Broken Symmetry

Why Research Universities Should Start Offering their IP on a Subscription Basis

Over the past several years, I have heard many complaints (from graduate students and faculty on the one hand, and venture capitalists or licensing excecutives for large companies on the other) about the difficulties associated with negotiating licenses or sponsored research agreements. One might naively imagine that such agreements are routine, at least at research universities. Many have a staff of technology transfer employees whose job it is to facilitate these agreements.

But the agreements are not usually so easy to close. In fact, the agreements are so difficult that (at least in places like the Bay Area) the easiest solution for faculty or students intent on seeing their ideas comercialized is to leave the university, either temporarily or permanently, to launch a startup or consult with an established company on a new product or service.

The biggest loser is the university. Or at least that's true if you believe that there is no need to worry that greater university-industry relationships will somehow corrupt university culture. Therein lies the rub. The fact is that many people both within and without the university believe that academics should be independent from the allegedly corrupting influences of commerce.

Nevermind the hypocrisy inherent in holding that view but, at the same time, encouraging faculty to compete for federal grant money that is distributed based on political values that are directly or indirectly influenced by the same corrupting commerce. Focus on the key premise: Does an increased flow of information back and forth between university and industry hinder the growth of knowledge.

The answer to that question must be no. Facts are gathered proactively in response to practical problems. It is these facts that form the basis for academic theory. Academics can collect them on their own, and should be encouraged to do so. But there is no way that academic institutions can keep up with the scale of production of data already ongoing outside the academic system. University-industry collaborations are the future of our global economy, and the university must adapt to the new reality in which the polite fiction of academic independence can no longer be respected. Academic independence -- to the extent that it ever existed in research universities -- has been replaced with dynamic balance, detente.

Which brings us back to the original problem. Suppose the top-tier research universities, whose endowments (not coincidentally!) are often significant portions of the top-tier venture capital funds were to demand that each of those venture capital funds pay an annual subscription for (say all non-biotech or pharma) university intellectual property on a non-exclusive basis. Exclusive deals would remain subject to negotiation. The funds would go primarily to preparation and prosecution of patent applications.

Imagine the collaboration that might result from the lowered transactions costs of collaboration. The alignment of interests between the university and its industry subscribers now permits seamless communication without concern of loss of patent rights or trade secrets. Inventors have better feedback on what, if any, applications are worth filing from industry, rather than from other faculty or from tech transfer office employees alone.

The endowments see reduced expenses -- no more patent prep and pros fees -- and additional income (in whatever is leftover from the subscription fees). Inventors are more likely to stay at the University rather than leave. Only the venture capital funds and companies that aren't paying for the IP that now goes out the back door have something to complain about, and then only initially. In a new equilibrium, a portion of the University becomes a kind of Bell Labs for the economy. Renegotiated employment agreements with star inventors bring billions of capital gains to the University directly, rather than indirectly through the venture capital funds, which charge at least 20% in carried interest plus fees.

But you have to believe that it would be good for faculty and students to talk more with engineers and scientists in industry. For the time being, most people don't.

Why Libertarians Should Stop Worrying and Learn to Love Intellectual Property

Toward a Libertarian Theory of Intellectual Property

We libertarians, being libertarians, are seldom to be found in agreement on first principles when it comes to anything, especially legitimate roles of government.  But if there were one principle to which all libertarians might agree, it would be this: That government, in carrying out its legitimate roles, should minimize costs.  The costs of government include not only the more obvious direct costs in the form of taxes and redistributions of property, but more importantly the much larger and more pernicious indirect costs of distortions to private institutions and organizations. (I follow the convention of some economists in distinguishing between the rules that define activity among a group of people ("the institutions") and the group of people itself ("the organization").) When government intervenes to benefit a particular group in society, even for noble of reasons, it can also undermine private institutions that have evolved to bring order, private institutions that may reflect a broader and more stable consensus than can be achieved even by a representative democracy.  At the margins of government reach, communities can and do by consensus ignore legal norms, thereby avoiding the distortions caused by the undermining of locally stable cultural norms.  We Americans should be as proud of the ranchers in Shasta County, California who ignore California trespass law as we are of the Founding Fathers who disobeyed the laws of a more ancient and powerful sovereign.

But true to libertarian form, I mean to challenge this most basic of libertarian principles.  For through my study and practice of intellectual property and antitrust law, I have come to the view that a broader proposition should be embraced: That all institutions in society, in carrying out their legitimate roles, should minimize costs.

Why the need for this broader proposition?  In short, because great benefits may be gained by keeping the same skeptical and minimalist eye, which libertarians naturally keep on government, on all institutions in society, whether public and private.  By focusing on government costs alone, libertarians have been blind to the costs of private institutions.  In the end, what difference does it make whether an oppressive institution is called public or private?  What libertarians are in favor of is more freedom, not less government.

Some readers might object: How can a private institution be costly like government?  The cost of government -- so these readers might say -- is coercion.  And by definition, no private institution can be guilty of coercion. 

My answer is that this objection begs the question.  Both public and private institutions interfere with individual liberties.  The constraints that parents place upon the liberties of their children -- mental, emotional, and physical -- are not different in kind from the constraints that governments place upon their citizens.  Parents' rules are not just because parental; governments' rules not unjust because governmental.   

A stubborn reader might nonetheless persist: If not different in kind, then in degree.  Government coercion is at a scale (of millions of people) and to a degree (of taking life) beyond private coercion.  A glance at twentieth century history confirms it. 

There can be no doubt that twentieth century history put a stink on government.  But did it leave private institutions smelling like a rose?  More importantly, the stubborn reader has already conceded my point by acknowledging that the scale and degree of coercion -- rather than public or private status per se -- is what makes government costly.  By this reasoning we can dismiss libertarians who argue against intellectual property simply because it is a government institution.

Having cleared away distractions, the more difficult question can be addressed:  Does intellectual property play a legitimate role at minimal cost relative to alternative institutions?  The question has both moral and economic dimensions.  Whether the role played by a given institution is legitimate is moral.  Whether there is not a better institutional form for accomplishing a given legitimate role is economic.  Intellectual property law should be favored by libertarians both for its moral and economic merit.

The Moral Case

The best argument ever made for the moral and economic merits of intellectual property was made very close to 150 years ago in Jacksonville, Illinois, where Abraham Lincoln gave a lecture (one in a series; multiple versions of which are available online).  Lincoln's lecture "On Discoveries and Inventions" concludes with famous words: "Before [the patent system], any man might instantly use what another had invented; so that the inventor had no special advantage from his own invention. The patent system changed this [by securing] to the inventor, for a limited time, the exclusive use of his invention; and thereby added the fuel of interest to the fire of genius, in the discovery and production of new and useful things."

What did Lincoln consider the moral case for patents?  To punish theft.  Without a property right in an invention, anybody who devoted the time and effort at inventing would be at the mercy of any dishonest character who managed to learn enough about the invention to copy.  To Lincoln, that seemed unamerican.  To Lincoln, the great difference between the United States and the nations of Europe was the result of "Discoveries, Inventions, and Improvements," which in turn "are the result of observation, reflection, and experiment."  In the United States, inventors earn rewards.

Some are skeptical of Lincoln's premise.  Wouldn't people spend time in "observation, reflection, and experiment" even without the rewards of intellectual property?

Some people, yes.  But for Lincoln the question was not whether inventing could go on without intellectual property.  Clearly it had in Europe, Greece, and Egypt.  (Although interestingly, the first patent system emerged from renaissance Venice.)  For Lincoln, the question was whether we ought to protect the livelihood of people who spend their time in "observation, reflection, and experiment."  Lincoln never worried, as did Thomas Jefferson, that ideas wouldn't spread fast enough if intellectual property punished copyists.

The Economic Case

The economic case for intellectual property is the most difficult.  The economic theory taught in law schools relies heavily on the principles of neoclassical economics, emphasizing equilibrium and the allocative efficiency of markets.  The recent paper by Bessen and Maskin provides an illustration.  A careful mathematical model is made of the net present value of patenting given a stream of innovations and the costs of licensing intellectual property.  But no theory or model is given for the source of the stream.  Many neoclassical economists seem to assume that inventions are an inevitable consequence of market competition.  No particular attention need be paid to inventors.  If the invention is efficient, an inventor will invent.  Even F.A. Hayek seems to have fallen into this circular reasoning.  More careful observation and reflection on inventing results in a calculus of costs and benefits in clear favor of intellectual property.

It is supremely ironic that Hayek opposed intellectual property because it was Hayek who founded the economic theory of institutions and organizations that reveals the economic case for intellectual property.  In particular, it was Hayek who first wrote about the problem of coordinating dispersed bits of information held by individuals in society.  It was Hayek who first explained why decentralized institutions should be favored over central planning.  What Hayek understood was that the costs of information gathering and processing increased with scale much faster than even the most well-run central planning could handle.  At best, the result of central planning at scale are institutions badly adapted or poorly timed to resolve disputes.  At worst, central planners are corrupted by incumbent authorities or vocal minorities into serving an elite group in society.  

By contrast, decentralized institutions in the form of privately adaptable rules provide a scalable, accessible mechanism for resolving competing claims to scarce resources.  The archetypal Hayekian decentralized institution is market price.  By looking at market price signals, a dispersed group of individuals through society can coordinate a variety of activities associated with production and consumption without a single meeting, much less an election.  The story has been told of Nixon being introduced to a central planner in China who simply could not grasp how there was no need for his job in the United States.  Those days seem ancient!

But what is it exactly that makes decentralized institutions superior to central planning?  Is it the fact that central planning is done by government?  Consistent with the analysis given above, the answer is no.  First, whether public or private, central planning is less efficient than decentralized institutions.  Institutional religion, for example, is not exempt from the problems of central planning that plague governments.  Governments simply limit the damage that can be done by the central planning of institutional religion.  The Founding Fathers struck a unique balance through the First Amendment, permitting the United States a unique equilibrium between religious and government institutions.  (But maybe it's better to say that the First Amendment was a consequence of the unique equilibrium that existed rather than its cause.)  Conversely, decentralized institutions are not perfectly private.  There can be little doubt, for example, that a threshold level of government is necessary to markets for insurance, much less complex derivatives. 

What makes decentralized institutions superior is their structure and dynamics.  Decentralized institutions comprise a set of rules that underdetermine the outcome of competing claims to scarce resources.  In many cases, the rules are mutable -- i.e., subject to renegotiation among parties and counter-parties.  As a group, the individuals subject to constraint by decentralized institutions get feedback earlier and more often than do the individuals subject to rule by central planners.  Moreover, the process of variation, selection, and retention of rules that seem to work well for subject individuals means that decentralized institutions actually learn and adapt to changing circumstances.

Intellectual Property as Complex Adaptive System

The most compelling economic case for intellectual property is that it provides a decentralized alternative to centrally planned alternatives, such as prizes, grants, or even tax credits.  Intellectual property does not determine economic outcomes.  Rather, like other systems of property and contract law, it constitutes a market whereby outcomes are determined through repeated private interactions.  Intellectual property law is a substrate on which a network of inventors, entrepreneurs, and established companies coalesces into an ad hoc organization formed with a particular social goal.  The cooperation of legally separate NFL teams to license the NFL brand on an exclusive basis to Reebok -- now on appeal to the Supreme Court in the American Needle case -- provides only a hint of what can be accomplished when dispersed organizations band together through intellectual property rights to accomplish specific goals.  The formation of patent pools for the licensing of drugs developed for treatement of HIV/AIDS are another.

Although Lincoln would not have chosen these terms, we can be sure that he nevertheless had this decentralized network of intellectual property rights in mind when he argued in favor of the patent system 150 years ago.  In his extended argument, he identifies the patent system as the fourth major stage in the progress of civilization.  Lincoln identified speech, writing, and printing as the first, second, and third stages.  What all four stages have in common is their status as decentralized institutions.  All are subject to renegotiation over time through an evolutionary process.  As I have noted elsewhere, had he anticipated their invention, Lincoln almost certaintly would have added internet protocols as a fifth stage.  Perhaps intellectual property should be called the fifth and internet protocols the fourth.

Elsewhere I have made the argument that the patent system should be understood as an evolving complex system, and that important problems with current system could be solved by understanding patents in those terms.  In the terms presented here, my argument is that decentralized institutions constitute a complex adapative system, although to avoid the somewhat unfortunate terminology I often abbreviate this to "systems theory," a moniker embraced by a diverse group of venerable authorities including Mihalyi Csikszentmihalyi, Douglas McGregor, and W. Edwards Deming.

In this post I cannot provide an appropriate introduction to systems theory.  I must instead assert that a comparative institutional analysis conducted within the framework of systems theory strongly suggests that a decentralized institution like intellectual property is constitutive of innovation in ways that alternatives such as prizes or grants could never be.  Whereas prizes or grants are made (in a best case scenario) when the prospective value of an invention comes in view for the central planners, intellectual property permits a dispersed group of private individuals and organizations to invest in new technology.  Whereas the internal rate of return to investment in new technology would be negative (for easily copied technology) or too small to incur opportunity costs (for almost any technology), the security of intellectual property rights promises the possibility of outsize rewards for a limited time.  We are all gamblers in view of the uncertain future.  Intellectual property simply encourages a gamble on investments that promise even larger social benefits over the longer term.  In this limited regard, anaologies to secured credit, derivatives, and insurance markets are not inapt. All of these institutions facilitate the creation of wealth -- in a literal sense -- by facilitating divisions of labor and voluntary exchange that would otherwise be impracticable.

Given the scope of its impact, even ten years is too short a time to evaluate the relative costs and benefits of a intellectual property. But historical evidence for the net benefits of intellectual property is not hard to find looking across the longer span of history.  As noted above, the patent system was born in renaissance Venice, and carried out across the European continent by artisans who sought a reasonable reward for time spent perfecting a particular skill.  Although the English and American patent systems got off to a bad start by failing to honor the basic quid pro quo of public disclosures of knowledge in exchange for limited exclusive rights, by the mid-nineteenth century (the Patent Act of 1836 to be precise), the patent system had taken on what is substantially its modern form.  Interestingly, the concept of trade secrets as intellectual property rights emerged around the same time.  The industrialization that took place in the United States subsequent to 1836 is at least comparable in scope to the fifteenth century renaissance in Italy.

In the past, libertarians have simply misunderstood intellectual property to be merely government-granted privilege. Libertarians should be in favor of intellectual property because it promotes freedom through private enterprise at a scale and to a degree anticipated only by speech, writing, printing, and the Internet.

Call for IP Hall of Fame Nominations

I have been told that nominations are now open for 2010 inductions to the IP Hall of Fame. The IP Hall of Fame is an institution sponsored by the IP Media Group, who also publish the excellent Intellectual Asset Management magazine.

Given the announcement of new FTC rules on sponsored posting, in the interests of full disclosure, I have... NOT received any consideration whatsoever for this announcement. I am an enthusiastic supporter of what the IP Media Group and IAM are doing to bring more attention to this industry, which is so vital to the future growth of our economies.

Previous inductees set a high bar for nominations, nonetheless there are many who are worthy of such an honor. Maybe you know who. Go submit your nominations!

Patents and Non-Compete Agreements

Another key portion of the Stanford v. Roche decision from the Federal Circuit relates to California's restriction on the enforceability of non-competes:

Under California law, “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” Cal. Bus. & Prof. Code § 16600 (2009). Stanford argues that section 16600 voids the VCA because Holodniy conceived the patented invention after departing Cetus, and the VCA violates public policy if it encompasses inventions conceived after employment terminates. Stanford also contends that once Holodniy’s research was published, it became public information, and that Roche’s interpretation of the VCA would prevent Holodniy from using this information in his later clinical studies.

We find no merit in Stanford’s arguments. By the plain language of section 16600, only those contracts that prevent “engaging in a lawful profession, trade or business of any kind” are void. Stanford provides no evidence that the VCA restrained Holodniy from engaging in any profession. Indeed, the record shows that Holodniy freely continued his HIV research at Stanford, publishing articles and using the knowledge he obtained from Cetus to further the science behind the patents-in-suit. Nor does Stanford explain how Holodniy’s assignment of his rights to Cetus prohibited Holodniy from using any public information in his later research. Moreover, California courts apply section 16600 to employment restrictions on departing employees, not to patent assignments.

This illustrates one of the most important sources of social value that patents offer. At least since Lincoln, owning human capital directly has been illegal in this country. But corporations and inventors need some way to credibly commit to each other. (Banks and poor students who want to go to expensive universities have a similar problem, which is solved by making student loans non-dischargable in bankruptcy.) Patents facilitate that bargain -- inventors option off the right to ideas they come up within in a certain period with patent rights, guaranteeing employers that their ideas won't leave with them (as they would if only trade secrets and non-competes were available) when they go to a competitor or retire.

One Reason Why the Supreme Court Should Reverse Bilski

Because if firms could patent business methods -- especially financial engineering -- then these types of disputes would be less costly:

Citadel Investment Group LLC, the $12 billion hedge fund firm founded by Ken Griffin, sued three former executives and the firm they started, Teza Technologies LLC, over claims they violated non-competition agreements.

“This is a case of industrial espionage,” Citadel said in a complaint filed today in Illinois state court in Chicago. The firm seeks a court order barring the individual defendants from conducting any business through Teza or related entities that compete with Citadel, for the duration of the agreements.

Patents are the cheapest way to handle disputes over allocation of the products of human capital.

Click on "Trade Secrets" or "IP Ownership" at right for earlier episodes in this series.

Damages Apportionment is a Rounding Error Compared to Social Costs of the Knowledge Problem

The Berkeley round of the FTC hearings on the Evolving IP Marketplace gave me plenty of food for thought. I was especially impressed with the faculty and tech transfer folks from Berkeley, including Carol Mimura, Henry Chesbrough, Peter Menell, and Richard Gilbert. Berkeley's recent moves to establish closer ties between industry and its faculty are going to ripple out to change the way we think about tech transfer and venture capital more broadly. If I recall correctly, Carol was overlooked by the person making introductions of the speakers on the first panel. Ironic since her presentation was by far the most important to my mind.

From the tone and substance of the remarks along with the larger attendance in the gallery, I gathered that the damages panel was considered by some to be "the main event." Not surprising, really, since damages apportionment has been the key issue blocking patent reform legislation over the past couple of years. The panel mostly rehashed the arguments we've all heard before, although there were a few hints at more creative solutions. More could have been said about relative institutional competence.

But here is my thought for Broken Symmetry readers to consider: Are measures of damages really the biggest issue for patent reform? Sure, damages are where the rubber meets the road as far as patent lawsuits, and hence licenses go. But the lesson we should have learned from the other panels is that patent rights are only part of the intellectual property that is being created and shared by inventors at startups, universities, and R&D labs in the United States. And it's not even the most important in terms of getting problems solved.

The biggest issue for patent reform in terms of social impact is what F.A. Hayek called "the knowledge problem." As any society grows, the dispersed bits of knowledge held by its members have to be coordinated so that organizations can grow through commerce and other forms of cooperation. The patent system that was perfected (if not invented) in the mid-19th Century United States is the most sophisticated system ever known for coordinating the creation and sharing of knowledge. Damages apportionment issues represent a rounding error compared to the massive social costs of redundant inventing, excessive secrecy, fear of idea theft, translation and language barriers, and other transactions costs to the sharing of ideas that the patent system is meant to reduce.

Food for thought.

What midlevel managers used to do when R&D was vertically integrated?

From Tech Transfer Tactics:

Smith, who shifted jobs a year ago to her refocused position, says that one of the first things she did was create a physical engagement map for one aerospace company that shows all of the places on the campus that they touch. The company’s representatives were surprised to see that they are working with the Latin American studies department, optical sciences, material sciences, the business college, electrical and computer engineering, as well as aerospace. “It was very important to show them the map,” Smith says. “They are a decentralized company and didn’t have their finger on the pulse of all of their relationships with the university."

Stephen Quake calls for Change in Technology Transfer

This op-ed by successful academic, inventor, and entrepreneur Stephen Quake is a landmark piece. The current system of technology transfer must evolve for the United States to maintain its competitive advantage as a producer of new technology:

Licensing is often a protracted process, and licensing officers so paralyzed with fear about making a mistake and not maximizing licensing revenues that they discourage all but the most persistent licensees. Because universities are non-profit institutions, the true measurement of technology transfer success should not be the total amount of licensing revenue, but rather the successes in helping faculty members patent inventions, in forming new ventures that create jobs, and in facilitating the commercialization of technologies that in many cases will help improve our society.

The best way for universities to achieve this would be to make the same decision the federal government did, and relinquish their control over licensing. Since in most cases faculty know the context of their invention and how it can be best commercialized, they should drive the licensing process, and the OTL should play a supporting role. The university deserves to receive some compensation, but this should be fixed by a simple formula and limited — bearing in mind that the vast majority of research funding that leads to inventions has been obtained by the faculty through grants, and that the university has already taxed a fair bit of that to support its facilities.

Please read the whole thing. There is almost nobody with more first-hand experience than Quake. He's telling us what's wrong with the system.

Commercial entities (from venture capital funds to public corporations) and universities face a prisoner's dilemma when it comes to IP rights. Cooperation offers benefits to both; but the incentive in individual transactions is to defect. Quake is calling for inventors to have more control over the process, and that will help. But even better would be for technology transfer offices to recognize a bigger role for private equity funds in assisting with the process. An intermediary with equity incentives will outperform even the best organized and well-meaning of in-house technology transfer offices.

Read the comments on the NYT page too. See how many in industry are frustrated with the technology transfer offices?

How are curious scientific exploration and R&D different?

Another quote from the article by Evan Osborne:

[A]rtists themselves often pursue their self-interest in the course of creation, both to further their own artistic goals and by lobbying governments to obtain special privileges.  The same reasoning that indicates that works that provide utility apart from the sheer pleasure of beauty cannot be beautiful themselves also arguably suggests that no work created in an attempt to pursue one’s own interest can be so characterized.  If the usefulness of an object to the observer negates the possibility of its beauty, why not the usefulness of the act of creation to the creator?  Objects created in the self-interest of the artist – for compensation, for renown or for the achievement of influence in the artistic world – are not divorced from interest either.  Artists who create work for the advancement of their own interest (including the pursuit of beauty itself), which is to say all artists, cannot in the Kantian formulation be said to have created a beautiful thing.  Kantian reasoning implies that no author can ever be trying to create beauty, his creativity being bound up in his interest.  This implies that if beauty exists, it arises merely by accident and unrelated to any intent of the creator, an absurd proposition.

There is no difference in kind.  The difference is one of degree, and the degrees are measured in time.  What a scientist discovers in the laboratory today will years later be the inspiration for new products and services.  The natural world is the source of inspiration for artists and inventors.  Artists and inventors merely demonstrate to others how what is already there in the world can make life easier or more enjoyable.  Kant was wrong to say that what is useful cannot be beautiful because what is useful must be beautiful, or it would not be used.  Kant lived in a time when new art and invention came slowly.  Memory fades the sense of joy we have in experiencing something new.

As our economy moves to successively longer time horizons, inventors and even scientists will be linked in to the cycles of supply and demand.  We would be farther along with this already were it not for some blockages between universities and industry.

The Third Rail in IP Law: Ownership

Via IP Dragon I found this article by Patti Waldmeir about how a new law in China might prevent foreign inventors from obtaining protection in China unless the invention is made on Chinese soil first filed in China:

If the revisions are adopted, foreign companies would have to draft patents in Chinese for inventions made in the country. But because China’s patent regime is so new – dating only from the early years of this century – there are relatively few Chinese-literate lawyers who are experienced in this area.

Substantive IP law can harmonize all it wants.  Unless ownership law harmonizes also, there won't be free-trade in IP.

Trade Secret Lawsuits are Ownership Disputes... How Filing More Patent Applications Might Avoid Some Litigation

WSJ reports that startup LimitNone is suing Google for breach of contract and trade secret misappropriation:

LimitNone, which no longer offers the product, says it worked on gMove as a member of an authorized Google developer program and with the assurance that Google wouldn't seek to build a similar tool itself.

Looks like contracts and trade secret protection weren't the right way to go for LimitNone.  I've been involved with a few trade secret lawsuits, and they are very messy.  People complain all the time about how difficult it is to interpret patent claims, and how poor the patent office is at examining them.  But filing a patent application does do one thing extraordinarily well: it plants a stake in the ground that says: "On this date, our startup knew this much about the technology and thought this part was what was valuable."

With that stake in the ground, the discussion about who did what when gets much simpler.  That's because describing the scope of the trade secret is only the smaller part of what makes trade secret lawsuits messy.  The larger part of the messiness is due to the competing claims between joint developers for ownership of the IP in question.

When a patent application is filed, some questions about validity and all questions about infringement are left to be determined later.  But the process of drafting the application and getting assignments tends to resolve ownership questions earlier, and at the moment in time when they are easiest to resolve.  A good patent lawyer will sit down with the various parties involved with a development effort, make a determination as to who contributed to conception, when, and what each person's obligations were and to whom at that point in time.  A couple hours worth of work can avoid millions of dollars of litigation.

Are there too many ideas... or not enough (good ones)?

Anybody who has spent time working in venture capital in Silicon Valley, almost no matter how short, has observed that it is common for multiple teams to be pitching the same startup idea at around the same time.

The conventional wisdom, accepted by nearly every venture capitalist that I've ever heard, is that this is evidence that ideas are cheap, and that it's the team and execution that matters in separating the winners from the losers.  If the supply of ideas is fixed and inelastic, then the team of entrepreneurs and investors that can make the best use of that inelastic supply will end up winning markets over the long haul.

But I have literally never heard any venture capitalist ask what seems to me like an obvious question given the undersupply of ideas relative to the teams available for execution -- namely, how can we increase the supply of ideas?

Now some of the venture capitalists -- particularly the small minority that have succeeded despite the drastically limited supply of ideas -- are likely to respond that the teams not funded are better off doing other things.  I'm not so sure about that.  I like the idea of more ideas, more startups, more innovation.

In fact, I think the great strength of the United States has been its encouragement of inventors and entrepreneurs.  Perhaps everybody would benefit if the differences between the supply of ideas and the supply of execution talent were more readily distinguished, and the supply of ideas got more funding.

What the Founding Fathers knew about R&D that we have forgotten

As evidenced by his lecture on discoveries and inventions, Abraham Lincoln had a deep understanding of the patent system.  It is amazing how his lecture, which is now well over 150 years old, can seem so fresh today.  He and Charlie Munger have inspired me to undertake a historical review of other important lessons of the imminent dead.  Today the lesson is from Scottish enlightenment thinker Adam Smith, famous for his authorship of The Wealth of Nations. I must shamefully admit that I have thus far been unable to make it through the entirety of his treatise.  I have nonetheless been the beneficiary of the wisdom of Adam Smith through the help of editors, from whom we have the following excerpt:

To take an example, therefore, from a very trifling manufacture; but one in which the division of labour has been very often taken notice of, the trade of the pin-maker; a workman not educated to this business . . . nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them.

Adam Smith goes on and on from here about the many benefits of the "division of labour."  Although controversial in his day, the benefits of "the division of labour" are in our day a fact so well-accepted by the majority that many people seem unaware of the history of this idea.  We seem to assume it a logical consequence of any business. That it is not.  In each case in which a division of labor is successfully implemented in business, there was first an entrepreneur who saw the benefit of separating one task into two.  Henry Ford brought the magic of divisions of labor to the production of cars through the assembly line.   Most people can't imagine this, but before him others probably scoffed at the idea that something as complex as a car could ever be assembled without a single person overseeing the entire process.

Are we not still scoffers?  In the United States, we now live in an age in which most lawyers, business people, and researchers believe that R&D and early-stage product development are incapable of being done by two teams.  The fact remains, however, that the best inventors and the best startup CEOs are not often the same person.  And the best R&D and the best product development tend to occur in different environments.  We have strained for the past twenty-years in the United States to force inventors into the role of entrepreneurs, and entrepreneurs into the role of inventors.  Being a hardworking nation, we have not been entirely unsuccessful.  But how much more successful might we be were we to accept once and for all that there is an efficient division of labor between R&D and commercialization (yes, even the "commercialization" done by startups)?

The patent system is the most sophisticated and efficient means for implementing a division of labor between R&D and commercialization ever conceived by humans.  It is by cutting back at patent rights in the United States that we have inadvertently forced inventors to become entrepreneurs and entrepreneurs to become inventors.  Let us not further disintegrate the division of labor between R&D and commercialization by weakening our patent laws in 2008.  Let us recognize that good inventors and good startup CEOs are not always (or often!) the same person.  Let us "promote the progress of science and the useful arts" in the ways our Founding Fathers intended, by a division of labour between R&D and industry.

Coase, the Internet, and a Market for Ideas

The Internet is changing the economic costs and benefits of many activities in our society.  The economics of innovation are changing too.  The result could be the emergence, for the first time in history, of an efficient market for ideas.

Before the Internet, we lived in a world in which the transaction costs of reaching an agreement over who, how, and when an idea would be used for profit were usually expensive relative to the benefits of coordinating the commercialization of that idea.  Even after a system of property rights was established through patent law, many companies found the cost of obtaining and enforcing patents -- not to mention the cost of avoiding or paying for other companies' patent rights -- high relative to the benefit of exclusive rights to a market for a limited period of time.  Inventors have generally chosen to assign by contract the rights in their ideas to an employer in exchange for a paycheck.  Companies have often chosen to maintain their ideas a secret, opting out of the costs of procurement and assuming the risk of unmitigated competition.  Only companies from a select group of industries -- industries that can generally be characterized as extreme in both capital requirements and vigorous competition -- have chosen to obtain and enforce property rights in ideas.

The Internet is now causing a massive shift in the balance of the costs and benefits of our system of property rights in ideas.  Ronald Coase is famous for advancing the hypothesis that in a world in which there are no transaction costs, an efficient outcome will obtain regardless of the initial allocation of property rights.  Transaction costs, of course, are never zero in the real world.  But Coase's Theorem is useful because it tells us to expect markets to emerge as transaction costs become small relative to the gains from trade.

The transaction costs of our system of property rights in ideas has hardly vanished because of the Internet.  Yet the Internet is dramatically diminishing these transactions costs.  The costs of searching for prior art, freedom to operate, and ownership information may have dropped the most because of the public availability of search algorithms, and databases of patent disclosures and assignments.  But even the costs of communicating ideas has dropped as the Internet has enabled us to send a mindboggling array of media around the world in an instant.

Imagine how this shift in economics could aid our government in "promoting the progress of science and the useful arts" if, instead of narrowing the scope of property rights in ideas, we were to broaden and strengthen the system by tailoring these property rights to correspond to the economic value that inventors contribute to our economy.  The emergence of a market for ideas would level the playing field for independent inventors and startup companies in their attempt to compete with big business.  Whatever else we see emerge from patent reform, here's to the hope that our reforms will promote the emerging market for ideas.

UPDATE: click through to see the charts published in Bessen and Meurer's new book, Patent Failure.  The  fact that litigation costs increased for non-drug companies but not drug companies starting in the 1990s could be the result of increased demand for litigators because of the drop in transactions costs associated with patent procurement set in motion by new communication technologies, including the Internet.

Is the patent system worth the barriers to entry it provides?

The answer is it depends, and the fact that it depends is what makes patent reform both complicated and interesting.

For purposes of this post, I'm going to divide the world of new technology into two boxes: "Computers" and "Pharmaceuticals," although I'm abstracting so far away from the details of the technology that it would almost be more fair to call them "Category X" and "Category Y."  The distinction I want to draw is a distinction between technology that is very difficult to reverse-engineer and technology that is very simple to reverse-engineer.  It is easy to observe that there is some software technology, for example, that is relatively difficult to reverse-engineer starting only from the publicly available versions of the software.  By contrast, by the time a pharmaceutical receives FDA approval, it is usually very easy to produce the exact same pharmaceutical compound using a slightly (or even substantially different) process.

How is this important to patent reform?  The difference explains why many (or most) engineers and business people in computer-related technology see the patent system as a burden, drawing off resources that would otherwise be devoted to innovation whereas pharmaceutical companies see patent law as a boon.  For computer-related technology the barriers to comptetitive entry are usually already high without the exclusivity of patent protection.  Ronald Coase observed how WIlliam Knudsen's human capital created competitive advantages and eventually barriers to entry for Ford by streamlining automobile manufacturing and assembly.  Similarly, computer companies gain competitive advantages and eventually barriers to entry by programming or building superior technology at the back end.  It was not easy to reverse engineer and duplicate what was done at Ford because it was the human capital rather than regular capital that provided the competitive advantage.  Something like that is also true of computer companies today, and perhaps of emerging technology markets in general.  While the markets are still immature and the technology is rapidly evolving, human capital becomes the key to achieving a competitive advantage and market share.  Differences in legal rights can become a rounding error.  Even differences in (regular) capital structure may be irrelevant.

Notice, however, that the opposite may be true of more mature technology markets, or markets where the technology is harder to reverse-engineer.  Without patent rights, the economies of scale in pharmaceutical markets may result in only a handful of very large, relatively undifferentiated competitors, and hence slower and less innovation.  A newer or smaller pharmaceutical company may need a guarantee of exclusivity in order to attact the (regular) capital necessary for completing the R&D process for a new drug or therapy.  Suddenly a system of patent rights doesn't seem like such a bad deal for investors in such a startup.

This is why patent reform is difficult.  Both sides have good points to make.  Now how do we resolve these differences?  The answer is we can't right now, but we should be able to over time.  The problem for computer companies is not that exclusive rights exist, but rather that the transactions costs of the system are relatively large compared to the marginal benefits they provide (such as the increased liquidity in the human capital of the engineers that work at these computer companies relative to a world in which only bilateral contracts and trade secret torts control how their ideas get used).  But transactions costs are going to continue to decline as the Internet grows, and the costs of our system of testing the valid and infringing scope of patents continues to decline with Internet-enabled technology.  Twenty years ago, it cost on average a few hundred dollars just to do a patentability search.  Now it's essentially free.  Similarly, patent ownership information is now readily available.  The patenting process is also growing more efficient as the PTO brings Internet-technology to bear on the problem of prior art searching.

If anyone from Congress is reading this post the message is this: Please don't demolish the patent system.  It's working for some right now, and for others, it's bound to become more efficient over time.

UPDATE: A recent empirical study supports my premise for the distinction between "Computer" and "Pharmaceutical" patents -- i.e., the relative ease of reverse-engineering.  The Internet, of course, is a technology that makes reverse-engineering easier.

VCs and NDAs

Today I'm attending the 14th Annual Private Equity CFO Conference in Redwood Shores, California. The speaker right now, a lawyer from Wilson Sonsini, is talking about whether VC firms should sign NDAs.

Just over six months ago I was defending a VC who had been named in a counterclaim brought by a defendant that my client was suing for patent infringement. I was amazed back then that a startup company that might be in need of VC funding would take such a risk -- who's going to meet with a company that might just sue for trade secret theft later? But here I am listening to a speaker explain that more and more VCs are breaking the industry rule against signing NDAs. What to make of this?

The legal issues are taking a back seat to the economic realities of the market. There is too much VC money chasing too few good new companies. Lower tier VC funds are trading more favorable legal terms (such as willingness to sign NDAs) in order to get access to the best deals.

But this just shows how some VCs aren't thinking clearly enough. Signing an NDA makes little or no economic sense for either the VC or the startup. Startups benefit from both the regular capital (i.e., $) and human capital that VCs offer. That human capital includes the network of potential recruits, other portfolio companies, and other VCs (with whom they may syndicate later financings). A VC who signs an NDA could be hamstrung from adding this value.

On the other hand, the VC firms who have this kind of human capital will also be the firms that are least likely to sign such NDAs. So maybe not much harm is done.

The takeaway for startups: ask if the VC will sign an NDA. If the answer is YES, then stay away. They're not going to contribute much besides money to helping your company succeed.