• M&A Insights: Spotlight on Intellectual Property Rights

December 2008
M&A Insights: Spotlight on
Intellectual Property Rights
A mergermarket study in association with CRA International and K&L Gates
In association with:
Contents
Methodology 1
Foreword 2
Survey Findings 3
Patent Due Diligence for Investment
in a Technology-Based Company 13
Strategic Intellectual Property Due Diligence 15
Contacts 20
Methodology
K&L Gates & CRA International commissioned mergermarket executives and private equity practitioners regarding their
to survey 50 senior executives and private equity practitioners perspectives on the importance of IP in M&A transactions.
regarding intellectual property (IP) in North America. During All results are anonymous and are presented in aggregate.
the third quarter of 2008, mergermarket interviewed senior
 Intellectual Property Rights
Foreword
mergermarket is pleased to present the Spotlight on Intellectual Not enough time for corporates
Property Rights sponsored by CRA International and K&L Gates. 52% of corporate respondents and 30% of private equity
As it stands, IP assets play a crucial role in the M&A process and respondents believe that IP due diligence has a significant
are important drivers of value for the transaction. The aim of this impact on the ultimate terms of a transaction. But corporate
survey is to examine the role of IP assets in M&A transactions, respondents bemoan the lack of time they have to spend on IP.
paying particular attention to how corporate executives and private Indeed, 58% of corporate respondents cited insufficient time
equity practitioners value IP assets, and also how they respond to as a major obstacle to conducting comprehensive and careful
the unique challenges and opportunities presented by IP overall. due diligence, compared to 30% of private equity respondents.
One can argue that the recent turmoil in the financial markets This, of course, presents a serious and even costly challenge,
may be traced, in part, to the failure to perform adequate as more than half (52%) of respondents believe insufficient
due diligence and asset valuations. This should serve as a due diligence is often to blame when an acquirer fails to secure
cautionary tale for those looking at IP assets in the context of rights to a target’s IP assets.
M&A. Fundamental analysis in a knowledge economy is not
a convenience. Now more than ever, the M&A community The challenge of cross-border deals
needs to pay attention to the basics for all assets, including Doing deals overseas can also be challenging in its own right.
IP. Certainly, many of the survey respondents are aware of Corporate and private equity respondents generally agree that
the important role IP assets can play in realizing a successful the target’s regulatory environment is a significant variable
transaction outcome. that will determine the strength of the IP asset down the road.
Because the regulatory environment varies from country to
One of the headline findings is that over half (52%) of
country, 84% of respondents say they must consider whether
respondents believe that IP assets will become increasingly
the target’s regulatory environment will allow them to defend
important to overall M&A activity in the next five years.
the acquired IP assets should any conflicts arise after the
Furthermore, IP assets are already an important part of M&A
deal is done. For example, one survey respondent from the
for a remarkable 72% of private equity respondents and 85% of
pharmaceutical industry noted the greater difficulty in dealing
corporate respondents who agree that IP portfolios are equally if
with IP assets in China compared to North America. Indeed,
not more important than other assets when evaluating a target.
respondents considered the Asia-Pacific region to be the riskiest
If IP assets continue to grow in importance over the next five environment for IP assets, while North America and Western
years as expected by respondents, M&A valuation methods will Europe are considered the least risky, but only in relative terms.
likely need to grow along with them. The valuation of IP assets
The outlook for Asia is largely positive however, as 77% of overall
undoubtedly weighs heavily on the ultimate terms of M&A
respondents believe the Asia-Pacific region will see significant
transactions, yet this survey reveals that respondents find the
changes to its regulatory environment in upcoming years.
valuation process challenging for a variety of reasons.
The expected transformation of the regulatory environment
The drawbacks of traditional valuation methods overseas, combined with the often cited explosion of IP issues
Another interesting outcome from the survey is that in the information age, will likely drive the importance of IP
respondents believe IP value is not fully reflected in traditional assets to the M&A community. We hope you find this survey
valuation methods like cash flow projections. Respondents useful and informative, and we welcome your feedback.
rated exposure to patent litigation, freedom to operate and
strength in key markets highest (at least 4 out of 5) in terms
of importance, and yet all of these factors are overlooked or
not readily incorporated by traditional valuation models. The
failure of traditional valuation models to capture the unique
features of IP assets and risks contributed to the particularly
strong dissatisfaction of private equity respondents with current
valuation techniques.
IP Sector M&A Spotlight – 2
Intellectual Property Rights
Survey findings
Importance of IP to transactions
How would you characterize the level of importance Over the next 5 years, how would you characterize the level
placed upon IP assets in M&A transactions today of importance placed upon IP assets in M&A transactions
versus 10 years ago? compared to today?
2% 4% 10%
9% Significantly more Significantly more
24% important important
Slightly more Slightly more
important important
Little to no change Little to no change
Slightly less Slightly less
important important
44%
Significantly less
36%
important
42%
29%
• The majority (53%) of respondents believe IP assets are more • More than half (52%) of respondents expect the importance of
important to M&A transactions today than they were 10 years IP assets to increase over the next five years. Two corporate
ago, while only 11% of respondents believe the importance of respondents cite the increasingly “data centric world” and
IP assets has decreased over this time. This minority consists “greater access to information online” as key drivers.
almost entirely of private equity practitioners, while corporate
• Private equity respondents, who in the previous question
respondents tend to agree that IP assets have become
were more likely to believe IP assets have not become more
more important. One corporate respondent explains: “Many
important over the past 10 years, are far more likely to believe
companies are just beginning to recognize the value of their
this will change over the next five years. 58% of private equity
IP assets.”
respondents expect the importance of IP assets to increase over
the next five years, compared to 47% of corporate respondents.
The decrease in importance to private equity may be the result that In the current uncertain economic climate, we expect to see less focus on
private equity tends to have startup and early stage companies whose IP over-leveraging deals and more emphasis on long-term performance.
may be primarily applications. Because those applications may never Every time there’s a wake up call on Wall Street, inevitably there’s a call
issue as a patent, the value to the equity investors may be lower. to go back to fundamental analysis - that’s what IP valuation and due
diligence is all about in today’s knowledge economy.
K&L Gates LLP
CRA International
3 – IP Sector M&A Spotlight
 Intellectual Property Rights
When identifying a target, how important is a company’s IP At what point do you typically evaluate a target’s IP assets
portfolio compared to other assets? in an M&A transaction?
100
8%
8%
28% While identifying
possible targets
80
20%
Percentage of respondents
During negotiations
During due diligence
60 24% 44% 42%
24%
40
36%
40%
20
12%
0
Corporates Private equity practitioners 14%
Not important Less important As important More important Crucial
• The overwhelming majority of each respondent group views • Respondents from both groups tend to evaluate IP assets in the
IP portfolios as equally important or more important than initial stages of an M&A transaction. 42% evaluate IP assets
other assets when identifying a target, with 84% of corporate while identifying potential targets and 44% evaluate IP assets
respondents and 72% of private equity respondents holding during due diligence, but only 14% do not evaluate IP assets
this view. until negotiations begin. A corporate respondent explains:
“We evaluate IP assets as soon as possible, and prior to
• While respondents generally agree that IP portfolios are at least
negotiations for sure. It is one of the critical pieces that we
as important as other assets, corporate respondents place a
look at upfront and early.”
noticeably stronger emphasis on their importance. 40% believe
IP portfolios are critical when identifying a target, compared to • Corporate and private equity respondents generally agree that
only 12% of private equity practitioners. Additionally, 16% of evaluating IP assets is a continuous process during an M&A
corporate respondents view IP portfolios as less important or not transaction. One private equity respondent notes that there is
important when compared to other assets, while more than a “some evaluation at all stages,” while another agrees that it is
quarter (28%) of private equity respondents agree. a “twofold process that lasts from identifying targets through
due diligence.” Similarly, according to a corporate respondent,
evaluation “intensifies with initial contacts and negotiations.”
An IP due diligence should not only include the standard The perceived time challenge of performing IP due diligence can be
enforceability and ownership investigations but also initial overcome by using available resources and IP intelligence and valuation
valuation investigations based in part on the enforceability tools earlier in the transaction process, thus transforming a legal
findings. necessity into a value-added deal activity.
K&L Gates LLP CRA International
IP Sector M&A Spotlight – 4
Intellectual Property Rights
Survey findings
Which IP asset is most important in M&A transactions? On a scale of 1 to 5 (where 1 = not difficult), rate the difficulty
of performing the due diligence in an M&A transaction for
the following classes of IP assets
5.0
Very difficult
8% 4.5
Patents
10% Rights licensed 4.0 4.08
33% from third parties
Trade secrets 3.5
Domain names 3.25 3.20
3.0
16% Trademarks
2.5
Copyrights
2.0
1.95
1.88
Not difficult
1.5 1.53
16% 17%
1.0
Trade secrets Patents Rights licensed Copyrights Trademarks Domain
from 3rd parties names
• Respondents ranked patents highest in importance to M&A • Trade secrets are generally considered more difficult to conduct
transactions. Several respondents from both groups suggest due diligence on than other IP assets. This could reflect the
that patents can present challenges post-transaction, challenges difficulty in identifying the specific economic benefits derived
which should be factored into the deal value. Defending the from trade secrets, and also the fact that confidential information
patent in case it is infringed upon, for example, could prove to such as trade secrets always runs the risk of being exposed.
be time consuming and costly. A corporate respondent explains:
• Corporate respondents were especially vocal regarding the
“People have become more aware about litigation and patents.
difficulty of evaluating patents. Several corporate respondents
It’s becoming more and more important.”
explained that in many cases, targets without patent portfolios
• Third party rights ranked second highest, and were also may still have untapped patentable assets that should not
mentioned specifically by several respondents from both groups. be overlooked.
Patent rights are important from two perspectives: company rights and Third-party review of a target’s IP management systems and processes
third party rights. The merger partner needs to know that the company’s under a three-way confidentiality agreement is an effective way
rights are protected and that no third party rights are infringed. to assess the degree to which a target protects its valuable trade
secrets. This approach also reduces risk of subsequent trade secret
K&L Gates LLP misappropriation allegations against the buyer in the event a deal is
not completed.
CRA International
5 – IP Sector M&A Spotlight
 Intellectual Property Rights
During due diligence, which of the following is most What impact do the results of IP due diligence have on the
important to the final valuation of a target’s IP assets? ultimate economic terms of M&A transactions?
100 100
4%
16% 20%
90 90
32%
80 80
Percentage of respondents
52%
Percentage of respondents
70 70 32%
4%
60 60
50%
24%
50 50
40 40
16% 24%
30 30
52%
20 20
30%
24%
10 20% 10
0 0
Corporates Private equity practitioners Corporates Private equity practitioners
Little impact
Understanding all proprietary information, as well as policies on its use or protection
Moderate impact
Understanding all trade secrets
Significant impact
Understanding which current and anticipated products incorporate target’s IP assets
Understanding all prior litigation, letters and agreements concerning IP
Understanding all patents, trademarks and copyright properties
• Corporate and private equity respondents express somewhat
different views on which factors are crucial to IP valuation. 52% respondents to link the ultimate economic terms of M&A
of private equity respondents believe understanding all products transactions to IP due diligence. More than half (52%) of
related to IP assets is crucial to IP valuation, compared to 24% of corporate respondents believe due diligence has a significant
corporate respondents. impact on the economic terms of a deal, but only 30% of private
equity practitioners agree.
• 32% of corporate respondents emphasized the importance of
understanding proprietary information and all policies related to
it, while no private equity respondents identified this as a vital
part of the valuation process.
One of the biggest issues for IP has been the loss or theft of trade
secrets. It is surprising that so few respondents recognize that
understanding proprietary information and policies to protect it is
an indication of the strength of management – often a key factor in
assessing a potential M&A target.
CRA International
IP Sector M&A Spotlight – 6
Intellectual Property Rights
Survey findings
What are the most common challenges when conducting
due diligence of IP assets?
70
60
58%
Pecentage of respondents
50 50%
46% 46%
44%
40 42%
38% 38% 38%
30 30%
20 20% 20%
10
0
Process begins too Failure to link Lack of Failure to identify Process Failure to align IP
late/insufficient time identified legal sufficient 'upside' IP overlooks due diligence
issues to resources opportunities (e.g. ownership activities with
impact on dedicated to IP option value) issues overall corporate
valuation and the process beyond traditional strategy
deal structuring business valuation
models models
Corporates
Private equity practitioners
• Respondents from both groups expressed similar dissatisfaction It is important to have the valuation consultants act in conjunction
with current valuation models and the valuation process overall. with the IP attorneys to determine the value of the asset. A strict
According to a private equity practitioner, valuation models comparables analysis has little value without a determination of IP
simply cannot capture risk associated with IP: “There is no 100% strength and third party rights.
certainty when it comes to evaluating IP risks.” One corporate K&L Gates LLP
respondent explained: “You can do IP due diligence for years and
still not uncover everything. That’s the real challenge.”
• Corporate respondents are less optimistic about IP risk While you can never identify all IP risks, a structured IP due diligence
assessment than private equity respondents, as risk assessment process and explicit IP valuation can help uncover the most important
is often a time consuming process that prevents corporate issues affecting deal pricing and structuring.
respondents from focusing completely on business strategy. CRA International
58% of corporate respondents cited insufficient time, compared
to 30% of private equity respondents; 46% of corporate
respondents cited lack of resources, compared to 38% of private
equity respondents.
• Private equity respondents were more likely to point out the
shortcomings of valuation models. 46% of private equity
respondents cited the failure of traditional business valuation
models, compared to 38% of corporate respondents; 50% of
private equity respondents cited the faulty link between legal
issues and valuation or deal structuring models, compared to
38% of corporate respondents.
7 – IP Sector M&A Spotlight
 Intellectual Property Rights
What are the most common consequences of insufficient Rate your level of agreement with the following statements
due diligence of IP assets? (where 1 = strongly disagree and 5 = strongly agree)
5.0
Strongly agree
80 4.5
80%
70
4.0
Pecentage of respondents
60
3.5 3.55
50 52%
48% 3.0
46%
2.98
40 2.85 2.8
2.5
30 32%
Strongly disagree
2.0
20
18%
10 1.5
4% 4%
0