IP Value in Bankruptcy
IP and the Bankruptcy Context
The notion that Intangible Assets (“IA”), and particularly Intellectual Property (“IP”) are an increasing proportion of total corporate assets is relatively undisputed by now. Industries such as pharmaceuticals, communications, and media are the clearest examples of this phenomenon. Pharmaceutical products depend on patent protection to establish a degree of niche monopoly to raise prices and recoup extraordinary investment costs, and patent offices across many jurisdictions routinely restore to patent owners the term lost to slow approval processes. Compatibility across diverse communication devices produced by otherwise competing manufacturers relies on standards and the pooling of patents embodying them. Media companies increasingly depend on controlling content, i.e. copyrights, rather than specific communication media, such as newspapers, television stations, etc.
At appropriate stages in the economic cycle, stock analysts justify apparently excessive price-to-earnings ratios by attributing the incremental valuation to the un-reported value of internally generated trademarks, patents, and intangible assets in general.[1] This is a widely shared notion, but it is not the best way to measure the value of a corporation’s IP, as evident by the consequence that it leads to an apparent evaporation of IP values in the subsequent and unavoidable bear markets as the book value of tangible assets is assumed to remain constant.[2]
Despite these difficulties, it is clear that most businesses find value in the characteristic adaptability and flexibility of: trademarks – which can be extended or licensed; patents – which can also be licensed and traded; and intangible assets in general. By contrast, tangible business assets can be quickly be in the wrong location, the wrong scale, using obsolete or noncompetitive production processes, and specialized in making outmoded products with few or very expensive ways to re-locate, re-tool, or sell.
Correspondingly, in corporate bankruptcy processes (restructuring and liquidation), intellectual property assets have been gaining in recognition as some of the most flexible, salvageable, and consequently most value assets the debtor possesses.
From an economic perspective, the bankruptcy process can be thought of as a set of laws providing for the regulated transfer of debtor’s assets to creditors in order to settle claims. Consequently, the debtor’s assets and liabilities must be valued, in a mutually and legally satisfactory way, to arrive at the appropriate transfer ratio between the parties. This is an eminently administrative process, not a freely negotiated transaction in a competitive market. Intangibles, furthermore, are typically unique and have few, if any organized secondary markets which can provide arm’s length prices to establish values as they do for financial assets.[3]
Therefore, the bankruptcy valuation process must be carried out in a context of competing interests, under a necessity or compulsion to sell/buy, while ensuring all available, relevant, and valuable assets are taken into consideration. In the 21st Century, intellectual property has thus emerged as a significant, relevant, viable, and valuable asset class which can settle an increasing proportion of the claims and supporting, in some cases, the possibility of restructuring the original business retaining a substantial proportion of its value.
In the general area of IP and intangible assets, in the face of the increasing need noted above, the fact that generally accepted accounting principles (GAAP) do not reflect internally-generated assets such as trademarks, patents, and other intellectual property is an obstacle. At the outset, therefore, it is difficult to determine with certainty what IP and intangible assets the debtor actually owns and, moreover, what their book values were on the eve of filing. Nevertheless, Acquired IP and certain types of intangibles have been recognized in GAAP financials as a result of the implementation over the last few years of FASB’s statements 141 and 142, as well as the international IFRS-3 standard.[4]
In practice, simple ratios and arbitrary “rules of thumb” have been used to fill this information gap, and closure, liquidation, financing, and restructuring decisions have been made on this incomplete basis. In the current environment, these practices are no longer acceptable, and the prevailing standard tends to include a specific audit of the IP and intangible assets, with appropriately wide variations among industries and the size and length of corporate history of the debtor.
Quality, Hierarchy, and Value
The intangibles a business entity undergoing the bankruptcy process possesses must be closely examined to determine realistic prospects for their monetization. The first consideration in this process is the performance of an IP inventory, whereby the basic questions as to the status of all registrations and applications are answered and licensees, licensors, as well as all other relevant intangible assets are clearly identified.
Business executives and their advisors must then refer to this inventory list and segregate core and peripheral assets. Core intangibles are those that are truly necessary for the continued operation of the line, or lines, of business which make up the core competency of the debtor. Over time and through M&A activities, the intangible inventory of most major companies gathers unused, obsolete, and redundant assets which must be identified as such. All non-core assets have a supporting role to play for the restructuring or liquidation of the bankrupt company and, as peripheral assets, their main characteristic is their separability from the core activities.
A clear example of this classification came up in the bankruptcy of a major innovator which had been developing chemical compounds for many years, prosecuting patents diligently, but only advancing some of these compounds into their core product.[5] Some of the patents that did not make it into the company’s core product were also bundled with brand names, which had trademark registrations, and extensive scientific documentation which would inform their best uses in other applications. From management’s perspective, at the outset the monetization of any IP seemed doomed because their core product and technology had suddenly become obsolete in the context of rapidly advancing technology, and due to a major breakthrough in the company’s main line of business. After a comprehensive IP audit, however, the patents, trademarks and trade secrets classified as peripheral assets not only had a higher fair market value than the core IP, but were enough to satisfy the majority of creditors’ claims in the case. Years after, the core trademark assets remain a valuable and active asset in the global economy, and several applications in disparate chemical industry segments have benefited from the technology identified and monetized as peripheral assets of the original company.
In general, therefore, there are two dimensions to the IP inventory process: a qualitative audit; and a strategic review. The qualitative audit aspect of the IP inventory deals with the comprehensive examination of the intangibles the company owns, the classification of the assets in the basic core/periphery framework, while the strategic review is concerned with identifying alternative users, industries, processes, and exploitation methods for the assets, particularly those in the periphery.
Significant value can be uncovered by this process, whereby IP specialists work closely with the appropriate members of the management team at the debtor company, and perhaps other analysts from the appropriate advisers in the process.
By: Fernando Torres MSc
[This is an excerpt of a chapter in the book Corporate Intellectual Property Management in the 21st Century, Wiley 2010, email us for further information. ]
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[1] Since U.S., and international, generally accepted accounting principles (GAAP) do not allow for the reporting of internally-generated intangible asset values, it is only through acquisitions that the market value of intellectual property is recognized in the balance sheets of publicly-traded companies.
[2] It also assumes that market participants value stocks based on their (assumed) accurate value assessment of the (un-observable) intangible assets used in publicly-traded companies.
[3] In the aftermath of the real estate bubble, however, so called financial “toxic assets” had no easily discernible prices, contrary to the assumptions at their creation and issue.
[4] The new accounting framework for business combinations requires acquiring entities to perform a detailed purchase price allocation that segregates the values attributable to trademarks and other IP from general “Goodwill,” which has long been the “catch all” term reflecting the excess of total consideration paid over book value.
[5] The debtor in this case is a well-known brand which has undergone several restructuring processes and is now a pure trademark licensing organization, no longer manufacturing products.