Stranded R&D

In 1980, Congress passed the Bayh-Dole Act.  Overnight with its passage, universities and government-funded R&D labs gained a comparative advantage in funding R&D.  Universities and government labs have a cost advantage in that many had already spent tens of billions of dollars setting up research labs for non-commercial purposes, including teaching and curious exploration.  Many scientists and engineers found the prestige of academia, and the increase in professional freedom it promises, a compelling offer.  The result has been a gradual shutting down of corporate R&D labs, and an expansion of industry collaboration with scientists and engineers now employed by universities and government labs.

Many people think of the Bayh-Dole Act as an unmitigated success story.  Several multi-billion dollar technology companies that are now household names (such as Genentech and Google) started in graduate school research labs.  Many inventors are happier in the more collaborative environment that academia offers.  Collaboration is an under-appreciated driver of innovation.

Unfortunately, so far universities have underperformed private benchmarks for the successful transfer of technology.  Despite spending almost an order of magnitude more on R&D (about $50 billion), the AUTM reports only about a factor of two more revenue from R&D (about $2 billion) than does IBM (about $1 billion on about $5 billion in R&D) over an overlapping period from the mid-nineties to the mid-zeroes of the present decade.  Although it is tempting to attribute the difference in returns entirely to the diversion of R&D funding into pure science (an attribution that ought to silence the Bayh-Dole critics who favor pure science), it is important to remember that there was a net inflow of the most productive researchers from industry into academia over the same period of time.  This concentration of the brightest minds of science and engineering within academia would probably have led to a faster increase in returns from R&D if there weren't something else going on.

And there is something else going on.  The costs of licensing and litigation of patents has skyrocketed over the same period of time.  The biggest reason for increasing costs has been the inelastic supply of patent lawyers relative to the exploding demand for their services.  Unlike patent prosecution, which can be done by non-lawyer patent agents and examiners, patent licensing and litigation are services that require a state bar license (and the three years of ABA-accredited law school that this usually requires).  Law firms are struggling to meet demand by increasing starting associate salaries (patent boutiques started the chain reaction in both instances over the past ten years), but the corresponding increase in associate to partner ratios at most law firms (necessary to keep profits-per-partner high and retain top partners) has led to a decline in the quality of services overall.

It is worth noting that many technology transfer offices are staffed by non-lawyer scientists and engineers with formal or informal business training.  Many of these employees are probably undervalued by the legal services market because of their lack of state bar credentials.  Seeing the value, university tech-transfer offices and other government and private firms not constrained by state bar requirements are scooping these types of employees up.  Non-lawyers will probably play a growing role in R&D funding and technology-transfer going forward, even in providing "legal" services.  The investment banks (such as Altitude Capital) and venture capital funds (such as Intellectual Ventures) that have recently entered the secondary market for patents are early signs of this trend.

The result of these macroeconomic trends in R&D is a market in which many startups and smaller companies are realizing only a fraction of the intrinsic value of their R&D.  Technology is stranded in later-stage startups and other small private companies that are not eligible for further venture capital financing, acquisition, or IPO.  Problems in the credit markets and the passage of the Sarbanes-Oxley Act have further exacerbated the problem for these companies in the acquisition and IPO arena.  In effect, the United States is piling up a vast, invisible junkyard of stranded R&D that could be socially valuable if placed into the hands of the right owners.

As the returns to investment in R&D decline, so too do the number of jobs available for researchers outside academia.  This is a problem that is vital to the health of the U.S. economy within its global environment.  If current trends continue, there will be more Ph.D. engineers living in China than in the U.S. by 2010.  The number of U.S. patents issuing to foreign entities is already nearly equal to the number of patents issuing to the U.S.  If the U.S. were to strengthen its patent system, we would be far better positioned than any other nation in the world to bring the power of market-based incentives to bear on the problem of attracting the most talented human capital -- the single most important problem we face in our long-term prospects for economic growth.

People are starting to recognize these problems.  Recently, the Brookings Institute has called for the government to setup a National Innovation Foundation.  But aren't the market-based incentives of a strong patent system a better way for the government to encourage R&D funding?  Although a handful of firms, including Intellectual Ventures, Ocean Tomo, and other new entrants are struggling to meet immediate needs, the inventors and startups most in need cannot afford to hire anyone to answer the lobbyists hired by the large corporations that are net payers of patent licenses (when forced to pay at the end of protracted litigation).

Although the big picture of innovation is so large and complex that it is difficult for most people to understand, the solutions are actually simpler and easier than most would imagine.  First, the patent laws should be reformed in ways that would promote private settlements of disputes over patent infringement rather than litigation.  Some recent changes to the patent law have been beneficial in this regard, and some detrimental.  Unfortunately, the Supreme Court's recent holding in Medimmune makes it harder than ever for inventors to get to the table with large corporations without ending up in litigation.  And after Mercexchange, startups and independent inventors do not have the threat of an injunction to keep licensees at the bargaining table when those startups and inventors have failed to find funding to themselves commercialize the technology.  Neither of these by themselves is fatal.  The threat of injunction was no doubt abused by opportunistic speculators from time to time over the past few decades.  But not in decades has it been more difficult for investors in R&D to see a return through patent licensing.

Second, if the government is going to provide funding to solve these problems, that funding might best be used to lower the barriers to entry for the practice of patent law.  For scientists and engineers, especially those who understand business, the opportunity costs of wages are probably much higher than the costs of a law school education.  Public funding of scholarships for scientists and engineers who intend to study law would over time decrease the transactions costs associated with patent licensing, and gradually decrease the amount spent on litigation as it becomes easier and easier for opposite parties to reach agreement on differing valuations of a technology.

Third, institutional investors should consider allocating a larger share of their funding to hiring more employees for their technology transfer offices now, and later for investing in private equity funds that specialize in R&D investment.  The technology transfer offices are now overwhelmed by the demands on their time in many cases.  As a result, they tend to focus on the biotech and pharmaceutical inventions that are likely to provide the largest payouts, ignoring the many other areas of R&D that could nevertheless have a transformative impact on our society.  In terms of private equity investments, over the short-term the lack of licensing revenue is going to impede the returns for these funds.  But restarting the R&D engine of economic growth is going to require the public and private sectors to work together.

These are complex problems that it will take teamwork to solve.

Update: Silicon Valley never fails to disappoint in its farsightedness.  Jaisen Mathai, Michael Arrington, and Stu Phillips are all groping around the edges of the problem.

Update 2: I was recently asked whether the figures for IBM and AUTM include capital gains from equity.  The answer is no, neither do.  I have seen no evidence and have no reason to believe, however, that the AUTM should be seeing larger returns from equity on its R&D than IBM.  So the larger point about relative efficiency in technology transfer seems still to be sound.