Arm took the risk and went to court with Qualcomm on the eve of the IPO

Arm, a British chip design company, chose to take a risk on the eve of its highly anticipated IPO: suing its big customer. However, Arm may have no choice but to resort to the law as it concerns how to distribute the revenue generated by its technology in new markets.

The lawsuit was filed in the U.S. District Court for the District of Delaware in late August. Arm's indictment alleges that Qualcomm, a mobile chip technology company, used Arm's intellectual property without a license. The case stems from Qualcomm's $1.4 billion acquisition of startup Nuvia last year, a chip design company based on the Arm architecture.

The acquisition underscores the technical interdependence of Arm and Qualcomm: Both companies are now looking outside of the mature smartphone industry to new markets where they can continue to expand. Nuvia's first design is an Arm-based chip for data centers, but Qualcomm says they hope to use the same design to break into other new markets that haven't yet widely adopted Arm technology, such as laptops and cars.

Stacy Rasgon, an analyst at Bernstein Research, said Arm is relying on customers such as Qualcomm to bring technology into new markets because they "need a growth story" to attract investors for an IPO that starts next year. "If you can only tell the story of the smartphone, it will not perform well."

However, despite months of negotiations, Arm and Qualcomm have not been able to agree on how Qualcomm will use Nuvia's technology. So, Arm chose to go to court. The company claimed that the licenses they had licensed to Nuvia were not transferable, and asked Qualcomm to destroy all intellectual property it acquired through the acquisition.

Qualcomm believes that the licensing agreement they signed with Arm a few years ago can cover Nuvia's technology, so it applied to the court to immediately dismiss the case.

The dispute sheds light on the intricacies of Arm's licensing arrangements -- and in some cases, it even puts Arm in direct competition with customers. During this process, some of Arm's major customers chose to increase the proportion of internal chip design, hoping to highlight the differentiation of their own equipment, thus posing a challenge to Arm's business model.

Arm has achieved great success in mobile devices with low-power chip designs. Last year, Qualcomm became the largest seller of Arm-based chips in mobile devices, according to market research firm Strategy Analytics. Qualcomm alone has contributed $12 billion to an estimated $35.1 billion in Arm-based chips used in smartphones, laptops, and tablets. It's followed by Apple, the tech giant that designs chips for the MacBook and iPad based on the Arm architecture, with $11 billion in sales.

Arm's licensing fees come from two licenses. One, called technology licensing, covers the computing cores based on the Arm architecture, which are the central "brains" of computer processors. Qualcomm would buy Arm's Cortex cores and use them in Snapdragon smartphone processors.

Arm's other license covers only its underlying chip architecture. That's the kind of license Nuvia got, and there are about a dozen similar companies, all of whom design their computing cores based on Arm's architecture.

Arm negotiates licensing terms with each customer on a case-by-case basis, and licensing rates are not disclosed externally, but rates under technology licensing models are usually higher because Arm needs to put in extra work to design computing cores. Last year, Arm's unlicensed revenue (the upfront fee it collects when signing new licensing agreements) grew 61%. But the company's $1.54 billion in licensing revenue still accounted for 58% of revenue, up 20% year over year.

Strategy Analytics analyst Sravan Kundojjala estimates that Qualcomm sells about 350 million to 400 million chipsets a year that use Arm's cores, each paying Arm about 80 cents in fees. But using Nuvia's "Phoenix" cores instead of Arm's Cortex cores could potentially save 40% to 50% of licensing fees.

Qualcomm said in response to the lawsuit late last month that it could use Nuvia's technology to compete directly with Arm, as well as other companies that use Arm's patents and use Intel's x86 chip architecture. Qualcomm also said it expects to use Nuvia's core in the crucial smartphone market, which is the largest piece of Arm's existing business.

Qualcomm is not alone in giving its products more advantages by controlling more of the chip design process. Apple is also licensing its own computing cores based on Arm's architecture, and they surprised the tech industry with the first M1 chips two years ago.

Nvidia is another big Arm customer, and when the company negotiated Arm in 2020, it agreed to pay $750 million for a broad license to Arm technology. Architectural licensing was included in the deal, but Nvidia recently said it chose to use Arm's Neoverse cores in its latest data center chips.

As top chip companies devote more resources to developing their own computing cores based on an architectural licensing model, "Arm's licensing fees through some customers appear to be lower," Rasgon said. "They're likely to have many customers moving to a royalty model," Rasgon said. But the value of this model is greatly discounted.”

Bob O'Donnell, an analyst at TECHnalysis Research, added that the shift could force the market to rethink Arm's charging model for intellectual property. "Some people think that Arm has not been charging enough in the past, so the architecture licensing fee should be increased," he said. Condogala said that due to Arm's high customer concentration, about one-fifth of customers contributed 80% of licensing fees, resulting in more pressure on the company's revenue.

It is not uncommon, however, to go to court over important intellectual property issues prior to an IPO. Yahoo sued Google for infringing a search advertising patent it owned before its 2004 IPO. The two sides eventually reached a settlement. For Arm, the pressure now is on how to demonstrate to potential investors how they can maintain decent licensing rates while looking ahead to a new phase of growth.

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