Acquisitions and private financings of technology companies present different risks and opportunities than traditional brick and mortar businesses. Due diligence and valuation in this environment require unconventional thinking.

Due Diligence in a World of Musical Chairs

Assessing risks and opportunities is one goal of the due diligence process. The right questions to ask revolve around the most fundamental question of all: What factors will most influence the ability of an innovative business to profit from its innovation? Our experience in working with such companies, as well as economic studies, point to several key factors.

One obvious example hinges on the nature of the company’s technology and how it has been treated. The less accessible the innovation, the better it is suited to capturing profits because imitation by competitors is less possible. For example, a process technology that has been well-guarded is not easily imitated by competitors. In contrast, a new product like the plastic hair-styling tool introduced in the early ’90s called the Topsy-Tail is easily imitated. This is an inherent feature of the company’s technology and of its methods of doing business, and it must be understood in the due diligence process.

Another important factor is the effectiveness of legal barriers to imitation. Without effective legal restraints, the free ride benefits that accrue to competitors and consumers can easily erode the profits captured by the innovating firm. The effectiveness of legal protections such as patents, copyrights, and trade secrets varies widely among industries and among different companies. In most cases, the strengths and weaknesses of these barriers are proportional to the effort of the company’s management to put these safeguards in place, and a hard look at this can be quite revealing. The due diligence team must fully understand the strengths and weaknesses of the legal barriers to imitation.

Another factor that influences long-run profitability is the degree of interdependence between the company’s innovations and the complementary assets needed to produce and/or market them. In some cases, these assets are quite generic and readily accessible, such as general purpose manufacturing and fabricating facilities. Where only generic assets are involved to produce and/or market an innovation, no one has an identifiable advantage, including the inventors.

As the manufacturing and/or marketing of the innovation becomes more dependent upon specialized assets, competitors who already own those assets have an advantage in reaping the profits from the innovation, often to the detriment of the innovator. Again, this factor is an inherent feature of the company’s business. It can be controlled to some degree through well-conceived contracts and business alliances, all of which should be vetted in the due diligence process.

Another question to consider is whether the technology has a dominant design paradigm. In the early stages of a new industry or new product, the designs are evolving, the production capital is of a general nature, and the manufacturing processes are adaptively organized. Eventually, the design competition begins to narrow the field to a range of dominant designs that revolve around only a few design paradigms. Competition begins to shift toward price and away from fundamental design alternatives.

An innovator operating in a pre-paradigm environment has tremendous opportunity but also runs considerable risk unless: (i) the business is protected against imitation by control over essential complementary assets; or (ii) the nature of the technology and the legal doctrines available to exclude imitation provides strong imitation barriers.

Without at least one of these safeguards, the innovator may invest large sums to perfect a design, only to have imitators modify the design slightly and seize a large piece of the market. As one economist put it: "When the game of musical chairs stops, and a dominant design emerges, the innovator might well end up positioned disadvantageously relative to a follower."

Valuation in a World of Change

Setting a fair price can be very tricky with new technology. Discounted cash flow (DCF) has been the dominant valuation method for decades. Its strength is that it approximates the real cash value of a company at any given time. One simply projects several years of a company’s future cash production and divides the result by a discount rate. In a company that is in a rapidly evolving business and depends on its intellectual capital and property, however, this sometimes doesn’t work. For most companies, knowing what any of these numbers will be next year is hard enough, let alone calculating them five years from now.

Recent articles in the Harvard Business Review, the McKinsey Quarterly, USA Today, and Business Week tout a more contemporary method — real options valuation — as a "revolution in decision-making." The focus is on options — decisions that are made after some uncertainties have been resolved. The classic example of an option is a call option on a stock that gives its owner the right, but not the obligation, to purchase a stock at some future date at an agreed-upon price. In real options, the options involve "real" assets, as opposed to financial ones.

The criticism of discounted cash flow analysis is that it reduces all uncertainties down to a single scenario and then adjusts them for risk by using an inflated discount rate. The problem with this approach is that by "boiling down all the possibilities for the future into a single scenario, DCF doesn’t account for the ability of executives to react to new circumstances — for instance, spend a little up front, see how things develop, then either cancel or go full speed ahead."

The key to valuing these options is to consider the uncertainty or "volatility" associated with the investment in the same way that Black, Scholes, and Merton did in their Nobel Prize winning work on financial options.

In the case of a technology-intensive company, the options afforded by its IP rights are important factors in the overall valuation process. The value of the IP rights of such a company is best measured using real options, recognizing that they are really an option to exclude certain forms of competition. The initial cost of the option is the cost of perfecting the legal rights. That investment provides the second option, which is the option of enforcing those rights against a would-be competitor.

Real Option Valuation – A Simplified Illustration

Consider an example of a company with a new wireless Internet device and a patent portfolio on that device. What is the value of that technology and patent portfolio? Although a full answer to the question requires more analysis than can be presented here, we can give a simplified version to illustrate the main ideas.

Suppose that the device is currently prohibitively expensive for the mass market, because it requires a new electronic component that is not yet widely available due to technical difficulties surrounding its manufacture. The company is presently engaged in research to resolve these technical issues. However, the company is not certain the research will be successful, as it will require certain scientific breakthroughs that may or may not happen quickly. They estimate that there is a 50 percent chance that the issues will be resolved and the device will be marketable at a reasonable price within two years, and a 50 percent chance that it will instead take five or more years. Moreover, in the latter case, we expect competing technologies to take hold in the meantime, rendering the company’s technology obsolete.

This information allows us to develop a tree diagram indicating the possible future scenarios, as shown in Figure 1.

Of course, in a real example, the tree would be much more complex, with a variety of current and future choices and scenarios. For example, each year there would be the decision whether to continue funding the R&D. During each year of delay, the potential market might decline, but rather than an all-or-nothing situation, it might be possible to still make some money marketing the device even after five years. Moreover, other sources of uncertainty, such as price, other costs, or demand, might be important to consider.

In general, the value of an option comes from the fact that it enables the holder to defer a significant investment to some future time when more will be known about the wisdom of the investment. In this case, the technology and patents give the company the right, but not the obligation, to market the device free of imitation at some future point in time. Were they to market it today, they would lose money, due to the prohibitively high cost structure, but in the future it may become cost effective. In this example, the value of the option will depend on the probabilities of the various outcomes as well as on the costs and revenues associated with each scenario.

In this example, as in all option situations, a single point-forecast like DCF will misvalue the option. By definition, options are worthless in a world of certainty, where you have perfect insight into what the future brings. Options become more valuable as volatility increases, or in other words, as the range of possible future scenarios gets wider.

There are other subtle points about valuing options. This valuation example assumes the company wants to maximize shareholder value. Although a shareholder is likely well diversified, the manager in charge of this specific project is not. The diversified shareholder expects some bets to pay off and some to fail. The manager’s whole career may be tied up in the success of this one project, so the manager may be significantly risk averse. As a result, the manager may undervalue the option and opt for an alternative project with lower total returns but greater certainty of success.

The full application of real option valuation to IP rights is complex and beyond the scope of this Technology Commentaries. Among other things, it requires a careful and realistic analysis of the strengths and weaknesses of the company’s exclusionary IP rights. For emerging technology companies, however, it may be the only appropriate method to learn the true value of the investment.

In short, the ability to profit from an innovation depends upon: (1) whether an industry paradigm for the product or process yet exists, (2) whether specialized or co-specialized complementary assets are required to commercialize the innovation, and (3) whether the nature of the technology and the legal tools to exclude imitations are strong or weak. Control over essential complementary assets can be arranged by contractual alliances or investments, and, likewise, the quality of legal protection can be influenced by careful management. The due diligence team, therefore, should give special attention to these two fronts.

 

This Technology Commentaries is a publication of Jones, Day, Reavis & Pogue and should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general informational purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at its discretion. The mailing of this publication is not intended to create, and the receipt of it does not constitute, an attorney-client relationship.

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