Venture capital and IP assets

September 2015 | COVER STORY | PRIVATE EQUITY & VENTURE CAPITAL

Financier Worldwide Magazine

It is no secret that many companies today run on the strength of their intellectual property (IP) assets. When managed properly, IP, including patents, trademarks, trade secrets and copyrights, can generate profits and high levels of returns for their owners, relative to other asset classes.

Indeed, it appears that today, IP assets are contributing more value to corporations than any other assets. In 1975, just 17 percent of the market value of S&P 500 companies was represented by intangible assets; by 2010, that figure had grown to 80 percent. According to Ocean Tomo, the implied intangible asset value of the S&P 500 reached 84 percent by January 2015.

Since IP forms the backbone of many firms, its importance cannot be overstated. Any industry in which companies make substantial investments in their research and development, technology and brands typically generate significant levels of valuable IP.

IP is a versatile and valuable commodity which, among its many uses, can help to drive value creation, differentiate an organisation from its competitors, motivate M&A activity and draw in new customers. When properly cultivated and protected, IP can be one of the most important tools at a company’s disposal.

Venture capital (VC) firms are particularly interested in deals motivated by the desire to acquire, or invest in, valuable IP assets. In recent years, the largest sectors for VCs generally have been life sciences, consumer electronics and communications. In these fields, the pace of technological change has been particularly impressive, and VCs have zeroed in. Deals in the e-commerce and mobile software/services spaces accounted for more than half of the top 25 VC deals in 2014. According to data from Statista, in 2014, VC funding in the US reached its highest level since 2001. Last year, deal growth was up 8 percent on the previous year, while VC investment climbed an impressive 62 percent. $47.3bn was invested across 3617 deals, with the tech sector accounting for three of every four VC transactions.

Opportunities

The VC industry is, of course, predominantly focused on returns, and this drives their investment strategies. As Barbara Clarke, a member of the Angel Capital Association and an angel investor with Astia notes, VCs are looking to invest in opportunities that will yield large returns, not just relative to investment, but large in absolute amounts; most are not interested in highly profitable opportunities that have only a small market size. This approach can have a significant impact on innovation, too, as Ms Clarke explains. “VCs can be credited with focusing on the path to market for innovation,” she says. “Most VCs and experienced investors evaluate the path of customer acquisition, examining how expensive it will be to scale up adoption of a particular innovation. Particularly in life sciences, that has had a big impact on the type of innovation that is getting investment. It isn’t sufficient enough to make, for example, a medical device that improves outcomes for patients if the path to adoption means that the entire protocol has to be changed. VCs have provided that discipline so that the value of the intellectual property includes the costs of getting to market.” The result of this, she adds, is that many companies with highly technical intellectual property are now seeking market expertise at an earlier stage than previous companies.

“The quality of the IP can determine whether the company has significant business advantage or a significant liability.”

But VCs have not always been as enamoured with IP assets as they are today. According to Ylan Steiner, a partner at King & Wood Mallesons, many had other priorities. “While there is a recognised correlation between IP assets and success in the VC sector, historically intellectual property has rarely been the primary driver for VC transactions,” he says. “Most industry veterans will comment that they will back a strong management team ahead of any other metric, with the development of the product and deliverability of a business plan dependent upon the management team.” For many VCs, having strong intellectual property, historically, has only been half of the equation. The experience and strength of a company’s management team has often driven VC interest in a target. How many years of experience a management team has in their given industry can be hugely influential in attracting VCs.

Despite many VCs’ previous reluctance to prioritise IP, times are changing. But it is not merely enough for VCs to complete deals; they and their target companies need to develop a solid understanding of the advantages of IP assets and asset management within their space. Moreover, VCs need to understand why certain IP is important to a particular firm or industry.

In certain sectors and industries, IP may be a company’s main asset, such as patents in the life sciences and technology sectors. In highly competitive markets like smartphone technology, IP assets are acutely valuable, acting as both a sword and a shield. In the technology sector, a dominant brand position and barriers to entry for competitive products is a primary driver of success. Only IP rights provide this opportunity. A better understanding of IP and IP management can bring significant value. It is not simply obtaining IP that is relevant to a successful exit for VC firms, but also understanding why IP matters in a competitive landscape and how to manage it well. A well-structured licensing and litigation strategy to defend and support IP can be vital.

Given that IP is of paramount importance, how should VCs evaluate it? Particularly in a start-up or early stage firm, due diligence is essential.

Due diligence

In order to successfully generate returns from IP assets, the IP assets must first be identified and inventoried. Some IP assets are easy to identify, while others are more difficult, particularly given that IP assets are often created in-house and are expensed as they are created. Accordingly, much IP cannot be found on a company’s balance sheet. As a result, the first step for VCs should be to interview knowledgeable staff members in order to understand the sources of a company’s IP.

These interviews and IP audits should form part of a wider policy of carrying out stringent and comprehensive due diligence procedures. For VCs, conducting thorough due diligence is a vital process as it enables the firm to fully evaluate their potential investment opportunity. Given the inherent risk in investing in start-up and early stage companies, the importance of these processes for VCs should not be underestimated. Potential portfolio companies should prepare for a meticulous and time consuming due diligence examination.

“In evaluating IP in a potential start-up or early-stage investment, VCs should obtain a complete list of IP relating to the company, determine the rights and obligations the company has in that IP, analyse how well the IP prevents others from competing with what the company is doing and is planning to do, and understand whether the company infringes the IP of others,” says John C. Paul, a partner at Finnegan, Henderson, Farabow, Garrett & Dunner, LLP. “Confirm all ownership rights reside in the company rather than employees, independent contractors, predecessors, the government, and so on. Understand what rights or obligations or defects exist relative to the IP, such as licences or other agreements, or problems with enforcement. Uncover any pending disputes or threats concerning the IP or the company’s potential infringement of the IP of others. Determine the value of those rights by assessing the legal strength and commercial significance of those rights and the possibility of designing around those rights.” He adds that sound IP due diligence is especially important for IP-driven investments, where the quality of the IP can determine whether the company has significant business advantage or a significant liability.

The importance of IP due diligence is, however, not simply limited to understanding and estimating the market potential of a company and its intangible assets. VCs should also use due diligence to identify any potential risks to future growth and profitability, as Neil Coulson, a partner at BakerBotts UK LLP, explains. “For start-ups and early stage companies, the IP assets can often represent the only legal assets of the company and VCs usually want to determine the value of a business’ IP assets at the outset. The main purpose of IP due diligence, however, is not to determine a monetary value for the assets but to determine what the assets are and to identify any issues which might affect execution of the business plan or which might lead to expensive litigation down the line,” he says.

It is also important for VCs to examine the terms of a company’s IP agreements with third parties, placing particular importance on licences and development agreements. VCs should focus on the importance of provisions which purport to transfer IP rights, as well as payment terms which have the potential to dramatically affect the profitability of the start-up.

IP due diligence plays a pivotal role for VCs as it allows organisations to make better investments. Thorough IP due diligence provides a complete picture of a target company’s IP agreements, filings and existing disputes, as well as potential areas for future disputes. Should any problems be identified during this process, they can be addressed as conditions for closing. By carrying out due diligence, both the VC firm and the start-up can benefit.

Post investment

Once an investment has concluded it is extremely important for VCs to ensure that their portfolio companies protect and manage their IP effectively. Regardless of what form the IP takes, protection can solidify the strength and profitability of the entire organisation. When IP is the lifeblood of a newly-acquired target, what steps can VCs take to protect the portfolio companies in the post-investment phase?

According to Mr Paul, VCs should ensure that their companies have and use adequate processes for understanding, developing and using their IP, and avoid infringing the IP of others. He outlines a number of steps VCs can take to maximise IP assets. “Regularly capture, analyse and protect valuable inventions and other IP that arise by timely filings. Develop and use a searchable centralised IP database with sufficient information for business people to understand each patent and how it supports and can be used to support the business objectives of the company. Reduce costs and generate revenue by selling, licensing or abandoning unaligned and non-performing IP. Identify and pursue infringement by others for business advantage and revenue generation. Adequately investigate the possibility of infringing the IP of others at key times. Develop IP that further supports the current and future business of the company and provides an adequate defensive position against competitors. And ensure that part of the company’s team or the VC’s team, internally or externally, has top expertise and experience in IP strategy and IP management,” he adds.

While VCs must exert some degree of control over the IP of their portfolio companies, it is also important that the VC-backed entity itself works hard to maintain its own IP rights. This is particularly important for portfolio companies that expand rapidly in the wake of VC investment. For portfolio firms, IP management requires consistent and regular review, investment and updates. Shortcomings on this front can have detrimental effects, causing the initial IP investment to suffer and diminish returns. Portfolio protection is particularly important, as Mr Coulson explains. “Most IP rights require active maintenance, for example through the payment on time of renewal fees in relation to registered rights or the maintenance of confidentiality in relation to trade secrets,” he says. “Portfolio companies should ensure, therefore, that their IP portfolios are comprehensively maintained. Enforcement of IP rights against third parties also requires positive steps. Portfolio companies should actively monitor the market for signs of third party infringement and take appropriate steps to protect their market share.”

Furthermore, prudent companies will take a pragmatic approach to the application of their IP when dealing with potential partners. Managing these relationships can determine long-term returns on the initial investment. “As companies scale and expand, business becomes more complex and the interactions among competitors, vendors and customers require particular attention for the protection of intellectual property. In many markets, customers and vendors can become possible acquirers,” points out Ms Clarke. “When early stage companies work with potential acquirers, it is essential to maintain the integrity of the intellectual property. Many early stage companies ‘over share’ about their technology to win sales, and they damage their intellectual property in the process. Valuable intangible assets extend beyond patents and trademarks. Contracts with key customers and vendors become even more important. When companies can strategically align with customers to block market access to competitors, that increases the value of the company.”

Conclusion

IP is a key component of any modern company. It can generate significant value for organisations and help attract the attention of VCs. It can also help companies to establish and maintain their standing within their particular field. As such, companies must be fiercely protective of their IP at every turn.

But in order for particular types of companies – particularly start-ups and early stage companies – to fully maximise their potential, it is imperative that they attract and embrace VC funding and knowhow as soon as possible. With crowdfunding revolutionising the way companies get off the ground, the battle for IP is becoming more intense. VCs need to ensure that their portfolio companies protect and enforce their IP rights at all times.

Richard Summerfield