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Why Protect IP? An Economic Approach – Part 2

Posted by Nicole Liotine | Apr 14, 2014 | 0 Comments

By Daniel P. Custodio – 

In Part 1 of this series, I discussed a qualitative assessment of various costs involved in pursuing patent protections, including government expenses and patent agent/attorney fees.  I also highlighted certain risks as well as potential strategic and tactical benefits that may result from obtaining a valid and effective patent.

But the questions remain: beyond a qualitative discussion, can a quantitative, economic assessment be made?  Can the cost of filing a patent application be justified economically?  Can an “apples-to-apples” comparison be made of the tradeoffs between costs and ROI?

While specific outcomes can never be guaranteed, it is nevertheless helpful to frame options in quantitative, economic terms.  In this Part 2, I illustrate several scenarios with examples of costs that may arise when obtaining a patent, and examples of costs or benefits of outcomes that may result when pursuing patent rights.  In these scenarios, I explore example outcomes and associated values by assuming various probabilities of successfully prevailing in the various cases.  Finally, I convert those calculated values into net present cash or net present values (NPV) to give an apples-to-apples comparison.

By these illustrations and the resultant NPV comparisons, I suggest how this type of analysis may be useful in framing considerations in economic terms.

Costs and Foundational Assumptions

As I mentioned in Part 1 of this series, obtaining an effective and valid patent is a necessary first step.  Without such a patent, it would be impossible to pursue strategic or tactical actions to protect the associated intellectual property rights (IPR).  Figure 1 suggests a hierarchy of foundational levels: the opportunities at the top of the pyramid would not exist without first establishing the foundational levels at the bottom.

      Figure 1.  Foundational Hierarchy of Protecting IP Rights

Two of the three scenarios below assume that a party obtains a patent.  In the third scenario, the party does not have a patent.

Accordingly, in the first two scenarios the party incurs costs by obtaining the patent.  The costs to obtain a patent progress over the course of 2.5 to 3 years and are not all expended upfront.  (www.uspto.gov)  In the example shown in Figure 2, I assume that the US Patent and Trademark Office (USPTO) costs of filing would be $1,610 over three years until the patent's issuance.  Further, as part of maintaining the patent rights, the first maintenance fee to the USPTO would cost $800 upon the third anniversary of the patent's issuance.  (www.uspto.gov fee schedule as of  1/1/14)

Figure 2.  Estimated USPTO Government Fees (Example Only)

Over the same time period, costs also accrue to pay a patent agent or attorney to prepare, file and prosecute the patent through interaction with the USPTO.  In the example shown in Figure 3, I assume that attorneys' fees to prepare, file, prosecute and maintain the patent would be $13,350.  (AIPLA Report of the Economic Survey 2013)

Figure 3.  Estimated Attorneys' Fees (Example Only)

In the scenarios below, the patent-holder polices its IPR by monitoring its competitors' products and services and identifying possible infringing conduct against its patents.

In the case where the patent-holder finds infringing conduct, the patent-holder may first seek to engage this competitor with a letter.  Such letters often initiate a process of dialogue and negotiation between the parties, which may lead to a negotiated license agreement.  The value of such a license may be determined by considering a number of factors explained in the “Georgia-Pacific Corp vs U.S. Plywood Corp” case, including prior license royalty rates obtained by the patent-holder, the commercial relationship between the parties, a hypothetically negotiated royalty rate that the parties might have reached, and other factors.  In this discussion, I do not talk further about these factors or the determination of a reasonable royalty rate from them.

Further, the parties may negotiate such license terms via discussions or mediation or arbitration proceedings.  Here, I do not discuss any factors associated with such activities.

If the competitor refuses to discuss or negotiate, the patent-holder may choose to enforce its patent by suing the competitor.  Correspondingly, the patent-holder may ask a court to enjoin the competitor's allegedly infringing conduct and/or seek damages arising from it.

In the scenarios below, I assume that the attorneys' fees through the end of trial would be $2.1M for a case valued between $1M and $10M.  (AIPLA 2013 Report of the Economic Survey @ 2013 Intellectual Property Insurance Services Corporation)  Similar to patent costs, a party would incur these fees over time.  In these scenarios, I assume the duration of time would be a trial lasting three years.

I consider that only money damages are sought and no other claims or counterclaims are involved (with one exception in Scenario 1).  I do not discuss how to determine the expected value of the case but instead simply assume the value of alleged money damages is $5M (the mid-point in the above category reported in AIPLA 2013 Report of the Economic Survey @ 2013 Intellectual Property Insurance Services Corporation).

I make two additional assumptions.  First, a highly “effective and valid” or “strong” patent is one where validity and infringement are easily proven; hence, the more effective a patent, the higher the probability of prevailing in a dispute.  Second, the longer a dispute progresses into subsequent stages, the greater the accrual of costs.  The corollary is that the earlier a dispute is resolved, the larger the avoidance of costs.  I do not discuss how to determine the “effectiveness and validity” of a patent.  Suffice it to say that it would involve construing the patent claims and comparing each aspect of them against each feature of the accused infringing product (as an example).

Illustrative Scenarios

In the scenarios that follow, the first scenario describes a patent-holder who owns a “strong” patent and seeks to enforce its IP rights against a competitor who allegedly is copying the patent.  The second scenario describes a patent-holder who owns a “moderately effective” patent, and who is sued by a competitor who alleges the patent-holder is infringing the competitor's IP.  The third scenario describes a company who owns no patents, and who is sued by a competitor who alleges the company is infringing the competitor's IP.

Scenario 1: A patent-holder owns a “strong” patent and seeks to enforce its IP rights against a competitor who allegedly is copying the patent.

If a strong patent is considered to have a 90% probability of prevailing at the end of trial, and the case involves alleged money damages of $5M, then a nominal settlement value for damages may be calculated as (90% x $5M) + (10% x $0), giving $4.5M.  Therefore, if the plaintiff patent-holder believes its strong patent may have a 90% probability of prevailing, then the plaintiff patent-holder would set its settlement target value of no less than $4.5M paid by the defendant-competitor.

Moreover, if the court finds that willful infringement was involved, the court may also award attorneys' fees to the patent-holder.  As an example, if the facts are considered to have a 75% probability that the court would find willful infringement and award attorneys' fees, Figure 4 shows a nominal settlement value of the attorneys' fees award may be determined as (90% x 75% x $2.1M) + (90% x 25% x $0) + (10% x 0% x $2.1M) + (10% x 100% x $0), giving $1.42M.

Figure 4.  Expected Value Decision Tree

Therefore, if the plaintiff patent-holder believes its strong patent has a 90% probability of prevailing at the end of trial, and the facts are considered to have a 75% probability that the court would award attorneys' fees, the plaintiff patent-holder would set a total settlement target value of no less than ($4.5M + $1.42M) or $5.92M paid by the defendant-competitor.  (An additional consideration is the cost-avoidance of future attorneys' fees, e.g., $2.1M to each party, which may be an additional incentive to both parties to settle early.)

Outcome 1.1

As a first potential outcome in this scenario, the parties agree to the above settlement figure before initiating and incurring trial costs.  In this outcome, the net gain to the plaintiff patent-holder would be $5.92M (while avoiding $2.1M in potential attorneys' fees) and the net loss to defendant-competitor would be in the same amount.

Outcome 1.2

By way of comparison, a second potential outcome is the parties do not settle but instead take the case all the way through the end of trial.  In this outcome, each party would incur out-of-pocket attorneys' fees through trial (e.g., $2.1M).  At the end of trial, if the plaintiff patent-holder prevails (a 9-in-10 chance in this hypothetical) then it would receive the damage award sought (e.g., $5M).  If the court finds willful infringement by the defendant-competitor, the plaintiff patent-holder may also receive an award of attorneys' fees at the end of trial (e.g., $2.1M).  In this outcome, the total award would be $7.1M.  In this example, at the end of trial the net gain to the prevailing plaintiff patent-holder would be $5M (comprehending the reimbursed attorneys' fees) and the net loss to the defendant-competitor would be $9.2M.

Outcome 1.3

By way of further comparison, a third potential outcome is the plaintiff patent-holder loses its case at trial (a 1-in-10 chance in this hypothetical).  In this outcome, there would be no judgment award.  At the end of trial, the plaintiff patent-holder would incur a net loss due to out-of-pocket attorneys' fees (e.g., $2.1M), and the defendant-competitor would incur the same net loss.

Scenario 2: A patent-holder owns a “moderately effective” patent and is sued by a competitor who alleges the patent-holder is infringing the competitor's IP.

In this scenario, a company is a patent-holder who owns a “moderately effective” patent that covers its technology.  This patent-holder becomes the defendant in a patent infringement lawsuit initiated by a competitor who alleges copying of its own patent.  If a moderately effective patent is considered to provide the defendant patent-holder a 70% probability of successfully defending its conduct, then the plaintiff-competitor would have only a 30% probability of prevailing at the end of trial.

If the case involves alleged money damages of $5M, then a nominal settlement value for damages may be calculated as (30% x $5M) + (70% x $0), giving $1.5M.  Therefore, if the defendant patent-holder believes the plaintiff-competitor may prevail only with a 30% probability at the end of trial, then the defendant patent-holder would set a settlement target value of no more than $1.5M paid to the plaintiff-competitor.  (An additional consideration is the cost-avoidance of future attorneys' fees, e.g., $2.1M to each party, which may be an additional incentive to both parties to settle early.)

Outcome 2.1

As a first potential outcome in this scenario, the parties agree to the above settlement figure before initiating and incurring trial costs.  In this outcome, the net loss to the defendant patent-holder would be $1.5M (while avoiding $2.1M in potential attorneys' fees) and the net gain to the plaintiff-competitor would be in the same amount.

Outcome 2.2

By way of comparison, a second potential outcome is the parties do not settle but instead take the case all the way through trial.  In this outcome, each party would incur out-of-pocket attorneys' fees through the end of trial (e.g., $2.1M).  At the end of trial, if the plaintiff-competitor prevails (a 3-in-10 chance in this hypothetical), then the defendant patent-holder would pay to the plaintiff-competitor the damage award sought (e.g., $5M).  In this example, at the end of trial the net gain to the prevailing plaintiff-competitor would be $2.9M (comprehending the out-of-pocket attorneys' fees) and the net loss to the defendant patent-holder would be $7.1M.

Outcome 2.3

By way of further comparison, a third potential outcome is the defendant patent-holder prevails at trial with a finding of no infringement (a 7-in-10 chance in this hypothetical).  In this outcome, there would be no judgment award and the net loss at the end of trial to each party would be the out-of-pocket attorneys' fees (e.g., $2.1M).

Scenario 3:  A company owns no patents and is sued by a competitor who alleges the company is infringing the competitor's IP.

In this scenario, a company becomes the defendant in an infringement lawsuit initiated by a competitor who alleges copying of its patent.  Assuming the defendant-company does not have any defensive patents, its defenses would depend mainly on the facts of the case and on the strength and validity of the plaintiff-competitor's patent.

In this scenario, the plaintiff-competitor owns a “moderately effective” patent that is considered to provide an 80% probability of prevailing at the end of trial.  Correspondingly, from the defendant-company's perspective it would have a somewhat long-shot of successfully defending the case with a 20% probability of prevailing in its defense.

If the case involves alleged money damages of $5M, then a nominal settlement value for damages may be calculated as (80% x $5M) + (20% x $0), giving $4M.  Therefore, if the defendant-company believes the plaintiff-competitor may prevail at the end of trial with an 80% probability, then the defendant-company would set a settlement target value of no more than $4M paid to the plaintiff-competitor.  (An additional consideration is the cost-avoidance of future attorneys' fees, e.g., $2.1M to each party, which may be an additional incentive to both parties to settle early.)

Outcome 3.1

As a first potential outcome in this scenario, the parties agree to the above settlement figure before initiating and incurring trial costs.  In this outcome, the net loss to the defendant-company would be $4M (while avoiding $2.1M in potential attorneys' fees) and the net gain to the plaintiff-competitor would be in the same amount.

Outcome 3.2

By way of comparison, a second potential outcome is the parties do not settle but instead take the case all the way through trial.  In this outcome, each party would incur out-of-pocket attorneys' fees through trial (e.g., $2.1M).  At the end of trial, if the plaintiff-competitor prevails (an 8-in-10 chance in this hypothetical), then it would receive the damage award sought (e.g., $5M) paid by the defendant-company.  In this example, at the end of trial the net gain to the prevailing plaintiff-competitor would be $2.9M (comprehending the out-of-pocket attorneys' fees) and the net loss to the defendant-company would be $7.1M.

Outcome 3.3

By way of further comparison, a third potential outcome is the defendant-company prevails at trial with a finding of no infringement (a 2-in-10 chance in this hypothetical).  In this outcome, there would be no judgment award and the net loss at the end of trial to each party would be the out-of-pocket attorneys' fees (e.g., $2.1M).

Comparison of NPVs

As noted, the costs and values of the various outcomes described above occur over time.  These costs and values may be converted into NPVs for a better direct comparison.

The NPV calculations that follow apply a 4% annual rate of return and ignore any potential rate of inflation.

As discussed above, a patent is assumed to take three years before the USPTO makes its final determination with USPTO costs of $1,610.  Additionally, the 1st maintenance payment would become due after the 3rd year following issuance of the patent with a USPTO cost of $800.  As shown in Figure 5, the NPV for these costs is $2.22k.

Figure 5.  NPV of Patent USPTO Expenses (Example only)

As discussed above, the attorneys' fees are assumed to accrue over three years with a cost of $13,350.  As shown in Figure 6, the NPV for attorneys' fees is $13.1K.

Figure 6.  NPV of Patent Lawyers' Fees (Example only)

Taken together, the total NPV for the USPTO costs plus attorneys' fees is $15.3K.

The tiered approach for pursuing defensive and offensive strategies for protecting IP, as discussed above, also would progress over time.  A letter may be sent immediately; arbitration or mediation may occur over the course of months or a year; patent litigation may last several years.  Following the scenarios discussed above, the NPV calculations for judgment awards assume that damage awards (if any) would be awarded at the end of a trial lasting three years.

NPV comparison of Scenario 1

If the parties take the dispute through the end of trial, each party is assumed to incur $2.1M over three years.  Figure 7 shows the NPV of $2.1M over three years is $2.04M.

Figure 7.  NPV of Patent Litigation Attorneys' Fees (Example only)

In Scenario 1, an NPV of a settlement value may be calculated for the alleged damages (e.g., $5M) multiplied by the 90% probability factor assumed in Scenario 1.  As shown in Figure 8, the NPV of $5M after three years is $4.62M, giving the NPV of the settlement value as (90% x $4.62M) + (10% x $0), or $4.16M.

Figure 8.  NPV of Patent Litigation Damages Award (Example only)

In Scenario 1, if attorneys' fees are also awarded to the plaintiff patent-holder at the end of trial, Figure 9 shows the NPV of $2.1M after three years is $1.94M, giving the NPV for attorneys' fees as (90% x 75% x $1.94M) + (90% x 25% x $0) + (10% x 0% x $1.94) + (10% x 100% x $0), or $1.31M.

Figure 9.  NPV of Award of Patent Litigation Attorneys' Fees (Example only)

In Scenario 1, the NPV for the settlement value for both damages and attorneys' fees is $5.47M.

Since this Scenario assumes that a patent has been obtained, the NPV for the patent-cost of $15.3K applies.  (And as noted, the NPV for any engagement costs expended for a letter or arbitration / mediation would also be considered.)

Therefore, using NPVs, the ROI comparison for Outcome 1.1 is a net gain to the plaintiff patent-holder of $5.47M (while avoiding $2.04M in potential attorneys' fees) on an investment of $15.3K.  The ROI comparison for Outcome 1.2 (a 9-in-10 chance) is a net gain to the plaintiff patent-holder of ($4.62M – $2.04M + $1.94M) or $4.52M (assuming a finding of willful infringement and reimbursement of attorneys' fees) on an investment of $15.3K.  The ROI comparison for Outcome 1.3 (a 1-in-10 chance) is a net loss to the plaintiff patent-holder of $2.04M in attorneys' fees on an investment of $15.3K.

NPV comparison of Scenario 2

In Scenario 2, an NPV of a settlement value may be calculated for the alleged damages (e.g., $5M) multiplied by the 30% probability factor assumed in Scenario 2.  The NPV of the settlement value is (30% x $4.62M) + (70% x $0), or $1.39M.

Since Scenario 2 assumes that a patent has been obtained, the NPV of the patent-cost of $15.3K applies.  (And as noted, the NPV for any engagement costs expended for a letter or arbitration / mediation would also be considered.)

Therefore, using NPVs, the ROI comparison for Outcome 2.1 is a net loss to the defendant patent-holder of $1.39M (while avoiding $2.04M in potential attorneys' fees) on an investment of $15.3K.  The ROI comparison for Outcome 2.2 (a 3-in-10 chance) is a net loss to the defendant patent-holder of ($4.62M + $2.04M) or $6.66M on an investment of $15.3K.  The ROI comparison for Outcome 2.3 (a 7-in-10 chance) is a net loss to the defendant patent-holder of $2.04M in attorneys' fees on an investment of $15.3K.

NPV comparison of Scenario 3

An NPV of the settlement value for Scenario 3 may be calculated for the alleged damages (e.g., $5M) multiplied by the 80% probability factor assumed in Scenario 3.  The NPV of the settlement value for damages is (80% x $4.62M) + (20% x $0), or $3.7M.

Therefore, using NPVs, the ROI comparison for Outcome 3.1 is a net loss to the defendant-company of $3.7M (while avoiding $2.04M in potential attorneys' fees) on an investment of $0.  The ROI comparison for Outcome 3.2 (an 8-in-10 chance) is a net loss to the defendant-company of ($4.62M + $2.04M) or $6.66M on an investment of $0.  The ROI comparison for Outcome 3.3 (a 2-in-10 chance) is a net loss to the defendant-company of $2.04M in attorneys' fees on an investment of $0.

Summary Table of Comparisons

The chart in Figure 10 below summarizes the comparison of NPVs for the various scenarios and outcomes above.  While it may be intuitively obvious that a patent-holder who owns a strong patent is better positioned than one who owns a moderately effective patent (or no patent at all), the table below directly compares NPV numbers from the scenarios and potential outcomes.

Scenario NPV of Investment NPV of Potential Return   in Settlement Scenario NPV of Potential Return   in Prevailing Scenario NPV of Potential Loss   in Losing Scenario
1 – Plaintiff Patent-holder sues Defendant Competitor Patent-cost NPV = $15.3K P Patent-holder receives net settlement of $5.47M (while cost-avoiding $2.04M) P Patent-holder wins case and net gain of $4.52M (9-in-10 chance and assuming   award of attorneys' fees) P Patent-holder loses case and net loss of $2.04M   (1-in-10 chance)
2 – Defendant Patent-holder sued by Plaintiff Competitor Patent-cost NPV = $15.3K D Patent-holder pays net settlement of $1.39M   (while cost-avoiding $2.04M) D Patent-holder successfully defends case and net loss of $2.04M   (7-in-10 chance) D Patent-holder loses case and net loss of $6.66M   (3-in-10 chance)
3 – Defendant Company sued by Plaintiff-Competitor $0 D Company pays net settlement of $3.7M (while cost-avoiding $2.04M) D Company successfully defends case and net loss of $2.04M   (2-in-10 chance) D Company loses case and net loss of $6.66M (8-in-10 chance)

Figure 10.  Summary Table

Conclusion

In the above discussion, I posed several hypothetical scenarios to frame different situations that a new business or startup company may face when creating and exploiting new IP.

After selecting illustrative scenarios, I defined and applied various assumptions to formulate potential outcomes.  Although I made many simplifying assumptions, these methods may frame models to calculate and compare potential costs and outcomes occurring over time.

I used the assumptions and outcomes to determine corresponding cost or benefit values that may occur over time.  I converted those values occurring over time into net present cash or net present values (NPVs).

By comparing the resultant NPVs, I was able to compare the potential costs and outcomes determined in the various scenarios in a time-independent and apples-to-apples manner.

I hope the above methods permit a quantitative, economic assessment that is helpful in answering whether a (potential) ROI justifies the costs of pursuing a patent.

IMPORTANT NOTE: This blog posting is based on my opinions formed by past and present business and legal experience.  DISCLAIMER: These blog postings are not meant to constitute legal advice.  Results and outcomes depend on a variety of factors unique to each matter.  Results and outcomes do not guarantee or predict a similar result in any future matter.

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