Managing in Tell Prop 20 article

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Citation: No. 196 Managing Intell. Prop. 20 February 2010

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Why anti-counterfeiting programmes payMany companies wonder whether fighting fakes can be justified financially. Hans Joachim Fuchsan d Shuqin Zhou explain why anti-counterfeiting programmes are good for the bottom line

ighting piracy and counterfeiting is not cheap. The budget required for an anti-counterfeiting programme is generally a six-figure sum for medium-sized com-panies, while multinational groups often spend seven- and eight-figure sumsfor programmes to protect patents, trade marks and copyright and to manageinfringement lawsuits. As a result, managers and executives are increasingly ques-tioning not only the effectiveness, but also the efficiency of these actions.

Will the expense really pay off? Ar e the costs for protecting intellectual propertyand for prosecuting infringement cases reasonable when assessed against the dam-age that they prevent? Behind these concerns lies a question about the monetaryvalue of IP and the cost of IP management: patent attorneys, specialist solicitors,external investigators and consultants for infringement cases as well as lawsuits andadministrative procedures all need to be financed.Breaking down the costsFighting product piracy and counterfeiting has to be profitable to maintain itslong-term legitimacy within the company. Even if measures are proved to beeffective, efficiency is not assessed. Efficiency of IP protection includes the rela-tionship between the results achieved and the financial resources employed. Itassesses the reasonableness of the pursued measures in line with a cost-benefitratio.Basically, the costs for protecting intellectual property in the long run have to besignificantly lower than the damage caused by loss, for example, du e to IP theft bycounterfeiters.

The cost-benefit ratio of IP protection is best illustrated with the example of prod-uct and trade mark piracy, because here we can quantify the damages caused bycounterfeiting. In contrast, this is not true for other areas of IP infringement such asindustrial espionage.

The monetary damages caused to original manufacturers due to product andbrand counterfeiting can be broken down into several components:Short-termIn the current fiscal year, counterfeits create a direct loss in turnover, since manypotential buyers deliberately turn down the original product and buy the copyinstead.Medium-termCounterfeiters copy one another. As a result, we can see a snowball effect that veryquickly creates large secondary markets and cheap counterfeit products. These com-petitive, cheap markets slowly but surely undermine the turnover of the originalmanufacturers. The essential problem for the manufacturers is not the loss inturnover resulting from the counterfeits presently offered for sale on the world mar-kets. Their main problem is the future loss of market share and, thereby, of turnoverand cash flow caused by the growing cheap markets and their counterfeit productsdamaging businesses and possibly even ruining them.Lon g--termContinuous counterfeiting damages the original brand, or rather the reputation ofthe original manufacturer, because the trade mark is steadily degraded. As the coun-terfeiting continues, the brand value decreases.

Further damage could result from compensation payments, if original manufac-turers are made liable for defects of counterfeit products. Th e costs caused by such

One-minute readAlthough IP ractitionersknow instinctively that

0 effective anti-counterfeit-~ jing programmes save corn-

5 -; panies money in he long(, 4 5 1 term, this can be difficult

to prove. To cost-conscious senior executives,these programmes often look like awaste ofresources fighting abattle tbat they maybelieve can never be won. Although legal vic-tories and photos of confiscated fakes showsuccess, they do not prove value for money. Inan alternative approach, these authors set outa ormula that they argue proves that thelosses to abrand from counterfeiting farexceed the cost of even the most lavish anti-counterfeiting programmes. This applies evenfor small- and medium-sized enterprises.

201 FEBRUARY 2010 WWW.MANAGINGIP.COMHeinOnline -- No. 196 Managing Intell. Prop. 20 February 2010


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cases are either noted within the com-pany or can be easily identified.Cost of IP protectionThe expense of protecting IP andprosecuting IP violations can easilybe calculated using the individualexpenditure items. However, theymay be reduced if the company Wreceives compensation from success-ful IP litigation, which is increasingly Original Neoplan bu sthe case. The damages awards areoften quite large. For example,Chinese Zhongwei Bus was told topay E2.3 million to German busmaker Neoplan for copying thefamous Starliner bus. Compensationpayments in the six-figure range arequite common in successful infringe-ment cases.The cumulative expenses for IPprotection and prosecuting viola- Zhongweibustions must be significantly lowerthan the damage caused by short-term losses in turnover,medium-term market share losses, reduction of the marketvalue and potential liability cases. The formula for calcu-lating the cost-benefit ratio in IP protection in the case ofcounterfeiting is as follows:KCostorKprotection | Current Loss in

in the period


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The short-term loss in one fiscal year can be calculated asfollows:T, T, I xPt- Effective fall in value du e to current loss in urnoverCF , = , cr* Short-term loss in cash =Loss in urnover x fixed cost rateThe terms are:T: Own current loss in urnover due to counterfeitsTo: Turnover of the counterfeiterI: Leverage factor. Indicates the influence exerted by the product of

counterfeiter Fl on one's ow n turnover.Pf: Price determinant. Indicates the ratio of fake price to original price.

Example: Fake price = /6 of the original price, Pf=cF: ixed cost rateCF: Short-term loss incashCalculating medium term damageAn American brand permanently lost its market share in Chinabetween August 1995 and May 1998. While the brand's marketshare assessed by market research apparently remained nearlyunchanged, deliveries of the original brand to Beijing steadilydecreased. This means that over the years original products wereincreasingly superseded by counterfeits. The counterfeiters tookover the brand. Similarly, in a relatively short period of time theGerman power equipment maker Stihl lost half of its marketshare in Indonesia to counterfeiters - it fell from 80% to 40%.

The medium-term damage due to lost market shares is cal-culated using the net present value or discounted cash flow -the cash value at the present time. The formula shows a calcu-lation over seven periods (for example, fiscal years).

CFt = TAM o x MSo X (1 MG ) t X kmst X KptNPVo = F, +CF resZWu CFt, + CF 2 CF7+ CFt7

+V ~ + 1 + ( + XVres1a=-

The terms are:CFt: Lost cash flow at the time t (due to lost market share)TAMo: Total Available Market in to nEURMSo: Market share in toMo: Market growth (% year)kmst:oss rate inmarket share in period tKr: Profit loss factor inperiod tNPVo: Net Present Value =Discounted Cash Flow, current cash valuei: Calculative interest rateCFe dao,:Lost cash flow in case of continuation of operation (after t)Vrua, Residual value factor

The permanent loss of market share caused by quickly grow-ing secondary markets leads to cumulative losses of cash flowarising over a period to- t. (for example, 2010 till 2016) and canreach very high levels over the years. Damages that occur at dif-ferent, later points in time are not equivalent in relation to thepresent moment. In order to evaluate the cash value of futuredamage, the capital costs rate is applicable. This is normallyhigher than the interest rate for outside financing as it takes intoconsideration the opportunity costs of the invested capital. Thecapital cost rate is the minimum rate of return that a companyshould generate. Normally the capital costs rate is not suitablefor discounting the losses. When it comes to evaluating the prof-itability of anti -counterfeiting, the assessment is the same as thatof an investment project. The decrease of losses in turnover orcash represents the profit due to the investment.

The residual value factor is a general value based on theassumption that the business will continue operating after theperiod of time considered in the loss account and that product

221 FEBRUARY 2010 WWW.MANAGINGIP.COM

and brand piracy will then still be an issue. That is to say thatthe losses will continue also after the period to. They can bedeclared as percentage rate of the lost cash flow CF7, while thisvalue may be estimated individually.Calculating long term lossThrough the extensive spread of counterfeited products andcopied trade marks, an original brand can be continuallyweakened within the market. It loses its exclusiveness andattraction and that lessens its monetary value over time. Sinceleading brands are often highly valued, even small damage fac-tors of a few percent already have relatively strong monetaryeffects. For example, a 5% loss of El billion brand valueamounts to a E50 million fall in value.

The damage factor has to be estimated. Through massivecounterfeiting of poor quality, the value of a former premiumbrand such as Polo Ralph Lauren might be reduced by 10%.The brand today is considered mainstream.

Based on market and industry experiences, we apply a dam-age factor to calculate the loss of brand value: VI .... Vbrand X 9.

The brand value Vbrald in Euros is calculable using variousmethods such as Interbrand, which is well known in manycompanies. The damage factor f is industry and company-spe-cific and varies between 5% and 30%. Various brand rankingsalso provide general criteria for potential losses in brand value.

Losses that result from liability due to IP violations are anoted factor in the company and can be incorporated into thecalculation of the total damage as a fixed position.Putting the formula to workThe financial impact of counterfeiting on a company is calcu-lated by adding the short-term, medium-term and long-termdamage as well as liability compensation paid or yet to be paid:

The methodology for a quantitative assessment of the com-mercial damage that results from product and brand piracywill be shown using a sample calculation. The example showsin three parts the calculation of the damage for a companyXYZ with the following base numbers:Total Available Market (to) TAMo: E5 billion a yearMarket share of XYZ (to) MSo: 25%Turnover of the counterfeiter (to) To: EO millionLeverage factor 1:5%Price ratio Pt: 6Fixed costs rate CF:0%Market growth MG:%a yearLoss rate in market share (as of ti) kMs:3% (ca 1/3)Profit loss factor KP:5%Brand value Vbrma1.5 billionDamage factor 0: 20%Calculative interest rate i: 6%Residual value factor Vidj : 0.2

Applying the above formulas and base numbers, the fol-lowing losses result for a defined period of time:The short-term loss (CFs) in cash is:

CFs =T xcF=ToxI x Pt c =100 x55 % x 6 x50 % =E165 millionThe medium-term loss CF.sE1.349 million (without residual value as of to)

Since this example spreads over seven years, the calculation modelresults are presented in he table below.The long-term loss (brand loss plus residual loss) incash CF , is:CF' = VbondP + esidual value =1.500 x20 %+ 661 =E961 million

HeinOnline -- No. 196 Managing Intell. Prop. 22 February 2010


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Value inmillion 4Turnover without damageTurnover with damageLoss in urnoverLoss inprofitsLoss in cash staticLoss in cash NPV

1.431 1.531 1.638896 959 1.026

1.876 2.0071.098 1.175 1.257 1.345

441 472 505 541 579 619 662199 213 227 243 260 279 298199 213 227 243 260 279 298187 189 191 193 1959 196 198 661

NPV* without residual value 1.349NPV* of residual value 661*Net present valueA lesson for the boardThe results underline that the damages that arise for a compa-ny through counterfeiting and eventually through loss of intel-lectual property in this realistic example rise very quickly. Inthe medium to long term, the damages might amount to bil-lions. It is obvious that the company's expenses for the protec-tion of its IP are far lower. The expenses for the protection ofintellectual property generally require budgets in the six toseven-figure range.

This article is a result of our long-standing consultingexperience in the field of IP protection and anti-counter-feiting in China. Analyses have shown that the damagesthat result from losses and illegal abuse may be ten timeshigher than the costs of IP protection. The positive cost-benefit relationship has not yet been recognised in the man-agement boards of many companies. It is true that we areseeing a growing understanding of the fact that the evalua-tion of underestimated immaterial capital - especially in

A// potential taxes were omitted to simplify the calculation.form of business protection rights - is playing an increas-ingly important role in commerce. It is also widely knownthat modifications in accounting law (for example IFRS/IAS38) in many cases require that acquired intellectual proper-ty be incorporated in the balance sheet and, therefore, beassessed monetarily. Even so, many managers are only nowstarting to realise that loss and abuse of IP can lead to dam-ages of such magnitude. Once this understanding gainsbroad acceptance, the budgets for IP protection mayincrease rapidly.

Hans Joachim Fuchs Shuqin ZhouChinabrand Consulting 2010. Hans Joachim Fuchs is managingpartner of Chinabrand Consulting and Shuqin Zhou is a senior manag-er at the firm

>>> ITMA International Meeting,London, March 24-26 2010>>> 18th Fordham Annual IP Law & Policy Conference,New York, April 8-9 2010>>> 2010 LE S International Conference,Sandton, South Africa, April 11-14 2010

Blo > BIO IP Counsels' Spring Conference,OFEC.NOLOCew Orleans, April 19-21 2010- >>> 132nd INTA Annual Meeting,IA Boston, May 22-26 2010

>>> FICPI 12th Open Forum,Munich, September 8-10>>> IPO Annual Meeting,

Intelle7 t laoo Atlanta, September 12-14

WWW.MANAGINGIP.COM FEBRUARY 2010123

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HeinOnline -- No. 196 Managing Intell. Prop. 23 February 2010

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