Disruptive Tendencies

Conflicting Goals in Asymmetrical Deals: Market Exclusivity

How many people have considered that Microsoft is, at its core, a licensing company? Or that the entire PC industry owes its existence to a licensing deal, the non-exclusive license to IBM for MS-DOS in the 80’s? How different a company would Microsoft have been had they signed an exclusive licensing deal? Chances are that it wouldn’t still be around. Bill Gates certainly wouldn't have become the richest guy in the world. As a licensing guy, I can only speculate on whether it was IBM's negotiating naivete or Microsoft's chutzpah that led to the deal being structured as it was.

Having sat on both sides of the table on various occasions, I have frequently found myself in a position where I’ve been able to help get to consensus because I understand where the conflicts may be and have been able to work through them.

Licensees almost always contend that they require some form of market exclusivity for competitive advantage. “Why would I sign a deal with you today if, tomorrow, my competitors can do the same thing?”

Licensors are thinking the exact opposite, “I can’t put all my eggs in one basket? I want to capture as much of the market opportunity as is possible, not be limited to a fraction of it.”

Perhaps even more importantly, what is the impact on the company’s potential for a liquidity event for its investors? Remember, once you’ve granted exclusive rights to a 3^rd-party, that prevents not only you, but any acquiring company, from pursuing that space. This may take a whole category of company off the list of potential acquirers at a later date. Try explaining that one to your investors!

So how do you reconcile these two positions?

The “need” for market exclusivity can often be a catalyst for M&A discussions, especially if the technology being licensed is the core franchise around which you’ve begun to build the company, or if the breadth of market exclusivity on the table prevents you from extracting value in other markets. But once again, these can be tricky waters to navigate. A technology acquisition requires you to consider valuation through a very realistic lens. The acquiring company will do an estimated build cost (# of person years x fully loaded cost per person year, around $200K per), and then offer a multiple based on their assessment of the value of time-to-market and your IP position, typically 3X-7X. As the inventor/entrepreneur, you need to be very realistic about their ability to get close enough to replicating that which you’ve built. Pride can get in the way, but do you really believe that Microsoft/Qualcomm/Oracle/Cisco engineers couldn’t do it?

If M&A discussions aren’t an option, then, in most cases, non-exclusivity should be the preferred path. One of the things, that the licensee doesn’t want to happen, is to invest its time and resources creating demand for a key feature, only to have a competitor come in and erode their margins selling the same widget at a reduced cost. A concession, that can help address this, is a form of price protection (MFN clause). In this type of clause, the licensor will agree to not license for less in comparable deals. The concept of comparability is key here. The consideration must be for similar product types, in similar quantities over a similar time period. If a subsequent licensee is pays a lesser royalty rate (or other form of consideration), a reduction in royalty rate will be accorded to the original licensee as well.

So, you’ve now heard that M&A is not an option at this time and non-exclusive rights aren’t either. Under what conditions can exclusivity make sense? My answer is twofold: Money solves a lot of problems, and that it is possible to tightly constrain the scope of a license, thus preserving your ability to license to others or for an acquiring company to practice in any field but the restricted field for which you’ve granted exclusivity.

How do you constrain the license grants? By placing boxes around the grants…I’ll explain more next time.

That’s my .02!

Martin Suter

martin.suter (at) iplicensing.net

 

Before Taking the Licensing Plunge, Consider These 3 Things

If I had to impart any words of advice to a company that is seriously looking at licensing as a go-to-market model, it would be the following three things:

1.       Understand all of the implications of a licensing strategy, including its impact on valuation and potential liquidity events for the shareholders;

2.       Develop guiding principles outside of the deal;

3.       Assess every deal through a strategic filter.

The first of these is critically important and requires the full buy-in from the Board and investors. Don’t assume that they automatically appreciate what these are. Licensing has implications for valuation and exit potential, and while the benefits are many (focuses scarce resources on core technology development, time to market, leverages existing channels to market, non-dilutitive cash inflow, etc.), the risks are also real. But many of these risks can be partially or wholly mitigated by a rational approach to the deal, and it is incumbent on you to show them how.

Which leads us to the second imperative: Develop guiding principles outside of the deal. Get the Board to sign off on these and empower you to negotiate the deal within the deal framework that’s been discussed. The last thing you want is the Board “helping” you to negotiate a deal in real-time or proffering opinions at the eleventh hour. Given the implications of a bad deal, there are certain things that will not be negotiable. These may be dealbreakers, but it’s far better to know going in where you have the support of the Board and often, this makes for easier negotiations. At worst, you can cut bait.

Lastly, every deal should be looked at in a strategic context. Does it make sense to grant any rights, even non-exclusive, in the Field of Use that is likely going to be the driver for a liquidity event? Granting rights in niche markets is very different than granting rights in a core market.

In future blogs, I’ll discuss some of the issues that are worth losing sleep over.

That’s my .02!

Martin Suter

 

Can't see the forest for the weeds (Board governance at start-ups)

Why is it that management teams in start-ups assume their Boards want to get down into the weeds every Board meeting and why do Directors buy into this approach and behave like weed inspectors? Board governance isn’t about inspecting everything that management is doing; it’s about holding management accountable for those things that are material.

Start-ups are high risk, but materiality should be those things that have the potential to impact valuation or derail a liquidity event. Sure, the product roadmap (aka Feature List eye charts) is important, but is it more important than GPL compliance?

What impacts valuation more than revenue? Yet how often do you see a Board congratulating management for “hitting their numbers” rather than asking whether these are the right numbers to be hitting? There’s no point in patting management on the back for a year in which a company grew 10%, if the market and their competitors are growing at >50% year over year.  Underperforming the market equates to declining market share, which will ultimately impact valuation, multiples, and liquidity opportunities, none of which deserve a pat on the back.

Rather than showing slides that show how the company is “performing to plan”, how about a slide showing how the company is “performing to market”?

It’s a fact of life today that companies leverage open-source software. There’s tremendous pressure to hit dates and add features, and many engineers will look to SourceForge, or similar, for code to help meet development timelines. Without a robust open source license tracking process, it’s very likely that, over time, one’s code base may not comply with all of the license obligations associated with the bits.

Non-compliance is material. Just ask Cisco, which had to publish the source code for its Linksys line when found to be in violation of its open source license obligations. Every licensing and M&A deal that I’ve done has required a representation, signed by an Officer, warranting compliance with copyright licenses. Sophisticated acquirers will require a 3^rd-party compliance assessment using a tool from a company like Protecode or Black Duck, and being “caught” during a due diligence will cripple any deal.

So rather than spending the R&D section discussing feature lists, shouldn’t Boards be focused on mitigating the risks of non-compliance with open-source license requirements? Why shouldn’t R&D be required to provide a slide, every meeting, summarizing the open-source licenses for code being used in shipping product?  Shouldn’t the CFO and CEO be required to sign-off that the company is in compliance, every quarter? Just as Financial Statements are provided and signed off on, so should GPL compliance, and as with annual audited financials, management should prepare and provide an audited 3^rd-party compliance report annually as well.

Non-compliance puts the company and its investors at risk and should be a firing offence, first time, no questions asked. It’s not the engineer that should be fired, unless he/she knowingly violated company policy (that is monitored and real and not “vapor”), rather it is any Officer of the company that was aware of non-compliance or who has oversight and ultimate accountability. This means, in most cases, the CEO.

Many start-ups take a very ad hoc approach to intellectual asset management (IAM), which is odd since it is an asset class that forms the essence of a company’s value. You may see a slide in a Board deck that lists patent applications, but rarely do you see any level of competitive analysis, either in terms of competitors’ patent positions, or potential infringers of one’s own patents. Significant money is spent on patents, without an understanding of the business objectives for so doing. As a result, many patents end up sitting in a filing cabinet or as a plaque on a wall and are never used to the company’s benefit.

So why is this material? Once again, it has the potential to impact valuation. Having been directly involved in a multi-hundred million dollar M&A transaction, where the justification of the 30X revenue multiple was based on IP portfolio strength, I can attest to the power of a coherent, well-documented IAM process. When this is supported by the knowledge of 3^rd-party IP in your space, as with a patent landscape analysis, you have a powerful justification for including IP in any discussion of valuation.

Furthermore, Directors and Officers have a duty of care with respect to the management of corporate assets. Recently, I read an article that suggests a corporate officer or director, who is aware of an infringement of some patents owned by his or her company and who fails to enforce these patents, may be held liable for breach of the duty of care with respect to the management of corporate assets. I’m not sure whether it’s ever happened, but it makes sense for Directors to expect more than a simple list of patents.

Rather than a slide documenting a company’s patents (which I can Google or BING anyways), how about an analysis of your IP and your competitors’? How about a discussion on enforcement of IP with some clear guidelines around it? How about pushing management about disciplines related to invention documentation? Are the engineering notebooks signed and dated? What about an international filing strategy? Which markets? Why?

Board members have visibility into a company’s liabilities; monthly Balance Sheets show this, but what of off Balance Sheet liabilities? Many SmallCo’s are disadvantaged at the negotiating table and as such, sign deals with indemnification clauses that effectively “bet the company”. Any contract that includes clauses for liquidated damages or in which the company provides an uncapped indemnity, should require Board approval. At a minimum, it is the CFO’s responsibility to advise the Board as to the existence of these hidden, potential liabilities, but it is the Board’s responsibility to require this of the CFO.

Lastly, I’d like to point out that Directors and Officers have an obligation to all shareholders, regardless of share class. Most Board members are representatives of investors, and often have preferred rights of some kind. But it is incumbent on Directors to represent all classes of shareholders, including common stock holders, and not simply to represent their own stock class.

So what’s my dream Board meeting?

It’s one in which the company is measured, objectively, against those metrics that matter. It’s one that isn’t comprised of 100 eye charts describing the minutiae of the business, but which is focused on issues of materiality.

CEO/Sales: How fast did the business grow relative to the market and its competitors?

CEO/R&D: Are you monitoring open-source license compliance? Will you stake your job on it?

CEO/CTO:  How are you leveraging IP to limit competition, grow revenues, create value?

CEO/CFO: What “bet the company” contractual indemnifications exist? What contracts currently under review have “bet the company” clauses?

Ultimately, it’s the Board that needs to convey to the CEO that these are issues of paramount importance to the company, its Directors, investors and all shareholders and that he/she will be held accountable. Don’t take us down the garden path every meeting and don’t pull us down into the weeds. Show us that you have your finger on the pulse of those things that matter.

To paraphrase Peter Parker, “With great power comes great responsibility”, but that’s why CEOs make the big bucks.

That’s my .02!

Martin Suter

 

Skype - Joltid Licensing Dispute: Epic M&A Screw-up?

eBay must be ruing the day that it signed the M&A deal to buy Skype for $2.6b, in addition to an additional $530m as part of the earn-out provisions. Its original vision of incorporating Skype functionality into its auctions never happened. Despite that, Skype has proven itself to be quite interesting as a standalone entity, with some value potentially to be recouped via a spin-out IPO. However based on an eBay 10-Q form filed with the SEC on 7/30/2009, this is now at risk over a dispute over a license.

It seems that some of the core functionality within Skype is based on peer-to-peer software licensed from Joltid, a company also controlled by the founders of Skype, Niklas Zennstrom and Janus Friis. So if I get this right, Joltid entered into a non-arm’s length license with Skype (pre-acquisition), a company that Zennstrom and Friis also controlled. When eBay acquired Skype, it would have known that while it was “buying” Skype, it wasn’t buying Skype source code, it was licensing it from Joltid. Given the amount of money involved in the deal, and the fact that the principals were the same, insisting on a perpetual, fully paid up license, in some Field of Use (voice, IM and video applications) with rights to derivatives would seem to have been very do-able.

Instead, it appears that Zennstrom and Friis pocketed a boatload of eBay cash, and retained control of Skype’s destiny via a licensing agreement. Now with the M&A (and liquidity) at risk, eBay is now over a barrel. Negotiate and pay for that fully paid up license, re-write everything, or write it all off as the worst deal of the century. OK, maybe that’s overstating it, the Time Warner-AOL deal sucked pretty badly too.

I’ve been involved with transactions that have nearly fallen apart at the eleventh hour because of legacy tech transfer licenses. “What do you mean we’ll have to pay 4% royalties ad infinitum? We’re buying the company!” When it gets to this stage and a deal’s at risk, the original licensor has all of the leverage, and will often be “bought off”, at the expense of the shareholders, to make the issue go away so the deal can get done.

Having negotiated multiple technology transfer and M&A deals, I have learned that it is imperative to construct the tech transfer deal with M&A in mind. Exclusivity in a well-defined Field, rights to Derivative Works, Non-Assertion of IP rights, a built-in cap or royalty buy-out to convert to a license in perpetuity, are all essential. Of course, in a non-arm’s length licensing agreement, like that between Joltid and Skype, the license terms would have been very different, but in this case it is incumbent on the acquirer to recognise this and force the issue while they have the leverage.

In hindsight, many would agree, this acquisition missed the mark strategically, resulting in a $1.43b writedown. But it’s hard to fault big, bold plays with the potential to break new ground. I have a deep admiration for those involved in transactions like that. But a key takeaway is the tactical execution by eBay’s M&A team appears to have missed the inherent conflicts of interest and let slide the licensing agreement with Joltid. Now, with no leverage, it’s biting them hard. Caveat emptor!

That’s my .02!

Martin Suter

(martin.suter at iplicensing.net)