Patents and finance – lost in translation

Patent expenses can be a large-line item on the balance sheet of many a chief financial officer (CFO). While developing a good patent portfolio requires significant cash and time, both can end up dwarfing many other legal expenses. Explaining these costs and the benefits of a strong patent portfolio to a CFO can be challenging for in-house counsel. The situation is not helped by the fact that few common metrics are helpful to both a CFO and an in-house counsel in understanding the usefulness or appropriateness of those patent costs as the expenses rack up.

This article proposes a set of analytics and metrics not only to help CFOs understand how patents help their investments, but also to allow patent costs to be apportioned to product lines, as well as to give a sense of how much protection those patents provide to particular product lines.

Patents 101 for the CFO

Patents give their owners a limited right to exclude others from making or using functional aspects of a particular invention. In plain terms, a patent allows you to protect aspects of your product that are new to the marketplace. By accumulating patents around a particular product line, you bolster the ability to exclude others from making or using the ideas embodied in your product. Generally, the more patents you acquire related to a product line, the more opportunity you have to use these patents to protect your product line, prevent copying of those ideas by others and use them as additional intangible assets related to that product line. Each patent has a scope of coverage, which is provided by patent claims that cover some aspect of a product and its novel features or aspects.

Another important aspect of patents for CFOs to understand is that each patent represents a snapshot of coverage for the product’s novel features or aspects at the time of filing – this benefit may depreciate over time as the product moves on to its next generation. In other words, unless you keep updating your patents, the first patent you file may not cover much of your product by the time your product reaches its fifth year of life.

Aligning patent terms with basic financial terms

One of the primary areas of disconnection for in-house lawyers when speaking to CFOs is that IP lawyers use different terms to describe the benefits and effects of patenting around a product line from those used by CFOs to characterise a corporation’s financial operations.

In-house counsel may describe patents in terms of risk mitigation or strategic assets. However, they seldom take these financial analogies to the next level and describe how these assets integrate with the corporation’s financial health.

Each CFO has a series of favourite measures that he or she likes to see utilised when communicating the fiscal health of the company or product line (eg, management cash, top-line revenue, operating income (OI), return on investment (ROI) and return on invested capital (ROIC)). Your first goal should be to find a metric that the CFO uses and prefers and to adopt it when communicating about your patent portfolio and its relation to that metric.

The key message here is that when communicating patent value to a CFO, give him or her a familiar metric with an overlay of how the patents in the portfolio are contributing to the health of that metric.

Selecting a useful financial metric for attaching patent metrics

Not only the language but even the calculations themselves can be adapted to the CFO’s preferred metric. Our goal for this metric is to create a factor that will indicate the baseline level to which your patents have protected your particular product line and the degree to which you have protected a financial metric in that product line.

For the purposes of this article, we use return on invested capital (ROIC). This is a financial measure that quantifies how well a company generates cash flow relative to the capital it has invested in its business and is an excellent indicator of the financial health of a company or product line. If a company can generate ROIC of between 10% and 25% year after year, it has a successful methodology of investing capital and generating revenue. Depending on the sophistication of the financial reporting, ROIC may be calculated by product line, which allows an in-house counsel to map patents to specific product lines.

Patents also fall into a long-term asset class or are considered capital assets. ROIC appears to be the financial metric most closely related to the use of budget to secure a company’s capital investment. Investments in capital expense and investment in a patent portfolio are also related concepts, which may make discussions with the CFO easier.

Figure 1. Product X – ROIC and baseline protected ROIC

Calculating the baseline of protected ROIC

The factor we are calculating in this article is the percentage of protection or coverage afforded by the granted patents, as well as the potential coverage of applications. The shorthand for this factored metric is protected ROIC (PROIC). This factor allows you to express the benefit or effect of the current patent portfolio integrated with an ROIC percentage.

First, calculate the ROIC of a particular product line or a blended product line.

ROIC= (net operating profit-adjusted taxes)

(invested capital)

Then determine how many patents are associated with that particular product line. Some patents may apply to a number of products. However, for the purposes of this analysis, we are counting them only as they relate to a particular product or project. Determine the scope of each patent’s coverage of that product and then calculate the patent factor (PF), which is expressed as a percentage of aggregated patent coverage to the whole product line.

PF=∑ (Individual patent coverage of product(%))

Initially, assume that each patent has a baseline patent scope covering of 1% of the product line (this is rarely the case, but do not worry – we describe methods to tighten or adjust this assumption below). Now simply multiply the numerator by the PF and calculate the rest of the ROIC as normal. This calculation assumes that you will never have more than 100% coverage, so normalise this to 100% in the rare case that you have more than 100 patents covering a single product line.

PROIC= (PF(net operating profit-adjusted taxes))

(invested capital)

For example, let us take a product line – Product X – which is worth $100 million top-line revenue annually with an ROIC of 15% and has 16 patents (see Figure 1). Your PF is 16% and your protected ROIC baseline is only 16% of your total ROIC value. This means that the remainder – 84% of your ROIC percentage – is unprotected.

Calculating the actual patent scope or finding scope proxies

In this example only 16% of your ROIC is protected – hardly an encouraging figure. But remember, this is only a baseline calculation and likely a minimum threshold at best. From this trivial calculation, you can now engage in a real calculation – as well as a conversation about what is actually covered and what you are actually spending on patents. As a by-product, the calculation should also reveal how many of your patents are providing no value at all.

To move onto the next step, we need a better method of evaluating the claim breadth and scope. There are at least three ways to do this.

Patent scope estimation: proxy calculation or coverage approximation

One way is to assign patent strength proxies (PSP) to each of the patents and your applications that represent an objective measure of the patent’s importance. Some of the standard proxies used by a number of patent research services to discover what aspects might indicate the importance of your patent include:

• forward citation analysis;
• patent family size; and
• the age or earlier filing dates of the patents.

‘Forward citation’ is defined as the number of times that other patent owners have referenced your patent in their own patent filings. This stands as a loose proxy for the usefulness or impact that your filing may have on other patent-filing companies in your industry. This is a better proxy for older patents, as many patent citations do not identify and cite to patents that publish contemporaneously. Therefore, if you are looking at patent application and newer patents, you may wish to spend some time identifying other supporting proxies. Table 1 shows a slice of a medical-device portfolio and the identification of the top-cited patent applications in this set of matters.

You can also use the set to discover whether the market feels that these patents are important. This evidence is also used to analyse the general overlap of your product line with those of your competitors (see Table 2).

Once you have sorted your patents, you might use classification systems (eg, International or Cooperative Patent Classification (IPC/CPC)) to sort each of your patents by these class codes and further refine your analysis; in this case, we will take a closer look at class A61N (see Table 3).

Patent family size as a coverage proxy

Family size is a relatively good indicator of importance for a patent and its relative coverage. This is because at the times of filing, the patent owners identified subject matter that would not be covered in a single patent and took the extra cost and effort required to identify claims that would allow a unique sibling to be granted. Additionally, the cost and effort of filing internationally implies that at that time, the company viewed this patent family as protecting the expansion or market position of Product X as it moved into other international markets.

Patent age as a coverage proxy

‘Patent age’ is defined as the number of years for which the patent has been issued and the number of times that the company has paid an annuity to maintain it. Annuity fees on utility patents in the United States are required at 3.5, 7.5 and 11.5 yearly intervals after grant. The life of a patent can be cut short if a company makes a conscious decision not to pay the annuity fee. Theoretically, therefore, paying an annuity fee implies that the company has reviewed the patent and deemed that it is still relevant. Figure 2 illustrates how this patent stands in priority date with other patent owners in its IPC/CPC class and gives a sense of whether this patent has any blocking potential.

Figure 2. Patent age as a coverage proxy

Source: IP dashboard by Black Hills Technology

Other proxies

Other types of PSP can include:

• a count of the words in each independent claim (fewer is better);
• counts of unique words in an independent claim;
• a count of prolific or important inventors that have contributed to the product portfolio; and
• scientific papers that cite your patent.

Tabulation and ranking your PSP

Once you select your PSP set, rank the patents by those measures and begin to assign coverage percentages. You can assign these percentages by first estimating the Product X features that each patent covers and then aggregating the results to a total percentage of Product X features covered; or, more subjectively, you can assign a percentage of coverage to the Product X generally. This ranking and percentages should be made with the help of your technology team.

Let us return to our baseline example of the 16 patents related to Product X.

Once completed, you will have a listing of patents, their relative contribution to protecting the ROIC of this product line and a general understanding of why they are important to the product line.

As you may imagine, this ranking and coverage is somewhat subjective. To offset this, a coverage range should be calculated. In this article we define these as ‘worst-case coverage’ (WCC) and ‘aspirational-case coverage’ (ACC). WCC requires a strict reading of what the patent covers and ACC assumes reasonable equivalency available to the read of the specification. Adding up the percentages results in a WCC of 39% and an ACC of 63%, which gives a much better view of the portfolio. It also allows the portfolio owner to eliminate costs for three of the 16 patents and provides a possible PROIC of between 39% and 63%.

This technique is still relatively easy to apply, but provides only a loose proxy of the scope of each patent in the portfolio. In addition, these proxies do not provide a good estimate of the coverage of new patents, as it is unlikely that there will be any forward citations.

These proxies do not indicate scope or claim coverage, they are only shorthand proxies. Before you discard or otherwise dispose of these matters, it is recommended that you engage in a claim-level review to confirm this assessment.

Side benefits

As an additional benefit to this analysis, you may discover that you have patents in your portfolio with no useful coverage or that cover an aspect of the product which is no longer relevant. In this analysis, we discovered that three of these patents are actually irrelevant to the product and would be good candidates for disposal or licensing or asserting to others. Clearing out unhelpful patents will also help you to eliminate other costs associated with them (eg, annuity payments).

Patent scope estimation: patent claim to product mapping

The second and better way is to map the independent claims of the patent to understand the actual scope and breadth of the patent estate related to this Product X line. This method requires you to create a claim map or to contract with a law firm or commercial provider to create a map. A method of mapping patent claims using patent experts and mapping software is going to be much more accurate than any pure machine technique, as it breaks the patent claims into human-generated concepts rather than word pairs selected by statistical or heuristic methods. Using this technique results in a much more objective method of mapping the actual claim to actual features that are covered by the patent. Additionally, it allows your coverage to be visualised, which can be particularly helpful for non-legal team members. A preferred format is a freedom-to-operate interactive map, which allows the engineering team to rank and rate their features in the actual map as a team.

Now that you have a claim-by-claim review of the features that a patent actually covers on your product, you can be much more precise in your estimation. For instance, you can now correlate actual features of Product X to actual coverage in the patent itself. As previously mentioned in the section dealing with proxy coverage, you can aggregate the results of each mapped claim to a total percentage of Product X features covered; or, more subjectively, assign a percentage of coverage to Product X generally. If you have previously performed the proxy analysis, you can use this to supplement or enhance your results, as shown in Table 5. Since you are now going through the product line claim by claim, you now have a more precise sense of the actual claims cover versus what was disclosed in the general specification of the patent itself. This will also show you where you may have gaps in coverage and allow you to try to bridge these.

This mapping should generally fall around your WCC and ACC ranges if you have performed the proxy analysis well. However, in many cases you may find a number of additional patents which may ultimately fail to claim any aspect of a current product line and be of no value for covering the current features of a product line. Correspondingly, you may find that the manner in which the claims were drafted might raise your coverage percentage, due to the more careful review of both claims and specification required by the mapping.

Reviewing our example for Product X, we can see that we have eliminated another patent from coverage. This mapping can and should be extended to your upcoming applications related to Product X, to see whether you can adjust any of these in order to enhance this coverage. It is also recommended that this type of review be performed periodically in order to align with shifts in product development and to allow the active adjustment of matters in prosecution to help keep Product X covered to the best degree possible.

As mentioned above, this methodology should also be used to affirm any patents that were rejected from a proxy evaluation.

Patent scope estimation: hybrid method (using both prior techniques)

If you are reviewing a larger set of patents for coverage (ie, over 50) the time required for claim mapping may be too long for a full review of all matters. The solution here is to perform the proxy review in order to identify any potentially broad patents as well as any further irrelevant patents. Alternatively, you can use a baseline estimate of 1% for each patent – however, this runs the risk of keeping irrelevant patents in your portfolio.

What to do with these results

Figure 3. Product X – ROIC and mapped protected ROIC

Returning to the example of Product X, our range of coverage has been pegged at 58%. Estimating the scope should have provided you with the knowledge and opportunity to shift costs and coverage from non-covering matters to active applications. You should also have an understanding of where there are gaps in the current coverage and where new patent-eligible features require coverage. An active claim mapping allows you to amend existing applications in order to cover these gaps or to drive new invention sessions to allow your inventors to cover any white space revealed by your claim map.

Additionally, at 58% coverage, you now have a direct measure which shows the CFO the quantified result of your patent coverage efforts. As shown below, the 8.7% mapped PROIC value against the 15% ROIC that your patents have for Product X also helps the CFO to measure how well these patents are helping the capital investment that he or she is managing.

Finally, you can now make a direct comparison to top-line revenue coverage (see Figure 3). Assuming that you spend $10,000 on each new patent application, you can now easily make the argument that filing five to 10 new patent applications (ie, costing between $50,000 and $100,000) that expand or maintain coverage on $58 million of annual Product X income is better than the initial $16 million coverage estimate provided by your baseline.

What to do with the unassigned patents

As mentioned earlier, you now know which patents do not cover your current or future product lines. These orphans likely still have value and you should not discard them immediately. Preferably, you should review or map these remaining patents to identify any addressable effect on your competitors, as well as to determine whether you should sell, license or donate these assets to improve your tax position or bottom line. Each of these steps will require some additional mapping to come to an actionable conclusion.

Creating a whole company protection metric and patent yield

If you wish, you can now extend this calculation to all of your patented product lines. Evaluating your entire patented product lines with respect to your patenting allows you to aggregate the various coverage metrics to arrive at a proportional coverage metric for your whole company. Make sure that you weight each of the protected percentages based on each product line’s total contribution to income.

Patent yield is the concept of making sure that each patent you hold in your portfolio has a meaningful contribution to your revenue-making activities or some other strategic purpose defined by the company. Eliminating patents with no foreseeable use in your company allows you to attribute the remaining patent expenses directly to products and their revenue contribution. Showing that each patent you hold has value will help the CFO to believe in the value of patents on the balance sheet.