Published: NH Business Review
There’s no question that an infusion of funding through an investor will provide a nice boost to a balance sheet. But, this type of boost usually comes at a steep price: investors typically want substantial equity interest in the business and a voice in its management. While some businesses definitely need this capital input, many enterprises effectively increase their valuation at significantly less cost through a strategic alliance.
The term “strategic alliance” has no established legal definition. It is a loose term for collaboration arrangement among enterprises with complementary skill sets for the purpose of achieving each participant’s economic goals. Typical goals are to obtain or enhance technology through joint development or to gain access to advantageous distribution channels, markets or joint manufacturing. The alliances are useful in allocating risk and costs as well as accessing capital, thus bringing values that each participant could not achieve alone or in a typical “buy-sell” arrangement. Below are some practical tips for using the strategic alliance to enhance value and possibly ease the way for future funding or an acquisition:
1. Strategic alliances that focus on marketing or publicity usually do not build substantial value. A potential investor or acquirer will be expecting your alliances to show validation of your technology or product; access to reliable suppliers and distribution channels or manufacturing efficiencies (e.g. learning curves, ramp up rates).
2. Patents are usually more valuable to investors and acquirers than trade secrets (unpatented proprietary information). Usually, the major issues for an investor concern whether key technology is patentable, whether a patent is valid and how much time remains on the patent. Patentable technology developed through a Strategic alliance can present the problem of who owns the patent and who has what license rights unless the agreement is carefully drafted. Patent rights can easily be lost inadvertently so patent attorneys should be consulted.
3. Be wary of strategic alliances with multiple participants. The enforcement of rights and obligations of each party becomes complicated and uncertain if more than two participants are involved. Two party alliances with clearly defined goals and objectively determinable performance requirements will create substantially more value than multi-party arrangements where the rights to technology become muddy.
4. Know the signs of potential failure of the strategic alliance and get out quickly and early. Only successful alliances increase valuation so it is necessary to devise clear indicators that a deal is failing. Keep the duration of the strategic alliance short (under two years but with an option to renew if performance targets are achieved). Consider selecting a few critical performance milestones and allow an option to terminate for convenience if these are missed, even granting termination rights at specified intervals. Be certain that any termination is clearly documented (obtain a written acknowledgement of the termination from the other party or parties), with minimal “survival” provisions.
5. Be cautious about extending equity interests to the strategic alliance partner even if you are seeking an eventual acquisition. An equity interest carries baggage of shareholder rights, dilutes shareholder value and may make future third party acquisition or investment more complicated. Instead of equity in exchange for funding, consider extending exclusive licenses, manufacturing rights and/or royalty free rights or discounted pricing (or credit) to the strategic alliance partner for a limited period or until the funding is recouped. You may be able to convince the strategic alliance partner to forego an equity interest by committing to clearly defined milestones, conducting progress review meetings, frequent progress reports and reasonable audit rights.
6. Key aspects of technology oriented alliances are protection of proprietary intellectual property (“IP”) and usage rights by alliance partners. This is an extremely complex area but may be conceptualized as two basic types of intellectual property: (a) each party’s “original” IP which was contributed to the alliance and (b) the technology which is developed or enhanced under the alliance and which incorporates or is based upon either or both parties’ “original IP” The strategic alliance document must describe in detail the scope and duration of each party’s rights to both types of IP in two situations (i) when the alliance is in effect and (ii) after the alliance terminates. Strategic alliance agreements that do not address these issues adequately will be perceived by a potential investor as inviting a lawsuit.
7. If you intend to have several strategic alliances, consider striving for alliances with different purposes and goals. You want to show a potential investor or acquirer that you have leveraged diversification and spread risk. Most investors and potential acquirers will be eyeing your company’s managerial and administrative skills as a part of the due diligence process. Having several well managed strategic alliances can showcase your business model, your well-run business processes as well as your technology. Be certain you can show a potential investor or acquirer that you can track the progress of each agreement against clear performance and financial metrics.
8. There is often a risk the strategic alliance may be perceived as a partnership for tax or liability purposes. Partnerships, whether intentional or accidental, can lower valuation. This risk can be decreased by creating a clear licensing arrangement or by including provisions in which the revenue allocation is dependent on how well each party performed its part of the project. In other words, consider an approach where each party’s profit (or loss) is determined based upon that party’s performance of the milestone or target tasks. Additionally, the strategic alliance agreement must contain provisions specifying that each party bears its own costs and expenses of performance (sharing expenses can be a hallmark of a partnership); each party remains an independent contractor; neither is the agent of the other and neither party can incur obligations or act on behalf of the other.
There are, of course many other ways a strategic alliance can be used to increase valuation. In all cases however, they must be carefully drafted to avoid pitfalls.
Julia Shappals if of counsel to the Corporate Department at the law firm of McLane, Graf, Raulerson & Middleton, Professional Association. She can be reached at [email protected] or (603) 714-4349. The McLane Law Firm is the largest full-service law firm in the state of New Hampshire, with offices in Concord, Manchester and Portsmouth, as well as Woburn, Massachusetts.