How Patents Impact Business Valuation

As I often tell business leaders who attend my course, 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.

Source: IncreMental Advantage research

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 effect by applying a specified process during the time in which the patent remains in force. Similarly, patents can be viewed as merely instruments that 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’. ThinkFire’s database of 309 deals collected between 2002-2008 indicates a median price per patent family of $112,000 and a mean price of $383,000.

Summary Results

Source: ThinkFire as delivered by Lew Zaretzky at the BCLT Seminar

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.

This featured guest post is written by David Wanetick, Managing Director at IncreMental Advantage, a strategic advisory firm. He leads all of the firm’s Devil’s Advocacy Audits. He teaches courses on Negotiations, Behavioral Economics and Decision Making at The Business Development Academy. David can be reached at [email protected].

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