The economic role of intellectual property
Nooman Haque and Greg Smith
Deloitte
In Adam Smith’s day there was little discussion of the role or value of intellectual property in the economy. Then the main sources of competitive advantage were the availability of natural resources and a skilled labour market. While these factors remain important, intellectual property must now be included as a critical driver of business profitability. For firms, intellectual property contributes to distinct products. For the economy as a whole, intellectual property fosters innovation and risk-seeking behaviour, but only if entrepreneurs believe that their property will be adequately protected. For many companies it is also a factor that leads to significant challenges of strategy, finance and business organisation.
Intellectual property as the driver of economic value
In August 2004, just days before its initial public offering, Google Inc was forced to slash its offer price by up to one-third. For most other companies, this would have not only precipitated a public relations disaster, but also signalled a weak financial future. However, at the initial public offering Google was still valued at 118 times its 2004 earnings and 10 times its revenues. Ninety-five per cent of that revenue came from the company’s patent-protected Adword and Adsense technology, which displays relevant advertisements to users during the course of a web search. These two patents were responsible for the bulk of Google’s income and arguably the growth prospects that justify its valuation. Google has made it clear that delivering the growth implied by its share price is strongly dependent on its ability to develop and exploit new intellectual property like Adsense, yet the company has already acknowledged the threat posed by existing players and new entrants to its market. Overture, a technology firm, claimed that Google’s advertisement-seeking technologies infringe on some aspects of its own patent. The settlement of the lawsuit cost Google approximately US$300 million and contributed to a first-quarter loss. The company also agreed to license several patents from Overture. However, Google still faces several patent claims around the world. Although it has the size to overcome many of these issues, these lawsuits are clearly a distraction from managing its core business.
It may be tempting to dismiss the challenges facing Google as irrelevant to most companies. After all, even pharmaceutical and media companies that rely strongly on intellectual property have some degree of uniqueness that makes copying their success difficult. Significant investments are needed to replicate the success of a blockbuster drug; it is not easy to create new global pop artists. This contrasts with the relative ease with which a search algorithm may be replicated, but Google lies at the far end of a continuum and there is every reason to believe that the challenges it faces are very relevant to many companies today. Intellectual property is increasingly the driver of economic value for many industries, not just the ‘new economy’ industries epitomised by Google.
Major changes in the IP sphere
Although it is only one measure of the importance of intellectual property, a report by the Organisation for Economic Cooperation and Development shows that the number of patent applications filed in Europe, Japan and the United States between 1992 and 2002 grew by more than 40 per cent. There is good reason for this growth. Economic research indicates that research and development results in productivity gains but, interestingly, the gains are shortlived, particularly for high-tech firms. In terms of contribution to value, other research suggests that high market values are more closely related to research and development than to patent stocks alone, suggesting that while patents are important, markets clearly understand the significant value that can be generated from intellectual property through non-patent means. Experience suggests that companies are increasingly likely to pay larger amounts of goodwill when acquiring other companies. Over the last 25 years there has been a growing tendency for companies, and the investors that track them, to place significant value on real sources of intangible value – clearly the markets believe that the advantage is shifting away from companies that offer marginal improvements in production to those that have a lasting (and possibly protected) base of intellectual property. Intellectual property has always been important, but its profile has grown in recent years through associated trends in globalisation and outsourcing.
A significant growth area in emerging markets is the exploitation of film, music and literature of artists created and initially cultivated in established markets. Sports stars, too, have international appeal – witness superstars such as Tiger Woods and David Beckham. Indeed, when Beckham transferred from Manchester United to Real Madrid in 2003, many sceptical commentators remarked that, at £25 million, he was over-valued in relation to his footballing talents. However, with Beckham the footballer came Beckham the marketing machine – the fact that Real Madrid has replaced Manchester United at the top of the global football revenue league table can be attributed to the success of the Beckham brand. Companies with permission to license global superstars have a competitive advantage over their rivals that traditional manufacturing or process expertise cannot capture.
A large proportion of goods traded over international borders contain a significant amount of intellectual property. This fact led directly to the World Trade Organisation Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPs) at the Uruguay Round (1986 to 1994), which aimed to reduce or eliminate cross-border differences in the treatment of IP rights. This is highly relevant for countries that outsource essential activities, but that are limited by the uncertainty of how their key assets will be protected in some territories.
Reaping IP rewards
The importance of intellectual property is clear. So is harnessing the IP value simply a matter of copying the strategies of those industries (eg, pharmaceuticals) where IP creation and exploitation are second nature? Surprisingly, the situation is more complicated than that and there are many factors that will inhibit a company’s ability to create intellectual property and reap the rewards.
First, consider the Google example again. Although its competitive advantage is protected by patents, some of the entry barriers to Google’s web search market are fairly low. Mathematicians can devise new algorithms at a low cost, distribution through the Web is practically free and even the refinement of the tools can be done by users working with beta versions. The high barriers (eg, IT hardware, IT specialists) could be replicated by a determined competitor with money, such as Microsoft or Yahoo!. Therefore, Google must keep working to develop new products and markets in order to preserve the value of its name. Ultimately, the Google brand becomes the only barrier to entry in this market. Other information industries such as music and film have higher entry barriers and have significant sunk-costs into creating and developing artists, but the challenge these industries face is that new technology and changing customer preferences have changed the way intellectual property is exploited in this sector. For example, people have the ability to buy individual songs from an album or download them as mobile phone ringtones. These trends can have conflicting effects on revenues. Clearly, paying for only the songs you want means that demand for some artists’ albums may decline, but an increasing variety of channels (eg, ringtones) can help counteract this effect.
Even in traditional patent-dependent industries such as pharmaceuticals, which enjoy not only strong patent protection but very high entry barriers, value can be eroded through government decisions and other external shocks that are difficult to foresee. For instance, on August 9 2000 a US court of appeal rejected a field-of-use patent that would have extended Eli Lilly’s protection for Prozac until 2003. The court did uphold the original patent until 2001, but the ruling effectively shortened Eli Lilly’s patent protection on the drug by two years. The market reaction was staggering: Eli Lilly’s share price plunged by 31 per cent and the company lost US$36 billion of its market value before trading in Eli Lilly shares was suspended for three hours. This market reaction appears to have been an overreaction, unless the market was also factoring in the value of other intangibles of which Eli Lilly was not even aware. Such intangibles would not have been research programmes underway or patent filings in progress, but simply the market’s expectations of Eli Lilly’s ability to identify successful projects in the future. If the market is pricing this ability, how many executives are truly exploiting it?
Sectors in which the pace of innovation is very high, because of either a highly productive and emerging research base or a fast-moving technology base to exploit new knowledge, require different strategies. For example, the pace of change in parts of the semi-conductor industry has taught companies not to rely exclusively on patents – the time taken to file and manage the process can be long. The diffusion of knowledge through the Internet and the more network-based ways of working, coupled with the short lifetimes of products in this sector, also mean that companies must get products to market quickly.
The challenge of the TRIPs Agreement, given the commercial pressure to manufacture and distribute products around the world, is that companies must carefully value and attribute intellectual property to their associated legal entities. Experience suggests that tax authorities, for example, take a dim view of assuming that all intellectual value resides with a company’s headquarters.
In addition, the nature of intellectual property itself is changing. While patents, licences and trademarks are the traditional sources of intellectual property, the scope of what can be protected has increased. Amazon managed to secure a patent on its ‘OneClick’ technology, but this is essentially a business process. Similarly, new technological developments can enhance the value of licensing rights. For example, it is likely that the next time the UK Premiership football rights are up for sale, mobile phone rights will be included. Such a development will not necessarily increase overall value for the clubs, unless they can ensure there is minimal cannibalisation from one broadcast medium to another. This is a challenge to segment and price in the market appropriately.
Meeting the challenges
These significant challenges can be met by examining some fundamental characteristics of intellectual property.
Knowledge-intensive firms such as consultancies can generate strong reputations among their clients, and a firm’s reputation is built on both individual talent and its ability to deliver high-quality business solutions. However, if scale is not an important driver of success, as in some niche strategy-consulting areas, then people can and do leave to start up on their own. For many such firms, strong knowledge-management systems can protect against normal events such as retirements or planned people moves. However, in some areas of investment banking it is not unknown for entire teams to move to another bank, and while relationships may be protected through legal contracts in the short term, such an event can still result in a loss of business.
The growth of the knowledge-management industry has taken place in tandem with the increasingly competitive situation within consultancies – this is as a result of firms attempting to implement systems and processes to spread knowledge effectively. This trend is also visible in the hedge fund industry, where it has been common for a firm’s success to be based on an individual trader. However, increasingly some firms in the sector are looking to become less reliant on key individuals by investing heavily in owning and developing their own models and ensuring that this knowledge is communicated to others. Of course, this creates a counter-risk that too many individuals share the knowledge, but retention schemes and the process of continuous innovation can insure against this.
If a company owns formulae or designs that can be patented, it is simple to do so, but many firms forget that owning a patent is not an automatic way to secure profits. Legally, a patent only prevents someone else from copying an idea; it does not guarantee that the patent owner will benefit. To ensure success flows from a patent, firms must actively invest in other capabilities such as manufacturing, distribution and sales to ensure that actual products are created. Failure to do so while a patent slowly expires not only reduces the potential returns but, because a patent actually puts a company’s knowledge in the public domain, may also spur rivals to innovate further, making the patent obsolete. Frustratingly, a patent may actually require its owner to become even more innovative, particularly if there are possible substitute inventions.
Companies with low entry barriers must innovate constantly to protect revenues from older products (eg, search engines) being eroded by competitors. Similarly, these innovations must lead to real new products. For example, Google has implemented this strategy and is branching out from being a search engine to providing internet-based knowledge management and solutions.
If the key issues in the industry are the rapid pace of research breakthroughs, quick knowledge diffusion and short product lifecycles, then relying on patents alone may simply hand the advantage to competitors by delaying the roll-out of a product. Although harder to implement, measures such as secrecy can work if coupled with lead time management and excellence in design capability. Secrecy may seem like a strange strategy in a world where knowledge moves quickly and keeping a secret appears to be impossible. However, Switzerland leads the world in the design of precision instruments, and this industry grew at a time when knowledge diffusion was rapid owing to the network-like structure of the emerging industry. The movement of staff between firms was also frequent, meaning that an individual firm could not count on holding the knowledge advantage for long. The benefit of doing business in this manner in an emerging industry was that overall expertise and knowledge grew rapidly, allowing Swiss companies to become leaders in the field. It was only when the pace of innovation began to slow that the use of patents became more widespread. This is common sense: a patent stops a company’s rival copying its design, but in a world where designs are changing rapidly the best way for a rival to secure an advantage is not to copy the company’s (probably outdated) design, but to invest in its own. It is only once a technology becomes mature that the benefits of patent protection begin to be realised.
Intellectual property is made valuable by an enforcement regime. Without such a regime IP goods with be valueless since it costs nothing to copy knowledge once created and, in perfect markets, prices equate with marginal costs. However, it does not follow that rigorous litigation and over-zealous licensing are necessarily the best way to generate value from intellectual property, although they may protect it.
Conclusions
In terms of measuring the value of intangible property, there are many established techniques that use a combination of actual sales forecasting, probabilistic modelling for the pay-offs from a patent portfolio and historical analysis. However, many companies overlook a key feature of their own organisation – namely, their own organisation. The architecture of a company, both internally and externally (including its reporting structures, incentive mechanisms and know-how), is itself a source of intellectual property and contributes to the creation of other intellectual property. Consider the Eli Lilly example – either the markets were wildly irrational with respect to the company or there was some other embedded intellectual property that the company had not appreciated. This could have been the business processes and structures that contribute to the identification of the intellectual property beyond the established and reported research programme.
Intellectual property has always been important, but companies have only just begun to look beyond the traditional sources of intellectual property and the mechanisms for exploiting it. As they do, they will be faced with a multitude of considerations and challenges.
