Intellectual property – the fundamental know-how that underpins corporate competitiveness – is the primary driver of business success in the 21st century.
In 2015 every company in every industry is an IP firm, but analysts and investors are poorly educated in understanding its impact on value. This paucity of knowledge is a function of limited pertinent academic research, poor-quality analysis/reporting and issue-driven investor focus, such as around patent litigation.
Contrary to the often sensationalist, event-driven and patent-centric media coverage, intellectual property comprises a rich and diverse set of assets, behaviours and networks that influence both short-term and long-term corporate value:
- Corporate revenues are heavily influenced by intellectual property (where licensing value is often buried in sales and where margins are supported by brand, trademark or patent but not attributed as such). For initial public offerings, there is evidence that intellectual property can increase the offer price significantly.
- In many industries corporate strategy and IP strategy are inseparable (eg, pharmaceuticals and semiconductors), but IP value is not often analysed as a line item. However, without strong patents or trade secrets in these industries, you cannot compete.
- Corporate bankruptcy has shown that intellectual property may have value – sometimes many times the value of the operating company that created it – to competitors and purely financial investors. However, case studies are largely anecdotal.
The fact is that while intellectual property is increasingly recognised as a value-driver, it is rarely included as a critical factor in company analysis. At best it gets a mention in the footnotes. The reason for this paradox is that understanding the IP situation of a company is difficult for non-specialists and, as has been noted in many other contexts, this challenge creates a “difficulty bias”. The result is a classical ‘head in the sand’ response – wherein financial analysts exclude what they do not understand from their analysis. Ironically, this is a mistaken bias because the analysis is not as difficult as it first appears.
The fundamental value of intellectual property derives from its exclusivity. It confers the right or ability to exclude others creating uniqueness. This provides companies with optionality, allowing management time and space to monetise their inventions by the route that creates greatest corporate value without concerns that others will copy them.
Many academic papers have explored this optionality. Such studies describe the optionality that patents in particular provide to operating companies in terms of the timing and allocation of R&D spending and product development. Some of these studies show a positive correlation between patenting and corporate performance, which is explained by the authors as resulting from IP-driven productivity improvements.
I have struggled to find a significant correlation between patenting and stock price using contemporary financial data, but perhaps the age of the bulk of studies is a relevant factor here, as many refer to data that ends before 2000. The IP landscape has changed significantly in the past 15 years as technology has become the predominate field of battle and technology patents skew the analysis. To illustrate this point, the top cited patents in the United Kingdom between 1976 and 1996 were written by Shell, Grand Metropolitan Group, ICI, Unilever and BOC covering synthetic resins, microwave heating, herbicides, anti-calculus and pharmaceuticals, respectively.
Interestingly comparatively few academic studies consider patents as financial assets or explore the notion of active investment strategies around their option-like behaviour. That is probably just as well, as I think the analogy is often stretched too far, but that does not mean it is a useless activity – and, importantly, senior management can relate to it.
Within operating companies it is commonplace to conduct an active hedging of operational, financial and market risk through the use of financial options. Indeed, this is the origin of these financial instruments, which are habitually used to hedge the risk of commodity prices for manufacturing. Financial options may also be used to smooth out currency fluctuations and be applied for highly strategic purposes, such as building stakes in competitors before acquisition.
Patents are equally powerful risk management tools when managed strategically. A well-constructed patent portfolio will hedge the competitive risk in product development. Patent specialists call this 'freedom-to-operate, but for a financial person or CEO this feels more familiar as a hedging strategy to minimise uncertainty. By protecting core technologies a company locks in certainty of net revenues (by avoiding unknown licensing costs) subject to enforcement budgets. Too many companies seem to have lost sight of this core purpose of operational risk management and have accumulated large patent estates whose scope spills far over their core business areas. Notwithstanding the fashion for 'adjacent patenting', this is expensive and obscures the fundamental value of core aligned patents in generating corporate value.
It is well known that intellectual property confers pricing power. From a business and investment perspective being able to rationalise why you will not suffer margin erosion is fundamental to valuation. Patent life allows forecasts of revenue to be assumed with greater certainty than otherwise and may also provide the up-side to generate high-value income through licensing thus reducing cost/income ratios.
Above all, intellectual property is strategic. The IP chess game played out over the past decade between mobile phone operators that has catalysed patent reform legislation has been an industrial version of the Great Game. The collapse in pharmaceutical revenues caused by the patent cliff has fuelled a tsunami of M&A in that sector for a similar period. If you want to acquire a competitor, what better reason than to grasp its inventions and what better way to do it than to box it in behind a patent thicket?
Investors can tell a lot about a company from how it files and manages its patent portfolio. Patent demographics provide investors with an instant snapshot of a company’s innovative trajectory. Overlaying this picture against that of competitor firms can provide a unique view of corporate competitiveness that, when combined with industry and financial analysis, is a lot more revealing than your usual Wall Street reporting.
Unhappily, the conversation around IP value remains heavily siloed. Legal, tax and R&D 'own' the conversation on patents, marketing own brands and trademarks, human resources own culture. The greatest value for IP professionals working with the investment community therefore is to tie these elements of organisational intellectual property together with traditional metrics of value into a single analytical framework. When that is done routinely, the contribution of intellectual property will become evident in the C-suite and IP professionals will be elevated to board level.
Until then, intellectual property will remain the worst-communicated secret in corporate value creation.
This article first appeared in IAM magazine. For further information please visit www.iam-magazine.com.