The Untapped Potential of IP Finance

By Nir Kossovsky
September 02, 2003

Over the past few years, business, legal, and accounting authorities have quite rightly pointed out that corporate IP has far greater potential than its owners usually exploit. The consultancy McKinsey & Company has offered that, as a rule of thumb, a company that owns at least 450 patents and spends $50 million or more a year on R&D should possess enough intellectual property to bring some of it to market. Typically, 10% of the patent portfolio could be put to work in this way. McKinsey also suggests that IP assets could generate 5% to 10% of a company's operating income with little initial capital investment. Thus, effective IP-asset management can be equivalent to the improvement that might be expected from a 20% cut in expenses or from a successful acquisition. See Elton JJ, Shah BR, and Voyzey JN, 'Intellectual Property. Partnering for Profit,' The McKinsey Quarterly, 2002, Number 4 Technology.

But talk, even at the engagement rates of a McKinsey consultant, is still relatively cheap. On the other hand, nonperforming assets do no one any good, and no rational CFO takes pride in sleeping patents and other inactive IP. So why is IP so hard to monetize? One potential explanation for the underutilization of IP assets may be that current conventional monetization strategies are difficult to implement with respect to such assets ' even when a company overwhelmingly needs and desires such financial benefit. So, the question remains: What alternatives could such a company employ?

Intellectual Property Finance in Theory

IP financial tools can help. IP finance comprises goals, analytics, and a deal logic that can provide bottom-line clarity. IP finance is concerned with the expected value of an intellectual property investment and the risk or variance of the actual returns relative to that expected value. IP finance, practiced skillfully, maximizes the expected return while minimizing the risk.

In order to manage IP as a corporate financial asset, three critically important characteristics of the IP must first be quantified: (a) expected return; (b) expected risk; and (c) expected correlation with other financial assets.

But every IP asset is unique ' a virtue from many perspectives ' but a challenge that at first blush would appear to preclude the use of modern financial tools in assessing these three factors. Who but a venture capitalist would willingly stake real money on the expected value and volatility of an innovative cancer therapeutic or on the expected return on a new business based on point-of-sale software?

From Balance Sheet Asset to Financial Asset

During the late 1990s, market observers noted the growing disparity between the value accountants believed they could reasonably document within companies and the value the markets felt they could squeeze out of companies. Many felt that IP, long denied the status of 'book asset,' explained much of the discrepancy. In July 2001, the Financial Accounting Standards Board promulgated FAS 142, which formally gave IP an identity and a value for accounting purposes: IP had achieved asset status.

But to be a financial asset in accordance with the modern tenets of finance, an asset needs to be a member of a class. An asset class is a group of assets with like characteristics, ie, similar correlation and return and risk parameters that tend to respond to economic factors in a parallel way and share a risk correlation that is high. A class conveys significant information on investment quality in the sense that an investor can discern readily from class features what might be the expected return, the risk of that return, and a reasonable price for the asset based on that risk.

An asset class is an imposed fiction of uniformity, but nonetheless it is essential to the working of efficient financial markets where: (i) the idiosyncratic risks of individual class members can be structurally diversified, and (ii) the behavior of the typical member of a class can be inferred from its reporting index.

Asset Classes: True Expected Value Protected from IP-Related Idiosyncratic Risks

Idiosyncratic risks happen. Although idiosyncratic risks affect a very small number of assets, their effects are substantial. The case of Eli Lilly and its patent risks is illustrative of this fact.

Eli Lilly and Company is a leading pharmaceutical company with a diversified portfolio of technologies including neuroscience, endocrine, anti-infective, cardiovascular agents, oncology and animal health. However, 25% of the company's revenue is derived from the sales of a single patented product: Prozac. See, Eli Lilly and Company, March 2003, CBS Marketwatch company information.

In January 1999, a federal district court affirmed the life of Eli Lilly's Prozac patent through December 2003. However, in August 2000, the U.S. Court of Appeals ruled that a generic drug company could begin making a Prozac substitute nearly three years earlier than Eli Lilly had planned. In fact, the ruling shortened Eli Lilly's patent protection to February 2, 2001 (later extended to August 2, 2001) and consequently, the effect of its decision wiped out approximately 30% of the company's value in one afternoon. See Eli Lilly and Company, October 2000, The Indianapolis Star Fact Library. In January 2002, the U.S. Supreme Court rejected Eli Lilly's appeal.

The balance of the pharmaceutical industry took a big hit in August 2000 because the industry, lacking the notion of asset class, could not differentiate among pharmaceutical patents for an indicator of value. For a few days, to the detriment of the industry, all drug patents were related to Prozac.

Asset Classes: True Expected Value Reported by an Index

Various groupings of stocks and bonds comprise the two broad classes of assets in finance today. Stocks and bonds asset classes are subdivided into more refined classes because empirically these further subdivisions have been found to be useful in making investment decisions. Each of the major asset classes is tracked by an index, and it is the index's performance that becomes the proxy for the performance of the individual members of the class.

The tracking index reports the asset class metrics in a standardized way. Large industrial companies are tracked by the Dow Jones Industrial Average, the overall market is tracked by the Standard and Poor's 500 index, small capitalized companies are tracked by the Russel 2000 value index, municipal bonds are tracked by the Lehman Brothers municipal bond index, etc.

IP Asset Classes

The notion that created further liquidity in stocks and bonds can also help create liquidity in IP and their derivatives, eg, technologies, media libraries and other copyrighted works, and brands. The asset class characteristics of IP derivatives have the class characteristics of the monetizable assets underlying those options Therefore, an understanding of asset classes as they relate to IP assets leads to three other key financial concepts:

Intellectual property rights are real options ' they are exercisable contingent claims on assets of potential net value.
Intellectual property rights comprise asset classes with quantifiable values and risks and cross correlations.
The value of those asset classes, and by implication, the expected value of IP within the class, can be indicated by a tracking index.

IP managed as an asset class is a necessary condition for deploying modern finance methods. These methods suggest that supply and demand dynamics, risk and uncertainty management protocols, and liquidity can all be optimized to enhance the financial return from IP assets.

Intellectual Property Finance in Action

IP asset managers have used brokers to create markets for individual assets. Now there are new IP financiers who bring with them the skill sets and tools to manage IP more like an asset class, and by implication, through more disciplined liquid markets.

These professionals come armed with calculators and capital. Using their own valuation methods, such IP financiers define an asset class around a carefully selected IP field and, after determining the value, volatility, and correlation characteristics of a chosen synthetic class, they then acquire select intellectual properties from a variety of sellers and assemble portfolios that could either be used to launch new businesses or be sold to strategic buyers. If needed, they will conduct additional research or marketing to enhance the value of these IP portfolios.

If you own technology that is of interest to such financiers, they may appear at your door with seductive promises of value creation and a reasonable return on your equity. Don't be shy. If your company is in need of a ready-for-development IP portfolio, you may be targeted for a sale. If you have a sufficiently robust IP portfolio and your own capital, such financiers may elect to partner with you, create a new entity, and leave you with a valuable minority equity investment. If you want to accelerate your value realization from performing IP and create opportunities for unexpected revenues through licensing, they are likely to have a solution ' one that will work.

Consider the case of one pharmaceutical company that was pursuing a cancer therapy strategy. While the company had developed a substantial amount of its own intellectual property in this area, there were five key patents related to this technology held by three different universities. The prospect of paying stacked royalties to all three was prohibitive, yet the IP rights were all necessary, and none were deemed singularly sufficient. Enter an IP syndicator that implicitly exploited the notion of asset class to successfully bundle the five patents and license them as a package. The package is now worth up to $300 million to the drug company, with the universities sharing the royalties.

In another case, a major food industry company developed a point-of-sale software system for its cash registers and order tracking. The software was best in class, and had excellent prospects for becoming an industry standard. The food industry company, however, felt that it did not have the internal expertise to operate a software and services company to serve the global restaurant industry. However, with the expert help of financers, the company launched 'eCompany Digital,' a stand-alone company staffed by software marketing and sales experts. Today, the company employs the software for its own business and enjoys the economic benefits of its minority equity interest in the software company it helped launch.

IP financing firms practice different variations of the strategies discussed in this article, and a number of methods in the field are patent pending. Irrespective of style, however, the products and services of these firms conform to the basic tenets of IP finance, and their assistance in helping companies effectively manage and monetize their IP assets may be invaluable to you or your client.

Nir Kossovsky, MD, MBA is CEO of Technology Option Capital, LLC and a Managing Director of Duff & Phelps Capital Partners in Pittsburgh, PA.