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As tech companies buy and sell patents for escalating sums of money, it's beginning to look a lot like a bubble. What should CFOs do to value their companies' intellectual property accurately and diligently?
David Rosenbaum, CFO.com | US
May 15, 2012
Last summer Google bought cell-phone maker Motorola Mobility for $12.5 billion, largely for its treasure chest of 17,000 patents.
Last month, preparing for its initial public offering, Facebook paid Microsoft $550 million for about 625 of the 925 patents Microsoft had just purchased from AOL for $1 billion. What's in all those patents, no one will say. It's possible that no one -- not even the folks at Facebook and Microsoft-know what they all contain, as software code is extremely difficult to catalog, classify, and track. Referring to Motorola's 17,000 patents, patent litigator and IP monetization practice leader for DeWitt Ross & Stevens S.C. Joseph Miotke says, "It would take centuries to map out all those patents." Mapping AOL's might take proportionally fewer centuries.
"What makes high-tech different is the complexity of the technology," Miotke says. "In the high-tech space, there are so many discrete portions of technology you can patent. And software developers are not thinking about patents. They grab bits of code from all over. So it's difficult to manage. You never truly know where anything comes from."
"It's quite possible to have only a small number of lines of code that may be highly utilized either in interactions with other hardware or software devices," says Bryan Benoit, national intellectual property practice leader at Grant Thornton, referring to a recent trial in which a jury found that 9 lines of computer code on Android, Google's mobile operating system, infringed Oracle's IP: 9 lines of code out of 15 million.
"It's the growing interdependence of technology," says Anne Culotta, a patent attorney at Culotta Law Firm, which "is unique in high-tech. A tiny piece of a device could be critical enabling technology and every piece is going to be covered by a host of patents.
"The dollar amounts involved in patent deals, and the scale in the high-tech sector is new," says Culotta. "You don't see this kind of newness and frenzy in other areas."
Welcome to the Bubble
The prices being paid for patents are skyrocketing. One could say that we are in a technology bubble, although it might be more accurate to say we're in the midst of an IP bubble. In today's so-called knowledge economy, a company's value increasingly is located in intangible assets, not in real estate, machinery, inventory, or even cash. "In the knowledge economy," wrote Baruch Lev, Stern School of Business professor of accounting and finance, in Measuring Business Excellence, a book he co-authored in 2004, "differentiation has become a key success factor," and in a time when IT is becoming commoditized through the cloud, ubiquitous connectivity, and cheap bandwidth, it is IP, intangibles, that provide that differentiation.
According to Ocean Tomo, an IP valuation and services firm, in 1975 more than 80% of an S&P 500 company's value lay in its tangible assets. By 2010 that ratio had flipped to a stunning degree and 80% of corporate value was located in intangible assets: goodwill and IP. As Lev wrote, "Traditional [accounting-based] information systems are not able to provide adequate information about corporate intangible assets and their economic impact. This has serious implications as it causes volatility of stock prices which results in undue losses to investors and misallocation of resources in capital markets."
"The balance sheet," Lev wrote, "contains a small fraction of the actual company value . . . the income statement does not reflect anymore the value creation system of today's businesses."
In other words, the financial statements CFOs use to establish a company's worth are not very good at valuing intangible assets, the place where the lion's share of a company's value today resides. And when there are disconnects between what you think something is worth, what the markets tell you it's worth, and what it may be worth a few quarters down the road, you have a recipe for the kind of volatility that leads to big winners and even bigger losers. You have a bubble.
The cause of economic bubbles is a matter for much argument, but it's generally agreed that they're characterized by the kind of price spikes seen lately in patents, driven by a disconnect between perceived and real value, and the belief that prices will always rise. The classic example is the Dutch Tulip Mania of the 1630s, during which tulips were thought to be fantastically precious. Dutch farmers dug up and trashed their crops to plant bulbs, and ruined themselves and much of Holland's economy when buyers vanished and prices plunged. Investors in tulip futures thought the flowers valuable when everyone else did. When the thinking changed, the bubble burst.
Similarly, in the mid-to-late 1990s, it was thought that any company with a dot.com after its name was inherently valuable; dot.coms and investors believed market share, an intangible asset, was more important than earnings, a tangible one. "For many, many start-ups" in the dot.com era, says Miotke, "the core asset was a patent portfolio. Companies spent fortunes building up those portfolios." Then in the spring of 2000, the big sell-off began and many of those companies went bust. Again, perceived value had trumped book value . . . until it didn't. And while we may shake our heads in wonder that anyone ever thought flowers so valuable, in the technology space estimates of value can prove equally transient.
Culotta points to Alcatel and Lucent. In 2006 France's Alcatel bought Lucent Technologies for $13.4 billion with the notion of becoming the world's largest equipment supplier to international telephone and wireless carriers. A little less than three years later, Alcatel-Lucent announced a $5.1 billion write-down due to an impairment charge to its IP. According to an analysis in The Wall Street Journal, that write-down was "due almost entirely to a revaluation of one of its wireless technologies"- CDMA - which was "one of the strategic rationales" for the $13.4 billion purchase.
CDMA turned out to be a transitional technology, not a foundational one, and if not quite a tulip, it wasn't what the company thought it was. Alcatel-Lucent survived, but one can assume that many of its investors did not.
Of course, Alcatel did not know that would happen when it purchased Lucent. How could it? Software patents are intangible assets and projecting their future value is not as simple as projecting (and amortizing) the future value of a truck. Software, writes PricewaterhouseCoopers's Tony Hadjiloucas and Richard Winter, is likely to have a valuable life "significantly shorter than goodwill," so it is likely that "the acquiring company's earnings will be lower than those expected as a result of identifying, valuing, and amortizing intangible assets" with the result that "earnings are likely to fluctuate more than ever.
"Having large amounts of goodwill-like assets on the balance sheet," they conclude, "increases the risk of impairment." And today the amount of goodwill-like assets companies carry on their balance sheets is gargantuan, as, by extension, is the risk.
How Did We Get Here?
"The world all changed April 1, 2011," says Miotke. Nortel, the multinational telecommunications equipment manufacturer, had filed for bankruptcy in 2009. All its assets were liquidated for about $2.1 billion, but its patent portfolio was separated out. The conventional wisdom, Miotke says, was that the portfolio was worth $100 million to $200 million. On April 1, Google bid $900 million. "Jaws across the world dropped," says Miotke. "It blew people's minds." The actual auction was held over four days in late June 2011 in the offices of a New York law firm. A consortium of six companies led by Apple and Research in Motion ultimately acquired the Nortel portfolio of some 6,000 patents for $4.5 billion.
"For some reason," Miotke says, Google, which had been upping its bid in million-dollar increments determined by the value of pi (that is, raising its bid $3.14 million each round), dropped out at $4.4 billion.
Miotke believes that Google's failure to acquire the Nortel portfolio led directly to its Motorola purchase. Today, he says, the industry is struggling to figure out a way to value patents and IP both to determine what its own IP is worth (should a company be selling) and what another company's IP might be worth should it be acquiring.
In a merger or acquisition, many companies have to scramble to figure out what the IP is worth. "IP may be driving acquisitions," Culotta says, "but it's the last thing valued." Under Financial Accounting Standards Board rules, it's only when a company acquires IP and other intangible assets, she says, that it's required to allocate a purchase price. That, Culotta says, is a "perennial frustration for IP attorneys and people who have to value deals," and she strongly urges that finance, or any intellectual asset-management group, do a valuation of the IP and allocate a purchase price before the letter of intent stage in an M&A.
However, this is especially difficult when it comes to software. "It all starts with how the software origination process is managed, tracked through the development phases, where it resides in software libraries, and archived within the overall software system," says Grant Thornton's Benoit. "In an ideal world, you have terrific controls in place to allow for specific identification and tracking of code as part of an IT management process." But, he says, the real world is far from ideal, and "you have situations where you have code in the overall system and you don't have a clear idea of ownership."
Benoit stresses that those kinds of vagaries are a huge risk for any business. "Intellectual assets are real value," he says. "As part of fiduciary responsibility, CFOs need to understand how specific IP might relate to the company's ability to generate revenue and ultimately earnings and, beyond that, cash flow."
What CFOs Need to Know
Ryan Goepel, CFO of Zeitecs, a private oil-technology company, sees IP assets as strategic. "If Blockbuster had been checking patent filings," he notes, "they would have seen Netflix coming."
Goepel monitors his competitors' patent activity. "Patents," he says, "are a leading indicator of where roadblocks are and where the competition is coming from." A CFO, he says, should be asking if his company's ability to sell its product is affected by its patents. Does it owe its market position to its patents? Zeitecs, for example, has a patent for a unit that monitors the pump at the bottom of a drill pipe. Zeitecs's technology allows the monitor to live outside the pipe so that if it fails, it can be replaced without pulling up the whole pipe, unlike the competition's. "Our value comes from that patent which enables us to offer a better unit," says Goepel.
"The CFO has to know his company's key patents," he says. Or, as Culotta puts it, "Relate your IP to a revenue source, either due to a sustainable premium on a product or service you make or sell. You have to be able to say, 'Here's my patent, and this is why I'm going to crush the competition and continue doing so for the next 10 years.' If you can do that, you're having a great day."
It's a good day, says Culotta, not only because the CFO knows the value of her IP but also because it becomes amortizable. If it goes into a goodwill bucket, under GAAP it is not amortizable, and if it's impaire — as was the case with Alcatel-Lucent — "you take a charge on your income statement."
Culotta believes one way to manage that risk is to have knowledgeable intellectual-asset managers involved early in a deal to model the value of the allocation predeal, and to have a CFO, or "point person" from finance to help "ensure smooth and appropriate recordings of assets."
Andy Spillane, chief product officer of UnboundID, an identity-management-integration software vendor, "owns" his company's IP and, as a software company, "our code base is what our company is all about." Spillane hasn't yet been asked to put a dollar value on his company's IP but, as UnboundID enters its fifth year of operation, he expects to be asked to do so: just as he expects that patent reform is "in the cards."
After all, as Culotta notes, "Doesn't it sort of bother you that we have a system that says intangible assets don't need to be recorded on a balance sheet? The market is out there making a statement of its view of those perceived assets even though they're not recorded. But as soon as two companies interact, suddenly those assets are worth $12 billion. It doesn't make sense." Especially, she adds, since premiums today are being paid for those assets "without a clear understanding of the subsequent impairment charges an organization [may experience] if one of those acquired IP rights is subsequently challenged or invalidated."
Does that sound like a recipe for an IP bubble? "Definitely," says Culotta.
Consequently, Grant Thornton's Benoit urges CFOs to be proactive in managing their company's IP portfolio.
"Do you want to do a better job?" he asks CFOs. "Then be aware."