The importance of intangible and Intellectual Property Assets in assessing the true value of an M&A deal

By Rajiv Suri, Senior Associate of the Intellectual Property and Commercial team of Alsuwaidi & Company

Intangible and Intellectual Property Assets in Mergers and Acquisitions (M&A)

Intangible assets play an important role when it comes to assessing or ascribing value to a commercial venture in transactions relating to M&A. Such intangible assets, include, intellectual property (IP) rights, such as trademarks, copyright, designs and/or patents, which are central to the success of businesses in all fields, especially innovative deep-tech companies. Intangible assets, as ‘LexisNexis’ points out, also include a massive variety of agreements, documents and records, which in themselves, have no fixed transactional value. The non-exhaustive list of other types of intangible assets that may come into play in M&A negotiations are noted at the end of the article.

As a consequence, serious assessment and evaluation of a company’s intangible assets and IP rights should be a top priority, among other factors, for anyone engaged in an M&A deal. However, as the focus of M&A deals is often to assess the revenue generating model and potential profitability of the target business, such intangible and IP assets may be overlooked. Such an oversight can prove to be costly.

Take, for example, the much-publicised case in 1998 when Volkswagen had completely overlooked intangible IP rights involving usage of the brand name “Rolls-Royce” when acquiring the ‘Rolls-Royce Motor Cars’ business. Although more than two decades have passed since this case came to light, it is still a good reminder for everyone to act diligently in M&A deals considering that human oversight can lead to catastrophic fallibility which can affect the overall ownership rights in any intangible asset including IP. The trademark “Rolls-Royce” was owned by Rolls-Royce PLC, which was a separate company and not part of the acquisition deal. In fact, Rolls-Royce PLC was acquired by BMW. This created a situation whereby although Volkswagen was manufacturing Rolls-Royce cars, they could not brand them as “Rolls-Royce”. Due to an oversight, which was obviously not deliberate, in an acquisition deal, Volkswagen lost out on brand equity associated with the “Rolls-Royce” brand as the said entity failed to negotiate on acquisition and use of the said brand name. Volkswagen had to settle with BMW, which allowed them to use only the BENTLEY brand name.

Another more recent example is that of case which came to light in Vietnam in 2019. It involved one of the top commercial banks i.e., Vietnam Bank for Agriculture and Rural Development (Agribank). Some years ago, in 2009, Agribank formed a subsidiary specializing in trading of gold, silver and gemstones in Vietnam. At this time, the bank owned 100% of the capital of this subsidiary. It, being a wholly owned subsidiary, was allowed to use its trademark “Agribank” in the company name. However, in later years, Agribank gradually divested all of its capital from this subsidiary. A stage came when Agribank did not own any shares in this company and gave up its control over the subsidiary. The company became a joint stock company.

However, when this conversion happened and Agribank lost its control, due to an oversight, it did not cancel the right to use the trademark “Agribank” of this ex-subsidiary. Consequently, the trademark “Agribank” continued to be in use in the company name of such Joint stock company. However, later the bank required the ex-subsidiary to legally remove the trademark from the company name. It had to spend a lot of time, money and efforts in pursuing legal remedy to achieve desired results.

Thus, as a lesson, it is very important to undertake comprehensive evaluation of the intangible assets including the intellectual property rights and their usage post-acquisition when weighing up a M&A deal.

The importance to be given to due diligence in M&A deals is further illustrated by AOL Time Warner merger in the early 2000s.

In 2001, when the dot-com bubble was inflating, AOL, formerly called America Online, one of the largest Internet-access subscription service companies in the US providing a range of Web services for users, acquired Time Warner for a whopping USD 165 billion. The merger formed AOL Time Warner. However, when the dot.com bubble burst the value of the newly formed company’s AOL division plummeted. In 2002, a year after the dot.com crash the company reported an astounding loss of USD 99 billion, which was ascribed to writing off the goodwill of AOL.

It is interesting to note that around this time, the race to capture revenue from Internet search-based advertising was heating up. However, AOL missed out on these and other opportunities, such as the emergence of higher-bandwidth connections, due to financial constraints. Instead, as a leader in dial-up Internet access, the company pursued Time Warner for its cable division as high-speed broadband connection, which it saw as the wave of the future. However, as its dial-up subscribers dwindled, Time Warner stuck to its Road Runner Internet service provider rather than marketing AOL.

With their consolidated channels and business units, the AOL Time Warners failed to execute on converged mass media and Internet content. Additionally, AOL executives realized that their know-how in the Internet sector did not translate into the capabilities needed to run a media conglomerate with 90,000 employees. In 2003, the company had to drop “AOL” from its name and became known as Time Warner. AOL was bought by Verizon in 2015 for USD 4.4 billion, a fraction of its previous value.

Thus, the above case, even though dated, once again lays emphasis on the fact as to how much important it is to assess your technical capabilities and competencies in the field of acquiring business. It is likely help you assess its possible growth potential on the basis of which you can take some calculative and intelligent decisions which may lead to avoiding any untoward situations post-acquisition.

Tangible assets versus intangible assets

According to estimates from the report issued by Ocean Tomo, the Intellectual Capital Merchant Banc™, titled ‘Intangible Asset Market Value Study’ (IAMV), intangible intellectual property assets now make up 90 percent of the overall value of the most valuable US Corporations listed on the S&P 500 stock market index. Between 1995 and 2015, the share of intangible asset market value increased from 68% to 84%. In July 2020, Ocean Tomo updated the IAMV Study to investigate the economic effects of the novel coronavirus. The findings suggested that COVID-19 accelerated the trend of increasing IAMV share.

However, this trend is not confined to the US. It is reflected in the value of companies elsewhere in the world. The above trend, as illustrated by chart, also holds for the S&P Europe 350 index even though to a lesser extent with an increase from 71% in 2015 to 74% in 2020.

In light of this upward trend, conducting due diligence of any target company’s assets, both tangible and intangible is a must especially be given the high value ascribed to intangible assets.

A checklist for due diligence in M&A deals

Here are some key check points for consideration while conducting due diligence with respect to intellectual property rights in M&A deals.

The presence of intangible assets and ownership of rights

First and foremost, the acquiring party should conduct thorough due diligence with respect to the seller’s intangible assets and the available IP portfolio. This would essentially mean to assess presence of all the intangible assets and IP owned by a Company which is within its acquisition, ownership, and control, licensed and/or maintained on its behalf. It is also important to check upon the internet and other social media for use of any such IP related content which will give you a reasonable idea as to its fair use amongst the trade and public at large and, if any international recognition is accorded to such usage. It is also worth mentioning here that these days, social media accounts are also major attractions. These accounts are typically one of the key media marketing tools to promote any company’s products or services. That is why the acquiring party needs to check the ownership and validity of the domains, the terms of the user agreement, privacy policy (ies), content policies, etc. This is of interest to determine that the acquiring party can freely access the seller’s content and if the policies that are in place are sufficient to protect the acquiring party.

Further, it is imperative to ensure that such IP rights are not blocked, created as being a security interest, or being used as a collateral for a loan from any financial institution and is free from any such encumbrances or liens. Interestingly, IP rights can create financing opportunities in the form of collateral for accessing bank loans or finance. In such a scenario, even though the ownership remains with the borrower, a lender can place conditions on use of the IP in the future. This could affect the ability to license or transfer the IP to others. It is, therefore, very important to check if any of the seller’s IP assets have been used as collateral with any bank or financial institution to gain access to institutional financing. This will avoid any liabilities which may crop up post-acquisition of a commercial venture.

Further, there may be a circumstance where a Company uses IP owned by its founder but doesn’t contribute it to a company. In other words, the IP still remains the property of the founder and it is not transferred to the Company. In such situation it is always advisable to check such credentials and if need be, have the IP assigned from the founder or the owner in favour of the (acquiring) Company so as to avoid any legal or technical issues post-acquisition with regard to commercial use of such IP.

The other scenario could be where certain IP rights are created either by employees during their employment or by independent contractors under their “contract for service” with no creation of agency relationship. In other words, under “contract for service”, the parties work independently through a contractual relationship. In such situations, it is worth checking if all employees and/or contractors, especially independent contractors have expressly assigned their IP rights over to the selling entity and do not hold such ownership rights themselves.

On the other hand, any work created by an employee during the course of his/her employment qualifies as being under “contract of service” and thus, the rights in such work would automatically vest with the employer. In certain jurisdictions this is not case, and hence it is advisable to have a clause in the employment contract which explicitly vests such rights created by an employee in any work in favour of an employer.

Hence, in the above scenarios it is very crucial for the acquiring company to check upon existence of the ownership of such intangible assets and rights in favour of the selling company.

2. Validity of IP rights

It is also very important to consider checking the validity status of IP rights specially to see whether they are still in existence. There may be circumstances where IP rights are shown to exist in the seller’s records and may even bear the names of its inventors and creators. However, these rights may no longer be valid either as a result of non-renewal of the rights or because they have elapsed and thereby fallen into public domain. In other instances, it may be that intellectual property applications alone have been filed, but these were never pursued or actively prosecuted before the relevant authority(ies). For these reasons, the acquiring party needs to have a clear view of exactly what is being acquired and the validity and extant status of related official records in all jurisdictions, especially where the target business operates.

3. Check on claims involving IP in litigation, if any

The acquiring party also needs to consider whether ownership of any IP rights held by the seller or the granting of any statutory rights in favour of the seller can be challenged or whether such rights encroach on any third party’s legitimate rights. In this context, it is worth checking if there are, or were, any cases filed in judicial courts for safeguarding or defending the seller’s interest in them. In other words, it is very important to check if there are any existing or pending claims in any litigation proceedings vis-à-vis the IP rights held by the seller.

4. Ascribing value to an IP asset

In jurisdictions where buyer would be assessed for tax purposes for acquiring an IP asset, it is advisable to have such IP evaluated. This is likely to help the buyer to take income tax basis in the asset equal to its costs. In other words, income tax basis is the reference point for determining how much tax you’ll pay upon a sale or exchange of a given IP asset or how much you can deduct for purposes of depreciation or amortization i.e., spreading of the IP assets cost over its useful life.

In summary, the valuation of IP assets involves reviewing:

the revenue earnings of such IP, and any related earning potential that can be ascribed to such an asset.
any taxes that need to be paid on revenue generated along with interest,
any depreciation and amortisation that can be attributed to such an asset.
any discounted cash flows or market capitalisation.

All such factors should be considered within the framework of the total value of the seller’s IP assets.

Conclusion

Overall, intangible assets including IP rights play a major role in increasing the value of any merger or acquisition. As such, the acquisition of intangible assets and specially the IP becomes the highlight of such transactions. From the viewpoint of the acquiring company, IP is an asset that can boost its growth, diversify revenue and profit generation capabilities. For these reasons, it is all the more important to undertake proper due diligence while acquiring intangible assets from any company to avoid any hidden liabilities or missing out on lucrative opportunities post-acquisition.

Intangible Assets

Stock option purchase plans.	Notices of exemptions.
Credit agreements.	Supplier and customer contracts.
Manufacturing contracts.	Loan agreements.
Insurance policies.	Partnership and joint venture agreements.
Agreements relating to bonus, retirement, pension etc.	Lists of proprietary processes.
Manufacturing breakdowns, including lists of products manufactured, personnel details and suppliers.	Agreements relating to the sale and lease of capital equipment.
Copies of all market research conducted.	Documentation of ongoing investigations or investigation claims from regulatory bodies.
Goodwill –the value of the company’s reputation within relevant business circles. Goodwill is usually only included in an acquisition.	Trade secrets – confidential information that affords the business a competitive advantage.
Customer lists and databases.	Meeting minutes, including meetings of committees, directors and shareholders.
Detailed employee data.	Voting trust agreements.
Shareholder agreements.	Agreements relating to conversions, exchanges, redemptions and repurchases.
Company stock books.	Quarterly reports.
Annual reports.	Shareholder communications.
Press releases.	Convertible debt agreements.