Just Call Me Angel

Smaller companies in search of cash have a new source: big companies.
Alix Stuart, CFO Magazine

When finance executive Ane Ohm joined Harqen, an early-stage company that makes tools to index and analyze recorded phone conversations, one of her reasons for taking the job was, in a sense, lofty: she hoped to meet angels. While the ones she was targeting are not quite as rare as the heavenly variety, angel investors are not as commonplace as smaller companies would like.

With bank financing still uncertain, small and midsize companies are looking to alternatives, with mixed results. Angel groups generally invest in only 1% to 10% of the opportunities that come before them, according to Marianne Hudson, executive director of Angel Capital Association. Those are slightly better odds than companies seeking venture funding or private-equity infusions will encounter, according to a recent survey by the Pepperdine Capital Markets Project, but just 13% of businesses that responded to that survey reported getting funding from any of those sources.

Small businesses on the hunt for cash may, however, benefit from the massive cash hoards that large companies possess. According to one recent study of more than 800 public companies, cash balances at the end of 2010 had more than quadrupled, on average, compared with 10 years earlier. Indirectly, these deep pockets may help growth companies by providing tired investors with renewed liquidity. “If the large corporates make more acquisitions and create more exits, they may get people excited about investing again,” says Jeffrey Sohl, who tracks angel investing as director of the Center for Venture Research at the University of New Hampshire’s business school.

More directly, many large companies are looking to sink money into companies that can possibly speed their own growth. An increasing number, including EMC, Google, and Juniper Networks, have established or renewed such efforts in the past two years. “Corporates see [such venture efforts] as outsourcing R&D,” says Gerald Brady, managing director with Silicon Valley Bank’s venture-capital group, who previously worked with Siemens’s venture-investment arm.

No matter how the capital comes in the door, however, finance executives need to understand that by cashing the check they are also accepting a new and active partner. Experts say that both angel and large-company investors want to be intimately involved in the business. That involvement can take the form of board seats, coaching programs for top executives, and even business-plan revisions.

Angels at Work
For Ohm at Harqen, such intervention has been a benefit rather than a burden. “I can’t say enough about how much value I’ve gotten from our angels,” she says. As vice president of finance and operations, she has participated in coaching and strategy programs run by her angel investors. That has helped her track what’s happening on the competitive landscape, and develop a vision for how the company should grow and evolve over time, so that when it’s time for an exit, “it’s a good transition,” she says.

Ohm joined after Harqen had raised two rounds from angels. The company is currently seeking its third round to help launch a new product. In her time with the company, Ohm has learned that angels stick close. The same investor, Lauren Flanagan, has led all three rounds, and has helped introduce the company to others that could help, including angel groups that aim to invest in woman-led companies.

Such closeness has drawn a tight circle around the types of investors Ohm will approach in this latest round. “When you have a really good group, you want to think very critically before you go outside of it,” she says. Her main goal is to make sure any additional investors contribute specialized expertise, a goal that could at some point extend to a corporate venture arm.

Angels typically look for high-growth firms with great market potential, even if they have no current revenues. Such firms are typically valued at $1.5 million to $2.5 million before the investment, with median deal size between $500,000 and $750,000, says Angel Capital Association’s Hudson.

Larger sums, however, may be more readily available because angels are increasingly syndicating their deals. Jeff Gray, CEO of cloud-computing start-up Glue Networks, says that “more than $4 million appeared [practically] out of thin air,” thanks to two angel groups that syndicated the deal with four others.

Here Come the Corporates
Corporate venture investors are also getting more involved in portfolio-company operations, in large part because they view such investments as a vital part of their own growth strategies. In the past, “they kind of stood back, and did not take board seats or an active role,” says Mark Heesen, president of the National Venture Capital Association. “Now they want to be an integral part of helping that company grow to the next level.”

“Our investment efforts are generally intended to be friendly; we’re fairly straightforward in the terms we propose, and we try to add value to the companies and make them successful,” says Jeff Lipton, a former engineer and VC who now heads up Juniper Networks’s venture efforts. Juniper reviews more than 200 companies a year, and ends up investing in only 7 to 10, about a 5% hit rate. The firm is open to acquiring, and has done so in at least two cases recently, but its main aim is to help products come to market that complement its core platform, Lipton says.

While corporate venture funding tends to rise and fall with corporate fortunes, the volume of dollars coming from corporate venture arms is up to $1.4 billion in the first two quarters of 2011. That puts it on pace to be the best year in a decade (see chart, above).

Most deals involve a co-investment between traditional and corporate VCs. Traditional VCs are more open to getting help than in the past, particularly in capital-intensive industries like clean technology and semiconductors. “There’s a sea change in how the corporate VCs are perceived; they are now the well-heeled, deep-pocketed investors that are also the likely acquirers,” Gerald Brady says. For their part, corporates appreciate the deep deal experience they can gain from partnering. “We like to follow financial investors and have them set the financial valuation,” says Lipton.

Each corporate fund has its own mandate, and it can vary greatly even within the same firm, as Juniper’s funds demonstrate. While the bulk of the investments go toward a broad range of early- and late-stage software firms, the $4 billion maker of high-speed switching routers will also consider hardware and component makers at any stage. It is also willing to consider even younger companies, though its investment time horizon is generally one to four years.

The moral of the story? With a little creativity, high-growth companies may find ways to shake loose much-needed capital from investors both large and small. To do so successfully, CFOs should research what investment groups are looking for — their goals and rules can vary widely — and be patient and persistent in wooing them. It wouldn’t hurt, of course, if the stock market were to make a spectacular recovery.

Alix Stuart is senior editor for small and midsize business at CFO.

http://www.cfo.com/article.cfm/14599833

SUCCESS MAXIMS

–Part 16–

Deeds

(Author Unknown)

I’d rather see a sermon than hear one any day.

I’d rather one should walk with me than merely show the way.

The eye’s a better pupil and more willing than the ear.

Fine counsel is important, but example’s always clear.

The best of all the preachers are the men who live their creeds,

For to see the good in action is what everybody needs.

I can soon learn how to do it if you’ll let me see it done.

I can watch your hands in action though your tongue too fast may run.

And the lectures you deliver may be very wise and true,

But I’d rather learn my lesson by observing what you do.

For I may misunderstand you and the fine advice you give,

But there’s no misunderstanding how you act and how you live.

Capital vs. Confidence

Banks say they want to lend to smaller companies, but credit remains tight. Is relief in sight?
Alix Stuart, CFO Magazine

Last September, Centennial Bank announced that the U.S. Treasury Department had granted it $1.8 million through the Small Business Lending Fund (SBLF). Jim Basey, Centennial chairman and CEO, says the Greenwood, Colorado-based bank was glad to take the capital, for several reasons. It came with a low interest rate (1% at press time) and few restrictions, other than confining loans to businesses with fewer than 500 employees and capping loan amounts at $2 million.

The recently recapitalized bank has been growing, with $70 million in business loans outstanding and an acquisition underway. But has the federal booster-shot led to any loans Centennial wouldn’t have made otherwise?

“No,” says Basey, without missing a beat. “We do the same credit screen on everything; we have to make sure every loan is done prudently.” In fact, the bank places a great emphasis on relationships, so “if someone walked through the door whom we didn’t know, we’d be pretty skeptical.”

Over the past three years, getting capital into the hands of smaller businesses — a universe that can encompass almost any company not traded on a major stock exchange — has become a cause du jour for politicians, researchers, celebrities, and even, well, big businesses. (Starbucks, for one, is collecting donations from customers to fund microloans to entrepreneurs.) The federal government has launched multiple efforts to stimulate the process, including the $30 billion SBLF aimed at banks and the $1.5 billion State Small Business Credit Initiative aimed at local development agencies, all of which is intended to be lent out in conjunction with private capital.

Yet nothing seems to be helping — so far. Experts caution that it’s still early to assess the results of the federal boosters, many of which have only recently left government coffers. Yet the outflow into the marketplace seems to be weak, for reasons that have virtually nothing to do with the availability of capital. “Quite honestly, I don’t think banks want to lend right now,” says Lawrence Manson, CEO of Nexgen Capital Partners, which advises banks on their investments. “You can have all the programs in the world, but it’s not the cost of capital that is constraining [banks]. It’s the inability of people to get comfortable with where the economy is going.”

Michael Eldredge, CFO of the $16 million telecom company AST Technologies, might agree that it’s all about confidence. His company recently received $5 million from PNC Bank on very favorable terms, but it didn’t come easy, despite the fact that AST has seen revenue increase by more than 30% and EBITDA grow by more than 80% in the past year. Eldredge spent a year working with bankers to secure a $2.5 million, five-year loan and a $2.5 million revolver. Thanks to a positive audit, the bank agreed not to tether the revolver to the state of payables and inventory, but the company will report on those monthly to the bank. And there are personal guarantees attached to the loans that will likely be removed in about a year pending favorable 2012 financials.

In the end, things worked out well for AST, but Eldredge doesn’t believe the spate of new programs had anything to do with it. “While there is more money out there,” he says, “we either don’t fit [many] banks’ profiles, or the rules remain problematic and archaic and ultimately prevent banks from lending their money. But if you can demonstrate a history of meeting or exceeding your goals, that gives bankers a comfort level that you’ll do what you say you’re going to do.” Also key, he adds, is developing a personal comfort factor with your bankers. “You have to form business relationships,” Eldredge says. “We’ve worked with some of the people at our bank for years.”

Banks unquestionably have money, and some companies are getting it, but what does that mean for small businesses in the current credit market? Here we survey the banking landscape for smaller companies, including assessments of what banks are doing to help and where some of the recently launched programs designed to improve the climate stand.

Small Business Lending Fund
This ambitious, one-year program aimed at smaller banks (those with under $10 billion in assets) was dogged by both procedural problems and low demand from banks, in part because small-business loan volume must increase in order to keep interest rates low. Banks applied for only $11.8 billion of the $30 billion Congress initially earmarked; just $4 billion in requests was ultimately approved, and then only to the healthiest banks. About half of those banks were former recipients of the Troubled Asset Relief Program, and were required to use the funds first to pay off that debt. That cautious strategy may keep taxpayers whole, but it puts the government in the position of lending to banks that in many cases don’t really need the money.

So far, it’s unclear whether or not that money is spurring any lending that wouldn’t have occurred otherwise. In January, the Treasury Department reported that banks had collectively increased their lending by $3.4 billion over the program baseline; the trouble is that the baseline was an average of (generally low) 2009–2010 levels. Many had made progress even before they got the Treasury funds in
mid-2011. The banks have some incentive to increase qualifying loans to maintain a low cost of capital, but many say that’s not a driving factor for them.

For example, the 140-year-old Blue Hills Bank, based in Hyde Park, Massachusetts, just launched its commercial lending division in early 2011, about a year before the Treasury granted the bank $18.7 million in SBLF funds. Starting with only $1.7 million in loans, “we don’t need [to make] much more than $17 million in loans for us to fill the plate, and our business plans go far beyond that,” says Stephen McNulty, longtime CFO of the $950 million (in assets) bank. “If there had not been [an SBLF], or if we had applied for it and gotten rejected, we still would have proceeded — and succeeded — with our plan.”

Bank executives also acknowledge that much of their loan growth often comes from taking market share from other local institutions, meaning that the total pool isn’t necessarily growing. The best-case scenario is that the money somehow creates a rising tide, where banks’ overall health sparks more lending. “The thinking was that the capital was available, and while we didn’t need it short-term . . . it sets a base for more-aggressive loan expansion in 2013 and beyond,” says McNulty. Even if the money helps fund more bank consolidation, it could be helpful, he adds, since “one larger bank has the ability to provide more capital than two or three smaller banks.”

How to get it: Businesses with fewer than 500 employees can qualify for the loans, with no revenue limits. The Treasury Department maintains a list of participating banks on its website. Note that, unlike the Small Business Administration process (described below), banks are not generally creating a separate category of “SBLF loans.”

State Small-Business Credit Initiative
The $1.5 billion program (which ultimately dispersed $1.4 billion) is much smaller than the SBLF but has great potential, since the government is asking lenders to leverage the capital 10 times over. According to a recent Government Accountability Office (GAO) survey, recipients expect to use the funds to create or support 153 lending programs, ultimately fostering up to $18.7 billion in new private financing and investment. All but two states applied for the funds, and all were approved.

Perhaps most helpfully, the SSBCI is designed specifically to help generate nontraditional loans. California, which in October 2010 received $168 million (one of the largest tranches) in SSBCI funds, is channeling them through two programs in the form of loan guarantees. One of the programs, the California Small Business Loan Guarantee Program, is available for nearly any company that is considered “near-bankable.” Loans (which go to California-centric businesses) can range from $5,000 to $2.5 million, and include companies with up to 500 employees.

The state’s loan-guarantee program existed before the SSBCI was launched, says program director Merrill Stevenson, but “had pretty much gone dormant” in 2009. With the fresh infusion of funds, the program (propelled by local financial development corporations, or FDCs, that advocate for the companies) had convinced banks to make 110 loans through the end of 2011, and is hoping to hit 200 in 2012. “A lot of banks are hesitant about getting back into lending, but FDCs are working with them and that’s helping,” says Stevenson.

Other states are using the money, in part, to set up venture funds. Missouri, for example, has used $16.9 million of its $27 million in funding toward a state-run VC fund that has already invested $7 million in 18 small businesses, according to Treasury Secretary Timothy Geithner’s October testimony to Congress.

Since the government has not yet set up a reporting system for this program, and since much of the money was only recently disbursed, little is known about its progress. The ambitious multiplier effect is one likely future disappointment; the GAO report noted that some recipients “expressed concern that achieving a 10:1 leverage ratio of private financing and investment to program funds could ultimately prove challenging.”

How to get it: The funds are mainly administered by state-sponsored economic development agencies, so start your research at the state level (and, in a handful of cases, at the municipal level). Some of the programs, like Missouri’s venture fund, have standard application cycles with universal deadlines; others are more ad hoc.

Small Business Administration Loans
The longest-standing federal program to aid small-business lending has had several good years, in part due to the same Small Business Jobs Act of 2010 that created the SBLF and the SSBCI. At the moment, though, it seems to be taking a hit, with the number of SBA-backed loans down about 50% in the last quarter of 2011, compared with the same quarter of 2010.

It’s not that the SBA is being cheap. Andrew McCune, an attorney with McDermott, Will & Emery who helps arrange SBA financings for clients, says he has never seen the SBA so proactive at trying to educate the marketplace on its offerings and, in some sense, sell them to banks. (The SBA generally guarantees the vast majority of a loan that a bank deems risky.) But, as Nexgen’s Manson notes, many banks are averse to even the hint of risk these days, and the guarantees do not change their minds.

One frustrated former CFO who has been pursuing an SBA-backed loan in the hopes that it will allow his company to acquire a small, profitable business in the Houston area says the program’s inflexible criteria are obstructing his progress. “While money is available, the terms are so severe that it is next to impossible to qualify,” he says. (He asked that his name not be used, as he hopes to work with the banks in the future.) One example: the bank will consider only tax returns from the selling business, and not the interim results, which show 40% growth this year. It also won’t allow for adjustments to back out the current owners’ personal expenses and reflect its higher real cash flow.

Collateral is another problem; the banks require it, “but will not utilize the existing $700,000 in inventory or receivables as collateral,” since they deem it unsellable, says the former finance executive. Instead, they want a lien on his house. (The SBA website notes that it “will generally not decline a loan when inadequacy of collateral is the only unfavorable factor,” but for all SBA loans, “personal guarantees are required from every owner of 20% or more of the business, as well as from other individuals who hold key management positions.”)

One potential ray of hope emanating from the SBA is the increase in other types of funding the agency is promoting, beyond standard bank loans. The agency’s budget indicates it is aiming to make more microloans available to “unbankable” entrepreneurs, while it is also crafting a new venture-like program. Parallel to all of that is the increasingly successful SBIC program, which lends money to private-equity firms at low rates for middle-market financing.

How to get it: The list of SBA lenders is on the agency’s website (www.sba.gov). It’s also worth poking around the byzantine site for some of the lesser-known alternatives.

Large Banks: Ready and Willing?
Government efforts aside, how easy is it for smaller companies to get a conventional bank loan or line of credit these days? The answer largely depends on whom you ask. Multiple sources indicate that credit is still tight for smaller companies. Between Q3 2010 and Q3 2011, the majority of finance executives polled in our Duke University/CFO Magazine Business Outlook Survey said they found borrowing to be about the same or slightly more difficult. Few said it was much more difficult, although those who did were concentrated in the under–$100 million revenue range.

Executives at the biggest banks counter that they are, in fact, aggressively seeking to lend to smaller companies. “We are all extremely motivated to extend more credit [to smaller businesses], and our people are very focused on it,” says Robert Hilson, head of Bank of America’s small-business segment, targeted at companies with up to $5 million in annual revenues. The dollar volume of new originations (including
credit-card-based debt) to such companies increased 21% last year, he points out, with loan-approval rates doubling in the past 18 months.

That growth has been bolstered by an internal reorganization and the presence of 700 newly hired small-business bankers in branches across the country. “We’ve always had people in our branches available to talk small business, but to be fair, we did not have the level of expertise in those banking centers that we have today,” Hilson acknowledges. Such bankers still don’t make the final decisions on loans, but “at the end of the day, they get paid for making good loans.”

As far as credit standards, “I don’t want to say our credit standards have loosened,” Hilson says, but the improving economy is allowing loan officers to be “more accommodating” and look at variables like future orders and interim reports along with historical financials when assessing a client’s ability to repay.

The same trend holds true at Wells Fargo, which saw new lending to companies with under $20 million in revenue rise 8% last year, to almost $14 billion, including a 40% spike in SBA-backed 7(a) loans for federal fiscal-year 2011. What drove the increase? “The quality of applicants has improved,” says Marc Bernstein, head of Wells Fargo’s small-business segment.

He sees the decline in lending over the past several years as a function of several factors. When the recession began, many businesses were carrying high levels of debt and faced declines in sales that made it harder to obtain additional credit. During the recession, “it’s not as if we required something dramatically different, it was that the businesses coming in looked weak,” says Bernstein. Now, loan approval rates are “the same as they were before the recession.”

Those claims are supported by data from the Thomson Reuters/PayNet Small Business Lending Index, which measures the volume of new commercial loans and leases to small businesses. It was up 18% in 2011, hitting a four-year high in November (when the annual statistics were compiled).

The situation is frustrating, to be sure: piles of money (including hard-earned taxpayer dollars) are parked at banks, while many businesses starve for lack of funding. In the end, despite the positive statistics at the macro level, many individual companies are left feeling that they still can’t get the money they need. In the not-too-distant future, the federal programs may live up to their lofty potential and create enough competition to spur banks to lend more readily. That certainly hinges far more on what’s happening beyond the banks’ vaults and approval systems. Says McCune: “Once there is more confidence in the economy, there is extraordinary liquidity available.”

If things go well, that could be the understatement of the decade.

Alix Stuart is a contributing editor at CFO.

http://www.cfo.com/article.cfm/14620354?f=search

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This article is part of our series onSelling Private Companies. In this post, we review the various techniques a business owner can employ in approaching buyers when selling their company, the pros and cons of the different techinques, and provide some recommendations based on AxialMarket’s observations working with hundreds of private mid-sized businesses.

When you decide to sell your company as an owner and/or management team, one of the first things you will want to do is begin researching and building a “Buyer List”. The Buyer List is a list of corporations, investment firms and individuals to be approached during the M&A sale process. As we discussed in “5 Major Differences Between Strategic and Financial Buyers“, potential buyers fall into two primary categories:

1. Strategic Buyers — These are operating companies that provide products or services and are often competitors, suppliers or customers of your firm. They can also be unrelated to your company, but looking to grow in your market to diversify their revenue sources. Their goal is to identify companies whose products or services can synergistically integrate with their existing business.
2. Financial Buyers — These include private equity firms (also known as “financial sponsors”), venture capital firms, hedge funds, family investment offices and high net worth individuals. They are in the business of making investments in companies and realizing a return on their investments.

Once you have researched and built the Buyer List, a key decision is to determine how many buyers you will approach and whether you will employ a sequenced or parallel process. There are three general techniques:

• Serial Approach/Negotiated Sale: You identify and contact the most logical potential buyer(s). You approach one buyer at a time and negotiate exclusively with that buyer. If unsuccessful, you approach the next party and continue to work your way down your list until you find a buyer.
• Targeted Auction: With this M&A process, you discretely contact a limited number of potential buyers. Typically, you will approach between 5 and 20 buyers, solicit indications of interest, and then negotiate with the most appropriate and interested buyers.
• Full Auction You identify and contact a broad universe of potential buyers. Strategic buyers will include firms that are your competitors, suppliers and customers. It will also include “creative” strategic buyers that are not currently operating in your industry. In terms of financial buyers, you will go out to a sizable number of investment firms and executives with the financial wherewithal to buy your company.

Each approach has strengthens and weaknesses. The strengthens of the “Serial Approach/Negotiated Sale” or “Targeted Auction” include reducing disruption to your business and limiting the chances of confidential information leaking out.  However, we have observed that those sellers who initially identify and approach a more thorough universe of qualified buyers are more likely to have a successful sale process. While certain circumstances can uniquely call for the limited approaches, they are very risky for business owners. The reality is that there are a tremendous number of considerations that a buyer is making when deciding whether or not to make an offer for your business. Many of these considerations can have nothing to do with your actual business.  For example, perhaps you approach the ideal financial buyer only to realize that they are raising capital for their next fund and can not get the deal done; or you approach the perfect strategic buyer but their CEO is focused elsewhere or still integrating a recent transaction.

Important things to consider in a sale process are:

• You Never Know For Sure Who the Buyer is Going to Be. Buyers’ investment decisions are influenced by many factors, many of which you will never fully know. In all the sale processes we have been involved in, only a small fraction of the time does the initially identified “perfect” buyer end up being the actual buyer.
• Time and Effort Required to Prepare is Constant. To realize the best outcome in a sale process, significant time and effort is required. You have to think strategically and critically about your business. You have to gather legal and financial information, assist in the preparation of marketing materials, build your forecasts and upload documents into a data room.  You have to emotionally prepare for the roller-coaster ride of the sale process. All of this is required whether you are approaching 1 potential buyer, 10 buyers, or 100.
• More Potential Buyers Usually Means More Options. As we discussed in “10 Consideration Other Than The Purchase Price“, there are many terms and issues other than purchase price which are crucial to negotiate in a business sale. Different buyers will often propose different structures and bring different strengths and weaknesses to the table. By having more options, you increase the likelihood of finding a buyer and deal structure that fits all of your goals.
• Full Auction Process Reduces Chance of Deal Fatigue. When employing limited approaches, sale processes tend to drag on. The management team and advisor are negotiating with one or two parties at a time and it is difficult to build momentum. When buyers see an opportunity and are excited about it, you want to build off of this initial enthusiasm. As time passes, other opportunities will come across their desk and their interest in your company can fade. By building a sufficient buyer list and keeping to a schedule of well-known milestones for preliminary and firm indications of interest, you generate momentum in your sale process and avoid deal fatigue.
• Multiple Interested Buyers Leads to Price Discovery. Price and value are two very different concepts (you can find a discussion here, and we will be covering this topic in an upcoming posting). Different buyers can have differing views on the value of your company. In turn, they will be willing to pay differing prices. You may or may not like what you hear, but the more potential buyers you hear from, the better you will know what the market believes the current price of your business is.

Selling a business is a serious and complex process.  While managing multiple buyers can be challenging, it is necessary to give yourself the best chance of closing a successful deal.

What is the right number of buyers to have on your Buyer List? It depends on your situation. We advise to err on the side of more than less. In the end, it is not about knowing the perfect buyer when the process begins. It is about finding the right party that will structure a transaction to fit your particular needs and ensure your business is positioned to thrive in its next phase.

https://www.axialmarket.com/blog/2010/7/how-many-buyers-to-approach-selling-your-business/

SUCCESS MAXIMS

–Part 15–

Doers

(Theodore Roosevelt, April 10, 1899)

It is not the critic who counts, not the man who points out how the strong man stumbled or where the DOER of deeds could have done them better.

The credit belongs to the man who is actually in the arena;

Whose face is marred by dust and sweat and blood;

Who strives valiantly;

Who errs and comes up short again and again;

Who knows the great enthusiasm, the great devotions, and spends himself in a worthy cause;

Who at worst, if he fails, at least fails while daring greatly;

So that his place shall never be with those cold and timid souls who know neither defeat nor victory.

Buyer beware:  If a company is “troubled”, it’s probably for a multitude of reasons.  Don’t attempt a turnaround in an industry you’re unfamiliar with — this is not a learning situation.  If you have little experience in that company’s industry, it will be very difficult to make the immediate decisions that are vital to returning the company to viability.

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8 Steps to Acquiring a Business

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How Patents Impact Business Valuation

As I often tell business leaders who attend my course, Valuing Early-Stage Technologies, valuing patents isn’t rocket science. It is much more difficult. Or to paraphrase Winston Churchill, valuing patents is a riddle, wrapped in a mystery, inside an enigma.

Measuring even a well-delineated permanent entity is much more difficult than may be imagined. As Neil deGrasse Tyson (a renowned astrophysicist) and Benoit Mandelbrot (the father of fractal geometry) have discussed, no one really knows what the circumference of the coastline of the United Kingdom is. The tides will cause varying degrees of erosion on the coastline depending on the hour of measurement, while the cumulative affect of choosing which rock formations to measure around will have a dramatic impact on the final assessment of circumference. Patent valuation is infinitely more difficult to determine than the measurements of a given land mass due to the interminable variation of underlying technologies, legal issues, business issues, and context in which patent valuations are conducted.

Companies that have patents often attempt to achieve a more attractive valuation by boasting about their patent portfolio. This is often a successful gambit as many investors, customers and media figures are impressed when a company reports a relatively large number of patents or pending patents in its portfolio. Thus, it is no surprise that many entrepreneurs and venture capitalists have admitted to me that they view patent preparation and filing costs akin to marketing expenditures.

Source: IncreMental Advantage research

However, valuation analysts should not reflexively assign a higher valuation to companies that own patents or are applying for patent protection. Companies can have a patent on a technology for which there is no possibility of commercializing or selling. Patents pending are particularly specious. Pendency (the length of time it takes the US Patent and Trademark Office to make a decision on a patent application) is now an average of 32 months. In some industries—such as semiconductors and electronics—pendency is more on the order of four to five years. Thus, the market targeted by a patent could become obsolete before the USPTO makes a decision. In fact, only between 2% and 5% of patents generate any royalties and another 45% to 50% don’t even have any strategic value. Further, two out of every three patents lapse because of failure to pay fees, most often because their owners believe that the thousands of dollars in maintenance fees exceeds the value of the patents.

What is a Patent?

It is first necessary to dispel a few of the common misperceptions revolving around the definition of patent. A patent is certainly not a right to a monopoly. Inventors can design around a patent by producing another technology that yields the same effects. Having a patent that becomes incorporated into a commercially successful product doesn’t always provide substantial profits to its owners. (The patent may generate nominal royalties because of its minimal value added to the end product or its early stage of development may require significant future investment on the part of the licensee.) A patent is simply a license to exclude anyone else from reproducing the same effect by applying a specified process during the time in which the patent remains in force. Similarly, patents can be viewed as merely instruments that grant their holders the right to sue alleged infringers.

What makes a patent vulnerable?

One reason that valuation professionals should not over-rate a patent is that the patent could very well be deemed to be invalid. Roughly 50% of the patents that are litigated are held to be invalid. Simply granting of a patent by the USPTO does not ensure patent validity. There is no way that one could expect patent examiners to only issue patents that would invariably be ruled valid during litigation. On average, patentees spend less than $10,000 on legal fees in connection with the drafting of their patents and patent examiners dedicate an average of 11 hours of review per patent application. Less than $10,000 in legal services and 11 hours of an examiner’s time can never withstand the $7 million average cost of litigation (that is expended in patent cases where more than $25 million is at risk) and thousands of hours of effort by locked-on lawyers dedicated to defeating a patent. In fact, the only way that a patent’s validity can be proven is through litigation. Determining which patents will be ruled valid is very tenuous: validity often hinges on the interpretation of seemingly common words such as ‘when’ and ‘either’. ThinkFire’s database of 309 deals collected between 2002-2008 indicates a median price per patent family of $112,000 and a mean price of $383,000.

Summary Results

Source: ThinkFire as delivered by Lew Zaretzky at the BCLT Seminar

Another major reason that patents are vulnerable is that patentees often cannot afford to assert their rights. With litigation costs on the order of $7 million, few solo inventors or small companies have the financial resources or managerial bandwidth to challenge infringers. If the suspected infringer is a large company, it can usually threaten the plaintiff with a countersuit as these parties may be violating one of the defendant’s patents.

It is this vulnerability that is a significant factor behind license brokerage rates (the rates realized when selling patents) ranging in a seemingly insulting band of between one and ten percent of the anticipated cumulative licensing fees. Buyers can acquire a patent for as little as one percent of the royalties that such patent is expected to produce because there are risks of the patent being ruled invalid immediately after the acquisition transpires, or there could be an injunction imposed on a product that incorporates the patent which would cause associated revenues to dry up.

This featured guest post is written by David Wanetick, Managing Director at IncreMental Advantage, a strategic advisory firm. He leads all of the firm’s Devil’s Advocacy Audits. He teaches courses on Negotiations, Behavioral Economics and Decision Making at The Business Development Academy. David can be reached atdwanetick@incrementaladvantage.com.

SUCCESS MAXIMS

–Part 14–

Affirmations

(by Thomas Jefferson)

• Never put off till tomorrow what you can do today.
• Never trouble another for what you can do yourself.
• Never spend your money before you have it.
• Never buy what you do not want because it is cheap.
• Pride costs us more than hunger, thirst and cold.
• We seldom repent having eaten too little.
• Nothing is troublesome that we do willingly.
• How much pain the evils have cost us that have never happened!
• Take things always by the smooth handle.
• When angry, count ten before you speak; if very angry, a hundred.

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http://www.gallup.com/poll/152654/Health-Costs-Gov-Regulations-Curb-Small-Business-Hiring.aspx