Bullish about patents?

Ok, so we have traded stocks, currencies, commodities, art, weather, electricity ... what next? Looks like the world is never out of ideas. At least James Malackowski, the CEO of Ocean Tomo has one. In an interview last month with Fox Business news, he discussed his ideas about an IP exchange. The interview video is available at www.foxbusiness.com.

The online patent auction platform created by Ocean Tomo has been one of the pioneer efforts in this area. There are several other websites offering a patent auction platform. But in most cases an auction is a one time phenomena in a patent's life. Then how does James Malackowski propose to build an IP exchange where patents could be traded like stocks, everyday, every minute. The concept of a "Synthetic Royalty Stream" appears to be one solution for this problem. Though synthetic royalty is not a very new concept but it is definitely not very popular either. Synthetic royalty is an investment mechanism where the investor would pay a lumpsum for a percentage share of a product's future revenue.

The issue now is to associate a synthetic royalty stream with a patent. Consider the case of a hypothetical company with one patent. Following are the steps in which the company can turn its patent asset into a liquid financial instrument:
1. Launch an SPV which holds the patent as an asset
2. Attribute a share of its product revenue to the patent and hence the SPV
3. Collect funds from investors in return of a stake in the SPV
4. The investors then trade their stakes as the product revenues rise or fall
5. These stakes will involve the risk of a substitute technology replacing the patented technology in the product

Several variants of the above mechanism can be used to make liquid financial instruments out of patents. The investment fraternity will need more technical support than ever to assess the risk associated with these instruments. Attributing a share of product revenues to a patent will involve development of standard methodologies for assessing royalty rates. This task will become even more challenging when revenues from multiple products need to be attributed to multiple patents. AT&T Knowledge Ventures (KV), under the leadership of Abha Divine has set an example of successful implementation of this process. AT&T KV implemented a methodology to annually measure the impact of its IP Portfolio on its per share earnings. It will take lots of such successful examples and a lot more standardization of processes before the world can start trading in IP.

Patent Valuation: Theory Vs Practice … and Whose Practice

The most widely known fact about Patent Valuation is that it is one of the best kept secrets in the Tech Transfer world. Edward Cooke, in his article “A little knowledge can go a long way” rightly describes the need and lack of a clear patent valuation approach. A clear indication of the absence of even a near exact valuation approach is the court’s irrational damage estimate of $358 M in the Lucent Vs Microsoft case. Though the damages have now been overturned but this clearly is no excuse of why the court was vastly away from what Microsoft and many other experts had estimated. The legal intricacies apart, the court proceedings even include debates on whether or not a particular valuation technique is correct irrespective of this case.

Most books on Patent Valuation stick to defining the Cost, Income, and Market approaches without discussing their feasibility. The most widely used of the three, the Income Approach, too cannot be followed in its textbook form. It is extremely difficult to estimate the change in sales and profits of a particular television model due to a small change in one of its circuits. And all this is expected to be estimated when there are hundred other bigger or smaller changes in its circuits, along with probably a change in its sales policy or may be its competitor’s.

The very reason that valuation techniques are still a well kept secret has given rise to multiple variants of the three basic approaches discussed above. Variants based on the income model probably are similar in structure, but what definitely differs is their evaluation of risks and royalties associated with a patent. These evaluations vary with the objective of the person/entity who is evaluating the patent. During an M&A deal an investment banker on the buyer’s side might chose to consider the probability of a patent being valid and the one on the seller’s side might chose to completely ignore this risk. For an independent evaluator, for whom ignoring such risks is no option, the question boils down to the importance that such factors deserve in estimating the overall risk of the patent. Validity litigations are to some extent a gamble for even the best written patents. However, this does not justify that each patent transaction should be done at half the value to account for such risk.

Many practicing entities in the patent transaction world find the law of averages to be their best excuse of not knowing / wanting to know the various risks associated with the patent. They assume that most risks will disappear when considered for a large patent portfolio. I have come across some glaring examples of players in the transaction space defining a “per patent value” for a large portfolio and selling patents as if they were all the same. Such cases have become more prominent post sub-prime due to increased abandonments to save on maintenance costs. There is a high chance that the risks and rewards associated with such transactions may be sharply mismatched.

When the portfolios are large, a scrutiny at individual level might not be justified economically. However the chances of error can be reduced by doing two additional low cost studies. First, a quick and dirty ranking of the patents in the portfolio should be done using statistical scoring tools or expert assessments. Second, the portfolio should be categorized into broad technology domains to enable differential pricing.

Last but not the least; a second opinion does not hurt, especially when the first one is coming from an investment banker.