For a number of reasons, buying and selling a business presents many challenges.  Even though each deal is unique, most transactions involve many of the same features and elements.  A lot can happen in a transaction, from the initial discussions through the final closing. It is important that while both buyers and sellers remain flexible they also ensure the final deal accomplishes their key goals. Transactions involving knowledge-based businesses have additional nuances that must be addressed, to ensure both parties benefit from the transaction. This article discusses some of the special issues presented in these types of deals, involving transferring intangible assets.

What is a Knowledge-Based Enterprise?

A knowledge-based enterprise (“KBE”) refers to a business that heavily leverages its creative, non-tangible assets, such as: information, data, goodwill, and know-how.  Legally, these types of assets are called intellectual property and are characterized as either: trade secrets, trademarks, copyrights, or patents (collectively, “IP Assets”).

Despite the intangible nature of these IP Assets, the value to the companies that create, own and use them is very real.  In fact, for KBEs, IP Assets comprise a significant portion of their overall enterprise value.  Therefore, knowing the proper way of transferring intangible assets is key to successful business transactions.

Computer hardware and software technology companies are the most obvious examples of KBEs, but a KBE can refer to any company that relies heavily on IP Assets in their business.  In addition, creative companies such as graphic design, advertising, music, sports and entertainment businesses are KBEs with intangible assets. Knowledge based businesses also include most service-based industry companies, such as restaurants, consulting and professional services firms like: law, accounting, medical, architecture, engineering and consulting firms.

For most businesses, physical assets can vary from computers and desks, restaurant equipment, business vehicles, and sometimes, even real estate.  However, a purchaser of a knowledge based enterprise will be most interested in acquiring and transferring intangible assets – the IP assets of the company. 

Selling Knowledge-Based Companies and Transferring Intangible Assets

There are almost as many reasons for selling a KBE as there are transactions, themselves.  Some businesses are sold because the founder is retiring or simply wants to pursue other ventures.  Such sales could be made to an outside party, or could involve a business succession plan to a family member or to a group of employees.  In other situations, the KBE only considers selling after being approached by a potential purchaser. In many cases, this type of sale leads to an exit for the seller’s management (often including the founder), but occasionally some or all of the seller’s management team will transition into a management role within the acquiring company.

Regardless of the reason for selling, the knowledge based business seller will want to ensure they receive a good price for their business, especially in selling and properly transferring intangible assets.  It is important the seller understand the true value of the company to help avoid the risk of either selling too low, or losing a potential purchaser by asking too high a price for the business.  

Buying Knowledge-Based Enterprises and Acquiring Intangible Assets

Much like the reasons for selling, there are a multitude of reasons why a purchaser would want to acquire a KBE. The terms of a transaction will be heavily influenced by the identity of the purchaser and what they plan to do with the KBE once it is acquired. 

For an outside purchaser that is already in the same industry as the seller, acquiring intangible assets of a business could be to fill a void in their technology offerings. Alternatively, a business could have a respected brand and the purchaser wants to leverage that goodwill by acquiring the IP assets such as trademarks or patents.  Often, purchasers of businesses seek to eliminate competition and either take over a greater share of the market, or expand into a new market by acquiring another business and its valuable intangible assets.

When the purchaser is a related party, such as a family member of the founder or key employees in the company, the purchase is intended to continue to grow the business through a next generation.  While this is typically a friendlier business transaction, the valuation of the intellectual property and other intangible assets should be properly considered. 

Another type of buyer is venture investors and family offices that specialize in buying and selling small to mid-sized companies that find KBEs to fit their business model.  These types of investors may purchase all the equity or assets of a KBE, or seek only to secure certain intangible assets of the company to use in another business. 

Regardless of the type purchaser and their plans for a business, their analysis and concerns will likely be the same:  ensuring they will receive value for their investment. This means, proper valuation of transferring intangible assets, such as: trademarks, copyrights, patents, trade secrets, business models, etc. 

Unique Challenges for Deals Involving KBEs

All business acquisitions involve challenges for both buyers and sellers, but deals involving knowledge-based companies have some unique issues due to the nature of their most valuable elements, namely the intangible IP Assets.

Valuation in Transferring Intangible Assets

One of the biggest challenges in buying and selling a KBE is accurately valuing the IP Assets and thus, valuing the KBE, itself. 

Traditional company value calculations involving multiples of revenue or EBITDA may work for companies with a long history, but chances are at least some of those are tied to IP Assets that can expire or be challenged or canceled by outsiders.  For an early stage venture, the IP Asset value may increase exponentially over the next few months or years, so pegging a specific present value can be virtually impossible. 

There is no simple, standard answer to how one should value a KBE. Buyers and sellers may engage valuation specialists, actuaries, or other consultants to calculate the estimated value of IP Assets and KBEs.  At a minimum, knowledge-based businesses should prepare a comprehensive inventory of all intangible assets that can be reviewed by purchasers during the due diligence process.  IP Asset due diligence is a critical element of a KBE transaction.  

Ultimately, however, the value of any business is the price someone is willing to pay for it.  KBE sellers need to understand the value of their IP Assets and company so they can negotiate a good deal for themselves when transferring intangible assets in a business sale transaction.  Similarly, KBE purchasers must ensure that they are acquiring a company that will continue to be valuable after closing.  

IP Asset Ownership

It is important for a knowledge-based company to properly own all the IP Assets it uses in its business.  Often, a company’s intangible assets were created by founders and/or independent contractors.  Unless those creators have executed written agreements with the business to officially transfer their rights, those individuals – and not the KBE - may own some or all of the IP and intangible assets. Such a situation could derail a proposed business purchase due to complications with transferring intangible assets properly and legally.

For example, if a company hires an independent contractor to write some software code for a fee, by law the contractor owns the code they write unless and until they assign the code to the company in writing. Thus, the company should ensure it has an executed copyright assignment or similar language in the development agreement with the developer. 

In addition, some of the IP and other intangible assets may be pledged as security for loans or lines of credit, may include third-party assets, may be subject to unfavorable licensees, or in some instances the transfer of the KBE could trigger a software escrow release.  These encumbrances will affect the ownership of the IP assets, which ultimately will affect the value of the KBE. 

Key Employees

Most of the intangible assets in a KBE are intangible assets such as intellectual property. However, in some instances the most important assets to a business will be a few key employees.  Because of their reputation, relationships, know-how, special skills, and creativity, these key employees are extremely valuable to the knowledge-based business.  As such, if those key employees leave the company at the close of a deal, the company will likely not be as valuable as it was prior to the transaction – even if the purchaser acquires all the other IP and intangible assets of the company.

To avoid this letdown, KBE purchasers will need to identify these key employees and enter into employment agreements with them to continue their employment after closing.  These type of key employee agreements can be critical for a purchaser, but because they involve future employment of individuals, negotiating these agreements can present a number of challenges to the transaction.  

Although the sale of a KBE may have many of the same elements of other business purchases and sales transactions, KBEs present some unique challenges that must be overcome to ensure buyers and sellers receive the sought-after benefits of their bargains, requiring proper valuation and transfer of intangible assets.

About the Author:

Jim Chester is a 20+ year business and technology attorney, professor, and entrepreneur.  He is a recognized authority in buying and selling technology businesses, global technology transactions, and providing strategic legal counsel for innovators and industry disruptors.  For more on Jim, visit here. He may be reached at jim.chester@klemchuk.com.

Sign up for Legal Insights blog here.  See all our content here.  

About the Firm:

Klemchuk LLP is a litigation, intellectual property, transactional, and international business law firm dedicated to protecting innovation. The firm provides tailored legal solutions to industries including software, technology, retail, real estate, consumer goods, ecommerce, telecommunications, restaurant, energy, media, and professional services. The firm focuses on serving mid-market companies seeking long-term, value-added relationships with a law firm. Learn more about experiencing law practiced differently and our local counsel practice.

The firm publishes Intellectual Property Trends (latest developments in IP law), Conversations with Innovators (interviews with thought leaders), Leaders in Law (insights from law leaders), Culture Counts (thoughts on law firm culture and business), and Legal Insights (in-depth analysis of IP, litigation, and transactional law).