Patent/Venture Portfolios

Patent Portfolios & Seed Stage Venture Portfolios

Building an early stage venture capital fund portfolio and building a patent portfolio are surprisingly similar.

Over the past decade, I have successfully built high-value patent portfolios for two companies using a methodical process I developed from first principles. I documented this in a book.

Allocating a fund to seed-stage startups and allocating a budget to inventions for patenting require remarkably similar approaches.

Novelty

Both patents and startups require novelty - patents must claim previously unknown inventions to be valid, while startups need some novel product or service to capture profits. Without novelty, both assets have little value.

Market size and profits

A patent gives its owner the exclusive legal right to monopoly profits from a market. A startup is only worth the de facto monopoly it can have from its advantage over competitors. [1]

This diagram shows what economists call a simple demand curve. Price is represented vertically, sales volume is represented horizontally. Volume and price are inversely related. The range of available trade-offs is determined by a given demand, represented by the diagonal line. A low price results in high sales volume. A high price results in low sales volume. Competitors tend to undercut each other's prices whenever they have no significant differentiation. In a highly competitive market, the price comes down to the level of the costs to make and sell the product. At that level, no competitor earns any profit.

When a patent owner has a non-competitive legal monopoly or a startup has a competitive de facto monopoly, it can choose to set any price it wants. Too high of a price will have lower sales volume and little profit. Too low of a price will have little margin above costs and little profit. A wise monopolist sets a price to maximize the area of the profit rectangle under the demand curve.

For patents and startups, their value is dependent on the size of the profits they can capture. That depends on the demand. A patent on a pioneering invention has more demand. A startup with an awesome product has more demand. The more the demand, the greater the profit potential.

Time frame

Patents can be enforceable for 20 years. [2] Since validly patented inventions are necessarily novel, there is initially no existing market. Similarly, startups have no customers until they begin building a product. The peak cash flows from patented inventions often occur 10+ years after initial patenting. Likewise, the exit timeline for startup investments often stretches to 10 years from seed stage. Both patents and startups thus require foresight and patience to fully capitalize on their potential.

Uncertainty

"An uncertain estimate is better than no estimate at all." --Jonah Probell

The past is perfectly certain. [3] But, the future is much harder to predict. This uncertainty compounds the further one projects into the future. Given the long time horizons, estimating probability distributions for patent and startup outcomes 10 years into the future is the difficult task a practitioner must undertake.

Interestingly, later stage investing is comparable to the business of licensing and transacting on the secondary market for patents. Both have much lower uncertainty and calculate valuation based on the amount of consistent cash flow.

However, even highly uncertain estimates remain necessary to support rational early stage investment decisions.

Power law

Both mature patent portfolios and venture capital funds follow a power law distribution, where the majority of the value is held in 10% or fewer of the assets.

This is not true early in the life of either portfolio. The divergence in mean and median value of assets grows over time. Since returns tend to be proportional to risk in the long run, building a patent portfolio starting from new inventions and a venture portfolio from early stage startups can provide excellent returns compared to other asset classes.

Due diligence

There are two pitfalls that can render a patent worthless:

(1) If multiple parties independently conceive the same invention, only the first to file a patent application will be awarded the patent rights. Conducting a prior art search can avoid wasting effort on patenting an already existing idea.

(2) Even with a valid patent, there might be no market demand for the invention, making the patent useless. Researching market trajectories and alternatives is key to ensuring the invention solves a real customer problem better than competing solutions.

Similar issues can doom startup investments:

(2) Without product-market fit, a startup will flounder. Even with some demand, the total addressable market may be too small to provide desirable returns.

(1) A startup entering a market with entrenched competitors can at best compete on price, destroying profit potential. As with patents, being second with an unoriginal idea typically leads to failure.

In both cases, conducting due diligence via prior art searches and market analysis is crucial before committing funds to avoid investing in worthless patents or startups without real potential.

DCF analysis

The purpose of obtaining a patent is to produce cash flow for the owner, either through sales of a protected product or via royalties from licensing. The purpose of a startup is to generate cash flow into the company as revenue from sales.

A discounted cash flow analysis (DCF) looks at the total value of the serviceable obtainable market (SOM), discounts that value by the probability of the patent or startup being able to achieve it, and further discounts that by the amount of time it will take to achieve the cash flow from obtaining the market. This yields the net present value (NPV) of the startup or patenting opportunity.

The skill in portfolio construction lies largely in converting the qualitative insights from due diligence into the quantitative probability estimates used in the DCF calculation. The actual calculation is a topic for a different essay.

Opportunity cost

Each investment has an opportunity cost.

The money spent on getting a patent and the money invested in a startup is money that cannot be used for any other patent or startup in the portfolio. The opportunity cost of each investment is the value of the next best investment available.

It is not optimal to make decisions one by one. The opportunity cost is unclear. A final decision on whether to proceed with patenting an invention or invest in a startup should consider the opportunity cost in the context of many other available options. To inform these decisions, it is helpful to have a spreadsheet or docket report with the estimated NPV of all potential investment options for the portfolio. Analyzing opportunity costs this way leads to better investment allocation and portfolio returns

Conclusion

The theoretical optimal processes for picking deals in a VC portfolio and choosing inventions for a patent portfolio are nearly identical . An expert in structuring one type of portfolio can apply that expertise, with some adaptation, to successfully build the other.

[1] Zero to One by Peter Thiel.

[2] Patent term is subject to many exceptions that I have overlooked for simplicity.

[3] Just ask any historian.

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