SMEs can leverage their IP to facilitate R&D financing

A recently published paper by Dr. Gaetan de Rassenfosse explains how firms can use their patents to finance innovation [1]. He argues that patents aimed at monetization of IP is more important for SMEs than for large companies and reports evidence that European SMEs face more difficulties than SMEs in the US to benefit from their patents. Dr. de Rassenfosse is a research fellow at the University of Melbourne and the IP Research Institute of Australia (IPRIA) [2].Financial constraints are particularly acute for SMEsFrom a theoretical point of view, investment in R&D is subject to various imperfections. Strong asymmetric information is one of them. The concept of asymmetric information applied to R&D suggests that inventors are more knowledgeable about the likelihood of success and market potential than investors (banks and venture capitalists). The argument goes that external investors have trouble differentiating between profitable and unprofitable inventions and will therefore not invest in R&D or require a significant risk premium. A second imperfection is related to agency costs, which further increase the premium required to finance R&D projects. The separation of management and ownership creates a typical principal-agent problem, where managers are typically more risk averse than investors (managers risk losing their job while investors risk losing one among many investments). Managers are keener to avoid bankruptcy and will therefore frown upon projects that are too risky. For these two reasons, it is often heard that dollars for R&D projects are the most expensive investment dollars that a company can raise. Since the firm’s cost of external capital is high, internal capital often appears as the preferred source of investment in research activities.

While large firms have the ability to finance R&D internally, this is often not an option for smaller firms, and as a consequence they must rely on external funders. Dr. de Rassenfosse explains how SMEs can leverage their IP to facilitate R&D financing. There are two ways in which patents can help finance innovation. Patents can be used: i) to reduce the cost of external capital; and ii) to generate additional cash flows.[3]

Patents can help finance innovation

The rationale for the former effect is twofold. First, patents can serve as a credible signal that reduces information asymmetry. By taking patents on promising innovations, the inventor reveals some information to investors. This information will make investors more able to differentiate between good and bad projects. By so doing, the inventor can negotiate more favourable financing conditions. Second, patents materialize the value of knowledge stock: they codify the knowledge and make it tradable, such that they can be used as collateral.

The rationale for the latter effect is obvious. Taking patents in view of licensing them out is a way to generate additional cash flows from licensing deals, especially in the absence of the complementary assets needed to exploit the invention internally (such as distribution channels or marketing capabilities).

Monetary patents are more prevalent among SMEs

Dr. de Rassenfosse uses the term “monetary patents” to refer to patents that are taken in view of attracting investors or licensing out the technology. Using data from an international survey carried out from June to September 2006 by the European Patent office, he studies firms’ motivations to patent. The survey asked firms who had applied for a patent to rate a series of statements to determine their motivations. The ratings ranged from 1 (completely disagree) to 6 (fully agree) and included: imitation (I patent mainly to prevent imitation by competitors); secrecy (I will not patent an innovation that I can keep secret); freedom (I patent mainly to protect my freedom of operation); investors (I take patents in order to convince investors or banks of the value of my invention); and licensing (I take patents in view of licensing).

Source: adapted from de Rassenfosse (2010), p. 21.

As expected, the most popular motivation was to protect against imitation with a mean score greater than 5.5 (see above figure). This was followed by freedom of operation, attracting investors, and then licensing. In relation to company size, the share of SMEs taking patents for monetary reasons (attracting investors and seeking to license their products) is considerably higher than larger firms – 40% for SMEs in contrast to 15% for larger firms. In addition to preventing imitation, larger firms were mainly concerned with protecting freedom of operation.

The fragmented market for technology in Europe hinders technology licensing

de Rassenfosse then wonders how the licensing rate differs between Europe and the United States. Considering willingness to license and the size of the patent portfolio, he finds that the share of patents licensed by European SMEs is significantly lower than the share licensed by SMEs in the US. Using advanced econometric techniques, he finds that European SMEs willing to license are twice less likely to have a high share of their portfolio licensed as compared with US SMEs willing to license, which he suggests is due to inefficiencies in the European market for technology.

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