What is Intellectual Property (IP)?
Intellectual Property (IP) is a key business asset often overlooked by investors, the C-Suite and company stakeholders. IP refers to the intangibles that exist to some degree in every business and offer a company added value. This could be a key brand, software, copyright, patents, trademarks, designs or trade secrets.
Every company has some level of IP, but not every company knows the market value of its IP. Yet, IP gives a company a competitive edge, so it's an important concept to grasp when analyzing a business.
Why IP Matters to Investors
IP matters to investors because it's a hidden value that's usually not on the balance sheet. While IP is intangible and may appear difficult to pin down, it can contribute to the increasing value of a company's stock price over time, as it is typically a key area of interest for analysts. Therefore, if investors can pinpoint companies with strong IP assets before the broader market recognizes the value, they could unlock bigger gains.
In Warren Buffett's 1993 letter to shareholders, he discusses Coke and Gillette, pointing out:
“The might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage, setting up a protective moat around their economic castles.”
In fact, Buffett regularly refers to 'an economic moat' as he sees it as the key to success.
Types of Intellectual Property
IP assets can be split into formal IP and informal IP. Formal IP covers trademarks, patents, software, copyright and designs, whereas informal IP includes brand and reputational value, trade secrets, a formal company strategy and market intelligence.
Formal IP
Trademarks must be registered. These are words, symbols, a picture, or a combination of these items that distinguish the company's goods and services from competitors. A registered trademark gives the owner the right to use it in connection with their own goods or services. It provides a level of brand protection and legal standing if anyone attempts to copy or imitate a company's trademarks.
Patents cover inventions and give the owner legal protection from anyone copying, selling, or using the invention without permission. A great advantage of a patent is that the owner can discuss the invention with others and set a business up around it without worrying about the inventions or ideas being stolen. It can take time to profit from an invention, but patents help make it possible by providing protection.
Software is a form of IP and can be protected by various intellectual property laws. These vary by country but include copyright, patent, and trade secret protections. Licenses can also be used to protect software use and distribution. Common software license types include proprietary, open source and free software licenses.
Copyright gives the creator of an original work the automatic legal right to use and distribute it as they see fit. There is no registration process for copyright, it's an automatic entitlement.
Registered Design rights vary by jurisdiction but give the owner a legal right to a registered design. This could be a 2D or surface pattern or 3D shape or configuration. To register a design, the design must be new and original and must not be in any way similar to any existing designs.
Informal IP
Brand and Reputation characterize a company and comprise creative works such as name, logo, designs, packaging, value proposition and more. Companies that take the time to build their brand image can cement it into the minds of consumers, differentiating it from competitors. Reputation is very important and must be managed with care. Reputation includes the public perception of a company's products and services and how it treats its employees and customers.
Trade Secrets can be particularly valuable to a company. A few examples include KFC, Cadbury, or Coca-Cola's secret recipes, Google's search algorithm, the formula for WD40's popular lubricant spray, Apple's manufacturing processes, or Tesla's battery technology. Protecting trade secrets like these is very important in ensuring the company maintains its competitive advantage and profits from them.
Business Strategy lays out what a company wants to achieve via short and long-term goals and how it plans to do so. Its strategy can influence public perception increasing or decreasing faith in the company. Investors like to see a company's business strategy when assessing its future growth potential.
Market Intelligence encompasses the growth opportunities, market trends and competitor movements in the industry and sector the company operates in. Savvy investors use market intelligence to assist in their investment decisions.
It’s been stated by many that the value of the companies in the S&P 500 typically have intangibles which account for more than 80% of their value. This benchmark of course used to be dominated by PLCs reliant on land, real estate, plant & machinery and other physical assets, but that has changed and the top performers in the S&P500 consider their brand, software, technology, patents etc. to be their most valuable assets. It’s the way forward in the modern economy.
- Stephen Robertson, Founder & CEO, Metis Partners
Who Should Appreciate the Importance of IP Assets?
Lenders increasingly recognize the value and importance of IP assets. Intellectual Property Backed Finance (IP-backed finance) is a method of funding where businesses use their IP assets, such as patents, brands, software, and copyrights, as collateral for loans. And lenders are attracted to IP-backed finance due to improved security, potential value appreciation, a wider pool of assets, stronger repayment incentives, and as an alternative to personal guarantees.
However, IP-backed finance poses challenges for the lender as it requires clear visibility of the company’s IP to make better-informed lending decisions. The lender must also consider how easily they could realize IP value, the risk of IP value volatility and how to confidently understand the risk profile associated with IP assets. Despite these challenges, successful IP-backed lending models exist and are growing, especially for high-growth and mature businesses.
The success of IP-backed finance depends on experienced advisers who understand deal structures, IP valuation methodologies, terms and conditions, and IP insurance. Metis Partners offers these services, along with intellectual property valuations and advisory services.
Investors should consider IP for the same reasons as lenders. It poses a business risk when not adequately protected, but IP management can be rewarding when IP value is recognized and leveraged.
Board Members are responsible for ensuring the company is fully aware of the value of all of its assets, including IP and the importance of safeguarding it.
Potential Acquirers - savvy acquirers will always consider a company's intellectual property when carrying out due diligence.
IP Narrative
Investors can detect a business that appreciates the value of its IP through its IP narrative. Whether it regularly mentions its intangible assets (brand, trademarks, software etc.), how it is using them and any discussion on how it intends to leverage them in the future. Furthermore, investors want to know if its IP moat is strong enough to protect the business against rising competition.
How Intellectual Property Can Create Value for Investors
Licensing IP: Sometimes, a company will license its IP to another company for a fee or royalty. Disney licenses its various brands, including Mickey Mouse, Marvel and Star Wars, for use in merchandise, food, films, and theme parks. Microsoft licenses its software to equipment manufacturers. Licensing can bring in recurring revenue while building brand reach and reputation.
Selling IP: Companies sometimes sell IP; this is common during liquidation proceedings. Selling IP provides a way for companies to generate cash if a business segment is no longer in keeping with the company or if an acquisition includes divisions that don't fit with the company's direction.
Investors often like to see a company sell its IP as it provides a timely cash injection. It also provides a way for companies to realize value from their IP without incurring commercialization costs.
IP as collateral for loans: When a company recognizes the value in its IP, it can leverage this as collateral to obtain a loan. For investors, this is often preferable to selling equity which can dilute existing share ownership.
Monetizing IP through partnerships: Like licensing, partnering with other businesses can be a lucrative way to expand brand reach and bring in recurring revenue. Coca-Cola partnered with McDonald's to sell its Coca-Cola products through the fast-food chain.
‘IP valuation is not an exact science’. That’s a phrase I’ve heard many times, and it’s true as lots of credible valuation firms tweak their methodology and use different assumptions, all of which are correct. They will take into account global economic factors, market and sector factors and, of course, different IP factors. One thing that’s clear is that IP valuation shouldn’t be complex, and the assumptions used about the quality and strength of the IP assets, how they underpin cashflow and scalability/growth of the business model, what key benchmarks and comparators are used, these factors should all be capable of being explained clearly and understood by the layman and certainly investors. IP valuation doesn’t need to be rocket science!
- Stephen Robertson, Founder & CEO, Metis Partners
Risks and Challenges of Investing in Intellectual Property
Litigation risks: With so many ideas floating around, there's a risk of infringement on patents, designs, copyright and even trademarks. This puts a company at risk of infringement or being copied. If a company has to go to court either to defend or prosecute, it will involve significant costs and potential reputational damage. Pending lawsuits are likely to scare investors.
Maintenance costs: There are ongoing renewal costs in maintaining patents and trademarks. Research and development to preserve and improve IP can also prove costly.
Difficulty of valuing IP: Ideas are elusive, and therefore IP valuation is a complex business. There are varying methods used in IP valuation, which depend on the strength of the IP, the market, and potential revenue streams.
Due Diligence for Intellectual Property Investments
Identifying quality IP: Due diligence can help investors determine whether the IP is protected and valuable and offers a robust competitive advantage relevant to the industry, all of which point to quality IP.
Evaluating the strength of IP protection: Assessing the strength of IP protection can help an investor avoid risk. Reviewing patents and trademarks to check they're effective can reassure investors that the IP is secure and protected from potential infringement or misuse.
Assessing the market potential of IP: Companies can employ the services of IP valuation experts to help them assess the strength and market value of their IP.
The Importance of Intellectual Property for Business Growth and Investor Insight
A company's IP assets help position it competitively while contributing to long-term growth and sustainable revenue streams. That's why the assets that contribute to overall IP value play a key role in the growth and success of a business. When investors account for IP, it can help them discover unrealized value often hidden off balance sheet.
If a company doesn't recognize the value of its IP, it could risk losing out. Listening to earnings calls or reading company filings can give investors insight into how well a business protects and manages its intellectual property.
By proactively managing and protecting its IP assets, a business can ensure it is well-positioned for long-term growth and success. Simultaneously, the company can leverage its IP to attract support and resources from investors, lenders and potential acquirers.
