Intellectual property: its growing importance to corporate finance

Dieter Turowski, managing director, investment banking division
Morgan Stanley, London


The ability to appropriately realise and leverage the value of intellectual property has become a critical priority and differentiator for an increasing number of forward-looking companies. In an environment of intensifying competition and resource constraints, corporate executives are becoming far more aware of the importance of IP and the important role it can play in supporting the value and growth of companies.

It is not surprising, therefore, that investment bankers have increasingly focused on understanding the importance of IP when providing advice to clients in M&A situations, or when seeking to raise capital. Examples of the types of challenges/issues faced by investment bankers might include the following:
  • In the context of an M&A transaction involving a pharmaceutical company, understanding the patent position of key products and the options available to protect these products.

  • In the context of raising venture capital to help a company exploit some potentially valuable IP, recognising how to structure a joint venture in order to attract a value added investor.

  • In taking a company public whose business model is focused on licensing IP, explaining to investors the attractions of such an approach, while taking into account the risk factors.

  • With respect to IP that is expected to generate reasonably predictable royalties over years to come, exploiting these cash flows to raise low cost securitised debt financing for the owner of the IP.
These types of issues, and many others, are becoming increasingly important in corporate finance transactions. The remainder of this article looks at four case studies in which understanding IP was critical to success.

Astra/Merck joint venture: IP issues in M&A
A situation that brings out issues associated with conducting due diligence and structuring M&A transactions is the 1998 restructuring of Astra's 50:50 joint venture with Merck, Astra-Merck Inc. (AMI), where Morgan Stanley acted as adviser to Astra. Among other assets, AMI owned the rights to sell Prilosec, at the time the world's largest selling drug, in the US market. The parties had decided to restructure the joint venture in order to allow Astra greater operational control of its US business, while at the same time allowing Astra greater freedom to pursue mergers or acquisitions.

The IP-related issues faced by the company and its financial, legal and tax advisers were considerable. Given that Prilosec's primary US patent was set to expire in 2001, there was a huge potential decline in Prilosec sales on the horizon. The bankers, together with the lawyers, had to understand the cash flow impact of various scenarios, depending upon the outcome of different strategies Astra had developed to defend the Prilosec franchise. Such strategies included an understanding of the value and strength of the formulation patent that would expire much later, the launching of a follow-on product based on a different compound with its own patent protection, and the opportunity to obtain an additional six months' patent extension known as pediatric exclusivity. These different scenarios would clearly have a very material impact on valuation.

The deal structure also raised some interesting IP-related issues. In order to buy out Merck's economic interest, but still leave them with some upside exposure to the business going forward, it was decided that Merck should receive certain payments structured as a percentage of sales. The structuring of these payments required substantial legal and tax advice involving the transfer of IP. Furthermore, the valuation of these payments required an assessment of their riskiness, which would of course affect the choice of discount rate. At one point an interesting debate took place among the financial advisers on the appropriate methodology for determining a discount rate for discounting royalty cash flows versus operating cash flows - a debate that would have a very material impact of value.

In the end, a highly complex deal was agreed that reflected each party's understanding and view of the various IP issues identified above. It was the most complicated transaction that most parties involved had ever been associated with, and took eighteen months to negotiate (not just because of the IP issues!). However, it is fair to say that only with a multidisciplinary team of advisers were both companies able to arrive at a solution that met their objectives.

Sampo, Accenture and Nokia: creating an IP-based start-up
Sampo, the Finnish bancassurance group, had always been a leader in providing its customers with Internet and mobile access. Its first Internet banking offering was launched in 1997, and its first mobile data offering was launched in 1999. Currently, 60% of Sampo's customers use online or mobile services, and 97% of retail transactions are executed outside of branches. In the early part of 2001, Sampo was at an advanced stage in developing its third generation of software for Internet and mobile banking, when it began to consider whether it really made sense to be spending such large amounts to develop bespoke software. Sampo decided to evaluate the concept of forming a new company to provide the platform to enable such services.

At the same time as Sampo was thinking about its options, Nokia and Accenture were having discussions along similar lines. The three parties came together, and decided that the idea was worthy of further development. However, all three parties agreed that the true test of whether this idea made sense would be whether or not it was possible to raise venture capital financing. Morgan Stanley was brought on board to seek out a venture capital partner for the company that was to be called Meridea.

The primary challenge to be addressed was to convert the intellectual property that existed - namely the idea, the experience of the partners, the product design and a substantial amount of code that had already been developed, into a business plan that would be sufficient to raise capital. Although one year earlier it might have been possible to raise venture capital simply on the basis of the quality of the founders and the IP that had been created so far, such a task was going to be far more challenging in the post bubble environment.

First, it was necessary for the founders to hire a high quality chief executive, and a team that could work with him. Some of the team came from the founders, and some (including the CEO) were external hires. Secondly, it was essential to determine the partner contributions, in the form of IP, capital and services, both at the time of formation and after formation. Thus, Sampo agreed to contribute the product design and code developed so far (although the code would need to be redeveloped given that it was not written as a platform for commercial purposes). Of equal importance, Sampo also agreed to become the charter client, whereby it would act as the test case for the first implementation, and bring its expertise as an early adopter of Internet and mobile banking technology. Accenture and Nokia entered into agreements that specified the nature of their contributions. Finally, it was necessary to develop the business plan and the 'story'.

With all of the above in place, the founders and the management team began to meet with venture capital firms. After numerous meetings and due diligence sessions with a variety of firms, 3i was chosen to come on board as the fourth partner. They brought business building skills, a strong international network, local presence in Finland and excellent credentials in IT/wireless investing.

The result was a Euros 48 million financing round from the four founders, which was Europe's largest first round venture financing in 2001. It is important to emphasise that although there was a strong element of IP that formed the seed of this capital raising exercise, the IP alone was not sufficient. Significant expertise and resources on the part of the founders and adviser were critical to establish a business case that could be financed.

ARM Holdings: IPO of an IP-based business model
Raising venture capital for a new company based largely on IP is clearly challenging, although ultimately the audience you are trying to convince to invest consists of VC firms that are sophisticated in understanding risk, technology and IP related issues. Raising equity capital from the public capital markets for an IP-based company is a very different type of challenge, one we faced in 1997 when taking ARM Holdings public.

ARM is a UK-based company that licenses high-performance, low-cost, power-efficient microprocessors and system chips to international electronics companies for use in an extensive range of applications. The company's product licensing business unit licenses the ARM architecture, cores, microprocessors, system chips, peripherals, software tools, buses, methods and models, while its EDA business unit works with third-party partners to provide ARM licensees with models, model generators and automated IC design tools.

The benefits of this business model are now well understood, as can be observed in the following quote from 15th April 2002 issue of Business Week: 'ARM almost single- handedly created a new business model: hawking intellectual property instead of selling actual chips. That has earned it the trust of customers such as Texas Instruments, Philips Semiconductor, and even Intel, which uses ARM technology in a line of speedy, power-stingy chips.'

Back at the time of the IPO in 1997, there was less understanding of this type of business model. The initial research report from Morgan Stanley explained the implications of an IP-based business model for investors. For example, it was observed that the development of a business relationship with a potential licensee was a very lengthy process, often lasting a year or more, but that once the relationship was established there was tremendous earnings leverage because there were no capacity constraints as you would have in a conventional product company. It also explained in great detail the revenue model for IP licensing, which consists of certain milestone payments as the licensee develops the product, supplemented by ongoing per unit royalties every time the licensee sells a product utilising the ARM IP. In summary, the barriers to entry created by an IP-based business model are potentially very attractive to investors.

It was also necessary, from a disclosure point of view, to make sure that investors were aware of the risk factors associated with this business model. Disclosure in the Risk Factors section of the IPO prospectus included four paragraphs of discussion on risks that included the following:
  1. there can be no assurance that pending or future patent applications will be approved, or will not be challenged by third parties;

  2. in addition to patents, the company also relies on copyright, trademarks and trade secret laws to protect its IP, and such protection may be limited or unavailable in some jurisdictions;

  3. litigation is common in the semiconductor industry, and questions of infringement involve highly technical and subjective analyses; such litigation, whether settled in favour of the company or not, would be costly and would divert the attention of the company's management from normal business operations; and

  4. loss of litigation could have a material adverse change on the company's business and financial condition.
In the end, investors analysed the pros and cons of an IP-based business model, and decided to invest. The IPO was very successful, with the offering 10x oversubscribed, and the price set well above the initial filing range. Moreover, since the IPO, ARM's market capitalisation has continued to increase (it is up by a multiple of five times since the IPO), and it has been less affected than many other semiconductor companies by the tech downturn. Furthermore, the market has also seen other companies with IP-based business models go public; companies like TTP Communications and Parthus Technologies have followed in ARM's footsteps.

Of course, the applicability of the analysis that went into the ARM IPO is much broader than just companies that license IP to semiconductor companies. The analysis is applicable in other IP-intensive industries such as genetics; for example, the Icelandic company deCODE genetics, another Morgan Stanley IPO, has based its business model on the patents it has filed covering hundreds of genes it has identified and their respective associations to disease. This analysis is also applicable in any product company that to a greater or lesser extent relies on IP to protect its market position. In summary, IP has become an issue of focus for investors in virtually any IPO of a company in a knowledge based industry.

The Bowie bond: securitising IP
This last case study relates to the $55 million securitisation in 1997 of future revenues from David Bowie's recordings. Although this case did not involve Morgan Stanley, it is interesting because it demonstrates the truly broad range of intellectual property that can potentially be utilised to provide financing for its owners.

Why did a securitisation of intellectual property rights make sense for David Bowie and his family? Firstly, artists like David Bowie generally do not have credit ratings, and therefore access to the capital markets is rather limited. A securitisation creates a structure that can get a credit rating, and therefore allow for investors to provide capital. And secondly, David Bowie and family are able to maintain ownership of the IP, which may be important for a variety of reasons. The transaction had a term of 15 years, and was self-liquidating, so that it is highly likely that full ownership without any encumbrances would return to David Bowie during his lifetime.

Since the Bowie bond was issued, various other forms of unusual asset classes have also been securitised. For example, DreamWorks raised $325 million based on the future revenues of 10 films that had yet to be made. Petroleum Geo Services, a Norwegian oil services company, raised capital by securitising the future proceeds of a library of seismic data used for oil & gas exploration. Real Madrid raised $50 million by securitising club sponsorship revenues from Adidas. No doubt we will see even more interesting and creative securitisations in the years to come, as investors become comfortable with this asset class, and as issuers look to diversify sources of funding.

Conclusions - and what's next
As is evident from the above case studies, investment bankers have come to appreciate to a greater and greater extent the important role that intellectual property plays in a variety of transactions ranging from M&A, to venture capital fundraisings, to tapping the equity capital markets and securitisation. No doubt as experience increases, more and more deals will be structured to take advantage of IP that companies or individuals own.

However, in the increasingly difficult environment we operate in, where litigation and class action lawsuits are routine, we should be aware at the same time of the potential pitfalls of not understanding what can go wrong. IP can turn out to be worthless very quickly, if a patent turns out not to be valid. And if this patent was the basis for a transaction, there will certainly be scope for litigation. All of which underlines the importance of appreciating the complex issues associated with IP, as this book aims to do

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