EBIT: The Answer to Your Patent Filing Decisions

A patent filing strategy for product X in country Y should start with analyzing actual or projected earnings before interest and taxes (EBIT)/operating income – not more traditional filing criteria such as revenue or manufacturing country or largest markets. After an at-risk EBIT/operating income contribution by product X is determined in each country, a business can answer this question: “Is a complete or partial loss of the EBIT/operating income in country Y so detrimental to the overall profitability of the business that patent expense (including potential enforcement costs) is necessary to protect the EBIT/operating income in country Y?” After EBIT/operating income is determined on a country-by-country basis, more traditional patent filing criteria can be considered.                

The Wrong Data

During WWII, the U.S. Army Air Corps (AAC) wanted to make its aircraft and pilots less susceptible to combat losses. An inspection of returning aircraft showed significant fuselage and wing damage, so the AAC added armor to these areas. The design modifications did nothing to reduce US aircraft combat losses.

Enter Abraham Wald, a mathematician from the Statistical Research Group. Wald realized that the AAC was excluding combat aircraft that suffered catastrophic loss from its analysis. These aircraft, resting behind enemy lines, were difficult to visually examine. So, Wald submitted “A Method of Estimating Plane Vulnerability Based on Damage of Survivors”, “a clever way of reacting to incomplete and missing data on aircraft survival.”  Wald proved, using statistical probability, that the AAC should “focus on the areas of the [returning] planes not showing damage. Those were the areas that couldn’t sustain a hit.” In short, Wald showed that while the AAC identified aircraft/aircrew survivability as the correct problem, it was looking at the wrong data to solve that problem.

Similarly, businesses and their in-house patent counsel have to solve the problem of conserving IP budgets while still protecting profits from sales. Traditionally, businesses and their in-house patent counsel apply homegrown, non-homogeneous internal criteria to determine when or where to file patent applications – often with a focus on gross revenue, manufacturing countries, major market countries, and patent costs. The major premise of this article is that businesses that only look at gross revenue or manufacturing countries or patent costs are looking at the wrong data set, i.e., returning aircraft instead of downed aircraft. Businesses should first look, on a country-by-country basis, at the EBIT/operating income contribution of a potentially patented product X when deciding to create patent expense to protect product X in country Y.

The Patent Process

As background for non-patent attorneys, when a patent counsel or patent agent is presented with a new invention disclosure, the attorney or agent typically does a trade secret/patent analysis, then does a utility/utility model/design patent analysis, then drafts a patent application with claims that both cover product X and that are deemed to be patentable over the known prior art, and finally files the patent application somewhere in the world.

Later, around the 6-month (design) or 12-month (utility) Paris Convention dates, the business, usually with budgetary input from in-house patent counsel, then decides whether the filed patent application will replicate itself in various jurisdictions throughout the world, remain a citizen of a single country, be published with or without further action, or die a lonely death at the U.S. Patent and Trademark Office (USPTO). When deciding which of these paths a particular patent application will travel, businesses and their counsel typically ask these types of questions: “Where will product X will be made or sold?”; “Where does a competitor make or sells its products?”; “How much does it cost to file in country Y?”; “What is the projected revenue of the claimed product X?”; “Can the claimed product X be licensed to another?”; and “Are injunctions available in country Y?” Many business IP dollars have been lost, and will continue to be lost, because none of these questions directly analyze the most important factor to any business – profitability.

A Focus on Protecting Profit

Business enterprises calculate profitability using a profit and loss (P&L) or income statement. A P&L statement starts with gross revenue. The costs of goods and services are then subtracted to arrive at a gross profit. The costs of goods and services are the expenses needed to make a good or service. Subtracted from gross profit are special, general, and administrative (SG&A) costs, such as the non-productional operational costs of financial controllers, attorneys, etc. The resulting difference is EBIT/operating profit. EBIT/operating profit is not net profit (available cash) because both interest and taxes have to be subtracted from EBIT/operating profit to arrive at net profit. But EBIT/operating profit does show whether a business enterprise is profitable. This same EBIT/operating profit analysis can be used to determine whether or when a patent application shouldbe filed in a particular country.

As a simple example, consider this basic equation:

Using static values of revenue of $1 million per year in country Y, cost of goods and services of $600,000 per year, constant SG&A of $100,000 per year, and an effective patent term of 20 years, Table 1 shows the results.

If a business looks just at revenue, much like the AAC was looking at just surviving aircraft, filing a patent application for product X in country Y is an easy decision. The lifetime cost of filing and prosecuting a patent application in country Y might be $75,000, including annuities and translations. Spending $75,000 of patent expense to protect $20 million in revenue is an eye watering return on investment. However, what the patent application really protects is $6 million ($300,000  per year * 20 years) of at-risk EBIT/operating income. A 108% difference compared to $20 million in revenue – not including enforcement costs. The question for the business: “Is a complete or partial loss of $300,000 per year in EBIT/operating income in country Y so detrimental to the overall profitability of the business that patent expense (including potential enforcement costs) is necessary to protect the $300,000 EBIT/operating income in country Y?”  If the answer is, “No.”, consider spending budget dollars elsewhere.

Adding more complexity, most products and services do not have constant annual sales. The product X EBIT/operating income contribution in years 1 through 5 might slowly ramp over time. In other cases, product X might contribute immediately to EBIT/operating income. At least one inventor teaches that 50% of issued U.S. patents are litigated within the first 10 years of issuance. Patent term T might also not be the full term. One author found that only 45% of all issued U.S. utility patents are maintained for their entire respective terms. While utility patent term is usually around 20 years, an effective patent term T might be < 20 years, such as T=10 or T=12. In the simple Table 1 example, EBIT/operating income at risk is closer to $3 million when T=10.

As another example, if the average revenue in country Y over effective patent term T drops to < $1 million per year, say because of customer price concessions, EBIT or operating income can drop further. Looking at Table 1, if a perspective patent application protects $750,000 of annual revenue in country Y for 20 years, with all other expense remaining equal, EBIT/operating income falls to $1 million over a 20-year term ($50,000 * 20 years). The business then must therefore decide if a potential loss of $50,000 a year in country Y is enough to justify patent expenses. But even if a patent application is not filed, $1 million in lifetime EBIT/operating income in country Y might, by itself, be enough to keep competition at bay. For example, Kevin O’Leary suggests that competition in China does not assert itself until sales for product X reaches $5 million annually in China.  Stated another way, even without a patent, competitors might not appear because the EBIT/operating income of product X in country Y is too low to justify start-up manufacturing and tooling costs.

EBIT Should Be Step One

In summary, a patent filing strategy for product X should start with analyzing its EBIT/operating income contribution on a country-by-country basis, not by using more ad hoc criteria such as revenue or manufacturing country or largest markets. After an at-risk EBIT/operating income is determined in each country, a decision can be made if a complete or partial loss the at-risk EBIT/operating income is so detrimental to the business that patent expense (including potential enforcement costs) is necessary. After all of this analysis is done, more traditional filing considerations can be assessed for completeness.