Leveraging Patents to Finance Life Sciences Companies

1. Leveraging Patents to Finance Life Sciences Companies Geneva, July 20, 2006 World Intellectual Property Organization Roya Ghafele, e-mail: roya.ghafele@wipo.int

2. The Main Take Away While Life Sciences is a crucial sector of the economy, it currently is not financed to its full extent. How can that paradox be explained? IP is key in innovation, however due to historically evolved practices it has not been given full attention in the investment process. On the investor’s side little knowledge about IP, paired with even less experience in valuing IP can be seen as key obstacles. The situation is further hampered by inadequate accounting standards. On the borrower’s side many firms seeking funding do not have an adequate IP strategy and often lack managing their intangible assets. To overcome this market failure there is a need for a cohesive approach including regulatory reform, awareness raising and training. At the borrower’s level firms need to better align their IP to their overall business strategies. At the lender’s level investors should seek to get better information about IP.

3. AGENDA Hypothesis: IP is crucial for Innovation However most investors lack the IP view Why? • Inadequate IP Accounting • Confusion with IP Valuation • Lack of IP strategies among borrowers What are possible solutions?

4. IP is an intangible asset, ... • Knowledge Content • Background of users & • context determine relevance • of IP to business Transferability IP is transferable to a new or similar business context • Non Rivalry in • Consumption • IP can be used • simultaneously • by different people • without diminishing • in its worth Nature of IP Perishability Over time IP may become outdated, e.g. technology cycles Spontaneity Successful IP creation is risky since there is a creative & a business element to it Partial Excludability IP guarantees a firm exclusivity and freedom to operate in the market

5. … which is key in Life Sciences R&D IP • Risky • Uncertain • Costly • Explorative • Complex • Hedges against risk • Rewards discovery • Attributes ownership • Facilitates knowledge trade • Codifies knowledge

6. Ignoring IP means giving up strategic choices • Owner decides what to do with research: IP can be gifted, donated, sold, licensed • Both basic and advanced research may be promoted IP protected Innovation • Research Findings are available for free • Basic Research may not get further developed Not IP Protected Innovation

7. AGENDA Hypothesis: IP is crucial for Innovation However most investors lack the IP view Why? • Inadequate IP Accounting • Confusion with IP Valuation • Lack of IP strategies among borrowers What are possible solutions?

8. P R I VATE Private and public investors are available. Who are Potential investors? • Informal, key is borrower’s network and social capital. Family, Friends • Informal, key is to convince a high net worth individual to invest. Business Angels Venture Capital/ Private Equity Firm • Formal, key is borrower’s will and ability to sell part of an early stage business. PE invests in late stage business, e.g. Leveraged Buyouts (LBOs) Joint Ventures/Licensing • Formal, key is mutual interest of licensor and licensee in the technology. Research Foundation • Formal, key is borrower’s academic potential. Profitability is not core, rather scientific novelty Stock Exchange (IPO) • Formal, key is growth and critical mass of revenues, late stage business. P UBLIC • Formal, traditionally are hesitant to invest in innovation. Commercial Banks Intergovernmental Development Banks & National Governments • Formal, key is borrower’s potential to demonstrate positive socio-economic impact of his/her project. Use entire variety of financial tools.

9. Types of investors differ by business maturity stage and perceived risk. Investors by risk and stage Founder Friends Family Business Angels High perceived Risk Private Equity Firms Venture Capital Firms Joint Ventures, Licensing Governments, Development Banks, Research Foundations Low perceived Risk Stock Exchange Commercial Banks Early Growth Seed Start-Up Established

10. Who is ready to invest on the basis of IP? Role of IP in valuation Degree of readiness to invest on the basis of IP ++++ ready +++ rather ready - rather not ready

11. Loans Leasing Factoring Venture Capital Business Angels Capital Private Equity Capital Financing methods split in debt and equity financing. Main financing methods don’t give enough credit to IP Debt Financing Equity Financing IP securitization IP as collateral IP Licensing IP in the business plan

12. Debt financing differs significantly from equity financing. Description of financing methods Debt finance Equity finance The investor borrows money at the cost of the borrower’s rated risk (is above the risk free rate, meaning money investor would earn e.g. by buying US treasury bonds). The money has to be repaid within a certain time horizon. The cost of borrowing that money is the “interest rate”. According to how rating agencies (e.g. Standard and Poor’s) judge the quality of the borrower’s willingness and ability to pay back the money, the cost of borrowing (interest rate) will be high or low. Profit lies in the interest s/he earns on lending the money. Collateral is asked for as a guarantee and legal recourse in case of bankruptcy. The investor has no involvement in the management of the company. “less risks, but less profits” The investor “buys” parts of the company, usually for a time horizon of 5-10 years. S/he makes a profit on the spread between the price at which s/he bought the company and sold it. (historically aim at 20-30% of investment) It is possible to have several “rounds” of investment. The borrower does not have to pay any interests for the money, but gives up part of his/her self determination on running the business. “high risks, but high profits” Equity investors are VC, Business Angels, Investment Banks, Private Equity Firms

13. AGENDA Hypothesis: IP is crucial for Innovation However most investors lack the IP view Why? • Inadequate IP Accounting • Confusion with IP Valuation • Lack of IP strategies among borrowers What are possible solutions?

14. Accounting finds it difficult to grasp IP Rationale behind Accounting Impact on Type of Language developed for IP • Historically evolved to report tangible assets/liabilities • Quantitative stock of performance • Documentation of past financial position • Factual, precise, objective, • comparable information • Determines perception of a firm’s management and other market participants • Silence about a lot of a firm’s IP due to inherent definitions and assumptions in accounting • Internally and externally • generated IP is treated • differently • Goodwill

15. This Seriously Impacts Business... Concept Impact The same IP may be perceived to be worth nothing or 100 Mn $ Internally Generated IP is immediately expensed, Acquired IP is valued at its acquisition cost, amortized or subject to an impairment test Fair value: “Amount at which an asset could be bought or sold in a current transaction between 2 willing parties, other than a liquidation.” Intangible Asset: “… identifiable, controlled by an enterprise as result of past events & should generate future economic benefits for the firm.” Goodwill: “price a market participant is ready to pay in excess of the value of a firm’s tangible assets.” Implies a benchmark, yet worth of IP depends also on context & background Much IP won’t qualify since it has an indirect impact on cash flows Difficult to make worth of IP explicit & compare Goodwill of different firms

16. Immediately expensed • Immediately expensed Internally Generated IP • Immediately expensed • Recognition of acquired IP: • § 255/4 HGB • Recognition of acquired IP if IAS criteria are met: • IAS 38 Acquired IP • Purchase Price distributed across all items: FAS 141 • Impairment Test of Goodwill: FAS 142 … However Explicit IP accounting gains Momentum — Comparison of different Accounting Standards — GermanHGB IAS/IFRS US-GAAP • Forbidden:§ 248/2 HGB • Exception: acquired IP Recognition of IP • Recognition of IP if IAS criteria are met: IAS 38 • Recognition of IP: • Novel approach under • FAS 141 &142 Trend towards the explicit recognition of IP increases

17. IP valuation criteria • Potential Returns • expected returns of IP protected business segments • expected risks of IP protected business segments • size of investment needed to generate IP • Business Viability • product differentiation through IP • is IP protected product/service • viable in the marketplace • competitive advantage through IP • clear development plan/financials • for generation of IP • Market • market share/growth for IP • protected business segments • market opportunity for IP • competitive threat through IP • ownership of competitors • entry barriers through IP IP VALUE • Legal Scope of the IP • level of protection granted by the IP • possibility to invent around the IP • possibility of infringing the IP of others • legal viability of the IP • duplication of IP due to inadequate patent search done by the IP office • Management Skills • expertise in managing IP • experience in managing IP • prior investments in the IP protected business segment (“sweat equity”) • motivation to enhance value of the IP

18. Different valuation emphasis for different investors. IP valuation in relation to overall business valuation Venture Capital/Private Equity Firm Exit possibilities are key. This is how the VC/PE makes money. Often no “science” available to assess early stage business since no historical company performance available. Quality of management team, benchmarking with what is already in the market matters. “Gut feeling”. IP is an important factor in the valuation. VCs look at the legal viability of the IP & how it relates to the business strategy. Business Angels Confidence in management is key. Angels invest in “what they know” & often seek to boost the local economy ( “hometown loyalty”). Informal valuation, no systematic approach. IP may matter if Angel has personal interest or the borrower can communicate the value of the IP. IP will be valued according to its potential to generate future cash flows. Research Foundations Academic track record, references, innovation, originality, societal impact, fit in foundation's research portfolio and orientation. Want innovative research does not necessarily have to have practical relevance. Company funded research can be biased by the sponsor’s interest. IP plays a marginal role in the valuation process. Even early stage technology funds do not value explicitly IP. The connection between IP and technology is not sufficiently made. Inter/Governmental Investors Look at macroeconomic, social and cultural spillovers. May show more tolerance towards profitability since are not under the same market pressure as private investors. Funding has a “development” touch. IP plays a marginal role in the valuation process. Early stage technology funds do not value explicitly at IP. The connection between IP and technology is not sufficiently made. . Source: Roya Ghafele

19. Approaches to IP Management • Key Questions • How does IP relate to the bottom line of your business? • How do you make money and what role does the IP play in it? • Relate your income streams to IP • What were the returns from IP protected business segments? • Does the IP help you to gain market share or profits? • Relate IP to your position in the Market • How did IP give you an advantage over competitors? • Do you have freedom to operate & exclusivity in the market? • Demonstrate your managerial skills • How determined are you to extract revenue from IP? • What experience do you have in managing IP? • Understand the legal scope of the IP rights • What level of protection does your IP guarantee you? • Is there a risk that you infringe the IP of competitors or that competitors (legally) steal your IP?

20. AGENDA Hypothesis: IP is crucial for Innovation However most investors lack the IP view Why? • Inadequate IP Accounting • Confusion with IP Valuation • Lack of IP strategies among borrowers What are possible solutions?

21. IP Management improves a firm’s position in the market M A N AGERS F O R • Communicates the value of IP to investors • Shows what IP the company owns • Puts a value to the IP • Explains how the IP relates to business segments I NVESTORS F O R • Get information on how IP drives growth • Receive adequate inputs for earnings/sales forecasts • Can better estimate risks/revenues of an investment • Can better understand the nature of a business • Increases predictability while decreasing volatility

22. Successful investor communication on IP bridges information asymmetry. IP investor communication Business plan What investors look for in a business plan • Executive Summary • What’s the growth and profit potential and the management’s capability to achieve the target? • How does the IP help to achieve to that target? • Body of the Plan • Company Overview : • How a do you want to make money? • Management Team: • Why are you the right people? • Products/Services: • How does the IP enhance the value? • Market Analysis: • How does the landscape look like? • What IP have competitors? • Funds requested: • How much money do you need? • 5 Year financial projections: • What’s the growth potential? What’s in it for me? Can I sell it profitably? What’s the financial potential? Is the management capable of growing the business? Have they done it before? Does the team understand how to penetrate the market? Is the product unique? Will it meet consumers’ demand? Is the market potential huge enough? Are there entrance barriers? How much money is needed? What are the exit possibilities? Grab readers attention, make him/her curious of the business.

23. Public Policy Choices • Human capacity building • Need for a Master Program providing IP training from a legal, business and technological point of view. • Awareness Raising, Training at the Business Level • Fully integrate the IP view in policies aiming at increasing the overall level of innovation, e.g. the Lisbon Agenda • Harmonize Regulatory Guidelines on IP valuation • Recommendations on standardized approaches would help • Standardize the Reporting of IP • Important steps have been made, but more needs to be done • Integrate the IP dimension in publicly funded projects • Where appropriate IP should be part of the selection process