Valuing intelligence

On March 2005, Research in Motion, the Canadian maker of the wildly successful Blackberry wireless business, was forced to pay $450 mn to settle a patent infringement suit. The dispute with NTP, a Virginia patent company, began in 2002 and some intellectual property (IP) experts believe Research in Motion could have put the case behind it at the outset with a far more modest payment. 

Given the increased unwillingness of US courts to defer to the business judgment rule that has long protected directors and management, some experts argue that a similar case against a US company could serve as a major wake-up call for boards of directors. The question: Did directors exercise proper oversight of the company’s IP assets? 

‘Research in Motion is a Canadian company, but it is quite conceivable that a Delaware court could deny a motion to dismiss from a US company facing a shareholder suit. Or the company’s directors could be at serious risk of exposure were the variables the same as in the Research in Motion case if the plaintiffs could show there was a failure to exercise due care that rose to the level of gross negligence or bad faith,’ says Robert Greene Sterne, who founded Sterne, Kessler, Goldstein & Fox, a Washington, DC-based IP law firm. 

Sterne’s point is that there is a significant lack of attention being paid to IP assets at the board level. He’s not the only one raising the issue. Consider a 2005 survey conducted by Foley & Lardner LLP: 86.4 percent of general counsels surveyed did not know how their companies value IP, while 41 percent weren’t sure if the appraised value of IP is accounted for in the company’s balance sheet. 

Those are troubling statistics, considering intellectual property assets often represent a huge portion of a company’s valuation in the marketplace. 

The valuation gap

One reason IP value is so poorly understood is companies do not need to account for it on their balance sheet, at least not unless the IP assets are purchased through an acquisition or merger. 

‘If a company develops in-house IP assets, those assets are not represented on the balance sheet. That is why a large portion of the companies’ value is not on the financial statements. Most of that unreported value is intangible assets, from brand to IP. In most instances, companies don’t care what their IP is worth. What they care about is how much revenue they can generate off it,’ says James Rigby, managing director of Financial Valuation Group, a financial consulting firm specializing in business, IP valuations and litigation. 

The problem is that it can be very difficult to value IP and intangible assets and put a dollar value from a financial perspective. 

‘If you’re licensing patents, you have a cash-flow valuation methodology. Without that measurement, it’s not a very clear-cut process. We all have a perception that some of the IP is valuable. Some companies have an active licensing program and they derive a lot of revenue from patents, but for companies not in that category, including our company, you don’t have a dollar value associated with your patents,’ says Perry Tarnofsky, vice president of legal affairs at Powerwave Technologies. 

Rigby agrees that valuing IP is a difficult business, especially as IP represents different values to different people. His advice is consistency of methodology: ‘Whether it’s purchased IP or internally generated IP assets, you have to use the same valuation methodologies to be consistent. Measuring against your peers is a key component of the valuation process.’ 

Jeffrey Fialko, a partner at Ernst & Young, says that despite the inherent difficulty of valuing IP, he’s seeing an improvement in the quality of the valuation. ‘As a part of our audit procedures, we review the allocation of purchase price for IP, and I think companies are getting much better in this area,’ he says. ‘Of course, many companies are seeking outside consultants to provide a valuation and assist with purchase-price allocation. We often suggest that a company get a third party to value IP. It depends on the size of company and level of sophistication, as some of the larger more technology-driven companies can do it internally.’ 

Board oversight

Despite the importance IP represents to companies, many boards fail to pay sufficient attention to the management of their IP assets. 

‘There’s really little discussion about IP within the boardroom. Boards of directors need to worry about their IP assets not only when they have a dispute or infringement, but all the time since it is often a very valuable corporate asset. Directors have to be asking management questions about the IP. What are IP industry trends? How are we managing the IP assets? How are we [encouraging] our top inventors and innovators, and what are we doing in terms of the IP assets that we have? Are we maximizing our IP return on investment?’ says Sterne. ‘It sounds like it should be just a management issue, but effective boards need to ask the questions as well.’ 

‘Ultimately, boards have a fiduciary responsibility for the oversight of their IP. The NTP v Research in Motion case should be a wake-up call with respect to the potential magnitude of judgments for IP infringement. The company was blindsided with a massive judgment,’ adds Trevor Chaplick, a partner at Wilson Sonsini Goodrich & Rosati, who with Sterne co-authored ‘Why directors must take responsibility for intellectual property’ in the February/March 2005 issue of Intellectual Asset Management Magazine. 

Chaplick believes boards have a duty of oversight for IP, but that directors often defer too much to management and don’t bother to review how IP is being managed. ‘The fact is IP represents a significant portion of a company’s valuation, particularly for technology companies. IP cases can move quickly, and a company can face disastrous consequences if [it’s] found to have infringed upon a patent.’ 

Sox implications?

IP consultants arguably have a vested interest in highlighting the potential risk for boards when it comes to IP management. But with today’s heightened visibility of boards, the more stringent regulatory environment, a far more aggressive group of plaintiffs and the willingness of courts to allow more shareholder suits to proceed to trial, more and more companies are listening closely to what IP consultants have to say. 

While Sox and more specifically, Section 404, do not provide expressly any new specific burdens on companies when it comes to IP oversight, Chaplick cautions it should not be cause for complacency. ‘Given the increased scope of internal control requirements under Sox, it may be easier for plaintiffs to demonstrate a breach of fiduciary duty if material weaknesses existed in a company’s internal controls with regard to IP.’ 

The flip side, he notes, is equally problematic. A board that designs oversight responsibilities that lead to excessive documentation of procedures may unwittingly make it easier for plaintiffs to demonstrate that a board failed to meet its own internal responsibilities. For those trying to create a framework for IP oversight at the board level, the task represents a difficult balancing act. 

‘We are a software company, so we only have IP. That makes us inherently more aware of IP concerns, because if we don’t aggressively protect our IP, we have nothing to sell,’ says Linda Wackwitz, executive vice president, chief learning officer and secretary at Quovadx. 

The company has what Wackwitz describes as ‘strong controls’ when it comes to activities where the company is directly gaining revenue from its IP, such as licensing and software. But she says there is more work to do. ‘One of the things [Sox] and the emphasis on internal controls has alerted me to is that we need to tighten our controls in some respects, such as with inbound licensing.’ 

To strengthen those internal controls, Wackwitz plans to establish audit procedures and policies around copywriting, open-source software and policies about periodic audits. ‘Every once in a while bringing in an outside adviser might be a component. I’m considering doing that every couple of years,’ she explains. 

Andy Sherman, senior vice president, general counsel and secretary at California-based Epiphany, views IP protection and strategy as an increasingly important area of oversight for board members. In order to properly oversee IP, he argues that boards need to ensure companies maintain a comprehensive and proactive IP valuation program that includes a high-level resource responsible for the program. 

‘The board should be satisfied that the company is taking the necessary steps to identify, monitor and protect its IP assets to ensure continuity of the business, and to preserve and enhance the company’s competitive advantage that stems from its key IP assets. To accomplish this, someone with authority in the organization must make sure the IP program has the right attention and resources,’ he says. 

At Epiphany, that role falls to Sherman. At larger companies, particularly those with a large IP footprint, there may be a need for a designated professional. For example, IBM has been a trendsetter with its IP portfolio that is overseen by a vice president of internet strategy. 

‘It really depends on the scale of the IP program. You need the right personnel and consultants to ensure you have the proper level of knowledge and expertise to develop a strategy that utilizes your IP tools in the most advantageous way. There must also be continuous monitoring of your IP program, and you need to enforce your IP rights zealously.’ 

‘One of the interesting things that has happened since Enron is that a lot of liability is shifting to boards. Liability from areas we didn’t expect, including IP,’ says Wackwitz. 

Whether or not we witness an example of a board suffering the consequences for breaching its fiduciary duty with regard to IP oversight remains to be seen. But in today’s environment one thing is certain, no one wants to become that case study.