Scratching the surface

Due diligence is fundamental to any major business transaction, whether that be an acquisition, sale, merger, investment, debt issue or IPO.

Due diligence has traditionally included financial, legal and management audits and potentially production and information systems audits. In today’s knowledge based economy this is no longer enough.

Today, intangible assets make up over 87% of the assets of most businesses and are considered a major and critical asset class. The purpose of due diligence in a transaction is to allow decision-makers to make informed decisions by providing them with accurate, high quality information at appropriate levels of detail.  If intangible assets aren’t subject to due diligence then it is almost certain that major risks or opportunities will remain hidden.

Do your homework

Intangible assets can present at least two unique challenges for due diligence.

First, unlike physical products, intangible assets (especially those that are unregistered such as trade secrets) are difficult to inventory or audit and so even bare identification can be problematic.

Take, for example, a group of investors we advised post the completion of a Series B capital raise for US$10M (based on a pre-money valuation of $US50M), when we were brought in to evaluate the company’s intangible assets.

Although the conventional due diligence conducted prior to the capital raise detected no material risk, our assessment identified that the company had a major problem with its software code. The code worked perfectly well – the problem was that it had been developed by the CTO while employed at their previous employer (a competitor). Hence the company faced a major chain of title issue – it did not own its core asset. The asset (the code) may have been invisible but it was critical to company’s future. The result: the company failed and the investors suffered a US$10M. This could have been avoided if proper due diligence has been conducted on the company’s intangible assets prior to the transaction. This problem (imperfect of chain of title of being unable to prove you own your intangible assets) is far more common than most investors realise – approximately 8 of 10 companies we see cannot prove they own key intangible assets.

Second, accounting standards such as GAAP and IFRS almost completely ignore intangible assets. They are either off the balance sheet entirely, lumped under the amorphous term “good will” or recorded solely at cost. This was acceptable in the 1970’s when intangible assets only accounted for 17% of company value and tangible assets did all the work. Today with that ratio inverted, this will no longer suffice. Too often because intangible assets aren’t effectively captured within the balance sheet or P&L they are overlooked when it comes to major transactions or are not treated with the respect they deserve given the financial performance they drive and the risks they can give rise too.

More than asking ‘does it have a patent?’

Unfortunately in the past too often when people have raised the issue of due diligence the question has been: “does it have a patent?” “Yes / No”, tick …· move onto “IT due diligence”. If that’s your idea of intangible asset due diligence, well then a fool and their money…

Comprehensive intangible asset due diligence involves:

1. systematic identification and assessment of all intangible assets relevant to the company and / or transaction;
2. assessing how those intangible assets are managed (what are the systems, processes and policies used by the company to manage these assets) to ensure effective management;
3. identifying future opportunities and current and historic risks that may impact these assets; and
4. assessing the potential impact of these assets (and attendant risks and opportunities) on the transaction itself. They literally have the potential to be “show stoppers” or become “deals of the century.”

Depending on the outcomes of (1) to (4), it may also be necessary to value some or all of the intangible assets in order to gain a better idea of how these will impact on the overall transaction. In the case of intangible assets (more than most other assets classes), the quality and strength of the asset should a) not be assumed and b) be recognised as having potential to materially impact on the value of the transaction as a whole (up or down).

For example, we worked with a company to undertake due diligence as it was preparing for a micro-cap $50M IPO. As part of this process, we conducted an audit of the company’s intangible assets, which identified an under-valued asset that had been purchased at $1M and depreciated to $0.5M in line with GAAP. Having identified this asset, we analysed the market and found three similar assets that had sold for $50M each. We then devised a strategy that allowed the company to enter into a sale and license back of the asset, which released $50M in cash to the (very happy) shareholders, while also allowing the company to continue with its IPO. We effectively doubled the value of the company for its shareholders by identifying a critical intangible asset that had been otherwise overlooked.

Who should do the digging?

The benefit of an intangible asset audit can flow to both the buy and sell side. For both parties it reduces the risks associated with the transaction. For the buy side it is presumptively clear that better understanding 87% of the assets of the target will lead to fewer mistakes and surprises. In addition if (as is currently commonly the case) the buyer is the only party to undertake intangible asset due diligence, then the buyers enjoys a massive information asymmetry relative to the vendor: enabling them to identify opportunities unseen even to the vendor or to drive the price down to account for previously unaccounted for risks.

For the sell side undertaking thorough vendor intangible asset due diligence can highlight the strength of the company’s intangible assets, how they add value and the fact that the management team takes these issues seriously. In addition, given that Directors have a fiduciary obligation to manage risks to all assets under their stewardship and control (including intangible assets), Directors should consider their own liability under the warranties and indemnities they give when involved in sell side activities.

It is important to note however, that an acquirer should undertake their own intangible asset due diligence to inform their own point of view that will be unsullied by the desire or characterizations of the other party. However, working from a comprehensive and well-constructed audit conducted by the other party should mean that it will take considerably less time and resources than one conducted in isolation.

Hidden value | Hidden risks

Intangible asset due diligence can highlight both risk and opportunity. Today, these assets permeate every business and should be considered seriously when undertaking due diligence for any transaction.

Undertaking intangible asset diligence as part of a transaction process can help to minimize risk and enable a strong picture of potential opportunities to be built up, so that the true value of the transaction can be realised. This ultimately is what drives investment returns.