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It can be a rough ride, but backing the right patent company can bring rewards. James Crux reports

Patents, and the companies that own them, are perhaps the bluest of blue-sky investments, which is why private punters find them so alluring.

The promises and plans of patent companies are easy to understand. They aim to raise significant sums of money, develop, test and prove their technology, and then lie back and watch the revenues roll in as larger companies license the technology.

A degree of security is woven into the fabric of the promise. Because the companies have patent protection (for a set number of years), they have control over who can use it, when it is used, and for how much.

Unfortunately, investors get so dazzled by the utopian dream of unlimited future profits that concerns about valuations and the likelihood of success are rarely addressed. As Numis Security's Julian Tolley explains: 'With these intellectual property licensing businesses, investors are trying to judge a valuation on the company's future business... [but] every one of them comes to market with an over-optimistic business plan.'

After a patent company's flotation, investors often see their funds spent at an alarming rate. Meanwhile, progress in the form of news flow can be frustratingly pedestrian. 'Typically, there is a huge upfront cash-burn while these plays develop research facilities, but then things tend to calm down,' adds Tolley.

All of this suggests that if you are going to back patent companies (and there are some very exciting prospects around) you need to adopt a checklist before parting with your cash.

One of the most important things to do is question the price at which you will be investing, and why you are doing so. 'You've really got to make a valuation call as to why the market would adopt [a company's] technology,' says Tolley.

Examining the business plan is another must. Smaller companies 'need to have a viable route to market, and need to find a niche position in that market'. This is because larger companies with greater resources could develop rival technologies.

Lastly, investors should prepare themselves for the long-winded licensing process, as licences over patents are a big commitment even for large players. Torotrak finance director Rebecca Joyce explains: 'It's a main board decision every time, and there could be six months between a contract being ready to sign and the actual signing.'

Corac – turbo charged

Aim-listed Corac, which specialises in compressor technology, raised £10 million last July. Its 'no oil' turbo compressor technology is also used in gas seal and a Shell-sponsored research and development programme for the down-hole gas extraction industry. Its no oil technology prevents oil contamination and has massive potential. Corac chairman Gerry Musgrave says: 'We're going after the niche pharmaceutical, food, beverages and gas market, which is worth between £1 billion and £2 billion a year and growing at 10 per cent per annum.'

Corac's 'down-hole gas compression' project could extend the life of gas wells by three to five years. As such, it could become part of a fast-growing world market for compressors worth in excess of £24 billion a year.

Last year, the company signed a joint development deal with Weir. It also struck a research and development deal with Shell in September, and claims negotiations are ongoing with a second oil company.

At 26.5p a share, Corac is valued at just £19.7 million. The company reported that it had £11.5 million of cash in the bank at its December year-end. Encouragingly, the board claims to have reduced its cash burn from £150,000 to £30,000 a month. It looks an interesting punt.

Pursuit Dynamics – ahead of schedule

Pursuit Dynamics is the owner of the patent to the pursuit marine drive – a marine propulsion system with advantages over existing offerings. With no submerged rotating parts, it is more environmentally friendly and cheaper to run and maintain than equivalent marine engines.

At a recent AGM, chief executive John Heathcote claimed the company had removed a 'major element of risk in the commercialisation process'. These forward strides were accomplished within the budget and the schedule announced by the board at flotation in May 2001, when the firm raised £4.2 million (before costs).

'Cash burn is between £100,000 and £110,000 a month,' explains Heathcote, 'and we have £1.6 million of net cash left.

'We're well ahead of where we said we'd be, though we're very much at the testing stage, and will be for some time.'

Heathcote hopes to enter into discussions with joint venture development and licensing partners by the end of the year. The initial target market is worth $6.5 billion (£4.5 million) a year, he says.

Investors can get their hands on the shares for 36p, giving the business a market cap of £13.7 million.

Oystertec – a nice fit

High-profile Aim stock Oystertec has a patent to a pipefitting product that recently won an award for the 'invention with the most commercial potential'. In short, the 'Oystertec concept' is that the pipe grips the fitting rather than the fitting adhers to the pipe. This makes it cheaper and easier to install, with applications in the plumbing, automotive and hydraulic markets.

Last November, Oystertec acquired the largest pipefitting business in Europe in the form of IBP. Then this March it bought leading hydraulic pipefitting manufacturer Europower. Both deals have provided its products with routes to market.

In the year to December, the company lost £11.3 million after accounting for a charge relating to the restructuring of IBP. For 2002, analyst Paul Compton of Collins Stewart expects a £700,000 pre-tax profit, with £12.7 million to follow in 2003 and £18.8 million pencilled in for 2004. With the shares changing hands for 33p, the company is trading on a racy 165 times forecast 2002 earnings. But this is forecast to drop dramatically to seven for 2003. With much potential, it remains a firm buy.

Transense technologies – concept stock

Transense Technologies is yet another interesting engineering concept stock listed on Aim. Shares in the automotive sensor developer soared recently on its fourth licence agreement with Honeywell, a leading manufacturer of pressure sensors. Transense will receive a licence fee and royalty on each package sold that incorporates its technology. Last year the world's largest tyre manufacturer, Michelin, signed an exclusive licence with the company for embedding sensors in tyres.

With the Honeywell deal, volume sales production should begin in the final quarter of this year. Although cash has yet to flow in, Transense has secured details with major companies to manufacture its products under licence – at no cost to itself.

The company lost £918,000 in the year to December, but its cash resources were strengthened after placing £2 million shares with an institutional shareholder.

Torotrak – closing in

Gearbox developer Torotrak has produced an 'infinitely variable transmission' (IVT) gearbox that should enable car manufacturers to save fuel. It hopes to generate royalty income from both tier one suppliers and car manufacturers.

The techMARK-listed play raised £50 million in July 1998 and has £21 million of cash left. Torotrak's Joyce says last year's £6 million cash burn will be cut to £4 million or £5 million this year. She is confident the company will not have to return to the market for extra funds.

Chief executive Maurice Martin boasts: 'Volume production, and resulting royalty income, remain a question of when, not if. Ford, General Motors and BMW are all convinced of the need for IVT, and we are now closing the supply side of the loop.'