IP Quality Must be a Key Feature in Any Financial Product Based on IP Assets

Will Wall Street be bullish on IP-based financing?
Will Wall Street be bullish on IP-based financing?

Neil Wilkof of the great IP Finance blog brought up a couple of interesting issues in his latest blog post entitled Securitization of IP: Urban Legend, or Playing Soon in a Theatre Near You? Specifically, he wonders if the desire for innovative (and not discredited) financial products today will result in the emergence of IP securitization as a model for raising capital and, if so, if the there will be a place for IP professionals in the process of valuing such IP.  I recommend Neil’s post to anyone who is interested in how IP assets might be leveraged to create opportunities outside of the usual protection of the IP owner’s products and technology.

Moreover, I agree with Neil’s view that if IP is going to be a recognized as a means to raise capital, improvements have to be made in the way finance and IP professionals interact. Put simply, if IP forms the basis upon which companies raise money, the quality of the IP must be well understood so as to allow development of a reality-based risk profile for the transaction.  This cannot be accomplished without putting someone who understands IP in the center of the process.

To use a simple analogy, if a bank lends money for the purchase of a house, shouldn’t the quality of the property, as well as that of the neighboring property, be a critical aspect of the transaction?  While innovators of financial products in recent years argued that distributing the risk to different parties made the quality of the real estate virtually inconsequential in the decision to lend money for a mortgage, we now know that this was not the case.  In view of the sub-prime meltdown, no one can truly question that, in the aggregate, the wrong criteria were used to make mortgage lending decisions.  Such decision-making was driven by the financial models used to determine risk which, in turn, were flawed.  These flawed assumptions were, in my outsider’s view, in large part caused by financial models created and executed by people who did not fully understand the content and operation of the data underlying the risk models. 

Similarly, I am afraid that we will be heading down the same path if financial professionals take charge of IP valuation for the purpose of creating innovative financial products using IP as the means of securitization.

I have been working toward bringing more substantive IP analysis into the valuation process ever since I served as an advisor on both sides of a substantial deal involving a consumer product acquisition. The value of the deal was premised on the fact that the numerous patents owned by the target company covered the product and would provide my client with a long-term sustainable competitive advantage.   The assumption was that this competitive advantage would ostensibly provide elevated pricing in a market segment that was typically the province of commodity pricing.  A detailed assessment of the patents showed that they checked out and the go ahead was made for the deal.  What wasn’t reviewed (or even suggested) by the M&A attorneys and investment bankers who were driving the transaction was whether the patents broadly covered the innovation (which was the assumption upon which the premium pricing calculations and NPV of the deal were based) or only the invention.

Shortly after the close of the deal, it became apparent that there were (literally) dozens of ways to solve the same problem, and that the client had paid well north of $100 MM for only one of these solutions.  In other words, the patents covered an invention not the innovation. Since there were other, non-infringing, ways to solve the consumer’s problem, competitive products began to enter the market.  Price erosion thus quickly occurred, and the client ended up paying a huge price for permission to play in a market that is only slightly above a commodity space.  What made it worse was that the client’s cost of entry was significantly greater than that of the competition, which further decreased the return on the acquisition. 

This “war story” of a failed vetting of patents rights in a large M&A transaction educated me to the fact both finance and IP expertise must be present in the IP valuation process.  Think about it: the competitive advantage obtained from a patent depends substantially on the breadth and quality of the underlying legal document(s).  This means that valuation of a patent portfolio can be greatly enhanced by including an analysis of the underlying legal components.  In this regard, over the last couple of years, I have reviewed a number of publicly announced deals and have correctly predicted poor results based upon a quick review of the patents involved.  Certainly, there are reasons other than IP to go forward with a deal, but if the financing of the deal is premised upon the IP, I believe that the quality of the IP and that of neighboring IP must be part of the equation.

I have recently begun working with IP valuation experts who understand the interplay between long-term value and IP quality and who wish to include my review in their process.  In order to obtain their buy-in to add a new data-set into their standard IP valuation paradigm, the key is to communicate that this type of IP quality analysis is different from the traditional form of IP due diligence.   I have found that finance professionals generally don’t like to work with IP lawyers because traditional IP due diligence takes to long, costs too much and, frankly, provides far more information than is needed in the context of a deal.   IP due diligence is given short-shrift in most deals because of this perception, I believe.

What I propose is that a “back of the envelope” subjective assessment be conducted in a fairly short time frame.  In other words, an overview of subjective quality of the IP, where this evaluation is done from a legal perspective.  This can be done quickly and fairly inexpensively by a patent expert who also possesses keen business sense.  This analysis is then suitably tee’d up to be placed in existing valuation models.  The key to making this happen on a regular basis is for finance and IP professionals to establish and solidify the lines of communication between them.  As Neil Wilkof indicates, cross-fertilization is clearly necessary.

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