In Aon’s latest C-Suite Series report on M&A – Leaving nothing on the table: Unlocking off-radar transaction value – we have seen the remarkable shift in the contribution to overall business value from tangible to intangible assets. This change is best illustrated by the shift in the proportion of total market value accounted for by intangible assets across the top five companies in the S&P 500. In 2018, intangible assets made up 85% of their market value. Compare that to the 1985 scenario, when intangibles only represented 32% of the market value of top five S&P companies' and a trend emerges which begins to explain why intellectual property (‘IP’) and intellectual asset management are becoming increasingly important to our clients, both in enhancing value and in reducing risk.
It's not just a reflection of the emergence of innovation and the dominance of IP in the Fourth Industrial Revolution or of technology companies either; look at FMCG, luxury or consumer goods companies, for example, where the third or fourth line on their balance sheets is intangible assets, representing 60% or in some cases as much as 70% of the balance sheet.
This paradigm shift raises important questions when it comes to M&A due diligence (DD) and IP DD. If you are looking to acquire a business, do you know exactly what you’re buying from an IP perspective? This is particularly true in M&A, where the acquirer will want to confirm that the value of the target company is supported by the degree to which the target owns, or has the right to use, all of the IP that is critical to its current and anticipated business, often the differentiating asset in high tech deals but also in patent- and IP-rich enterprises. Often the assets are not backed by IP registrations or those registrations can be challenged; indeed, in some cases the inventors or creators of the IP are no longer with the company and the ownership rights are unclear.
There are relatively significant examples of companies that have bought expensive IP portfolios as part of acquired businesses without looking closely enough (or at all) at the target IP assets and, often, did not realise what IP value they were leaving on the table. In some of those cases, the seller was in fact exiting the market entirely and would have given those IP assets away readily and likely very cheaply but the deal scope and M&A team only looked at the operating business not the IP of the group used exclusively by or associated with the target.
Knowing the underlying IP value
While there is still a long way to go, the board level focus on IP and IP value creation has improved in recent years. This is mainly due to buyers becoming more receptive to conversations leading to valuing the underlying IP assets and appropriately identifying the IP value of target companies; and often to identifying IP that can immediately be divested or is non-core (which often sits stagnant on the balance sheet, post-sale). Being clear on the IP DD beyond the basic transactional legal work can be a hugely rewarding exercise post-investment, with careful management and integration, offering clients significant additional value. We have consistently, and increasingly, found that there are hidden pools of value which IP specialists always focus on, IP lawyers may look for but which, often, M&A transaction lawyers may not. This of course is changing as the relative value of IP as a proportion of overall value in transactions is increasing, as part of the data-intensive, IP-rich, 4th industrial revolution.
Of course, the overall objective – and the responsibility at board level – is to maximise value for shareholders and stakeholders. In an M&A transaction, if you’re the seller, you should be confident that you’re valuing the assets based on the total tangible and intangible value. Increasingly, whether the sector is defence, pharmaceutical, chemical, manufacturing, or oil and gas, IP and technology is the differentiator and the competitive advantage often resides in that intellectual property. We still often find it surprising that companies do not value something that is worth 75-85% of the total value of a company in the same way that you would value all the tangible assets, such as real estate or other property?
As we help raise the awareness of buyers and sellers, we will increasingly see metrics and KPIs and in some cases, board level IP scorecards, being used to drive valuations and proper treatment of IP as the value drivers in a transaction. Often you can change everything else such as the buildings and the equipment but the real competitive advantage is in the people; the know-how and the IP.
Protection of IP is also key. If you’re buying a business where much of the IP lies in the technology and software, for example, it’s important to fully capture your trade secrets, as part of innovation capture and IP patent or know how pipeline and to conduct source code due diligence to make sure not only that the IP has not been copied from a third party but also that it is not vulnerable to challenge or attack. In the case of source code, it is critical to ensure that your source code does not provide a gateway for hackers into your systems and allows them to steal your trade secrets or IP (or infringe open source protocols or licenses). Cybersecurity expert tools exist to scan and cross-check databases for source code issues against databases and our Cyber advisers have provided such analysis successfully on numerous transactions.
Of course, much has been written about the need for IP warranties and indemnities and risk transfer methodologies in transactions, so I will defer to those and avoid stating the obvious need to address such needs and gaps. However, the world of IP Liability and Indemnity risk transfer has evolved significantly in the last 10 years and the days where IP liability was too complex, restrictive and expensive are far behind us. Adequate and considered coverage against patent invalidity, liens, third party claims, inadequate evidence of employees IP assignments and failure to obtain third party consents, issues caused by broad licenses to compete - are all worth remembering, as are the corresponding warranties and indemnities related to IP infringement, litigation, consent to assignment restrictions under IP agreements etc.
In the increasingly networked business world we inhabit, it would be remiss to omit a mention of copyright and IP ownership of media, websites and assignments of domain names as a potential issue when discussing 'leaving value on the table'; many are the instances where domain names are not 'migrated' post deal and disgruntled employees register new domain names and websites for the hybrid JV names of the parties or 'squat' on domain names of the acquirer in countries their internal teams forgot to register. You'd be surprised how often, in the author's experience, short-term cost considerations preclude long term value creation and the expense of later domain and website disputes.
IP in IPOs
Much has been written and learnt about IP issues pre- and post- IPOs, in the A-Z lexicon of value creation, from pre-IPO acquisition strategies, such as the Uber patent acquisitions prior to its IPO to issues around independence / IP dependency such as in the OPC Drums case, where rights to use core design patents employed in the manufacture of most of its products were found to have been terminated.
Dependence on core IP assets is increasingly prevalent and strategic, legal and non-legal due diligence requires particular attention to the subject company's dependency on third party IP in the run-up to IPO disclosures and valuation is crucial.
Identifying and plugging gaps in IP ownership, third party rights dependency and reducing or completing IP ownership diligence is an important early step on which to focus.
Active IP and intellectual asset strategy prior to the IPO is required to deal with the complexity of IP rights ownership and dependency issues, both as an active defence and to create strategic value creation plans to enhance value. This will include, increasingly, information and data-management and access controls to innovation leaders and inventors, as part of the IPO planning activities - and not just to maintain consistency between information disclosure and the legal status of IP rights.
Finally, in light of litigation that often follows strategic IP-rich IPOs, capital should be set aside to allow for pre-IPO IP DD, IP acquisition and risk mitigation strategies and active defence, even where the transactional liability cover and agreements have been scrutinised and complete disclosure appears to have been given, if such a Shangri-La really exists.
IP as collateral
Another key focus for dealmakers should be in the use of IP as collateral to create new financing opportunities. When the next economic downturn comes – if it’s not around the corner already – people will be wondering why they are not maximising their revenue from the valuable captive assets on their balance sheet instead of simply seeing them in terms of protection and cost.
Chinese lenders have stolen a march on UK banks, for example, by lending to SMEs based on valuations of IP-backed collateral. This enables businesses to accelerate and finance their growth but not at the expense of giving away equity and large proportions of their company. By using collateralised IP, the cost of capital can be significantly less than the equity diluting approach, which offers up all kinds of new opportunities.
China’s National Intellectual Property Administration (CNIPA) and its top banking regulator have promised a new set of policies to facilitate Chinese SMEs’ access to IP-backed lending. The announcements come after China’s cabinet, the State Council, endorsed IP finance as a way to spur growth among SMEs.
(Source: IAM : https://www.iam-media.com/copyright/china-seeks-boost-ip-lending for full article)
The China Banking and Insurance Regulatory Commission (CBIRC) declared in early July 2019 that commercial banks will have to report IP-backed finance in their credit plans for this year. It says it will encourage more lenders to fund projects on the basis of IP portfolios. CNIPA did not specify what steps it will take, but said that the goals of an upcoming new policy on IP finance would be improving risk management and enhancing ‘innovation in services’. The administration provided a snapshot of China’s IP lending ecosystem during the first six months of 2019: (1) $8.5 billion in loans backed by patent and trademarks supported more than 3,000 projects (2) Patent-collateralised loans funded 2,710 of those projects (3) More than 2/3 of these projects qualify as ‘microfinance’, with loans worth no more than 10 million yuan ($1.4 million); and (4) In total, 6,450 accounts with Chinese financial institutions have received IP-backed loans.
The British Business Bank launched British Patient Capital in 2018, which was given 'resources of £2.5 billion to deliver a new investment programme to invest in high-growth innovative firms and crowd in private investment'.
This will increase the provision of equity investment, including to IP-rich firms.
This is one of one of many reasons that the work of the UK Intellectual Property Office and British Business Bank is so timely and important, as highlighted in their 2018 Report, where they have outlined the need to enable SMEs to have greater access to UK lenders and debt funding and the obstacles to and potential for using IP to access finance. The paper considers the role of Intellectual Property (‘IP’) as collateral for growth debt finance, rather than in supporting other forms of finance (i.e. equity).
Therefore, many consider that it is high time for lenders in UK and Europe to recognise that IP-rich innovation led SMEs require access to more developed IP-backed debt funding solutions, which are often better value as compared to the higher cost of equity capital. China has already mobilised its considerable resources to push this domestically and internationally.
Of course, the strategic view would advocate a keen focus on intellectual assets. Every business – whether involved in an M&A situation or not – should now be focusing on the hidden value in their IP, treating it as a board level agenda item to encourage IP Counsels and Chief IP Officers to grow and enhance their intangible revenue growth in line with their business strategy.
If it’s not a Board agenda item already then perhaps CEOs and CFOs, who have a fiduciary duty to their shareholders, need to look at their tangible and intangible asset ratios and figure out whether they are allocating resources appropriately, between their relatively small tangible asset ratio on their balance sheets and the much larger and faster-growing intangible assets. The opportunity to enhance value in almost every aspect of the transactional value chain and optimise transactions to extract IP value is here now and the business case for doing so is increasingly coming to the fore.
To understand how M&A transaction practices are evolving; how to develop deeper insights; hedge risk more effectively and extract more value from intangible assets, download the full report