(This week, David Wanetick, Managing Director of IncreMental Advantage provides readers if the IP Asset Maximizer Blog with an excellent overview of the various factors that he believes affect patent valuation. Please let me know if you would like to be a Guest Blogger.)
How Patent Vulnerability Impacts Valuation by David Wanetick of IncreMental Advantage
As I often tell business leaders who attend my course on Valuing Early-Stage Technologies, valuing patents isn’t rocket science. It is much more difficult. Or to paraphrase Winston Churchill, valuing patents is a riddle, wrapped in a mystery, inside an enigma.
Measuring even a well-delineated permanent entity is much more difficult than may be imagined. As Neil deGrasse Tyson (a renowned astrophysicist) and Benoit Mandelbrot (the father of fractal geometry) have discussed, no one really knows what the circumference of the coastline of the United Kingdom is. The tides will cause varying degrees of erosion on the coastline depending on the hour of measurement while the cumulative affect of choosing which rock formations to measure around will have a dramatic impact on the final assessment of circumference. Patent valuation is infinitely more difficult to determine than the measurements of a given land mass due to the interminable variation of underlying technologies, legal issues, business issues, and context in which patent valuations are conducted.
Companies that have patents often attempt to achieve a more attractive valuation by boasting about their patent portfolio. This is often a successful gambit as many investors, customers and media figures are impressed when a company reports a relatively large number of patents or pending patents in its portfolio. Thus, it is no surprise that many entrepreneurs and venture capitalists have admitted to me that they view patent preparation and filing costs akin to marketing expenditures.
However, valuation analysts should not reflexively assign a higher valuation to companies that own patents or are applying for patent protection. Companies can have a patent on a technology for which there is no possibility of commercializing or selling. Patents pending are particularly specious. Pendency (the length of time it takes the US Patent and Trademark Office to make a decision on a patent application) is now an average of 32 months. In some industries—such as semiconductors and electronics—pendency is more on the order of four to five years. Thus, the market targeted by a patent could become obsolete before the USPTO makes a decision. In fact, only between 2% and 5% of patents generate any royalties and another 45% to 50% don’t even have any strategic value. Further, two out of every three patents lapse because of failure to pay fees, most often because their owners believe that the thousands of dollars in maintenance fees exceeds the value of the patents.
What is a Patent?
It is first necessary to dispel a few of the common misperceptions revolving around the definition of patent. A patent is certainly not a right to a monopoly. Inventors can design around a patent by producing another technology that yields the same effects. Having a patent that becomes incorporated into a commercially successful product doesn’t always provide substantial profits to its owners. (The patent may generate nominal royalties because of its minimal value added to the end product or its early stage of development may require significant future investment on the part of the licensee.) A patent is simply a license to exclude anyone else from reproducing the same affect by applying a specified process during the time in which the patent remains in force. Similarly, patents can be viewed a merely instruments which grant their holders the right to sue alleged infringers.
What makes a patent vulnerable?
One reason that valuation professionals should not over-rate a patent is that the patent could very well be deemed to be invalid. Roughly 50% of the patents that are litigated are held to be invalid. Simply granting of a patent by the USPTO does not ensure patent validity. There is no way that one could expect patent examiners to only issue patents that would invariably be ruled valid during litigation. On average, patentees spend less than $10,000 on legal fees in connection with the drafting of their patents and patent examiners dedicate an average of 11 hours of review per patent application. Less than $10,000 in legal services and 11 hours of an examiner’s time can never withstand the $7 million average cost of litigation (that is expended in patent cases where more than $25 million is at risk) and thousands of hours of effort by locked-on lawyers dedicated to defeating a patent. In fact, the only way that a patent’s validity can be proven is through litigation. Determining which patents will be ruled valid is very tenuous: validity often hinges on the interpretation of seemingly common words such as ‘when’ and ‘either’.
Another major reason that patents are vulnerable is that patentees often cannot afford to assert their rights. With litigation costs on the order of $7 million, few solo inventors or small companies have the financial resources or managerial bandwidth to challenge infringers. If the suspected infringer is a large company, it can usually threaten the plaintiff with a countersuit as these parties may be violating one of the defendant’s patents.
It is this vulnerability that is a significant factor behind license brokerage rates (the rates realized when selling patents) ranging in a seemingly insulting band of between one and ten percent of the anticipated cumulative licensing fees. Buyers can acquire a patent for as little as one percent of the royalties that such patent is expected to produce because there are risks of the patent being ruled invalid immediately after the acquisition transpires or there could be an injunction imposed on a product that incorporates the patent which would cause associated revenues to dry up.
The Impact of Uncertainty on Patent Valuation
There is tremendous uncertainty associated with assessing the value of patents. However, it is this uncertainty that can be used to make an argument about the value of a patent. The valuation analyst could review certain characteristics pertaining to a patent and argue that such set of factors is a positive or a negative factor in the patent’s expected value. For example:
Years of patent life remaining. Most investors would not want a patent that has limited years of patent protection (e.g. one that is more than 16 years old). However, a patent that was too recently issued (e.g. within the past three years) is unlikely to have been litigated. The average age of patents when they are litigated is three years old. It is better to acquire a patent after it has been proven valid during litigation or has passed through the period when challenge to its validity is most likely. As a sweeping generality, those patents that are most valuable are between 10 and 13 years old.
Number of inventors listed on a patent. A higher number of inventors listed on a patent indicates that the patent is of higher quality than a patent that has a lower number of patent inventors listed. The reason is that more intelligent scientists or engineers believed in–and dedicated their time to championing–the technology behind the patent. However, having numerous inventors listed on a patent can be a source of vulnerability: if these inventors are deposed or cross-examined when their patent’s validity is challenged, it becomes more likely that one of the inventors will mention the existence of prior art. Also, failing to list an inventor on a patent risks giving rise to litigation.
What makes a patent valuable?
While the complexity of—and uncertainty surrounding—patents makes it impossible to derive definitive valuations, there are a host of factors that are determinative of patent value. While a few of these factors are provided below, it is critically important to realize that businesses that attempt to commercialize their patents, don’t receive the value (deal) that their technology (patent) deserves, they receive the value (deal) that they negotiate.
Anticipated licensing revenue. A standard procedure in patent valuation is determining the net present value of royalties that will be received as a result of licensing the patent. One benefit of developing a highly delineated model of projected royalties is that very specific factors can be taken into account.
Ability to trigger sales of end products. Patents are most valuable when they cause consumers to buy more of the product or newer versions of the product. For instance, some ten years ago Intel and Microsoft were able to spark sales of personal computers when they introduced new semiconductors and software. Consumers willingly retired perfectly good PCs as they raced to embrace PCs with the greatest processing power and snazziest software. Similarly, patents that increase the utility for existing or new users are generally very valuable. Examples of this can be found in the patents behind the features on cell phones. Finally, patents are valued dearly when the patented feature is a primary factor in the demand for the product. This is to say that the patent is the product. Examples of this contention include the primary patents underpinning many pharmaceuticals, Velcro and Post-It notes.
Ability to generate add-on sales. A licensee may derive important ancillary benefits associated with selling products with imbedded cutting-edge technologies. The benefits may be in the form of greater traffic generation to its web-site, catalogs, or stores. A more direct example of generating add-on sales would be a patent that improves on the functionality of ice skates could also contribute to higher sales of protective gear. In such instances, the licensor should seek higher licensing fees from the licensee since the licensee will enjoy spill-over benefits associated with selling the cutting-edge technologies.
Ability to generate sales in new markets. Licensors typically seek lower royalty rates from licensees who will sell the related products in a new market compared to the royalty rates they seek from competitors who will challenge the licensors in their existing markets. While the royalties per unit from the former licensee will be lower there are two factors that are accretive to patent value in this scenario. First, the total royalties generated by a licensee pioneering a new market are likely to be substantial. Secondly, licensees penetrating new markets do not pose the profit denigration issues for licensors that competing licensees represent.
Stage of development. Typically, the earlier in the commercialization stage a technology is, the lower the licensing value. This is because there are significant risks in the technology never being brought to the market and if the technology eventually becomes market ready this will only be achieved at great expense. In the scenarios in which the licensee would have to make much of this investment, the licensing fees would be less lucrative for the patentee.
Quality of law firm. Services such a PatentCafe rate and rank law firms on their history of writing patents that successfully sustain invalidity challenge. Patents drafted by law firms that score highly on such rosters are generally of higher quality than patents that score poorly on such surveys.
Quality of patent examiner. Patents that are granted by patent examiners with longer tenures and more impressive records of granting patents that successfully sustain invalidity challenge are statistically more valuable than patents without such lineage.
Size of portfolio being sold. Our research indicates that each patent family will receive the highest price when between 25 and 76 patent families are included in a patent portfolio. Portfolios with more than 76 patent families are discounted because the buyers believe that the sellers are purging a lot of their mediocre patents in the portfolio sale. On the other side of the spectrum, selling too few patents yields a discounted value per patent because of the natural aversion that patent managers have to seek significant funds (e.g. $3 million) from their Boards of Directors in order to buy a small number of patents (e.g. two). (See Chart below.)
Strategic implications. A given patent usually has dramatically different value for various potential licensees or acquirers. Savvy licensing professionals will conduct intensive due diligence to understand the dynamics of their potential licensing partners in order to seize the incremental advantages associated with deconstructing their business models. Some of the factors that determine how much value a licensee or acquirer would place on a particular patent include:
- Ability to commercialize. The value of licensing a patent is reduced if the licensee would have to make significant capital investments to produce a product that incorporates the patented invention compared to a licensee who already has the requisite production infrastructure in place.
- Stature of the inventor. In many closely-knit industries such as colorectal surgery, the players with buying power are well-aware of the most renowned inventors. These decision makers are often inclined to buy products that incorporate the inventions introduced by renowned inventors. In these scenarios, patents granted to the most respected inventors inherently have more value than patents granted to unknown inventors. This incarnation of “the Matthew Effect” is analogous to the value that art dealers place on provenance (the history of an artwork’s ownership).
- Value of depriving competitors of key technologies. Sometimes (particularly large) companies license in or acquire technology solely to keep it out of the hands of competitors. Depriving a competitor of a crucial ingredient in producing a product could result in their delay in introducing competing products to lucrative markets and force them to make significant expenditures in terms of having to design around hard-to-reproduce technologies. Professionals engaged in negotiating patent licensees should shop their technologies to several competing potential licensees so as to raise the competitive spirits among the potential licensees.
- Acquirer’s or Licensee’s portfolio concentration. The breadth and depth of the destination portfolio is a function of the value that an acquirer will place on a patent under consideration for purchase. For instance, companies contemplating acquiring a patent for strategic (rather than commercialization) reasons that have no patents in a particular discipline will typically value a patent with broad claims covering that discipline more favorably than a company that has a rich patent thicket in the given discipline. The explanation for the variance is that companies that already have a robust portfolio derive less incremental freedom to operate by acquiring such a patent than companies for which such acquisition could be used as a Trojan Horse for placing a stake in a new discipline.
- Capital raising implications. Licensees can win economic advantage by realizing that winning a license agreement can be enormously helpful to a patentee seeking to raise capital. In other words, a large company can often pay a lower royalty rate when it knows that its agreement will validate the licensor’s technology and such validation and license agreement will increase the ability of the licensor to attract funding. The leverage that the licensee may exert in such a scenario is a function of the number of licensee agreements that the licensor has executed. The licensee will have quite a bit of leverage if it stands to become the first licensee but perhaps no leverage if it is the twentieth such licensee.
- Economic impact of licensing agreement. A licensor can negotiate a reduced royalty rate by demonstrating that its licensing agreement will enable the licensee to achieve reduced production costs for its entire product line. For instance, if a licensee is currently producing 150,000 sensors at a cost of $1.25 each, it may be able to reduce its costs per sensor to $1.00 if it enters into a license agreement to produce another 50,000 sensors.
- The profitability of the industry and the importance of acquiring such patents. The wealthier the purchasers or licensees are, the more they can afford to pay. Thus, companies involved in direct battles with competitors will pay more than companies with no particularly pronounced competitive concerns. The rivalry between Qualcomm and Broadcom is resulting in generous licensing and reassignment opportunities for patent-holders. However, when this rivalry diminishes, so too will their compensation to inventors and patentees. Finally, patents that are expected to be adopted by standard setting bodies are valued higher than business method patents.
Patent valuation requires knowledge of the relevant inventions, market conditions, and patent law. It also entails the ability to bring a myriad of facts and considerations together to build an argument about the value that you believe your patent merits. In the final analysis, the value of patents is not only a function of the revenues and other economic and strategic benefits that it will yield. It is also a function of the timing of the transaction and the negotiating abilities of the principals involved.
About the Author: David Wanetick is a Managing Director at IncreMental Advantage, a business valuation firm with an expertise in valuing emerging technologies, based in Princeton, NJ. He teaches Valuation of Emerging Technologies and Negotiating Licensing Agreements at The Business Development Academy. He may be reached at firstname.lastname@example.org.