IP Finance and Law: Four Vignettes

Intellectual property is an asset class and patents, prominent members of that class, are call options on the economic value of the covered technology. Because patent value can be substantial, and because the values of companies can be significantly impacted by the value of IP assets, the intersection of finance and patent law is increasingly common. In particular, here are four vignettes in which they intersect.

Markman-based Equity Arbitrage

While equity markets are “efficient” in the sense that they immediately process all information available to make reasonable investment decisions, they may not appreciate the full financial impact of relatively esoteric news ' such as the outcome of a Markman hearing. See Fama, Eugene F., et al., 1969. “The Adjustment of Stock Prices to New Information,” International Economic Review, Volume 10, Issue 1. (Feb. 1969), 1-21. This is the rationale in certain equity research circles where one IP-savvy senior analyst at Lazard Freres & Co. has claimed that “knowing the results of the Markman can be a profitable way to bet on the outcome of the trial or on which party will have to agree to a major settlement.”

Intrigued by this apparent arbitrage opportunity, I asked a dozen senior IP attorneys representing both corporate and private practice perspectives to respond to this assertion. Importantly, on the whole, the group concurred that the Markman results reduced the uncertainty of the outcome. However, there were nuanced responses that should give pause to any consideration for a massively leveraged investment. (To protect the anonymity of those surveyed, representative qualifying comments are reproduced below without attribution.)

The general finding is that a successful Markman hearing will lead to a successful prosecution of a case. However:

• “The more precise statement is that the Markman decision is indicative of how the literal infringement question will be resolved. So, if a party wins the Markman decision, it is likely that he will win the literal infringement question. Sometimes, the Markman decision will also give parties insight into how the question of infringement under the doctrine of equivalents will be decided – but not always.”
• “The jury is still needed to determine damages, so a successful case as to liability does not necessarily mean significant damages, or attorneys' fees – the essence of the case.”
• “Often, the party whose fate is doomed after the Markman, will stipulate to the other side's position to get a dispositive ruling from the court, after which they can run to the Court of Appeals for the Federal Circuit to appeal.”
• “Because the Federal Circuit is overturning such a large fraction of Markman decisions (I've seen reports of 50% reversal rates in some surveys), losers at the Markman stage are often choosing to wait for appeal rather than settle. This is further complicated by the fact that Markman decisions are most often not directly appealable, but must be appealed after a full trial on all of the merits at the District Court level.”

Litigation Investment Hedge Funds

The cost of IP ownership includes the costs of prosecution, maintenance and enforcement. From this perspective, the awardee of a patent is simultaneously the seller of a “put option” to all potential infringers. In a dispute, the potential infringer will “put” to the potential awardee demands for costly legal services. The potential costs of fulfilling this “put option,” estimated at upwards of '1m in the United Kingdom and $2-4 million in the United States is a significant business issue.

Driven by capital appreciation motivations similar to those of angel investors and early-stage venture capitalists, there are now litigation-support funds providing debt capital to attorneys. One of the largest of these financiers, Oasis Capital, recognizes that cash flow is an ever-increasing challenge for law practices. It is backed by a large hedge fund and is able to offer loans in excess of $2 million. This level of capital support can enable even traditional law firms that lack a war chest to accept the types of cases typically available only to contingency-based law firms. The debt instruments are backed by the cash flows expected from an anticipated diversified book of litigation business; the larger law firms are better credit risks.

The hedge-fund backed law firm investments differ from conventional bank loans in that the financier of the former has expertise in the practice of IP law and litigation and recognizes the implicit value of the IP asset class and the client's ability to capture that value. Consequently, law firms that usually have few fixed assets to collateralize, but a good track record of litigation successes, can find a knowledgeable lender to help them monetize their full range of IP assets. In other words, the financial investors are betting on the intellectual capital of the law firm.

In addition to these new financial investors, there are already a large number of contingency IP litigation law firms that will acquire a significant stake in the IP and assume all costs going forward as the integrated owner/plaintiff/counsel. See Kossovsky N, Brandegee B. “Monetization Strategies Other Than Licensing,” Les Nouvelles, 2003; 38(2): 77-78. These firms are strategic investors in that they are betting their own money on their own expertise to value the IP and to extract that value through litigation.

Infringement Insurance and Consulting Packages

A legal opinion of non-infringement is a risk transfer instrument; infringement insurance is also a risk transfer instrument. The former is based on a detailed study of a specified number of IP assets; the latter is generally the result of an actuarial analysis of the universe of IP portfolios. This distinction was clear until early March of this year, when Daniel Egger, founder and president of Open Source Risk Management LLC (OSRM), introduced his firm as the first company to specifically target helping companies deal with open-source IP risks. OSRM's offerings comprise both a consulting service and an insurance-like IP indemnification plan for all mainstream Linux distributions.

Specifically, OSRM will use code-scanning and copyright infringement detection technologies, such as that offered by Black Duck Software Inc., to assess a client's code base to identify any code that might lead to plausible legal claims. OSRM also offers both risk-mitigation consulting services, based on its set of best practices protocols and indemnification packages, a form of insurance-like protection against open-source-related litigation. The insurance product backstops OSRM's professional opinion; it is analogous to a law firm's malpractice insurance, which covers the law firm's risk. However, this product differs from malpractice insurance in the transparency of pricing and in the limitations of liability protection. The details of the offering are sketchy at this time, but OSRM claims that it is the only provider of “comprehensive vendor-neutral insurance solutions.”

The issue of Linux IP caught fire for businesses when, in early 2003, The SCO Group Inc. (NASDAQ: SCOX), asserting that Linux infringes its Unix IP, began to sue companies that use Linux. SCO, with 5 years of negative net income and with shares trading at below $5, in the spring of 2003 sued IBM for trade secret misappropriation and unfair competition. SCO claimed damages of $5 billion. The financial impact on SCO was favorable. By October 2003, SCO reported its first year of positive net income with a margin of 7% and its shares were trading above $15. At least one capital market player was significantly impressed and, on Oct. 17, 2003, invested $50 million for an at-market stake in the company.

To date, most Linux users have been reluctant to play by SCO's rules in the company's mounting crusade to be compensated for its IP. But following another round of lawsuits in March 2004 against car manufacturer DaimlerChrysler and U.S. car parts company AutoZone, SCO's threat of legal action now has teeth, and it's getting harder for other Linux adopters to stay out of the fray. OSRM's consulting service and indemnification plan should thrive given SCO's current litigation tactics. However, it remains to be seen whether OSRM will make money with these risk management products.

IP Investment Portfolios

One of the complicating factors in the SCO litigation is the question of IP ownership. Apparently, it is not clear which of the millions of lines of computer code in the various generations of Linux are covered by the Unix patents owned by SCO and which lines of code represent freeware augmentations by a myriad of contributors. Indeed, the relationship between a patent ' the call option on the economic value of the covered technology ' and the cash-generating product ' an embodiment of a potential plurality of technologies ' is neither linear nor transparent. Even Chief Technology Officers (“CTOs”), the presumed traffic managers of the R&D, commercialization, and IP creation efforts, are likely unaware of the nature of the relationship.

There are many potential explanations for CTOs' and other corporate executives' failure in this regard. My favored explanation is that the confusion is a consequence of: 1) the increased volume of patented incremental improvements; 2) the increased number of patents for a wider range of materials and methods that might have once been freeware; and 3) the rapid dissemination of information that results in rapid adaptation and improvements in all matters of IP. Each of these factors independently increases a company's IP risks; since these IP assets comprise a company's economic claims on innovation, these IP risks are also risks to a company's net income. The bottom line is that these IP risks collectively translate to an increased risk of returns on technology investments and consequently a more deeply discounted present value to any individual IP asset.

If the above explanation is true, the most rational investment strategy in IP would be to develop and/or acquire portfolios comprising related IP that covers a mix of distinct and interrelated technologies for a product or market. See Kossovsky N, Brandegee B, Giordan JC, “Intellectual Property Fair Market Value: Implications for R&D, Corporate Finance, and IP Litigation,” Research Technology Magazine, 2004. 47 (3) 1-10. Portfolios are fundamental elements of modern financial theory and are especially useful when the variances of return on investment ' as they are with patents and other forms of IP ' are log-normally distributed. Evidence that financial markets are beginning to appreciate the value of portfolios with respect to intellectual property assets can be found in a recent announcement by Jazz Pharmaceuticals, Inc.: At the end of March, the company announced the completion of a $250 million financing with private equity and venture capital investors. The company, which has no R&D activity of its own nor sells any product and is only in its second round of capital raising, will use the funds to augment its pharmaceutical product portfolio through licensing, acquisitions and collaborations.

Conclusion

Financial issues have always, implicitly, been at the forefront of any company's patent strategy and management. Today, financial issues remain at the forefront of corporate decision making regarding patents, but the range of opportunities presented by correlations between patents and finance and the implications of such correlations for patent strategy and management have become far greater, more complex, and more closely related to the day-to-day drivers of corporate value.

Intellectual property is an asset class and patents, prominent members of that class, are call options on the economic value of the covered technology. Because patent value can be substantial, and because the values of companies can be significantly impacted by the value of IP assets, the intersection of finance and patent law is increasingly common. In particular, here are four vignettes in which they intersect.

Markman-based Equity Arbitrage

While equity markets are “efficient” in the sense that they immediately process all information available to make reasonable investment decisions, they may not appreciate the full financial impact of relatively esoteric news ' such as the outcome of a Markman hearing. See Fama, Eugene F., et al., 1969. “The Adjustment of Stock Prices to New Information,” International Economic Review, Volume 10, Issue 1. (Feb. 1969), 1-21. This is the rationale in certain equity research circles where one IP-savvy senior analyst at Lazard Freres & Co. has claimed that “knowing the results of the Markman can be a profitable way to bet on the outcome of the trial or on which party will have to agree to a major settlement.”

Intrigued by this apparent arbitrage opportunity, I asked a dozen senior IP attorneys representing both corporate and private practice perspectives to respond to this assertion. Importantly, on the whole, the group concurred that the Markman results reduced the uncertainty of the outcome. However, there were nuanced responses that should give pause to any consideration for a massively leveraged investment. (To protect the anonymity of those surveyed, representative qualifying comments are reproduced below without attribution.)

The general finding is that a successful Markman hearing will lead to a successful prosecution of a case. However:

• “The more precise statement is that the Markman decision is indicative of how the literal infringement question will be resolved. So, if a party wins the Markman decision, it is likely that he will win the literal infringement question. Sometimes, the Markman decision will also give parties insight into how the question of infringement under the doctrine of equivalents will be decided – but not always.”
• “The jury is still needed to determine damages, so a successful case as to liability does not necessarily mean significant damages, or attorneys' fees – the essence of the case.”
• “Often, the party whose fate is doomed after the Markman, will stipulate to the other side's position to get a dispositive ruling from the court, after which they can run to the Court of Appeals for the Federal Circuit to appeal.”
• “Because the Federal Circuit is overturning such a large fraction of Markman decisions (I've seen reports of 50% reversal rates in some surveys), losers at the Markman stage are often choosing to wait for appeal rather than settle. This is further complicated by the fact that Markman decisions are most often not directly appealable, but must be appealed after a full trial on all of the merits at the District Court level.”

Litigation Investment Hedge Funds

The cost of IP ownership includes the costs of prosecution, maintenance and enforcement. From this perspective, the awardee of a patent is simultaneously the seller of a “put option” to all potential infringers. In a dispute, the potential infringer will “put” to the potential awardee demands for costly legal services. The potential costs of fulfilling this “put option,” estimated at upwards of '1m in the United Kingdom and $2-4 million in the United States is a significant business issue.

Driven by capital appreciation motivations similar to those of angel investors and early-stage venture capitalists, there are now litigation-support funds providing debt capital to attorneys. One of the largest of these financiers, Oasis Capital, recognizes that cash flow is an ever-increasing challenge for law practices. It is backed by a large hedge fund and is able to offer loans in excess of $2 million. This level of capital support can enable even traditional law firms that lack a war chest to accept the types of cases typically available only to contingency-based law firms. The debt instruments are backed by the cash flows expected from an anticipated diversified book of litigation business; the larger law firms are better credit risks.

The hedge-fund backed law firm investments differ from conventional bank loans in that the financier of the former has expertise in the practice of IP law and litigation and recognizes the implicit value of the IP asset class and the client's ability to capture that value. Consequently, law firms that usually have few fixed assets to collateralize, but a good track record of litigation successes, can find a knowledgeable lender to help them monetize their full range of IP assets. In other words, the financial investors are betting on the intellectual capital of the law firm.

In addition to these new financial investors, there are already a large number of contingency IP litigation law firms that will acquire a significant stake in the IP and assume all costs going forward as the integrated owner/plaintiff/counsel. See Kossovsky N, Brandegee B. “Monetization Strategies Other Than Licensing,” Les Nouvelles, 2003; 38(2): 77-78. These firms are strategic investors in that they are betting their own money on their own expertise to value the IP and to extract that value through litigation.

Infringement Insurance and Consulting Packages

A legal opinion of non-infringement is a risk transfer instrument; infringement insurance is also a risk transfer instrument. The former is based on a detailed study of a specified number of IP assets; the latter is generally the result of an actuarial analysis of the universe of IP portfolios. This distinction was clear until early March of this year, when Daniel Egger, founder and president of Open Source Risk Management LLC (OSRM), introduced his firm as the first company to specifically target helping companies deal with open-source IP risks. OSRM's offerings comprise both a consulting service and an insurance-like IP indemnification plan for all mainstream Linux distributions.

Specifically, OSRM will use code-scanning and copyright infringement detection technologies, such as that offered by Black Duck Software Inc., to assess a client's code base to identify any code that might lead to plausible legal claims. OSRM also offers both risk-mitigation consulting services, based on its set of best practices protocols and indemnification packages, a form of insurance-like protection against open-source-related litigation. The insurance product backstops OSRM's professional opinion; it is analogous to a law firm's malpractice insurance, which covers the law firm's risk. However, this product differs from malpractice insurance in the transparency of pricing and in the limitations of liability protection. The details of the offering are sketchy at this time, but OSRM claims that it is the only provider of “comprehensive vendor-neutral insurance solutions.”

The issue of Linux IP caught fire for businesses when, in early 2003, The SCO Group Inc. (NASDAQ: SCOX), asserting that Linux infringes its Unix IP, began to sue companies that use Linux. SCO, with 5 years of negative net income and with shares trading at below $5, in the spring of 2003 sued IBM for trade secret misappropriation and unfair competition. SCO claimed damages of $5 billion. The financial impact on SCO was favorable. By October 2003, SCO reported its first year of positive net income with a margin of 7% and its shares were trading above $15. At least one capital market player was significantly impressed and, on Oct. 17, 2003, invested $50 million for an at-market stake in the company.

To date, most Linux users have been reluctant to play by SCO's rules in the company's mounting crusade to be compensated for its IP. But following another round of lawsuits in March 2004 against car manufacturer DaimlerChrysler and U.S. car parts company AutoZone, SCO's threat of legal action now has teeth, and it's getting harder for other Linux adopters to stay out of the fray. OSRM's consulting service and indemnification plan should thrive given SCO's current litigation tactics. However, it remains to be seen whether OSRM will make money with these risk management products.

IP Investment Portfolios

One of the complicating factors in the SCO litigation is the question of IP ownership. Apparently, it is not clear which of the millions of lines of computer code in the various generations of Linux are covered by the Unix patents owned by SCO and which lines of code represent freeware augmentations by a myriad of contributors. Indeed, the relationship between a patent ' the call option on the economic value of the covered technology ' and the cash-generating product ' an embodiment of a potential plurality of technologies ' is neither linear nor transparent. Even Chief Technology Officers (“CTOs”), the presumed traffic managers of the R&D, commercialization, and IP creation efforts, are likely unaware of the nature of the relationship.

There are many potential explanations for CTOs' and other corporate executives' failure in this regard. My favored explanation is that the confusion is a consequence of: 1) the increased volume of patented incremental improvements; 2) the increased number of patents for a wider range of materials and methods that might have once been freeware; and 3) the rapid dissemination of information that results in rapid adaptation and improvements in all matters of IP. Each of these factors independently increases a company's IP risks; since these IP assets comprise a company's economic claims on innovation, these IP risks are also risks to a company's net income. The bottom line is that these IP risks collectively translate to an increased risk of returns on technology investments and consequently a more deeply discounted present value to any individual IP asset.

If the above explanation is true, the most rational investment strategy in IP would be to develop and/or acquire portfolios comprising related IP that covers a mix of distinct and interrelated technologies for a product or market. See Kossovsky N, Brandegee B, Giordan JC, “Intellectual Property Fair Market Value: Implications for R&D, Corporate Finance, and IP Litigation,” Research Technology Magazine, 2004. 47 (3) 1-10. Portfolios are fundamental elements of modern financial theory and are especially useful when the variances of return on investment ' as they are with patents and other forms of IP ' are log-normally distributed. Evidence that financial markets are beginning to appreciate the value of portfolios with respect to intellectual property assets can be found in a recent announcement by Jazz Pharmaceuticals, Inc.: At the end of March, the company announced the completion of a $250 million financing with private equity and venture capital investors. The company, which has no R&D activity of its own nor sells any product and is only in its second round of capital raising, will use the funds to augment its pharmaceutical product portfolio through licensing, acquisitions and collaborations.

Conclusion

Financial issues have always, implicitly, been at the forefront of any company's patent strategy and management. Today, financial issues remain at the forefront of corporate decision making regarding patents, but the range of opportunities presented by correlations between patents and finance and the implications of such correlations for patent strategy and management have become far greater, more complex, and more closely related to the day-to-day drivers of corporate value.