In this case, the value of the intellectual property may outweigh the potential compliance risks.

Think long term Great intellectual property is rare. Sellers remember what it was like dealing with a particular buyer and often the sale is not the end of the relationship. In the music industry, songwriters retain an interest in how their works are exploited and may litigate if works are used inappropriately (eg, Sting/Virgin Publishing) or leave (eg, EMI/Terra Firma). In the technology sector, the seller or inventor may prove critical in an enforcement action years after the event (eg, Severinsky/Toyota). Some sale agreements impose non-compete clauses on the seller, subject to royalty payments and commitments to support a roll-out. One of the largest legal settlements in the medical device industry (Michaelson/ Medtronic) resulted from failure to honour such an agreement. Satisfied sellers become nodes of influence that drive new intellectual property towards

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Fraserburgh 84 Brook Street, Mayfair London W1K 5EH, United Kingdom Tel +44 20 7866 6177 Fax +44 207 866 6175 Web www.fraserburgh.uk.com

Chris Donegan Chief executive officer [email protected]

Chris Donegan is an Intellectual Asset Management 300 IP strategist who specialises in working with investors to monetise intellectual property from multinational companies. Dr Donegan is a former research scientist, investment banker and management consultant, and holds a PhD in molecular neurobiology from Imperial College London. Dr Donegan is an International IP Strategists Association fellow and an adviser to the Advanced Studies Centre at Keble College, Oxford University.

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