18 Jul’19

CPA Global: IP in IPO Webinar: Q&A Answers

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In our recent webinar: “IP in IPO: IP Valuation Lessons from Recent public Exits”, hosted by CPA Global, we discussed the role that IP plays in startup valuations, and the types of IP assets that were created by startups who recently went public. This webinar features a study we have been conducting and updating since 2015, which covers Unicorns (startups with valuations exceeding $1 Billion) and their IP positions.  Since some of the Unicorns went public in 2018-2019, we continue to explore what types of IP issues frequently emerge pre-IPO, and how are companies dealing with them, and what impact- if any – does IP have on Unicorn valuations. We recommend listening to the webinar first before reading this blog, which documents our responses to the Q&A session following the webinar.

Q: How has the new court application of 35 USC Section 101 (e.g., Alice Corp) against software patents impacted software-focused IPOs?

A: The Alice decision (and ensuing Supreme Court decisions and PTAB developments) have created a lot of confusion and uncertainty in the market with regards to subject matter eligibility and the overall validity of patents covering software inventions.  That being said, the correlation between these developments and software company IPOs is not an easy one to draw.  For once, as my webinar demonstrated, many of the Unicorns going public (all of which are in the general Software area) have managed to grow their valuations into the billions of dollars without having patents.  Whatever the reason may be for the lack of patents (one might argue Alice has something to do with it, others might argue different reasons), these companies could grow significantly without patents, and some of them even managed to exit in a successful IPO without increasing this patent portfolio proportionally to the increase in their valuation.  So I would argue that the Alice decision had nothing to do with Software company IPOs.

Q: Do you have any suggestions for how to prepare or develop a patent portfolio so that it will have a higher valuation, and hence contribute more as a business asset?

A: As I explained in my webinar, there are legal sides to a company’s patenting strategy, and there are business sides to that same strategy.  The legal side is best handled by lawyers, they can search and determine where patent protection should be pursued based on prior art and the patent landscape in the market.  From a business/valuation perspective, a patent portfolio will have value if it is well-aligned with the assets that bring the most value to the business.  In companies where Technology is the most valuable asset (usually correlated with heavy investment in R&D, like pharma and biotech) patents can have more value compared to companies where Brand is the main asset (consumer products, as an example).  Also, in companies where Trade Secrets are deemed to be the best mode of protection, patents can have less value compared to companies where a patent is the preferred mode of protection.  Once it has been determined that it makes sense to invest in creating a patent portfolio as a way to increase the value of the company, the key is to have a good combination of offensive and defensive goals, geographical distribution, technology coverage, etc.

Q: Do you have any suggestions or advice for unicorn startup companies that may have a relatively high number of active patent assets for its valuation?

A: I would argue that you need to worry about having “too many” assets at a later stage in your lifecycle.  While a Unicorn could theoretically sell or divest of its IP assets, it is not recommended to do that particularly in the pre-exit stage.  A Unicorn (particularly pre-exit) is still in a building mode.  There may be industries the company would like to enter in the future, where the patents could benefit them in leveraging freedom to operate with incumbents/competitors.  Additionally, if they haven’t exited yet, a patent portfolio can be much more valuable to a potential buyer than it is to the Unicorn, so there is no downside to having more patents as the company is still figuring out its exit strategy.  The only downside to having more patents is having to pay maintenance fees, plus incurring additional prosecution costs to grow the portfolio.  However, as that should not be a financial hurdle for most Unicorns, I would recommend Unicorns (pre-exit and even post-exit) to hang on to their patents!

Q: For Unicorns, have you looked at timeframe of litigation data? do unicorns acquire inorganic assets?  Is there a timeframe when NPEs approach unicorns? (Pre-IPO? Etc)

 A: The studies presented in the webinar did not specifically look at litigation, or any other reason for buying.  The only tracking we did was for the timeline and the time leading to the IPO exit event.  Unicorns buy patents for a variety of reasons, and I am sure that litigation-related reasons (either litigation avoidance, or freedom to operate, or counter-suing in a pending litigation) play a role in those decisions.  What I find as a general observation (I don’t have empirical proof of that) is that often times patent acquisitions are highly correlated with the people running the patent function at an organization.  Particularly when you see changes in strategy, such as a buying program put in place (see Uber as an example) it’s usually driven by new leadership put in place to manage the patent portfolio creation activities, and they come from a place with higher awareness to the strategic advantages of patents.
As far as your second question about when NPEs are approaching Unicorns, anecdotal evidence indicates that t is usually done at a time when the Unicorn  – or any other startup for that matter – has crossed a critical mass of revenues and users (“crossing the chasm” is the phrase most commonly used to describe that phase in a startup’s lifecycle) and is at a vulnerable point that could be leveraged to reach a resolution that is more favorable for the NPEs.  In that regard, it is not different from any other litigation strategy, and the fact that there’s a unicorn involved that has no patents does not really create a disadvantage with an NPE, because NPEs cannot be countersued anyways so having your own patents does not help defend against an NPE.

Q: You mentioned that IP evaluation may not correlate with company’s value but is there anything you can do to fill in this gap?

 A: What I said with regards to IP valuation is that there is no place on the financial statements of a company where you can find the value of its internally-generated IP assets.  The accounting rules in the US and around the world don’t require companies to value their IP on the balance sheet.  The “Gap” I was referring to is a reporting gap.  There are ways to fill in the gap, but they all involve engaging in a special valuation of the IP assets of the company.  This IP valuation is not going to be part of any business valuation because business valuations are not targeted at valuing assets separately.  In order for the IP valuation to be informative and realistic, the valuation itself needs to be preceded by a careful assessment of the assets, followed by a strategy phase, where the valuation firm is working with management to identify the possible monetization scenarios to be included in the valuation.

Q: Is the later acquisition of patents a result of actual need for additional IP? or is it driven by third-party patent holders going after deep pockets and a way to avoid lawsuits? 

A: A later acquisition of patent (a phenomenon I was referring to as  “backfilling”) takes place usually as a result of a threat or perceived threat to the company’s freedom to operate (FTO).  The kind of patents that you buy, as opposed to filing organically, are those that are available in the secondary market and those usually have value since there is some infringement associated with them.  The actual need to IP to support current products is usually met by internal filing and sometimes through an acquisition of an operating business (not a patent acquisition, but a business acquisition).

Q: Is there a traditional patent valuation methodology (cost, market, etc.) you prefer for startups, and why?

A: The valuation method selection is secondary in importance to the valuation context and scenario.  First there needs to be a determination whether the startup has created enough IP to warrant a separate valuation.  Something of value needs to have been created or accumulated (think along the lines of the slide showing the three types of assets: technology, data and brand) and/or some IP protection needs to have been developed around these assets.  The next question is what is the business model of the startup, and what IP assets bring the most value in that context.  Then comes the question of how the Ip assets bring value to the startup, which would prescribe the valuation scenario.  And only after all of that has been determined, comes the question of the valuation method.  The method really depends on the data available, and I have applied all three of these based on the circumstances.

Q: How do you distinguish between the value high quality patents (those of key importance to the business) vs. other patents in looking at financials? The high quality patents can be worth far more than the rest of the portfolio.

The process that I described in the webinar for arriving at a Price per Active Asset is a process of normalization, so two companies can be compared to one another.  In order for this comparison to be meaningful, the normalization process needs to be uniform across the board.  So for every company, we divided their equity value by the number of active US assets (pending and issued).  Underneath this is an assumption that patent portfolios have a certain distribution and that this distribution is the same in most companies.  There’s no practical or subjective way to rank the asset in a portfolio without getting into months of analysis for each company, so for purposes of an industry-wide data analysis the normalization that we did is the easiest way to get to a point of comparability between companies.

Q: Have you looked at unicorn patent strategy by jurisdiction? Do you have any recommendation on how they should strategize internationally?

A: We have not really done that since we only looked at US assets and only checked for US Unicorns (which tend to have a majority of their assets be US assets).  There are not that many non-US Unicorns, and if there are then I would guess that China may be the next country of origin for Unicorns, and I would also venture to think that China-based Unicorns are also going to have the majority of their assets as US assets (this is just a guess, I haven’t checked the data).  I would not expect to find much difference between jurisdictions because the patenting patterns that I pointed out are ore a function of the industry (Software) then a function of geography.  I don’t really have any recommendations for foreign filings for Unicorn companies that would be any different from the generally recommended best practices for foreign filings for other companies.

Q: To what extent does a valuation of one or more patents equate to their capability to capture a significant share of a significant market over any other IP solution?

If I understand the question correctly, you want to know the marginal contribution of one additional patent to increasing market share, as opposed to any other type of IP protection.  I am not sure I can answer this question as stated, because the main point I was trying to make in the webinar was that for Software companies there is no observed correlation between having patents and having a large market share, or a large valuation.  The value that patents can bring to a Software company is not directly measured by market share (a you can more easily do in pharma or biotech companies, for example).  You need to look for the value in their strategic positioning, that is not always evident in market share, like: having an improved bargianing position vis-à-vis its competitors, reducing risk to their freedom to operate, etc.  As far as other types of IP protection, I would argue that a strong Brand can actually translate into higher market share in software companies, and a brand is protected by Trademarks and Copyrights, not so much by patents.  The other one that can increase market share is Data, which again is not protected by patents.

Q: Is there a minimum valuation for a small company to be able to go public? What (minimum) revenue range is considered acceptable?

A: Not really, as you can see if you look at some of the Life Sciences IPOs which are very small, and are often still in R&D stages.  As far as software companies, which were the focus of my talk, companies tend to stay private much longer than they used to, so it’s often the problem that companies due to go public but are trying to avoid it, for various reasons.  Keep in mind that, as venture-backed startups, companies have pressure from VC investors to get to an exit event at a certain value, so there is that pressure on the one hand.  Companies tend to go public when they would like to get access to funds through the capital markets, as they have exhausted their private funding options.  It’s usually a leverage for additional growth.  Finally,  the SEC have their own rules as to the safety and stability of the company, and regardless of their size or revenue, the SEC will do their own diligence and often times ask companies to restate their earnings as a condition to listing in a stock exchange.

Q: are patents still important today when majority of assets are data and trade secrets? and when most startups are concerned with being first in the market, etc.?

A: The answer varies by industry.  For Software companies there is no observed correlation between having patents and having a large market share, or a large valuation.  The underlying assets that bring value, such as Brand or Data, are often not subject to patent protection and are better protected by other types of IP.  A strong Brand can actually translate into higher market share in software companies, and a brand is protected by Trademarks and Copyrights, not so much by patents.  The other one that can increase market share is Data, which again is not protected by patents.

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