Patent monetization is dominated by the much-maligned patent trolls, but that is starting to change as banks join the valuation fray, write Eran Zur and John A. Squires in this opinion piece.
There is little doubt that the world of patent monetization is dominated by patent trolls. A troika of favorable patent assertion fora, contingency-fee based legal services, and a proliferation of patent ownership structures that stand divorced from commercialized inventions has produced breathtaking return multiples for so-called non-practicing entities (NPEs, which are organizations that own patents but do not commercialize them). The currency of this assertion market is the vast arbitrage exploited by the NPEs. Several factors account for this – including the lack of any acceptable, up-front methodology for valuing patent as assets per se, the significant legal expense defendants face from such assertions, and the costly and post-facto timing of court-ruled infringement determinations. All these work to dislocate the patent market from the commercial market in which patents are used in the real economy.
This has not always been the case. More than 16 years ago, Rembrandts in the Attic (Harvard Business School Press, 1999) disclosed IBM’s patent licensing prowess, which literally added billions of dollars a year to Big Blue’s bottom line. Next came Edison in the Boardroom (Wiley, 2002), and patent monetization efforts of all stripes, ranging from patent aggregators to exchanges, quickly followed. Systemically, jurists all but assured the marketplace that patents are automatically valued based upon the underlying inventive contribution.
In short order, however, virtually all the new market players and exchanges were quickly cleared out, save for the speculators. One driving reason for the exodus remains how difficult patent valuation truly is — even in open court.
Legal notions of automatic patent valuation never materialized because, as it turned out, the market rarely valued patents. Instead, courts did — and did so at times unpredictably and sometimes poorly. Still, despite attempts by aggregators and others to craft one, no generally accepted convention exists for patent valuation. As a result, almost by definition, each patent transaction presents its own special situational considerations.
The market therefore had little choice but to be overtaken by arbitrage. Coupled with the high cost and post-facto timing of court rulings, the patent market became disconnected from the commercial market in which patents were used and provided an engine for patent arbitrage opportunities to dominate.
Equipped with attractive, new financial alternatives, banks are beginning to hit the trolls right where they live — in the arbitrage.
Now, however, that domination may be ending. Aside from various U.S. legislative efforts to thwart predatory patent assertions, a new counterweight to the NPEs has emerged: the banks. Equipped with attractive, new financial alternatives, banks are beginning to hit the trolls right where they live — in the arbitrage. The past two years have seen a steady drumbeat of various bank-driven patent financings and securitizations, including the recently announced $300 million debt financing provided by Blackrock to Jawbone, which makes fitness devices. Media reports have recently highlighted the fact that Jawbone’s parent firm, AliphCom, has sued Fitbit over alleged threat of intellectual property as well as patents.
Banks are now entering the patent market, but in a manner that eschews arbitrage. Rather, select capital providers may have found a better valuation mechanism — based upon credit-return models — and appear to be looking back to the future by re-adopting the Rembrandts in the Attic view of patents as assets per se. Innovatively, however, the asset analogy most befitting patents as a financial instrument is that of a derivative — that is, a patent derives is value from its enforceability. As such, credit-based monetization alternatives are being constructed. Patents can now be mortgaged, effectively “monetized-in place” in a fresh and now market-friendlier manner.
The Fundamentals: Patents-as-derivative Instruments
“Beware of geeks bearing formulas.” — Warren Buffett (Berkshire Hathaway Letter to Shareholders, October 2009)
If Warren Buffett recoiled at the notion of financial derivatives, he might well be rendered comatose at the postulation that patents are complex derivatives. Nonetheless, that is what patents are — and have always been envisioned to be.
A construct of law, patents are property rights granted for a limited time (20 years from filing) by the government in exchange for the disclosure of the underlying invention. (Upon expiration, patent rights pass into the public domain.) Patents are therefore considered negative rights, providing the owners specifically the right to exclude others in the commercial marketplace. A patent’s value is, therefore, fundamentally based upon its enforceability. (The converse is also true — a patent which does not cover any real economy embodiments may have little present value, although may increase in value as the underlying technology catches up.)
Economically, patents are derivatives because their value derives from the real-world goods and services covered by the metes and bounds of the patent claims. If real-economy goods or services infringe the patent, then in theory, the patent has a determinable value (legally “no less than a reasonable royalty” and on occasion, a competitor’s lost profits). Thus, two worlds exist — the rights world of patents and the commercial world in which the patented inventions are put to use. Mapping patents to the commercial world creates a pricing approach based upon these fundamentals.
This real economy of commercialized inventions is also the marketplace in which jurists initially would have had us value patents. The problem, however, is that this market does not value patents in the abstract. Rather, courts do, and patents are worth what the courts say they are. Not only is this expensive and inefficient, but patent prices, of course, are not determined at the time of bargaining, but rather at the conclusion of lengthy legal proceedings.
Worse, courts can get valuation wrong — at times awarding damages beyond the scope of the government-granted patent claims. In the technology sector, these oversized awards stem from the sheer complexity of interoperable components and systems sold as part of functional units, if not integrated devices. And because technology invention tends to be incremental, to the extent an individual patent owner can be awarded damages on the price of the entire end product as opposed to their specific patent claim, a litigation incentive arises. As a result, speculation continues to fuel patent enforcement and the arbitrage opportunities work to further occlude any meaningful price discovery.
The problem is that this market does not value patents in the abstract. Rather, courts do, and patents are worth what the courts say they are.
A further complication arises from the substantial legal costs to defend a patent infringement suit (recently estimated by PWC at approximately $4 million). If, in the bid/ask of a potential patent sale, speculative behavior drives an ever-inflating price ceiling (given the possibility of oversized damages), a price floor becomes set by the extreme expense of litigation defense, marked at just under nuisance value (and foreclosing any ability for price discovery below it). Once again, there is no patent price to be derived from the fundamentals.
A Return to Fundamentals: Patents as Assets Per Se
After more than a decade when the currency of patent monetization was arbitrage, can a financial derivative patent pricing model — one which correlates returns to fundamentals — get a foothold? If the recent spate of deals including Blackrock’s Jawbone financing is any indication, we may already be seeing a market shift, with patents now being recognized — and financed — as assets per se. By jettisoning the arbitrage approach and reestablishing pricing by fundamentals, lenders can displace the courts by effectively saying what the patents are worth — as collateral to the borrower. Patent-debt financing products can thus be created which are priced to realize a lender’s credit-based returns and risks — risks far different from speculative approaches.
To do so, the lender’s underwriting process will need to map the to-be-borrowed-against patent rights to their real economy counterparts to value the patent asset, based upon the fundamentals. The lender accordingly writes a patent mortgage. Importantly, however, the lender now has downside protection, with the patent as collateral, to protect it from the risk of default. Also, for certain borrowers with sizeable patent portfolios, the lender has ample flexibility to structure and, if need be, recoup the loan. Should the patents become repossessed, the lender can look to the patent marketplace, needing only to sell (or assert) the quantum of assets necessary to recover any unpaid loan amounts (and the lender’s return on the loan).
Additionally, credit-based alternatives can work in specific situations where arbitrage cannot. Such approaches may be a particularly effective and welcome as a source of funding for companies that may have exhausted their financing rounds, but which have patent positions that offer them a competitive advantage that would be lost or impaired by a sale or otherwise put at risk by enforcement.
Taking the market as a whole, the better a lender’s underwriting process and the more correlated its process is in recognizing patent fundamentals, the stronger the “credentialing effect” that lender’s participation in patent-backed financing will have in the marketplace. Patents that support loans from well-regarded lenders can and will be viewed as having higher overall quality — whether they remain in place with the patent owner, or whether the assets enter into the marketplace upon default.
Effectively, the lender’s detailed assessment of the patent’s fundamentals are one and the same as the merits of the case.
Favorable alternatives for enforcement can be created as well, providing the patent owner with the ability to finance litigation and retain more favorable upside economics afforded to it by the lender’s realization of credit returns versus higher equity-style arbitrage returns. And the credentialing effect for the patents by lender participation may in turn have a perceptible in terrorem effect for litigation defendants.
Facing a litigation-financed portfolio, defendants will have to weigh the prospects that the assertion is sufficiently financed to take the case through trial — and beyond. The lender’s presence therefore may create an impetus for defendants to seriously consider settlement prospects early on, based upon the assumption that the lender’s financial investment in the case passed a rigorous underwriting muster. Effectively, the lender’s detailed assessment of the patent’s fundamentals are one and the same as the merits of the case. This should also help level the playing field for smaller or distressed companies by providing them with the financial wherewithal to withstand litigation strategies designed to exhaust their resources.
A viable alternative to contingency-fee litigation is thus created. Presently, plaintiffs cede substantial economics to contingency-fee counsel since counsel is taking lion’s share of the risk. With appropriate underwriting and structuring, litigation financing may provide a mechanism for significantly cheaper money for the patentee. This in turn may further rationalize the market, as lenders need only to realize their credit returns, not the multiples driving the equity-arbitrage troll assertion market.
In the long run, better price discovery results since a lender’s underwriting restores patent pricing to its derivative-based fundamentals, and lenders therefore find themselves closer to the center of patent price discovery. Better still, the lender effectively creates its own market data in near-real time — at the time the patents are being mortgaged.
At bottom, more market-friendly patent monetization alternatives are created by entities that are patent-friendly. With lending based upon a “patent-as-asset per se” view, companies that were the initial innovators may have also created for themselves a financing lifeline by borrowing against their previously untapped assets. Patenting can become a strategic option, especially for start-ups — patenting early on in the company’s lifecycle can have a significant potential benefits downstream — debt financing may allow you to borrow on them later. It seems safe to say that in today’s macroeconomic and geopolitical world, a self-determined, long-term, asset-based lifeline would be highly valued. In the microeconomic realm of patents, that shift may already be underway.
Eran Zur leads a patent debt financing business and was previously a co-founder of RPX Corporation (NASDAQ: RPXC), a defensive patent aggregator. John A. Squires is a partner with Perkins Coie LLP. Prior to joining Perkins Coie, Squires was the founder of Goldman Sachs & Co.’s patent practice and chief intellectual property counsel. The viewpoints expressed are solely those personal to the authors and bear no reflection on any opinion or position as may be held by the authors’ employers, partners, organizations and/or clients.