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I am fascinated by the idea of “Dark Matter”, a substance which is invisible but is thought to constitute the vast majority of mass in the universe. It cannot be measured directly, but its presence can be inferred by the gravitational effects it exerts on everything around it. This strikes me as being a lot like innovation. Although it is now believed to be the most important driving force in economic growth, economists cannot measure it directly. It is observed primarily for how it appears to pull and push virtually everything else. Economists have devised a variety of ways to measure it indirectly which is one reason we spend so much effort analyzing patenting, R&D spending, and a lot of other things. This is why measurement is so important to progress in managing innovation. Until we can directly measure the most important economic aspects of innovation (such as gaining visibility into the markets for ideas, IP, and innovation) it will simply remain “dark matter”. That’s why I say, if you can’t measure IP, you can’t manage IP.

Patents create value for their owners in a variety of different ways. One of the biggest problems with nearly all patent valuation techniques is a failure to be explicit about what kind of value they are attempting to measure. It is essential to have an accurate model of value types in order to identify the source of the information that is needed, and also to formulate the correct approach for interpreting that information.

The Four Kinds of Patent Value

Patents basically allow the rights holder to pursue legal measures to prevent others from practicing the subject matter. This is the reason why many people are quick to point out that patents are only valuable in the way that they act as a blocking mechanism, and this is certainly true. However, although it is very important, it is not accurate to say that the value of a patent is purely a function of its enforceability. In practice, there are different ways to use patents to create value, and people are getting more creative about it all the time.

I group the major ways patents create private economic value into four dimensions.

1. Practicing
   
   The first and most obvious method for realizing economic value from patents is by producing and selling products which embody the patent. This is what is known as “practicing” the patent. Value derives from the producer’s ability to exclude competitors and therefore earn monopoly profits. In practice, this type of value is virtually impossible to measure directly particularly because it is nearly impossible to determine exactly how much value is attributable to the patent’s exclusionary rights versus all other factors such as superior design, branding, timing, market power, other intellectual property, and existing manufacturing efficiencies. Another problem is that the value that a company may ascribe to a patent in this context will not normally be the same as the price at which the patent would transact in the market.
2. Licensing
   
   An alternative to practicing a patent is to license its rights to another entity. Licensing value is realized when the licensee pays royalties and other fees to the licensor. Thus, value is created through royalties on the sales of any products that embody the product and therefore can be viewed as a function of the ultimate value from practicing the patent. This provides at least one way to observe directly the value specifically attributable to the patent in its ultimate application, and therefore addresses the problem with measuring practicing value. Licensing transactions also offer the opportunity to observe prices that occur in the market between willing entities. In practice, these are virtually impossible to observe because patent licenses are always confidential.
3. Litigating
   
   An entity that does not practice or license a patent can sometimes receive value by leveraging the special legal status of patents. Recently, some patent holders (often referred to as “patent trolls”) use patents as an asset in a threatened or real patent infringement suit. In this case, the patent holder does not intend to practice the patent, but seeks value primarily through settlements and court awarded damages. The majority of patent disputes are settled out of court and are confidential. But, even if known, settlements and awards cannot represent the “market” for IP as they do not occur between two willing entities and amounts are distorted by legal rather than commercial considerations.
4. Deterring
   
   “Defensive” patenting is the practice of filing patents for the purpose of providing a basis for counter-infringement claims in patent litigation. In a sense, it is the opposite of litigation value. As patent infringement litigation has accelerated, many companies have filed defensive patents to serve as a deterrant by increasing the cost to opponents of asserting patent rights. Obviously, measuring this kind of value is virtually impossible as its economic benefits are unknown except in rare cases.

One of the purposes of this taxonomy is that it helps us to understand the roles that IP plays in business strategy and therefore helps us to construct more coherent and effective IP management practices. Another benefit, is that it provides a way for better understanding patent valuation. Most patent valuation techniques suffer from a lack of clarity on this point. Because patents can create different kinds of value, we have to be clear which kind we are estimating when we do patent valuations otherwise our results will not be valid. In addition, being clear about the kind of value we are estimating makes it obvious what types of data are relevant. In subsequent posts I will show how this model of patent value is essential to almost everything we do in IP management.

In a previous post, I argued that there are a lot of examples where aggregate market data are useful despite the fact that they often obscure a lot of pricing variability associated with heterogeneous products. In other words, market prices are averages of aggregated data that actually obscure a lot of pricing variation. Nevertheless, these data are extremely useful for management, in making investments, and a lot of other areas. My point is that aggregated IP/patent transaction data would be very useful to a lot of people and organizations. Here is just one interesting example of the value of market data from my own background…

In a former career, I worked as an economist analyzing global trade in fruits and vegetables mostly in support of World Bank and USAID projects to develop agriculture in emerging economies. I worked on several teams that built models which were used to focus hundreds of millions of dollars of investments in agricultural production, packing, transport, and marketing of fresh products throughout the world. Our clients had a very simple need. They needed to know what products to produce, how much, and where to sell them to make the most profit. Naturally what they can produce is constrained by their climate and location. But there were always several different products they could produce effectively and it was critical to know which would be the best investment. The data that are available to build market profitability models aggregate data in ways that obscure huge variations in what are actually very heterogeneous products and markets. For instance, for pricing and volume data we would often have a category like, “Grapes: Fresh”. Just think about the variety of grapes that are offered and the different venues, and formats where you buy them. “Grapes: Fresh” doesn’t really capture much variety. Yet, we were able to use this data very effectively to predict the volume of product that our clients could profitably deliver into every market around the world, in any given week. Any grape expert can tell you that the pricing data we were using obscured the very important reality that it matters a lot what kind of grapes you deliver, and in what format, for determining the price. However, this didn’t prevent us from using this data and combining it with that expert knowledge to be able to answer our client’s most important question.

The same is true for IP. Just because a product is not perfectly heterogeneous does not mean that aggregated/averaged market pricing information is not useful. In many cases, this data is essential in establishing fluid global markets. I am convinced that the same will be true for patents and other intellectual property. Once we can finally observe the market prices for large numbers of transactions (licenses and sales), this data will greatly reduce the “friction” associated with these transactions and a fluid global market in IP will finally emerge.

NOTE: This is the first part of a three-part post on the need for a new paradigm in IP valuation. More to come… (Part 2 | Part 3)

I have been pondering the wisdom of this classic quote by Peter Drucker, “If you can’t measure it, you can’t manage it.” (sometimes he is also quoted, “You can’t manage what you don’t measure”), and just how important the basic idea is to managing patents and other types of intellectual property. The implication is that you really can’t - manage IP that is - because we simply can’t measure the one thing that is most essential to management: VALUE.

I noted in my initial post on this blog, just how much the global economy has changed because of IP. The global economy has experienced a tectonic shift from a reliance on physical capital to intellectual capital. This tectonic shift is illustrated in the proportion of the value of corporations that is attributable to its intangibles – rising from around 20% 40 years ago to over 80% today.

It is fair to say that the world has not adapted to this new reality. Our current business infrastructure, practices, and regulations are designed across the board to support the tangible economy of the past. Accounting methodologies adequately measure and report physical assets. Business management practices offer powerful ways to strategically manipulate tangible, financial, and human resources. The financial world has evolved a rich variety of tools and instruments for capitalizing tangible businesses and activities. Government regulation and tax policies comprehend tangible assets and businesses. The problem is that none of these tools can be adapted to work with intangibles and intellectual property.

This is a major problem in the case of patents which have expressed, perhaps more than any other single economic institution, the dramatic nature of the ideanomic transformation. Patent applications have exploded by more than 400% over the past two decades, and patent licensing and litigation have grown even more dramatically. If innovation is truly the new “industrial religion, then patents are now the cardinal virtue espoused and zealously sought by the faithful. Intellectual property has become one of the most valuable and important economic assets in the new ‘idea economy’.

The Challenge

The challenge in this new regime is that patents cannot be managed like any other kind of business asset. All of our business tools, practices, techniques, and instruments were designed to manage tangible and financial assets, and as a result they simply do not work with patents. The impact is that it is much more difficult to trade patents like other assets and as a result a global “market” has not yet emerged despite predictions of its eminent arrival. In fact, it is virtually impossible to do anything with patents that we do with other assets.

We can’t manage them like a portfolio of any other kind of asset to accomplish even simple tasks such as optimizing the value of the portfolio or diversifying the economic risk in the portfolio. We can’t borrow against them, securitize them, insure them, or even audit them properly. It is a striking reality of the world economy that what has suddenly become perhaps the most valuable business asset is the one we are least able or equipped to manage successfully.

The fundamental reason for this is as striking in its simplicity as the era of ideanomics has been in its transformational sweep. The problem is rooted in our inability to know the economic value of intellectual assets. Virtually all business practices, techniques, and instruments – in fact practically everything we do that falls under the heading of “management” – requires knowing something about the value of the thing we are managing. Fundamentally, we need to be able to measure the things that we manage. It is true of physical assets like inventory, plant and equipment, real estate, and even human resources. It is also true of financial instruments. As the old adage applies very well to intellectual property: you can’t manage what you don’t measure.

In this context what is needed is a view on a very particular definition of value. Although we may be very interested in the intrinsic value, or the social value, or the scientific importance of IP for a lot of reasons, what we need most is to be able to use our accumulated set of business skills in managing IP is the “fair market value”. This is the price that the asset can be traded in the marketplace between willing parties (some times referred to as “fair value”) which is the universal gold-standard for defining the value of any asset, and upon which almost all management, auditing, and financial processes are founded.

The only way to know or measure this exact type of value is by observing the transactions that take place in the “market” for any given asset. In fact, it is obvious that one could not even pretend to effectively manage or trade in any kind of assets or resources without having up-to-date information about the market price. Ultimately, market pricing information is the key input enabling virtually all management capabilities, and is the catalyst enabling most of the processes and financial infrastructure of the modern business.

The Invisible Marketplace

The problem is that intellectual assets, and particularly patents, are not traded openly where the price can be observed. IP transactions are almost always confidential, and this is the reason that there has never been any systematic way to observe market prices. The absence of this critical information creates considerable friction in transacting intellectual property. As a result, fluid markets for IP have not fully developed. Though patent licensing has been growing at a very rapid pace, it remains small relative to the size of the asset base. Estimates of the value of un-utilized patents are in the trillions of dollars.

The lack of visibility on the markets for IP is one of the most significant challenges we face in our transition to the era of ideanomics. Companies need IP pricing information to focus their innovation investments, to maximize the value and quality of their IP portfolios, to reduce the cost of low-value patents, and to negotiate better license terms. Attorneys need it to craft more valuable patents for their clients and to facilitate negotiating infringement settlements. Auditors need it to more accurately measure and report corporate assets. Investors need it to analyze companies and sectors to inform their investment decisions. Financial institutions need it to be able to lend against and even securitize IP. Insurers need it to underwrite intellectual assets. This data is needed in evaluating assets and companies for mergers and acquisitions and for public offerings. It truly is the most important piece of missing data in the ‘idea economy’.

The folks over at WorldMapper.org have some pretty fascinating maps of the world, including one that shows the size of countries proportional to their contribution to the world’s patenting (data are from 2002). Where is the Southern Hemisphere you ask? (You can see pictures of it in National Geographic of course!)

Obviously it is not exactly an “innovation map” but they also have a similar map showing contribution to scientific literature (data from 2001). Patenting and scientific literature have been shown to be useful proxies at least for scientific and technological innovation in many studies. Of course, what these both leave out is every other kind of innovation.

But it sure throws the disparity of participation in the idea economy into bold relief. And it raises the legitimate question of whether the idea economy will really have the flattening or leveling affect that is often claimed. To the extent that intellectual property is one of the most important economic assets of the new millenium, what can the southern half of planet Earth do to participate in the idea economy?