Generating Cash from a Patent Portfolio: An Overview

We have all seen the statistics:

• About two-thirds of today's S&P 500 market capitalization comes from intangible assets, having doubled in proportion from 20 years ago.
• More than $100 billion is collected annually in IP licensing income.
• More than $200 billion is written off every year from IP impairments.
• More than $300 billion in infringement (mostly innocent) occurs annually.

Today most professionals realize that the increasing value of intellectual property (IP) is a trend that will not be reversed. The accounting and reporting for intangibles is already catching up with the “real world,” most notably via Sarbanes-Oxley. More pertinent to this article is the fact that the financial services community is beginning to respond broadly with new products and services designed specifically to take advantage of this newly discovered wealth.

This is the first of a series of articles that will review various methods to generate cash from a patent portfolio. Only a flavor of each method is presented for this article; future articles will delve into the newer or more unique methods. It should be noted that the actual monetization of patents is often separate and distinct from the process of value creation ' the traditional focus of many IP professionals. Value creation comes in many stages, including invention, patenting, pooling, cross-licensing, and the methods discussed below. Cash is the ultimate byproduct, and, it is hoped, the ultimate goal of any economic effort, including patenting.

Today there is a rising need to use all forms of IP, especially patents, to improve companies' bottom lines. Most other assets have already been squeezed; future expected interest rate increases, overburdened balance sheets, and a recent drive to hold management more accountable for turning these “hidden” assets into something more tangible have made patent monetization a priority in many IP departments.

Before turning to actual transactions, a wise IP manager will first go through the typical IP management steps of identifying, cataloging, and assessing the strengths and weaknesses of the company's patent portfolio. Such an exercise is time consuming yet enlightening, though it will not be discussed here. Once a company's patent house is in order, then the various monetization methods can be reviewed to determine which make the most sense for the various groups of available patents.

A brief description of several methods of cash generation follows, with a table that summarizes key metrics of each transaction.

Sale or License: The oldest and simplest method of monetizing a patent is to sell it, either as an actual transfer of title or as a “constructive sale” whereby all rights for the life of the patent are licensed. Straight patent licensing also has a long history, and the market for patent licensing has been and is expected to remain very active.

Lawsuit: Patent infringement suits are a very expensive way (though sometimes the only way) to obtain large amounts of cash, yet the number of suits, and the size of awards, has been steadily increasing. Often, lawsuits are used to prod potential licensees toward an agreement.

Owned-Pool Contribution: When holding patents in a heavily patented technology field, and if that field requires standards in order to obtain market acceptance, then becoming a member of a member-owned patent pool likely makes sense. Patent pools such as the MPEG pools or GSM pools are well known and have had success. Members of these pools contribute patents and then divide the resultant royalty income based on a variety of revenue-sharing formulas. While these pools have the advantage of increasing the probability of obtaining licensing revenues, they are also more complex to create than an in-house licensing program.

Donation: Patent donations became a popular method of deriving benefit from IP in the mid- to-late 1990s because of the resulting tax write-off. A corporate entity donates patents, and usually some cash and know-how as well, to a qualified charitable organization like a university. The company is then able to take a tax deduction for the total value contributed. Publicly reported donations have been known to exceed $50 million. Unfortunately, the very popularity of this technique is drawing increasing scrutiny by Congress and the IRS. Proposed changes in the donation laws may curtail or eliminate favorable conditions for donation. The IRS is also acting on a new policy of close examination of patent donations, and the majority of valuations for recent patent donations have been adjusted downward.

Securitization: Securitization does not actually generate extra cash, but instead accelerates the collection of cash from the future to today. A patent holder with an existing royalty stream “sells” that stream of cash flows for a fixed sum today. The entertainment industry has historically completed numerous copyright securitizations, and patent license securitizations are just now beginning to appear, especially in the pharmaceutical industry. Deals in this area can be sizeable, with reported transactions as large as $100 million. The implicit rate of return demanded by lenders, who are the purchasers of the cash flows, is often lower than that of mezzanine financing. Key to a securitization is the quality of the expected cash flows, both in terms of the expected licensing revenues and the credit worthiness of the licensees.

Sale/License-Back: Modeled after the sale/leaseback transactions of the real estate world, Sale/License-Back (SLB) transactions seek to exploit the advantages of patent pools in a tax-favorable way. The patent holder sells one or more patents to a third party, which then licenses those same patents back to the original patent holder. The patents are also placed in a pool of similar technologies for out-licensing to other parties. Depending on the transaction structure, some of this additional out-licensing income may be rebated to the original patent holder. The two main advantages of the SLB include reduced cost of funds and increased probability of licensing due to pooling effects. The two main disadvantages of the SLB are a loss of control of the patents and a typical need for certain tax assets in order to begin the transaction. Currently, SLB transactions are being heavily discussed within various industry and consulting groups. Several transactions labeled as “SLB transactions” have occurred over the last few years, but these are more similar to securitizations than true SLB transactions.

Technology Option Capital: This cash generating method, often referred to as TOC, aggregates both patents and early-stage know-how of competing R&D programs. Multiple companies each contribute their competing IP on a project, and in return each party receives equity in the project and an option to repurchase the ending technology. Outside debt capital provides cash for operating expenses, and debt insurance reduces the bondholder risk. As development efforts continue, “Survivor”-type votes are used to select the surviving technology. Cash comes back to the initial patent contributors via their equity (in the event one company exercises its option purchase rights or the technology is successfully commercialized). TOC deals are currently being reviewed by several Fortune 500 companies, though no known transactions have been completed.

Risk Management: A new area of patent monetization involves using patents as partial payment for various risk management (ie, insurance) policies. In the long run, generally tax-deductible policyholder premiums are paid today in exchange for generally nontaxable insurance claims to be paid back in the future. Using patents to pay a portion of the premiums is a way to “flip” the payment stream. Patents and cash are used to pay the premiums, while the policyholder receives a license back for its own use of the patents. The license fee is variable, based on the occurrence of a loss. In the event of a loss, the policyholder receives a tax-free cash payment from the insurance company, with the licensee fee for use of the patents then increasing. There is no limit to the type of risks that can be covered with this method. Using patents as cash for risk management techniques is only just now beginning to be considered by IP professionals.

Summary Chart: The chart below gives a brief overview of some of the parameters of each cash generation method. “Prevalence Today” describes how common each transaction is today. “Relative Transaction Size” gives an indication of the typically expected size of each deal. Whether the original patent owner keeps control of the patents for defensive cross-licensing purposes is noted by “Control of Patent Rights.” Transactions that obtain their initial cash benefit largely from tax savings are indicated in the “Tax Advantage Structure” column. “Transaction Time” gives an indication of how long it may take to perform a typical deal. “Transaction Difficulty” aggregates the external and typical internal impediments to finalizing a transaction. Finally, “Lifecycle Stage of Patent” shows if young or old patents tend to work best within the indicated structure.

The monetization methods outlined mix corporate finance-driven goals with traditional patent holdings, a combination that has yet to be fully proven to the market. It will take time for companies and financial institutions alike to explore the potential with each of these new methods and grow any transactions. Other types of financial vehicles, like junk bonds and mortgage-backed securities required several years to move from the fringe to acceptance. As future articles explore the above transactions, watch the headlines for examples ' you may become a witness to ground-up development of a new frontier of IP monetization.

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We have all seen the statistics:

• About two-thirds of today's S&P 500 market capitalization comes from intangible assets, having doubled in proportion from 20 years ago.
• More than $100 billion is collected annually in IP licensing income.
• More than $200 billion is written off every year from IP impairments.
• More than $300 billion in infringement (mostly innocent) occurs annually.

Today most professionals realize that the increasing value of intellectual property (IP) is a trend that will not be reversed. The accounting and reporting for intangibles is already catching up with the “real world,” most notably via Sarbanes-Oxley. More pertinent to this article is the fact that the financial services community is beginning to respond broadly with new products and services designed specifically to take advantage of this newly discovered wealth.

This is the first of a series of articles that will review various methods to generate cash from a patent portfolio. Only a flavor of each method is presented for this article; future articles will delve into the newer or more unique methods. It should be noted that the actual monetization of patents is often separate and distinct from the process of value creation ' the traditional focus of many IP professionals. Value creation comes in many stages, including invention, patenting, pooling, cross-licensing, and the methods discussed below. Cash is the ultimate byproduct, and, it is hoped, the ultimate goal of any economic effort, including patenting.

Today there is a rising need to use all forms of IP, especially patents, to improve companies' bottom lines. Most other assets have already been squeezed; future expected interest rate increases, overburdened balance sheets, and a recent drive to hold management more accountable for turning these “hidden” assets into something more tangible have made patent monetization a priority in many IP departments.

Before turning to actual transactions, a wise IP manager will first go through the typical IP management steps of identifying, cataloging, and assessing the strengths and weaknesses of the company's patent portfolio. Such an exercise is time consuming yet enlightening, though it will not be discussed here. Once a company's patent house is in order, then the various monetization methods can be reviewed to determine which make the most sense for the various groups of available patents.

A brief description of several methods of cash generation follows, with a table that summarizes key metrics of each transaction.

Sale or License: The oldest and simplest method of monetizing a patent is to sell it, either as an actual transfer of title or as a “constructive sale” whereby all rights for the life of the patent are licensed. Straight patent licensing also has a long history, and the market for patent licensing has been and is expected to remain very active.

Lawsuit: Patent infringement suits are a very expensive way (though sometimes the only way) to obtain large amounts of cash, yet the number of suits, and the size of awards, has been steadily increasing. Often, lawsuits are used to prod potential licensees toward an agreement.

Owned-Pool Contribution: When holding patents in a heavily patented technology field, and if that field requires standards in order to obtain market acceptance, then becoming a member of a member-owned patent pool likely makes sense. Patent pools such as the MPEG pools or GSM pools are well known and have had success. Members of these pools contribute patents and then divide the resultant royalty income based on a variety of revenue-sharing formulas. While these pools have the advantage of increasing the probability of obtaining licensing revenues, they are also more complex to create than an in-house licensing program.

Donation: Patent donations became a popular method of deriving benefit from IP in the mid- to-late 1990s because of the resulting tax write-off. A corporate entity donates patents, and usually some cash and know-how as well, to a qualified charitable organization like a university. The company is then able to take a tax deduction for the total value contributed. Publicly reported donations have been known to exceed $50 million. Unfortunately, the very popularity of this technique is drawing increasing scrutiny by Congress and the IRS. Proposed changes in the donation laws may curtail or eliminate favorable conditions for donation. The IRS is also acting on a new policy of close examination of patent donations, and the majority of valuations for recent patent donations have been adjusted downward.

Securitization: Securitization does not actually generate extra cash, but instead accelerates the collection of cash from the future to today. A patent holder with an existing royalty stream “sells” that stream of cash flows for a fixed sum today. The entertainment industry has historically completed numerous copyright securitizations, and patent license securitizations are just now beginning to appear, especially in the pharmaceutical industry. Deals in this area can be sizeable, with reported transactions as large as $100 million. The implicit rate of return demanded by lenders, who are the purchasers of the cash flows, is often lower than that of mezzanine financing. Key to a securitization is the quality of the expected cash flows, both in terms of the expected licensing revenues and the credit worthiness of the licensees.

Sale/License-Back: Modeled after the sale/leaseback transactions of the real estate world, Sale/License-Back (SLB) transactions seek to exploit the advantages of patent pools in a tax-favorable way. The patent holder sells one or more patents to a third party, which then licenses those same patents back to the original patent holder. The patents are also placed in a pool of similar technologies for out-licensing to other parties. Depending on the transaction structure, some of this additional out-licensing income may be rebated to the original patent holder. The two main advantages of the SLB include reduced cost of funds and increased probability of licensing due to pooling effects. The two main disadvantages of the SLB are a loss of control of the patents and a typical need for certain tax assets in order to begin the transaction. Currently, SLB transactions are being heavily discussed within various industry and consulting groups. Several transactions labeled as “SLB transactions” have occurred over the last few years, but these are more similar to securitizations than true SLB transactions.

Technology Option Capital: This cash generating method, often referred to as TOC, aggregates both patents and early-stage know-how of competing R&D programs. Multiple companies each contribute their competing IP on a project, and in return each party receives equity in the project and an option to repurchase the ending technology. Outside debt capital provides cash for operating expenses, and debt insurance reduces the bondholder risk. As development efforts continue, “Survivor”-type votes are used to select the surviving technology. Cash comes back to the initial patent contributors via their equity (in the event one company exercises its option purchase rights or the technology is successfully commercialized). TOC deals are currently being reviewed by several Fortune 500 companies, though no known transactions have been completed.

Risk Management: A new area of patent monetization involves using patents as partial payment for various risk management (ie, insurance) policies. In the long run, generally tax-deductible policyholder premiums are paid today in exchange for generally nontaxable insurance claims to be paid back in the future. Using patents to pay a portion of the premiums is a way to “flip” the payment stream. Patents and cash are used to pay the premiums, while the policyholder receives a license back for its own use of the patents. The license fee is variable, based on the occurrence of a loss. In the event of a loss, the policyholder receives a tax-free cash payment from the insurance company, with the licensee fee for use of the patents then increasing. There is no limit to the type of risks that can be covered with this method. Using patents as cash for risk management techniques is only just now beginning to be considered by IP professionals.

Summary Chart: The chart below gives a brief overview of some of the parameters of each cash generation method. “Prevalence Today” describes how common each transaction is today. “Relative Transaction Size” gives an indication of the typically expected size of each deal. Whether the original patent owner keeps control of the patents for defensive cross-licensing purposes is noted by “Control of Patent Rights.” Transactions that obtain their initial cash benefit largely from tax savings are indicated in the “Tax Advantage Structure” column. “Transaction Time” gives an indication of how long it may take to perform a typical deal. “Transaction Difficulty” aggregates the external and typical internal impediments to finalizing a transaction. Finally, “Lifecycle Stage of Patent” shows if young or old patents tend to work best within the indicated structure.

The monetization methods outlined mix corporate finance-driven goals with traditional patent holdings, a combination that has yet to be fully proven to the market. It will take time for companies and financial institutions alike to explore the potential with each of these new methods and grow any transactions. Other types of financial vehicles, like junk bonds and mortgage-backed securities required several years to move from the fringe to acceptance. As future articles explore the above transactions, watch the headlines for examples ' you may become a witness to ground-up development of a new frontier of IP monetization.

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