Timing and the
Value of Ideas

by Geo. McCalip

Introduction

This paper will discuss a theory for increasing profits based on intellectual property. We will look at how timing effects the value of an idea. Our conclusion causes us to challenge the common wisdom regarding the timing of investment in patents.

Wall Street has traditionally used a credit rating, based on the history of a company, to assist in determining the value of a bond. Michael Milken revolutionized the bond market by proving three points:

• repayment of a bond depends at least as much on future performance as it does payment history.
• raising the reward (i.e., interest) offsets the increased risk of basing an evaluation on projected earnings as opposed to proven payment history.
• knowing the business you invest in lowers risk of basing the evaluation on projected earnings.

(Brief aside: no one who invested in a Milken sponsored "junk" bond ever lost a penny in one of those investments.)

Can we apply these same principles to intellectual property? If yes, how can we profit from doing so?

Analysis

Addressing the first point, we note that the current value of any intellectual property obviously depends on the future sales of products based on that property. However, common wisdom says to base any evaluation on the proven historic sales of the product.

As for the second point, given that we choose to accept a higher risk in order to earn a higher yield on our investment, how would we go about doing this? Let us look at an example using three scenarios.

First Scenario:
An inventor has patented a device and successfully licensed it for manufacture. Projected royalties for the patent conservatively total $100 million. The inventor, wanting to fund other projects, would rather have cash now than over the 20 year life of the patent. After doing due diligence and negotiating, we purchase the patent for $25 million. Royalties total the projected $100 million; this gives us a yield of slightly over 7% per annum.

Second Scenario:
We have the same inventor and same device but six months earlier. The patent has issued, but the inventor has not marketed the idea. After evaluating the patent, we offer the inventor $5 million for the patent which she accepts. Investing another $20,000 in marketing, we license the patent out and earn $100 million over the 20 year life of the patent, or a yield of slightly over 16% per annum.

Third Scenario:
We meet the same inventor 20 months earlier. After our signing a nondisclosure agreement, she tells us about the idea, which she has not yet submitted for a patent. We do an initial patent search and preliminary market research and decide the idea can be both patented and marketed. We agree to finance the patent and marketing in exchange for 30% of the royalties. (Most investors would never touch this deal; they would insist on at least 50%; however, let us do the numbers.) Our out of pocket expense for this project comes to $40,000, $10,000 of which goes to the inventor as an advance against royalties. We recoup the $10,000 within the first year when we negotiate a signing bonus on the license agreement, and carry the deal on our books as a $30,000 investment. Per our licensing arrangement the royalties total $100 million over the 20 year life of the patent, earning us $30 million or a yield of over 41% per annum.

Considering the amount of market research and marketing involved in the second and third scenarios, we will accept the third point as a given. If the investor does not know the market, he or she can profit by paying for market research.

Further Analysis

While the risk obviously rises with each of the above scenarios, even the first carries some risk. A patent on an improvement in VCR technology does not look as attractive today as when it was issued in 1999.

With limited risk and higher reward, the second scenario looks very attractive. Indeed Bill Gates has built Microsoft using a variation on this, by buying already developed software and marketing it. But even using a best case example here, we see the same drawback discussed above. Gates had already sold MS-DOS to IBM before he licensed Seattle DOS. No one doubts the value of his investment in Seattle DOS, but the product was out of date within two years.

We find the high reward factor of the third scenario attractive, but realize the risk involved. However, let us take a closer look. For the sake of discussion, assume the average project costs $30,000 to patent and market to the point of licensing, assume a successful project generates $100 million in royalties and assume we only take 30% of the royalties. (Of course, not every project generates $100 million in royalties, but let us keep the comparison of apples to apples.)

• If half of the projects failed, it would raise our average investment per successful project to $60,000. This would still give us a yield of well over 36% per annum.
• A success rate of one in three would mean an investment of $90,000 per successful project and would still yield almost 34% per annum.
• At a success rate of one in 20 (the average of all patents granted) our investment of $600,000 would still realize a yield of over 21.7% per annum.
• Even if we factor in that only about two thirds of all applications get a patent granted, this would mean an investment of $900,000 and a yield of over 19% per annum.

These per annum yields are based on the standard formula of FV= PV (1 + i )^N (as calculated on a TI-BA35) where:

FV = Future Value PV = Present Value i = the interest rate per period n= the number of compounding periods

Set to $30,000,000 (our 30% of $100,000,000) Set to $30,000 per project Computed Set to 20 (a patent lasts 20 years)

Why only take 30%? This will assure a steady flow of ideas for evaluation, and let us "cherry pick" the most promising. We would not have a hard and fast rule of 30% of royalties, but at that percentage, the above numbers obviously yield an acceptable return.

Conclusion

Since even the worst case of the third scenario (i.e., one success in 30 projects) earns a higher yield than the best case in the second scenario, we have to conclude that the common wisdom does not hold up to scrutiny.

To realize the highest possible yield, the best time to invest in an idea is at the earliest possible moment. While this will require more due diligence than other investments, the rewards more than justify the efforts.

One might argue that this analysis holds as long as the expense per project remains low enough. We would counter that $30,000 to $50,000 would get a very high percentage of patents to the point of licensing. We would further note that where the expense per project has reached a prohibitive level (e.g., medical patents) the manufacturing companies already fund the projects from the very beginning and receive far more than 30% of the royalties.

Returning to the example of how Milken revolutionized the use of bonds as institutional investments, we would note that this became the driving force for the economic expansion of the 1980's and 90's. Hopefully this paper can also contribute to the betterment of all of our lives by helping bring an increased number of worthwhile ideas to market.

 
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