The Correlation Between IP and Startup Valuations

The role that intellectual property (IP) plays in startup valuations is a critical issue for startups and investors alike. It can guide the IP strategy of a startup, as well as impact investment decisions and valuation considerations.  This article aggregates five of the most common questions that have routinely come up during my 25 years of working as a startup advisor and IP valuation expert in Silicon Valley, particularly in the software industry.  It can be used as a playbook for startups embarking on managing their IP portfolio to grow corporate value.

Can a startup develop a patent portfolio that will increase its overall valuation?

There are legal aspects to a company’s patenting strategy, and there are business aspects to that same strategy.  The legal side is best handled by lawyers, who can search and determine where patent protection should be pursued based on prior art and the patent landscape in the market.  From a business/valuation perspective, a patent portfolio will have value only if it is well-aligned with the assets that bring the most value to the business. 

The chart below (Exhibit 1) which lays out the typical intangible assets (technology, brand, data) one finds in a software company, and the types of IP rights associated with each types of assets, as represented by the lines connected assets to IP protection.

In companies where technology is the most valuable asset (usually correlated with heavy investment in R&D, such as pharma and biotech) patents can have more value compared with companies where the brand is the main asset (consumer or media products, as an example).  Similarly, in companies where data is deemed to be the most valuable asset (as is the case in many software companies), patents may have less value as the preferred mode of protection, since data cannot be protected by patents.  The underlying assets that bring value, such as brand or data, are often not subject to patent protection and are better protected by other types of IP, such as copyrights and trade secrets. 

Should startups prefer patent acquisition v. organic filing, as an efficient way to grow their patent portfolio?

Organic filing (i.e., filing to cover inventions resulting from internal R&D development) is the most straightforward way to procure patents.  However, since many startups are constrained by resources, they do not always prioritize patent protection, to a point where they can miss on a window of opportunity to protect their innovation.  The actual need for IP to support current products is usually met by internal (organic) filing and sometimes through an acquisition of an operating business holding the IP.  Under the current U.S. “first to file” patent regime, startups that show no organic patent growth may have lost the ability to patent a large portion of their core inventions due to missing key priority dates and may need to make up for it by buying patents (or companies holding patents) in response to competitive threats, spending millions of dollars in the process.  Google’s acquisition of Motorola Mobility for $12.5 billion in 2011 was primarily driven by the need to improve its IP position through a massive acquisition, in order to enter the mobile market.

A patent-only acquisition takes place usually as a result of a threat (or perceived threat) to the company’s freedom to operate (FTO).  There are several junctures where any company, and in particular a startup with an abnormally high valuation, is most vulnerable when having a weak IP position: entering new markets with established incumbents, and approaching an exit point such as an IPO (or M&A).  The kind of patents one can buy, as opposed to filing organically, are those that are available in the secondary market and those usually have value since there is some infringement associated with them.  In recent years we have seen a phenomenon often referred to as “backfilling” where companies buy patents to fill in gaps in their FTO, with priority dates that sometimes precede their founding dates; companies like IBM and AT&T have been oh the forefront of selling patent portfolios to startups such as Uber and Twitter, for purposes of backfilling their portfolios.

How are IP portfolios reported on the financial statements of a startup?

There is no place on the financial statements of a startup, or any company for that matter, where one can find the value of its internally-generated IP assets.  The accounting rules in the U.S. and around the world do not generally require companies to report the value of their internally-developed IP assets on the balance sheet.  In that regard, there is an IP reporting gap, which is exacerbated by the fact that IP transactions are highly confidential and not generally reported at all, or at any level of detail that would allow the creation of pricing databases that could aid in the valuation of similar IP assets.  Finally, even if there was full disclosure of IP transactions and pricing, the IP assets themselves are unique and it is not easy to find a direct comparison, particularly when it comes to patents.

Close up of keys on an old cash register

There are ways to fill in the gap, but they all involve engaging in a special valuation of the IP assets of the company.  This IP valuation is not going to be part of any business valuation because business valuations are not targeted at valuing assets separately.  In order for the IP valuation to be informative and realistic, the valuation itself needs to be preceded by a careful qualitative assessment of the assets, followed by a strategy phase, where the IP valuation firm is working with management to identify the possible monetization scenarios to be included in the valuation (more on that in the next question). 

Is there a specific patent valuation approach (market, income, cost) recommended for startups, and why?

The valuation approach selection is secondary in importance to the valuation context and scenario.  First there needs to be a determination whether the startup has created enough IP to warrant a separate valuation.  Something of value needs to have been created or accumulated and/or some IP protection needs to have been secured around these assets. The next question is: what is the business model of the startup, and what IP assets bring the most value in that context?  Then comes the question of how the IP assets bring value to the startup, which would prescribe the valuation scenario.  And only after all of that has been determined, comes the question of the valuation approach and method. 

When it comes to the valuation of patents, as a matter of practice, I find that in many cases involving startup companies, the market approach is very frequently applied.  This valuation methodology is based on comparable patent transactions, which can be gleaned through patent transaction databases and other public disclosures. The application of the income approach – based on the out-licensing opportunities associated with the patents – depends on the ability to create reliable projections of addressable markets.  Given the fact that startup patents are usually young patents, they often do not have an enforcement potential (since infringement usually occurs in mature markets where the patents have been out long enough to capture existing products) and any licensing potential entails a technology transfer type of model, involving licensing the patent into future products that do not currently exist.  This type of modeling is most commonly used when valuing IP for equity or debt funding purposes.  In my practice we have developed a valuation metric called the Potential Value of Addressable Markets (PVAM) that allows a startup to demonstrate to investors the full value of the IP on a licensing basis, that is not constrained by the startup’s ability to include the IP in its own products.  Finally, the cost approach is generally not suitable and is very rarely used, in patent valuations. 

Has the United States Supreme Court’s decision in the case of Alice Corp v. CLS Bank (2014) had a significant impact on software company valuations and exits?

The Alice decision of 2014 is one example of recent Supreme Court decisions, coupled with other developments at the USPTO following the America Invents Act (patent reform) of 2011, that have generally created ambiguity and uncertainty with regards to subject matter eligibility and the overall validity of patents covering software inventions.  In the Alice case, the Supreme Court ruled that an abstract idea does not become eligible for a patent simply by being implemented on a generic computer. There is strong evidence from the patent transactions market showing a devaluation of software patents and a significant slowing down in trading in these assets following the Alice decision and related developments.  That being said, the correlation between these developments and software startup valuations and exits is not an easy one to draw.  For once, as our research shows, many of the Unicorns (pre-exit startups with valuations of $1 billion), 75% of which are in the general Software area, have managed to grow their valuations into the billions of dollars without having any material patent holdings.  One might argue that the Alice decision had something to do with the lack of patents, others might argue different reasons.  Since there is strong evidence that startups can grow into billions of dollars in valuation without patents, and some of them even managed to exit in a successful IPO or acquisition, I would argue that the Alice decision has little to do with software startups valuations and exits.

Efrat Kasznik is president of Foresight Valuation Group, an IP valuation strategy and consulting firm based in Silicon Valley. She has over 20 years of experience consulting on the creation, commercialization, and valuation of intangible assets including testifying as an expert in disputes involving IP and startup valuations and damages. Kasznik is a lecturer at the Stanford Graduate School of Business, and she has been recognized as one of the top IP strategists in the world by Intellectual Asset Management Magazine every year since 2013.