How to Avoid Another Rolls Royce? The Role of IP Due Diligence in M&A Transactions

A recent Harvard Business Review article states the following: “Deal making is glamorous; due diligence is not” [1]. The article goes on to say: “That simple statement goes a long way toward explaining why so many companies have made so many acquisitions that have produced so little value”. One of the most extreme examples of IP due diligence-gone -wrong happened in 1998, when German car maker Volkswagen purchased the assets of Rolls Royce and Bentley automobiles for about $900 million. Volkswagen did not realize until after the deal was closed that the IP assets did not include the right to use the Rolls Royce trademark… The trademark was owned by another car maker, BMW, pursuant to a prior agreement. Volkswagen had therefore acquired all the rights necessary to manufacture the car, but did not have the right to brand it as a Rolls Royce! This story highlights the critical role of IP Due Diligence in the acquisition process, and should serve as a reminder to M&A corporate teams, especially with the recent rise in acquisition activity.
 
The San Jose Mercury called 2010: “the season of billion-dollar deals…”[2] From HP’s $1.1 billion purchase of Palm Inc. to Symantec’s $1.3 billion acquisition of VeriSign. Many large Silicon Valley companies are emerging from the recession with large cash reservesand are looking for opportunities to reshape their businesses around emerging technologies. According to Dealogic [3] technology companies have bought over 1,500 firms for over $50 billion this year. This represents a significant increase over the same period last year, when sector companies bought just about 1,000 companies for a little under $30 billion.

Frankly, acquisitions are risky deals. In a seminal 1987 study, Harvard Business School professor Michael Porter found that companies sold off many more acquisitions than they kept. He also found that companies with acquisition strategies reduced, instead of creatingshareholder value. Later studies reinforced Porter’s conclusions. A KPMG study conducted 15 years later found that over 80% of mergers were unsuccessful in producing any business benefit, as measured by shareholder value. That study further identified due diligence as one of three key activities that successful acquirers had prioritized in the pre-deal phase, and that had a tangible impact on their ability to deliver financial benefits from the deal (synergy evaluation and integration project planning were the other two).

Although big companies often assemble large teams and spend lots of money analyzing the size and scope of a deal in question —the fact is, the momentum of the transaction is hard to resist once senior management has the target in its sights. Due diligence all too often becomes an exercise in verifying the target's financial statements rather than conducting a fair analysis of the deal's strategic logic and the acquirer's ability to realize value from it. Seldom does the process lead managers to kill potential acquisitions, even when the deals are deeply flawed. The lack of prioritization of IP due diligence further compounds the problem. Corporate, tax and accounting issues often take precedence, and by the time the deal team gets to dealing with the IP, the deal structure has already been set.

The topic of IP Due Diligence was discussed in a recent panel moderated by Foresight Valuation Group, as part of the IP Summit, which took place in Silicon Valley. The panel included some of the Valley’s largest corporate buyers (Intel, Cisco, Juniper) along with corporate lawyers and IP consultants with knowledge of M&A due diligence activities. The panel members have all agreed that the process of IP Due Diligence, in the context of corporate M&A deals, should be prioritized, both in terms of timeline (earlier in the deal) and importance. The panel identified several major topics that could be addressed to streamline the IP Due Diligence process:

1. Education about the risks associated with the IP portfolio. Given the general risk associated with acquisitions, tech deals are even riskier than average, because of the complexity of the products involved. The IP portfolio is a key asset in technology deals, much more so than in any other deal. IP due diligence is therefore absolutely critical to managing risks associated with the deal. Knowing the risks associated with a flawed IP Due Diligence process can go a long way towards encouraging senior management to allocate more resources to the process. The panel members brought examples of serious problems with IP portfolios of acquisition targets (lack of licensing rights, forged inventor assignments) that could have devastated the post-deal integration had they not been found through the due diligence process.

2. IP Assets should be incorporated in the valuation of the target. IP assets are treated as an afterthought, and usually do not drive the value of the target. A deal is not driven by the IP assets, but vice versa, and this is an unacceptable situation when it comes to high tech acquisitions. Several of the panelists mentioned the fact that investment bankers and other financial advisers participating on the deal often sideline issues that could alter the value of the deal, or complicate the process. It is therefore the case that IP assets are not evaluated and priced separately from the target, but are rather priced after the deal is concluded, often for accounting purposes, where the price of the deal needs to be allocated among the various assets purchased with the target. IP Valuation is a general issue that hinders many transactions, due to the lack of efficient markets for IP (no comps) and the lack of transparency when it comes to reporting IP deals, and the valuation considerations that went into pricing them. Improving the transparency through better reporting of IP deals will go a long way in improving IP transaction markets, and will also help with M&A due diligence and the quantitative assessment of IP assets in the pre-deal phase.

3. Integrate the seller in the process. Considering the seller’s post-deal indemnifications exposure with respect to the representations and warranties given in the transaction agreement, sellers should have a vested interest in the IP Due Diligence process. Sellers should be integrated in IP Due Diligence in a way that would help both sides streamline the process in a more efficient and cost effective way. Panel members representing buyer organizations actually mentioned that, from a seller perspective, better presentation of IP assets will help the sellers in getting better terms for the deal, which is not necessarily in the buyer’s best interest. That is an interesting point to keep in mind, as the buyer’s and seller’s objectives aren’t always aligned.

[1] “The Secrets of Great Due Diligence”
[2] Silicon Valley Companies Make Billion Dollar Deals
[3] Intel, Dell Acquisitions Come Amid Mounting Tech Takeovers  

The Oprah Winfrey Network – Deal or No Deal??

An IP Valuation Case Study (Part 1 of 2)

We would like to present the case of The Oprah Winfrey Network (OWN) as an example of how the values of intangible assets can sometimes be found in daily news stories. This case presents some interesting valuation questions and provides a rare glance into a highly publicized joint venture based primarily on intangibles.

The following story first appeared on USA today in January 2008:

“Oprah Winfrey is getting her own cable channel, called OWN: The Oprah Winfrey Network. A deal announced Tuesday with Discovery Communications will create a 50-50 cable and Web venture. In the cashless transaction, Discovery will contribute its Discovery Health Channel, to be converted to OWN in late 2009 and simulcast in HD. Launched in 1999, the channel reaches more than 70 million cable and satellite homes. Winfrey's company, Harpo, will kick in her website, Oprah.com. “ 1

Putting our IP valuation experts’ hat on, we ask ourselves: is this a fair deal? For a 50-50 cashless deal to be fair, each party’s contribution needs to have about the same fair market value. OWN will be structured as a joint venture partnership where each party makes an” in-kind” contribution of assets - in this case: mostly intangible assets – in lieu of cash. It is this unique structure that makes it a very interesting IP valuation case study …

Let’s look at what each party is contributing to the deal:

1. Discovery – is contributing its Discovery Health Channel, which, by its own admission, was a struggling media entity at the time the deal was announced:

“Discovery Health faced an uncertain prognosis. It is drawing fewer than 200,000 prime-time viewers at a time when cable and satellite services want to cut payments for channels with small audiences. "They need audiences to jump-start (Health)," said SNL Kagan's Derek Baine. He said that Discovery Health became profitable in 2007, with $7.4 million in cash flow on revenue of $141.8 million. Discovery spokesman David Leavy said those numbers are "a bit high" but would not be more precise.” 2

2. Oprah – Winfrey's company, Harpo Productions, is contributing the website, Oprah.com, a very popular websites at the time the deal was announced, according to several sources:

“OWN will feature mostly original, nonfiction programming… focusing on topics Winfrey is known for -- health, love, spirituality, child-rearing and personal growth. The channel will coordinate with Oprah.com, Winfrey's Web site, which averages about 6 million unique visitors per month.” 3

“Oprah.com offers extensive expert advice, interactive workbooks, photos, video, inspirational stories, books and features to more than six million unique visitors with more than 80 million page views per month.” 4

What is the fair market value of each of the parties’ contributions into the OWN joint venture? Since we have no access to any of the parties’ detailed financial data (Harpo is privately owned), our analysis will be based on publicly available information.

Discovery Health Network. A cable network is a media property that includes a bundle of tangible (equipment, infrastructure) and intangible (broadcasting rights, content, and subscribers) assets. The most valuable asset for cable networks is their subscriber list, which is an intangible asset. Cable network values are often benchmarked using valuation metrics such as the ‘value per subscriber’, or ‘cash flow multiple’. We have looked at some transactions involving similar cable networks, and found two relevant data points relating to similar “lifestyle” channels: Bravo and Oxygen (another media venture backed by Winfrey), both purchased by NBC 5.

The table shows a wide variation in the value per subscriber metrics: while NBC paid $23 a subscriber for Bravo, it only paid $13 a subscriber for Oxygen (some analysts called the Oxygen deal a “bargain”). However, the table also shows that prices seem to be more correlated with the annual cash flow generated by the network, with a ‘cash flow multiple’ (=total value/annual cash flow) of around 8-9. While Discovery Health Channel has 70 million subscribers (it’s part of the large Discovery family of channels), that particular channel has been around since 1999 but only turned a profit in 2007, generating a mere $7 million in cash annually. It does not seem right to compare it on a value per subsriber basis to Oxygen, with a similar number of subscribers, since Oxygen generates almost 15 times as much cash flow as Discovery Health. It seems more appropriate to apply the cash flow multiple to the cash flow generated by Discovery Health (about $7 million a year), as that ratio is better correlated with acquisition prices:

Discovery Health’s Fair Market Value ($mill) =

9 x 70 mill subs = $63 million

>> we believe that the fair market value of the Discovery Health Channel in early 2008 was probably less than $100 million,

Oprah.com Website. A website is a bundle of intangible assets (domain, content, code, back links, etc), that are mostly protected by Copyright laws. Websites can largely be classified into E-commerce sites (selling goods & services online, ie. Amazon.com) and content driven sites. There are various models for valuing Content-driven websites, most of which are primarily based on web analytics related to traffic (ie, are a function of the number of unique visitors, number of web pages viewed, etc). The Oprah.com website can be classified as a Content-driven website, and therefore, we have turned to comparable transactions around the time the deal was annoinced to figure out the prices paid for similar web properties.

An analysis of news articles from the 2005-2007 time period reveals that an often-quoted average ‘value per unique monthly visitor’ in web content deals was around $38 per visitor 6. In addition, larger sites seemed to be generating a higher price per visitor than smaller sites, ranging anywhere from $20 to over $200 7. We found two relevant data points related to transactions that took place in late 2007, and involved large content driven web properties:

We believe that the Oprah.com site should be valued at least at the average price of $38/visitor, but more likely at the $55-$65 range (or even higher, since it’s larger than both deals presented above) using the 6 million unique visitors, as reported by Harpo:

Oprah.com’s Fair Market Value ($mill) =

$38 x 6 mill unique visitors = $230 million
$60 x 6 mill unique visitors = $360 million

>> we believe that the fair market value of Oprah.com website in early 2008 was at least $200 million, and probably higher than $300.

Our analysis leads to an interesting valuation “puzzle”: why would Oprah Winfrey, one of the savviest business people in the world, be entering a 50-50 joint venture where the fair market value of her contribution is at least two or three times that of her partner’s?

While we cannot give a definite answer, we think that we have a few possible explanations, which we will share with our readers in Part 2 of our discussion of the OWN deal. In the meantime, we would be interested in your opinions - what would you advise Oprah Winfrey: Deal, or No Deal ?!…

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1 http://www.usatoday.com/money/media/2008-01-15-oprah-cable-channel_N.htm
2 Ibid.
3 http://www.washingtonpost.com/wp-dyn/content/article/2008/01/15/AR2008011501562.html
4 http://www.targetmarketnews.com/storyid01160802.htm
5 http://www.nytimes.com/2007/10/10/business/media/10oxygen.html?_r=2
6 For example: http://www.websitebroker.com/articles/website-valuation/simple-ways-to-value-your-website
7 http://seekingalpha.com/article/92809-valuation-metrics-of-large-vs-small-website-acquisitions?source=article_lb_author

http://www.foresightvaluation.com/

The IP Valuation Spectrum

This is the first in a series of blogs about IP valuation. We wanted to address this topic because we’ve found it to be one of the most misunderstood topics in the management of intellectual assets. During our 15 years of working as IP consultants, we saw the migration of IP valuation from being a tool for estimating IP damages into more “main stream” applications. In order to understand the process we need to lay out the framework for thinking about IP valuation. Although the first question I always get after presenting myself as an IP valuation expert is: “how do you value patents”? I believe that it is actually the wrong question to ask, or at least, it should not be the first question. There are two fundamental questions that should be asked and answered first, in order to put the valuation into the right framework:

1. Why do you need to value the IP in question?
2. When do you need a valuation expert?

The answer to the first question requires a bit of a history…

With its roots in the IP litigation of the 1980’s and 1990’s, the valuation of IP (primarily patents) was initially limited to damages calculations in legal cases involving claims, such as patent infringement. With the introduction of tax planning involving IP, such as transfer pricing and patent donations, the need for IP valuation increased and the valuation of intangibles became critical in non-litigation circumstances. In tax reporting, companies now had to include the fair market value (FMV) of IP involved in transactions, such as the inter company transfer of IP or the donation of a patent to a university. New accounting rules related to business combinations, introduced in the mid- 2000’s, expanded the need for IP valuation even more, as companies were now required to report the Fair Value (FV) of intangibles that were purchased as part of a target in an M&A deal.

In addition to the above circumstances – tax, accounting, and litigation –, which we refer to as “Compliance” situations, there are other situations where an IP valuation could be beneficial for transactions, commercialization decisions, licensing, or general corporate planning. During the same timeframe, which saw the proliferation of tax and accounting rules mandating the valuation of IP, IP management teams were beginning to gain momentum in US corporations. Large companies with large patent portfolios were becoming increasingly sophisticated in managing their IP portfolios and had the need for IP valuations. The types of transactions they needed a valuation for included: spin-offs, in kind contributions, licensing, patents sales, and other commercialization activities. Since there are no governing regulations (such as IRS, SEC or other agencies) controlling the process, we refer to these IP valuation circumstances as “Non-Compliance”.

With regards to the second question – when do companies need to hire an IP valuation expert – the answer is two fold: when there is a very high degree of scrutiny, and when the opinion needs to be “bullet-proof” with the highest level of accuracy. Most Compliance circumstances fall under this category, and so the recommendation or requirement under these circumstances would be to hire a third party, independent IP valuation expert. The non-compliance situations are more of a “gray” area… the higher the degree of scrutiny of the level of accuracy required, the more likely the valuation cannot be done in house and an expert needs to be brought in.

The chart below displays the IP Valuation Spectrum, the compliance vs. non compliance situations and our recommendation on when as expert may be needed. The Compliance situations are highlighted in a box, with the rest being the Non-Compliance situations:





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10 Lessons Learned @ LES Anniversary Event

FVG just sponsored the Licensing Executives Society (LES), Silicon Valley Chapter’s 10th Anniversary event, held at Hewlett Packard in Palo Alto. The day-long event presented a host of speakers on topics ranging from the new direction of the USPTO to the challenges facing start ups in the current funding environment, and was well attended by over 100 participants.

Below is a list of 10 lessons that we have learned at the event – one lesson for every year that the chapter has been around…

1. The USPTO is working hard on reconnecting with its stakeholders. It was interesting to get two perspectives on the state of affairs at the USPTO under the new leadership of David Kappos. One was by Todd Dickinson, the former head of the USPTO under the Clinton administration, who gave a comprehensive overview of the last decade in his keynote address. Andrew Hirshfeld, USPTO Chief of Staff (standing in for David Kappos who unable to attend at the last minute) gave a hands-on view of the various initiatives taken by the office to improve contact with stakeholders, including: increasing examiners’ productivity, addressing backlog and churn problems, and so on.

2. Public Debate over IP Reform is heating up. After the release of two studies on IP, one by the National Academy of Sciences and other by the FTC, there is growing debate over how to bring laws up to date and how to be more forward thinking. Todd Dickinson has participated in sessions “inside the beltway” and seen how different groups have presented their views, including congress, industry, lobbyists and public interest organizations, such as the software alliance. Needless to say, there is a lot of work ahead.

3. Accounting for intangible assets is completely misunderstood. From a sample of audience questions and private conversations, we conclude that there is a high degree of ignorance when it comes to understanding accounting for intangibles. …we plan to address this topic in one of our future blogs, especially since the US GAAP accounting rules for intangibles are about to change with the introduction of IFRS (international accounting standards) over the next decade.

4. IP valuation is still a vague concept for many people. Todd Dickinson characterized IP Valuation in his keynote address as “notoriously difficult”. I have spoken to over 30 people throughout the conference (mostly attorneys), and the 2nd question I consistently got (after asking what FVG does…) is – how do you value patents? This is another topic that will be addressed in our future blogs

5. Engineers are not trained to succeed as entrepreneurs. Several panel discussants voiced their dissatisfaction with the curriculum at US universities and how it stifles innovation. While we disagree with the generalization inherent in such statement, it seems like it might have some merit when it comes to engineers. As summarized by one of the panelists, engineering graduates usually lack the three most important requirements for starting a company: (1) Understanding a business model; (2) Evangelism; (3) Teamwork. That explains why so many engineers end up in business school to get an MBA…

6. University role to grow in entrepreneurship & innovation. In the panel “The Crystal Ball: A Perspective of the Future”, Katherine Ku, Director of the Office of Technology Transfer at Stanford University gave her overview of University – Industry relations. She emphasized that when it came to education, there is great demand for classes on entrepreneurship from both students and faculty. She sees the role of research growing at universities as funding for R&D shrinks in the private sector (especially pharma) and there being a healthy mix of “open innovation” & “proprietary research”. As a result, she predicts the growth of licensing activity at universities

7. The “Value” of IP has grown immeasurably over the last decade. Todd Dickinson, in his overview of the last ten years, spoke about how the “value” of IP has grown immeasurably - its uses have expanded and its role in acquisition deals has grown. He noted the rise of trolls and the role of patent auctions, such as Ocean Tomo.

8. IP is still not driving VC funding. When asked about the role of IP portfolios in securing start-up funding, a distinguished panel of entrepreneurs and investors unanimously recommended start ups to “get a customer first, and the patents will follow…” We thought that this was a very eye opening comment!

9. Consensus is in; there will be a Venture Capital shakeout. As panelists discussed the role of startups, naturally discussion veered to funding and the question arose whether “VC’s were a dying breed”. All five panelists agreed that there will be a shakeout in the upcoming years. Of the 800 plus VCs, perhaps a half would disappear. The strong, well established firms will still be around, investing, but there is change ahead.

10. You must have a great team and a pretty darn good product to have a successful startup. When you have a panel full of successful entrepreneurs and funders, including Bill Reichert, Managing Director, Garage Technology Ventures, you know someone is going to ask “How do I get funding?” Well the answer is unchanged. You need an a team of talented entrepreneurs and a pretty darn good product. The two are linked, since if your market changes or your product needs to change, you need a nimble, smart team to roll with market conditions.

Visit us at www.foresightvaluation.com