When a company develops a hot technology, the founders can quickly find themselves courted for mergers and acquisition. While an early exit can be desirable, especially at the right price, it’s incumbent on acquired companies to be clear on all claims to their intellectual property before executing a transaction or they could find themselves liable for damages.
Nevium was contracted as an IP damages expert witness to analyze the contributions of two companies in one such case in the molecular diagnostics and genetic sequencing market and assess damages. With far-reaching implications for individual diagnosis and treatment as well as public health outcomes, DNA sequencing technology is a high-stakes arena for innovation. As often happens with sophisticated technology in a dynamic market, commercialization requires the skills and resources of more than one party, leading to a complex business relationship that must be carefully disentangled in the event of acquisition.
One company—Distribution Partner—provided molecular diagnostic instruments and services for DNA sequencing. A second company—let’s call them Sequencing Systems—held an exclusive license from a university for a sequencing technology developed in academia. With its sole source of revenue resting on research grants, and under the gun to bring a product to market using the patents licensed from the university in order to avoid losing exclusivity, Sequencing Systems entered into an agreement with Distribution Partner—which already had a product successfully in field—to market and distribute products based on the licensed technology.
Timing is Everything
In January Distribution Partner achieved the first installation of an instrument based on Sequencing System’s technology. In March of the same year, Sequencing Systems met a third company—Acquisition Corporation. In June, Acquisition Corporation performed due diligence to purchase Sequencing Systems. In August, Sequencing Systems terminated its relationship with Distribution Partner.
Our discovery showed that Sequencing Systems referenced the relationship with Distribution Partner in several official communications, including a letter to the university demonstrating fulfillment of the licensing agreement, a Small Business Innovation Research (SBIR) application, and a letter to its Board of Directors as late as July. Whereas a letter of intent between Sequencing Systems and Acquirer was dated April and an agreement and plan of merger was dated in June. Distribution Partner was not informed of the acquisition until two months after the acquisition was completed.
At stake in this partnership was an opportunity potentially worth hundreds of millions of dollars, per Sequencing Systems’ SBIR application. Distribution Partner projected it could sell 45 instruments in the first year, achieving total revenues of almost $20 million. For year five, they projected growth to 120 instruments, with more than $50 million total revenue. For its part, Sequencing Systems estimated its revenue would reach almost $100 million during year five, including instruments and consumables. Both parties expected revenue and earnings to accelerate as installations of the product drove demand for higher margin consumables.
Valuation & Damages
In order to calculate damages, we had to first calculate the value of Sequencing Systems’ business. Of the three generally accepted valuation methodologies, we relied on the Income Approach, which assumes the value is the present value of the future earnings capacity available to the owners, since both companies were banking on future profits. Using the income approach, we valued the business at $50 million.
In building our valuation analysis we developed a sales forecast for instruments, consumables, and service contracts related to the technology, as well as a profitability and cash flow forecast for each of the companies. We looked at the value of the business opportunity available to both parties and calculated the portion of the acquisition price achieved by Distribution Partner’s contribution. This apportionment calculation was used to calculate the value each of the parties would have derived had they continued working together.
Since Sequencing Systems’ acquisition by Acquisition Corporation cost Distribution Partner the chance to pursue the opportunity outlined in the forecasts, the present value of the lost business opportunity was equivalent to Distribution Partner’s economic loss. Of the $50 million valuation, the value of the business opportunity for Distribution Partner was $15 million.
Sequencing Systems and Distribution Partner essentially split the duties to bring a product to market, including research, development, testing, manufacturing, distribution, sales and support. In examining the tasks required to bring the product to market, we determined that Distribution Partner performed approximately 30% and Sequencing Systems performed 70%. Therefore, Distribution Partner’s share of the $30 million paid by Acquisition Corporation would have been $10 million.
No technology is created in a bubble; it often takes more than one party to successfully bring a tech product to market. For any party being courted for merger or acquisition, it is imperative to disclose any such discussions or negotiations with relevant business partners so they may be accounted for in any resulting transaction and to avoid post-acquisition litigation and damages claims. Parties that have ever potentially contributed intellectual property included in the sale of a partner company would do well to scrutinize the timing of the transaction in relation to their payout—if any.