Examining the Correlation Between IP and Startup Valuations

In a recent article published in the Business Valuation Update, Efrat Kasznik (Foresight Valuation Group) covered six of the most common questions that routinely come up with regard to the correlation between intellectual property (IP) and startup valuations. These questions are important for each startup (particularly in the software industry) looking to manage IP as a strategic business asset.

1. How can a startup develop a patent portfolio that will increase its valuation?

There are legal aspects to a company’s patenting strategy, and there are business aspects to that same strategy. The legal side is best handled by lawyers, who 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.

The chart below lays out the typical intangible assets (technology, brand, and data) one finds in a software company and the types of IP rights associated with each type of asset, as represented by the lines connecting assets to IP protection.

In companies where technology is the most valuable asset (usually correlated with heavy investment in research and development, such as pharma and biotech), patents can have more value compared to companies where the brand is the main asset (consumer products, as an example). Similarly, in companies where data are deemed to be the most valuable asset (as is the case in many software companies), patents may have less value as the preferred mode of protection, since patents cannot protect data. 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.

2. Are patents still important to the valuation of software companies, if the main assets (software, data) are not necessarily protected by patents?

For software companies, there is seemingly no observed correlation between having patents and having a large market share, or a high valuation. If we look at a group of U.S. unicorns (about 95 companies) and compare the distribution of patent holdings to the distribution of valuation, we can see the greatest discrepancy when it comes to the group of consumer internet companies (software companies such as Uber and Airbnb); that segment of unicorns accounts for about 40% of the valuation but holds less than 10% of the patents.

However, patents increase in value in software companies as they mature and approach an exit event or enter new markets (as history has shown with companies such as Facebook, Google, and Microsoft). A startup (particularly preexit) 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 startup holding the patents, so there is an upside to having more patents as the company is still figuring out its exit strategy.

3. How can startups increase their patent portfolio and when is the right time to do that?

There are several junctures where any company, and in particular a startup with an abnormally high valuation, is most vulnerable when having a weak IP position: entering new markets with established incumbents and approaching an exit point such as an initial public offering (IPO) or merger & acquisition (M&A). Under current U.S. “first to file” patent regime, startups that show no organic patent growth may have lost the ability to patent a large portion of their core inventions due to missing key priority dates and may need to make up for it by buying patents (or companies holding patents) in response to competitive threats, spending millions of dollars in the process.

A later acquisition of patents takes place usually as a result of a threat (or perceived threat) to the company’s freedom to operate (FTO). The kind of patents one can buy, as opposed to file organically, are those that are available in the secondary market, and those usually have value since some infringement is associated with them. The actual need for 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). Google and Facebook are two well-known examples of companies that had to deal with these types of situations and ended up with massive IP acquisitions:

• Google’s acquisition of Motorola Mobility for $12.5 billion in 2011 was primarily driven by the need to improve its IP position through a massive acquisition, in order to enter the mobile market; and
  
  
• Facebook was hit by a patent lawsuit Yahoo filed a month prior to its IPO, which is a very vulnerable exit point where a lawsuit can be detrimental and potentially even derail an IPO. Since it had very few patents to fight back and countersue Yahoo, Facebook ended up paying hundreds of millions of dollars buying patents from AOL, IBM, and Microsoft in order fight the lawsuit and bolster its IP position to reduce its exposure in the future.

4. Where in the financial statements of a startup can one observe the value of its IP assets?

There is no place in the financial statements of a startup, or any company for that matter, where one can find the value of its internally generated IP assets. The accounting rules in the U.S. and around the world do not generally require companies to report the value of their internally developed IP assets on the balance sheet. In that regard, there is an IP reporting gap, which is exacerbated by the fact that IP transactions are highly confidential and not generally reported at all, or at any level of detail that would allow the creation of pricing databases that could aid in the valuation of similar IP assets. Finally, even if there was full disclosure of IP transactions and pricing, the IP assets themselves are unique and it is not easy to find a direct comparable, particularly when it comes to patents.

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 will not 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 IP valuation firm is working with management to identify the possible monetization scenarios to be included in the valuation.

5. Is there a specific patent valuation approach (market, income, cost) recommended for startups, and why?

The valuation approach selection is secondary in importance to the valuation context and scenario. First, there needs to be a determination of whether the startup has created enough IP to warrant a separate valuation. Something of value needs to have been created or accumulated and/or some IP protection needs to have been secured 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 approach and method.

When it comes to the valuation of patents, as a matter of practice, the author finds that, in most cases involving startup companies, the market approach is most frequently applied. The cost approach is generally not suitable, and is very rarely used, in patent valuations. The income approach—based on the out-licensing opportunities associated with the patents—depends on the likelihood of licensing and the ability to create projections of addressable markets. Given the fact that startup patents are usually young patents, they often do not have an enforcement potential (since infringement usually occurs in mature markets where the patents have been out long enough to capture existing products) and any licensing potential entails a technology transfer type of model, involving licensing the patent into future products that do not currently exist. This type of modeling, while feasible, ends up being too expensive for most startups, and, as a result of budget constraints, most valuations of patents in startups resort to the market approach. The market approach entails two common methodologies: relief from royalty, which is predicated on the royalty savings enjoyed by virtue of holding the patent and is based on market-observed royalties and the startup’s own product revenues. The other common methodology is based on comparable transactions, which can be gleaned through patent transactions databases and other public disclosures.

6. Has the Supreme Court’s decision in the case of Alice Corp v. CLS Bank (2014) had a significant impact on software company valuations and exits?

The Alice decision of 2014 is one example of recent Supreme Court decisions, coupled with other developments at the USPTO following the America Invents Act (patent reform) of 2011, that have generally created ambiguity and uncertainty with regard to subject matter eligibility and the overall validity of patents covering software inventions. In the Alice case, the Supreme Court ruled that an abstract idea does not become eligible for a patent simply by being implemented on a generic computer. There is strong evidence from the patent transactions market showing a devaluation of software patents and a significant slowing down in trading in these assets following the Alice decision and related developments.

The correlation between these developments and software startup valuations and exits is not an easy one to draw. For once, as research shows, many of the unicorns (75% of which are in the general software area) have managed to grow their valuations into the billions of dollars without having any material patent holdings. One might argue that the Alice decision had something to do with the lack of patents; others might argue different reasons. Since there is strong evidence that startups can grow into billions of dollars in valuation without patents, and some of them even managed to exit in a successful IPO or acquisition, the author would argue that the Alice decision has little to do with software startups’ valuations and exits.

Conclusion

IP plays a significant role in startup valuations, and, because the author was able to follow closely the life cycle of recent, well-known IPOs, she was able to observe what types of IP issues frequently emerge for startups and how companies are dealing with them.

Click here to read the full article from the Business Valuation Update, the voice of the valuation profession since 1995. For more resources on intellectual property valuation, visit our resource center that includes guides, current news and research, and much more.