Foreword by Andrew Chilvers
For ambitious companies eager to expand into overseas markets, often the conventional route of organic business development is simply not fast enough. The other option to invest in or buy a business outright is far quicker but often fraught with unforeseen dangers. And even the biggest, most experienced players can get it badly wrong if they go into an M&A with their eyes wide shut.
If you search for good and bad M&As online the Daimler-Benz merger/acquisition with Chrysler back in 1998 is generally at the top of most search engines on how NOT to undertake a big international merger. Despite carrying out all the necessary financial and legal measures to ensure a relatively smooth deal, the merger quickly unravelled because of cultural and organisational differences. Something that neither side had foreseen when both parties had first sat down at the negotiating table.
These days the failed merger of the two car manufacturers is held up as a classic example of the failure of two distinctly different corporate cultures. Daimler-Benz was typically German; reliably conservative, efficient, and safe, while Chrysler was typically American; known to be daring, diverse and creative. Daimler-Benz was hierarchical and authoritarian with a distinct chain of command, while Chrysler was egalitarian and advocated a dynamic team approach. One company put its value in tradition and quality, while the other with innovative designs and competitive pricing.
Brian Buss and Doug Bania discussed The Art of Deal Making: Using External Expertise Effectively as part of the IP chapter.
What is your best practice approach to IP due diligence as part of the deal making process? E.g. Schedule of IP and establishment of transferable ownership rights?
Valuation of key intangible assets should be a component of any due diligence process. Today’s businesses rely on intellectual property (IP) and intangible assets to generate financial performance, with intangible assets typically accounting for a larger portion of overall enterprise value than tangible assets. An IP valuation improves deal making by providing both seller and buyer a clear picture of the key assets that drive financial performance. With an understanding of the relative values of key tangible and intangible assets, buyers can focus their due diligence on the key assets that will be acquired, and sellers can clearly present and communicate the financial and economic benefits of the assets they have built and developed.
Identification and valuation of key intangible assets at the seller will also focus overall due diligence efforts. Using valuation as a component of transaction due diligence enables transaction advisors to focus on how the most important assets at the target contribute to revenues, cost savings, profitability, and cash flow. As the buyer will become the owner of the seller’s IP, a clear understanding and measurement of how that IP generates sales, profits and cash flows is essential in review and execution of any business transaction.
Which methods of valuing patents, trademarks or trade secrets are most common in an M&A deal in your jurisdiction (e.g. cost, value or market approaches)? Any examples?
The process of valuing IP and intangible assets typically involves one or both of two calculation methods: the relief from royalty method and excess earnings methods. Both methods indicate the portion of profits achieved by the party using the IP that is contributed by the IP asset.
The relief from royalty method values IP assets using the context of a hypothetical negotiation where the IP user pays a royalty to an unrelated IP owner in an arms-length, willing buyer, willing seller IP license transaction. The relief from royalty method typically relies on benchmarks license agreements involving comparable assets. The amount of hypothetical compensation the IP user would be willing to pay, and the IP owner would be willing to accept, is forecast over the remaining useful life of the IP asset and future amounts are discounted to a present value using a discount rate reflecting the required rate of return for the subject asset. Essentially, this method provides an indication of the financial compensation one party would be willing to pay to use the subject IP asset. The amount of compensation, typically a royalty on financial performance, is an indication of the portion of profits expected to be achieved by the IP user that are derived from use of the IP asset.
Excess earnings methodologies focus on quantifying the impact of the IP asset on the party using the IP asset. For business transactions, excess earnings methods provide an indication of the profits achieved by the seller from its ownership of IP. In other words, if the seller owns and uses a recognized brand, an excess earnings methodology indicates the portion of total profits achieved from contribution of the brand assets. Excess earnings methodologies quantify how and when the IP asset is providing pricing power, driving increased sales volumes, and/ or reducing costs. For example, a strong brand may not result in high price points or increased unit volumes but can be valuable if the brand reduces the business’s overall marketing and advertising expenses.
What warranties and indemnities do you recommend putting in place to ensure IP value is fully preserved?
With advance planning and evaluation, a seller should be able to warranty ownership of its key assets. Equally important, the seller should also be able to warranty ownership of “complimentary” intangibles. For technology assets, complimentary intangibles can be code, test results, trade secrets and other assets that complement and enable use of patented technologies. For marketing assets, complimentary intangibles can be domain names, social media pages, marketing procedures, customer lists and other assets that complement and enable use of registered marks and copyrights.
Through IP valuation buyers and sellers will identify those IP assets that provide the greatest contribution to total enterprise value. Thus, pre transaction, sellers should confirm ownership of both the key identified IP assets and their complementary intangibles. This process of bundling IP and complementary assets enables more effective and transparent warranties.
Top Tips – To Accurately Establish IP Ownership Process
• For IP valuation, do not rely on only one valuation methodology. Valuation analysts should utilize multiple calculation methodologies and reconcile the differences indicated by each calculation.
• For establishing IP ownership in evaluating marketing assets such as trademarks, brands and copyrights, confirm ownership of domain names and social media sites. At too many businesses, domain name registrations and social media creation were outsourced, and management often assumes these assets are owned by the business. Its never too early to check, confirm and ensure website domain names and social media pages are properly owned by the business.