You have a great idea. Is patenting the best way to protect it? How much do patents cost? How do you find out if your idea is patentable?
Robert M. Hunter, Ph.D.
Registered Patent Agent
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If you are not in the inventing game for the money, you should seriously consider picking a less expensive and time-consuming hobby. That is not to say that enjoyment of the process is not important--because there can be long dry spells in the income department, with income tending to arrive in chunks (hopefully, big chunks). Fame can be nice, too. But making money from your invention(s) is the goal for any serious inventor, especially for a serious inventor without a day job or trust fund.
Inventions can make money—big money. The polymerase chain reaction (PCR) patents were sold for $300 million. The inventions that IBM and Texas Instruments have licensed produce hundreds of millions of dollars of royalties for each company every year. Patents on genetic engineering and music synthesis produced tens of millions of dollars of royalties every year for Stanford University.
THE INNOVATION PROCE$$
As the description of the steps in the innovation process presented below indicates, "it takes money to make money."
See the document web on Funding Your Invention for ideas on how to obtain the "seed capital" for developing your invention are presented.
So—how do you make money from an invention? There are two basic ways: (1) licensing the invention and (2) growing a company around the invention. Each of these options will be described below. First, however, methods for valuing your invention (estimating its worth) are discussed.
There are a number of approaches to valuing an asset that has income potential, like a technology or a company. One way to value an asset with income potential is to estimate the present worth of the future income stream. It is best to set up a spreadsheet to do the calculation so the user can conduct "what if" analyses. The first column of the spreadsheet should list each item for which projections will be made in a separate row. The other columns of the spreadsheet show the calculated value of each item for each year of the useful life of the asset. Either below or above the table, one should place a smaller table that lists the "assumption variables" in a first column and the editable value of the variable in the second column.
The list of items for which projections are made varies with the asset, but for a technology or company they usually include the following (one row for each).
Total number of units sold annually (market size):
Market share (percent of total market the technology will capture):
Selling price per unit (in dollars per unit):
Gross profit (as a percentage of selling price):
Income tax rate:
Net profit after taxes (in dollars):
Present worth (in dollars):
Of course, one can add "subtotal" rows to display other items of information or intermediate calculation results. The listing of "assumption values" might include the following (depending on how much the user wants to "automate" the analysis:
Rate of increase of market size (in percent):
Rate of increase of market share:
Rate of increase (decrease) of selling price:
Discount factor (used to calculate present worth):
People (especially inventors and technology entrepreneurs) are usually wildly optimistic about how much their technology is worth. If they are to be successful in having some of that optimism "rub off" on the buyer, they should provide a basis for and document all their numbers (and assumptions) to the maximum extent possible. The valuation document should contain references to the sources of the data they use. For example, to substantiate an expected profit percentage, one should prepare a manufacturing cost estimate (at the volumes expected) and then apply percentages customary in the specific industry for "overhead" items like R&D, engineering, marketing and sales, etc. These factors can be derived from a review of annual reports of companies in the industry (which are available for free either on the Web or from Investor Relations departments). Then the total cost per unit is deducted from the expected selling price per unit to establish a gross profit, etc.
The most difficult factor to come up with is the discount factor. It is the way that both the cost of money and risk are factored into the analysis. It is not unusual for discount factors in the 25-35 percent per year range (compounded annually) to be used. This may sound disgustingly high, but when one realizes that angels and venture capitalists use discount factors of 50-100 percent for startups, numbers used in industry sound like " free money." In setting the discount rate, one should consider such factors as how "proven" the concept is, how close it is to a product, how solid are the patents, how broad the patent claims are, how acceptable the product is to "lead customers," etc.
If you are simply selling a license for a technology, another factor should be considered in the analysis-a reasonable royalty rate. Royalty rates can vary all over the map and depend on the industry in which one is working. Organizations like the Association of University Technology Managers (AUTM) and the Licensing Executives Society (LES) publish lists and statistical analyses of royalty rates. Many industries use about 5 percent of the selling price as a typical rate (for an exclusive license), but rates can vary from 0.1 to 25 percent or higher. A rule of thumb often used in negotiations is that an inventor "earns" about 25 percent of the net income (profit) from an invention.
A second way to value an asset that is often applied to valuing the stock of technology companies is to use the price to earnings (P/E) ratio approach. With this approach, one prepares a business plan that includes reasonable (most probable) five-year financial projections. The value of the company is estimated at the end of the five year period by multiplying the net after-tax earnings by a P/E ratio (typically of about 20, which is common for NASDAQ (over the counter) companies, or higher--30, 40, 50--if the business plan is more exciting). Then the value of the company is discounted to the present using a dreaded discount factor. As was mentioned before, investors in startups typically demand 10 times their money back in five years (that is a compound rate of return of 57.5 percent per year for you math whizs). So if the company will be worth $10 million in five years, it is worth $1 million today. Pretty disgusting, huh!
Relatively recently, software-implemented products have been developed for valuing patents. Here are links to explanations of a couple of them:
The best approach to negotiating a price is to do your homework but to have the seller first tell you what he wants to pay for the technology. You may be pleasantly surprised. Even if you are, ask for 10-20 percent more so the seller will not feel that he paid too much (provided you do not expect get more). It is not unusual, however, for a sophisticated buyer to offer half of what he expects to pay for a technology. What is important is that both sides approach the negotiation with the goal of developing a "win-win" result. Money (while it does come in handy) does not bring happiness-enjoying what you do and not regretting what you have done, does.
As to the advantages and disadvantages of each approach, simply selling the technology outright is usually the simplest. But inventors (what the people are called who use this approach) rarely get rich. The people who do get rich (or die trying) are usually people who grow businesses and then sell them.
Speaking of rights, the value of a technology is only as great as its owner's ability to prevent others from practicing it without their permission. Unless the owners can maintain control over the use of their technology (e.g., by obtaining patents or by maintaining it as a trade secret), why should anyone pay them anything for it? Ideas that are not converted into some sort of "intellectual property" are free for all to use. But that is another story.
Rights in intellectual property can be transferred in the same ways that rights in other kinds of property can. The transfer of selected rights in an invention or patent, without giving up ownership, is called "licensing." The transfer (e.g., sale) of ownership of an invention or patent is called "assignment."
Finding a Licensee or Buyer
Finding someone to license an invention (a licensee) or finding a purchaser for an invention (an assignee) is hard work. It typically take several times more effort and time to license or sell an invention than it takes to patent the invention and prove that it works. Forming a competent team is important even if you plan to license your invention. Why is teamwork so important?
One reason is that many different skills are required to develop an invention to a licensable stage—management, accounting, finance, marketing, selling, engineering, fabrication, research, inventing, etc. In inventing, "lone eagles get plucked." In that inventors are usually only good at inventing and, maybe, some limited marketing, they will need help to be successful. You will never have all the skills you need inside your organization. Thus, networking is vital. Metcalfe’s Law states, "The utility of a network is proportional to the square of the number of its users."
A second reason is that inventing and selling activities must occur concurrently rather than sequentially. According to Andy Grove of Intel Corp., "The world now runs on Internet time." These days, inventors simply do not have the luxury of moving their ideas into the marketplace slowly.
Many successful inventors start with a licensee’s or buyer’s problem in mind and then invent a solution to the problem. Those inventors have a ready-made list of potential customers for their invention. For example, the Federal departments and agencies that participate in the Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) programs, issue solicitations containing descriptions of problems they want solved or inventions they want developed. Some large companies publish similar lists of kinds of technologies they are seeking. Almost all large companies have a web site that contains a listing of the technology area they work in or products they sell, for example:
Dow Chemical Company
If you can fit your invention into a "hole" in a manufacturing company’s product line, you may have found a potential licensee. Or reducing the cost of producing an existing product can work. Replacing an existing product with a "better" one is almost impossible. They may talk to you, but your time will be wasted. Companies have invested a lot of money in their existing products, and will not easy drop them, even for something radically better. Talk to their competitor who does not have an existing product in that slot.
Licensing inventions starts and ends with customers. Every invention/technology must be considered a business. And a "business" without customers is a hobby. Here are some general rules about customers:
Customers are the people who work for the companies, not the companies.
A potential customer for you is someone else’s dissatisfied customer—a customer with a problem. Customers are people with money and the authority to spend it.
Only customers’ problems require solutions. If you really understand a problem, solving it is usually trivial.
If you want to sell something to someone, you must first listen to that person.
Now, suppose you invented something without having an actual customer’s problem is mind. What you have in hand is "a solution looking for a problem." Most "inventions" fit in this category—that is one reason why the inventing business appears to be so risky. Solutions looking for a problem are difficult to sell. You really do need to identify who will benefit and how they will benefit at some point. Start now.
Come up with a list of at least 20 companies that manufacture and sell products in the technical field of your invention. You can use a search engine or a web-based directory, like Thomas’ Registry of American Manufacturers. Realize that market leaders are usually not "hungry" enough to be open to outside ideas—focus on the second and third tiers in the market. If you have a truly innovative invention, you should look for companies with a longer term perspective than the typical U.S. company. In that case, try to find companies with one of the following characteristics:
The company is owned by its founder.
The company is owned or managed by a first- or second-generation immigrant to the U.S.
The company is a foreign, preferably European, company.
Contact the marketing department of the companies. That’s right, the marketing department—not the engineering department. Marketing people are typically on the lookout for new ideas, even if they come from the outside. Engineers (who did not come up with the idea themselves) are typically very negative about outside ideas. (When you eventually do have to deal with the engineers, try to let them feel like they came up with an even better way to implement your invention—they love that!) In larger companies, try to develop at least three different contacts. People who work for large companies have a habit of disappearing.
Start developing trusting relationships with your contacts/customers. You know—first date, second date, third date, etc. A trusting relationship must have been established before intellectual property can be transferred. Make an effort to understand the problems they face. If they want to talk about their everyday problems, let them. Ask open-ended questions: who, what, when, where, how. Listen. Keep the customer talking so they will want you to come back. At intervals, paraphrase what the contact has said. People like to work with people who listen. The frequency of your contacts (visits, telephone conversations, lunches, etc.) should be no greater than every six months. Try to bring a no-cost "present" along with you—your newsletter, an industry white paper, a competitor’s annual report, etc. Anything that strengthens the bond between you will do. Don’t tell other peoples’ secrets—that reflects badly on your ability to be trusted. Sooner or later, your contacts will want to learn more about your invention. If you do this part right and you are lucky, you will find someone whose interests parallel yours, someone who wants to help you succeed—your champion! Nothing happens without an internal champion. Once you find one, do anything you can to help him or her succeed by helping you.
A common question that arises during an invention "marketing" effort is, "How much should I tell a potential licensee about my invention, and when?" As every situation is somewhat different, a common sense approach must be taken. In general, however, the answer is, "Tell each potential licensee only what he/she needs to know at each point in the process." Most people will tell you what they need to know. Don’t bother them with extraneous information—it’ distracting. Before either party discloses confidential information, a confidentiality agreement should be in place, preferably a two-way agreement and preferably one that is in writing. A typical pro forma confidentiality agreement is available as a Word file on this web site.
Try not to be too paranoid. A little caution is OK. Excessive paranoia appears to be a "workplace hazard" for inventors. Before someone can trust you, you must be able to trust them. Nothing happens in the technology transfer field without trust. So, cool that imagination! Your potential licensee does not want to steal your invention. Neither does he/she want to buy a "pig in a poke." Show him/her the pig!
Types of Licenses
There are generally two types of licenses: exclusive licenses and non-exclusive licenses. Under an exclusive license, no one but the exclusive licensee can practice the invention. Under a non-exclusive license, more than one licensee can practice the invention.
During your contacts with potential customers, one of the aspects of your relationship you will want to clarify early on is whether the licensee really wants exclusivity. They usually all say they do at first, but often, when the implications of exclusivity are made clear (e.g., commercialization efforts required in each field of use, larger amounts minimum royalties, etc.), a non-exclusive license is sometimes determined the best course for all concerned.
Typical License Terms
Licensing agreements should be drawn up by attorneys with experience in such matters. Contracts are nasty documents that explain "what happens next" when something goes wrong. Nobody looks at them when every thing is going well. Typical license agreements have the following terms:
A title that explains what the document is.
The effective date of the agreement.
A statement of who the parties to the agreement are.
Recitals, called "whereas clauses," that explain the intentions of the parties.
A license grant that explains what type of license it is. If the license is not exclusive, the field of use and/or the geographic area within which the licensee may practice the invention is described.
A description of the technology/invention/know-how that is being licensed, usually including a listing of the patents in an appendix.
The payments (e.g., running royalties and minimum annual payments) involved, how they are determined and accounted for, and when they must be paid.
How long the license lasts and what happens after the license term is over.
An agreement to share information and an agreement to keep secrets.
How improvements to the invention are treated and who owns them.
A description of the efforts the licensee agrees to take to commercialize the invention, which can be "best efforts" or characterized by a timeline.
An agreement by the licensee to mark patented or "patent pending" products.
Which party is responsible for suing infringers of the patent, if either, and how the costs of the suit and any moneys recovered are treated.
Which party is responsible for paying patent-related costs, such as reissue costs, maintenance fees, foreign filing costs, etc.
How conflicts are resolved, typically by arbitration.
Under which state’s law the agreement is to be interpreted and where suits may be brought.
The mailing addresses of the parties to the agreement.
A statement about how the agreement can be amended by the parties. Such statements usually require that amendments must be in writing and agreed to by both parties.
The signatures of the parties.
Negotiations of a license agreement with a large company can take six months to a year, depending on how fossilized the large company is. If you have followed the instructions given here it is not too difficult. You know your customers. You know their problems. You know how much money your invention will make or save them. They participated in the development process. They trust you.
It is important that you NOT involve your attorney in the actual negotiations until the parties have agreed to the basic terms. Use a license agreement checklist like the one above to make sure that all the terms are discussed.
Persist. These things take time. Remember the "first date, second date, third date" idea? Well, it applies here, too. Be assertive but not aggressive. Keep things moving on your end. Develop an understanding for the internal bureaucracy that your "champion" is fighting for you.
Negotiate a win-win deal. Whether the potential licensee realizes it or not, he/she is (hopefully) going to have a long-term relationship with you. If, after you have made a deal, either of you feels that the other has taken unfair advantage, your working relationship will sour and will be much less productive than it could otherwise be
There are tax consequences every time the asset is transferred-so be careful. The income tax consequences of selling any capital asset are that one has to pay federal and, usually, state income taxes on the gain, which can be treated either as regular income or as a capital gain. If the asset is held long enough to become a capital asset, the capital gains tax rate generally decreases as the length of the holding period increases and increases as the taxable income of the seller increases. (Filing a patent application is one way to prove the beginning of the holding period of the invention is discloses, but, of course, one can own an unpatented invention.) The IRS provides a unique "loophole" for inventors who sell their technology outright or exclusively license all the rights in it.
After both parties sign the agreement, first celebrate, then repay your backers and begin the process anew. If you don’t improve your invention, someone else will. Have fun! It’s a PROCESS, remember?
The second (and potentially more profitable) way to make money from your invention is to form a new venture to make and sell it. While inventors often "earn" about a quarter of the net profit from inventions, it is the owners of companies that make and sell products that embody inventions who "earn" the other three quarters of the profit. And, they get paid for working there.
The first step in forming a new venture is to prepare a business plans. Business planning ideas are presented in a related document web.
Team building is even more important with this commercialization option. Although the entrepreneur must "wear many hats" during the startup phase, he/she must eventually find people with experience in management, finance, accounting, marketing, selling, R&D, design, engineering, manufacturing and quality control.
A laboratory prototype is a far cry from a robust and cost-effective product. It is not unusual to spend $1 million or more on development of even very simple (e.g., mechanical) products.
Manufacturing of a new product can present formidable challenges to a startup company. The National Institute of Standards and Technology administers a program called the Manufacturing Extension Partnership that provides hands-on help for small and medium-sized manufacturers.
In summary, two methods can be used to make money from your invention: licensing and building a company around it. Licensing, which is easier that new venture formation, requires the least investment capital on the part of the inventor, but typically produces a lower return. New venture formation is more difficult, but often much more profitable for the owners of the company. In deciding between these two approaches, an inventor must consider his/her personal capabilities and limitations, the availability of investment capital, and the nature of the invention and its marketplace.
© 1998-2003 Robert M. Hunter PLLC