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Ceyda A. Maisami is the founder of PatentCRUNCH, an IP consulting firm in New York, New York. She specializes in assisting startups and entrepreneurs with patent prosecution and portfolio development. She can be reached at firstname.lastname@example.org. Leslie A. McDonell is a partner at Finnegan Henderson Farabow Garrett & Dunner LLP in Cambridge, Massachussetts. She specializes in providing strategic counseling regarding the protection of intellectual property in the pharmaceutical, biotechnology, and medical device industries. She can be reached at email@example.com.
A number of newsworthy initial public offerings (IPOs) in 2011 helped trigger curiosity and media attention around the IPO market. IPOs raised $155.8 billion and initial offerings generated $38.8 billion in 2011, Bloomberg data shows.1 According to PwC’s quarterly IPO Watch survey, as of mid-December, the fourth quarter of 2011 had seen 28 IPO pricings on the U.S. stock market, raising $6.4 billion.2 A few of the companies from this year’s offerings include Pandora, LinkedIn, Groupon, Zynga, and TripAdvisor.
However, when compared to a very active fourth quarter in 2010, which saw 63 IPOs worth a total of $9 billion (excluding General Motors’ $15.8 billion offering), and compared with $252 billion raised in all of 2010, IPO activity in 2011 saw a 29 percent decrease in proceeds.3 Regardless of the decrease in volume, the 2011 IPOs captured a lot of attention because of their speculative pricing. For instance, Groupon was valued on its first day at $15 billion, LinkedIn at $9 billion, Zynga at $8 billion, TripAdvisor at $3.5 billion, and Pandora at $1.5 billion.4 These numbers are significantly higher than the respective company’s trailing revenues. For example, in Zynga’s case, the company is trading at more than eight times its trailing revenue.5 What makes these dollar figures interesting is that when they are compared to the valuations of more established corporations like Google, Apple, Yahoo, and Amazon, they appear to be significantly higher, as Google is currently trading at about six times revenue, Yahoo at four times revenue, Apple at three times revenue, and Amazon at two times revenue.6 Moreover, much like Zynga, the highly anticipated Facebook IPO is expected to provide a $10 billion public offering, which would value the company at more than $100 billion.7
With such large extremes in valuations and first trade day pricing, as patent specialists, we can’t help but wonder how patent portfolios influence this IPO market. Most of us will agree that patents should have a significant role in determining a company’s performance. We would expect that they represent an important share of a company’s value. Researchers at Wharton School and Ross School of Business suggest that having large patent portfolios increase both the likelihood of sourcing initial capital from a prominent venture capitalist (VC) and of achieving liquidity through an initial public offering.8 However, a patent portfolio’s direct effect on pricing of an IPO is a more complex question to answer.
An IPO is the first sale of stock by a private company to the general public.9 A process of an IPO includes various steps, starting with the preparation of a registration statement, legal due diligence, and corporate planning. As part of the planning process, a private company performs a legal audit of its material operations and contracts to prepare for its offering document disclosures. For instance, a technology company with an intellectual property portfolio may seek a thorough review by intellectual property counsels.
Once the registration statement (also called the S-1 registration statement) is drafted, it is filed with the Securities and Exchange Commission announcing the company’s intent to go public. An S-1 includes a prospectus, which presents a company’s financials, growth strategy, and risk factors, in addition to the securities being offered for sale, like their type, quantity, and price. The price listed on the S-1 statement is called the offering price that investors must pay for allocated shares in an IPO. This is not the same as the opening price, which is the price at which a new stock starts trading.10
A well-known pattern associated with the process of going public is the frequent incidence of “underpricing,” as measured by the high initial returns of an IPO that occur when the initial offer price of an IPO is below the closing price at the end of the first day of trading.11 Underpricing can be minimized if the offer price reflects the value of the company more accurately. Underpricing is a concern in any IPO for even highly valued companies such as Facebook. Like any corporation, Facebook would not want to sell shares to the investment community for lower than their actual market value and possibly lose out on additional gains that could have been received if the offer price more accurately reflected the value of the company.
There are a variety of predictors of IPO pricing, including venture capital backing, underwriter prestige, company size, company age, the level of CEO equity, and internal company activities that directly impact value creation of the company. Research and Development (R&D) and associated intellectual property activities are good examples of potential value creation opportunities.
In order to examine the influence of these activities on IPO pricing, we accept that there is a strong correlation between innovation and company value. R&D and innovation are critical factors to succeed in competitive industries. Companies invest in R&D in hopes of developing innovative products and services that lead to increased performance. These investments also include legal expenses for drafting and prosecuting patent applications.
Nevertheless, the inherent uncertainty on the economic returns to innovation leads to substantial information asymmetries between corporate insiders and external investors. Such asymmetries might result in higher underpricing for the company going public.12 Patents may help reduce the risk of underpricing by minimizing information asymmetries between potential investors and companies who have made intensive R&D efforts. This is mostly due to the fact that patents disclose information about the technologies developed by and available to the company. Moreover, because patents are only granted after a thorough examination process by the national patent office, they are a good indicator of quality. Also, they make the company more attractive to investors like VCs.
Now, we will discuss a variety of these factors to further analyze the role of patents in underpricing.
A company’s patent portfolio discloses technical information about that company’s inventions. As the number of patents or patent applications increase in the portfolio, more information about inventions are disclosed. In 2006, researchers Chin et al. found a positive association between number of patents and long-term IPO performance due to the ability of patents to provide valuable information regarding a company’s innovation pipeline to external investors.13 Their findings showed that companies with more granted patents had better aftermarket stock performance relative to companies with fewer granted patents.
The recent Zynga IPO is a good supporting example of Chin et al.’s association between number of patents and long-term IPO performance. As seen in Zynga’s S-1 statement, the company has a growing patent portfolio. Zynga disclosed in its S-1 filing of July 1, 2011, that it had 78 pending applications. Some months later on December 15, 2011, Zynga filed an updated S-1 statement with a disclosure of patent portfolio representing 254 patent applications. Accordingly, outside investors became aware of Zynga’s fast-growing patent portfolio, and excited the market for its stock. One may argue the fact that Zynga is still trading at close to eight times revenue means investors are still valuing it very generously, perhaps on the assumption that Zynga will continue to grow its patent portfolio in its efforts to create new games. So, the investors may be relying on the expanding R&D activities, which is proven by its increased number of patent filings.14 Such growth in the company’s patent portfolio will reaccelerate the company’s growth.
However, more recent studies state that IPO evaluations of a company’s innovation activities such as patent filings are context dependent. Even though patents provide information regarding a company’s innovation, such information is largely uninterpretable by the investment community without a context. The investors can’t necessarily understand the correlation between patents and inventive value for the company. As a result, the investors do not know if patents will have a positive effect on the pricing of an IPO without knowing the context in which a patent is granted.
In certain contexts, where there is a clear link between innovation activities and potential value creation, a patent can provide information on the potential to profit from an invention.15 Accordingly, the occurrence of information asymmetries and possible underpricing is reduced. On the other hand, in other contexts, where the link is less transparent between innovation activities and potential value creation, a patent may reflect the increased information requirements to assess the value of the invention.16 When patents increase the need for company-specific information in order to be accurately assessed, the possibilities of information asymmetries and respective underpricing are increased.
There are various studies that focus on IPO performances, specifically underpricing. Most studies document a relationship between patent portfolios and underpricing, but very few examine the quality level of a patent as a factor within their assessment of IPO performance.
The underlying quality of a patent may be measured with various indicators: the number of claims, length of claims, prosecution history (number of rejections, number of years from filing to allowance), forward citations to the patent, backward citations in the patent application, and family size. In 2008, German researchers Bessler and Bittelmeyer investigated the relationship between innovation and performance of German firms that went public from 1997 to 2002, in particular whether IPOs with more or higher quality patents performed better than IPOs with lower quality or no patented technology. For this, they focused on the impact of patents on underpricing and long-run performance and explained the magnitude of these valuation effects with patent-specific variables such as the number of International Patent Classification classes, family size, and the number of backward and forward citations, as well as with industry variables. The empirical evidence suggests that the quality of patents is a reliable indicator for the success, both short- and long-term performance, of companies that went public, and also suggests that the valuation effects are more pronounced for higher quality patents.17
IPOs in 2011 were distributed among various industries including high-tech, energy, consumer products, and financial services. Below is a table summarizing the data for the last quarter of 2011:
The effects of a patent portfolio on a company’s economics may vary from industry to industry. For example, for companies in technology intensive sectors, having a larger patent portfolio increases the likelihood of securing initial funding from a prominent VC. Prior research shows that ventures that receive initial funds from prominent VCs are more likely to receive higher valuations in initial public offerings.19
Some researchers believe that the main factor to consider is the transparency between innovation and underpricing. Transparency is affected by the underlying technology of an innovation and associated motives for patenting. We can categorize the underlying technology into two groups: complex and discrete. Complex product technology companies are where transparency between innovation and underpricing is low, and discrete product technology companies are where transparency is high.20 Industries with an International Standard Industrial Classification (ISIC) code less than 2900 (e.g., chemicals, pharmaceuticals, and metals) are coded as discrete, and those with an ISIC code of 2900 or higher (e.g., machinery, computers, and electrical equipment) are coded as complex.
In contexts characterized by high transparency between patents and value appropriation, researchers Heeley et al. found that presence of patents reduces underpricing.21 Using evidence from the pricing of shares on the first day of public trading, the authors concluded that patents in discrete technology sectors such as biopharmaceuticals and chemicals serve an economically meaningful role as signaling devices to public equity investors.22 In these industries, the link between patenting and value appropriation is transparent (when an individual patent confers monopoly rents as in the case of many pharmaceutical drugs), and the presence of a patent will reduce information asymmetries between informed and uninformed investors, and the associated level of underpricing.
On the other hand, in contexts characterized by low transparency, the researchers documented that as the level of innovation activities increases as represented by patents, there will be greater information asymmetries between informed and uninformed investors about the value of the firm.23 Such greater information asymmetries will accordingly increase the underpricing.
Moreover, complex technologies, like information technology, compared to discrete technologies, generally have a large number of components underlying their products. It is common for these companies to lack ownership of all the essential elements of the technologies they are developing. Accordingly, their motive for patenting complex technologies may be to use the patent portfolio to block competitors from developing a competing alternative, unlike the discrete technologies that would use patents to prevent copying and so securing quasi-monopoly rents for the invention.
Analyzing the impact of patent commercialization on underpricing, Morricone et al. used a sample of 130 semiconductor companies that went public in the United States between 1996 and 2007 to determine the effects of patent licensing on IPO performance. Their findings documented that IPO underpricing might not be influenced only by the possession of patents, but also by the strategic use to create and capture value.24 They discovered the decision to adopt a licensing-based strategy increased the likelihood of underpricing at the moment of the IPO. This is because the companies adapting licensing strategies tended to have more intangible assets, whose values were difficult to assess. Accordingly, this increased information asymmetries and therefore led to underpricing.25
Before going public, certain company information is usually not available to the general investment community. For example, R&D spending data and patent data, which are used to assess firm innovation activities, are detailed confidential knowledge of a private company to which outsiders have no access. However, as part of its Exchange Act reporting obligations, when filing for an IPO, a company will be required to make disclosures about its business and operations, and provide detailed information regarding said R&D spending, products, customers, customer contracts, or management.
The primary document in an IPO filing is a prospectus. A prospectus resembles a business plan, including information like business description, corporate governance, historical and forecasted financial data, and product descriptions. It also includes a section related to intellectual property. For example, Zynga disclosed the below information about its patent portfolio as a part of its prospectus:
Our business is significantly based on the creation, acquisition, use and protection of intellectual property. Some of this intellectual property is in the form of software code, patented technology and trade secrets that we use to develop our games and to enable them to run properly on multiple platforms. Other intellectual property we create includes audio-visual elements, including graphics, music, story lines and interface design.
While most of the intellectual property we use is created by us, we have acquired rights to proprietary intellectual property. We have also obtained rights to use intellectual property through licenses and service agreements with third parties. These licenses typically limit our use of intellectual property to specific uses and for specific time periods.
We protect our intellectual property rights by relying on federal, state and common law rights, as well as contractual restrictions. We control access to our proprietary technology by entering into confidentiality and invention assignment agreements with our employees and contractors, and confidentiality agreements with third parties. We also actively engage in monitoring and enforcement activities with respect to infringing uses of our intellectual property by third parties.
In addition to these contractual arrangements, we also rely on a combination of trade secret, copyright, trademark, trade dress, domain name and patents to protect our games and other intellectual property. We typically own the copyright to the software code to our content, as well as the brand or title name trademark under which our games are marketed. We pursue the registration of our domain names, trademarks, and service marks in the United States and in locations outside the United States. Our registered trademarks in the United States include “Zynga,” the names of our games and company taglines, among others.
We actively seek patent protection covering inventions originating from the company and acquire patents we believe may be useful or relevant to our business. We currently own one issued U.S. patent which expires in 2021 and, as of November 1, 2011, had 254 patent applications pending worldwide.26
In addition to data related to a company’s patent portfolio, undisclosed patent litigation may come to surface on IPO registration papers. For example, Zillow Inc.’s IPO registration showed five patent infringement claims against the company since 2009. Disclosed data showed that Zillow’s legal expenses increased by $400,000 in 2010 compared with 2009 because of the heightened litigation activity.27
Another example may be from Zynga’s statement, which disclosed that it was not a party to any lawsuit at the time of filing its S-1:
From time to time, we may become subject to legal proceedings, claims, and litigation arising in the ordinary course of business. In addition, we may receive notification alleging infringement of patent or other intellectual property rights. We are not currently a party to any material legal proceedings, nor are we aware of any pending or threatened litigation that in our opinion would have a material adverse effect on our business, operating results, cash flows, or financial condition should such litigation be resolved unfavorably.
Included in general and administrative expense within the consolidated statements of operations for the year ended December 31, 2010 is a net gain of $39.3 million related to legal settlements. In 2008, we recorded $7.0 million of general and administrative expenses related to a legal settlement.28
Disclosure of legal information may result in higher information symmetries as the investors may require additional information about these lawsuits to determine the risk level associated with those cases. Accordingly, the underpricing would increase.
Patents are viewed as the output of R&D efforts, and a growing patent portfolio is a good indication of a company’s expanding R&D and innovation pipeline. Patents are considered assets with inherent value for their company. Accordingly, one may assume that a patent portfolio is great friend of a company’s IPO performance in the market.
However, a patent’s value does not necessarily reflect a potential for profit in every industry. Moreover, not every patent measures at a good quality. Further, use strategy assigned to patents may not benefit a company in an IPO process. Finally, certain information disclosed through patents may create information asymmetries, which can lead to a low performance in an IPO. For example, in order to assess the value of a patent in contexts of high technological and competitive interdependencies, a potential investor may require information on the technology itself, and the nature of the relationship between potentially multiple owners of related intellectual property. Based on the above points, one could argue that patents and IPOs are almost enemies.
Yet, as mentioned in this paper at various times, the effect of patents on an IPO may be positive or negative. As a result, one may claim that patents and IPOs are like strangers testing and setting boundaries through various interactions. As Bloomberg reports, the IPO market is not going to slow down any time soon.29 For example, in the web industry, with Facebook and at least 14 other Internet companies considering IPOs in 2012, the industry could raise $11 billion through IPOs next year, the largest amount for web-related companies since 1999. These upcoming events and many others will provide additional opportunities to measure the relationship between patents and the IPO market, and conclude where they stand in respect to one another.
1. Lee Spears, Facebook Poised to Lead Biggest U.S. Internet IPO Year Since 1999 Bubble, Bloomberg (Dec. 28, 2011), http://mobile.bloomberg.com/news/2011-12-28/
2. Press Release, PricewaterhouseCoopers, Highly-Anticipated Fourth Quarter Offerings Provide Positive IPO News Heading into 2012, Says PwC (Dec. 20, 2011), available at http://www.pwc.com/us/en/press-releases/2011/pwc-us-ipo-watch-q4-2011.jhtml.
4. Fred Wilson, Some Thoughts on the IPO Market for Web Companies, AVC (Dec. 22, 2011), http://feedproxy.google.com/~r/AVc/~3/XxnMMfPQ2tc/some-thoughts-on-the-ipo-
5. Henry Blodget, The Truth about Zynga: The Only Reason the IPO “Flopped” Is Because Idiot Investors Paid Too Much, Bus. Insider (Dec. 19, 2011), http://articles.businessinsider.com/2011-12-19/tech/30533215_1_zynga-ipo-market-ipo-price#ixzz1hwsSh8Z9.
7. Kirsten Salyer, Facebook Contemplates a Big Status Update: The Ticker, Bloomberg (Dec. 29, 2011), http://www.bloomberg.com/news/2011-12-29/facebook-contemplates-a-big-status-update-the-ticker.html.
8. David H. Hsu & Rosemarie H. Ziedonis, Paper Presented at the DRUID Summer Conference in Copenhagen, CBS, Denmark: Patents as Quality Signals for Entrepreneurial Ventures (June 18–20, 2007).
9. Initial Public Offering, Wikipedia, http://en.wikipedia.org/wiki/Initial_public_offering (last modified Mar. 7, 2012).
10. Darren Chervitz, IPO ABCs: Speak the Basics, MSN Money, http://moneycentral.
hoovers.com/global/msn/index. xhtml?pageid= 1954 (last visited Mar. 7, 2011).
11. Jay R. Ritter, Initial Public Offering, 2 Contemp. Fin. Dig. 5 (1998).
12. Re-Jin Guo, Baruch Lev & Charles Shi, Explaining the Short- and Long-Term IPO Anomalies in the US by R&D, 33 J. Bus. Fin. & Acct. 550 (2006).
13. Chen-Iung Chin, Picheng Lee & Gary Kleinman, IPO Anomalies and Innovation Capital, 27 Rev. Quantitative Fin. Acct. 67 (2006).
14. Blodget, supra note 5.
15. Michael B. Heeley, Sharon F. Matusik & Neelam Jain, Innovation, Appropriability, and the Underpricing of Initial Public Offerings, 50 Acad. Mgmt. J. 209 (2007).
17. Wolfgang Bessler & Claudia Bittelmeyer, Patents and the Performance of Technology Firms: Evidence from Initial Public Offerings in Germany, 22 Fin. Markets & Portfolio Mgmt. 323 (2008).
18. Press Release, supra note 2.
19. Yael V. Hochberg, Alexander Ljungqvist & Yang Lu, Whom You Know Matters: Venture Capital Networks and Investment Performance, 62 J. Fin. 251 (2007).
20. Heeley et al., supra note 15.
22. Hsu & Ziedonis, supra note 8.
23. Heeley et al., supra note 15.
24. Serena Morricone, Federico Munari & Raffaele Oriani, Proceedings of the IV EPIP Conference in Bologna, Italy, on Measuring the Value of IPR: Theory, Business Practice, and Public Policy: IPO Performance and Strategic Management of IPRs: Evidence from the US Semiconductor Industry (2009), available at http://www.epip.eu/conferences/epip04/files/MORRICONE_Serena.pdf.
26. Zynga Prospectus, NASDAQ (Dec. 15, 2011), http://www.nasdaq.com/markets/ipos/
27. Austin Kilgore, Zillow IPO Filing Reveals Suits, Am. Banker, Apr. 25, 2011, available at http://goliath.ecnext.com/coms2/gi_0198-748478/Zillow-IPO-Filing-Reveals-Suits.html.
28. Zynga Prospectus, supra note 26.
29. Salyer, supra note 7.