A small biotech company has come up with a revolutionary new seed for sugar beets that are exactly the same as regular beets but yield twice as much sugar. The company wishes to sell the patent (which is valid for twenty years) so that the inventors can pay off their venture capitalists and retire to an island with lots of sun and palm trees. What is the value of the patent?
The price of a product is determined by the market. Let’s assume that there are no inputs for the new seed technology (it’s already produced and can simply be cloned), and that agricultural goods are commodities sold to a dispersed market of buyers who, individually, exercise little power over the price. The price, then, will be based on the value of the product to the buyer, and on competition from similar and substitute goods. Since this is a patented product, there are no similar goods, and therefore no alternate seed sources.
Candidate: What are other potential substitutes and are there any peculiarities for these products?
Interviewer: Substitute goods are regular sugar beet seeds and possibly seeds for sugar cane.
Candidate: Why not grow sugar cane?
Interviewer: Sugar cane is grown in entirely different climates and is not considered to be a competing product in this market.
Candidate: That rules out one possibility and makes the solution easier. The only possible competition is from regular sugar beet seeds. The value of that product should be compared to the value of our new seeds. In order to be grown into beets, seeds require land and labor. The farmer using our new seeds has two possibilities: he can grow twice as much sugar with the same amount of land and labor or he can grow the same amount of sugar with half the land and labor, since the yield of the new beet is twice that of the old one. Let’s look just at land for simplicity here.
Interviewer: Do you believe the farmer can sell twice as much sugar?
Candidate: One individual farmer in a commodities market should be able to sell all his increased output at the market price, but if every farmer uses the new technology and doubles his output, the price will have to fall. The question then becomes whether the demand for sugar is elastic. Using common sense, would you expect anyone to consume more sugar (bake more cookies or make more lemonade) when the price of sugar drops? Probably not, because sugar is already a pretty cheap staple product and rarely the most expensive ingredient in something. You might want to think about other uses for sugar such as making alcohol to use as a substitute for gasoline. This market’s demand would probably be elastic.
Interviewer: That is a good point, but let’s assume demand for sugar is fixed for now.
This is an example of a clue where the interviewer does not want you to pursue this any further. In most case interviews, the interviewer usually gives subtle hints that will indicate to the candidate that either he/she is digressing from the topic at hand or is delving too deep into the subject and it probably goes beyond the scope of the interview. Having established these facts, get back to the original line of the argument and continue.
Candidate: If demand for sugar is fixed, then the only possibility for the farmer is to use only half the land to grow the same amount of sugar. So now you need to determine the value of the land saved. This could be determined by the market price of agricultural land times the area saved.
Interviewer: Selling the land is a bit of a problem. There is a glut of land available, and it is unlikely that the farmers will be able to sell their land at all within a period of a few years.
Oops! Now what? Another possibility is to see if the farmer may have other uses for the land.
Candidate: Can he grow a different crop?
Interviewer: It is possible to grow other crops on that type of soil. For instance, cabbage grows well in those types of climates. The problem is that the profit margins on cabbage are only 20 percent of those on sugar beets.
It seems that the farmers will not derive a whole lot of benefit from the new seeds. You have looked at the end consumers of refined sugar and at the producers of the beets now.
Candidate: What other players could possibly benefit from the new invention? A good way to approach this is to use a value chain or process flow.
Interviewer: Why don’t you tell me?
Candidate: How does the sugar finally reach the consumer?
Interviewer: Sugar beets are produced by the farmer and then shipped to the sugar refinery by truck. The sugar refinery makes sugar crystals from the beets and packages them. The packaged sugar is then shipped to retailers, where it is distributed to the end consumer.
The sugar that reaches the end consumer is the same sugar and in the same amount that would be shipped if old seeds were used. Because, the transportation process involved in both the cases is the same, there are no cost savings there. From the farmer to the refinery, however, the amount of beets shipped would be only half the traditional amount. As a result, trucking expenses should drop by 50 percent.
Candidate: Will the refinery realize any production benefits from the reduced number of beets?
Interviewer: As it turns out, the processing cost of the new beets will be 25% percent higher per beet than the old ones.
Candidate: If the number of beets is reduced by 50 percent and the cost per new beet is only 25 percent higher, there will be a 25 percent production cost savings to the refinery. The refinery should be willing to pay the farmer a higher price for the new beets. The total savings from the new seeds can be summed up as follows: farmers gain 10 percent on their profit margins from growing cabbage on half their land. Here’s why: Because profit margins on cabbage are only 20 percent that of beets, 20 percent on half the land equals 10 percent. Trucking expenses from the farmer to the refinery are cut by 50 percent and production costs are reduced by 25 percent. Next we should find out how much each step contributes to the final price of sugar.
Interviewer: Growing the sugar is 40 percent of the cost, trucking 10 percent, refining 30 percent, and distribution 20 percent.
Candidate: The savings are 10% x 40% = 4% in growing; 50% x 10% = 5% in trucking; and 25% x 30% = 7.5% in refining. This adds up to a total savings of 16.5%. Multiply this number by the annual sugar demand and you get a dollar value of annual savings.
Interviewer: How would you estimate the annual demand for sugar?
At this point you drop your head in exhaustion for you will have to do an estimation case within a business case. In a typical case interview, unless it is a specific estimation example, you can come up with a suitable assumption. For example, in this case, you can assume that the resulting figure is $3 billion- You can briefly explain to the interviewer how you arrived at the number — an explanation is given in the sidebar below.
The value of the patent is the net present value of 20 years (the length of the patent) of 16.5% x $3 billion, which I estimate to be the annual demand of sugar.