Invention Model 2

Invention Model

I. INTRODUCTION

Companies that deliver high returns to investors have:

High rates of return on invested capital (ROIC), and
High available unit growth that allows future earnings to be reinvested in more capital at the same high rates of return

In the Invention Model, we compare an invention to its incumbent substitute in terms of performance, market price and unit cost in order to predict the unit growth and returns on invested capital that will be incurred during the buyers’ transition to the invention.

The invention’s ‘deltas’ in performance and market price make unit growth available by incenting an incumbent’s buyers to transition to the invention, and the invention’s ‘deltas’ in market price and unit cost set the ROIC at which this unit growth will be realised.

The invention’s performance and cost deltas are fixed by the technical and production characteristics of the competing technologies. And the invention’s market price delta results from the economics of buyers and sellers: if exit barriers and switching costs of the incumbent’s buyers are low, the buyers’ willingness to pay for the invention can be defined and will be greater than or equal to the market price of the incumbent; and if entry barriers of the invention’s seller are high (i.e. if the seller has monopolistic bargaining power), the market price of the invention will equal the buyers’ willingness to pay.

In the profitable growth scenario of the model as depicted above, the invention has:

A performance advantage over incumbent and emerging substitutes
A market price that stabilises at or above the market price of the incumbent because (a) the incumbent’s buyers have low exit barriers and switching costs and are thus willing to pay for the invention at least what they’re paying for the incumbent, and (b) the patents and other entry barriers of the invention’s seller prevent the market price from falling below this level due to bargaining
A unit cost advantage over incumbent and emerging substitutes

The higher performance at a parity or premium market price unlocks unit growth, and the parity or premium market price at a lower unit cost results in superior returns.

Note we can use a delta plot to represent how the invention compares to its incumbent substitute in terms of performance, price and cost:

Here is a checklist for researching inventions:

And here is a scorecard for scoring an invention against its incumbent, using the example of two transcatheter heart valves:

DurAVR's single-piece design produces performance deltas of +23%, -33% and 100% on the dimensions of valve area, blood pressure and durability, respectively. These performance advantages are an inducement for hospitals to transition to the DurAVR valve.

Research has shown that, given these performance deltas, the current price of the Sapien 3, the low exit barriers, switching costs and bargaining power of hospitals, and the effectiveness of patents on the single-piece design, 0% is the price delta at which the hospitals' transition to the DurAVR valve will occur, thereby making unit growth available.

Given this price delta and the cost delta of -16% per unit, which is due to the smaller quantity of sutures used to manufacture a DurAVR valve, we can see that the unit growth can be realised at a higher rate of return on invested capital than the Sapien 3.

Conclusion: commercialising the DurAVR valve will make unit growth available at an attractive rate of return on capital.

II. TRANSITION (PHASE ONE)

Performance delta

One path to unit growth is to commercialise a new invention. If the invention has a performance advantage (or "delta"), buyers are incented to transition from the inferior substitute:

A performance delta is incurred when an invention has a level of performance that is superior to a substitute technology. Performance is normally multi-dimensional. For example, medical implants compete on rejection rates, infection rates, aesthetic outcomes, etc.

The buyers' transition to the invention constitutes unit decline for the substitute and unit growth for the invention. The question for the Invention Model is whether the price at which the transition is occurring, and the costs associated with the invention, are conducive of ROIC.

Note: the rate of adoption (slope of the curve) is limited by such factors as buyer awareness, access to growth capital, etc.

Price delta

Preview

If the invention shows superior performance, and buyers can exit existing relationships with the incumbent and their costs to switch from the incumbent are low, buyers will be willing to pay as much for the invention as they’re paying for the incumbent. If buyer bargaining power is also low and sellers are protected by entry barriers, buyers will have to pay as much for the invention in the market as they’re willing to pay (i.e. their consumer surplus will be zero). And given that, under these conditions, the buyers’ willingness to pay is as high as the price of the incumbent, buyers will be paying as much for the invention in the market as they’re paying for the incumbent - i.e. the invention’s price delta will be greater than or equal to zero.

We can express these relationships in a simple formula: if the buyers' exit barriers from the incumbent (ExB) are zero, the buyers' willingness to pay for the invention (WTP(I)) can be defined, and will be equal to the price of the incumbent substitute (P(S)) plus a performance premium (PP) minus switching costs (SC).

The price at which the transition will occur (P(T)) is equal to the buyers' willingness to pay less a consumer surplus (CS) that results from buyers and sellers applying downward competitive pressure on price (a function of buyer bargaining power (BP) and seller entry barriers (EnB)).

The price delta is equal to the transition price minus the price of the incumbent substitute:

We derive the price delta by simplifying:

Willingness to pay

The willingness to pay is the maximum price that buyers will pay to transition to the invention. If the incumbent's buyers are subject to exit barriers, then the willingness to pay will be undefined.

Otherwise, we express the willingness to pay as the sum of the price of the substitute and a performance premium minus switching costs:

It is necessary to construe the willingness to pay as a function of the price of the incumbent substitute because sellers of the incumbent technology will likely reduce price in retaliation to the invention's entry, thereby changing the buyers' price-performance trade-offs and thus their willingness to pay for the invention.

Where performance is multi-dimensional, the performance premium is the sum of the premiums for all dimensions. Performance premiums will be greater than or equal to zero for those dimensions on which the invention outperforms the incumbent, and less than or equal to zero for those dimensions on which it underperforms the incumbent:

Where buyers are firms, the performance premium is set where profit is maximised - that it, it is a maximum beyond which the transition to the invention would reduce profit. Where buyers are households, the performance premium reflects a subjective judgment on the utility of the performance delta. Utility depends on the dimension and magnitude of the performance delta. For example, a 100% improvement in the aesthetic outcomes of a medical device may carry a lower utility than a 50% improvement in rejection rates.

The buyers' costs to switch from the incumbent must be subtracted in order to derive the willingness to pay. Switching costs include sunk investments made with the incumbent (in infrastructure, training, relationships, etc.) and additional investments required with the invention.

If incumbent lock-in (exit barriers and switching costs) is low, the buyers' willingness to pay for the invention will equal the sum of the price of the incumbent and a performance premium that is greater than zero. In other words, if incumbent lock-in is low, the buyers' willingness to pay for the invention will be greater than or equal to the price of the incumbent.

Exit barriers

The model assumes that there is a price at which buyers are willing to transition to the invention for its superior performance. This assumption does not hold when buyers are "locked in" to sellers of the incumbent technology - that is, when there are structural features, such as contracts, user networks, or installed complementary products, that sellers of a superior invention cannot overcome by either discounting price or offering additional product or service benefits. In other words, the buyers' willingness to pay for the invention will be undefined when the incumbent's buyers have high exit barriers.

The zero-friction condition

Under conditions of zero friction (i.e. where the barriers to exiting from the incumbent and the costs to switch to the invention are both zero), the buyers' willingness to pay for the invention will equal the price of the substitute plus the performance premium:

Transition Price

Having derived the willingness to pay, we proceed to consider the downward competitive pressure that the invention's buyers and sellers will apply to this maximum price, thereby introducing a consumer surplus, in order to derive the price at which the transition will occur in the market:

The difference between the buyers' willingness to pay and the transition price (i.e. the consumer surplus) thus reflects (1) seller pressure, which is a function of the ease with which sellers may enter, and (2) buyer pressure, which is a function of the willingness and ability of buyers to bargain.

(1) Seller pressure

Competitive pressure may induce sellers of the invention to offer a price below the buyers' willingness to pay. This pressure is reduced by entry barriers that minimise the number of sellers:

Patents
Trade secrets

(2) Buyer pressure

Buyers are willing to bargain (to reduce the price below the willingness to pay) in proportion to:

Their level of profitability (and resulting profligacy)
The percentage of their total expenses comprised of invention purchases
The priority placed on invention performance resulting from:
- The costs of product failure
- The benefits of product performance
- Buyers' ability to discriminate between products on performance

Buyers are able to bargain in proportion to their:

Concentration
Information
Threat of backward integration
Threat of substitution

If buyer bargaining power is low and seller entry barriers are high, then consumer surplus will be zero.

Price Delta

The price delta is the transition price minus the price of the substitute:

By substituting terms, we can show the components of the price delta:

And we can simplify to derive the equation for the price delta:

In summary, if exit barriers are zero, then the price delta is equal to the performance premium minus switching costs minus consumer surplus, where consumer surplus is a function of buyer bargaining power and seller entry barriers.

As such, the price delta will approximate the buyers' performance premium when the entry barriers of the invention's sellers are high and the exit barriers, switching costs and bargaining power of the incumbent's buyers are low. Because the performance premium is positive, the price delta will be greater than or equal to zero under these conditions.

Cost delta

With the price delta determined, we look to the invention's costs to determine the ROIC at which the unit growth will be realised.

A cost advantage is incurred when an invention's production process involves operating costs and/or capital employed that are lower than a substitute technology. For example, synthetic skin graft solutions have lower manufacturing costs than their biologic substitutes:

Above we have explored how technical and market factors drive the invention's advantages in performance, price and cost, and how these advantages culminate in the invention's rates of unit growth and returns on capital:

The buyers’ willingness to pay for the invention less the price of the incumbent is the price delta they’re willing to pay. Assuming superior performance, it will be greater than or equal to zero if their exit barriers and switching costs from the incumbent are low.

If their consumer surplus is zero – because their bargaining power is low and seller entry barriers are high – then this is also the price delta they have to pay – i.e. at market.

III. ROIC COMPARISON

In considering the buyers' transition to the invention, it is useful to compare the returns that will be attained by sellers of the invention to those currently attained by sellers of the incumbent technology. In other words, will the buyers' transition to the invention increase or decrease the earning power of the capital servicing those buyers?

For example, if the buyers transition to the invention at a premium to the price of the incumbent, and the invention's costs are lower than those of the incumbent, the returns attained by sellers of the invention will be higher - i.e. the earning power of capital will have increased as a result of the transition:

IV. DELTA PLOT

The solution space in which an invention competes can be visualised as a delta plot with axis for performance and another for price and cost:

V. LOCK-IN (PHASE TWO)

In the transition phase, inbound exit barriers and switching costs - i.e. those incurred by buyers in transitioning FROM the incumbent TO the invention - are sufficiently low. During the "lock-in" phase, sellers of the invention attempt to erect outbound exit barriers and switching costs - i.e. those incurred by buyers in transitioning FROM the invention TO an emerging substitute. If sellers of an invention can lock their buyers in by introducing contracts, network effects, installation mechanisms, gradual investments in training and equipment, etc., it can establish a defence to substitution.

VI. SUSTAINABLE COMPETITIVE ADVANTAGE (SCA)

In the Invention Model, a competitive advantage is a performance and/or cost delta attributable to an invention. This competitive advantage is made sustainable by patents and/or trade secrets covering that invention as well as any lock-in features (such as network effects, installation mechanisms, etc.):

SCA = Performance and/or cost delta + Patents and/or trade secrets + Lock-in features

The invention's advantages result in above-average growth and returns in the short-run, and its intellectual property and lock-in features are a defensive structure (or "moat") that sustains these results in the long-run:

VII. SECONDARY FACTORS

Value

Market penetration: Available unit growth comprises that portion of the target market not yet penetrated. As such, the size of the total addressable market (TAM) and the current market penetration rate are important factors in determining value and the timing of the investment.

Upside: A shorthand for available upside divides the projected and current market capitalisations, where the projected market cap is the product of the invention's peak sales and the industry's sales multiple:

Management

Commercialisation: Management and board must have industry-specific experience in product commercialisation, and have access to the industry networks required to drive invention adoption.

Continuous innovation: Management must be investing in second and third generations of the invention.

Capital

Commercialisation: The company must have access to capital markets to fund commercialisation.

Litigation: The company must be sufficiently capitalised to enforce patents and other intellectual property rights.

Key Opinion Leaders (KOLs)

Board positions: The company should have industry KOLs on its advisory board.

Product evaluations: Industry KOLs should be predicting uptake of the invention.

VIII. ECONOMIC CHARACTERISTICS OF THE MODEL

Monopolistic returns: As a result of patents and trade secrets, the firm commercialising the invention is the only seller of the invention and is thus the sole source of supply of the performance delta.

Multiple phases: The model describes a transition phase, during which low inbound exit barriers and switching costs allow buyers to be switched from sellers of an incumbent. This allows unit growth to be unlocked. This is followed by a lock-in phase, whereby outbound exit barriers and switching costs are gradually erected by sellers of the invention.

Predation: The transition phase is a zero-sum game - i.e. sellers of the invention grow at the expense of sellers of the incumbent technology. In other words, the model is a predation model - sellers of the invention ultimately feed off sellers of the incumbent by capturing their revenue source.

IX. STRENGTHS AND WEAKNESSES OF THE MODEL

Strengths

Predictability of unit growth: The model's target market consists of the incumbent's buyers, making the customer-set easy to locate for research purposes. Furthermore, performance deltas are objective comparative measurements of the capabilities of products, in contrast to utility measures, which are subjective consumer responses. As a result, the "who" and the "why" of the transition are easy to define. This enables a high degree of accuracy in predictions of buyer adoption and unit growth. This is due to the fact that the Invention Model is a market penetration strategy - i.e. one where the target buyers are already purchasing a solution to the problem that the invention is solving, and is thus a situation where the buyers are already sufficiently aware of and motivated by the problem in order to purchase a solution. Predicting the buyers' transition is thus simply a matter of quantifying: 1) the premium that buyers will pay for the invention’s performance advantage, 2) the effect that the buyers' exit barriers and switching costs have on the buyers’ willingness to pay for the invention (relative to the price of the incumbent), and 3) the bargaining power that buyers will apply to drive the market price below their willingness to pay. Contrast this with a market development strategy, where the buyers need to be educated about and motivated by the problem that the invention is solving.

Predictability of market price: When buyer exit barriers and switching costs from an incumbent are negligible, the lower bound on the buyers' willingness to pay for a substitute invention is already known: it is the price of the incumbent. Predicting a market price for the invention under these conditions is a matter of estimating the consumer surplus that will result from the application of buyer bargaining power and from the entry barriers that protect the seller from prospective entrants. The existence of a price for an incumbent therefore enables a higher degree of accuracy in predictions of a market price for the invention.

Invention as the explanatory variable: Of the four forces in the model (performance and cost advantages, and seller and buyer economics), the first three are explained by the invention process: technical change can result in improvements upon the existing capabilities and production characteristics of a solution to a problem - i.e. performance and cost advantages; and the intellectual property (patents and trade secrets) attributable to that invention can provide entry barriers and thus attractive seller economics.

Weaknesses

Technical change and uncertainty: Inventions are subject to unforeseeable technical change (i.e. substitution), which introduces uncertainty (unquantifiable investment risk).

Investment terms: Inventions have shorter product lifecycles than staple products due to obsolescence. Furthermore, when patents expire, other sellers will take market share and apply downward competitive pressure on price, thereby causing growth and returns to fall. These factors reduce the quantity of future periods available for reinvestment of earnings.

Exit barriers: The model is not applicable when prospective buyers are "locked in" to sellers of the incumbent technology by means of contracts, user networks, etc.

X. INVENTION CHECKLIST

Seven quick questions to ask about an invention:

Performance advantage: is it better than incumbent and emerging substitutes?
Cost advantage: is it cheaper to produce?
Entry barriers: is it patented?
Exit barriers: can its buyers exit existing relationships with sellers of the incumbent technology?
Switching costs: will its buyers incur costs to switch from the incumbent technology?
Bargaining power: do its buyers have and exercise bargaining power?
Lock-in: is there scope for sellers of the invention to erect exit barriers and switching costs once buyers have transitioned to the invention?

XI. INVENTION SCORECARD

XII. SUMMARY

The Invention Model attempts to answer the following question: when should you invest in a company commercialising an invention?

For a company to be a sound investment, it will require a high ROIC and high available unit growth. The ROIC (return on invested capital) is the rate at which the company can generate earnings on its capital. For example, if it invests $1m in assets and generates $300k in earnings, it has a ROIC of 30%. Available unit growth is the ability for the company to sell more units of its product each year. If it has available unit growth, it can reinvest its earnings and effectively compound them at a rate of return equal to its ROIC. In other words, when unit growth is available and earnings are reinvested, a company’s ROIC will be the rate at which the company’s intrinsic value - and thus the value of the investment - is increasing.

What drives unit growth and ROIC?

One way to acquire unit growth is to offer a product that outperforms the incumbent solution, and to price it at or below the buyers’ willingness to pay so that buyers will choose to transition from the incumbent. The ROIC will then be set by the product’s unit costs. If R&D results in an invention with both performance and cost advantages, then the technical prerequisites for investment returns have been met.

Consider PolyNovo's skin graft technology. Because it is synthetic, it outperforms its biologic competitors in rejection rates, infection rates and aesthetic outcomes. And because it is built in a lab, as opposed to grown on an animal, its costs of production are significantly lower.

What drives the buyers’ willingness to pay for the invention?

Buyers will be willing to pay for an invention if they can exit their relationship with sellers of the incumbent product - in other words, when their exit barriers are low. Assuming this condition is met, the willingness to pay for an invention that offers superior performance will be greater than or equal to the price of the incumbent product if their costs to transition to the invention are insignificant - in other words, when their switching costs are low.

Hospitals are not contracted to PolyNovo's competitors, and the costs to train and equip surgeons for implanting the product are negligible. As a result, PolyNovo can price its product at parity with existing solutions and rely on its performance advantages to take market share.

If buyers are willing to pay X for the invention, will X be the market price?

If buyers have bargaining power (i.e. if they are concentrated as a buyer group, have information, have a threat of backward integration or a threat of substitution), they may exercise it to force the market price below what they are willing to pay. And if the seller is not protected by patents and trade secrets, other firms will offer to sell the invention and will likely reduce price in order to take market share. As a result of these two factors, buyers will be able to buy the invention for a price (the market price) that is below what they are willing to pay - that is, a consumer surplus has been introduced. Consumer surplus is therefore minimised when the invention’s buyers are low in bargaining power and its sellers are protected by patents and other entry barriers.

In the case of PolyNovo, hospitals do not concentrate as a buyer group and have no viable threat of backward integration. Surgeons also prioritise performance over price and are therefore price-insensitive. PolyNovo's production process is patented and protected by trade secrets, and as such is the only available supplier of its NovoSorb technology.

In summary, we are looking for inventions that outperform their incumbent and emerging substitutes, are cheaper to produce, and will switch buyers from the incumbent technology (thereby unlocking unit growth) at a price that is conducive of returns on capital because (a) buyers have minimal exit barriers and switching costs in transitioning from the incumbent - meaning the buyers' willingness to pay for the invention will be greater than or equal to the price of the incumbent, and (b) buyers have minimal bargaining power and sellers are protected by patents and trade secrets - meaning the market price will equal the buyers' willingness to pay (i.e. consumer surplus will be zero).

We also consider the available scope for sellers of the invention to lock buyers in by erecting exit barriers and switching costs once the transition is complete.

APPENDIX

A. Notes on pricing

Segmenting buyers

Buyers should be segmented on the basis of performance premiums. For example, the variance of premiums among US hospitals in medical devices is small, as is the variance among Indian hospitals. US and Indian hospitals constitute two segments because the buyers in their respective groups are highly uniform in their premiums, and because there is a large difference in the premiums of the two groups.

The buyers in a perfectly uniform segment are all-or-none with respect to their performance premiums. For example, a perfectly uniform segment would be comprised of buyers all of whom would switch to the invention up to a premium of, say, $100, and none of whom would switch at $101.

Behaviour of performance premiums

Above we have construed the performance premium as a constant ($):

WTP = P(S) + PP

However, some situations may be better represented by construing the performance premium as a multiple:

WTP = P(S) . PP

B. Growth model

Assume zero earnings growth in the steady state (i.e. without incremental additions to invested capital). In other words, without future additions to capital, the business’s earnings in year 10 are the same as year 1. The enterprise value at time 1 is thus a perpetuity:

If we assume zero debt, and we reinvest the first year’s earnings in more invested capital, each year’s earnings increase by (1+ROIC).

The ROIC is therefore the multiple by which the enterprise value is being increased each time earnings are reinvested in additional capital:

The number of reinvestment periods available is set by the business’s available unit growth. Note that, initially, the business is making proportionally larger additions to invested capital in each period, and thus approaches its unit ceiling at an accelerated rate.