Valuing Patents and the "Patent Paradox": Why Do Companies Patent Anyways?

Dennis Crouch over at Patently-O brought up this interesting question the other day regarding patent valuation: "Would you or your clients be willing to invest time and/or money in developing a new innovation that had only a small chance of reaping huge rewards if you knew that the expected (and most likely) return would less than your original investment? "

The question is based upon the premise that patents have essentially become "lottery tickets," where patentees file scores of arguably negligible patents on the infinitesimal hope that a few of them will have an extremely high payoff.

It is a valid question that plays into the modern phenomenon referred to as the "patent paradox": if patents on inventions have little or no expected economic value, why do individuals and commercial corporations patent so heavily? Or, if patents are valuable after all, where does their value lie?

Professors Gideon Parchomovsky and R. Polk Wagner at the University of Pennsylvania published an excellent paper titled "Patent Portfolios" which addresses this very issue. Empirical studies analyzing the value of patents suggest that the average value of an issued patent is surprisingly small. In fact, the vast majority of U.S. patents spend more time collecting dust than revenue for their respective owners. According to a previous study by Mark Lemley, the total number of patents litigated or licensed for a royalty (as opposed to a cross-license) is on the order of five percent of issued patents. Worse yet, data about renewal rates reveal that nearly half of U.S. patents are abandoned before the 10 year mark, and two thirds will lapse before the full 20 year statutory term.

From an economic standpoint, a 1986 study of over 1 million European patents conducted by economics professor Ariel Pakes concluded that, on average, 50 percent of patents in France, Germany, and the U.K. are worth less than $2,189, and that 90 percent of the patents have a value of less than $25,000. A similar study conducted in 1998 by Mark Schankerman echoes Pakes’ findings. Using renewal data, Schankerman estimated the mean patent value at $4,313 for pharmaceutical patents, $4,969 for chemical patents, $15,120 for mechanical patents and $19,837 for electronics patents.

Hence the paradox - if these numbers are so bleak, why has patenting continued to increase dramatically year after year? A number of legal scholars and economists have previously provided some theories for this behavior:

The Lottery Theory of Patents (F.M. Scherer) - "spectacular prizes will be awarded to a small number of winners . . . but you can't win if you don't play!" Although the metaphor has some merit, there are some obvious limitations. Unlike lotteries, which are completely random, the inventive process is knowledge based, where the level of knowledge in the art plays a key role in determining the likelihood for success. Also, success in patenting isn't a binary proposition - "losing ticket" patents can prove valuable when combined with other patents or technologies. Moreover, even corporations that have not captured any lucrative patents may nevertheless benefit from the research they conducted as it puts them in a better position to compete for other inventions.

The Defensive Patenting Theory - the flipside of the lottery ticket theory - while the lottery ticket theory views patents as high-risk investments, the defensive patenting theory views them as a type of insurance. The value of patents under this theory lies in a protective "nuclear option" as the subject matter of potential litigation.

Patents as Internal Metrics (R. Levine) - Recognizing that patents are a relatively ineffective means for capturing value, economist Richard Levine, alone and together with others, has suggested that patents may serve important intra-firm purposes; specifically, that patents might be used to measure employee productivity. In the context of R&D, it is virtually impossible to directly measure employee effort, and the only quantifiable parameter is results. A natural way to approximate successful results is to look at patent filings. Therefore, patents are valuable insofar as they serve as a metric for evaluating employee productivity.

Professors Parchomovsky and Wagner address these and other theories in their paper and find that each theory, by itself, provides an incomplete answer to the patent paradox. In fact, the professors found that viewing individual patents for determining "value" was not the best approach. Rather, when one looked to the portfolio, instead of the individual patents, real value could be identified:

The fundamental argument here is that the real value of patents lies not in their individual significance, but instead in their aggregation into a patent portfolio—a strategic collection of distinct-but-related individual patents that, when combined, confer an array of important advantages upon the portfolio holder. We find that the benefits of patent portfolios are substantial enough to encourage patenting behavior irrespective of the expected value of the underlying individual patents themselves; the marginal expected gain in value of adding an additional patent to a well-crafted
patent portfolio will almost invariably exceed the marginal costs of acquisition. We argue that this theory provides the best explanation yet for modern patenting trends, which show a propensity for firms to patent even where the net expected value of obtaining the individual patent is likely to be zero (or even less). Under the patent portfolio theory, such decision-making is rational because individual patents are required inputs for the construction and maintenance of a patent portfolio. That is, in the modern patenting environment, the prosecution of an individual patent is best understood as a means to the commercially-desirable end of a patent portfolio, rather than the end itself.

The paper goes on to provide some case studies of the portfolio theory of patents (Qualcomm, IBM, Gemstar), and illustrates how a collection of closely-related patents defining a patent portfolio can operate much like a ‘superpatent’:

[i]n much the same way that the holding of a U.S. patent grants the right to exclude others from within the scope of its claims, the holding of a patent portfolio will allow the holder to exclude others from the collective scope of its claims. Where such patents are both (patentably) distinct yet cover coterminous subject matter, the breadth of the right to exclude conferred by a patent portfolio is essentially the sum of the individual patent rights. But the scale advantages of patent portfolios are more than merely additive. The broader protection conferred by patent portfolios offers a range of benefits to the holder different in kind as well as size from a simple collection of unrelated individual patents.

This is a highly-recommended article for corporate counsel looking to understand the various approaches to patenting strategies, or for any person looking to make sense of modern-day patenting practice.

Of course, there are numerous patentees, both big and small, that occasionally "go for broke" on a few patent filings, but this is a perfectly rational approach when taken in the context of an established (or emerging) patent portfolio. To the extent possible, portfolios should be something more than an exclusive collection of mere incrementally-improving patents . . .