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May 2, 2008

Stranded R&D

In 1980, Congress passed the Bayh-Dole Act. Overnight with its passage, universities and government-funded R&D labs gained a comparative advantage in funding R&D. Universities and government labs have a cost advantage in that many had already spent tens of billions of dollars setting up research labs for non-commercial purposes, including teaching and curious exploration. Many scientists and engineers found the prestige of academia, and the increase in professional freedom it promises, a compelling offer. The result has been a gradual shutting down of corporate R&D labs, and an expansion of industry collaboration with scientists and engineers now employed by universities and government labs.

Many people think of the Bayh-Dole Act as an unmitigated success story.  Several multi-billion dollar technology companies that are now household names (such as Genentech and Google) started in graduate school research labs.  Many inventors are happier in the more collaborative environment that academia offers.  Collaboration is an under-appreciated driver of innovation.

Unfortunately, so far universities have underperformed private benchmarks for the successful transfer of technology.  Despite spending almost an order of magnitude more on R&D (about $50 billion), the AUTM reports only about a factor of two more revenue from R&D (about $2 billion) than does IBM (about $1 billion on about $5 billion in R&D) over an overlapping period from the mid-nineties to the mid-zeroes of the present decade.  Although it is tempting to attribute the difference in returns entirely to the diversion of R&D funding into pure science (an attribution that ought to silence the Bayh-Dole critics who favor pure science), it is important to remember that there was a net inflow of the most productive researchers from industry into academia over the same period of time.  This concentration of the brightest minds of science and engineering within academia would probably have led to a faster increase in returns from R&D if there weren't something else going on.

And there is something else going on.  The costs of licensing and litigation of patents has skyrocketed over the same period of time.  The biggest reason for increasing costs has been the inelastic supply of patent lawyers relative to the exploding demand for their services.  Unlike patent prosecution, which can be done by non-lawyer patent agents and examiners, patent licensing and litigation are services that require a state bar license (and the three years of ABA-accredited law school that this usually requires).  Law firms are struggling to meet demand by increasing starting associate salaries (patent boutiques started the chain reaction in both instances over the past ten years), but the corresponding increase in associate to partner ratios at most law firms (necessary to keep profits-per-partner high and retain top partners) has led to a decline in the quality of services overall.

It is worth noting that many technology transfer offices are staffed by non-lawyer scientists and engineers with formal or informal business training.  Many of these employees are probably undervalued by the legal services market because of their lack of state bar credentials.  Seeing the value, university tech-transfer offices and other government and private firms not constrained by state bar requirements are scooping these types of employees up.  Non-lawyers will probably play a growing role in R&D funding and technology-transfer going forward, even in providing "legal" services.  The investment banks (such as Altitude Capital) and venture capital funds (such as Intellectual Ventures) that have recently entered the secondary market for patents are early signs of this trend.

The result of these macroeconomic trends in R&D is a market in which many startups and smaller companies are realizing only a fraction of the intrinsic value of their R&D.  Technology is stranded in later-stage startups and other small private companies that are not eligible for further venture capital financing, acquisition, or IPO.  Problems in the credit markets and the passage of the Sarbanes-Oxley Act have further exacerbated the problem for these companies in the acquisition and IPO arena.  In effect, the United States is piling up a vast, invisible junkyard of stranded R&D that could be socially valuable if placed into the hands of the right owners.

As the returns to investment in R&D decline, so too do the number of jobs available for researchers outside academia.  This is a problem that is vital to the health of the U.S. economy within its global environment.  If current trends continue, there will be more Ph.D. engineers living in China than in the U.S. by 2010.  The number of U.S. patents issuing to foreign entities is already nearly equal to the number of patents issuing to the U.S.  If the U.S. were to strengthen its patent system, we would be far better positioned than any other nation in the world to bring the power of market-based incentives to bear on the problem of attracting the most talented human capital -- the single most important problem we face in our long-term prospects for economic growth.

People are starting to recognize these problems.  Recently, the Brookings Institute has called for the government to setup a National Innovation Foundation.  But aren't the market-based incentives of a strong patent system a better way for the government to encourage R&D funding?  Although a handful of firms, including Intellectual Ventures, Ocean Tomo, and other new entrants are struggling to meet immediate needs, the inventors and startups most in need cannot afford to hire anyone to answer the lobbyists hired by the large corporations that are net payers of patent licenses (when forced to pay at the end of protracted litigation).

Although the big picture of innovation is so large and complex that it is difficult for most people to understand, the solutions are actually simpler and easier than most would imagine.  First, the patent laws should be reformed in ways that would promote private settlements of disputes over patent infringement rather than litigation.  Some recent changes to the patent law have been beneficial in this regard, and some detrimental.  Unfortunately, the Supreme Court's recent holding in Medimmune makes it harder than ever for inventors to get to the table with large corporations without ending up in litigation.  And after Mercexchange, startups and independent inventors do not have the threat of an injunction to keep licensees at the bargaining table when those startups and inventors have failed to find funding to themselves commercialize the technology.  Neither of these by themselves is fatal.  The threat of injunction was no doubt abused by opportunistic speculators from time to time over the past few decades.  But not in decades has it been more difficult for investors in R&D to see a return through patent licensing.

Second, if the government is going to provide funding to solve these problems, that funding might best be used to lower the barriers to entry for the practice of patent law.  For scientists and engineers, especially those who understand business, the opportunity costs of wages are probably much higher than the costs of a law school education.  Public funding of scholarships for scientists and engineers who intend to study law would over time decrease the transactions costs associated with patent licensing, and gradually decrease the amount spent on litigation as it becomes easier and easier for opposite parties to reach agreement on differing valuations of a technology.

Third, institutional investors should consider allocating a larger share of their funding to hiring more employees for their technology transfer offices now, and later for investing in private equity funds that specialize in R&D investment.  The technology transfer offices are now overwhelmed by the demands on their time in many cases.  As a result, they tend to focus on the biotech and pharmaceutical inventions that are likely to provide the largest payouts, ignoring the many other areas of R&D that could nevertheless have a transformative impact on our society.  In terms of private equity investments, over the short-term the lack of licensing revenue is going to impede the returns for these funds.  But restarting the R&D engine of economic growth is going to require the public and private sectors to work together.

These are complex problems that it will take teamwork to solve.

Update: I was recently asked whether the figures for IBM and AUTM include capital gains from equity. The answer is no, neither do. I have seen no evidence and have no reason to believe, however, that the AUTM should be seeing larger returns from equity on its R&D than IBM. So the larger point about relative efficiency in technology transfer seems still to be sound.

Posted by Michael Martin at May 2, 2008 10:27 AM | Patents In Business

Comments

I am curious about what you said that "patent licensing and litigation are services that require a state bar license." Is there any state bar rules requiring a bar license to do patent licensing and litigation?

Thanks for your response!

Posted by: SS at May 6, 2008 1:13 PM

SS,

Representing a client in court requires a license to practice law in the U.S. Under the U.S. system, each state decides for itself how to license attorneys, although there are some national organizations (including the American Bar Association) that have an influence on the states.

Licensing transactions may not require legal advice, but they often do when intellectual property is involved because of the complexity of the law. The rule in most states in the U.S. is that only lawyers are permitted to give legal advice.

I hope this helps.

Posted by: Michael Martin at May 6, 2008 1:53 PM

While I take issue with some of the remarks here (like we need more patent lawyers, jeez, cut us a break), I'll make one comment.

The transfer of R&D activities out of corporations and into universities is real, but the payback is minimal. It is very difficult to obtain useful licensing rights back from universities, especially state universities. Their collective expectations are unrealistic in regard to royalty rates and the time frame to market for any particular innovation. Add to that their inability to transfer/assign their patents as a whole, and I frequently find myself advising my corporate client against university entanglements. Unfortunately, we're still sub-contracting our R&D to them, since it's cheaper than doing it ourselves. However, the old addage "you get what you pay for" still applies.

Posted by: bierbelly at May 7, 2008 9:37 AM

bierbelly,

Unless I misunderstand what you're saying, I believe you've just said is that your personal experience confirms the hypothesis that university tech-transfer offices could do a better job with matching private funding to R&D. They're doing the R&D well, but they're not placing it with corporations efficiently.

If that hypothesis is correct (please somebody else prove me wrong), then one logical conclusion is that there might be a good opportunity for private-equity funds to step in and assist with technology transfer.

Posted by: Michael Martin at May 7, 2008 11:26 AM

bierbelly,

I forgot to add a response to your commment on more patent lawyers.

If we make the patent system in the U.S. the best in the world, good U.S. patent lawyers are going to be busy doing work for every inventor in the world. No matter how many new patent lawyers there are.

Posted by: Michael Martin at May 7, 2008 11:54 AM

Michael,

In many instances, especially with state universities, the state laws prohibit their institutions of higher learning from "efficiently" transferring patent rights. (Efficiency is a matter of opinion, of course). As a corporate lawyer, while we can arguably obtain an exclusive license under a univeristy patent, sponsored by us, we can't get all patent rights (an outright assignment). This prevents us from obtaining the right to sue infringing competitors, and having to rely on the university (which has no money to begin with, at least not for IP) to institute the suit. It won't happen. So what's the point of obtaining the license from the Univ in the first place? They won't sue us either, unless its U of CA system.

Further, it's difficult to see how IP entanglements with a university can be effectively managed by the R&D supporter/prospective licensee. We hand over to them the right to prep and pros the application, but at our cost. They have no idea of what is important to our business needs, nor do their outside law firms, so claims are drafted and amended without concern for the sponsor's business needs. What happens if our commercial embodiment (which probably won't be determined for some years down the road) is amended out of the claims? What if it's never put into the claims to begin with?

Unfortunately, US corporations are farming out their R&D to the point that what comes back in return we can't protect. If we can't protect it, why dump $100MM into hard capital to commercialize it, and why would anyone else do that?

Posted by: bierbelly at May 8, 2008 5:33 AM

"we can't get all patent rights (an outright assignment). This prevents us from obtaining the right to sue infringing competitors, and having to rely on the university (which has no money to begin with, at least not for IP) to institute the suit."

What if you paid more upfront to the tech-transfer offices for the patent portfolio? Is it that the universities flat-out refuse to sell? (Assume we're talking about private universities here.)

"They have no idea of what is important to our business needs, nor do their outside law firms, so claims are drafted and amended without concern for the sponsor's business needs."

What if there an intermediary that specialized in matchmaking and pricing R&D services were to handle the prosecution?

Posted by: Michael Martin at May 12, 2008 1:44 PM

Universities and Industry are in a Prisoners' Dilemma.

Even when universities cooperate by accepting funding and later offering to transfer out blockbuster technology on reasonable terms, industry often defects, opting to infringe patents or steal trade secrets rather than share a sizable percentage with the university and its inventors.

Even when industry cooperates by providing funding on reasonable terms, universities sometimes defect by refusing to transfer out at all, or asking unreasonable terms given the uncertainty of the market.

It is unambiguously true that both would gain more from cooperation. But so far few universities or industries have been able to communicate and collaborate effectively in multiple round negotiations. Perhaps an intermediary with experience and connections to both cultures would facilitate smoother communication and coooperation.

Posted by: Michael Martin at May 14, 2008 5:37 PM