Avoiding value slippage

Co-authored by Sophie Maugan, Partner at Cleveland Scott York, and Ian Thomas, MD at Turquoise.

What is IP?

There is a tendency to equate intellectual property with ‘technology’, as we imagine that any innovative product is immediately surrounded with patents and other forms of legal protection to prevent competitors from copying it. Actually, much of what we know as technology relies on execution of a business model and doesn’t have much (or any) meaningful IP protection.  Many digital economy businesses have been built on being first to market with a new product or service and rely heavily on marketing and branding to maintain their position.  In fact, such businesses (think Uber, eBay, AirBnB) almost always attract imitators who do not face any significant IP-related barriers to entry.

‘Hard’ IP has to be something genuinely innovative, i.e. different to what has come before, like a new medicine, piece of hardware or chemical process.  Because it can be protected via patents and/or other registrations, it can have standalone value, independent of the person or business that created it and the party that currently owns it.  Moreover, that value can be long-lasting, as IP protection typically extends out 15-20 years or longer.

Companies in IP-intensive industries tend to generate double the sales, have greater long-term growth and generate trade surpluses compared with non-IP intensive organisations.

The VC perspective

IP-heavy businesses present both a challenge and an opportunity for venture capital investors.  This type of technology tends to be capital-intensive to develop and slow to commercialise.  Against that, it can be particularly valuable to larger acquirers who can use their established sales channels to sell it on a much larger scale than would ever be possible for the original owner of the IP.  And, of course, there is a risk that the original innovation does not turn out to be as commercially valuable as expected.

Where an investor does decide that an investment is justified, it is essential to ensure that the IP of the business is secure and continues to be so.  If not, the technology may fulfill its potential only to be copied by competitors, leaving little value in the investment.  Even where IP has been registered, there are considerations around to what extent possible infringement should be monitored and how to respond if it occurs.

Know your © from your ™

There are four main types of IP protection that can be registered:

• Patents: exclusive rights to manufacture, import, use or sell an invention (and exclude others from doing so)
• Copyright: right of authorship over a piece of work, allowing the holder to make and sell copies (and limit how others can use it)
• Trademark: a recognisable mark that identifies a product or service to differentiate it from others
• Designs: protecting the appearance of a product in order to distinguish it from others.

VC investors are typically only interested in patented IP; other forms of registration are nice to have but not felt to offer much protection.  Of course, patents are not available or appropriate for all businesses but we are focusing here on those that can benefit therefrom.

The basics of protection

There are a number of basic steps that companies should take to identify, evaluate and protect their IP:

• Know what you have: companies should maintain an internal IP register that records all significant innovations so that they can be assessed for possible patenting
• Make sure it’s yours: employment contracts need to ensure that IP created by employees is assigned to the company and that confidentiality is maintained
• Decide what it’s worth: only commercially valuable IP is worth registering, so innovations should be evaluated rigorously (see below)
• Invest in protection: IP registration can be expensive but is almost always the best form of protection on a cost-benefit analysis
• Avoid the ‘trade secrets’ trap: keeping IP as a trade secret to avoid the costs of registration is usually a false economy and the value of IP that cannot be patented needs to be looked at closely to determine what it is really worth.

What to protect

Venture-backed companies will typically have some patents in application (or, possibly, granted) but will still be developing their technology and expect to register additional IP in due course.  As a result, establishing a monetary value for the IP on a standalone basis is rarely possible or worthwhile.  Of more use is a framework for deciding which innovations are worth protecting and which are not, focusing on protecting inventions that are likely to improve market power or provide a competitive edge.

The following questions provide a starting point for deciding whether or not to patent:

• How easy is it for competitors to design around the patent? If this can be easily achieved then there may be no advantage in patent protection. However, if a patent could potentially obstruct competitors from bringing a similar product to market then it is likely to be worth patenting if the expected extra profits justify the registration costs
• Will it be possible to detect infringement? If you cannot detect infringements then you cannot take action against infringers.  This could be the case for a patent on a manufacturing process, if it is not possible to determine what process has been used to produce a rival product simply by examining that product itself.  Backend processes involved in Cloud-based systems is another example; it may not be possible to access the full backend systems of a suspected infringer, therefore it will be difficult to determine whether any infringement is taking place
• Can the innovation be reverse engineered by competitors? If so, then a patent may be a valuable, or even the only, deterrent
• Are competitors likely to be working on similar innovations? Patenting in areas that competitors are working in can make it difficult for them to launch and protect similar inventions. It can also deter competitors from initiating litigation in case they fear retaliation and can create cross-licensing opportunities
• Is it a radical new technology or an incremental improvement? Patents for breakthrough technology will have longer lasting value compared to incremental improvements that may be superseded quickly.
• Can it be kept a secret? Patents in most countries last for 20 years from filing, after which the invention will be available for all to use.  Keeping the invention as a trade secret may be appropriate in occasional circumstances; for instance if the idea could have very long term value and where the details cannot be obtained through reverse engineering.  However, this strategy relies on maintaining confidentiality which can be challenging.

There may be other factors to consider, such as the publicity benefits of having a portfolio of patents or, in the UK, reduced rates of corporation tax under the ‘Patent Box’ scheme.

Other things to consider

Freedom to operate

Having a patent provides its owner a right to exclude others from exploiting that invention but does not automatically guarantee freedom to use the patented technology without risk of infringing third party rights.  For example, a company may have patented an improvement on a competitor’s earlier innovation but that improvement may fall within the scope of the competitor’s patent for the earlier innovation, in which case the improvement cannot be exploited without permission from the owner of the original patent.  Of course, the competitor will not be able to exploit the subsequent innovation without permission of the more recent patent holder.  Therefore, simply having a patent does not provide freedom to operate (FTO) and establishing FTO can be a lengthy process in its own right.

IP insurance

The upfront costs to launch patent infringement proceedings can be very high, which can deter IP holders from enforcing their rights (particularly when they are small companies with much larger competitors).  However, it is possible to obtain insurance to cover the costs of enforcing IP rights as well as for defending allegations of infringement (which can be equally important for small players faced with predatory tactics from deep-pocketed incumbents).  Policies and premiums vary depending on the risks associated with the relevant industry and there are specialist IP insurance brokers who can advise in this area.

Valuing IP

In cases where a company has moved beyond the technology development phase and has launched a commercial product, it may be possible to value its IP as a total package.

Methods for doing so include:

• Cost: assessing the cost to develop and create the IP rights (including how much it would cost a 3^rd party to invent something similar); however, this method does not take into account the market value of the product, so may under- or over-estimate the value of the IP
• Market value: assessing the product’s market value based on sales of similar offerings; while this provides a realistic figure, it can be difficult to obtain reliable data within a competitive environment or if there is no existing market-place for the innovation
• Economic benefit: assessing the future net income stream from the product after costs are taken into account and discounted at an appropriate rate to reflect risks and financing costs; in many ways this is the best way to evaluate new technology but relies on key assumptions that may prove to be inaccurate.

Extracting more value

Early-stage companies often do not consider whether there is potential value in licensing existing IP into market applications that do not form part of their business plan.  Whilst this may require additional investment by the licensee in developing a product specifically for the new application, it can represent an additional future income stream (possibly royalty-based rather than upfront).  Often the barrier to realising this value is lack of resource within the company that holds the IP for exploring the wider commercial opportunities and negotiating deals.

IP is a vast topic and the options available need careful thought. It is something that every organisation who is looking to protect its current and future potential value should be considering.  Making the time at the beginning to identify what approach the company should adopt in relation to safeguarding its intellectual property is a crucial element for any business wanting to succeed.

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