Technological Forecasting & Social Change 79 (2012) 180185

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Technological Forecasting & Social Change

FROM MY PERSPECTIVE

The patent paradox New insights through decision support using

compound options
David H. Goldenberg a, Jonathan D. Linton b,
a
b

Lally School of Management and Technology, Rensselaer Polytechnic Institute, Troy, NY, United States
Power Corp Professor for the Management of Technological Enterprises, Telfer School of Management, University of Ottawa, Ottawa, ON, Canada

a r t i c l e

i n f o

Article history:
Received 13 April 2011
Received in revised form 19 July 2011
Accepted 13 August 2011
Available online 28 September 2011
Keywords:
Real options
Decision support
Patents
Intellectual property
Policy

a b s t r a c t
By considering the patent from the perspective of a compound option it is possible to offer useful insights into what a patent does, when it is worth patenting, and the effects of changes to
patent regulation and enforcement in terms of maximizing economic and societal benefits. A
paradox exists because stronger patent laws with longer durations allow greater profit to
the inventor, but strong and long patent protection discourages related innovation as the protection for the underlying technology becomes broader and duration is longer. Through the
demonstration that under current regulation the net present value of a sample patentable invention must be a little over half a million dollars ($556,000) at the time of patent filing, insight is offered into when it is economically advisable to patent. The effect of changes to
patent regulation can also be rapidly assessed using this technique. Consequently, the compound option provides value to policy makers for decision support in assessing the impact of
changes to patent policy and to inventors and patent attorneys on assessing whether it is economically rational to patent.
2011 Elsevier Inc. All rights reserved.

1. Introduction: what do patents really offer the patent owner?

Historically, patents protected against a loss in profits resulting from a breach of the patent. In high profile cases such as Polaroid's
Land Camera and the Black and Decker's Snake Light, the patent holder demonstrated that a loss in profits was a direct result of patent
violation [1]. As a result, Black and Decker obtained settlements that in some cases involved an amount greater than the market price
of the competing products [2]. Polaroid was only able to claim for a loss of profit on the number of additional cameras that they could
have produced in their existing facilities, if Kodak had not entered the market while the patent was still in effect. New questions have
been raised about the role of patents due to patent trolls, for example in the case of Rim vs. NTP a large settlement was received by a
firm that owned a patent, but had no intention of offering product or services based on these patents [3].
This evolution in patent interpretation not only has implications for inventors and private laboratories, but also non-commercial
institutions that patent technology, with no intention of producing products based on the technology they patent. For example,
instead of a university or a federal laboratory licensing a patented technology to a third party, they may wait for the third party to
make a profit and demand the payment they desire as there is no longer a requirement to demonstrate a loss of profit to receive
awards, the incentive to license technology is changed.
Thus the problem, if a patent gives too much protection the resulting monopoly transfers value to the holder at the expense of
the product producer and users discouraging production and use of new products [4,5]. Conversely in the absence of protection,

Corresponding author at: Telfer School of Management, DMS 6108, University of Ottawa, 55 Laurier Avenue East, Ottawa, ON K1N 6E5, Canada.
E-mail address: [email protected] (J.D. Linton).
0040-1625/$ see front matter 2011 Elsevier Inc. All rights reserved.
doi:10.1016/j.techfore.2011.08.017

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181

innovation and invention are discouraged. Thus the policy makers' task is to identify the ideal balance to encourage innovation.
Increasingly, there are concerns that the legal system is not working as intended [6,7] and is actually discouraging the innovation
it intends to encourage [810].
Past studies suggest that the use of patents is limited outside of the pharmaceutical and chemical industries [11]. While more
recent studies [9,10] suggest that other industries such as semiconductors and automotive utilize patents, it is clear that patents are used selectively by certain industries and not by others. This suggests that our current approach to patent regulation
maybe overly appealing for a small number of industries and associated firms, while being inappropriate for innovation occurring
in many other industries. A starting point for better understanding this balance is to determine under what circumstances patents
are valuable. While the literature has identified an increasing number of reasons for patenting [10], the primary reason remains
the protection of profitability of an invention through the right to exclude others from producing a product and collecting damages if the patent is infringed [10]. Consequently, we focus on determining the value of an invention, that is its current market
value, to make it worthwhile protecting at the time of patenting.
2. Valuation of patents
By determining the value that a patent must have to be worthwhile, we gain insight into whether the patentable invention
under consideration should be patented. Past techniques for valuing patents focused on a variety of different approaches, including: Rules of thumb royalty rates based on gross revenue [12,13]; Cost Approach based on the investment required to develop
technology that could offer or replace the patented property [14,15]; Income Approach the profit that is a result of the patent
[14,15]; and Options approach [4,16,17]. We propose the use of a real options approach and add to the existing literature by offering a compound option as a more appropriate representation of how a patent functions. The analogy of a compound option as a
patent is offered. Thus is followed by a sample calculation to assist in determining what intellectual property must be worth currently to warrant patent protection at the time of patenting.
The source of a patent's value is that it provides an option for the holder to sue in case of an identifiable breach of the patent.
Given that the firm decides to exercise the option to sue, the firm then obtains another option to pursue collection of the payments associated with the awarded suit if the payments are worth more than the cost of collection. This two-step process an
option on an option makes the patent a two-step compound option on the present value of the cash flows associated with collecting the awards of an infringement suit. That is, the first option is to sue the patent infringer and the subsequent option is to pursue
collection of awards from the infringer. Consequently, Geske's [18] compound option pricing model (1) has been applied to obtain
insights into valuing patents (see Appendix A).
When a firm purchases a patent, the intent is to protect the cash flows associated with the potential markets protected by the patent.
This is accomplished as the patent allows the holder to sue potential infringers of the patent, during the time that the patent is in effect.
Suing infringers is the option purchased by the patent. There are other possibilities available to the firm, like charging a licensing fee to
the infringer. Suing does not guarantee the firm that it will recover lost cash flows, because the firm has to win the suit and to collect
the award from the infringer. If the firm wins the suit, there is the cost of collecting damages and the possibility that damages will
be uncollectable. Thus the patent is an option to sue, which in turn is an option to collect cash flows associated to winning the
legal suit. Hence, there are three decisions related to a patent: (1) Whether to patent intellectual property, (2) Whether to sue in
case of infringement, and (3) Whether to attempt to collect lost cash flows if the patent holder wins the suit.
If the patent holder wins an infringement suit, it may not be worthwhile paying the fees associated with collecting the award.
In other words, the option to sue must first be in-the-money in order to economically justify suing. And if the legal suit is won,
the collection option must also be in-the-money in order to justify the associated expenditure. For example, if the infringing
company is bankrupt or declares bankruptcy, an award is not worth collecting as the expected collection cash flows (damages)
are less than the present value of the legal fees required in order to effectively collect.
The two-step compound option pricing model is useful as it describes and quantifies the essential features of a patent. Having demonstrated how a two-step compound option has the same properties as a patent, its operationalization is considered. As mentioned
earlier in this paper, the collection of damages in cases of infringement is the primary reason given for seeking patent protection
[10]. The compound option approach captures the value associated with the primary reason for patent protection, but does not
assess the value associated with other benefits that a patent may offer. These other reasons include: formation of defensive Intellectual
Property (IP) blockades [9,10,19,20,22,23], formation of offensive IP blockades [9,21,22], firm reputation [10,21,22], market extension
[1921,23], internal performance indicator [10,1922], exchange potential [9,10,1923], licensing potential [1923], and in
response to the practice of other firms [9,23]. In order to determine, whether an invention that is not worth patenting based on the
primary reason for infringement protection is still worthwhile patenting an assessment should be made on the probable value of
these additional benefits.
3. Data requirements for calculation of the patent value as a compound option
To calculate a two-step compound option pricing model one requires:
1. t: the current time (date)
2. St: Stock price at time t
3. : Volatility of the stock price return underlying the compound option

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4.
5.
6.
7.
8.
9.

D.H. Goldenberg, J.D. Linton / Technological Forecasting & Social Change 79 (2012) 180185

1: the time at which the first option can be first exercised

:Total time to maturity
r: continuously compounded annual interest rate
K1 Exercise price at time 1 the exercise date of the first option contained in the compound option.
K: Exercise price at maturity
C: the cost of the option in this case the costs associated to filing and maintaining the patent.
For the purpose of application, variables 1 through 9 are now reinterpreted in the context of a patent.

1. t variable 1 is the current date defined as the time at which the patent is purchased.
2. St variable 2 is calculated in this application of the compound option pricing model the current market value of the patent.
3. variable 3 the dynamics of changes in the underlying stock price. This is the volatility of percentage changes in the present
value of the collection cash flows. As required by the compound option model it is assumed to be constant over the life of the
compound option.
4. 1 variable 4 is the duration of the patent's life. In our illustration, we assume that the patent holder waits until the patent
expires before filing legal suit against all infringers, that is to exercise the option to sue.
5. variable 5 is the amount of time from patent initiation to the point in time from which damages can be collected. This includes the time for the legal suit to be decided and assumes that the legal suit will be successful.
6. r variable 6 is the continuously compounded annual interest rate. This parameter is a discount rate appearing in all rational
option pricing models.
7. K1 variable 7 is the first exercise price representing the cost of exercising the option to file a legal offered by the patent. This
exercise price represents the value at the time of initiating a legal suit all the legal fees over the life of the suit. One exercises
the suit option by filing a legal suit against infringers and contracting to pay the legal fees. In summary, K1 is defined here as the
present value when time 1 has elapsed of the legal fees associated with the suit but exclusive of collection fees.
8. K variable 8 is analogous to variable 7, K is the present value of the legal fees required to collect damages, assuming that the
legal suit succeeds and damages are awarded.
9. C - variable 9 is the cost of the option. In this case the costs associated to filing and maintaining the patent.
4. Operationalizing the patent as a compound option and comparison to practice
Reasonable numerical values for variables 1 through 9 for filing a patent and pursuing a legal suit when the patent is infringed
are:
1. patent initiation date
2. to be calculated
3. The volatility of an industry/market can act as a proxy for the primary industry covered by the patent. can be increased or
lowered to better reflect the earnings volatility associated with the patent.
4. 15 years
5. 20 years
6. 5% is a reasonable proxy for the risk free rate. This can be adjusted to better match the specific patent period under consideration.
7. $5,000,000
8. $10,000
9. $10,000 appears to be a reasonable estimate for the cost of a patent. Of course costs can be lower in the case of an individual
completing the required documents or higher in the case of some corporate filings of patents.
Using these parameters, and assuming a of 20% (the volatility of the S&P 500) we invert the model for the compound option.
That is we solve for the stock price (present value of the damages). However, we are effectively given the compound option price
in 2 (the estimated patent cost). Therefore, we solve the model for the implied stock price, a stock price that is consistent with the
input parameters and the given patent price. This implied stock price represents what the present value of potential damages
must be today in order to economically justify spending $10,000 on a patent (given the other parameters). For these parameters
the implied stock price is $555, 520.That is, unless one expects to collect damages, equal in present value terms to $555, 520 it is
economically irrational to spend $10,000 on the patent. Thinking in terms of multipliers, based on the assumptions used, the present value of damages must be 55.55 times the patent's cost to justify purchasing the patent!
Of course the multiplier just offered reflects a specific situation. The cost of the patent will vary depending on: the country (or countries) in which the patent is registered [24], whether the inventor is a small or large entity, and the number of
claims and complexity of the patent [25,26]. The volatility will vary depending on the volatility of the underlying asset; the
likelihood of collecting the anticipated cash flows which is a function of the anticipated court settlement (prior to initiating
suit) and likelihood of collection of all or part of the award (prior to initiating collection proceedings). The difficulty of determining at the time of initiating the patent process: whether a breach of patent will occur, the magnitude of the loss suffered by the patent holder resulting from the breach, the willingness of the party(ies) involved in the breach to settle, the
cost of pursuing the suit in court, the cost of collection, and the final fraction of the settlement that is collectible complicates

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183

apriori calculations. These factors involve potential differences in stock price, exercise prices, volatility and time periods used
in the compound pricing option model.
When valuing a patent it is critical to consider whether in fact patent protection is currently warranted based on its protective value
[9,10], other options such as trade secrets [27,28] may be more appropriate, and the criticality and benefits of other reasons for patenting
need to be assessed such as: formation of defensive IP blockades, formation of offensive IP blockades, firm reputation, market extension,
exchange potential, and licensing potential [9,10,1923]. Patent value is uncertain ex-ante. After the fact, it is apparent that out of any
portfolio of patents only a few patents are actually used. Many firms allow patents to expire long before the end of the patent's life,
by failing to pay the renewal or maintenance fees. By patenting more than is needed one avoids trying to decide apriori, which patents
will become valuable. Firms may patent as much as possible for a variety of reasons [9,10,1923]. Being faced with a list of factors
that increase the complexity of patent valuation and the decision of whether to patent or not, the insights offered by the
compound option into the required value of an invention to justify a patent is of even greater value.
If it is decided that patenting is undesirable, one must still assess the effect of someone else patenting the invention. In such as
case, it is worth taking appropriate action to avoid later questions regarding who has ownership rights. Two common ways of
addressing this concern is: (1) patenting for the purpose of demonstrating who the inventor is or (2) donating the knowledge
to the public domain through appropriate means of disclosure.
5. Conclusions
While this note does not provide an answer to whether or not policy underlying the patent system is optimal, being able to
calculate the implied value of a patent under the current system and alternate systems, one is able to align policy with the desired
quantity of protection offered by a patent. This allows for an enhanced ability to ensure that the patent system supports innovation. It also supports the development of patent policies that are more sophisticated than the current one size fits all system. Software for calculating the minimum current value of a patent to make it worthwhile protecting under different conditions is
available at: ETIM.uottawa.ca bhttp://ETIM.uottawa.ca/N. Through the use of this routine, it is possible to make the calculations
that provided the proposed current market value of $556,000 as a threshold for patenting. Through the use of this routine it is
possible to calculate the threshold value for patenting given different sets of assumptions.
Acknowledgements
Thanks to the Canadian Social Science and Humanities Research Council (SSHRC) for providing funding to support this research.
Appendix A Input Variables
The program will accept the following input variables:
St
T
t1

r
K
K1

Stock price at time t

Total time to maturity
Intermediate time
Volatility
Interest rate
Exercise price at maturity (T)
Call price at intermediate time (t1)

Calculations
, that corresponds to the intermediate call price, K1. The BlackUsing the Black-Scholes Call equation, find the stock price, St1
Scholes Call price is
C S; E; t SN d1 Ee

rt

Nd2

where



2
logS=E r =2 t
p
d1
p t
d2 d1 t
Using an iterative, root-finding technique, look for a stock price that solves the following equation.



C S t1 ; K; Tt1 K1 0

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D.H. Goldenberg, J.D. Linton / Technological Forecasting & Social Change 79 (2012) 180185

, computed above.
Then, compute these other variables. Note that q depends on the price, St1
Tt
1 t1 t





log St =S t1 r 2 =2 1
q
p

1

logSt =K r 2 =2
p
h

Finally, find the compound option price.




p
p
p p

N q; h; 1 = K1 e 1 Nq
Ct St N q 1 ; h 1 ; 1 = Ke
where the cumulative bivariate normal probability is
2

1
1 x 2xy y
p exp
Na; b;
2 12
2
12
a

!
dx dy

and the cumulative normal distribution is

1
z
x2 =2dx
Nz p e
2
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David H. Goldenberg is on the faculty of the Lally School of Management, Rensselaer Polytechnic Institute. His research explores derivatives markets and mathematical nance. Many of his articles have been featured in the top-tier nance journals including the Journal of Financial Economics, the Journal of Financial and
Quantitative Analysis, Management Science, the Journal of Financial Research, Financial Review, and the Journal of Futures Markets.

Jonathan D. Linton is the Power Corporation Professor for the Management of Technological Enterprises at the Telfer School of Management, University of Ottawa.
His research focuses on operational concerns associated with emerging technologies and close loop supply chains. His research articles have appeared in Journal of
Operations Management, Journal of Product Innovation Management, Nature Materials, Technological Forecasting and Social Change and in a number of other refereed
publications and books. Dr. Linton is the Editor-in-Chief of Technovation and on the Editorial Board of IEEE Transactions on Engineering Management and Technological
Forecasting and Social Change. Prior to joining academe, he spent a number of years working as an employee of and consultant to a number of rms in technology intensive industries.