Patent protection is necessary for a functioning market economy. Businesses need to have assurance that they will be able to reap benefits from successful invention and innovation and the investments they require.
However, patents eventually expire. They last for 20 years in the U.S. from the date the patent is filed. When that time period ends, businesses face something known as a patent cliff.
What is a patent cliff?
A patent cliff is a term given to the end of a profit stream once the patent expires. The concept generally applies to the pharmaceutical industry since drug companies make most of their money from patented products that eventually become generic drugs once the patent expires.
The "cliff" in the patent cliff signifies the revenue or profit falling sharply once the patent expires.
Why the patent cliff is important
In the pharmaceutical industry, a blockbuster drug can make or break a stock, and with some biotech companies, one drug could represent a majority of a company's revenue or profits.
If you're analyzing a stock like this, it's important to be aware of the company's patents, as an approaching patent cliff can make a stock look cheap -- even though it's cheap for a reason since its profits will soon fall sharply.
If you're analyzing a pharmaceutical company, you'll want to take note of patent expirations and the drug pipeline to see if the company is developing any drugs that could help it recoup some of the money lost when it goes over the patent cliff.
Investors may discuss the effects of the patent cliff on specific pharmaceutical companies or on the industry more broadly since it's a perennial source of concern and the reason why drugmakers need to constantly spend on research and development and refresh their product portfolio.
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