Banking on royalties: “The IP model values intellectual capital which a services model doesn’t do full justice to,” says Srini Rajam

For years technology firms in India have debated how they can move up the value chain. Most technology firms in India, such as Wipro, HCL and MindTree, are services firms. Engineers jointly develop products such as routers and semiconductors with their clients. The intellectual property (IP) in such a model rests with the client. The firms are only paid for their resources - time and material - which limits their ability to charge a premium for IP. Also, services is a linear model: revenues grow directly in proportion to the number of people employed.

So, why don't these firms develop their own products that can be sold in their own brand name? After all, the products business is more lucrative, being a non-linear model. The firm doesn't need an army of programmers to develop the product and if it is successful it can earn far higher returns than from services. A few technology firms, such as Saken and FutureSoft have tried to build products, with only moderate success. The fact remains that India has no successful true-blue tech product company. Lack of risk capital, high chance of failure (only one in 10 product companies is commercially successful) and very high investments have kept companies away from this model.

Now, a three-year old company, Ittiam Systems, is trying out a model which falls somewhere in between these two extremes of the services and the product business. Launched in April 2001 (see 'Cool Rider', BW, 23 April 2001), Ittiam is a digital signal processor (DSP) systems software firm. Ittiam's engineers (a team of 110) design applications such as streaming video, portable media player, digital still camera and so on, which run on DSP (chips which go into a variety of devices like mobile phones, digital cameras, Internet modems and network devices). The team also has a silicon IP design using which semiconductor companies can manufacture chips that go into wireless LAN devices. Among its 40 customers are names like Sony, Premier, VEO and semi-conductor firms like TI, ST Microelectronics and Silicon Labs.

Ittiam's line of work is not new; there are dozens of companies in India that design applications for DSPs. But its model certainly is. Ittiam does not provide services to technology firms; instead, it licenses its intellectual property to clients for which it earns royalties. In 2003-04, Ittiam earned a revenue of $4.8 million with a net profit of $1.03 million. The entire revenue came from licensing its IP and royalties.

Just like a product firm, the IP firm develops its own solution but, unlike a product firm, it does not sell to the end customer. Instead, it licenses the solutions - technology building blocks - to another firm which uses them to create a product for the end customer. For example, one of Ittiam's clients is Premier Image Corporation, a Taiwan-based consumer electronic company. Premier recently launched a digital camcorder, priced $199-299. This product has several pieces of software written by Ittiam's engineers which run applications like MPEG4 video, MP3 audio and MP4 video and audio synchronisation. For every unit of that product sold, Premier pays a royalty to Ittiam. In the services model, Premier would have employed Ittiam engineers for a project lasting about six months or a year for developing an application and kept the IP rights to that application.

IP licensing is not a new phenomenon. Even the services firms Wipro, HCL and MindTree have licensed their IP to clients. But the difference is that for these firms, IP licensing brings in only a part of the revenue. Ittiam is, perhaps, the first technology firm in India which is 100 per cent driven by IP licensing.

The Company

In terms of volumes, this year Ittiam expects a million end products - digital cameras, video players and wireless LAN devices - in the market which will carry its technology. Of the $4.8 million revenue earned by the company last year, 5 per cent came from royalty. This year the royalty component will double. The royalty model is more profitable than the services one because royalty directly impacts a company's bottomline since the company has to create the technology only once.

In fact, thanks to the income from royalties Ittiam has not had to raise any more money after the initial $5 million that it received in 2001 from Global Technology Ventures. That, and the fact that the entire development effort of the firm is based in India. Chairman and CEO Srini Rajam says that if Ittiam were based in the US, to do the same amount of work (110 employees, 40 customers and 18 patents) it would have had to raise several times that amount. "An IP licensing company takes at least 5-7 years to break even," says Rajam.

So how has Ittiam managed to become profitable in just three years? Apart from the cost advantage of being based in India (only three employees, looking after sales and marketing, are outside India), it is also a result of Ittiam's development strategy.

In the DSP universe, Ittiam is focussed on three major product lines: digital audio video, wireless LAN, and voice and video over Internet protocol (VOIP). The company follows a "swiss-army knife approach to development". For example, Ittiam has created a reference design for a digital media player which can be used to make a digital still camera, a portable media player or even a network camera. This versatile reference design helps in spreading the development costs over a wide spectrum of products and customers.

The Model

So why haven't there been more IP licensing firms? Even worldwide, the number of pure IP firms is very few. Will Strauss, who runs an online market research firm dedicated to the DSP industry called Forward Concepts, estimates that there are about 25 DSP software firms which follow a model similar to Ittiam's. In the silicon IP business the number is just 16. The reason is that the IP business, though profitable, is not really scaleable. The largest IP licensing firm in the world - ARM - has a turnover of just $150 million. Why is that so?

Let's compare the IP model with the product business. The life of an IP is limited by the lifecycle of the customer's products. So if Sony is selling a particular model of digital TV which has a piece of Ittiam's software in it, the lifecycle of that model is 2-3 years. Which means that Ittiam will have to keep looking for new technologies to license.

Even the size of the addressable market between a product firm and IP firm is very different. Ittiam estimates its total addressable market size to be $1 billion, the size of the consumer devices which carry that IP is about $1 trillion. Take royalties, for example. A simple DSP sells for about $15-20, of which the royalty value may be just 5-10 per cent. Which is why not many investors like this model. "If you want to create a Rs 1,000-crore company in a hurry, then the IP model is not the right model. It will take some time to get there," says Rajam.

But while the size of the IP business is much smaller than that of the products market, the technology investment in the business remains the same. Both IP and product firms invest the same way in R&D - predicting the road-map, filing for patents and investing for the future. Where it differs from the product business is that an IP firm does not have to invest in manufacturing, sales, marketing, and distribution.

The other issue in the IP business is predictability. Ittiam's business model depends on a combination of licensing fee and royalties. It takes 2-3 years to develop a solution that can be licensed. Royalties flow in after the products hit the market. Once the product goes out of the market, income from royalties stop. Then again, not every licence may result in income from royalty as some of the products may never go into mass production. In fact, Rajam says that in Ittiam's steady state, the income from royalty will be capped at one-third of revenue.

But even then Rajam feels that the model is good for India. "It allows you to leverage India's strength, which is India's intellectual capabilities. You work on creating new algorithms, designs and applications, and at the same time you avoid the logistical headache, which is supply chain, distribution, logistics and so on. The IP model values intellectual capital which a service model doesn't do full justice to. The IP model is attractive when you want to have an expert team which is small."

At this stage, Ittiam's numbers support Rajam's claims. He is aiming to close 2007 with a turnover of $25 million-30 million with 250-300 people. That means a per capita productivity of $100,000, which is double that of a typical IT service firm's.