With the plethora of listed patent vehicles that now exist, and looking at recent deals such as Vringo/Infomedia Services and Spherix/Rockstar, I have been wondering about the relative lack of stock-based IP deals that have been executed over the past few years – and by extension, the strategic value and consequences of a listing for the shareholders, management and vendors or clients of a non-practising entity (NPE).
There is a considerable body of academic research from the stock markets on the relative benefits and value drivers of stock versus cash deals in M&A transactions – for example, the consistent finding that shareholders of acquiring companies fare worse in stock transactions than those of the assets or stock they acquire.
The explanation for this phenomenon lies in shareholder value added (SVA), which for IP acquisitions is the difference between the purchase price of the intellectual property and the expected net value of any subsequent licensing or litigation. Irrespective of any financial carried interest that the seller may have in the IP workout, when the deal is paid for with stock, the calculation of SVA produces a lower number. So, relatively speaking, stock-based IP acquisitions are a bad deal for the NPE’s shareholders. The exception is when there is no cash-equivalent deal to be made (eg, the NPE does not have the cash).
In many IP transactions that I have looked at, the seller desires to own a 'back-end' participation in the success of a licensing or litigation programme conducted by the buyer using the acquired intellectual property. This entitlement is a fundamental part of most NPE acquisition strategies. In this respect, stock-based back-ends have merit for sellers in that they do not require auditing to assess what the back-end should be – the stock price is transparent.
In most IP acquisitions, the seller knows far more about the assets than the buyer. This asymmetrical information position allows the seller to place a more accurate value on the intellectual property than the buyer. Combining this with the SVA differential, it would seem economically rational that sellers should favour stock-based compensation for their IP sales.
Given the implied and actual advantages for sellers of intellectual property to participate in stock-based deals, why are so few IP transactions structured in this manner?
The essential difference between a cash or a stock-based acquisition or an 'asset for equity' exchange is that the sellers share more risk with the buyer in the latter transaction. Outside of a long-term relationship between the parties, in which execution risk can be better assessed or perhaps offset against other (non-financial) factors, such risk sharing is usually unpalatable for the seller. Thus, cash-based deals predominate.
My belief is that the lack of a strategic relationship between most sellers and NPEs (making evaluating execution risk harder as they have no experience of working together) is a critical factor here, as is the straightforward desire to have a simple deal. These factors often express themselves as a compliance policy in the seller's IP department, dictating cash for patent sales rather than any other form of deal. In a bullet payment competitive auction market for quality IP assets, cash is king.
Notwithstanding the current reality, it would be interesting for a large blue-chip patent owner to experiment a little in this area, and I believe that this will happen. For example, when the chief IP officer decides on some IP housekeeping, patents could be sold or syndicated into the entire ecosystem of NPEs for stock instead of for cash (or a mix thereof). This would provide the seller with a diversified liquid portfolio of equity interests in the entire NPE universe, providing industry upside economics. Alternatively, the seller could decide to work strategically with a preferred buyer using convertible debt as vendor financing (as in the most recent Spherix/Rockstar deal), or treating the NPE much as IT directors today treat IT outsourcing partners – as an arm's-length but monogamous relationship.
It will be interesting to see how these models develop against a backdrop where listed NPEs largely disappoint investors with lacklustre stock performance and sellers become more strategic and sophisticated about IP monetisation.
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