Patent Valuation and License Fee Determination in Context of Patent Pools

I. Introduction

A patent pool is essentially “An agreement between two or more patent owners to aggregate (pool) their patents and to license them to one another or third parties. Pools usually offer standard licensing terms to licensees and allocate a portion of the licensing fees (royalties) to patent owners according to a pre-set formula or procedure.[1]

A patent pool particularly faces intense scrutiny by way of competition/ antitrust law and each step of structuring of a patent pool has to be done keeping the prevalent norms of antitrust law in context. This article merely brushes with the antitrust aspect, as a discussion on that topic is beyond the scope of this particular article. However, suffice is to say that like other aspects of structuring of a patent pool, patent valuation and licensing fee determination is also subject to antitrust law concerns.

Part II of this research paper is a discussion as regards factors which determine patent value in context of a patent pool. Similarly, Part III is a discussion as regards factors that determine license fee in context of a patent pool. Thereafter, Part IV discusses the methods which are applied for patent valuation and license fee determination. A number of these methods are independent evaluation methods and hence their dynamics when applied in context of patent pools may need to be altered in light of the discussion in Parts II and III. Part V discusses certain aspects of actual patent pools in the technological field to better understand the principles which have been discussed in Parts II-IV. Finally, Part VI concludes this research paper.

II. Determination of Patent Value in a Patent Pool

One of the prominent pillars of a patent pool is an appropriate patent valuation process. Patent valuation is a difficult and subjective task.[2] Moreover, the result of a patent valuation independently outside of a pool might be quite different from when it is part of a pool transaction. A “pool regularizes the valuation of individual patents – making, as the United States Supreme Court put it, ‘a division of royalties according to the value attributed by the parties to their respective patent claims’”.[3] However, this value attribution process is not an arbitrary one but incredibly dynamic, and constantly evolving. This difficulty is furthered by the fact that the term “patent value” itself is subject to interpretation. Patent value essentially comprises of the economic benefit that the patent can bestow.[4]

A number of factors as discuss hereinafter determine the value of a patent. It is not necessary though that all the factors would come into play in context of every exercise of valuation of a patent in a pool. The factors determining patent value can be largely classified into a discussion as regards the types of patents in a patent pool in context of their relative importance and other complementary factors which further affect such importance.

A. Categories of Patents in a Patent Pool

Patents in a pool can be classified based on their necessity and quality. Thus, arises the concept of essential and non-essential patents and strong and weak patents.

Essential and Non-Essential Patents
As the terms indicate, essential patents are those which are imperative for the success of pool creation and thus naturally have considerably more value. Non-essential patents on the other hand are patents which though not imperative may bring efficiency advantages to the pool. However, what exactly comprises an essential patent is a subjective and constantly evolving definition determined by each patent pool according to its commercial needs and capabilities. For example, the number of patents in the MPEG-2 pool, all of which are declared to be essential to the MPEG-2 standard, increased from 27 in 1997 to more than 900 in 2010.[5]

Essential patents naturally have more economic value than non-essential patents.[6] “A pool that includes non-essential patents can increase prices for some consumers, while decreasing prices for other consumers.”[7] Also, inclusion of inessential patents can raise potential concerns about foreclosure of alternative technologies and higher royalties for some licenses than would have occurred if these patents were excluded from the pool.[8] These concerns though should be balanced against the costs of excluding potentially essential patents from the pool.[9] Such concerns were raised in context of the DVD 3C patent pool.[10] Thus, it has to be decided on a case by case scenario as to whether the patent pool will include only essential patents or both essential as well as non-essential patents.

“Whether a patent pool improves a market’s transactional efficiency depends on the competitive characteristics of the patents included within the pool’s offering.”[11] Properly demarcating all required patents for a technology is important during patent pool formation. Otherwise it may create a “hold out” problem where a patent owner will “hold out” for higher royalties, “knowing that the manufacturer has individually negotiated for and already acquired the rest of the necessary … patent licenses, and that the value of all those licenses depends on obtaining a license to its own patent.”[12] Essentiality of a patent can be determined based on certain characteristics of patents:

a. Blocking Patents
Blocking patents comprise of improvement patents on an existing technology. Thus, the improvement patent is deemed to be “subservient” to the earlier, “dominant’ patent”[13] and the subservient and dominant patents are said to block one another.[14] This is so because, the subservient patent cannot be exploited without infringing upon the dominant patent.[15] Likewise, the dominant patent cannot be developed in the improved embodiment without permission from the subservient patentee.[16] For example, the Wright brothers patents for aeroplane wings were improved upon by Glenn Curtiss and Alexander Graham Bell by using a set of wing flaps, or ailerons. The Curtiss patent, however, was found to infringe upon the Wright patent. As a result, Curtiss had no legal right to make, use, or sell his ailerons without a license from the Wright brothers, and the Wright brothers had no legal right to make, use, or sell Curtisss commercially successful form of the stabilizing device. Their patents mutually infringed and blocked one another and they had to form a patent pool.[17] Similarly, public key encryption method was devised and patented at Stanford University, and licensed to Cylink. Soon thereafter, a team of scientists at the Massachusetts Institute of Technology developed and patented an algorithm, and licensed its use to RSA. The RSA algorithm was successfully commercialized and became an industry standard. Cylink and RSA constituted blocking rival patents and the issue was resolved by formation of a patent pool.[18]

b. Complementary PatentsComplementary patents cover technologies that are largely lacking or inefficient absent a license to a separate patented product.[19] They occur as a consequence of independent invention. Thus, value of complementary patents increases when combined with a separate patented invention; they act synergistically, each increasing the value of the other.[20] “Two products or technologies are complements if an increase in the price of one of them reduces the demand for the other.”[21] For example, production of a light bulb requires patent rights to both the vacuum bulb as well as the filament.[22] A patent pool that only contains complementary patents may have substantial market power if the pool does not face competition from alternative or substitutable technology.[23] This though, could lead to the occurrence of royally stacking i.e. double-marginalization, which can occur when firms sell or license complementary products or technologies and demand is sensitive to price.[24] It refers to the addition of successive mark-ups by suppliers in a vertical relationship.[25]

Competing patents result when there exist totally novel products or processes that provide market substitutes for patented goods, or when inventors sufficiently modify existing patented goods so that the original patent is deemed “invented around” and not infringed.[26] “Two products or technologies are substitutes if an increase in the price of one of them increases the demand for the other.”[27] A patent pool may obtain market power by obtaining control over substitutable patents too.[28] An individual who acquires the rights to a competing patent eliminates or significantly lessens his need for competing patents within or outside of the pool.[29] Thus, the value of a pool consisting of competing patents increases with acquisition of substitute patents.[30]

Strong and Weak PatentsA patent pool can comprise of strong as well as weak patents. The value accorded to the patents would naturally be in accordance with its “strength.” “‘Low patent quality’ is shorthand for such problems as overlapping claims, inappropriately broad claims, slow patent prosecution, and patents on obvious inventions.”[31] Patents are “probabilistic rights”[32] Their scope and extent often remains probabilistic until their claim determination which may often be done only upon adjudication. Similarly in situations of a patent flood,[33] the overall quality of patents may become lower.[34] The additional protection of the pool affords a weak patent enforcement rights that it may not have secured standing alone.[35] Thus, even weak and invalid patents become important and can be used to exclude competitors, for example for litigation threats.[36]

Some patent pools contain explicit agreements to support weak patents, such as covenants not to challenge patents, joint defense agreements, and allocation of patent rights to parties who are best able to defend them.[37] Some patent pools achieve a similar effect not by explicit agreements, but by creating an institutional environment where patentees find that it is mutually advantageous to recognize each other’s patents.[38]

B. Other Factors Determining Patent Value in Context of Patent Pool

Besides the patents themselves, other complementary criteria impact on patent value. These comprise of the holistic environment in which the patents subsist, as discussed hereinafter.

Subject matter of Invention“Value is highly dependent upon the subject matter of the invention.”[39] Certain subject matter fields or innovations do not have sufficient commercial importance or market demand to warrant investments.

Scope of InventionA particular subject where there is extensive minefield of patents already in existence is less likely to have considerable patent value due to the limited patent scope as opposed to a field where patents are relatively lacking and there is possibility of a broader patent scope. Analogously, “value of a patent is derived from an ability to preclude others from practicing the unique innovation described by the words of the patent’s claims.”[40] “Generalizing, a patent employing broad claim language is typically more valuable than a patent of narrowly written claims in the same technology arena.”[41]

Size of Patent PoolThe size of a patent pool i.e. the number of its members and their patents is an important facet in determining the value of patents involved. Greater the number more are the governance issues as well as royalty determination issues, which in turn affect the valuation of the patents. This though does not imply that pools should be of a specific size, only that their size should meet efficiency demands.

Value of Patent PoolThe patents under the purview of a patent pool determine the pool’s value which in turn determines the value of the patents within as well as out of the pool. Value of a patent pool may be limited if certain holders of essential patents are not members.[42] This may occur due to various reasons such as if it was perceived that the patent may have more value as an independent entity, or due to strategic interests, or choice of joining different pools.[43] Correspondingly, if the patent pool does not contain all the patents it cannot curtail royalty stacking issues for the users. For example, Alcatel-Lucent pursued infringement claims for patents that it alleged covered the MPEG-2 standard and were not in the pool.[44]

While it is evident that collecting all necessary patents where the end product or standards is determined is extremely difficult, it becomes considerably more difficult where there is no predetermined or identifiable end-product.[45]

Patent PortfolioCertain academic studies are of the opinion that “the real value of patents lies not in their individual significance, but instead in their aggregation into a patent portfolio: a strategic collection of distinct-but-related individual patents that, when combined, confer an array of important advantages upon the portfolio holder.”[46] This theory has been applied to explain the patent paradox where the patent intensity, i.e. patents obtained per research and development dollar has risen dramatically even as the expected value of individual patents has diminished.[47] Thus, greater the control of an entity over a portfolio of patents, more would be its negotiation power in context of valuation.

SignalingIt has been opined that the value of patents inheres not so much in the exclusivity they confer upon inventors, but rather in their ability to serve as credible signals.[48] Firms use patents to credibly convey information about the invention to the market who otherwise might not be willing to expend the costs necessary to obtain the information.[49]

Defensive AspectPatent value is also ascertained based on its use to serve as an insurance, whereby competing firms use them as “bargaining chips” to negotiate and secure certain niches in the marketplace.[50] This is so especially from the negotiation as well as the litigation viewpoint.

Valuation DynamicsIn context of certain subject matters, inability of the patents to be valued or possibility of dynamic changes in value creates problems in structuring the patent pool, or it might lead to issues of according over-value or under-value. For example, in the process of biological research, where hypotheses are often adjusted and experimentation continually refined, it is impossible to anticipate the particular value of a given research tool for an investigative procedure.[51] Similarly, in context of the Human Genome Sciences, the patent for the gene that encodes CCR5 protein, was likely not valued very highly, because of unsurity of its utility, which changed when independent research established its importance in the fight against HIV.[52]

C. Role of Independent Evaluator

Often, independent experts in the relevant technology are employed for patent valuation purposes. Their role includes the responsibility of providing a mechanism for determining the market value of each participating patent for the purpose of setting appropriate royalty rates within the patent pool.[53] Also, they would evaluate the current state of the art and determine which patents are essential and which aren’t.[54] An evaluator’s is a continuing responsibility throughout the existence of the duration of the patent pool to monitor developments in the field so as to ensure each patent’s essentiality and incorporate additional patents if necessary.[55] Concerns though have been expressed as regards the expert’s ability and impartiality.[56]

III. Determination of License Fee for a Patent Pool

Theorists, have suggested criteria to gauge viability of patent pools.[57] The various elements involved in structuring of a patent pool do not function in a vacuum. Each has an impact on the other and ultimately they determine in totum, the licensing fees.

A. Pool Dynamics

The factors catalyzing pool creation impact on the licensing fee that is set. A patent pool may primarily be structured due to government influence,[58] court influence,[59] commercial and business perspective,[60] to achieve or pursuant to standard setting,[61] and social objectives.[62] Accordingly, riders may be placed on creation of the pool and setting of licensing fees.

Analogously, members comprising the patent pool affect royalty determinations. Different perspectives can be observed in commercial entities as opposed to research entities or voluntary organizations. Similarly, the negotiation capabilities are different for established commercial conglomerates as opposed to entrepreneurs, or smaller entities.[63] Similarly, patent pools may distinguish between patent contributing licensees and mere licensees in fixing royalty rates.[64]

Furthermore, pool governance as well as nature of the pool would have an impact on royalty determination. Pools can essentially be of two types based on regulation of members or licensing- open and closed.[65] Correspondingly, the patent holders themselves may have different perspectives or expectations of their rights.

The negotiating entity too has an impact on royalty determination. “Agreements between the members of the patent pool and third parties can be established directly through patentees and licensees or indirectly through an entity specifically created to administer the pool.”[66] There are a considerable number of business models involved in context of a patent pool that define the parameters of the relationship between what are primarily classified as IP creators and IP consumers.[67] These dynamics have considerably altered with the strong and prolific emergence of IP intermediaries; they in turn affect the royalty rate negotiations.[68]

B. Negotiation Dynamics

License negotiations involve complicated factors, such as uncertain outcomes, asymmetric information about the values of technologies and the contributions of licensees to a technologys value, the credibility of disagreements, differential bargaining power and skill, and the individual circumstances of licensors and licensees.[69] Royalty determination depends on “the bargaining skills of patentees, their licensing objectives, the qualities of their patents, opportunity costs that patentees may have if they choose not to license their patents, the likelihood of injunctions, and the methods that courts apply to calculate infringement damages.” [70] Pool members act strategically to maximize their share of the pool’s revenues.[71] “The defining characteristic of patent ownership has been described as the right to extract royalties ‘as high as [one] can negotiate with the leverage’ of exclusivity.”[72] “The patent holder can ask for a high starting price; the potential infringer can counter by pointing to potential substitute technologies; and ultimately the process should yield a price that accurately reflects the marginal advantages of the patented technology.”[73] Again, negotiation strategies include deploying a number of tactics by corporates to whittle down an independent inventor’s patience and his price, thus reducing the licensing fee from the desired amount.[74] Correspondingly, there is no average length of time or amount of money needed for successfully creating a patent pool; it depends on the number of members involved in the negotiations and their commitment and willingness to negotiate an appropriate price.[75]

Timing of the license negotiation too has an impact on determination of the royalty scheme. Licensing can occur in two primary settings: ex ante licensing, i.e. prior to pool formation; and ex post, i.e. post pool formation. In ex ante licensing, the manufacturer has a choice to alter existing products to incorporate the patented features, and can thus perform a rational cost-benefit analysis prior to making any product alterations.[76] Analogously, a holdout who demands royalties prior to the final organization of the pool can only demand a royalty that reflects the additional value that his new patent adds to the collection.[77] If he demands more than this value, the pool will work around the holdout’s patent by adopting a different standard, adjusting the patent pool to cover slightly different technology, or dissolving itself.[78] In ex post licensing, on the other hand, a holdout is in a stronger negotiating position, and can demand not only the marginal value of his patent, but also the switching costs that would be incurred if the established standard or licensing regime were limited by a court injunction.[79] Complicating this situation are licenses that are granted ex ante but negotiated ex post.

Furthermore, patent pools are generally voluntary collaborations; however, it is also possible to compel parties to join the pool or risk losing revenue from a large segment of the industry.[80] Depending on the situation, the negotiation dynamics and hence the royalty scheme would be affected.

Rules governing damages for patent infringement also affect patentees’ decision to join a pool or to license independently, as the threat of injunctive relief can provide a patentee with bargaining power that can be disproportional to the number of patents he owns.[81]

C. Terms of License

The terms of the license considerably influence royalty determination. These include, nature of licensed products,[82] character of license- whether exclusive or non-exclusive,[83] granting clause, geographic scope of the license, field of use governed by the license, provision of sublicensing, grantback provisions, future usage governance, non-assertion clauses, reach-through provisions, termination clause, and licensee’s ability to challenge patents in the pool.

Included herein too would be the treatment of after-acquired patents, which in turn can be classified into two types: (1) improvement patents based on a patented technology licensed by another member of the patent pool; and (2) patents unrelated to patented technologies licensed to the members of the patent pool.[84]

License governance in context of graduated and progressive licensing would also influence royalty determination. This would include “provisions for pool members to license their patents without licensing all the patents in a pool”[85] And the freedom “to license their patents bilaterally, i.e., outside of the pool structure.”[86]

IV. Methods for Patent Valuation and License Fee Determination

There are three basic methods of valuation: the cost method,[87] the market method,[88] and the income method.[89] In context of patent valuation, these methods find varied expressions. “A truly accurate assessment of patent value requires intensive legal and technical evaluation of individual patents.”[90] The economics literature, however, has also proposed several proxies for patent value based on objective and readily available information.[91]

In context of patent pools the dynamics of patent valuation methods is altered and they need to be viewed through the prism of factors discussed in Part II. This doesn’t imply that approaches to objective patent valuation are not relevant.[92] “However, such valuation approaches focus only on characteristics of patents at the time of issue and neglect to consider what happens afterwards.”[93] “Technology developments or price fluctuations, among many factors, may alter the relationship between two patents … In turn, this may decrease the value of any static analysis conducted by experts.”[94]

Determination of the licensing fee of a patent pool is based on the joint affect of certain transactions. Again, as with patent valuation, so also with licensing fee determination, in context of patent pools, the factors discussed in Part III need to be given heed. The transactions influencing licensing fee determination essentially comprise of valuation of the patent, which in turn is used to set a royalty rate pertaining to allocation of various fees received by licensing of the pool patents. Thus, royalty payment is comprised of two components: a royalty rate and a royalty base, upon which the rate is applied.[95]

A. Determining an Appropriate Royalty Base

The scope of the royalty base can be determined in two principal ways- apportionment and entire market value rule.

The apportionment principle implies that when a patent reads on the entirety of an infringing product, the royalty base should be the total value of the sales (or use) of that product.[96] When the patent at issue covers only a component of the infringing product, the value of the sales or uses of that item must be apportioned between the patented invention and the remaining unpatented components.