PROTECTING INNOVATIONS

 

When you think of video technology, do you think of Ampex, the company that invented the first commercially viable VCR? Probably not. Despite its innovation, Ampex was edged out of the digital recording market — and it’s all to do with licensing.

Ampex licensed its cutting-edge technology to rival firms like Sony, who improved on the Ampex VCRs, dominated the market, and finally made the original technology obsolete.

This is a classic case of what researchers call the “boomerang” effect: the risk that a new technology’s licensee will develop it further to the point that they can overtake the licensor. Clearly, companies that license their technology need to protect themselves from potentially getting left behind. But given the complexity of technology innovation, and the uncertainty of the market, it’s impossible to design a licensing contract that protects for every eventuality.

That’s why some companies use a “grant-back clause” in their licensing contracts — a requirement that any improvements made to the licensed technology must be shared with the licensor. While a grant-back clause protects the licensor, it can make the licensee less invested in developing the technology.

Balancing potential gains and prudent protections in contracts isn’t easy. So how do firms decide whether it’s a good idea to include a grant-back clause? Research by Keld Laursen, IESE’s Solon Moreira, Toke Richstein and Maria Isabella Leone, published in Organization Science, homes in on two key factors that have a significant influence on the decision:

whether the innovation is a core technology for the company, and
whether the technology’s future is uncertain or secure.

They test the significance of these factors by analyzing 397 patented and licensed technologies in the pharmaceutical industry.

So, what’s the managerial take-away? The results of this study suggest that including a grant-back clause is most desirable when a licensor is trading a core technology and when there are high levels of uncertainty about the technology’s future.

Managers looking to increase rents from technology innovation must understand not only the opportunities and risks of licensing, but also how to design effective licensing contracts with provisions like the grant-back clause. The insights from this research may help guide the decision to use a grant-back clause or not.

When a Grant-back Clause Is Desirable
A firm’s core technologies are central to its ability to create value, and so these assets need to be protected. A company must retain control of its core technologies with patents and careful contract provisions so that it can use its innovative knowledge and experience effectively and create future innovations.

For the potential licensee of a licensor’s core technology, the grant-back clause can reduce potential future benefits from the technology contract. But the benefits of accessing this technology may outweigh these disadvantages, especially if it is an unfamiliar technology (say, a gene therapy innovation licensed by a more traditional drug company).

When a firm is uncertain about the future of a technology — for instance, when a patented breakthrough is still far from being commercialized — this effect is intensified. Licensors are most likely to add a grant-back clause in the case of technology that is both core to their business and uncertain.

When Companies Avoid the Grant-back Clause
A licensee also needs to protect its future rents in the licensing agreement. If the technology traded is closely related to the licensee’s own core patents, that company is unlikely to agree to a grant-back clause, as it will want to use its core experience and expertise to develop the technology. In this case, it will not want to share future property rights with the inventor.

So, the patent-holder may forgo a grant-back clause in these circumstances, especially if the technology is not core to their own business. If the licensor considers the licensee’s potential developments predictable and low-risk, the grant-back clause is also likely to be deemed unnecessary.

In sum, contracts matter. Licensing arrangements should strike a delicate balance between protecting innovation and allowing both companies involved to maximize their gains. Knowing when to include a grant-back clause can allow companies to strike this delicate balance and better create joint value.

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Support for freedom and independence requires opposition to intellectual property. The proposition that knowledge and ideas can be made the exclusive property of one who discovers or expresses what was previously unknown, is contrary to the nature of the intelligent mind, whose content is assembled from a mixture of the experiences of others and oneself. Intellectual property strikes at the very heart of the social-intellectual process that makes all aspects of progress possible. Government impediments to the free flow of information undermine the very dynamic of an advancing civilization.

Smartphone is covered by three hundred thousand patents! As technology grows increasingly complex, companies must navigate a web of intellectual property protections. Innovation and competition are suffering from the race to create enormous patent portfolios.

Patent thicket is a dense web of overlapping intellectual property rights that a company must hack its way through in order to actually commercialize new technology.

There aren’t patent thickets in industries where you have a relatively close link between a single patent, or a very small number of patents, and the product. For example, with pharmaceuticals, you can have a product that comes from one patent that protects one molecule. In these types of industries, patent thickets are less likely to exist, as companies do not need to obtain access to technologies patented by others.

On the other end of the spectrum, there are industries where you need many patent-protected technologies to manufacture a single product. The prime example is smartphones, where you need access to various technologies—the LCD screen, antennas, Wi-Fi standards, processors, batteries, and so forth. You have a similar situation with computational tools like audio or video codecs and with anything that relies on semiconductors—integrated circuits, memory chips, even light emitting diodes. Here, companies often acquire licenses for parts of the end product that are patented by others.

The idea of the thicket comes from situations where there are so many patents potentially held by different owners—and they may overlap in their protective scope—that it’s not even clear which people you need to talk to get all the necessary licenses. The competitive landscape suffers when there is a patent thicket. If companies are in the situation where they need to negotiate with other companies—and potentially competitors—to get access to technologies or patents, there is mutual dependence. Samsung needs licenses from Motorola and Apple to manufacture a smartphone. Since the other companies also need licenses, they end up granting cross licenses; however, if one company has a bigger patent portfolio, it can demand payment to make the deal work.

It’s a prisoner’s dilemma. Everyone has an incentive to have the biggest patent portfolio. When Google came up with the Android operating system, they had a fairly small patent portfolio. They were facing competitors like Apple, which has a huge portfolio. There was always the threat of Apple pulling access to the patents or taking them to court, so Google acquired Motorola, not for the hardware business, which they sold to Lenovo, but for the patent portfolio—to be an equal player at the table.

Patent portfolios are assets in themselves. When Kodak went into the bankruptcy, its patent portfolio was a major asset that is still being commercialized today by the new owners. Another example would be when Ericsson exited the mobile handset part of their business to focus on network infrastructure—they sold off more than 2,000 patents to an entity with the sole purpose of generating revenues by licensing this patent portfolio. Non-practicing entities like this are not active in any product market. They are basically patent aggregators.

There is a lot of discussion and numerous observed cases of non-practicing entities strategically holding up players in the industry, saying: I have a patent you might infringe upon, and if you don’t give me a reasonable licensing fee right now, I’ll go to court and shut down your factory.

The risk for non-practicing entities is zero. They don’t have a factory someone could close down. However, the threat of being taken to court creates an incredible amount of uncertainty for companies active in product markets, running factories that could be shut down. And, in the United States’ patent system, non-practicing entities have a relatively good opportunity to create this uncertainty. In other jurisdictions it is harder.

The impact of patent thickets on innovation and competition is huge. The costs arising from patent thickets are adding to the cost of R&D. This really slow down innovation. Companies are squeezing more patents out of the same R&D expenditure as they did 10 or 20 years ago. There is a patent explosion driven by the prisoner’s dilemma these companies are in.

Large companies are always saying, “There is no problem with patent thickets because cross-licensing is cost-neutral. Everything is fine, and there is innovation and progress.”  But what they never talk about is if you don’t bring any patents to the table, essentially you won’t be allowed to enter the market. If you don’t have anything to bargain with, they might not give you the licenses.

Thickets have a negative effect on entry into these industries. From a competition perspective, that’s concerning. Additionally, there is a huge effect on transaction costs from thickets—filing fees, patent attorneys, everything associated with the drive to accumulate the biggest patent portfolio.

Patent thickets are, in part, a result of company strategy, but more, they are the consequence of the nature of the technology that is needed for a product. In many cases, the ownership of all the technologies needed to manufacture a product is going to be fragmented across multiple players. That’s a structural problem you can’t tackle.

We have to cool down the patent explosion. For that, basically there are two parameters people are thinking about: increasing the cost of getting a patent and making it cheaper to get rid of low-quality patents. It would be possible to simply increase the cost of filing for patents, but there is a concern that would leave out small companies. One of the consequences of the explosion in the number of patent applications is that the patents that are granted are legally weaker, because each application is getting less scrutiny.

In the ’90s, there were a couple of case law decisions in the United States that basically wiped out many of the limitations on what can be protected by patent rights. There was a spike in patents that were not based on a physical invention. A door was opened to software and business method patents. Amazon patented one-click buying and enforced it. The patent was invalidated, later. But, due to the uncertainty, they were able to get some money out of it.

Another example is Apple’s swipe-to-unlock patent, which covers putting your finger on the lock screen and to moving your finger in a horizontal direction. The word “horizontal” is very important because you can avoid infringing on the patent by, for example as HTC did, putting a circle on the lock screen that you can pull in any direction to unlock your phone. These patents can have some strange consequences. Over time, the courts have gotten stricter with these patents. This is beginning to regulate itself at the moment.

Another piece of dealing with weaker patents is when someone claims patent infringement, the potentially infringing party will often countersue through an invalidity suit. In effect they say, “I don’t know whether I infringed on your patent, but you shouldn’t have these patents in the first place.” If they can get a court to declare the patent invalid, it preempts any infringement. There has been debate on whether invalidity challenges can be made more efficient and cheaper as a way to weed out low-quality patents.

The patent system itself is pretty harmonized through the WTO treaty, which includes the Trade Related Aspect of Intellectual Property, or TRIPS, agreement. It specifies the pillars of all intellectual property protection, which includes the patent system. The basic parameters are all the same. A patent can be given on an invention that is novel, useful, and not obvious.

The differences are largely on the implementation of the TRIPS agreement and on the enforcement side in courts. Patent laws govern how patents are granted and what rights are associated with patents. When it comes to enforcement of those rights, then you’re usually entering civil law. And there you get everything you can imagine in terms of variation across the globe. Texas has become famous for being home to many patent litigation cases, because courts and juries in Texas courts are seen as friendly to patent owners and as awarding high damages.

There is little doubt that the world of patent monetization is dominated by patent trolls. A troika of favorable patent assertion fora, contingency-fee based legal services, and a proliferation of patent ownership structures that stand divorced from commercialized inventions has produced breathtaking return multiples for so-called non-practicing entities (NPEs, which are organizations that own patents but do not commercialize them). The currency of this assertion market is the vast arbitrage exploited by the NPEs. Several factors account for this – including the lack of any acceptable, up-front methodology for valuing patent as assets per se, the significant legal expense defendants face from such assertions, and the costly and post-facto timing of court-ruled infringement determinations. All these work to dislocate the patent market from the commercial market in which patents are used in the real economy.

This has not always been the case. More than 16 years ago, Rembrandts in the Attic (Harvard Business School Press, 1999) disclosed IBM’s patent licensing prowess, which literally added billions of dollars a year to Big Blue’s bottom line. Next came Edison in the Boardroom (Wiley, 2002), and patent monetization efforts of all stripes, ranging from patent aggregators to exchanges, quickly followed. Systemically, jurists all but assured the marketplace that patents are automatically valued based upon the underlying inventive contribution.

In short order, however, virtually all the new market players and exchanges were quickly cleared out, save for the speculators. One driving reason for the exodus remains how difficult patent valuation truly is — even in open court.

Legal notions of automatic patent valuation never materialized because, as it turned out, the market rarely valued patents. Instead, courts did — and did so at times unpredictably and sometimes poorly. Still, despite attempts by aggregators and others to craft one, no generally accepted convention exists for patent valuation. As a result, almost by definition, each patent transaction presents its own special situational considerations.

The market therefore had little choice but to be overtaken by arbitrage. Coupled with the high cost and post-facto timing of court rulings, the patent market became disconnected from the commercial market in which patents were used and provided an engine for patent arbitrage opportunities to dominate.

Now, however, that domination may be ending. Aside from various U.S. legislative efforts to thwart predatory patent assertions, a new counterweight to the NPEs has emerged: the banks. Equipped with attractive, new financial alternatives, banks are beginning to hit the trolls right where they live — in the arbitrage. The past two years have seen a steady drumbeat of various bank-driven patent financings and securitizations, including the recently announced $300 million debt financing provided by Blackrock to Jawbone, which makes fitness devices. Media reports have recently highlighted the fact that Jawbone’s parent firm, AliphCom, has sued Fitbit over alleged threat of intellectual property as well as patents.

Banks are now entering the patent market, but in a manner that eschews arbitrage. Rather, select capital providers may have found a better valuation mechanism — based upon credit-return models — and appear to be looking back to the future by re-adopting the Rembrandts in the Attic view of patents as assets per se. Innovatively, however, the asset analogy most befitting patents as a financial instrument is that of a derivative — that is, a patent derives is value from its enforceability. As such, credit-based monetization alternatives are being constructed. Patents can now be mortgaged, effectively “monetized-in place” in a fresh and now market-friendlier manner.

A construct of law, patents are property rights granted for a limited time (20 years from filing) by the government in exchange for the disclosure of the underlying invention. (Upon expiration, patent rights pass into the public domain.) Patents are therefore considered negative rights, providing the owners specifically the right to exclude others in the commercial marketplace. A patent’s value is, therefore, fundamentally based upon its enforceability. (The converse is also true — a patent which does not cover any real economy embodiments may have little present value, although may increase in value as the underlying technology catches up.)

Economically, patents are derivatives because their value derives from the real-world goods and services covered by the metes and bounds of the patent claims. If real-economy goods or services infringe the patent, then in theory, the patent has a determinable value (legally “no less than a reasonable royalty” and on occasion, a competitor’s lost profits). Thus, two worlds exist — the rights world of patents and the commercial world in which the patented inventions are put to use. Mapping patents to the commercial world creates a pricing approach based upon these fundamentals.

This real economy of commercialized inventions is also the marketplace in which jurists initially would have had us value patents. The problem, however, is that this market does not value patents in the abstract. Rather, courts do, and patents are worth what the courts say they are. Not only is this expensive and inefficient, but patent prices, of course, are not determined at the time of bargaining, but rather at the conclusion of lengthy legal proceedings.

Worse, courts can get valuation wrong — at times awarding damages beyond the scope of the government-granted patent claims. In the technology sector, these oversized awards stem from the sheer complexity of interoperable components and systems sold as part of functional units, if not integrated devices. And because technology invention tends to be incremental, to the extent an individual patent owner can be awarded damages on the price of the entire end product as opposed to their specific patent claim, a litigation incentive arises. As a result, speculation continues to fuel patent enforcement and the arbitrage opportunities work to further occlude any meaningful price discovery.

A further complication arises from the substantial legal costs to defend a patent infringement suit (recently estimated by PWC at approximately $4 million). If, in the bid/ask of a potential patent sale, speculative behavior drives an ever-inflating price ceiling (given the possibility of oversized damages), a price floor becomes set by the extreme expense of litigation defense, marked at just under nuisance value (and foreclosing any ability for price discovery below it). Once again, there is no patent price to be derived from the fundamentals.

After more than a decade when the currency of patent monetization was arbitrage, can a financial derivative patent pricing model — one which correlates returns to fundamentals — get a foothold? If the recent spate of deals including Blackrock’s Jawbone financing is any indication, we may already be seeing a market shift, with patents now being recognized — and financed — as assets per se. By jettisoning the arbitrage approach and reestablishing pricing by fundamentals, lenders can displace the courts by effectively saying what the patents are worth — as collateral to the borrower. Patent-debt financing products can thus be created which are priced to realize a lender’s credit-based returns and risks — risks far different from speculative approaches.

To do so, the lender’s underwriting process will need to map the to-be-borrowed-against patent rights to their real economy counterparts to value the patent asset, based upon the fundamentals. The lender accordingly writes a patent mortgage. Importantly, however, the lender now has downside protection, with the patent as collateral, to protect it from the risk of default. Also, for certain borrowers with sizeable patent portfolios, the lender has ample flexibility to structure and, if need be, recoup the loan. Should the patents become repossessed, the lender can look to the patent marketplace, needing only to sell (or assert) the quantum of assets necessary to recover any unpaid loan amounts (and the lender’s return on the loan).

Additionally, credit-based alternatives can work in specific situations where arbitrage cannot. Such approaches may be a particularly effective and welcome as a source of funding for companies that may have exhausted their financing rounds, but which have patent positions that offer them a competitive advantage that would be lost or impaired by a sale or otherwise put at risk by enforcement.

Taking the market as a whole, the better a lender’s underwriting process and the more correlated its process is in recognizing patent fundamentals, the stronger the “credentialing effect” that lender’s participation in patent-backed financing will have in the marketplace. Patents that support loans from well-regarded lenders can and will be viewed as having higher overall quality — whether they remain in place with the patent owner, or whether the assets enter into the marketplace upon default.

Favorable alternatives for enforcement can be created as well, providing the patent owner with the ability to finance litigation and retain more favorable upside economics afforded to it by the lender’s realization of credit returns versus higher equity-style arbitrage returns. And the credentialing effect for the patents by lender participation may in turn have a perceptible in terrorem effect for litigation defendants.

Facing a litigation-financed portfolio, defendants will have to weigh the prospects that the assertion is sufficiently financed to take the case through trial — and beyond. The lender’s presence therefore may create an impetus for defendants to seriously consider settlement prospects early on, based upon the assumption that the lender’s financial investment in the case passed a rigorous underwriting muster. Effectively, the lender’s detailed assessment of the patent’s fundamentals are one and the same as the merits of the case. This should also help level the playing field for smaller or distressed companies by providing them with the financial wherewithal to withstand litigation strategies designed to exhaust their resources.

A viable alternative to contingency-fee litigation is thus created. Presently, plaintiffs cede substantial economics to contingency-fee counsel since counsel is taking lion’s share of the risk. With appropriate underwriting and structuring, litigation financing may provide a mechanism for significantly cheaper money for the patentee. This in turn may further rationalize the market, as lenders need only to realize their credit returns, not the multiples driving the equity-arbitrage troll assertion market.

In the long run, better price discovery results since a lender’s underwriting restores patent pricing to its derivative-based fundamentals, and lenders therefore find themselves closer to the center of patent price discovery. Better still, the lender effectively creates its own market data in near-real time — at the time the patents are being mortgaged.

At bottom, more market-friendly patent monetization alternatives are created by entities that are patent-friendly. With lending based upon a patent-as-asset per se view, companies that were the initial innovators may have also created for themselves a financing lifeline by borrowing against their previously untapped assets. Patenting can become a strategic option, especially for start-ups — patenting early on in the company’s lifecycle can have a significant potential benefits downstream — debt financing may allow you to borrow on them later. It seems safe to say that in today’s macroeconomic and geopolitical world, a self-determined, long-term, asset-based lifeline would be highly valued. In the microeconomic realm of patents, that shift may already be underway.

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