Broken Symmetry

Who owns that patent? Has it been licensed?

Non-specialists may be surprised to learn that the answers to these basis questions in many instances remain indeterminate. Susan L. Glovsky provides an excellent post on PatentlyO on the subject:

The time has come to enact national legislation that provides clear record title to patent applications and patents. The value of patents is too great to continue with the present system. Moreover, patents are a federal right and should be addressed at a federal level. A national system would harmonize U.S. law with those of other countries, which generally have a national system for recordation of patent rights. Recently, the Patent Office proposed rules that would require disclosure of any assignee of patent rights. But these rules simply do not go far enough. Legislation is necessary in order to provide a comprehensive internationally recognized system that assures the recordation of patent title, security interests, and other encumbrances through filings solely in the Patent Office.

See also Patent Reform through the Creation of Economic Facts. A few years ago, I suggested here that an econometric analysis of patented features that focused on frequency-averaged measures of sales and manufacturing might be useful as a mechanism for valuing patents. That is way too complicated to be workable right now at least. But with reliable information about ownership and prior licensing of a portfolio available, comparable-based patent valuations would become more feasible for the many market participants who do not come with their own private database of such information.

Patent Reform through the Creation of Economic Facts

This piece by Hernando de Soto on the "Destruction of Economic Facts" caught my eye not long ago:

During the second half of the 19th century, the world's biggest economies endured a series of brutal recessions. At the time, most forms of reliable economic knowledge were organized within feudal, patrimonial, and tribal relationships. If you wanted to know who owned land or owed a debt, it was a fact recorded locally—and most likely shielded from outsiders. At the same time, the world was expanding. Travel between cities and countries became more common and global trade increased. The result was a huge rift between the old, fragmented social order and the needs of a rising, globalizing market economy.

To prevent the breakdown of industrial and commercial progress, hundreds of creative reformers concluded that the world needed a shared set of facts. Knowledge had to be gathered, organized, standardized, recorded, continually updated, and easily accessible—so that all players in the world's widening markets could, in the words of France's free-banking champion Charles Coquelin, "pick up the thousands of filaments that businesses are creating between themselves."

The result was the invention of the first massive "public memory systems" to record and classify—in rule-bound, certified, and publicly accessible registries, titles, balance sheets, and statements of account—all the relevant knowledge available, whether intangible (stocks, commercial paper, deeds, ledgers, contracts, patents, companies, and promissory notes), or tangible (land, buildings, boats, machines, etc.). Knowing who owned and owed, and fixing that information in public records, made it possible for investors to infer value, take risks, and track results. The final product was a revolutionary form of knowledge: "economic facts."

The patent system is an example of one of these "public memory systems," which has facilitated transactions in intangible (exclulsionary) rights.

The focus of de Soto's attention is on the financial services industry, and in particular on how innovation in financial services has destabilized and undermined the consistence of public memory systems. On his view, this is a root cause of our ongoing recession:

Over the past 20 years, Americans and Europeans have quietly gone about destroying these facts. The very systems that could have provided markets and governments with the means to understand the global financial crisis—and to prevent another one—are being eroded. Governments have allowed shadow markets to develop and reach a size beyond comprehension. Mortgages have been granted and recorded with such inattention that homeowners and banks often don't know and can't prove who owns their homes. In a few short decades the West undercut 150 years of legal reforms that made the global economy possible.

Go ahead and click through to read the whole piece. His is profound insight. Note one earlier link on BS to a similarly thought provoking piece by de Soto.

What about the patent system? Has the patent system undergone a similar destruction of economic facts over the last twenty years?

Not really. More the opposite seems to be true, in fact. At least since the Federal Circuit was established, and especially lately since patent office records worldwide are now available online, the patent system has never functioned more effectively.

And yet, even with all of these improvements, it seems to me that the patent system has not yet been able to provide enough "economic facts" for the market to transition from litigation to transactional norms in handling the allocation and reallocation of patent rights. In effect, there has been no destruction of economic facts within the patent system because the patent system never created economic facts to begin with.

The production of "economic facts" in the sense that de Soto describes should be the ultimate goal of any patent reform. We have seen many incremental and even discontinuous leaps in that direction over the past few decades. But we are not there yet.

Problems with ascertaining title and encumbrances on title are foundational to any economic facts about patents. The systems for handling these economic facts with respect to real property and even copyright are more highly developed than they are for patents, even though title goes to the very root of how patents are valued now because problems with standing can result in zero returns to enforcement.

All of the issues that have been addressed lately, including Therasense yesterday, will help move us incrementally closer to a world in which patent rights transact without litigation. But a focus on the creation and maintenance of a "public memory system" -- a source of "economic facts" about patent valuation -- will get us there quicker.

At the end of the day, valuing patent portfolios is not more complex than the valuation of collateralized debt obligations, currency derivatives, or interest rate swaps. The difference is that those intangibles have (or at least had) a foundation of "economic facts" to facilitate transactions.

A $900 Million Question of Federal Common Law?

Google today announced that it was selected to serve as the stalking horse in the bankruptcy auction of Nortel's patent portfolio. Its stated purpose:

we hope this portfolio will not only create a disincentive for others to sue Google, but also help us, our partners and the open source community—which is integrally involved in projects like Android and Chrome—continue to innovate. In the absence of meaningful reform, we believe it's the best long-term solution for Google, our users and our partners

Not insignificant to this logic, and hence to Google's $900 million bid, is the question of whether any patent licenses to Nortel would be assignable to Google if Google is successful in its bid. (Note: the value of such licenses would be considered separately from the value of any patents owned by Nortel.) Does Google's $900 million expressly include the assignment of licenses to Nortel?

Even if the parties' agreement says yes, the answer is non-trivial. The authority on the question of whether and when non-exclusive licenses should be assignable is split, and even the authority on what authority should apply to the question of whether and when non-exclusive licenses should be assignable is split!

To wit, the Ninth Circuit has ruled that federal common law applies to the question of whether licenses are assignable. See in re CFLC, Inc. v. Everex Sys., Inc.. By contrast, California state courts have applied California law. See Superbrace v. Tidwell and Dopplmaier.

What law applies is kind of, um, important. The Ninth Circuit avoided the transfer of patent licenses to a buyer in bankruptcy after ruling that federal common law applied. If California law had applied, the transfer would have been completed.

Nortel filed for bankruptcy in federal court in Delaware. Have Delaware courts or the Third Circuit ruled on this question? Not yet.

I guess we'll have to see how Nortel's licensors feel about having Google as a licensee before we find out whether the Delaware Bankruptcy Court agrees with the Ninth Circuit on this point of law.

In a pure accident of fate, the Supreme Court is right now in Stanford v. Roche considering how the Federal Circuit's application of federal common law to a question of contract interpretation should be decided. Interestingly, not every Judge on the Federal Circuit agrees that there should be federal common law, or at least that state law should be preempted, on these issues. I wonder whether those judges would change their minds if they took also the federal system of bankruptcy law into consideration.

Tech Transfer "Professional"?

I wish I could say that the author means the whole thing tongue in cheek, but he appears to actually mean it:

It is super easy to spot the overtly "bad" academic inventors: no funding, no data, surly disposition, body odor, etc. Even a brand new technology commercialization professional can spot these jokers their first week on the job.

The overtly bad inventor is also great because no one blames you for not working with him/her. Their chairperson things that he/she is a mediocre scientist --- a true "hiring mistake" --- and wishes they would go away. And, you don't have to worry about them complaining to the upper university administration because they hate the guy/gal too.

...

Even though you won't have any creative control, you should protect their idea because (a) it is a good idea and (b) a technology commercialization person has never lost their job for patenting inventions from well-regarded faculty members who publish is great journals.

One could not fabricate a better piece of evidence that we are wrongly managing the disclosures, patenting, and marketing of university technology. Supreme Court, are you listening?

Inflation and Commercial Research and Development

Guess when these words were written:

The Democrats may or may not be less concerned with a balanced federal budget than the Republicans.... [T]he responsible Republican leadership has said again and again that if business should really turn down they would not hesitate to lower taxes or make whatever deficit-producing moves were necessary to restore prosperity and eliminate unemployment....

Even if this change in policy had not become generally accepted, certain other changes have occurred that would produce much the same results, though possibly not so quickly.... [Historically], much of the federal revenue came from customs duties and similar excise sources. These fluctuated moderately with the level of prosperity but as a whole were fairly stable. Today, in contrast, 80 per cent of the federal revenue comes from corporate and personal income taxes. This means that any sharp decline in the general level of business causes a corresponding decline in revenue.

Meanwhile, various devices such as farm price supports and unemployment compensation have been imbedded in the laws. At just the time that a business decline would be greatly reducing the federal government's income, expenditures in these fields made mandatory by legislation would cause governmental expenses to mount sharply. Add to this the definite intention of reversing any unfavorable business trend by cutting taxes, building more public works, and lending money to various hard-pressed business groups, and it becomes increasingly plain that if a real depression were to occur the federal deficit would easily run at a rate of...

How do you measure innovation without reference to patents?

Or to put the question differently, how should patents be valued if not by the cost of litigation?

This is the question posed today by venerable Silicon Valley sage Tim O'Reilly:

It seems to me that there ought to be a way to measure the introduction of new products, and rank them by novelty and by widespread acceptance, in some way that reflects a more substantial measure of innovation and its impact on the economy.

There is no single right answer to this question. For earlier ruminations, see Reigniting the Engine of Growth, which was cross-posted to PatentlyO (where some of the comments were very good). But the best answers will share at least this in common: Simplicity

Complex rules are too easy to game. To discourage fraud and bad behavior, rules have to be simple (not just valuation rules, by the way, this is true for any rules).

But innovation is complex. Doesn't that preclude any simple measure? Yes and no. Yes in that any measure will be an approximation. This is true for any complex phenomenon, however. That doesn't stop us from measuring temperature, humidity, barometric pressure, and then forecasting the weather. Weather forecasts are not perfect, but at certain times and in certain places they are useful. Why else would we bother? The small talk alone is not sufficient.

The ultimate answer must be that there are ways to measure innovation. Indeed, everything that for-profit organizations do is complex, even putting aside innovation. Yet we have a highly developed set of rules we follow and measurements we take in tracking the performance of these for-profit organizations. They're called accounting rules and financial statements.

Some people think that you can go even one more step removed and look at the public market price of for-profit organizations, compare that against the number of patents pending or issued, and make predictions about how a company's stock price will move in response to the number of patents. That may work in a few isolated cases, but in general public stock prices are driven up and down by too many other influences. If you stick with the financial statements, you're only increasing your signal to noise ratio

To recap what is obvious for anybody exposed to accounting but unfamiliar to the rest, financial statements include (1) a snapshot in time of the assets, liabilities, and equity of a company (this is called the balance because it has to balance assets with liabilities and equity) and (2) a time-averaged summary of revenues and expenses (this is the income statement, or just P&L for "Profits and Losses"). Actually most also include a cash-flow statement, but we can ignore that for purposes of explaining how innovation might be measured. The cash-flow statement is there so that people can figure out how much of the revenue and expenses were "accounting adjustments," which smear revenue and expenses out over time, rather than actual cash changing hands.

So how can a financial statement give you insight into how innovative a company is? The answer is that whenever a company makes an actual improvement (whether or not that improvement is patented!) in a product or process for making a product, that actual improvement will be reflected in its stream of revenues and expenses.

For example, say PayPal introduces a new feature on April 1. Before April 1, PayPal was spending $0.30 per customer to generate $0.50 in revenue per customer. After April 1, PayPal spends $0.25 per customer and generates the same $0.50 in revenue. The value of the feature is $0.05 per customer. In this example, the PayPal increased its profit margin. That's the most obvious way that innovations add value to companies, and it's the one that most people think of, but it's not the only one!

In some cases, the company may not actually have lower costs or be able to charge higher prices as the result of an innovation. Yet the company may still be more profitable as the result of the innovation. This seems to be the more common case for most incremental innovations, which in fact are the majority of those patented in my experience.

Some of you are scratching your heads, wondering: "How can a company be more profitable if it doesn't charge higher prices or pay less in costs?" The answer is turnover. Consider Company X, which sells 10 widgets a day for $100 after paying $60 to make each them. Total profit per day = 10 x ($100 - $60) = $400.

Now consider Company Y, which sells 100 widgets a day for $100 after paying $60 to make each of them. Total profit per day = 100 ($100 - $60) = $4000.

What's the difference between these companies? Turnover rate. Company Y is selling widgets for the same price at the same cost much faster than Company X. You might think this is easy to do, but in fact it is very difficult.

Now of course if Company X and Company Y have otherwise identical accounting entries, the difference in turnover rates will show up as a difference in earnings on the next financial statement. And if the differential in turnover is sustainable over many accounting periods, it will almost certainly show up as increased earnings.

The problem that readers of public financial statements have in backing out these inventory turnover rates is that many products (both old and new) are combined into a single earnings figure. Moreover, adjusting entries often washout the signal reflected in increased (or decreased!) inventory turnover rates. In practice, at least retail investors have to do a little extra research to figure out whether inventory turnover ratios are increasing or decreasing for particular products, and by how much.

So there you have it, Tim. That's my suggestion for a simple way to measure the value of innovation: Read it off the time-series of revenue and expenses. If you can convince the SEC to get public companies to report this info, we will all be indebted to you.

Not coincidentally, inventory turnover ratios are also the number one way Warren Buffett identifies for companies to raise the return on equity.

Thanks to Paul Kedrosky for the link.

Myhrvold on Invention Capital

From HBR:

Outside the pharmaceutical and biotech industries, few companies consider inventing, or producing patented intellectual property, to be their primary mission. Corporate R&D has become mostly “D”: the development of products. Hardly any large corporations have “inventing” as a job category—even though it requires a different mind-set, has different goals, and must be managed differently than research and development positions. At universities and government agencies that fund academic research, patents typically don’t enter into tenure or grant decisions. Published research is rewarded, but invention usually is not. Indeed, these organizations primarily fund blue-sky programs aimed at expanding scientific knowledge. That’s a worthy thing to do. But it’s quite different from invention, which applies scientific knowledge in novel ways to create something useful, something that has economic value.

Via Zura. I have more to say about Menand's arguments in The Marketplace of Ideas, Myhrvold's "invention capital," and Kauffman's proposal for "free agents." But I'm buried in "discovery" -- a classic legal misnomer.

What is Wrong With Technology Transfer Office Culture?

Jon Sandelin from Stanford University's Office of Technology Licensing published an article in the Summer 2009 issue of an AUTM journal called University-Industry Relationships: Potential Risks. Perhaps unsurprisingly, the article is gated and available only to members. Already in the title you can see where Sandelin comes out on the idea of having more commercial ties with universities. One of the messages repeated on this blog over the past year has been that feedback loops promote innovation. The feedback loops between universities and industry are perhaps the most difficult to forge and maintain of any in our innovation pipeline. We should be promoting these feedback loops aggressively. Unfortunately, the tentative, preening, and antiseptic tone of this article is all too characteristic of tech transfer culture inside top-tier research universities.

Sandelin does a good job listing some of the benefits of tech transfer. But consider the "summary of risks" he comes up with:

1. That patenting and licensing by universities may inhibit rather than promote the progress of science and production of innovation
2. Of a loss of public trust in the university and/or its employees
3. Of unfulfilled commitments to research sponsors, students, or the university
4. Of bias when reporting research results or not reporting research findings that would be adverse to the interests of an industry patron
5. Of exploiting the work of students to benefit personal interests of their supervising professor
6. Of adverse and embarrassing reports in the media, whether actual or perceived, that affect the reputation of the university
7. That new discoveries made by university employees are not reported to the university or to a federal funding agency as invention disclosures, but are instead diverted to a company in which the employee has a financial interest

That's it. Wait. That's it?! Of these, only 4 is what I would consider an actual risk to the university. Look at the other six items on this list more carefully. What is really there?

First off, what on earth can he mean by one? If one is true, then why are we even bothering? The tech transfer experiment has been a wild success. As economist Kenneth Arrow noted recently, some of the best work results when academics are asked to work on a problem they've never thought about before. Tech transfer relationships work because universities get data from industry that is as valuable to academics as the theory that industry gets from universities.

Two just shows how little conviction Mr. Sandelin has in the fact that he is doing something important and beneficial for the university and its employees. Why would these people not trust the university if it is doing things that benefit society at large by cooperating and collaborating with private companies? Does he believe making money is inherently evil? If so, why not come right out and say that instead?

Three strikes me as very strange. Isn't the possibility of unfulfilled commitments to research sponsors a risk for the research sponsors? How is that a risk for the university? Similarly, why would students see more industry relationships as a risk? Students need jobs after they graduate, and somebody has to provide work.

Five would be hilarious if it weren't sad because it demonstrates how big a problem negotiating ownership rights is when it isn't done properly upfront. Universities love to ask graduate students to sign a thick contract when they start that gives away all of their rights. Most grad students, of course, never read the fine print and only find out how badly they've been taken advantage of later when somebody makes millions on their blood, sweat, and tears.

Six also makes me wonder. That's not a risk of relationships with industry. That's a risk of dysfunctional relationships with industry. Why would that be a problem for a university like Stanford, I wonder?

So of these seven risks, it is only four, the risk of bias caused by taking money from a particular group, that strikes me as very serious. But that risk is a risk for any institution, public or private, for-profit or not-for-profit. There's nothing really more difficult or challenging about solving that problem at a university. In fact, it's probably easier to solve that problem at universities, where most academics prize their professional reputations far above any particular grant money. Let the researchers themselves be the ones to decide whether it's worth risking their reputation on taking funding from some large corporation. Then just make sure that everybody can lookup and find out from whom researchers are getting their support. That's how we do things in this country.

It's very frustrating to see how backwards the thinking is at what is considered one of the best technology transfer offices in the world.

Excellent Sentences from Joff Wild at IAM

However, how do you measure value when IP can be so frustratingly intangible - what price that collaborative relationship with a competitor that a piece of IP may enable, for example? One at least partial solution to this conundrum may be to make royalty rates far more transparent. One suggestion was that all licensing deals agreed in the US should be publicly recorded at the USPTO so that people could see the sums involved. This would have to be compulsory as no-one would do it voluntarily.

From the IAM Blog.

Highlights from the 2009 IP Business Congress

Monday and Tuesday of this week I attended the second annual IP Business Congress, which this year was venued at the Four Seasons Hotel in Chicago. There were almost 400 attendees at the event, which was a good turnout given the economic climate. Attendees represented stakeholders in nearly every part of the IP Market, both primary and secondary. As expected, the panels organized by IAM magazine were excellent and informative, especially the question and answer sessions afterward. This is an event that I expect to put on my calendar annually.

Highlights for me as an attendee to this event included (1) the first panel on Monday on the state of IP rights in China, India, Japan, Europe, and the United States; (2) the panel on patent pools on Monday afternoon; (3) the panel on open innovation on Monday afternoon; and (4) the Gala dinner on Monday night. Tuesday's panels were also excellent, but of less interest to me because of my more direct involvement with many of the issues addressed on Tuesday.

State of IP Rights Internationally

Harvey (expert on China) kicked things off by noting how IP rights had been a strong influence on the development of rule of law more generally in China: IP was the first private property right to be recognized by the Chinese government after the cultural revolution. Harvey also explained that in number of lawsuits, there is more IP litigation in China than in any other nation. The picture he painted was of a thriving IP system in China that was operating decoupled from the rest of the IP world. The coupling of China's IP system into the rest of the world's will produce winners and losers of epic proportion, and now is the time for us to think strategically about how to prepare our clients and customers for this inevitable merge of the Chinese system into the rest of the world.

McGinley (EPO Officer) followed Harvey with sobering statistics on the patent application bubble that is growing inside the US, EPO, and Japanese patent offices: 2 million applications althogether are now pending inside these offices. Given how the rate of examination has not kept up with the rate of growth in filing, McGinley suggested that the system was beginning to resemble a pyramid scheme! This was a brave position for a government official to take, but everybody in the system should appreciate what McGinley is trying to do. Where might we have been had more financial regulatory authorities here in the U.S. pointed out the pyramid-scheme-like growth of the subprime mortgage market? McGinley was short on answers as to how to solve the problem, but he did suggest that Chinese officials were probably at the top in terms of training practices and the reduction of systematic errors in examination. This seemed unsurprising to this listener given the on-the-ground experience of many Chinese with more complex manufacturing workflows!

The presenter from Japan had little of interest to say, and presented some confusing interpretations of statistics on patenting in Japan. For example, he pointed out that the largest number of patents issued in Japan were to computer companies rather than pharma companies. Pharma companies need only one well-drafted and prosecuted patent to protect their products. This is not very surprising, and is true everywhere in the world.

Basheer from India gave in many ways the most interesting presentation. His was mostly a diplomatic presentation of facts about the IP market in India, where the political agenda is driven by the success of generic drug manufacturers. As a few BS readers may know, Basheer is also one of the authors of the consistently excellent (but very detailed!) Spicy IP blog. From listening to Basheer, one could piece together a picture of India in a critical state, in which more or less IP protection could result from a sharp push in either direction. Too difficult to call for the time being. On my view, it seems that Indian biotech and pharma researchers have a regulatory arbitrage over their U.S. counterparts, who have many years of redtape to cut through before carrying out even relatively safe clinical trials! Note that beating heart transplants are now being carried out in Indian hospitals. There are many high-risk, high-reward medical treatments now avaiable in India that may never be available in the United States. Another trend to watch carefully.

The first question/comment for this panel was also notable. It came from Sherry Knowles of GSK, who noted that Chinese generic manufacturers were getting drugs to market before US manufacturers by simply scraping clinical data off the clinicaltrials.gov website on which U.S. manufacturers, such as GSK, have to post their data by law! There's one for the USTR to call to Chinese government attention.

Patent Pooling

The Monday afternoon panel on patent pools included Sisvel founder Dini, Hinman from Verizon, and Michel from the FTC. Dini gave a great pitch for hiring independent administrators (such as Sisvel) for allocating profits among patent pool participants, and for getting such admins involved at as early a stage as possible. Michel gave a presentation of the recent history of FTC regulation of patent pools, including a summary of the federal court holdings relating to Rambus's participation in JEDEC. Hinman talked about the perils of patent pool participation, and noted that even opt-out could be anti-competitive. Referring to one patent pool in particular, he pointed out that all but two industry participants had entered. I saw Michel scribbling notes!

The upshot is that if your company is involved with patent pools, you need to hire experienced outside counsel with knowledge at the interface of IP and Antitrust law to help ensure your business strategy reduces the risk of antitrust liability. Your author knows and works with a few such experts, and is happy to make an intro. Note that most corporate lawyers or IP lawyers will not be aware of the perils of competition law because the Bush and Clinton administrations were relatively lax on this front. All indications are that the Obama administration will be more active in enforcing competition law.

Open Innovation

By now the term "open innovation" has become relatively well-known within the business community. Some IP owners may believe that open innovation represents a form of socialism -- an alternative to a system of property rights. Attendance to this panel would have been the antidote to such misunderstandings of this theory. Panelists Weedman from P&G, Simonton from Exelixis, and Bergelt from the Open Innovation Network (and formerly of Paradox) talked about the dynamic growth that the feedback loops established by open innovation networks facilitate for the companies that take open innovation seriously.

Because the theory of open innovation is a paradigm shift from traditional neoclassical economic theories, only a handful of businesses (including P&G and Exelixis) have been fortunate enough to find leaders willing to foster the organizational commitments necessary to make open innovation work. This business model is the future of every large public corporation in the world. Watching these businesses continue to outgrow their competitors, others will eventually follow.

Gala Dinner

One of the best parts of the event was meeting the attendees. Over drinks before the Gala dinner, I had the chance to catch up with Niels Reimers, who later that evening was inducted into the IP Hall of Fame for his path-breaking work in technology transfer. In this rare moment of opportunity, I had the chance to ask Niels about how he worked at Stanford. By Niels's description, he was practicing the same technique followed by the best founders and managers in Silicon Valley both then and now -- "management by walking around." Dave Packard and Bill Hewlett, Bill Perry at ESL, and Nils at Stanford were all doing management by walking around. Niels's personal accounts of his work connecting Stanford music department (!) professor John Chowning with Hamamatsu corporation engineers were a highlight among highlights for this event.

Later, when Niels cited the Teece Model of innovation in his acceptance speech, I nearly fell out of my chair. The same model was cited by FTC Commissioner Tom Rosch in his speech about new theories in competition law on June 1, 2009. Note that Teece was also cited in the explanation of systems theory provided in your author's letter comment to the FTC on the Evolving IP Marketplace.

Final Thoughts

Another highlight made possible by my attendance to the event, but not directly related thereto, was an invitation to a breakfast with Congressman Bill Foster on Tuesday morning. I am already a fan. Foster is an entrepreneur and physicist who decided (after 22 years of building superconducting magnets to detect subatomic particles) to roll up his sleeves and try to help fix government. I'm pretty sure there's nobody else in Congress who would know what the title of this blog refers to. The discussion of the patent system and innovation at this breakfast was the best I've heard ever anywhere, but it also revealed to me the underlying problem facing patent reform: nobody has a complete view of the whole system. Almost everybody (at least) focuses on the broken incentives and procedures facing them in their subsystem, without stepping back to see how all of the subsystems coalesce into an competitive and innovative ecosystem. Nonetheless, the kinds of questions asked and answers given at this breakfast suggest that already the level of discourse has progressed far beyond the pat answers that were served up last year when patent reform was before Congress. There is more widespread awareness at least of how the public has been manipulated to some extent by the more technologically sophisticated and media-connected subset of stakeholders in the system. Perhaps we will have sensible patent reform after all. Here's to that hope.

2009 IP Business Congress and some Shameless Self-Promotion

Broken Symmetry readers may or may not realize that your author's day job involves patent procurement and enforcement. Your author was recently honored to have been named one of the World's Leading IP Strategists by Intellectual Asset Management magazine -- a peer nominated process mediated by IAM.

From June 21 through 23, I will be in Chicago for the 2009 IP Business Congress. IAM sets a standard of excellence for the industry, and this event promises to be no exception, with a list of industry luminaries speaking. If you've got the time, it'll be worth dropping in.

And if you are planning on attending, are a reader of Broken Symmetry, and are interested in meeting up, just click on the link on the left and email me. I always enjoy meeting readers.

Spring 2009 Ocean Tomo Auction: The Secondary Market Evolves

Although many of the attendees to the auction may have come away with the sense that the auction market is closed until the recession ends, a look at the numbers says otherwise. In particular, the total volume of sales at the auction was around $3 million -- considerably less than the immediately preceding auctions, but on par with the the first auctions held by Ocean Tomo about four years ago. For the auction market at least, it has been a lost half-decade rather than a lost decade as it has been for the equity markets.

I have some first-hand experience here. This was my second auction. The first I attended was in Chicago in October 2007. The impression I had there was the same that many who first attended yesterday probably came away with -- i.e., that this is a very thin market, with few bidders, and very specialized property for sale. For an investor, thin markets are a good thing, presenting the opportunity for arbitrage given the right connections and funding. From that perspective at least, things are looking better now than they did a few years ago. It was clear, for example, that some bidders who had been involved in 2007 were no longer around for this auction. There is no reason to believe, however, that there is less valuable IP available for sale.

On the other hand, it was obvious to me as somebody representing a seller that most sellers were ill-advised at this auction. Thanks to some careful pre-auction work, we (at Drinker Biddle & Reath) were able to close the sale for our client's lot. (Sorry, but due to client confidentiality rules I cannot say more.) Unfortunately, this was not the result for many of the sellers at the auction yesterday. In some of these cases, I could pick out from the description in the catalog some obvious problems that might have prevented bids from coming in. In others, it was clear to me as somebody who has worked at a VC fund that there was no market whatsoever (at least for now) for the technology claimed by the portfolio. In all of these cases, the sellers probably could have been better advised on how to value their IP and present it for sale at the auction.

Noteworthy also was the level of excellence demonstrated by Ocean Tomo in putting together these events. At both of the auctions I have attended, Ocean Tomo has assembled a first-class group of panelists to provide information and training for the inventors, business people, lawyers, and investors who attend. I might add too that they know how to pick their venues. No rubber chicken for lunch at these events. Ocean Tomo and its sponsors are providing a valuable public service to the market at the same time they are doing good business at these events.

Despite these successes, it is becoming clear by now that because of the transactions costs associated with the valuation and exchange of IP, auctions are usually the best option only for smaller, more isolated portfolios. Once the strategic value of a portfolio exceeds a certain threshold, IP owners will find it more worthwhile to hire lawyers or private brokers to package and market a portfolio to potential buyers.

Some people might think this spells doom for Ocean Tomo. Those people are sorely mistaken for the simple reason that the packaging and marketing of IP requires highly specialized training, along with access to a specialized network of professional buyers and sellers. Regardless of whether Ocean Tomo continues its auctions with the same frequency with which they have been held over the past few years, there is no doubt that it has accumulated an amazing group of professionals and perhaps the best social network of accountants, lawyers, brokers, buyers, and sellers that is available to non-repeat players in this market. This is only a guess, but an educated one: the IP market is evolving and Ocean Tomo is about to evolve with it.

IP Valuation

I'm very disappointed to have missed out on the discussion in the comments to this post at the IAM blog, but glad at least to have found the comments now through a comment over at the interesting new IP Prospective blog. Some of the following remarks were made also by commenters there (go read the whole blog post and comments). IP valuations are often done very differently depending on whether the IP is considered a proprietary asset or whether it is intended to be licensed out or sold. As a rough cut, I'd say that in the former case, IP is viewed as equity and in the latter, as an asset.

So long as we're talking about the same thing the two valuations should end up agreeing. The fact that they don't often agree goes more to how we're not talking about the same thing than it does to differences in methods of valuation. In both cases, valuations should ultimately rely upon some discounted cash flow analysis.

What are we talking about when we talk about IP? There is no single right answer because there is no single purpose for IP. Yet the right answers narrow down considerably if one focuses on definitions that incorporate characteristics of every category of IP recognized by law (trade secrets, copyright, trademark, and patents). Here's one cut at such a definition: IP is any good or service protected by exclusive rights that gives a company a competitive advantage. If the company would not have the competitive advantage without the exclusive rights, then valuations should focus on the legal strength of the IP in valuing it. If the company would have its competitive advantage from the IP regardless of whether the legal rights were enforceable, then valuations should focus on the economic advantages in terms of reduced costs or increased price inelasticity without paying too much attention to the legal issues.

One thing that's worth nothing, however, is that if the market for IP rights were more transactional rather than litigation-driven, these two approaches to valuation would collapse into one. Transactional norms -- because transactions are voluntary -- tend to mimic the needs of the parties to a transaction.

Lemley and Myhrvold have an interesting suggestion for promoting transactional norms, which is echoed by a number of earlier commenters: make full disclosure of the terms of licensing or assignment of patent rights part of the quid pro quo for patenting. Comparables aren't great in real estate either, but the real estate market clears with enough bad comparable information available to both parties.

ADDENDUM: I may be shortchanging the importance of valuation methodology a little here. Last year I did a whole post on how valuation methodologies could be improved. See here. That post was making a big stretch, however, since frequency-averaged measurements of costs or price inelasticity are not part of accountants' or even economists' toolkit right now. There are glimmers of hope that they may come to be adopted. See this post and the linked article on how relationships between firms is discernible from the synchronization of market prices.

At the core of any competitive advantage is some capability (Teece) or routine (Nelson and Winter) of a firm to cooperatively produce for a market. Looking at time-correlations (i.e., equivalently, frequency synchronization) is a good way to see how an innovation improves competitive advantage. If I were an academic, I'd be writing a book on this now.

Reigniting the Engine of Growth with the Sparkplug of Invention

Why do patents end up in litigation?  Typically, people answer that it is the amount of money at stake.  This answer is not wrong.  Since the cost of litigation is relatively constant, people should be (and in fact are) more willing to pay lawyers to litigate claims that are very large compared to the cost of litigation.  But this is not a full answer to the question.  For this answer does not explain why patents specifically should end up in litigation more often.  In fact, trillions of dollars in legal rights are exchanged everyday around the globe without litigation.  By comparison, the amount of money at stake in patent lawsuits is relatively small.

The Theory of Focal Points

Economist Thomas Schelling is famous for advancing a theory of conflict and cooperation. According to Schelling, even when communication (and hence negotiated agreement) are difficult or impossible, two people can cooperate through a shared focal point. For example, if I told you to meet me in New York City tomorrow but for some reason I couldn't tell you where and when, we might still meet by going to a famous spot at noon, such as Grand Central Station or the top of the Empire State Building.  Our shared vision of these famous spots is a focal point that permits us to coordinate.

The theory of focal points explains why some groups of people fight and some cooperate.  When the focal point for a first group is mutually exclusive to the focal point for a second group, conflict emerges.  When the focal point is shared or non-mutually exclusive, cooperation emerges.  To some extent, all conflict between people can be viewed as a costly renegotiation of focal points.

With Schelling's theory in mind, let's revisit the question of patents.  What are the focal points for the various parties involved in patent litigation?  To simplify the question, suppose there are only two groups involved in patent litigation: "inventors" (or their employers) and "producers" (i.e., the people who sell products or services that practice a claimed invention).  Ignore for now the detail that some inventors are also producers, and that some producers are also inventors.

When patents are litigated, the focal point for inventors is on obtaining a large royalty or payment for the right to practice the invention.  By contrast, the focal point for producers is on paying a small (or no) royalty or payment to practice the invention.  Although both inventors and producers seek profit, at the point in time when patents are litigated, these focal points are mutually exclusive because (at worst) both have incurred costs of R&D for developing the invention.  Patent litigation thus becomes a zero sum game.

The Focal Point of Profit

At first glance, therefore, one might think that inventors and producers are doomed to conflict.  Before rushing to that conclusion, however, it's worth noting that in some broader sense, at least, inventors and producers share a focal point -- namely, profit.

Profit is an unusually broad focal point.  As Adam Smith is famous for pointing out, the voluntary exchange of goods and services creates profit.  With profit the focal point, the problem of avoiding conflict between inventors transforms into a problem of identifying and promoting the circumstances in which the voluntary exchange of inventions for cash can take place between inventors and producers.

If such voluntary exchanges never occurred, we might have reason to doubt whether conflict between inventors and producers could ever be avoided.  Fortunately, such exchanges do, in fact, occur.  Thus, it can be inferred that the conflict arises over how what is exchanged (services and patent rights) should be valued.

Again, this might seem puzzling at first because, at least in principle, there should be no difference in how value is measured.  At least within the United States, the same rules for accounting and reporting financial statements apply to both inventors and producers.  In principle, the inventors and producers should be able to compare their financial statements, and reach some agreement over the value of an invention.

But since this never seems to occur, the most reasonable inference seems to be that the conflict arises from a difference in how we interpret accounting and financial statements.  In fact, it is precisely here that the focal points of inventors and producers diverge.  Having had the rare opportunity of working both in patent law and accounting, it has been my privilege to be one of the first to have noticed this.  In short, a better theory of accounting would help resolve conflicts over patented inventions and restore a cultural norm of cooperation within patent law.  Astute readers should note that, in addition to patent law, Venice was the birthplace of double-entry accounting in the 15th century.

Problems with the Static Picture of Cost Accounting

As described by William H. Waddell and Norman Bodek in Rebirth of American Industry, the theory behind the most dominant method of accounting (which is called "cost accounting") was developed at General Motors in the early 20th century by Alfred Sloan, Pierre DuPont, and Donaldson Brown.  The relevant detail about this theory is that it was designed to measure (and hence manage) return on investment (ROI).  To that end, the paradigm that Sloan, DuPont, and Brown had in mind in developing their rules for accounting was a static picture.  Specifically, their picture was of what the corporation would be worth in liquidation.

With the picture of the corporation in liquidation in mind, it is easier to understand why so many things that we might intuitively imagine to be costs are instead treated as assets under cost accounting.  For example, under the cost accounting system, unsold inventory is reported as an asset.  Cost accounting assumes that the inventory could be sold at cost in liquidation.  The reporting ignores, of course, the fact that unsold inventory will incur expenses.  More importantly, it ignores that what's unsold before liquidation is less likely to sell at cost in liquidation.

Under the cost accounting system, IP is called an asset on balance sheets.  Again, the assumption is that patents can be sold at cost during liquidation.  Again, this assumption begs several important questions.  Perhaps most importantly is the question of why, if the IP is so valuable, it could not be used to attract financing or revenue, thereby avoiding liquidation.  There were (and are) reasonable answers to that question when debt or equity are unavailable for reasons that have nothing to do with the demand for the patented invention.  But its salience suggests that there might be better ways to measure the value of IP.

Whereas all patents cost something to procure, market demand only emerges for a handful of all patented inventions.  Thus, the system of cost accounting has given managers and investors the perverse incentive to aggregate thousands of patents, inflating their balance sheets, much like we saw prior to the subprime mortgage debacle.  Firms invest billions of dollars in new technology, spend millions on patent portfolios, inflating their asset accounts -- all before attracting a single customer!  Not to be outdone, when the corporation fails, the cost accounting system encourages us to sell the patents at auction, and let third-parties extract whatever they can from the legal rights.  On my view, the system of cost accounting, coupled with the shortage of patent litigators who really understand technology, are responsible for the emergence of the worst kind of patent trolls.

Dynamic Accounting and the Promise of Cooperation

Fortunately, there is now a light at the end of the tunnel.  In fact, many corporations have shifted away from the static picture of corporations inherent in cost accounting to a more dynamic picture.  Lean accounting, in fact, was practiced at Ford Motor Company almost 100 years ago, before Ford was eclipsed by the success of General Motors.  It turns out that cost accounting is a perfectly fine system of accounting when demand is basically infinite relative to the cost of supply.  If the market is never cleared, then the corporations that use cost accounting will end up reporting higher return on investment (ROI) than the corporations that use lean accounting.  Lean accounting is an inherently more stable mechanism for promoting growth within a corporation in part because it does not tradeoff short-term gains in income against long-term sustainable growth.  But once GM started doing it, everybody else in the automobile industry, and eventually the entire economy, had to follow.

Under a dynamic theory of accounting, IP is more like equity than it is like an asset.  That's because the primary value of patent rights is in promoting invention and collaboration, both of which are dynamic because people are dynamic.  Elsewhere I have explained how inventors are customers.  Within the cycle of growth of corporations, inventors and customers are the source of information about demand.  It is no accident that unmet need was considered by Judge Learned Hand to be the most important of the secondary considerations on obviousness.

By contrast, assets are static.  By adopting rules for reporting and managing the IP that are more consistent with the actual mechanism whereby it increases profit, we will in turn discourage wasteful conflicts.  A very important corollary to this is that stronger patent rights would be beneficial in promoting collaboration and avoiding conflict.  Strong property rights discourage people from litigating what could be solved through negotiation at an earlier point in time. As Robert Frost noted, "Good fences make good neighbors."  With a change to the accounting rules, these early negotiations will happen more often.

Finally, let me emphasize that changes to financial statements need not be dramatic.  For example, the simple addition of average daily debit and credit flows for each balance sheet account would permit the shift in managing and investing that I'm advocating here. Since most accounting is now done by computers, this kind of change is actually very cheap.  The value of inventions could then be measured easily by comparison between the average daily debit and credit flows before and after an invention had been implemented.  Suddenly, inventors and producers have a numerical way to measure the value of an invention.

IP is not an Asset: Patents and Inventors Need to Stick Close

Earlier this week, Peter J. Wallison argued that conventions in fair value accounting may in part be the cause for the recent bubble markets.  Specifically, Wallison pointed to the convention (implemented under FASB 157) that requires assets to be carried at "market" values, even when those assets are not being held for trading purposes.

Almost any scientist or engineer would immediately have recognized the truth of this argument.  Our understanding of any system -- chemical, electrical, mechanical, or financial -- will be limited in part by the accuracy of our tools of measurement.  When one considers how FASB 157 required banks to report the values of MBSs, CDOs, and CDO^2s on their balance sheets far above what the banks would themselves have been willing to give away for the same assets, one understands how the financial markets quickly lost track of the intrinsic value backing the securities traded.

This wisdom has direct relevance to the secondary markets for IP.  Most of the firms now in the secondary markets for IP have taken the view -- and are conducting their businesses -- as if IP were an asset.  This is because IP does bear some characteristics of an asset.  Namely, like real and personal property, IP can be protected through exclusive rights.  The analogy to property has thus come to dominate our understanding of the nature of IP.

Although accountants often treat IP as an asset, IP is not a commodity.  IP is more like equity, although it is not like other equity.  IP is a limited exclusive right to human capital (namely, to inventors' time solving a technological problem).

Maybe part of the reason that Abraham Lincoln understood the importance of patent law is because he understood that human capital cannot be owned.  The photograph shows the Emancipation Proclamation, whereby Lincoln did more for the cause of freeing human capital than many other men together have done in the course of human history.  Lincoln loved the patent system because he understood that it too could lead to more freedom.  Scientists and engineers work best free from the immediate demands of business people and customers.  The idea of a patent system carries within itself the promise of more innovation and more freedom.

POSTSCRIPT: Please note that I do not believe that inventors are literally enslaved right now.  There are obviously huge differences between the enslavement of millions of black Americans and the metaphorical enslavement of inventors who are now forced to do work other than inventing because of the broken patent system.  I do, however, believe that making people more free leads always to a multiplicity of unanticipated social benefits.