ABSTRACT

Title

Intellectual Property: The dominant force in future commercial transactions comprising mergers and acquisitions

Brief Summary

This essay seeks to gauge the dominance of Intellectual Property in commercial transactions involving mergers and acquisitions by assessing the role of IP in the different stages that make up a transaction. The essay tries to highlight the evolution of IP in the mergers and acquisitions process from being perceived as a mere tool of risk assessment to playing a leading role in M&A strategy and deal structuring. A mention is made of the monetisation of IP through securitisation and licensing and specific emphasis laid on the significance of valuation of IP. In effect, the article stresses on IP’s role as an enabler of strategy, valuation, negotiation and price discovery rather than a disabler as a result of its risk assessment role.

Word Count

Two thousand nine hundred and seventy four (2974)

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Introduction

Intellectual Property (IP) is a dominant force in a wide variety of areas including commerce, communication, culture, science, taxation and international trade. Within a business context, IP influences marketing, R&D, tax planning, corporate finance, operations and technology and forms an integral part of strategy. Today, the ability to create the basis of profit and to protect that profit increasingly depends upon intellectual property as critical business assets and upon how a company manages those assets.1

Therefore, one finds companies maintaining sophisticated tools to manage everything from innovation targets and portfolio optimization to licensing and securitisation.

In the context of mergers and acquisitions (M&A), companies have begun to recognise IP’s role in mitigating risk, in making valuations more accurate, and in giving an investor a better understanding of the target company’s business. For the corporate lawyer representing a party to an international merger or acquisition, intellectual property is primarily of interest as it affects the overall value of a company's assets and liabilities.2

As a testament to the increasing importance of IP, several companies have begun to appoint a single contact point in the form of a CIPO (Chief Intellectual Property Officer) who is strategically involved with the M&A process from an early stage and who plays a lead role in addressing all aspects of the IP component of the transaction.

Mergers and Acquisitions – A prelude

A merger or an acquisition is a very significant strategic decision taken by management and shareholders in the life of a company since it involves the restructuring of the company. Whereas a merger involves the creation of a new entity from earlier independent entities, an acquisition - also known as a takeover if the target company is listed - involves the purchase of one company by another.

The stages of an M&A include:

1. Growth and target strategy

2. Due diligence

3. Valuation, negotiation and price discovery

4. Compliance: Dealing with regulations

1 THE IMPERATIVES AROUND INTELLECTUAL PROPERTY ASSET MANAGEMENT; 49-JUL Advocate (Idaho) 242 Charles R. McManis: INTELLECTUAL PROPERTY AND INTERNATIONAL MERGERS AND ACQUISITIONS; 66 U. Cin. L. Rev. 1283

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5. Integration: Post-acquisition

Putting IP in Perspective

IP’s role in M&A remains contextualised and industry-specific. In cases where IP constitutes a significant component of core assets of a targets business, IP would factor in much more than in a situation where tangible assets constitute the core value of a target company. Thus, for example, an extensive portfolio of granted patents may be of little value to a business if none or very few of the products made by the business are referable to those patents.

One factor amongst many

Additionally, IP is but one amongst several factors in consideration whilst conducting due diligence. Tax planning, culture integration, HR processes, compliance issues, contractual issues with suppliers and customers, business financial statements and forecasts are amongst the other factors that are also reviewed.

Intellectual Property: Contextualised Yet Ubiquitous

In today’s globalised world one finds the emergence of knowledge economies which thrive on innovation: where information and ideas command a price. While one may observe the shift of manufacturing bases from the developed world to the developing world, there is also a measurable amount of innovation taking place in developing nations. India is a good example with its pharmaceutical companies investing heavily in R&D and IT/software service companies climbing the innovation ladder at a rapid pace. Thus, irrespective of the geography one might be in, innovation, ideation and information are unlikely to be far away.

Just like innovation is not limited by geography, intellectual property (of which innovation is a major component) is not limited to any particular industry/sector. IP in itself is an expansive field that includes copyrights, trademarks, patents, designs and trade-secrets. Further, conceptually, all of these forms of IP are ever-expanding and continually reaching out across industry and service sectors. Trademarks, for example, are no longer restricted to words, symbols, logos, numerals and pictures but have been expanded to include smells, shapes, colours and tastes.

Therefore, no matter which segment of the industry or service sector is involved in attempts at a merger or an acquisition, one can say with much certainty that intellectual property will appear on their “radar” during the transaction.

Branding: A prime example

A prime example of the omnipresence of intellectual property is found in the form of brands. Branding is applicable to everything from luxury goods and fast foods to motor fuel, personal care and retail. No matter which branded product or service is the subject-

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matter of marketing, it will find reference in strategy, valuation and risk-assessment during an M&A process. Company strategy, while assessing a target company’s assets will include assessment of the value of the brand and the risk profile of the brand/trademark from both a marketing and legal perspective.

IP – A dominant force

In order to gauge the dominance of IP during the course of an M&A, it would be apt to assess its role in the various stages of an M&A.

A) Strategy

IP led M&A

IP is increasingly at the forefront in M&A transactions. In cases where the acquisition is IP-led, IP forms the core part of the business strategy. One way of categorising strategy is as follows:

1. Offensive use strategy

The existence of an IP portfolio (especially of patents) offers a considerable “high-ground” for companies to strategise and make powerful decisions. Large companies such as Microsoft and IBM are known to acquire IP aggressively and threaten to enforce them against users (unless they agree to license terms) and competitors (which results in reduced opportunities for product development and market growth for competitors).

However, the “poster-boys” of the offensive strategy happen to be much smaller in size. These small companies are infamously known as ‘patent trolls’ as they acquire patents or patentable inventions with stealth and earn money by litigating against deep-pocketed “infringers”. The sole purpose of such companies is to extract money from potential violators. Neither do they have the personnel nor the resources to actively develop and manufacture products based on the patents they acquire.

While acquisitions of patents for offensive use are a major concern for operating companies the financial opportunity that this model offers is tremendous.

2. Defensive use strategy

The essence of this strategy lies in focusing more on freedom to operate rather than IP litigation. The strategy involves the acquisition of sufficient IP in order to be “eligible” for future cross-licensing as well as to deter companies from filing lawsuits for the fear that they may be cross-sued. Companies following this strategy use their IP portfolio as a bargaining chip.

Non-IP led M&A

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Where the business strategy per se does not consider IP but some other tangible or intangible asset, IP still remains fundamental to the transaction. This is particularly so because of the fundamental transition in how IP is used today in that its value is recognised as capable of being separate from a company’s core business. The IP goldmine: Abundance of opportunity

The Intellectual Property bandwagon has more to offer than rights protection alone. Monetisation of IP and the creation of an IP asset class has created exciting opportunities for persons/corporations that own such IP. IP securitisation and IP licensing are two forms of exploitation of this new asset class.

IP securitisation

Securitisation of tangible assets has existed ever since the 1980’s. It involves the transfer of assets to a Special Purpose Vehicle which issues securities based on those assets. The securitised asset is remote from other assets of the originator which remain unaffected in any event of bankruptcy.

The first time IP was securitised was in 1997 when David Pullman devised what are known as ‘Bowie Bonds’($55 million in bonds), backed by the royalty and publishing income receivables from singer David Bowie. Ever since, other musicians have followed in his footsteps. Today, one can find potential for securitisation in patents, trade-secrets, trademarks and domain names as well.

Securitisation of these assets is not without risk and each type of IP when securitized, has its own unique risk factor. Moreover, for a successful securitisation, the value of the royalty stream must be predictable and the risks measured and understood. For this, a thorough due diligence involving careful valuation and cautious asset identification is a must.

Licensing

Licensing offers a revenue stream for companies without asking of them any concerted effort to manufacture and sell innovation-based products in the marketplace. Take IBM as a model example: its licensing of IP itself helps generate close to over two billion dollars annually. In order to maintain its competitive edge, IBM acquires companies with technology/IP portfolios that fit in strategically with its business plan. It does not develop everything on its own. Acquired innovation is put to good use through the expansion licensing model where focus is on out-licensing i.e. capturing revenue completely outside of what the company considers its core competitive model or industry.

B) Due diligence

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Without a doubt, due diligence is central to an M&A and its fallout as it underscores information gathering and planning and assists the purchaser in evaluating the target’s business.

The process of due diligence may be categorised as including:

1. Financial due diligence

2. Commercial due diligence

3. Legal due diligence

Traditionally, IP has been introduced onto the discussion table at the fag end of the acquisition process and its purpose pigeonholed to risk assessment. The process in itself is time consuming and involves:

- Ownership/Title checks :

- IP renewal checks

- Risk determination

- Risk allocation amongst buyers and sellers through representations, warranties, indemnities etc

- Review of licenses, assignments, employment contracts, confidentiality agreements

- Anticipation of third party infringement claims

Since the nature of protection varies according to the kind of intellectual property, the risk factors and risk mitigation strategies differ as well.

A few illustrations

Copyright

An author of a copyrighted work retains ownership even if the work has been paid for. Thus, an explicit contract transferring title is necessary. Further, an author always retains moral rights to his work which may impact a new owner’s use of that work. This too must be factored in whilst assessing risk

Trade secret

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A company with a valuable trade secret must have safeguards against leakage of information. These safeguards might include employee contracts and strict confidentiality clauses or other means (such as effective technology) of maintaining secrecy. An in-depth review of procedures must be done.

Trademarks

There are some relevant questions that need to be asked while reviewing risk in case of a trademark:

• Is the trademark a source and origin identifier?

• Has its use become uncontrolled i.e. has extensive use by owner or third-party resulted in dilution of the brand?

• Has the target company actively protected its mark against infringers? If it has not policed its mark properly, has the legal strength of the trademark weakened?

• Are there any limitations on use with respect to geographic scope or product market?

• Have all major markets been covered during registration by the target company?

C) Valuation

A merger or an acquisition would not be worthwhile if the financials of a deal aren’t sustainable. During due diligence, efforts are made to uncover every aspect of the targets business in order to facilitate a thorough financial evaluation.

Historically, sustainability of a commercial transaction involving M&A has depended upon the valuation of tangible assets of the targets business. Today, however, the role of intangible assets in a company’s value has increased dramatically and with it the requirement of apportioning the purchase price in terms of intangible assets and other assets. According to Brookings Institute data, the value (as measured by market capitalization) of Standard & Poor 500 (S & P 500) companies has shifted during the time period between 1982 and 2002. According to one source, as much as three-quarters of the value of publicly traded companies in the United States comes from intangible assets, up from around 40 percent in the early 1980s.3

The dramatic reversal of valuation being based on tangible assets versus intangible assets is apparent.

Valuing IP

3 "A Market For Ideas," The Economist, Oct. 20, 2005

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The most popular and robust methodology of financial valuation is the discounted cash flow approach wherein future aggregate cash flows are anticipated and their value discounted (against cost of capital) to net present value.

Especially in the case of IP valuation, the challenge lies in fine tuning the discount rates for which there are a range of factors that need to be considered. The discounting has to be done against future revenues generated through exploitation of the IP asset (incremental value generated through excess revenue over cost) keeping in mind the systematic risk of each intangible asset, with a riskier asset obtaining a higher rate than less risky assets. Applying the correct discount rate is vital as otherwise it can have a negative impact downstream i.e. lead to an incorrect valuation of the intangible asset which will impact the amortization charges thereby hitting the P&L account and in turn affect the accuracy of the bottom line and earning per share (EPS) estimations. Unfortunately, unlike in the case of tangible assets (where capital markets form a benchmark), there is no benchmark to ascertain risk for intangibles. This uncertainty leaves a lot to be desired for accuracy, robustness and reliability in financial reporting.

Accounting standards

Under the new international financial reporting standard for business corporations (IFRS 3), a greater degree of transparency has been brought into the acquisition process, forcing companies to be more rigourous in their assessment.

IFRS 3 is a recognition of the rising significance of intangible assets as an economic resource, as they continue to make up an increasing proportion of the value of an acquired business4.

IP – invaluable

With brands such as Coca Cola, Wal-Mart, Citibank, IBM commanding a brand value exponentially higher than the physical assets that they own (Google, according to one survey5 has a brand valuation of 66 Billion U.S. Dollars) and pharmaceutical and biotechnology companies living and dying by their patent in the market place, it wouldn’t be an exaggeration to claim IP as having become an invaluable asset. If this be so, then for all purposes including M&A transactions, accurate valuation of the IP portfolio of a company will be of primary significance in the future. D) Regulation

When companies are screening their intended merger/acquisition against the competition rules of a jurisdiction, they may be well advised to keep a watchful eye on the impact that an aggregate portfolio of IP can have on a merger review.

4 KPMG: Business Combinations Valuing Acquired Intangibles, May 20065 Millward Brown Optimor, Top 100 Most Powerful Brands, 2007

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With respect to the European Commission and the United States Department of Justice's Antitrust Division, a review of cases over the last decade shows how merging parties' intellectual property assets and agreements can prove a red flag in merger reviews6.

It is fair to state that the most carefully scrutinised mergers from an IP perspective are in the pharmaceutical and medical-analysis sector7. There are three reasons for this:

1. It is easy to draw a link between a specific patent and a specific drug or therapy.

2. Drug pricing is a politically sensitive issue, especially in developing countries where it can have large-scale implications on national health systems.

3. In other sectors, ownership results from keeping broad IP portfolios covering a range of IP.

Other situations can also lead to scrutiny. For example, the existence of a cross-license arrangement between merging competitors can lead the authorities to conclude that the merged entity will have a blocking position with respect to relevant product lines8.

There is an observable trend in merger review towards close scrutiny of intellectual property portfolios which probably reflects the growing importance of intellectual property assets in business as a whole9 and correspondingly shows the need for a careful analysis of the IP position of the target.

E) Integration Challenge

One of the challenges that IP throws up is in the creation of a uniform platform during a merger or acquisition. This has reference to the post-acquisition process of integration where the values, technologies, processes, data of companies have to be reconciled. In the case of companies with IP portfolios the following become important:

a) Data integrity – There must be no data anomalies. The accuracy of data must be verified.

b) Field mapping – Data must be transferred from one database to another

c) Validation – Another level of scrutiny might be necessary and compliance with rules will need to be factored in.

Another challenge involves the tracking of new filings i.e. as new filings happen during the M&A process, there is a need to establish consistency with existing records. This

6 Colm MacKernan: RED FLAGS IN THE TROUSSEAU: A SURVEY OF THE COMPETITION TREATMENT OF IP IN M&A ASSETS; E.I.P.R. 2004, 26(10), 461-466

7 Ibid8 Ibid 9 Ibid

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tracking system acts as an additional tool in the “checks and balances” artillery of an M&A team.

The key to success of an M&A is a systematic, detail-obsessed approach that leaves no room for guesswork or sloppy data-handling. When these pieces come together, IP managers become a vital weapon in the M&A arsenal, helping to inform the process with concrete data points and defining the value of each prospective deal.10

Conclusion

The role of intellectual property in commercial transactions involving M&A has evolved steadily over the decades. While previously its role was circumscribed to legal due diligence and risk assessment, today that role has expanded to provide significant strategic and tactical advantage in deal structuring. Moreover, the perception of IP as a disabler (where hurdles during risk assessment would result in the deal being called off) has changed to its being seen as an enabler in negotiation and price discovery. Another visible trend is the monetisation of IP and the leveraging of this asset class through securitisation and licensing.

The future role of IP in M&A is bright. With the conceptualisation of the role of a CIPO, IP will get represented early in management discussions. This will also pave the way for the evolution of the role of the legal department (just as has happened with the creation of the CTO from the IT department) from being seen as useful for docketing and risk assessment to being respected for its wider understanding of valuations, financial statements and business operations.

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10 An acquired taste: Managing IP through M&A by Alexander R Butler, MDC a Thomson Business

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