Technology Commentaries: Due Diligence and IP Valuation in Technology Deals

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...