On the Creation, Protection, and Delivery of Shareholder Value—Lessons from the Color Kinetics Experience

9/4/07Follow @FlagshipVenture

Entrepreneurship and innovation are powerful forces that, when combined, can lead to the creation of great value. Last week, the local startup community saw one of its finest recent examples of entrepreneurial innovation, Color Kinetics (CK), deliver nearly $800 million in cash to its shareholders—myself among them—upon the completion of its merger with Royal Philips Electronics. With about $80 million in revenue run-rate and a current year EBIT (earnings before interest and taxes) expected in the $4-6 million range, Color Kinetics garnered a valuation that far exceeded typical multiples. Instead, the company’s value reflected the unbounded potential of its innovative LED-based lighting solutions as evidenced by CK’s rapid profitable growth over the past five years under the exemplary leadership of CEO Bill Sims.

Looking back, an early share in a large or growing marketplace, an outstanding team, satisfied and loyal customers, and competitive advantage are often present in such high-value transactions and share between them most of the credit. In the case of Color Kinetics, one additional factor deserves significant credit and that is the intellectual property estate built by the company during its decade of existence. Atypical of many high-technology companies, but quite typical in biotechnology, the strategy of patenting early and often contributed ultimately to the company’s ability to protect and deliver the substantial value it created.

I was approached by one of the founders of Color Kinetics and its first CEO, George Mueller, exactly 10 years ago this week. At that time, he and his co-founder Ihor Lys had the vision of a world filled with color-changing, LED-based, intelligent lights. They had a functioning prototype and the need for capital to begin manufacturing and selling their new lights. Not knowing a lot about the lighting market put me in the company of most, if not all, potential investors in CK. The limited market diligence I could do confirmed that there was a very large lighting market that was stagnant and vulnerable to innovation. Much more exciting than the market-disruption potential, however, was the vast and open IP landscape that existed around the team’s innovations. Based on experiences from the biotechnology industry where the prevailing wisdom is to “patent or perish,” it became apparent that Color Kinetics should establish patents as core to its strategy for value creation.

Building a large patent estate proved to be a very costly undertaking for Color Kinetics. With limited capital, the company had to continuously balance investments in marketing or product development with further investment in new patent filings or enforcement. This balancing act was made even more difficult by the doubt, scrutiny, and even scorn expressed at the value of CK’s patents by prospective investors, the press, and eventually competitors. (This Forbes Magazine article from 2002 provides a nice snapshot of a time when it wasn’t clear what the future would hold for the company.)

Since the first patent was granted in January 2000, Color Kinetics’ patent portfolio has grown to 79 issued U.S. and foreign patents and over 180 pending patent applications. The company implemented a broad-based licensing program that has made the IP available to nearly 50 licensee companies, including industry leaders such as S.C. Johnson, B/E Aerospace, and Ford Motor Company. These licenses are expected to contribute about $5M in licensing revenues this year, most of which drops straight to the bottom line. The company also enforced its IP rights through two patent infringement suits, one of which resulted ultimately in a paid license and damages recovered by CK, and the other was settled as a result of the Philips merger (Philips had previously acquired the party involved in the second suit).

LED-based lighting is well on its way to transforming the lighting industry. The combination of Color Kinetics and Philips represents a formidable alignment of innovation and marketing power. Moreover, both companies have an intense focus on creating intellectual property to protect their investments in R&D and deliver value to their shareholders. While the entrepreneurial phase of Color Kinetics’ life may be ending, the innovations and value creation should persist for a long time.

Noubar was a founding investor and board member in Color Kinetics from inception until last week. He is a co-founder, Managing Partner, and CEO of Flagship Ventures. Since 2000, Noubar has also been a Senior Lecturer at MIT’s Sloan School of Management, where he teaches a course on Entrepreneurship (15:390B) on Monday nights.

Noubar Afeyan, PhD, is Founder, Managing Partner and CEO of Flagship Ventures and leads its VentureLabs venture creation unit. A technologist, innovator, entrepreneur, and venture capitalist, Noubar has co-founded and helped build 26 life science and technology startups during the past two decades. In addition, he is a Senior Lecturer at MIT's Sloan School of Management where he has taught courses on technology-entrepreneurship, innovation, and leadership since 2000. Follow @FlagshipVenture

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  • steve

    I would attribute the rich multiple to the potential of the market and the IP licensing business model. IP licensing is a great business when pulled off correctly. Nathan Myhrvold is fond of calling it the next software, and Deloitte predicts IP licensing revenue could hit 500 billion this year alone. Companies like Qualcomm and Dolby run their licensing businesses at about 90% margins making it much more profitable than product revenue.

  • Bedros Afeyan

    It is good to hear of a success story of this kind where intellectual toil and sustained vision lead somewhere. With the patent laws changing for the better very recently, perhaps the trend of frivolous patents and litigation escalation will abate.

    What would be very useful to know in more detail is how CK management did the deft maneuvering of staying on course, pursuing patents in the hundreds and product line and manufacturing development at the same time.

    By way of counter example, I was involved with a company which was innovating in a brand new space that could revolutionize the then booming photonics industry. The CTO was crazy about our (physicist’s) innovations while his partner in charge of manufacturing and process development looked at us with veiled hostility and extreme suspicion. It is the large scale manufacturing process challenges that brought the whole house down at the end. Should we (the physicists) have been thinking about that instead of coming up with multiple other designs for photonic transistors and their uses instead?

    Eventually, the venture went belly up and the far reaching patents which were either filed or pending filing, were discarded or ignored by the established company that bought the innovative one which couldn’t deliver past fantastic prototypes (decades ahead of its time, as it turns out). The physics team was disbanded and silenced much before the manufacturing problems were seen to be unsurmountable. Instead, expert teams in the latter were hired in mid-course to come and save the day which abysmally failed.

    So more facts on how to reconcile these trends would be helpful. What metric(s) can lead to the proper timing and resource allocation balance between clearing the path to the promised land (innovations, patents) and creating the thrust to propel one towards it in the first place (manufacturing and product engineering)?

  • Liz Allison

    As one of Noubar Afeyan’s fellow board members at Color Kinetics, I would add three points to Noubar’s observation
    that the broad CK patent portfolio added greatly to CK’s value in the sale.*

    - The fact that CK stayed the course and made huge (relative to the size of the company) investments in its IP portfolio testifies to the value of having board members from a variety of backgrounds, independent of industry knowledge. It had been a long time (1878) since the basis of competition in the lighting industry had been IP. Had Noubar not been on the board, had he not been such a conceptually informed, steady advocate of the value of IP, CK would almost certainly have chosen a more traditional route of investing in applied product development and marketing rather than IP.

    - IP investment is, to an uncomfortable extent, a faith-based strategy. When CK did its IPO, analysts wanted to hear about revenue and trophy installations, not IP. Direct IP driven revenues (licensing and OEM) were disappointing for years. It was not until cooperating companies with great depth of lighting expertise started looking at the SSL/LED industry that IP value could be monetized. So re: the posting above, there has to be board support for the strategy that is grounded in something other than current numbers…but a group of well-financed potential ‘informed buyers’ as well.

    - IP is a “professional driver required” strategy. Without a president (Bill Sims) who drove very, very hard on the operating side, CK would not have had the time or the track record to attract the attention of major players in the lighting industry.
    ————
    *To fill the time when I used to talk to Noubar about CK, I’m currently estimating a model that should give more quantitative insight into the relative contributions of company performance, projected industry and company growth, and the IP portfolio. First run looks like IP accounted for 40-45%.

  • http://www.IdeaBuyer.com Patents for sale, Patents US, Patent Information

    In regards to delivering more shareholder value, the ip portfolio being open for licensing and sale would be a good way to start. The ROI on the R&D could increase drastically if they focused on their core competencies and liquidated or favorably licensed the rest.

  • http://www.opsecsecurity.com identity solutions

    How are these companies performing now? (after the current US economic problems)