Vertical Pulse

Unintended Consequences

Decision makers must be aware that their policies often have unintended consequences.

Executive Compensation   One example of unintended consequences is associated with the requirements for senior executives of publicly-traded companies to disclose their compensation. Initially, the thinking was that the disclosure of executive compensation would make it easier for shareholders to pressure senior executives to reduce their compensation, at least during periods faltering company performance.

However, the opposite happened: CEO compensation rose dramatically after these disclosure requirements went into effect. The unintended consequence was that CEOs were able to seize on the wealth of public information about the compensation of their peers. Such disclosure requirements enable CEOs to argue that their compensation should at least be commensurate with that of their peers, especially during times of similar performance.

YouCut  As much as I hate to admit it, I believe that there will be unwanted unintended consequences with Rep. Eric Cantor's initiative YouCut. I couldn't agree more that government spending is out of control and that Congress needs the American electorate to pressure Congress to reign in its irresponsible spending. (I happen to live in the congressional district of arguably the most fiscally irresponsible member of the House of Representatives, Rush Holt. I see Holt basically using taxpayer money to buy votes for his reelection by earmarking wacky boondoggles for his supporters.)

YouCut has the best of intentions. The basic idea of YouCut is that Americans can vote on which government programs should be cut. YouCut offers Americans the opportunity to voice their ideas as to where government spending can be reduced. These are highly respectable goals. The concern that I have is that Americans will tire of participating through YouCut and that spend-a-holics like Rep. Rush Holt will use waning participation in YouCut to justify their promiscuous spending of the taxpayers money. Fiscally irresponsible members of Congress will be able to argue that since there was no public outcry regarding their earmarks, the electorate essentially supports such programs.

China's Increasing Militancy   China's increasing militancy is having an unintended consequence: Asian nation's are seeking closer relations with the United States. For instance, Japan is extending the length of time that American forces will be allowed to remain at military bases in Japan.

Negotiating Points from Crisis and Command

I recently read Crisis and Command by John Yoo. I found the book to be a very informative and readable historic account of the ebbs and flows of presidential power. A few of the historical accounts provide lessons for negotiators. For instance:

Sometimes subordinate negotiators can exceed their authority and return with very satisfactory agreements. Thomas Jefferson sent Robert Livingston and James Monroe to Paris to negotiate the purchase of New Orleans from Napoleon. However, Napoleon decided to sell the entire Louisiana territory, not just New Orleans. These envoys decided to exceed their authority and purchase all of Louisiana for about $15 million. This Louisiana Purchase doubled the size of the United States, gave it permanent control of the Mississippi and New Orleans, and dislodged France and Spain as serious threats to American national security in the West. 

In negotiations, putting all of your cards on the table and attempting to appease the politically correct constituency by being "transparent" is just stupid. During the Berlin airlift, President Truman signaled his determination to defeat the Soviet blockade of Berlin by deploying two squadrons of B-29 bombers to Germany, the planes that had dropped the atomic bombs on Japan (though unbeknowst to the Russians, they were not equipped with nuclear weapons).

Delegitimizing Bullying Tactics in Negotiations

There are a host of measures one can take to neutralize bullying behavior on the part of an opponent in negotiations. One of these measures is to delegitimize the basis on which the bullying behavior is based. If you can demonstrate that the bully is not committed to the underlying pretense upon which he is requesting concessions from you, you will have discredited his thesis.

This scenario played out in the City of Los Angeles threatening to boycott Arizona for its recently introduced immigration legislation. Los Angeles threatened to curtail its procurements of products purchased from companies based in Arizona as well as refrain from sending its employees to participate in seminars and training sessions facilitated in Arizona. Commissioner of Arizona's Corporate Commission, Gary Pierce, articulated the above point by declaring that if Los Angeles truly believes that Arizona's immigration policies are reprehensible and believes that boycotts are needed to send such a message to Arizona, then Los Angeles should have the strength of its convictions to enforce a complete boycott. Los Angeles should not just boycott those products and services that are convenient. Thus, Mr. Peirce said that if Los Angeles continued to purchase electricity generated in Arizona, then the Los Angeles City Council would be hypocritical.

Importance of Physical Stamina in Negotiations

Prolonged negotiations result in physical, mental and psychological strain. Those in better physical shape have an advantage of those who are in poor physical shape. As World War II was coming to a close, it was Joseph Stalin who had twice summoned the ailing, wheelchair-bound Franklin Roosevelt around the world to his very doorstep in rapid succession. Some historians believe that Stalin purposely called for Roosevelt to make a second very difficult journey to Yalta (February 4-11, 1945) after Stalin observed how weak Roosevelt appeared in Tehran (November 28 - December 1, 1943) in an attempt to sideline Roosevelt. Indeed, Roosevelt died on April 12, 1945, shortly after he returned from Yalta.  

Negotiating Prices of Medical Devices

In most cases, doctors decide which medical devices are necessary for their patients. Since the hospitals pay for the devices, the doctors have had little incentive to hunt for reduced prices.

However, a new initiative being championed by several hospital systems calls for doctors and hospitals to share cost savings on the purchase of medical devices. Thus, the process governing the negotiating of buying medical devices should shift in favor of the hospitals and away from the device makers.

Controlling the Negotiating Process

It is important that you control the negotiating process. One example of a company trying to control the process surrounding its negotiating position is that Bank of America tried to keep cases pending against it from landing with U.S. District Judge Jed Rakoff, in the hopes of avoiding another confrontation with the judge over the bank's handling of the Merrill Lynch takeover. Bank of America sent a letter to U.S. District Judge Denny Chin that asked that about 15 civil shareholder lawsuits pending before him be assigned randomly and not handed to Judge Rakoff.

The Value of Withheld Indemnifications

A senior licensing executive from a prestigious technology transfer office recently posed the following question to me: “Our TTO is not willing to grant an indemnification to our licensee. In view of this position, to what extent should we discount the value of our licensing agreement? Should we reduce our demands for upfront payments? Seek lower running royalty rates? Waive part of our first milestone payment?”

Upon reflection, I can build an argument as to why no discount need be granted. There are three strategies I would employ to support this contention.

Corresponding Concessions   First, technology transfer officers should not feel obligated to grant a concession just because the licensee requests one. Instead of making a unilateral concession, you should make corresponding requests for concessions to the licensee for indemnification. For instance, the difficulty of providing indemnities becomes crystallized for the licensee when they are asked to indemnify the TTO for any product liability claims that it receives. Many licensees would be adverse to indemnify TTOs for misappropriation of trade secrets. Similarly, you can state that the agreed upon upfront payments, milestones and running royalty rates are less than you wanted, in part, to take into account the fact that there will be no indemnification.

Michael Albert, who chairs Wolf Greenfield & Sacks’ Litigation Department in Boston, points out that most businesspeople negotiating on behalf of licensees believe that indemnifications are mumbo jumbo that should be left for the lawyers to contend with. This (mis)perception is fortunate for licensors and they are well served to defer the discussion of indemnification until as late in the negotiations as possible. The rationale is that there is usually so much in the way of sunk costs and momentum by the later stages of the negotiations that the licensee will concede on the indemnity issue.

 

Second, the two most frequent indemnifications that a licensor may not wish to grant to a licensee—indemnifications that revolve around ownership and freedom of operation—can be dealt with separately. Other permutations of indemnifications sought by licensees are easy for the licensor to grant and are rarely a source of contention. These indemnifications include representing that there are no prior licenses, no future licenses will be granted (when negotiating with a potential exclusive licensee), and there are no security interests in the affected patents.  

Patent Title   As far as the hygiene of patent ownership goes, the licensee should realize if the TTO committed fraud (or inequitable conduct), they could be sued for such malfeasance. The TTO should make it clear to the licensee that they can ascertain the interaction between the patentee and patent examiner by reviewing the prosecution history at the USPTO’s site.

As Eric Lund, Commercialization Manager of Technology Commercialization at the Pacific Northwest National Laboratory, indicated, “many institutions will provide representations and warranties that assure the licensee that the licensor owns the patent. While these institutions will provide documents that support the TTOs ownership claims if there is litigation, they will not indemnify for legal fees since it is impossible to know when someone will come out of the woodwork to claim that he was an inventor.” Further, some challenges to patent integrity can be easily addressed; for instance, by adding a new-found inventor to the patent.

Freedom of Operation  I do not think any consideration should be granted to a licensee for withholding an indemnity based on freedom to operate. As the licensee typically has far more resources than the licensor, the licensee is quite capable of hiring a law firm to issue a freedom of operation opinion letter. Since the licensor does not know all of the end applications that could incorporate its technology (indeed, the licensee does not always know all of the ways that its in-licensed technology will be deployed), the licensee cannot possibly be expected to issue indemnities in these open-ended situations.

Sumita Ghosh, Director of the University of Texas’ (Arlington) Office of Technology Management, points out that some licensees take a more measured stance by requesting that the licensors affirm that there is no conflicting research occurring within the licensor’s organization. It is reasonable for the licensor to decline to grant even this more limited freedom of operation indemnity since it is impossible to know all of the research occurring throughout a large university system. And looking forward, no guarantees can be made that competing research will not take place: one university campus can’t tell another campus what research to pursue. Also, research institutions that receive funding from various governmental authorities can be required to research the projects their sponsors assign to them.

One course of action that can reduce the risk for the licensee without causing the licensor to make an indemnity is to have the investigator sign off on the license. This should indicate that the investigator responsible for the patent knows of no competing research initiatives. Another amenable approach for the licensor to take is to discuss what other research their organization is pursuing. Some of the further research could complement the patents currently being licensed. These forthcoming patents could eventually be licensed to the licensee in question.      

If the licensee credibly claims that the failure to obtain a freedom to operate opinion letter will break the deal, you can reduce the value of the license by (half of) the $30,000 to $50,000 that such opinion letters typically cost to produce. Freedom to operate opinion letters should be written after conducting latent semantic and Boolean searches and, if the budget is limited, should focus on the licensee’s competitors first. The lawyer should note which patents he has reviewed and discuss the breadth of such claims. As Steven Henry, Shareholder at Wolf, Greenfield & Sacks, counseled, freedom of operation opinion letters should discuss the specific market sizes available for the client to pursue, include an assessment of the aggressiveness of the other patent holders, and likelihood of winning any potential patent litigation. Finally, freedom of operation opinion letters should indicate that the practicing of such art will not induce infringement since 35 U.S.C. § 271(b) holds that "whoever actively induces infringement of a patent shall be liable as an infringer."

Carve Outs and Concessions   Some aggressive licensees will demand that royalties be placed in an escrow account so that royalties will be returned if fraud is proven. Other licensees may push for a provision that calls on royalty payments to be reduced by a predetermined percent of legal fees expended in connection with patent quality challenges or defending against accusations of infringement. As a fallback position, when deals really may crater unless the licensor makes some compromise on indemnities, I recommend taking the following courses of action to reduce exposure to indemnities:

· State universities and government research organizations should avail themselves of sovereign immunity laws which limit the liability for such institutions. Thus, any indemnity granted should specifically state that the indemnity is limited as per (state) law.

· Instead of stating that there is no infringement, the licensor can represent that it has no knowledge of any patent infringement.

· Restrict the scope of the warranty to infringe­ment in specific countries.

· Limit the extent of any indemnity payments to (a percent) of royalties received.

· Set time limits for indemnities.

· Re­strict the indemnity to proven claims and claims settled with its consent since so many infringement suits are commenced for competitive reasons rather than on the actual merits of the patents involved. Early settlements and arbitration awards should be excluded.
 

· Any indemnity should become invalid if the product is improperly used, maintained or repaired or if the product was improperly combined with another product.

 

· Finally, it should be determined if any indemnities should be structured as thresholds or baskets. Thresholds hold that, once damages reach a threshold, the indemnitor is required to pay the indemnitee for the first dollar of damages and every dollar thereafter. If the indemnity is structured as a basket, the indemnitor is only liable for damages in excess of a ceiling.

Assessing the Probabilities of Obtaining a License

I never met an inventor who didn’t want to know the value of his inventions. Accounting rules allow intangible assets to be recorded on balance sheets at their ‘highest and best uses’. The highest and best use of inventions is typically to license the invention to a company capable of delivering products that incorporate the invention to the market. Licensing typically yields a higher value than using related patents to ensure freedom of operation, blocking competitors, or removing a technology from the market in order to eliminate the risks of displacing successful products.

There are a host of valuation tools—such as the Discounted Cash Flow, Relief from Royalty, Decision Trees, Probability Weighted Expected Return Methods—that we use to determine the value of inventions and patents once licensing occurs. All of these valuation methodologies require an assessment of the probability of securing a license.

To make this determination we have developed a Licensing Probability Model (LPM). LPM is a dynamic model that produces different probabilities of securing a license as new information is fed into it.

The three major components of the LPM are Expected Financial Returns, Deal Congruity and Deal Momentum. Below is a brief review of these components.

Expected Financial Returns – The biggest impetus for a licensee to license in an invention is the expected financial returns. A quick formula for estimating these expected returns is:

Expected Financial Returns =  Market Potential + Strategic Motivation - Upfront Costs – Risks of Implementation

The vast majority of the readers of this article are familiar with the terms above. So a remedial review of them is not necessary. However, the important issue in building models is not filling them in by rote process, but rather by asking penetrating questions. As Pablo Picasso said, “Computers are useless. They only give you answers. The question is what is important.” Some of the questions that we ask to populate the Expected Financial Returns part of the LPM are:

· Market Potential   Does demand already exist? Jacob Reinbolt, Partner at Procopio, Cory, Hargreaves & Savitch LLP, points out that technologies that facilitate natural extensions of products into new markets offer high risk-adjusted value. An example of this principle is placing social media applications on smart phones.

· Strategic Motivation   How badly does the customer need the technology? According to Mark Wicker, Partner at Morrison & Foerster LLP, industries (such as pharmaceuticals) that have enormous revenues at risk, high rates of obsolescence, and few remaining years of patent life will be highly motivated to adopt new technology. On the other hand, industries that face less competition and are considering replacing basic compounds are likely to wait until the government tells them they can no longer use current products before they license in new technology.

· Upfront Costs   What is the cost of delivering the technology to the market? How long will it take to deliver the technology to the market? Will market demand wane in the meantime?

· Risks of Implementation   How developed is the technology? The earlier the stage of development, the more pronounced the risk and the lower the value of the technology. Is the technology to be licensed already a product? Is the licensor licensing all of the relevant technology to the licensee? Have searches been conduct to detect how practicing the licensed art might infringe on the patents of others?

· Risk of Implementation   What has the inventor done to de-risk the invention for the licensee? Measures such as obtaining independent technology validation, a freedom of operation opinion letter, business model validation, or a customer contract reduce the risk for licensees. For cash-strapped inventors, it is most important that the investments to de-risk licensing risks for the licensee demonstrate that the technology offers a direct path to rapid revenue.

Deal Congruity

Just because a deal appears to be financially rewarding doesn’t mean that the deal will be consummated. Inventors must identify specific companies with requisite financial resources to license in their technology. There must be close alignment in the business objectives of the two parties. To determine the extent of the strategic fit that exists between the licensor and potential licensees, we ask questions such as:

· What was the genesis of the invention? Shane Hunter, Partner at Townsend and Townsend and Crew, notes that inventions that solve problems faced by researchers are more likely to be licensed than inventions that come about as a matter of happenstance. For instance, a solution to a problem that has long befuddled legions of researchers will more likely find a licensee than an invention whose inspiration occurred when a lone inventor banged his head on the toilet as he fell to the floor.

· What is the licensee’s commitment to commercialize the technology? This answer is a function of the licensee’s history of developing licensed-in technology and its history of managing collaborations with licensors. Other issues to consider along these lines include:

o    Does the technology serve the licensee’s primary or ancillary business units? Are targeted markets natural progressions for the licensees? Are the potential licensees allocating their research dollars to the primary markets to be addressed by the invention? If not, is the reason because of a lack or relevant resources? Are the licensees downsizing in areas of importance for the successful commercialization of the technology?

o    Have the licensees committed (or are they likely to commit) their best manufacturing facilities to the project? Best regulatory affairs personnel? Most capable sales and marketing staff to the initiative?

o    How receptive is the licensee to license in new technology? The answer to this crucial question is a function of the degree of potential opposition by the licensee’s lawyers and the degree of potential opposition by licensee’s research and business development professionals to license in technologies.

· Can the licensee’s pipeline accommodate the technology? While an invention can offer attractive return on investment potential to a licensee, the licensee will not be willing to license in such invention if its pipeline is congested. If the pipeline cannot accommodate the technology in the near-term, a very high discount rate must be applied going forward to account for the fact that the odds of achieving a license agreement decline rapidly over time. This is because companies want the latest technology, shelved technology becomes stigmatized and there is significant turnover in the licensing departments of large companies.

Deal Momentum

In addition to deals penciling out and existence of strategic congruity, the people factors must be in place for deals to close. Among the considerations to review in determining whether the people factors will act as lubricants or irritants are:

· Was the deal brought to the licensee by a respected intermediary? Inventions brought to the attention of licensees by licensing agents, patent brokers or lawyers are often well received by licensees as they have already been vetted to some extent. Also, the agents’ familiarity with the licensees’ processes raise the probabilities of closing a license.

· The willingness of the inventor to participate in the negotiations is important: The inventor can make the otherwise bland words in a patent come alive. Their excitement for the technology can be infectious. However, in other instances, the inventor is too busy (pursuing other research or has committed to delivering extensive client consultations) to focus on negotiating the licensing agreements at hand.

· Stephen C. Ferruolo, Partner with Goodwin Procter LLP, notes that the reasonableness of the inventor is an important factor in negotiating license agreements. Many inventors have completely unrealistic expectations regarding the value of their inventions. Further, the role of the inventor in contributing to improvements to the technology or in its commercialization is another issue that demands agreement between the inventor and licensee. In some cases, arrangements can be made to have the inventors (or key research people) transfer their employment from the licensor to the licensee.

· Are you negotiating with people that have decision making authority? How high up in the organization has approval been obtained? How high up in the organization must approval be obtained? Is there an internal champion for your project? An interesting method of determining internal alignment is when senior members of the licensee sign off on a Memorandum of Understanding.

· Are negotiations progressing smoothly? The answer to this question is a function of the stability of your negotiating partners, consistency of communication, agreeing on the majority of issues throughout the negotiations, and the potential for future deals between the two parties. Other important indicators are the licensee’s willingness to sign off on Non-Disclosure Agreements, Memoranda of Understanding and Term Sheets.

The above discussion obviously does not provide a comprehensive list of issues to take into account when estimating the likelihood of obtaining a license. However, considering the Expected Financial Returns (for the licensees), Deal Congruity, and Deal Momentum should provide a framework for making such assessments.

The above are among the issues discussed in my Valuation of Emerging Technologies and Negotiating Licenses Courses, which are run by The Business Development Academy.