Investment in the Intellectual Property Driven Firm and Required Rates of Return
Laine Simpson1, Principal and Director, ENPRIS Pty Limited
What do you, as a manager need to provide to your shareholders as a return from their investment in the intellectual property (“IP”), or more widely intangible assets (“IA”) of your firm? Is it 10, 20, 50%? Can a shareholder diversify its investment in IP (for instance, across the firm) or will the shareholder price its investment on a non-diversifiable basis?
Starting from fundamentals, the return that an angel investor would like from an investment in IP is very different than that sought by a large public company. Adding to the complexity is the question of how a leveraged buyout firm or consortium prices its required rate of return on an investment in a predominantly IP-driven firm (for instance, the recent leveraged buyout of SunGard).
Please refer to the following table for an illustration of the return on investment that a different profile of investor may wish to earn on that investment in a predominantly IP/IA driven firm.
Investor Category |
Angel |
Venture Capital |
Private Equity |
Public Company |
Required Annual Return |
60-70% |
30-35% |
20+% |
12-20% |
In this article, we will focus on the Angel, Venture Capital and Private Equity investor. Publicly listed companies and closely held companies are excluded from this analysis.
Starting with the Angel investor; this is the area which presents most risk in relation to the commercialization of IP. Fundamentally, therefore the Angel investor will require a 60-70% return on his/her investment to be adequately compensated for the risk of the investment. This is typically the one investment in the shares of a firm that mirrors an investment in IP/IA, with the major asset composition (outside of cash) comprising trade secrets, non-compete agreements, patents and the like, with a collective view to establishing/commercializing a product or range of products . From a fundamental perspective, the IP within the firm, forming the majority of the firm assets is non-diversifiable. In laymen’s’ terms it’s all-or-nothing for the investor.
Additionally, most angel investors will not hold more than 5 or 6 investments across their portfolio (which if larger and spread across a number of industries could provide a layer of diversifiable risk) and accordingly any diversification of risk across different firms will be minimal, especially if operating in the same industry. Accordingly you need to optimise your strategy and layer of risk to allow for your angel investors to be rewarded appropriately and over a short timeframe (2 to 3 years).
Venture Capital investors will typically invest at a stage where your product/products have been commercialized and you now have several or more clients, a partial or full management team, several employees and you are continuing to engage in R&D. Again, this area presents significant risk in terms of market penetration and competitive threats. The implementation of defensive strategies utilising IP/IA will often be a major focus of your venture capital shareholders. The venture capital investor will require a 30-35% return on his/her investment to be adequately compensated for the risk of the investment. This investment will still partially mirror an investment in IP/IA, however other elements such as tangible assets, liabilities (such as debt) and goodwill are financial features of the firm. However the breadth of IP/IA will have extended to assets such as customer contracts, licences, assembled workforce, copyright, trademarks and the like. Diversification across the firm starts to take effect given this broadened range of IP/IA. Venture capital investors may hold 20 or so investments across their portfolio, providing some diversification and lowering risk at the company level, however most venture capital investors typically focus on one or two industries (certainly on a fund level) and gain no lowering of risk via diversification at the industry level. Venture capital investors are generally rewarded over a short to medium (in risk investment terms) timeframe (typically 5 to 7 years over a 10 year fund life).
The private equity realm becomes interesting. This typically features a greater focus on financial structuring and engineering, with the return on investment dependent on the stability of the firm’s cash flows, the performance of the capital markets, or the ability to leverage a trade and simply write down the debt portion to increase the value of the investment in the firm. Accordingly, the required rate of return on the IP/IA in the firm may not be linked to the actual return that the private equity/leveraged buyout investor requires. Where a private equity firm does look to aggressively grow the business over its holding period, a venture capital type model will apply, albeit with greater IP/IA diversification effect due to the relative maturity of the firm at this point and the commensurate increase in customers, products, competitive position and so forth. Private equity/leveraged buyout investors are generally rewarded over a very short timeframe (1 to 5 years).
In summary, the manager needs to understand the investment framework and mindset of the angel, venture capital or private equity investor from whom they have sourced equity capital. This should ensure that at least you and the investors writing your cheques are aligned and can move the business forward with the one common goal in mind.
Disclaimer: The reader should not construe this as financial advice nor should they depend on any elements of this article in making a decision pertaining to their own individual circumstance. Where, by jurisdiction, this article contravenes any of the laws or self-regulatory restrictions imposed under that jurisdiction, the reader should delete the article immediately including any copies.
The views expressed in this article are those of the author and do not necessarily represent those of the SME's division of WIPO. The author could be contacted at International 61-412-304-802 / laine@enpris.com, ENPRIS: www.enpris.com
