Zero to One: Patents, Profits and Competitive Advantage
I just finished reading Peter Thiel’s Zero to One. Thiel does a great job explaining how the lure of monopoly profits drives innovation. His thesis is this:
Competition is the enemy of profits.
Companies become profitable by escaping competition and becoming "creative monopolies".
The best measure of company value is the present value of expected future cash flows.
Future cash flows are generated when a company has a sustainable competitive advantage.
Competitive advantage results from some combination of scalability, network effects, branding and propriety technology.
For biotech companies, competitive advantage usually comes in the form of proprietary technology. Patents (along with trade secrets) are the primary ways to keep control over technology. So, how do patents contribute to future profits and, by extension, to value? Patents create a zone of competitive exclusion, which buys a company space and time for profits to be made.
Patents buy space by protecting features of a product for which customers are willing to pay a premium.
Don’t think of patents as covering technologies. Think of patents as covering features that satisfy some customer need. The more important the need, the more valuable the patent.
By excluding competitors from features that make a product attractive to customers, patents do two things:
Patents increase your market share.
Patents allow you to charge a premium for the product.
This principle is described in the graphic below:
Patents on pharmaceutical drugs can control a large area of market space. An effective, first-in-class drug will develop a huge market share, and command a price many times the cost of production. Studies show that when a proprietary drug goes off patent, the price of the drug drops by 30% to 80%, and the company loses 80% of its market share within six months. That’s a lot of space, and a lot of profit.
Patents on incremental improvements to platform technologies control less market space. For example, an invention that increases DNA sequencing speed by 10% is certainly attractive. But in combination with many other features that compete for customer attention, that amount of increased speed may not command that much of a price premium and, therefore, will generate less relative profit.
Patents buy time by delaying competitors from putting a product with equally attractive features on the market.
During that time, a patent will protect monopoly profits, creating value for a company. But how long will that time last, and how valuable is the patent? It depends on how difficult the patent is to design around.
Patents that are difficult to design around will control a market for a long time. Take, again, the example of pharmaceutical drugs. Developing a new drug that provides the same pharmacological effect and that does not infringe a patent can be quite costly and risky. In such a case, there may be no effective competition until the drug goes off patent. Amgen’s patents on erythropoietin are a prime example. Amgen still controls the erythropoietin market twenty five years after it introduced the product.
Patents that can be designed around control the market for a shorter period. Faced with a potentially blocking patent, a company will ask, “How long will it take and much will it cost to get around these patents?” Then the company will decide whether to get a license, design around the patent, or sharpen its pencil and prepare for war. But until the company finds a way around the patents, the patent holder enjoys monopoly profits.
Patents: Wall or Speed Bump?
People frequently think of a patent as a “wall” – providing total protection until the wall is breached, after which, calamity. But it some cases, it may be more appropriate to think of a patent as a “speed bump” which, in a race, slow competitors down, allowing you to be one step ahead, at least for some time.
A patent that functions as a wall will generate cash flows long into the future. But even if a patent is just a speed bump, the period of market exclusivity has some present value to the company.
Every patent provides some space and time in which profits can be made. If you can get a patent that commands an entire market for 20 years, that's great for you. But many patents create smaller zones of exclusion, and for less time. A good patent strategy will develop both kinds of assets, recognizing that any amount of space and time you can obtain will protect some future cash flow and, therefore, provide value.
Finally, building a patent portfolio is expensive. If you consider the money spent on patents as an investment, you have to ask what sort of return on investment you need to justify the expense. That is a problem for another day.