Can a business survive just on patent royalties?

March 1, 2000
I have developed a fundamental technology that has a wide range of applications. Because starting multiple businesses is daunting, what about forming a company based solely on royalty income?
1304qa Chang New

Q: I have developed a fundamental technology that has a wide range of applications. Because starting multiple businesses is daunting, what about forming a company based solely on royalty income?

A: Intellectual property (IP) is being recognized as a valuable commodity. IBM reported more than one billion dollars in annual patent-licensing royalties last year! This contradicts the saying, "You'll never get rich on royalties." So if professionally managed, a technology-licensing company can be a viable business. I emphasize "professionally managed" because you can't assume people will beat a path to your door just because you have developed a new technology.

An IP business is no different from any other business; you'll have to actively promote what you want to sell so people will hear about it, get excited about it, and then pursue a business with it. I suggest that you initially focus your energy on one or two of the most promising applications and devote substantial energy to help your clients develop the technology further. These successes will give you the validation needed to interest others; also, what you learn there can provide cross-fertilization to other applications.

At the same time as you build your core business, you must develop applications patents to shore up your position. You are in the best position at this point to know what is required to apply your invention, and additional patents will also extend your royalty stream. You have to plan ahead—remember it took laser technology 40 years to get to the state we are in today.

Q: What are the keys to preparing a successful business plan?

A: There are many books and articles on writing business plans. A good reference is "How to Write a Great Business Plan," by William A. Sahlman, Harvard Business Review, p. 98 (July-August, 1997). The key, of course, is the business model itself. Does the business idea make sense? Can the company succeed with its approach? Assuming the market exists, a successful company usually has a very strong sense of its core competencies or of the sustainable competitive advantages. This is important, because it takes immense focus of a typical startup's limited energy and resources in order to succeed. And then of course, the team has to be able to execute the plan.

It may be beneficial for me to describe what most investors do with a business plan. Once you understand that, you can then decide on how to approach writing one. Understand that the purpose of the business plan is not to close the financing, rather it is to get investors interested so they will take it to the next level of investigation. The decision to invest is based solely on what is discovered in the due diligence that follows. First, investors will look at the executive summary to see if the business model makes sense. For any specifics they don't understand, they will thumb through the main body of the plan to find the answers. But mainly they are looking for self-consistency in what is written and also with what they already know. They will then look at the resumes of the team to see if the principal players have what it takes to execute the plan.

Then they will look at the financial projections. There they are mostly looking for revenue projections, to get an estimate of the market size; for gross margin, to get an indication of the profit potential of the business; and for cash-flow projection, to scope the level of investment needed to pull it off. They take the numbers with a big grain of salt, of course. They are really looking for thoroughness in the plan and a feel for the experience level of the management team. In short, the business plan is what gets you past the "smell test." The work of getting funding has just begun.

Q: My partner and I need an outside board of directors to help us turn our contract business into a commercial enterprise. Can both of us stay on the board? And how do we recruit directors, and how much do we pay them?

A: It defeats the purpose if you load the board with insiders. It is customary for one of you to become an observer who attends meetings but does not vote. Directors are there to round out the knowledge base. Executives of local companies are usually good choices because they are current on the issues companies face, and they are well networked locally when you need help. And if you plan to go to an IPO any time soon, make sure some of the directors are CEOs of public companies. How much you pay a director is quite circumstantial. For a startup, the rule of thumb is about 0.5% stock in the company as options, vested over four or five years.

About the Author

Milton Chang

MILTON CHANG of Incubic Management was president of Newport and New Focus. He is currently director of mBio Diagnostics and Aurrion; a trustee of Caltech; a member of the SEC Advisory Committee on Small and Emerging Companies; and serves on advisory boards and mentors entrepreneurs. Chang is a Fellow of IEEE, OSA, and LIA. Direct your business, management, and career questions to him at [email protected], and check out his book Toward Entrepreneurship at www.miltonchang.com.

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