Back in business

Despite a recent spate of deals, generating significant royalty revenue from patents alone remains challenging in China; but for those with the right tech and know-how, the years ahead look full of opportunity

All of our licensing issues ultimately stem from China. If Chinese companies don’t take a licence or underreport shipments, then all of our licensees complain – former Fortune 500 licensing executive

For all its importance, China’s hitherto dynamic licensing market has experienced something of a lull in the last couple of years. However, recent news of major patent licensing deals involving several major blue-chips suggests that the market may now be stirring back to life, a year after Chinese regulators wound up an investigation of Qualcomm’s patent licensing practices and nearly two years after another probe into InterDigital was suspended.

The hefty fine slapped on Qualcomm and the fallout from the InterDigital saga – in which executives and employees of the US company were allegedly threatened with arrest – also partly explain why both operating companies and non-practising entities (NPEs) actively pursuing licence deals in China are reluctant to make any waves. This prevailing note of caution means that would-be licensors now stand or fall on their ability to convince local companies of their potential value as business partners. Today more than ever, the carrot is proving more useful than the stick.

On the other side of the equation, meanwhile, the IP strategies of domestic companies are becoming increasingly sophisticated. A large gulf exists between truly global concerns and those focused on the domestic market, but many of the former now have robust R&D and respectable patent portfolios of their own. There is still interest in buying up patents in bulk, but these companies increasingly appreciate that licence agreements can create a win-win that allows them to expand their market share abroad. As they consider how best to exploit their own patents, they will increasingly find themselves on the other sides of those deals.

Gaining momentum

Between November 2015 and February 2016, Qualcomm announced a string of standard-essential patent (SEP) licence deals covering most of China’s major smartphone manufacturers, including ZTE, TCL, QiKu, Xiaomi and Lenovo. The San Diego company did not disclose the financial terms, but said they were in line with the terms of the ‘rectification plan’ that was part of its February 2015 settlement with China’s pricing watchdog. The National Development and Reform Commission (NDRC) called for rates of 5% for 3G devices and 3.5% for 4G devices, using a royalty base of 65% of the net selling price.

The agreements will have come as a relief to Qualcomm, which previously revealed that its China negotiations were proceeding more slowly than it had hoped. Comments from a November investor call shed light on the tough tactics that it faced. “We have had some of the licensees take probably a little more aggressive negotiating stance and start withholding payments while we’re negotiating,” observed president Derek Aberle, adding: “We do have confidence; they acknowledge that they owe the royalties and that we will get paid on these once the agreements are concluded. But the timing of that is uncertain.” With major licences now inked, Qualcomm is set to receive these catch-up payments; but in the interim, having to explain this missing revenue to investors likely increased the pressure to close the deals.

Lewis Ho, a partner with Dechert who handles China licensing matters for both operating companies and NPEs, reports that in addition to the well-publicised deals inked by Qualcomm and Ericsson - which extended its existing cross-licence with Huawei in January - a substantial amount of NPE activity is going on below the radar.

Outside the SEP space, however, there has not been a pronounced uptick in activity, because fewer negotiations were on hold awaiting NDRC guidance. Steve Joroff, head of Asia-Pacific IP licensing for IBM, which does not license SEPs, told IAM that while the investigations did come up for discussion, they failed to side track negotiations: “We saw some Chinese companies looking for an opportunity to use that against us and apply some limitations, but it just didn’t exist.” Joroff suggests that licensing activity has remained steady even in recent years, at a level which is fairly low relative to the size of China’s tech sector.

Growing up

When Qualcomm lamented the stalling tactics it had encountered in earnings calls with analysts, it was by no means describing a phenomenon that is unique to China. And even in this regard, patent owners acknowledge that Chinese companies are becoming more sophisticated. “Five years ago, the delay tactic was to shut the doors and refuse to meet with you,” says Roy Chen, managing director for patent pool administrator Sisvel in Hong Kong; “but the new tactics match those of companies in other countries, such as postponing meetings and requesting overmuch or irrelevant documents.”

Joroff agrees that the desire to put off an agreement is typically a motivating factor on the opposite side of the negotiating table: “Often the other party’s main task is to avoid doing a deal as opposed to understanding the potential value it can bring them. That’s an easy thing to do, so that sometimes makes a deal impossible, even if you do have a lot of value to offer them.”

But as Chinese companies seek to grow their businesses overseas, they are increasingly developing mature IP functions charged with securing freedom to operate in overseas markets. The trend is opening possibilities not just for sellers and brokers, but also for licensors. “The prospect of enforcement in Europe and other developed markets means that companies with significant business there need to negotiate with you over a licence,” says Chen. The difference between these companies and those with an exclusively domestic focus is stark. “Our successes have been with companies that do business outside China,” agrees Joroff: “They either already derive value from IP or are open to learning how.”

According to Guy Proulx, chairman and CEO of Transpacific IP, there is much more than just the clarified policy on SEPs behind the rise in deals being sealed: “Companies in many cases have large market shares to protect and you now have out-and-out aggressive competition between companies like Huawei, Xiaomi and Oppo, which are also contending with the likes of Samsung and Apple. Those pressures are really driving the changes in terms of how licensing is done.”

Even when IP teams have a mandate to secure freedom to operate overseas, a licence can be a very hard sell. “A number of companies are still out there buying patents, but getting them to take a licence is always a difficult negotiation,” Proulx continues. Sometimes, Chinese companies will refuse a licence, but still offer to buy a portfolio of patents outright. Many are concerned largely about domestic rivals and want to obtain exclusive IP rights in order to fence them out of certain markets. Compared with the straightforward benefits of ownership, the more abstract value of a licence can be harder to grasp for outfits that are inexperienced in the IP world. “The less mature companies do not understand what they’re getting in a cross-licence in general,” acknowledges Joroff. “They don’t think they are getting enough value, even if you can show them that they are infringing a number of your patents.”

But the time is ripe for those select few Chinese companies with more developed R&D and patent portfolios to actively pursue cross-licences and grow their market share outside of China. “Negotiations are always tough in China when it comes to making sure the licensee sees the value and the licensor gets an acceptable return,” says Proulx. “But in many ways it is a good time now for Chinese companies to step out because the rich patent valuations of a few years ago are not there anymore.”

Figure 1. China payments for the use of intellectual property

Figure 2. China receipts for the use of intellectual property

Softly, softly

Despite the troubling hints of possible detention in the InterDigital investigation and the eye-watering $975 million fine levied on Qualcomm by the NDRC, the big licensing players confirm that the regulatory decisions handed down in China have placed the industry on a more solid footing. Qualcomm executives have long insisted that despite the one-off financial penalty, the clarifications on SEP policy will allow them to collect more revenue from China’s vast ecosystem of standards implementers.

Ericsson - another SEP owner that has been very active in Asia in recent years - suggests that the most significant aspects of the decisions are what has not changed. Vice president of patent strategies and portfolio management Gustav Brismark says that the Qualcomm decision “made it clear, to the extent there was ever any doubt, that the current industry of licensing on the end-device level is legitimate”, since the sale price of the end device was accepted as the appropriate royalty base. “So here there is no change; just confirmation of current industry practice,” he adds.

Another significant feature of the decision, in Ericsson’s view, is that it is confined to the Chinese market. “The limitation of the remedy’s application to devices sold for use in China by Chinese manufacturers shows us that the Chinese agencies are conscious not to adopt remedies that have potential extraterritorial reach,” continues Brismark.

Table 1. Expectation indicators for China’s National IP Strategy, 2014-2020

 

2013

2015

2020

Export income from royalties and franchise fees for proprietary rights (in $100 million)

13.6

20

80

Chen agrees that the regulations surrounding SEP licensing are better defined following the decision, and should perhaps become even more so in the future - although “in the world of SEPs, it’s never perfectly clear anywhere”. He goes on to maintain that the Chinese authorities may be gradually coming round to the licensor’s point of view: “The government used to see these issues entirely from the licensee’s perspective. But now that Chinese companies have large portfolios and are increasingly looking to monetise them, the government will want to take a more balanced approach that accounts for the interests of both parties in a licensing negotiation.”

Figure 3. Invention patent licence activity* recorded with SIPO

*Data includes new patent licence agreements alterations to existing agreements, and cancellations of patent licence agreements

However, for all the progress made towards strengthening IP protection in China – most recently through the creation of specialised IP courts last year – the consensus remains that bringing high-profile infringement litigation as a licensing strategy is a risky gambit. Operating companies are wary of endangering their non-licensing business in China by potentially incurring another antitrust probe. “We just don’t have a track record for these types of cases in China yet and that causes uncertainty,” says Chen. “Some big companies are undoubtedly looking around and thinking that the moment might be right to pursue litigation enforcement in China, but nobody wants to be the first to do it.”

Nor do NPEs necessarily want to stick their heads above the parapet. Ho says that while he has filed suit on their behalf in the past, the last thing his NPE clients want is a high-profile campaign: “My advice is always to keep it very low key. The traditional model of trying to sue people and get licensing royalty revenue from China is gone. The preferred strategy is to team up with local companies and educational institutions and be seen as their business partner in R&D and IP protection.”

But the need to walk in with a proposal that makes sense from a business perspective for both sides is no limitation, insists Proulx; it is just good business when it comes to the China market. “Chinese parties are not willing to overpay, but they do want to be covered for their areas of risk,” he explains. “You have to really explain the tech and explain why there is a licence that needs to be done, and approach things reasonably from day one.”

Figure 4. Select patent licensing developments in China, 2015-2016

Patents not enough

The fact that a litigate-first strategy is considered unproductive at best, unviable at worst means that for prospective licensors, the carrot is more important than the stick. As patent-only deals are difficult to get done, licensors – and especially NPEs – need to get creative with what they can offer potential partners in China.

The emergence of broader commercial agreements as compared to pure patent licences is not necessarily new; nor is it restricted to China. As Brismark points out: “Licensing terms and conditions, as their name suggests, have always involved consideration and terms that go beyond cash. The possibilities are endless and in bilateral negotiations, parties decide on arrangements that work best for their purposes.” But the trend is perhaps more pronounced in China, for two reasons. First, the lack of high-profile patent litigation means that the threat of a lawsuit on its own is not a very effective way to drive a deal. Second, Chinese companies are striving to catch up not just in terms of patents, but also in terms of general R&D capabilities; so big tech companies have plenty to entice them in the way of tech and knowledge transfers.

“In China, we do few, if any standalone cross-licences,” says Joroff. “We will do something else that goes along with a patent licence - whether it’s a patent assignment, a technology licence, a joint development agreement or a source code licence transfer.” For most Chinese companies, IP strategy is not directed from the C-suite, so crafting a deal that involves broad technological collaboration rather than a straightforward cash-for-licence exchange can help the IP team to secure buy-in from the board. “Whether you’re selling them patents or helping them expand their product line, including other things makes it easier for them to say yes,” Joroff explains.

NPEs adapt

The prevailing environment is especially challenging for NPEs – if they want to keep a low profile enforcement-wise while also getting deals done, they need to convince licensees that they are more than just patent asserters, but also a source of the accompanying technical expertise that can help Chinese companies to improve their product offerings and IP strategies.

“All of the major discussions we’re in over eight or nine-figure deals involve not only significant patent portfolios, but tech transfers and applications to products”

Proulx sees both NPEs and operating companies running successful licensing campaigns in China using various models, including partnering with local Chinese companies in a carrot and stick approach. But he suggests the operating companies have an advantage, with more options for collaborative paths to pursue. “It is tougher for non-operating companies,” he continues. “All of the major discussions we’re in over eight or nine-figure deals involve not only significant patent portfolios, but tech transfers and applications to products.”

Given the growing interest among Chinese companies in monetising their patents, IP know-how can itself be the basis for an effective soft approach from an NPE, says Ho: “Some of the NPE clients are not just licensing or selling patents to the Chinese companies; they are also coaching them on how those assets can be used to maximise their valuation, such as by counselling them on how to negotiate with their competitors on royalty and cross-licences.”

In general, he adds, “NPEs are making friendly approaches rather than contentious ones because they know Chinese companies are looking for partners with strong IP portfolios to collaborate with”. As an example, he points towards China’s ‘unicorns’.” (venture-backed companies worth over $1 billion), of which there are up to 25. Maintaining those heady valuations means promising consistent growth, including outside of China - and that requires intellectual property that many of them simply don’t have. Ho prefers to make the approach through venture capitalists on the board rather than their often under-developed IP teams: “You need to convince the investors backing the company that they need to build up their IP portfolio in order to maximise their valuation.” Showing how patent licences can help companies to expand into new markets and thus keep their promise to investors goes a long way towards dispelling the idea that NPEs simply want to drain money out of successful start-ups. “Most of these companies do not have a large IP department and their senior management lack expertise in IP or are not convinced of its value,” cautions Ho; “so you need to find the right angle and help them to find the reason to do a deal.”

At the end of the day, the low-key, collaborative approach which seems to be the recipe for both NPE and operating company success in China may also be best for the long-term health of both the licensing market and China’s IP landscape generally. “I’m not sure the lack of litigation is holding back the growth of the licensing market,” muses Proulx. “Patents are about tech, at the end of the day, and having more tech transfer discussion and deals is good for IP in general and its growth in China specifically.”

Joint ventures

Earning revenue from patents in China typically involves a tech or knowledge transfer as part of a broader commercial deal. Of the large companies doing business in China, many also have joint venture relationships with Chinese entities, both state owned and private.

The latest example was a $280 million joint venture between Qualcomm and the Guizhou Province government aimed at developing server chips. The US company plans to sell its own chips through the company, but also license its technology and co-develop new products. Qualcomm continued to form local partnerships in China while it was under investigation by the NDRC, including through a partnership with semiconductor company SMIC and a pledge to pump $150 million into Chinese start-ups.

Considering whether these relationships have any direct impact on the patent licensing business, Qualcomm senior vice president and general manager Anand Chandrasekhar said: “China is a very, very large market, so will there be some spillover? We don’t know; but if there is a halo effect, then fantastic - we’ll take it.”

Joint ventures require a lot of due diligence on the part of the foreign company to ensure that its proprietary technologies and trade secrets are protected. Lewis Ho, a partner with Dechert, warns NPEs and other clients to think twice about the joint venture model: “I am quite pessimistic about the structure as it means to some extent a loss of control over certain business decisions and trade secrets, which you need to be prepared for.” But he acknowledges that they may be necessary for large companies in some situations - for example, as part of a regulatory settlement.

For large foreign companies, joint ventures with state-linked firms can be an unavoidable cost of doing business in China. But while they require care from an IP point of view, they may also play a positive role in the development of China’s IP environment – they show that businesses driven by patent revenue can help China’s tech sector to evolve.

Compliance concerns

The fact that Qualcomm has been able to close its major outstanding deals in China is no doubt encouraging, but executives have made it clear that the devil is in the detail. Whether its China revenues prove a success or disappointment will hinge not just on what is written in the agreements, but also on how they are implemented. The company has long complained about underreporting of licensed device sales in China, going so far as to say that the overall global market share gains being made by Chinese OEMs may have a negative effect on future revenues.

To put a number on the gap, Aberle told analysts in the company’s most recent earnings call, “if you looked at the delta between what we gave as the global device sales and the reported device sales, it was about 9% or $25 billion in 2015”. He identified three main causes of this: device sales that were not yet licensed, licensed device sales for which royalties were being withheld as a negotiating tactic and underreporting by licensees. As the company signed more agreements with major players, said Aberle, the royalties in the first two categories would increasingly be captured, “which will leave you really with the compliance question - which will still be something we need to work through”.

Qualcomm is in the enviable position of being able to measure the quantity of chips sold against reported device sales - a resource that not all licensors have. Ho notes that while this concern is not unique to China, it is a major one for both practising and non-practising clients when collecting end-unit royalties: “We typically try to insert lots of audit rights letting licensors inspect the factories and the books; I have to say, it’s usually a highly contested provision, but we try to insist on it.” Many licensors ask for detailed periodic royalty reports that disclose extensive raw sales data which can be used for verification. External sources such as government data and private market research can also shed light on shipments. “The Chinese environment is no different from others - you need to do your homework and monitor activity closely to prevent flouting of the contract,” cautions Ho.

Of course, this once again raises the issue of how the licensing market functions when many of the typical enforcement remedies are essentially off the table. Qualcomm stated in reference to China: “We’re prepared to enforce our agreements and take other actions against certain OEMs that are not negotiating in good faith, underreporting royalties or refusing to conclude agreements in the near term.” Ho says that the issue of how to resolve disputes with Chinese licensees is still very much a live one: “You will not preserve the confidentiality of the royalty rate and other terms in a court battle. I still believe arbitration in Hong Kong or Singapore is the best compromise that both Chinese and US companies can accept.” Hong Kong is often a compromise candidate in terms of the agreement’s governing law, he adds.

Role reversal

In the meantime, the strides made by big patent-rich players in China, such as Huawei and ZTE, suggest that Chinese companies will increasingly be the ones earning revenue from patent deals. “We will see Chinese companies on the licensor side more and more,” predicts Brismark, noting that they are already among the key technology contributors to 3G Partnership Project cellular standards.

In part, there is a push from the Chinese government for companies to find more ways to commercialise intellectual property that already involves forms of monetisation, including using intellectual property to raise capital. But Proulx says this is also becoming a self-fulfilling phenomenon: “The desire to commercialise or monetise is becoming a push at the CFO level - they want to see if they can get some return. In some industries like biotech and medical devices, we see it readily happening already.” Proulx adds that Transpacific is conducting more valuation exercises from Chinese companies than ever before, as they seek to assess potential returns.

This heightened interest in monetisation is likewise a good sign for foreign patent owners, because a willingness to negotiate licences is part and parcel of being an active monetiser. “I would love to see large patent holders in China start attempting to generate income from their portfolios,” says Joroff, “because that’s the type of company you can have a mature and reasonable conversation with. They understand the balancing value of what they’re giving and what they’re getting.”

At a certain point, believes Sisvel’s chief licensing officer, Ben Beune: “Chinese companies will discover that just owning patents has little value and move beyond using them for defensive purposes.” When Sisvel first called for patents to form its long-term evolution pool, the China Academy of Telecommunication Technology showed a lot of interest in how IP owners in the United States and Europe had been able to generate revenue from their patents. Today, it is the only Chinese patent owner participating in the pool. “We absolutely want to work with more Chinese companies as licensors,” says Beune. “For patent pools, bigger is better.”

Of course, a true role reversal, in which Chinese entities as a group become power players in the patent licensing world, is still a long way off. Ho believes this presents great short-term prospects for foreign licensing entities. Once China has developed mature home-grown equivalents to NPEs and other patent-focused entities, openings for outsiders may dry up. “NPEs from the US and Europe have a golden opportunity over the next five years in China,” he concludes. “A number of growing Chinese companies will still need their help and support to transform their business models and become international players.”

Action plan

China’s licensing market is still small relative to the size of its tech economy, but this does not mean there is not value to be found for operating companies and NPEs alike looking to license patents. Seasoned hands suggest that these are the keys to crafting a realistic deal:

  • Make a soft approach. Not only is the litigation and regulatory environment uncertain, but Chinese companies with businesses overseas have more tools than ever at their disposal. Licensors enjoy much more success when they make a constructive approach with a deal that makes business sense for both sides.
  • Pure patent deals are not getting done. Whether it is a tech transfer, know-how exchange or joint development agreement, including more than just IP rights and cash in a deal makes it much easier to secure buy-in from the other side.
  • Approach investors. China has many valuable but young tech start-ups that have not yet developed a real corporate IP function. Seek out venture capitalists on the board to explain how strengthening the company’s patent position is crucial to facilitating expansion outside China and justifying lofty valuations.
  • Tailor the deal. Chinese companies have little appetite for overly broad deals. They want to identify their biggest risk areas and address them in a targeted, cost-effective way.
  • Explain and educate. Chinese companies are increasingly keen to develop their own monetisation programmes. Often, the patent strategy expertise of a foreign company is one of the most important things it can offer the other side in an exchange.
  • Monitor compliance. Underreporting of royalties is not a China-specific problem, but it has been in the spotlight lately. Audit rights are often among the most contentious points of negotiating an agreement.

Jacob Schindler is IAM’s Asia-Pacific editor, based in Hong Kong

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