Mighty oaks from tiny acorns grow

“Focus on your product first; patents can come later.” So goes the received wisdom that is dispensed to technology entrepreneurs, start-ups and companies seeking to grow, diversify and break into new markets.

And there is nothing wrong with that advice per se. After all, if you don’t have a product or service that people want to buy, then you don’t have a business.

Crucially, the adage does not advocate overlooking patents altogether. But for entrepreneurially minded scientists, engineers or programmers, IP protection can seem tangential to the core goal of getting their innovations out into the big, wide world. Moreover, the cost of applying for, prosecuting and maintaining a patent can at first blush seem prohibitive. Throw in the heightened risk factors in today’s environment and it becomes even more apparent why patents have become a turn-off for many smaller businesses.

On the one hand, even if they manage to secure patent protection for their inventions, small and medium-sized enterprises (SMEs) will usually lack the financial resources to effectively enforce their rights by themselves. The latest developments in the United States appear to have compounded the problem: fee shifting - which would make plaintiffs liable for opponents’ costs in the event of an adverse ruling - is increasingly under consideration by US district courts and is on the legislative agenda. The threat of patent invalidation, including through the inter partes review regime introduced by 2011’s America Invents Act, also looms large.

Meanwhile, the compact, narrowly focused portfolios that are typical of smaller businesses can leave them especially vulnerable to claims that they themselves are infringers, from both deep-pocketed corporations and non-practising entities.

That said, however, strong IP assets and a strong IP strategy remain as important as ever for SMEs; in a sense, the prevailing unpredictability and uncertainty make them even more critical. “SMEs should absolutely focus on building their business, but they should not neglect building the requisite IP portfolio,” advises Michael Gulliford, founder and managing principal of patent management and strategy consultancy Soryn IP Group. “We see time and time again that well-built patent portfolios lead to increased valuations, so there is no excuse for not considering such a portfolio as a necessary part of the business.”

Gulliford accepts that in certain industries, such as software and internet – where the primary goal is often to build a huge user base, acquire user data and sell the company in less time than it takes to get a patent issued – IP issues will be further down the ‘to do’ list than in others, such as biotech. The US Supreme Court’s decision in Alice, with its weakening of software-related patents, has only served to reinforce that attitude. But even in those industries, prospective investors will increasingly want to know that at least some patent applications have been filed where appropriate, suggests Gulliford.

“It is important to remember that the patent market in the United States is, and always has been, highly cyclical and the environment even a few years from now could very realistically be quite different to that we see today,” he adds. “The pendulum will swing back, though likely not as far as it had swung a few years ago. We’re already seeing signs that the patent market is improving in a number of ways, including with respect to inter partes reviews. Perhaps with the exception of those few software and internet-focused industries, all innovation-intensive companies should be setting aside the requisite funds to develop and manage a patent portfolio.”

Own worst enemy?

However, the truth is that the greatest obstacle to SMEs having secure IP foundations is not the prevailing legal environment; it is the businesses themselves, and their lack of understanding and foresight about the benefits that IP assets can bring them.

Gerard Eldering is president of InnovateTech Ventures, a firm that leverages new technologies emerging from universities and the wider public research sector and builds businesses around them. After almost two decades at the nexus of tech transfer and venture capital, Eldering has learned that a truly IP-savvy start-up is a rare beast indeed.

“Sometimes we have a perception that an entrepreneur walks in the door and we assume they have VC funding, they know a lot about patents and have been round the block, and they know they need to build an IP portfolio,” he said at IPBC Global in San Francisco in June 2015. “That’s not usually the case. The reality is that less than 1% of tech companies ever get VC funding. Most make it - or don’t make it - without VC funding. Even those that get it and have a smart and experienced management team, with good mentoring from the VC firm, still don’t understand patents.”

For Eldering, when it comes to IP awareness, start-ups fall broadly into one of two camps. The first of these he labels ‘IP ignorant’. Particularly for the university-based inventors whom he usually works with, patent strategy just does not feature heavily in their thinking most of the time. “Maybe they did file a patent on their technology at some point; but once they start building the business and the structure around it, doing further R&D, raising capital – an overwhelming set of tasks – for most of them, building the IP portfolio over time gets pushed to the back of their minds,” he said. “Building that portfolio is something they need to work on on an ongoing basis. It’s not something that can be put off to year two or three.”

At the other end of the scale are what Eldering calls “IP-crazy” SMEs. He gave the example of one industry contact who had requested his help to introduce funding sources to a start-up client. Eldering learned that the company in question had not conducted minimum viable product analysis or reached out for customer feedback, but was nevertheless asking for $100,000 to make initial patent filings. “That doesn’t make sense,” he said. “They need to start working on that product and get out there and talk to customers. Because you know that after they do that, in a year or two, the product concept is very likely to change – and spending thousands of dollars on patent filings in the very early stages will likely be wasted money. There needs to be a happy, healthy medium.”

Spending smart

Securing a sound IP position is a necessary cost of doing business, and hitting that happy medium between ignorance and craziness means that SMEs must be prepared to devote a proportion of their available funds to patenting and related activities.

“In some ways, because these activities are laying the foundation for the entire company, intellectual property will be a greater percentage of operating expense early on than once the company gets deeper into product development and commercialisation,” says Erin-Michael Gill, executive vice president and chief IP officer at Finch Computing, a big data SME based in Virginia, United States. “This will be true for all start-ups that have intellectual property underlying their company, independent of sector. As the company matures, those ratios change.”

In the case of Finch – a recent spin-out from a larger software company – commercialisation of existing technology and further R&D around it was the immediate objective. Gill and his team thus swiftly began plotting a patenting strategy that soon resulted in the new company having 25 pending applications in the United States (see box, left).

Any number of elements will dictate how much money an SME should spend on portfolio building and management, including the nature of the business and its technology, the industry in which it operates and the geographical markets it is targeting. The stage which the company has reached in its lifecycle can also prove decisive in IP spend allocation. Speaking at IPBC Global, Eldering shared a typical IP spending regimen for a start-up offering a high-tech, physical consumer product (see Figure 1). If the company receives $500,000 at the seed funding stage, he suggested that $30,000 – less than 10% - should be set aside for patenting in the United States and, potentially, at global level via the Patent Cooperation Treaty (PCT) system.

Figure 1. Start-up IP funding allocation model

Source: InnovateTech Ventures

“As they get into the A round, say the same company gets $2 million in funding – that will be devoted primarily to product development, since by that stage they’ve talked to their customers and really understand what their product is,” he continued. “Here it is wise to amp up that portion that is dedicated to the patent portfolio – so here we assume they set aside $250,000 to file, so over 10%. Then they’re in the B round and are focused on sales and marketing of their first core product. They still need to work on the IP portfolio, adding new, improved patents and exercising some of the international rights; but percentage-wise, it’s going to be much less of that round.”

Of course, this is just one example; some companies will need to spend more or less on IP protection at different stages. As Eldering pointed out, a start-up built around a medical therapeutic method, for example, will likely have many more years of intensive R&D behind it than the hypothetical consumer technology product company above; as such, its IP spending at the earliest stages of its development will probably consume a more significant proportion of its seed funding.

Covering all bases

Those new businesses building up a patent portfolio from scratch, or from one or two fundamental filings, must weigh a number of different considerations. “What sounds simple ends up not being so simple,” said Gulliford when presenting at IPBC Global 2015. “You work with a lot of companies that think they know what they’re doing; but once prosecution gets going, things can get out of control pretty fast and the portfolio takes on a life of its own. You start getting patents that are narrower than you would have liked.”

‘Quality over quantity’ has become a mantra of today’s patent market, but SMEs need a little of both, he suggested: “By ‘quantity’, we don’t mean hundreds or thousands of patents, but enough to avoid the problem that we frequently see come up: an interesting start-up that has developed one or two core assets covering its technology, but unfortunately has left it there and now it finds someone is copying its tech to a tee.”

Enforcement is one way to try to right that wrong, but having only a couple of patents in place makes this a highly risky proposition, especially in the current climate. “The problem there is that it is hard to guarantee you’ll get through an inter partes review, a litigation and so on, and that those core assets will remain intact,” he continued. “So let’s think of a couple more patent families we can add on to that so that if there is an infringer, you can go after it without so much risk to your core intellectual property.”

As such, Gulliford is an advocate of creating a portfolio that is offensively, as well as defensively, oriented from the outset, as this should keep a greater number of strategic options open for the SME in both the near and long term: “What we regularly see is that companies begin with the goal of building an offensive portfolio, but once budget worries kick in, defensive assets tend to rule the day. Offensive patents can dissuade assertions from competitors, seeing that you have patents that read on them as well. They enable potential licensing opportunities. They also provide avenues for monetisation that don’t involve risking the validity of core defensive assets.” All it takes is a few hours of brainstorming to come up with other ways that a hypothetical competitor could achieve the same results as the SME’s technology through a different means, and to try to patent those solutions as well. “If the budget is there, strategic acquisitions are also a quick way to build an offensive position,” he adds.

Another advantage of a strong, multi-faceted patent portfolio is the possibility of piquing the interest of prospective investors. Surveys of the VC community present divergent conclusions on the impact, if any, of patents on investment decisions. However, Gill for one is clear that patent protection is crucial to secure funding, even in today’s tumultuous environment. “Even if it is only a ‘check the box’ exercise, not having IP in an IP-heavy industry is an obvious and significant negative to most investors,” he says.

According to Gulliford, the quality of a start-up’s patent portfolio does not just inform prospective investors about how well protected the technology and product are; it also tells them something about the team they are looking at working with. “The sophistication of a prospective investment or acquisition target’s IP strategy should be part of the investor’s or acquirer’s overall analysis,” he says. “At a minimum, those interested in making acquisitions should be considering the scope of a target’s coverage and the quality of the patents in the acquisition target’s portfolio. The scope and breadth of a company’s IP not only have the potential to significantly influence valuations, but are also indicators of the sophistication of management.”

Growing up

A company that is further along in its development will approach patenting from a slightly different angle. Building a portfolio around fundamental assets requires SMEs to look more closely at the patentability of incremental improvements to their product, as well as at advances in areas such as manufacturing methods and software.

In a sense, GN Store Nord is about as far from being an ‘early-stage’ company as you can imagine. Founded in 1869, this Danish company laid the first transcontinental telegraph cables across imperial Russia. In terms of IP strategy, however, it shares characteristics that will be familiar with many start-ups. Over the many decades since its foundation, it has undergone numerous restructures. Today, its main business is producing hearing aids and headphones. The most recent restructuring rounds at the company are still ongoing; and with innovation a key focus, vice president of intellectual property Anders Arvidsson is leading efforts to reposition and refresh the company’s patent portfolio around its established core technologies with an eye on the future.

“An incremental innovation often comes from existing R&D activities,” he says. “It may be an improvement of an existing product, system or methodology.” He gives the example of the four-stroke internal combustion engine, which is built on a long succession of incremental innovations based on an initial disruptive innovation patented in 1861 by Alphonse Eugène Beau de Rochas, and developed many years later by Nikolaus August Otto to make a working engine. “In my view, incremental innovations are usually more likely to foresee future implementation and become commercialised than disruptive innovations,” he continues. “If you have identified a disruptive innovation, there is a high risk of commercial failure upon entering the market if there is no demand or it is not mature. Still, market-creating innovations are based on disruptive innovations, which means they can be far more valuable. Thus, disruptive innovations should be monitored carefully and it is appropriate to implement a different IP strategy to manage such innovations, which GN does.”

Both incremental and disruptive innovations can occur serendipitously, and Gulliford echoes Arvidsson in underlining the importance of an IP strategy that can capture the value of such innovation. “A lot of a company’s patent jewels should come not from the original idea for a technology, but from solving the unexpected problems that arise along the way to trying to execute that original idea,” he says. “Take, for instance, the airplane. The Wright brothers theoretically could have patented the original idea of using lift to make an object fly; but it wouldn’t have been until they began experimenting with prototypes and how to make something actually fly that they would have encountered a load of unexpected problems along the way.”

Being a first mover in a technology area is a significant strategic advantage for an SME because it gives it the opportunity to be the first to encounter, solve and patent those unexpected problems that arise on the way to execution, he adds. “After all, there is a good chance that competitors will have to cross the same bridges later on, and such patents are also less likely to be invalid in litigation.”

The right stuff

For both start-ups at the very outset of their commercial journey and more mature SMEs, the effective creation and management of intellectual property demands the establishment of a functional IP structure – including a team of experts. “The key is to implement a multi-person patent review panel that is on top of the innovation happening in a company and ensures that solutions are elevated to patent applications when and where appropriate,” says Gulliford.

Such a panel also goes some way to counter the so-called ‘founder’s bias’ that is often evident in smaller companies, he adds. This refers to the increased likelihood that the central figure in a company – whether the individual who founded it, the inventor of the core technology or someone else – will disproportionately favour his or her own ideas about the business’s evolution over contributions from other team members, including when it comes to making decisions about which inventions to patent.

Speaking more broadly, SMEs should have an array of different skill sets at their disposal on the teams – both within the company and externally in terms of service providers – tasked with creating, managing, enforcing and exploiting their IP portfolios. Simply instructing a patent attorney is not enough if anywhere near the full value of the SME’s patents is to be realised. “Many patent attorneys do an excellent job of prosecuting and enforcing patent applications,” says Gill. “However, without understanding how and why a patent should be filed in the first place – after all, it can take tens and in most cases hundreds of thousands of dollars to build even a small patent portfolio – use of these legal services in isolation doesn’t make a lot of sense for a business.”

That is where an IP strategist, or a business adviser with expertise in the field, can step in. “Unlike a large company, an SME typically doesn’t have the ability to have a full-time in-house IP strategy person,” he observes; this is why reference guides such as the IAM Strategy 300, which now lists both in-house and external advisers, are so valuable. “There is also a range of great resources available out there to smaller companies to help them ensure that the right assets are being filed to support their business needs.”

For some cash-strapped SMEs, the suggestion that they should spend precious dollars on employing an IP strategy specialist and retaining a multitude of external advisers may seem little short of preposterous. But a centralised IP function - whether in-house or otherwise - makes as much sense for small businesses as it does for the largest corporates, and could ultimately prove to be more cost effective in the long term.

“The role of IP strategists is manifold,” says Gulliford. “They must manage outside counsel and see to it that quality patents are issuing; oversee the development of a patent portfolio that aligns with the business goals of an organisation; ensure that the budget set aside is being used in the most efficient and strategic way possible; and make sure the organisation is realising the full value of its intellectual property.”

Effective IP strategists at the top of their game will also be up to speed with the current dynamics of the patent market and aware of the full suite of solutions available to clients. “For instance, many SMEs with successful technologies quickly find themselves being copied,” says Gulliford. “But out-of-court licensing doesn’t happen very much here in the United States at the moment, and litigation costs millions of dollars. In that situation, it is the strategist’s job to guide the SME through the processes and to bring in litigation financing if necessary and get the best deal.” It is likewise the strategist’s job to run patent acquisition and divesture programmes and identify other potential forms of IP-centric transactions. “These are things that are just out of reach for the average patent attorney, who doesn’t have the occasion to participate in all of the many facets of the patent market,” he adds.

Adding value

With a strong portfolio underpinning the business and an effective team of IP strategists running the show, SMEs are in a position to begin considering what comes next for their patents. As previously mentioned, monetisation has become tricky for even the largest and best-resourced patent owners of late. The traditional, mainstream options are to sell, license or assert one’s patents. As can be seen in Table 1, for each of these tactics, the pros would appear to be outweighed by the cons in the current climate.

In terms of selling, patent valuations are lower now than they have been in recent years. “If you don’t have evidence of use or claim charts and you are a smaller entity, it is almost impossible to sell,” Gulliford stated at IPBC Global. “There is talk of the average patent family selling for $50,000; but what people need to realise is that maybe 99% of the patents that are on the market aren’t selling at all. So when we talk about a patent that actually gets an offer, we’re talking about the best of the best.”

Pure patent licensing rarely seems to occur without an accompanying lawsuit being filed, although broader technology licensing deals might typically lead to more harmonious results. Litigation can promise the biggest rewards, but comes with the greatest risks – including the prospect of invalidation of the patent, an outcome that is potentially fatal for SMEs.

In response to the increasingly patentee-unfriendly US market, a number of novel monetisation models have begun to emerge that could offer lower-risk routes to IP value creation for SMEs.

IP-based debt financing – whereby a lender advances money to a rights holder using its IP assets as collateral (see Figure 2) – is one option that is growing in prominence; the launch of Fortress Investment Group’s IP finance business and its loans to companies including Netlist, DSS, Inventergy and Andrea Electronics is an obvious example.

Figure 2. IP-based debt financing

Some banks and other investors are now beginning to issue debt financing based on the value of a company’s intellectual property. This is typically issued to the IP owner based on a discounted value of its IP assets, which may be collateralised in a special purpose vehicle (SPV).

Another strategy that has its origins in the worlds of music copyright and pharmaceutical patents is royalty securitisation. In their simplest form, these arrangements see investors obtaining a whole or partial stake in future licensing revenues derived from a rights holder’s IP assets (see Figure 3). Depending on how such deals are structured, the IP owner receives either an upfront lump-sum payment, recurring payments over time or a combination of both from the investor. This has proven particularly useful for pharmaceutical and biotech SMEs in securing capital to finance ongoing R&D activities.

Figure 3. Royalty securitisation

Under this model, an investor issues upfront payments, debt payments or a combination of both to an IP-owning company in exchange for rights to all or part of any future licence fees and/or royalties derived from its IP assets. The royalty payments will typically be made to a special purpose vehicle, which will then pay out shares of the royalties to the IP-owning company and the investor(s).

A deal earlier this year which saw investment management firm BlackRock lend $300 million to wearable device start-up Jawbone featured elements of both of the above, with the loan secured by “current and future licences, intellectual property, royalties, accounts receivable and revenue from intellectual property or licences”, according to a Bloomberg report at the time.

However, the malaise that has gripped the US patent system has also had a chilling effect on the investment ecosystem surrounding IP assets, and Gill believes that this makes even the novel paradigms outlined above unlikely to succeed at present. “For investors that see patents as a residual asset securing an investment or a loan, the value has cratered,” he says. “All but a very few lenders – in my experience – look at IP assets at all, and even fewer think about trying to understand those assets. Equity investors want to see that patents have been filed and in some cases granted, but few are adding to the valuation of a company due to their IP because of the current environment and potential for even further eroding of the IP environment.”

Likewise, while speaking at IPBC Global, Gulliford accepted that any viable market for such deals remains embryonic and largely beyond the reach of SMEs for now. Nevertheless, he argued that smaller entities should be considering the possibilities as part of a proactive, progressive IP strategy: “While these kinds of deals maybe aren’t possible for smaller entities right now, it is important to understand what’s possible in the future if you set up your IP operations in the right way.”

Other future opportunities that should be on SMEs’ radars today include those presented by the European Union’s long-gestating unitary patent right and the Unified Patent Court (UPC) in which it will be enforced – both slated to be up and running by early 2017. While opinion is divided on whether the new system will be any better for business (and particularly for SMEs, which proponents have argued will be among the major beneficiaries) than the status quo, there is a consensus that someone, somewhere will profit from it.

“On a personal level, I’m very supportive of the unitary patent and UPC, which could finally demonstrate that the EU can act as a market for patent enforcement,” says Arvidsson. “As it is now, there are many smaller EU countries which represent limited market exposure. As a consequence, it simply does not make any sense enforcing patents in many of these countries, due to the cumulative legal costs.” However, Arvidsson believes that only time will tell how efficient the new EU system could prove to be; and in the meantime, his company is still keeping its eyes turned westward across the Atlantic. The growing importance of inter partes reviews and the possibility of further legislative reforms may be challenging, but the United States remains one of the world’s – and GN Store Nord’s – largest consumer markets.

“It is true there is an exponential trend for filing inter partes reviews against US patents,” he acknowledges. “Still, I’m quite positive about inter partes reviews, since it allows the defendant a fair chance to defend its position instead of merely having legal fees as a part of the plaintiff’s leverage in negotiations. In my view, it is the patents that should add value to a company – not the avoidance of legal fees such as the cost of driving the litigation. Even if there is a shift in how patent value is estimated in conflicts, we still see US patents as the most important tool to protect GN’s business for this market.”

Similarly, Gill suggests that while the upheaval in the US patent market may have led to a strategic rethink, the fundamental motivations for SMEs in filing US patent applications remain the same, and will do for the foreseeable future. “Most small businesses and start-ups that secure patents do so for two reasons,” he says. “First, as a source of external validation –to show that what they are pursuing is both novel and inventive; and second, to enable greater marketing and business development by interacting more deeply with a potential partner or competitor with less fear of IP theft. That hasn’t changed to a meaningful extent within the current environment; though the uncertainty with the future of Section 101 and patent eligibility more generally has definitely changed IP strategies.”