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Top IP Management Mistakes: Saving Money on Maintenance Fees

By: Fernando Torres, MSc

Challenges of IP Management

Managing an organization’s IP portfolio is full of challenges in the context of global competition, which turn particularly acute in the current economic dynamics of the turnaround from the financial crisis.

There are a few good information sources on the Best Practices for IP management. The International Trademark Association (INTA) and the World Intellectual Property Organization (WIPO) serve the global community of large companies and SMEs respectively. Something that is often missing, however, is learning from the mistakes of others. This may be because organizational culture has a way of suppressing mistakes from public view, or because emphasis is often placed on the case-specific nature of such problems, rather than abstracting the general lessons from the experience.

In any case, aside from maintaining a current inventory of intangible assets including intellectual property, designing and enforcing quality controls with internal and external publics, IP managers must continually ensure the organization’s IP policies support and advance the company’s mission and strategic directives.

When the latter process goes wrong, most IP managers can learn a valuable lesson. In this post, we address a critical mistake that we witnessed at a corporate restructuring client some years ago, dealing specifically with global IP.

Mistake #1: Saving Money on Maintenance Fees

In the last few years before a Chapter 11 filing was necessary to restructure the business, the subject company’s IP managers had finally inventoried the complete patent portfolio that had accrued in both the USA and Europe as a result of the company’s growth and M&A activity. The key and elusive piece of puzzle was a matrix, cross referencing the individual patents and the specific product lines and respective factories in which they were applied.

Simultaneously, a central piece of the strategy the company’s top management tried to implement was cost savings across non-essential activities.

Armed with their summary matrix, when the harried IP managers decided on their contribution to the cost saving measures, they identified European patent annuities (yearly maintenance fees) as a material target and proceeded to rationalize the portfolio by suggesting to stop paying those maintenance fees on patents in those European jurisdictions were they did not have significant levels of sales (Italy was a big offender).

The problem here was informational. The IP management summary did not clarify that the patents in those jurisdictions were covered manufacturing processes, not end-products. A couple of years later, in the aftermath of the bankruptcy filing, the company negotiated to settle debts of its European subsidiaries while holding on only to the IP, namely the European patents.

The prior mistake reared its head: the manufacturing plants and their advanced technologies were unprotected in several European countries and the assumed European Patent Portfolio was full of holes and phantom patent assets that had lapsed due to unpaid fees. Thus, regardless of any negotiation prowess, the competitive advantages of proprietary technical advances in the manufacturing plants were discounted by the bidders for the plants, and the company could only sell a few disjointed and not very valuable patents that covered final-product features that change very often in the fast paced markets in used to dominate.

Thus, a superficial understanding of the IP inventory gave way to a substantial loss of value for the restructured company. Needless to say, the US operations were liquidated and the European factories were sold for a fraction of the going concern value.

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Trademark Dilution Revision Act

President Bush Signs the Trademark Dilution Revision Act

On Friday, October 6, 2006, the President signed into law, among other bills, H.R. 683, the “Trademark Dilution Revision Act of 2006,” which amends trademark law to clarify the protection provided in cases where use of a mark is likely to cause dilution by blurring or by tarnishment of a famous trademark. See this article for more details.

Valuing Unproven Technology for Asset Sales

New Developments in Valuing Unproven Technology
for Distressed Asset Sales
By: Fernando Torres, MSc

Introduction

In the context of a corporate bankruptcy, creditors naturally focus on the short-term viability and liquidity of the business. In many cases, pursuing financing to continue operations involves selling assets outside the ordinary course of the core business. Two central concerns in these situations are whether all possible assets have been identified, and if they been accurately valued. Increasingly, the types of assets that are uncovered are intellectual property, such as patents, copyrights, and trademarks.

Depending upon the specific history, industry, and other characteristics of the business, there may be patents and patent applications that refer to technology not critical to the core business. It has been our experience that substantial value can be found in these technology assets if, and only if, an accurate valuation can support a sale.

Frequently, the challenge in valuing these assets is the lack of a reliable secondary market and that their application, outside of the original business, may be unproven or uncertain. The consequence of these characteristics is that the most often used valuation techniques (market-based or discounted cash flow) cannot be reliably applied. In this article, we present an alternative valuation approach that captures the value of the potential these technologies have and provides reliable values for these increasingly prevalent types of assets.

Patent Values as Options

A patent is a right to exclude others from applying the technology described through the claims, and does not constitute the obligation of the patent owner to put the technology to use. This right has a finite lifespan, typically less than 20 years. At this level of generality, a patent it shares the key characteristics with a financial stock option, specifically a “call” option; the right, but not the obligation, to buy a stock for a set price during a specific time frame.

As an example, suppose a patent has only two years remaining and that, if implemented, there is a 30% chance that it will generate a profit of $10 million within one year, and a 70% chance that it will lose $1 million. By the second year, the probabilities and profits are assumed to be the same. These premises generate three possible scenarios at the expiration of the patent’s statutory lifespan:

  • A 9% chance of $20 million in profits (0.3 x 0.3)
  • A 2% chance of $9 million in profits (0.7 x 0.3 + 0.3 x 0.7)
  • A 49% chance of $2 million on losses (0.7 x 0.7)
The key question is what is the market value of that patent? In other words, what is the highest amount a buyer would be willing to pay for this patent? As in most economic decision questions, the answer depends on what else can be done with the resources that would otherwise be invested in this asset; what is the opportunity cost?

Assuming an interest rate of 5%[1], a potential buyer could borrow funds to buy the patent and repay the loan, after two years, including compound interest (At $1.025 per dollar borrowed). The solution can be illustrated considering the following two possibilities:

If the buyer pays $5 million for the patent, the probability-weighted outcome in two years[2] will be $4.6 million in profits, but $5.51 has to be repaid for the use of the funds for two years, so there would be a loss of $0.91 million.
If the buyer pays $4 million for the patent, the probability-weighted outcome in two years will be the same $4.6 million profit, and $4.41 has to be repaid for the use of the funds for two years, so there would be a net gain of $0.19 million.
The maximum amount a buyer with a 5% cost of capital would pay would be $4.17 million[3], that is the amount that equates the outcome with the cost of the funds; it measures the maximum[4] value of the technology. Naturally, in a bankruptcy or reorganization, actual pricing would be lower.

This simplistic example illustrates that, depending on how high the interest rate is, the value of the patent is less than the expected value of the profits. Additionally, it highlights that the necessary inputs are the cost of capital, the term of the patent, its profit possibilities, and the associated probabilities of the scenarios.

In practical applications, the well-known Black-Scholes model allows for the generalization of this approach to a continuous time (rather than discrete “years”), and represents the various scenarios as a probability distribution, mathematically identified by a single risk parameter (the statistical variance). The value of the option or the patent depends then upon the difference between the current value of the patent and the cost of capital, as well as the variance and the time left before the patent expires.

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[1] For instance, the yield on a 2-year U.S. Treasury note.
[2] The sum of $20 million x 9%, minus $2 x 49%, plus $9 million x 42%.
[3] The exact solution is: 2 x (0.3x$10 – 0.7x$1) / (1.05)2 = $4.172 million.
[4] Given the foreseeable applications and alternative outcomes noted.

Trademark Dilution

Is Protection Against Dilution Back on Track?

by: Fernando Torres, M.Sc.

Dilution is a major threat to established and famous trademarks. Naturally, trademark owners look to federal regulations to protect their marks. The Federal Trademark Dilution Act of 1995 (FTDA) amended the Lanham Act (adding section 43(c)) and followed provisions of the Trade-Related Aspects of Intellectual Property Rights (‘TRIPS’), including Trade in Counterfeit Goods which was part of the Uruguay Round of the GATT agreement. The FTDA includes a provision designed to grant dilution protection specifically to “famous” marks, expanding to four the causes of action for unlawful business conduct in relation to famous trademarks:

  1. Trademark infringement;
  2. Counterfeiting;
  3. Unfair competition; and,
  4. Trademark dilution.

Trademark dilution is defined in the FTDA as the lessening of the capacity of a famous mark to identify and distinguish goods or services, regardless of the presence or absence of:

  • Competition between the owner of the famous mark and other parties, or
  • Likelihood of confusion, mistake, or deception

Courts had previously found that dilution can occur as a result of either “blurring” or “tarnishment.” “Blurring” typically refers to the “whittling away” of distinctiveness caused by the unauthorized use of a mark on dissimilar products. “Tarnishment” involves an unauthorized use of a mark which links it to products that are of poor quality, or which is portrayed in an unwholesome or unsavory context that is likely to reflect adversely upon the owner’s product.

Ordinarily, only injunctive relief is available under current law. However, if the defendant willfully intended to trade on the owner’s reputation or to cause dilution of the famous mark, the owner of that mark may also be entitled to other remedies available under Trademark Law, including defendant’s profits, damages, attorneys’ fees, and destruction of the infringing goods. The availability of monetary relief is a significant departure from state dilution laws, which have typically provided only for injunctive relief.

Trademark Law until 1995, as interpreted by state courts, generally required a showing of consumer confusion about the source or affiliation of goods and services. In contrast, Federal Dilution Law protects the distinctive quality and selling power of the trademark itself, even if consumers are not confused. Interpretations varied before the FTDA. The Fourth Circuit Court of Appeals required evidence of actual diminution of the established trademark’s “selling power,” while the Second Circuit required just a “likelihood of dilution”. The 1995 federal standard, by incorporating the spirit of TRIPS, began to be interpreted as requiring only “likelihood” of dilution or damage, and promoted uniformity and certainty in the face of varying state-by-state standards.

Following passage of the FTDA, the circuit courts of appeals split as to whether the statute required the owner of a famous mark to prove actual harm as a prerequisite to injunctive relief. This question was eventually addressed by the Supreme Court in the first dilution case heard, the case of Mosely v. V Secret Catalogue, Inc. In a dilution action between the lingerie company Victoria’s Secret and a small retail company (Victor’s Little Secret) that sold, among other items, adult “novelties,” the Court determined that the FTDA “…unambiguously requires a showing of actual dilution, rather than a likelihood of dilution.” And found against Victoria Secret’s dilution claim. More specifically, the Supreme Court opinion was that:

The mere fact that consumers mentally associate the junior user’s mark with a famous mark is not sufficient to establish actionable dilution…such mental association will not necessarily reduce the capacity of the famous mark to identify the goods of its owner…”Blurring is not a necessary consequence of mental association (Nor, for that matter, is “tarnishing.”) [1]

An important implication of that decision, for owners of famous marks, is that the difficulty, or standard, to protect a truly famous mark is now greater the more famous a mark is, since it becomes less likely that consumers will find that the diluting mark (junior use) actually impairs the distinguishing capacity of the mark. In other words, to succeed in prosecuting a dilution claim, a mark should be famous enough to warrant such protection, but not so much that proof of “actual dilution” becomes impossible.[2]

The Supreme Court decision prompted a second look at the FTDA. The balancing act between the interests of trademark owners, competitors and consumers needed to be addressed by the legislature. The House of Representatives (April, 2005) and the Senate (March, 2006) passed a bill (HR 683) that will establish the “Trademark Dilution Revision Act of 2006” (TDRA) when signed into law by the President.

TDRA amends the FTDA[3] and is, at least in part, based on a submission by the INTA. It specifies that a famous distinctive mark is entitled to an injunction against any person who commences use in commerce a mark that is likely to cause dilution by “blurring,” i.e., impair its distinctiveness, or “tarnishment,” i.e., harms its reputation, even if there is no:

  1. Actual or likely confusion among the public;
  2. Competition between the owner and the person; or
  3. Actual economic injury to the owner.

In an action based on dilution by blurring, beyond an injunction, if the infringer willfully intended to trade on the famous mark’s recognition, or in a case of dilution by tarnishment, willfully intended to trade on the famous mark’s reputation, the owner may also seek damages, costs, and attorneys’ fees, as well as destruction of the infringing articles under separate Lanham Act provisions.

In contrast to current law, precedent, and interpretations of the law, under TDRA actual harm is not a prerequisite to injunctive relief. The revised act also defines dilution by “blurring” as well as by “tarnishment,” expands the threshold of “fame” (denying protection for “niche-only” marks). Finally, trade dress will also be protected if the owner can prove that such claimed trade dress is not functional, is famous, and is famous separate from any famous registered marks included in the claimed trade dress. The first use in commerce of the diluting mark, however, must be after the enactment of the Revision Act for remedies beyond injunction.

For now, protection against dilution appears to be back on track, but until the new law is signed,[4] it still is not back up to speed.

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[1] 537 U.S. ___ (2003); 123 S.Ct. 1115 (2003) page 15.
[2] Snyder, T. “Diluting FTDA Claims: The Supreme Court Narrows the FTDA But By How Much?” Mealey’s Litigation Report: Intellectual Property , April 21, 2003, Vol. 11 #14.
[3] Subsection (c) changes title from “Remedies for dilution of famous marks” to “Dilution by Blurring; Dilution by Tarnishment.”
[4] HR 683 was passed by the House on April 19, 2005, by a vote of 411 – 8, and by the Senate, with amendments, on March 8, 2006. UPDATE: Signed into law on October 6, 2006.

Options and Royalty Rates

The Real Options Approach to Accurate Licensing Rates
by: Fernando Torres, M.Sc.
Picture the situation. The company has spent millions developing a new technology, the patent has been issued, and the Intellectual Property holding company (IPH) is ready to leverage the innovation by licensing to various subsidiaries. At what rate should the licenses be structured? What about compliance? The transfer pricing specialists are called, and they come back with: “There are no close comparables!” It seems the new technology is truly innovative and conventional methods to determine transfer prices break down. What now?
The Question
When an industry’s royalty rate ranges are wide, say from 3% to 10%, or the industry or relevant markets themselves are nearly impossible to pin down, what additional analysis is required to properly set fairly valued licensing rates? Conventional “Relief from Royalty” methods cannot be applied with confidence and, worst of all, guessing begins.
If the license (or royalty) rates are set too low, the IPH would under-serve its purpose to take advantage of tax and liability arbitrage. If the rates are set too high, the subsidiaries’ financials will suffer, and external (potential) licensing opportunities will likely be lost. So the question is, is there a licensing rate that, given the projected profits from the innovation, or other intellectual property, will cover both parties against these risks?
This article presents an alternative approach that can support IP owners, and their advisors in achieving their goals in this area.

The Background
As intellectual assets have become one of the most, if not the most, important portion of the value of the global economy’s leading enterprises, issues such as transfer pricing, valuation, and leverage have come to the forefront of business decisions.
Similarly, the tools used by specialists and other practitioners have to evolve to continue supporting that decision making process. Yet the most common method still being applied in the field is taking simplified Net Present Value (NPV) calculations applied to royalty income streams calculated on the basis of “representative” royalty rates. These rates are typically derived from transactions that are supposedly (but rarely) “comparable,” according to certain established criteria. This, in essence, is what the preferred IRS method (Comparable Uncontrolled Transaction methodology or “CUT”) does.
Obviously, the greatest obstacle in relying on the CUT method is finding past transactions involving unrelated parties with a high-enough degree of similarity. Questions that must be asked to select the “comparable” transactions include whether, or not:

  • the patents, or technologies, are similar
  • the parties involved are independent from each other
  • the market characteristics are similar
  • the investment commitments are similar to the case under consideration
  • the terms and conditions are comparable (e.g. territory, duration, exclusivity)

While in many trademark, copyright, and even technology licensing cases suitable comparables can be found, it is the nature of patents, in particular, and true innovations, in general, that such transactions will not be easy to identify. That is the main reason new approaches are derived.
The basic alternative to (outside) comparables is making full use of the (internal) information regarding the patent or other item of intellectual property [1] being licensed. In other words, if your company’s transfer pricing analysts cannot find outside comparables, it may be time to look inward.

The Premise
Patent licensing shares at least one attribute with all other relevant business decisions: it involves risk. While this may not be earth-shattering news for most, it does point us in the direction of where an alternative approach can begin.
Where decisions involving financial risk are concerned, sound management principles suggest considering ways and vehicles to hedge that risk. Consider the prospective licensee of our truly innovative technology, wouldn’t it be ideal if the contract commitments could be altered as actual investment, production, and/or sales figures began to be known? Business life does not work like that, so decision makers have a clear incentive to bid for the license in such a way that they are protected from the risk of over investing and spending, as well as from under performing in terms of sales.
One of the central vehicles to hedge risk in modern finance is an “Option.” A financial option on a stock, for instance, is simply the right to buy the stock for a predetermined price (the “strike” price) before the option expires, but it does not entail any obligation to buy.[2] Consequently, the holder of the option will only exercise this right if it becomes profitable to do so, and will not exercise that right if the future market price of the stock does not surpass the strike price.
Suppose our licensing executive could structure an agreement in such a way that a royalty is payable if, and only if, the project involving the innovative patent turns out to be profitable. Naturally, the patent holder (the IPH in our example) would not find such a contract very attractive in real life. Nevertheless, there are financial methods to determine how much such an option would be worth to the licensee and, conversely, what the corresponding value would be for the Licensor to sell the technology if it is unprofitable to develop it in-house. Financial options have been valued in different ways, but the most solid methods are derivations from the famous “Black-Scholes” model.[3]

The Model
Arguably one of the key conceptual advantages of the Black-Scholes model[4] is the precise isolation of the factors (all “current” values) that determine the price for the option:[5]

  • The time to expiration
  • The risk of the underlying asset
  • The time-value of money (risk-free interest rate)[6]
  • The current and strike prices of the asset

Drawing the parallel with our patent, as the underlying asset in the option analogy, it certainly has a finite lifespan, the risk of the industry (or industries) where it is to be implemented can be ascertained, and the prices refer to the expected profit streams from its implementation. The equation that synthesizes the model is quite daunting, and an experienced valuation consulting firm can greatly add value to our licensing executive by thoroughly reviewing the details of the licensing deal and properly using the formula to arrive at the corresponding royalty rate.[7]

The Formula

Where: RR is the Royalty Rate as a proportion of sales, PR is the Profit Ratio or margin on sales, N(∙) is the Normal Distribution Function, σ is the standard deviation of the market, T is the life span of the patent, and r is the Risk-free interest rate.

Fairly Valued Rates
Recall the rate-setting situation we started with. In the course of actual negotiations, each side could have a different insight into the future profitability of the technology, and their own actions will affect it as well. Consequently, negotiated rates may reflect the extent of the disclosures and the thoroughness of the due diligence, rather than the (ideal) fair values for the licensing rates (or transfer prices) corresponding to the inherent risk of the project. Applying the objective valuation method introduced above, in contrast, what we can calculate are fairly valued royalty rates. That is, given the risk and economic life of the patented technology as well as general economic conditions, the fairly valued royalty rate will balance the risk-adjusted profit expectation of the licensor and the licensee. That is how an objectively-determined fair value for the license is obtained.[8]

A Case in Point
A recent case where we applied this methodology dealt with finding the fair value for the royalty rates to be charged by the IPH to the manufacturing subsidiary for the patented formulation of a major nutraceutical product. The range of royalties in the nutraceutical market is extremely wide, from 1% to 12% and of little value as a reference.
The patents involved had relatively short lives left, newer patents were about to become available, and the industry has experienced relatively high volatility. The rates the option-pricing model allowed us to determine narrowed the range to 1.8% plus or minus 0.4% and served as a basis for a realistic valuation of the internal transfer of the patent assets, which enabled the client achieve important goals of their cross-border tax strategy.

Case Study

In this case: The Royalty Rate as a proportion of sales is 1.8%,
the Profit Ratio or margin on sales is 17.7%, the standard deviation of the market is 13.7%,
the remaining life of the patent is 7.5 years, and the risk-free interest rate is 3.9%.



Take Away
Intellectual property is a significant component of enterprise value, and the proper leverage of the increasing corporate investments in patents, trademarks, etc. needs to be based on sound analytical support. When dealing with innovative products, technologies, or business models conventional “comparables” are not available, almost by definition. Modern, sophisticated analytical methods are available to incorporate the information internal to the innovation and develop objective and fair licensing fees. Seeking advice from intellectual property specialists who can support innovative companies achieve their IP pricing objectives, internal and for external negotiations, is the most effective strategy.

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Footnotes:

[1] Although the method discussed may be applicable in other types of property, its characteristics can be better explained in the case of patents. Consequently, this article will focus on patents.
[2] This is a simple description of a “call” option, while the right to sell at a predetermined price is called a “put” option. There is a specific relationship between “calls” and “puts” that allows our analysis to be substantially the same in either case.
[3] This model, published in 1973, was derived by Fischer Black and Myron Scholes, based on previous research by Paul Samuelson and Robert Merton. The 1997 Nobel Prize in Economics was awarded to Merton and Scholes, Black having died a couple of years before.
[4] See e.g., Dixit, A. and Pindyck, R. Investment under Uncertainty , Princeton University Press, 1994; Anson, Mark, The Handbook of Alternative Assets, Wiley, 2002; and Anson, Mark, et al, Credit Derivatives: Instruments, Applications, and Pricing, Wiley, 2004.
[5] Like any model, this simplification of a real-world problem inevitably requires assumptions. Space prohibits a thorough discussion of them, but there is a general consensus that the model is sound. A detailed treatment can be found in For an overview of these approaches, see R. Pitkethly, “The valuation of patents: a review of patent valuation methods with consideration of option based methods and the potential for further research,” and M. Reitzig, “Valuing Patents and Patent Portfolios from a Corporate Perspective,” in: UNECE, Intellectual Assets: Valuation and Capitalization, United Nations, Geneva and New York, 2003.
[6] Conventionally this is the yield on three-month U.S. Treasury Bills.
[7] Although typically the model is expressed in terms of prices, an algebraic equivalent can express the solution in terms of a royalty rate, as a proportion of the price. Furthermore, as Denton & Heald correctly argue, in this case the market and strike prices of the “real option” must be equal, thus simplifying the formula from the original Black-Scholes model. See: F. Russell Denton and Paul J. Heald, “Random Walks, Non-Cooperative Games, and the Complex Mathematics of Patent Pricing,” 55 Rutgers Law Review 1175-1288 (2003).
[8] Obviously, the model’s formulas can be extended to incorporate different royalty structures, adjust for exclusivity and territorial restrictions, and other key specifics of the license agreement involved.

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Economics of Intellectual Property
The goal of this blog is to publish articles and white papers on the economics of Intellectual Property in an effort to generate interest in the subject, while providing access to current topic discussions.