Introduction
Recently, a friend of mine published a paper modeling PCT applications as “real options.”1 Patents are classic examples of “real options,” and I was reminded of a paper of mine in which I model patents as “an option to sue.” Understanding this modeling strategy provides a helpful framework for understanding certain aspects of patent valuation under uncertainty.
Background
A financial option on an underlying asset (say, a share of stock) gives the option holder the right to buy (a call option) or sell (a put option) the asset at a pre-defined price (the strike price). The mathematics for pricing options was developed by Black and Scholes years ago. Options have value when the underlying asset price is stochastic (random). Further, the option has more value when it is in the money. For example, a call option is in the money when the current share price is above the strike price, because the option holder can recognize an instantaneous gain. However, when the share price is well below the strike price, the right to buy the stock at the (higher) strike price is virtually worthless.
Financial options are useful for hedging risks. However, economists have long exploited option-pricing mechanics for pricing “real options”: any asset with the characteristics of financial options. As far back as 1986, Ariel Pakes modeled a patent as an option to renew the patent right by paying maintenance fees. Other researchers have modeled patents as the option to develop related products or to license the technology. A patent application can be thought of as an option to pursue patent protection (or to drop it in favor of trade secret protection for which publication is not mandatory). I have modeled patents as an option to sue.
The Option to Sue
Any legal scholar will tell you that the only real right embedded in a patent is the “right to exclude” others from using the technology. However, as I point out in my paper, because enforcement is imperfect and costly the right to exclude becomes the right to sue with some probability of success. As with financial options, the option to sue need not be exercised for it to have value.
In today’s patent litigation environment, infringement plaintiffs anticipate validity defenses, the success of which means invalidation of the patent right. That is, patent enforcement is risky because the patent holder risks losing the patent outright. The resulting opportunity cost of litigation is especially high if the patent holder is in parallel negotiation with several potential licensees.
In the paper I model the patent as a portfolio consisting of two assets: (1) an asset that pays a stochastic profit flow, representing current or expected royalties, and (2) an option to go to court, where the legal question is that of validity. The option to go to court can be thought of as a put option; that is, the patent holder has the right to “sell” the current profit flow in exchange for the probabilistic court-imposed outcome—a reasonable royalty (if the patent holder wins) or nothing (if the patent is ruled invalid).2 Part of the appeal of this model is that it explicitly recognizes that patent holders will tolerate a certain amount of infringement (or underpayment) before exercising their option to sue. In the paper, I describe the contexts under which patent holders will tolerate more or less infringement. In the language of financial options, how deep in the money does the option need to be before it should be exercised?
Enforceability and Uncertain Property Rights
A central theme in this paper is that policymakers should explicitly recognize the role of enforcement in patent value. At the administrative level, some amount of legal uncertainty is inevitable; however, it can be influenced by the patent examination quality at the PTO.3 Further, the results have implications for standard essential patents, where non-exclusive licensing is commonplace.
Regarding appropriation, the paper demonstrates that patent value stems not simply from breadth and length, but rather breadth, length, and strength. Legal uncertainty is especially pervasive in emerging technology areas, and especially in emerging patenting areas like biotechnology in the 1980s and 1990s, software in the 1990s, business methods in the 2000s, and AI patenting more recently. In new patenting areas, patent value will evolve over time as the courts and the PTO define clearer standards. Occasionally, major court cases may introduce more uncertainty.4 The degree of uncertainty over validity will drive litigation rates.
While understanding the mathematics behind option pricing may be challenging, practitioners can benefit from the intuition that it brings to patent valuation and management.
For more information, please contact Dr. Alan Marco at +1 312 327 8040 or [email protected].
1 More on this paper in an upcoming post.
2 Because the patent holder currently owns the asset on which it owns the put, it is in a “covered position.” With financial options, one can exercise a put option from a “short position,” i.e., selling something you do not own.
3 See my previous posts on patent quality: https://oceantomo.com/insights/understanding-patent-value-patent-quality/
4 See my previous post on the Alice decision: https://oceantomo.com/insights/the-alice-decision-and-uncertainty-in-ip/
