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Valuing the knowledge economy

Ask someone to name a few of today’s most exciting, innovative companies and they’ll probably suggest names such as Google, Nike, Apple, Amazon and Samsung. In a single generation these companies have become ubiquitous, made a huge impact on our daily lives and become major drivers of stock markets. One thing they have in common is extensive intellectual property (IP), in other words, their brands, trademarks, patents and copyrights.

It’s estimated that currently up to 80 per cent of stock market values are based on intangible assets. This compares to just 20 per cent in 1975, the year before Apple was founded. This remarkable difference reflects the fact that many companies in 2014 operate in industries with very little machinery or other fixed assets. Accordingly the observed company value must be attributed to intellectual assets such as brand value and other IP.

Most of the studies of the relationship between a company’s IP and its stock market performance have focused on blue chip stocks since they comprise the bulk of the major equity markets. Typically companies have been ranked according to the total number of patents filed or the percentage of their revenue they invest in research and development. The results of such studies have been generally inconclusive with as many patent-heavy companies underperforming as outperforming. It seems that measuring the contribution of IP to corporate value is not a simple numbers game.

As a result, researchers often fall back on anecdotal evidence that IP matters and there is a ready supply of case studies to support this idea. During the bankruptcy of Nortel Networks, for example, the company’s IP portfolio was auctioned for more than 48 times the closing value of the stock. The market it seemed had completely mispriced value.

The importance of IP is particularly apparent in the pharmaceutical sector, where the expiry of dozens of critical patents has wiped billions from the value of the industry over the past few years. On March 12 for example, Pfizer’s stock was suspended for 20 minutes on news that its blockbuster pain drug Celebrex would lose its patent protection 18 months earlier than expected. Pfizer stock closed down almost 3 per cent, a meaningful number for a company with almost $200 billion in market value. Event-driven market moves like this have meaningful impact for investors and may be magnified by tactically positioned hedge funds, but such impact is often short lived. An illustration of this is the bounce in Apple’s stock price following its successful $1-billion patent action against Samsung, now overshadowed by more strategic factors, such as its long-term future without Steve Jobs.

 IP itself does not generate shareholder returns, but the intelligent management of IP does

Many innovative companies with large and valuable patent portfolios have seen dramatic declines in stock price over the past decade. Among household names that suffered this fate are Nokia, Kodak and Motorola, with the latter eventually being acquired and dismembered by Google. EMI, The Beatles’ record company, owned a copyright library that was without parallel and yet it collapsed in 2012 to be broken up and sold. Legendary Hollywood studio MGM filed for bankruptcy in 2010, in no small measure the result of Ted Turner’s decision to remove the library of classic films, which later formed the kernel of TCM. Perhaps the most famous example is that of Marvel Comics, bankrupt in 1996 and sold to Disney for $4.2 billion in 2009 primarily on the strength of its IP.

So, given the evident importance of IP what explains the apparent lack of correlation between IP and stock price? The answer is clear – management. However impressive its IP might be, what really matters is how a company uses it. This involves developing, managing and protecting it.

Beyond the competitive arena of the world’s largest companies, IP has a critical impact for small and medium-sized enterprises (SMEs), a broad category that embraces startups and businesses with turnover approaching $1 billion. SME business models are often built on the ability to license their IP to larger companies or where in-house IP provides a competitive advantage. In this situation, patent challenge, third-party infringement or counterfeiting can significantly impact valuation and stock price. It may also create breach of covenant conditions attached to debt finance. Given the smaller headcount of SMEs, key staff are often repositories of valuable knowledge and, if they leave, their IP leaves with them. Another often overlooked risk is the inadvertent infringement by SMEs themselves, as their researchers operate within tight budgets and short time frames where IP management often takes second place to winning customers.

Those SMEs most vulnerable to an “IP shock” are those being floated on the stock market or undergoing a major change of ownership. When investment banks or private equity firms value the company or take management on a “roadshow” to meet potential investors, IP is frequently highlighted as a risk factor. An IP challenge during the pre-flotation process can derail the entire show. Twitter is perhaps the most famous recent illustration of this, paying IBM $36 million just ahead of its initial public offering in 2013 to ward off a lawsuit that might have had a valuation impact many multiples of the payment.

As technology plays an ever greater role in our lives, so will IP. Slowly but surely investment banking analysts are gaining a better understanding of this and company chief executives who can respond to the inevitable questions about their IP strategy will see benefits in their stock price. IP itself does not generate shareholder returns, but the intelligent management of IP does. This is evident when comparing the performance of Apple and Nokia or Canon and Kodak. Investors in each company have learnt the importance of aligning business and IP strategy – and each has a salutary story to tell.