Valuing companies for mergers & acquisitions purposes generally follows a traditional route, looking at multiples of earnings, net present value, cash flow and the like. But there is another factor that can determine whether the target company is a ‘star’, a ‘wannabe’ or something of a ‘has been’ — that’s its intellectual property (IP).
Yet despite the increasing awareness in the business community of the value of IP, for many companies, IP due diligence in M&A remains largely a back office, risk-centered exercise based on a rudimentary assessment of a target’s intellectual assets, often conducted at the eleventh hour.
If the IP department is consulted, they are asked questions such as: “Do these people own the IP they say they own? Are they going to maintain these IP Rights throughout the life of the deal? Are any of the IP Rights licensed to a third party? And do we need to review these arrangements before we acquire the IP portfolio?” The questions help to mitigate short-term IP risks, but do not really address longer-term IP risks or opportunities — and can also ignore or underestimate the inherent value of the IP.
In the absence of a definitive valuation for the IP of an M&A target, the buyer will often assume that, if a target is successful in its commercial products and business strategy, then its IP assets and strategy must be in order. There may also be assumptions that the IP has already been factored into a company’s valuation. For example, it might be assumed that an organization that’s exploiting its IP will be charging higher margins (which in turn increase earnings); it might also be assumed that IP will be allowing the company to improve on its operating leverage, leading to increased cash flow.
These assumptions may well be correct, but it can be very dangerous to automatically assume that IP and business strategies are aligned. We have seen examples of companies which had very good innovation and IP strategy that for some reason was not carried through to product strategy and commercial success. Think of bankrupt telecommunications company Nortel Networks, for example. On the flip side, we have also seen very successful companies suffer through lack of a coherent IP strategy or a realization that they need to ‘get into a new game’. This can take the form of short-term financial hits in order to acquire large volumes of patents, for example Google’s 2012 acquisition of Motorola Mobility; or damaging patent infringement like Blackberry maker RIM’s $612M payment in 2006 to NTP, Inc.
A potential acquirer should also consider whether there may be future downside in a target company’s IP position, or if the IP portfolio may contain currently under-exploited IP that could be better managed and optimized. Efficient management of under-exploited IP could cause a significant upswing in the value of the intangible assets and, hence, the company itself. However, clearly, the reverse could be true if there are any potential issues with the company’s IP assets and strategy that might limit their longer-term usefulness and value.
So what are the key disciplines that need to be employed when assessing the IP assets of a target company?
The first thing is to start early. IP due diligence has to be top of the agenda as soon as potential target acquisitions are identified. Clearly, it’s important to gain a comprehensive understanding of the target’s IP portfolio and its IP strategy, whether it’s designed to boost the company’s competitiveness and drive commercial growth or simply to protect what the company has. You will also need to identify and understand:
- The IP assets that are critical to the company’s ongoing and future commercial success.
- How the acquired portfolio will complement your existing IP portfolio — the gaps it will help fill and where there may be overlap.
- Whether the patents provide you with competitive leverage/competitive advantage.
- The relevance of the target’s patents — are they just for defending their own products or are there patents others might want to license?
- The strength of the relationship between the target company’s research and development (R&D), IP portfolio and product/service range.
- The age profile and geographical scope of the patents – for how long and where can they be enforced?
- If the company is still filing patents. If so, what and where?
- Whether the patent portfolio is reliant on only a handful of key inventors.
- Possible encumbrances — are some patents licensed to third parties or currently the subject of litigation?
It is not always easy to value IP, even for IP specialists. However, by giving due consideration to the issues outlined above, an acquirer can start to get a feel for the value of the target company’s IP portfolio and any significant upside that may exist, while also identifying potential risks to future growth.
Although there are M&A deals which are increasingly IP-led, particularly in telecommunications, IP is not the main driver for the majority and may just be one of a number of assets that need to be considered. Even so, it does seem strange that, despite the increasing awareness of the importance of IP, more is not being done to understand the impact of what can be an enormously variable valuation criterion. In that respect, IP is definitely the ‘X-Factor’ in M&A valuations — and getting it right can make the difference between a hit and a miss.