Patent Cliff: What It Means, How It Works

What Is a Patent Cliff?

A patent cliff is a colloquialism to denote the potential sharp decline in revenues upon patent expiry of one or more leading products of a firm. A patent cliff is when a firm's revenues could "fall off a cliff" when one or more established products go off-patent, since these products can be replicated and sold at much cheaper prices by competitors.

While it is applicable to any industry, in recent years the term "patent cliff" has come to be associated almost exclusively with the pharmaceutical industry.

Understanding Patent Cliffs

Currently, the term of a new patent in the U.S. is 20 years from the date on which the application for the patent was filed in the United States. Many other factors, however, can affect the actual duration of a patent.

Patent cliffs are the associated drops in revenue that can come when a firm sees a key product's patent expire. When this happens, a competing firm can bring substitutes for the product to the market more cheaply and easily, which takes market share from the original product. Developing a drug is a costly and time-consuming process, with sizeable research and development (R&D) expense.

Getting a drug approved is also an expensive and lengthy process with various clinical trials required to prove that the drug is safe. In recent years, costs have decreased due to advances in biotechnology and genomics. Additionally, for every drug that makes it to the market, a number of drugs never make it out of the lab or end up not being approved by the Food and Drug Administration (FDA).

The exclusivity of the drug allows pharmaceutical companies to recoup losses from failed drugs. Profit margins may seem impressive for a single brand-name drug, but it is much less impressive given that it subsidizes the cost of research and failed drugs. Once exclusivity ends, generic drug companies are allowed to produce the same drug, sold under a different brand name. The cost of a generic drug is significantly less for the consumer and the pharmacy. For both parties, generic drugs costs can be as much as 80% to 85% less than the name brand.

The world's biggest pharmaceutical firms, such as Pfizer (PFE) and GlaxoSmithKline (GSK), thus stand to lose billions of dollars in revenues and profits from the patent expiration on such blockbuster drugs as cholesterol drug Lipitor and asthma medication Advair respectively.

Patent Cliffs and Competition from Generics

Numerous firms have established profitable businesses by manufacturing generic alternatives to off-patent drugs, which can be sold at a fraction of the price of branded drugs. The "patent cliff" threat has spurred increasing consolidation in the pharmaceutical industry, as companies strive to replace blockbuster drugs whose patents are expiring with other drugs that have the potential to become big sellers.

Generic drug manufacturers have no significant research departments to subsidize. Instead, they simply have to copy the compounds used to manufacture the drug. The compounds are made public due to FDA regulations. Due to far lower research and development expenses, as well as a significantly lower burden for approval, the profit margins for generic drugs are higher despite significantly lower prices.