In response to Value and Quality Based Patent Portfolio Management
by Dieter Reinhardt and Alexander Wurzer
I agree with the author’s premise that value and quality are independently arrived at, and then the patent portfolio “is brought into alignment with their contributions to the market value of the business enterprise and to elaborate matching licensing strategies.” However, the applicable order of operations in determining Patent Quality and Patent Value matters. Moreover, the definitions of Patent Quality and Patent Value are in the eye of the beholder.
The Elusive Definition of Patent Quality
In my experience, Patent Quality is defined by its market use in commercialized products or services. Patent claims define the boundaries of an invention, and are the basis for all patents issued. If the patent claims can be proven to be used within a product or service that is being sold in the marketplace, the patent is being Utilized.
A Utilized patent indicates an income stream that could be either paid/licensed, or saved/relieved, depending on the ownership and assignment record of the patent. By legal definition, a patent is a right to exclude. In financial terms, it is also a right to license or litigate. It could be sold or re-assigned. Strategically, it may be cross-licensed, or used as a blocking position within a market. Increasingly, it is being used as collateral for debt lending, but that has not come close to mainstream. There are other intrinsic value calculations with Utilized patents, but for this article, let’s keep it simple.
If a patent is not utilized in the marketplace, it has Option value, or it is Expired (and has nearly no value). Option value is a patent's likelihood of being adopted into a commercialized product or service at some future date. Recently granted patents and patent applications have Option value until it is licensed or commercialized. Once the patent is commercialized, it could be considered “In The Money”, depending on the assignee and commercializing entity, which is not always the same.
If a patent is being used by the original inventor, in its own commercialized product or service, the Commercializing entity saves a hypothetical royalty rate that it would have otherwise had to pay a third party if it had licensed it. Commercializing entities have been stating this royalty rate between 3% to 12% for about 20 years now. This can be corroborated by a review of all the technology-based royalty rates that have been adopted for financial reporting purposes under ASC 820.
On the other hand, if the patent is being used by a third party, the expectation if you are in the United States is that the patent is invalid and not infringed. It was not like this prior to the American Invents Act (AIA), but it is the standard for valuing a patent today. This handicaps Patent Value by a discount of 60% to 80%, from a market transaction perspective, because the standard assumption about Patent Quality is that it is not good. (Come at me in the comments if you disagree).
Because patent claims need clear boundaries and definitions, patent continuations and complementary patenting lead to sizable patent portfolios being applied for and granted by governments. Most patent experts agree, however, that over 90% to 95% of patents carry little to no value because they are not being utilized in the marketplace. Could they carry option value? Sometimes, on rare occasions. But more often not.
With that in mind, only a very small portion of issued patents are of Quality, after they’ve passed the onerous task of the PTAB’s invalidation process. Valid, infringed, and litigation winning patents are real unicorns. Sadly, like the Black Magic Voldemort's they are, Big Tech is on an active Patent Unicorn Killing Spree. The American Wizards of Invention (i.e., the individual and SME inventors) are being slaughtered, and it makes Patent Quality an extraordinarily hard determination unless it is litigation battle-tested.
Patent Value vs. Patent Price
Value consists of three simple components: cost, market, and income. Each makes up its own valuation methodology and it is a Western capitalist society principle. Any other consideration besides those three principles is intrinsic value, and specific to a situation.
Once the Patent Quality analysis has been assessed, the patent valuation approach can be determined. In simplest terms, if the quality of your patent is “not being commercialized in the marketplace” and thus, only having Option Value, we can assume that it is “Far Out Of The Money”. Therefore, a Cost Approach to value makes the most sense. For example, how much did it cost to prosecute the patent and its continuations? How much are ongoing maintenance costs, and are there future expectations of income generated from the patent to pay those maintenance fees? That’s 90% to 95% of all patents.
For an Income Approach, however, the value proposition is much different. It is based on the future expected sales of commercialized products (or services) times a royalty rate that is agreed upon by a licensee and licensor. It is a straightforward base calculation, but after that, the madness of income approach variables begins.
In the example above, if you are the Patent Inventor and the Commercializer, you’ll likely have the complementary assets Mess. Reinhart and Wurzer discuss in their report, resulting in a self-declared royalty savings of 3% to 12%. Said differently, the value of Developed Technology within a business enterprise is often considered to be about 11% to 13% of the acquired company, so if an enterprise is valued at $100M, and it has typical technology development with patents, know-how, and trade secrets, the Developed Technology value will account for about $11M to $13M of the enterprise (on average).
“What gets measured gets managed.”
The Accounting Profession is missing out on a great opportunity to “measure and manage” the value of intangible assets, if it could only start thinking a bit more creatively. Over the years, I’ve completed enough “relief-from-royalty” valuation analyses to understand that intangible assets are easy to “value” but incredibly hard to price. It shouldn’t be this way but governments are too willing to allow large-scale intangible asset mismanagement. In most corporations, intangible assets are optimized to avoid paying taxes through transfer pricing mechanisms. Even more sickening, is that in the US, we’ve allowed Big Tech to control the narrative that patents stifle innovation and that patent trolls are killing small companies. The reality has been quite different, from my experience, and the valuation of developed technology assets within an M&A vs. the pricing of patent portfolios has never been more dislocated in my lifetime. Since regulators and auditors seem uninterested in measuring and managing the financial value of Developed Technology, value vs. price is uncorrelated, unmoored, and disassociated.
A good friend of mine in the Patent industry likes to say “Patents don’t matter very often, but when they do matter, they matter A LOT!” How do you know when they matter? The patents are valid, infringed, and a damages announcement or settlement (announced or in-private), has been made. The future forecast of licensing income agreed upon, present valued to the current date, defines the income approach for a patent or patents. You can add a myriad of other variables, but Royalty Base time Royalty Rate creates the basis for an Income Approach valuation. This will exclusively lead to the highest possible value of a patent in 99% of all values, but because Developed Technology is not managed or accounted for, the value of Developed Technology is often like a mirage that only has value during the “good times” and vanishes during economic downturns.
The Market Approach to Patent Valuation
Conversely, the Market Approach for valuing patents criss-crosses the axis of Value vs. Price. Said differently, patent appraisers consider similar market rates for determining an appropriate royalty rate that compares the licensing rates between two unrelated parties. At least, that’s what is asked for in a litigation, financial reporting, or transfer pricing valuation report. Determining an appropriate royalty rate is a form of the Market Approach that becomes a critical input for the Income Approach.
Separately, in considering the outright sale of a patent portfolio, the Market Approach considers the price paid for a similar patent portfolio through an outright acquisition. Privacy and non-disclosures in these transactions mean that similar pricing metrics are often sealed, leading to a dearth of information to assist with pricing discovery. That leaves patent appraisers to rely on the sub-optimal pricing that is made public by Allied Security Trust’s patent purchase program. Or the annual survey of patent pricing from Richardson-Oliver. Not an ideal set of data to choose from because the announced prices are artificially low and typically a fraction of the Income Approach value indications.
Ultimately, the varied approaches to valuing Patents create an irreconcilable outcome that renders patent valuation nearly meaningless. Patent Quality is essential to understanding the risk factors related to Patent Value, but until a Patent has been battle-tested, its quality is uncertain, and it is extraneous value is suppressed by the systematic threat of invalidation.
At least that's how I see it from my experience.
Comments welcome, and apologies for any typos or grammar errors.