IP insider: Your patents – is ignorance rational?

As the secondary market in patents continues to grow, the pratice of licensing a whole portfolio without valuing the majority of patents within it is making less and less sense

A decade ago, most technology companies had a single strategy for licensing their patent portfolio – to use their patents to secure broad licensing agreements with their competitors in which all patents were licensed for all business activities of each company.

When companies with thousands of patents struck such broad licensing deals, neither firm knew the value of each patent that it licensed to the other. Generally, a handful of patents were chosen by each side to convince the other that a licence was needed and to determine a balancing payment to compensate one side for any imbalance in relative portfolio strength and applicability. In other words, the parties chose to remain ignorant about the value of the vast majority of patents included in the licence.

This ignorance was rational. Those deals made sense then because they eliminated the risk of infringement for both companies and few alternatives existed for deriving value from patents in the technology industry. In almost all cases, the highest value to be extracted from licensing a technology company’s patents was the licence it resulted in for its competitor’s patents.

Fast forward to today: simple portfolio licensing is increasingly the exception rather than the norm. The emergence of a secondary market in which patents are bought and sold has vastly expanded the options available to a patent holder seeking to extract value from its patents. It is no longer rational to be ignorant.

As the options have increased, so too has the complexity of managing a patent portfolio. For example, a patent holder must now consider whether a patent is more valuable in its own portfolio or in someone else’s; whether the income and risk avoidance achieved by retaining and licensing the patent outweigh the value realised by selling it. A potential buyer will base its purchase price on the income and risk avoidance value to it from owning the patent. The value of ownership will be different for buyer and seller, and the patent should end up with the party which will derive the higher value from ownership.

In this way, the secondary market can change the dynamics between the negotiating parties. For example, a company may opt to purchase patents from a third party as a means of levelling the playing field when confronted by a licensor with a superior portfolio. A company must consider whether the cost of purchasing patents infringed by the licensor is offset by the reduction in licensing fees, as well as the residual value which comes from owning the patents. Similarly, a licensor can now generate income by selling off excess patents. In most cases, a licensee will not accord additional value to a licence to infringed patents past a certain threshold. For example, a patent owner which has 40 patents for which it can demonstrate infringement by another party is unlikely to receive additional licence value for patents beyond an initial sub-set of those 40 patents which cover that party’s product revenue. This is partly because of a custom in the technology industry of capping licences at a modest percentage of licensee revenue – usually 5%. It is also a byproduct of the licence versus fight decision-making process. If a licensor attempts to extract additional incremental value for every patent licensed with no cap, the cost in many instances will reach and exceed the point at which the licensee will simply refuse the licence, choosing instead to litigate. Beyond this rational ignorance threshold, an owner can sell patents without reducing the value it will receive from the other party.

This balancing act has changed the licensing practices of many patent holders. When evaluating sale value, the seller must understand that the amount that a buyer will pay for a patent often depends on whether and to whom it is licensed – particularly whether it is licensed to a buyer’s competitors. This can lead to changes in the use of patents that increasingly have made the broad cross-licences of the past the exception rather than the rule.

We have witnessed major changes in the way that technology industry patents are being used in licensing and sale situations. The secondary market has made it less rational to ignore the value of individual patents included in licensing deals. A new type of multi-dimensional analysis is needed to manage patent portfolios and optimise the value of patents. This is much more complex than the simpler patent management models that prevailed just a decade ago in the era of the broad patent cross-licence.

Since the purpose of the patent system is to encourage innovation, it is important to evaluate whether the system continues to serve its fundamental objective. The evolution of patent licensing from a model in which a high degree of ignorance of patent value was justified to one in which the value of all patents must be considered coincides with the increasing recognition of the economic importance of patents as carriers of innovation value and the increased centrality of innovation in our economy. It is a sign of a coherent evolution in the treatment of patents in an economy increasingly based on innovation.

So while it brings increased complexity, we believe that more rational knowledge is good for innovation. Rational knowledge of the secondary market for patents is no different from rational knowledge of the secondary markets for other forms of property, such as real estate and automobiles and other valuable assets – enabling them to move sensibly to their point of highest economically efficient use in a specialised world.

David Kappos is a partner at Cravath, Swaine & Moore, New York, and is the former director of the US Patent and Trademark Office. Richard Ludwin and Marc Ehrlich are associate general counsel at IBM, New York

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