MAKING INTANGIBLES A VALUABLE TANGIBLE ASSET GENERATING VALUE BY RELYING ON INTELLECTUAL CAPITAL

John D. Swaimswaim@negoceval.com

+41 78 808 78 50

Geneva, Switzerland11 July 2006

REVOLUTIONARY CHANGES IN THINKING ABOUT INTELLECTUAL PROPERTY AND VALUE

Economic Paradigm Shift— Relative importance of Intangible Assets/ IP

– In the U.S., since 1980, the average ratio of market capitalization to book value has risen from slightly over one to a multiple higher than five.

– In 1970, intangible assets represented less than 20% of the market value of the majority of U.S. public corporations. Now they represent 90%.

Communication/IT Revolution

Mergers & Acquisitions

TANGIBLE AND INTANGIBLE ASSETS HAVE VASTLY DIFFERENT CHARACTERISTICS…

Value from Tangible Nature v. Value from Property Rights and Intangible Factors

One Place at One Time v. Multiple Uses for Multiple Returns

— Intellectual Property as a “bundle of rights”

Depreciation v. Cumulative Property of Knowledge"Knowledge is cumulative, with each idea building on the last,

whereas machines deteriorate and must be replaced."

- Baruch Lev

…LIKE THE ECONOMICS OF THINGS VERSUS THE ECONOMICS OF INFORMATION

Costly Replication v. Zero Cost Replication

Diminishing Returns v. Perfectly Increasing Returns

Efficient Markets v. Requirement of Imperfect Markets/Tendancy towards Concentration

RELATIONSHIPS AMONG THE DIFFERENT TYPES OF ASSETS

Highest and Best Use Analysis— Generally achieved within the context of a business

enterprise

Business Enterprise as a Portfolio of Assets— Monetary Assets— Tangible Assets— Intangible Assets

– Intellectual Property

Complementary Assets

ROLES OF IP IN VALUE CREATION

Creating Economic Value

Creating Strategic Value

ROLES OF INTANGIBLE ASSETS & IP IN CREATING ECONOMIC VALUE

Excess Earnings concept— Intangible assets & Intellectual Property create value

when their exploitation enables an enterprise to produce earnings in excess of the returns required by markets on the assets (tangible & intangible) employed in the business.

— Intangible assets are generally riskier than monetary or tangible assets and require higher returns.

ASSET CHARACTERISTICS

Source: Russell L. Parr and Gordon V. SmithValuation of Intellectual Property and Intangible Assets

MONETARY TANGIBLE INTANGIBLECash

ReceivablesInventory

VALUEIN USE

GeneralPurpose VALUE IN

LIQUIDATIONSpecialPurpose

ReturnRequirement

Financing

InvestmentQualities

8-10% 10-15% 15-40%

DebtDebt &Equity Equity

Liquid Versatile Nonliquid,Narrow Market

ROLES OF INTANGIBLE ASSETS & IP IN CREATING ECONOMIC VALUE

Producing an Economic Advantage— From Direct Exploitation

– Increased revenues from new/enhanced products– Reduced costs from proprietary process technology

— From Indirect Exploitation– Licensing revenues

Raising Barriers to Competition

Protecting or Creating a Strong Market Position

Use in Financing the Enterprise

ROLES OF INTANGIBLE ASSETS & IP IN FINANCING THE ENTERPRISE

A business that can generate excess returns is attractive to equity investors.

— Traditional view is that intangible assets are financed with equity

— Investments in Intellectual Property are, in general, relatively risky.

— Providers of equity are certainly don’t want to lose their money, but they are willing to take higher risks in order to share in the potential upside of an investment. They want potential rewards to match the risks they take. Equity investors face the highest risk of losing their complete investment.

— Providers of debt want to be repaid with interest. As they do not share in the upside of the investment, they assume lower risk than equity investors.

ROLES OF INTANGIBLE ASSETS & IP IN FINANCING THE ENTERPRISE (cont.)

Traditional view is changing.— When 90% of the value of corporations is

intangible, new lending structures must follow.— IP based debt structures have been growing (at an

uneven pace)– Traditional secured debt– Securitization of IP revenue streams

– Music Industry– Film Industry– Pharmaceutical Industry

TRADITIONAL SECURED DEBT

Lender focuses on the credit worthiness of the borrower.

— Is the cash flow sufficient to service the debt, and preclude abandonment of the business?

— How much risk is associated with the cash flow forecast?— Strength of balance sheet

Lender focuses on value of the collateral in case things go wrong.

— Collateral: asset pledged to a lender until a loan is repaid. If the borrower defaults, the lender has the legal right to seize the collateral and it sell it to pay off the loan.

— The lender is granted a security interest in the property of the borrower.

SECURITIZED LENDING

Securitization: A device of structured financing where an entity seeks to pool together its interest in identifiable cash flows over time, transfer the same to investors either with or without the support of further collateral, and thereby achieve the purpose of financing.

Shifts the burden of repayment from the borrower to a designated pool of assets.

Assessment of credit risk shifts from the borrower's financial/business condition to security of the specified stream of cash flows.

Use of Special Purpose Vehicles to insulate the collateral from claims of other creditors

Requires a legal mechanism for taking security over a cash flow

Highly structured nature may be expensive and require relatively large deals. This should improve over time.

SECURITIZED LENDING - RISKS TO BE ASSESSED

Infringement

Technology: market acceptance

Technological obsolescence (the corollary for a trademark would be whether the trademark is in fashion and popular)

Functional obsolescence

Licensee payment risk

Servicing risk

Legal risks

SECURITIZED LENDING - CREDIT ENHANCEMENTS

Examples of Credit Enhancements— Back-up servicer— Lower Loan-to-Value ratio

COPYRIGHTS: COLLATERAL VALUE /SECURITIZATION POTENTIAL CHARACTERISTICS

Characteristics consistent with relatively higher collateral value— Currently active literary, dramatic or musical work— Text— General purpose, versatile software with an established market

Characteristics consistent with relatively lower collateral value— High infringement potential— Dormant literary, dramatic or musical work— Advertising program, training materials— Special purpose software specific to company operations

PATENTS/PROPRIETARY TECHNOLOGY: COLLATERAL VALUE /SECURITIZATION POTENTIAL CHARACTERISTICS

Characteristics consistent with relatively higher collateral value— "Keystone" patent supporting commercially successful product(s)— Versatile patent/proprietary technology that could support a wide range of

products or be employed in a wide range of processes— Market-ready— Congruent innovation

Characteristics consistent with relatively lower collateral value— Untransferable technology (much individual know-how / learning involved)— Technology supporting commercially unsuccessful product(s)— Technologically obsolete— Specific / narrow use technology— Embedded in a tangible asset (e.g. in machine designs or settings)— High development cost for commercial viability / adaptation to another use— Incomplete development— Discontinuous innovation

TRADEMARKS: COLLATERAL VALUE / SECURITIZATION POTENTIAL CHARACTERISTICS

Characteristics consistent with relatively higher collateral value— Extendable to a wide range of products or services— Associated with commercially successful products and services— Well established

Characteristics consistent with relatively lower collateral value— Narrowly defined, and identified with only a specific product or

service— Associated with commercially unsuccessful products and services— Newly introduced— Jurisdiction regards the granting of a security interest to be the

present assignment of an ownership interest— Geographically narrow

ROLES OF INTANGIBLE ASSETS & IP IN CREATING STRATEGIC VALUE

Option or flexibility value— The legal protections afforded IP may allow

management flexibility that is not captured using traditional discounted cash flow techniques.

Synergy— “Bundle of rights” nature of IP makes IP a particularly

flexible tool for entering into transactions that create synergy.

REAL OPTIONS: INTELLECTUAL PROPERTY CAN BE LIKE A STOCK OPTION

Stock options provide the holder the right, but not the obligation, to purchase (“call”) or sell (“put”) the underlying asset.

Holder is able to wait and learn before spending.

A patent provides the holder with the exclusive right, but not the obligation to market the product or attack new market segments. Management has a series of options to wait and learn.

Before investing in Phase II of a new drug development project (wide-scale deployment), management learns outcome of Phase I (technology risk).

Before investing in Phase II, management can reassess market developments (market risk).

What is synergy?

Whole is greater than the sum of the parts (Type I)— “Synergy is the increase in performance of the combined firm over

what the two firms are already expected or required to accomplish as independent firms.

Where the acquirers can achieve the performance that is already expected from the target, the net present value (NPV) of an acquisition strategy then is clearly represented by the following formula:

NPV = Synergy – Premium” Mark L. Sirower, The Synergy Trap: How Companies Lose the

Acquisitions Game (New York: The Free Press, 1997, 2000), 20 & 29

What is synergy? (cont.)

Unexpected performance (Type II)— “Synergy means behavior of whole systems unpredicted by the

behavior of their parts taken separately….Synergy means behavior of integral, aggregate, whole systems unpredicted by behaviors of any of their components or subassemblies of their components taken separately from the whole.”

Buckminster Fuller, Synergetics (New York: Macmillan Publishing Co., Inc.) 1975, 3

— “In management terms, synergy means competing better than anyone expected. It means gains in competitive advantage over and above what firms already need to survive in their competitive markets.”

Mark L. Sirower, 77

Sources of “Type I” Synergies

Revenue Enhancements— Sell a broader line of products/services over an enhanced distribution network— Increased market power may allow price increases

Cost Reductions— Consolidation of functions and positions— Elimination of redundant fixed assets— Spread overheads over a larger revenue base— Greater market power with respect to suppliers can result in purchasing economies

Practice Improvements— Leverage technological and process improvements (intangible assets & Intellectual Property) over

a broader base

Financial Economies— Smaller companies generally exhibit greater risk than larger companies. Acquisition of a smaller

company by a larger company can reduce the acquired company’s cost of capital. — Financing costs, for example borrowing costs, may also be reduced.— Greater economies in cash, working capital and fixed assets management— Tax benefits (e.g. use of net operating loss carryovers, transfer pricing benefits)

Sources of “Type II” Synergies

Increased Core Competencies— “In the long run, competitiveness derives from an ability to build, at lower

cost and more speedily than competitors, the core competencies that spawn unanticipated products. The real sources of advantage are to be found in management’s ability to consolidate corporate-wide technologies and production skills into competencies that empower individual businesses to adapt quickly to changing opportunities.”

C. K. Prahalad & Gary Hamel, “The Core Competence of the Corporation” Harvard Business Review, May-June 1990.

Intangible Assets & Intellectual Property deployed as “strategic capital” to exploit new opportunities.

— “Strategic capital…defined…as the value of unrealized opportunities.”F. Peter Boer, The Real Options Solution: Finding Total Value in a High-Risk World

(New York: John Wiley & Sons, Inc., 2002), 22

CONCLUSIONS

Intellectual capital and intangible assets now drive the world economy.

A key success driver for the enterprise in this environment is its ability to profitably exploit its intellectual capital and intangibles.