The question is: Why does only a small portion a patents make money for their inventors?

In Part 1 – Buyer’s Perspective, I discussed the fact that a patent is not a clearly-defined asset; that is, there is a tremendous amount of uncertainty surround what the buyer is getting with the patent.   In particular, it’s difficult to convince a potential buyer to buy a patent, because he faces so much uncertainty regarding the legal rights being gained from in-licensing the patent, as well as the resources required to get the patent in-house and adapted to meet his needs.  Given all the uncertainty involved, most buyers are better off either working around the patent or pursuing some other investment opportunity than that offered by the patent at issue.

Here in Part 2 – Seller’s Perspective:  I discuss why patents are not usually worth as much as their inventors think.

 Patents Are Not Usually Worth as Much as Inventors Think

To the extent that the seller of a patent can find a potential buyer, most prospective licensing/sale deals fall through because the seller asks a much higher price than the buyer is willing to pay.  There are several reasons that the price the seller asks the buyer to pay is too high from the buyer’s perspective.

In my earlier blog post, Creating Capital Markets for Patents, I noted several reasons why the seller might overstate the potential value of a patent to a prospective buyer.  Those reasons, plus some additional ones, are discussed below.

First, it has been suggested that “1% to 3% of patents generate a profit for their inventors.” Potential buyers will discount the expected value of the seller’s patent by up to 97 to 99 percent to account for the fact that only a small portion of patents end up being valuable.  The potential buyer may discount the patent at issue even further to account for all the other potential uncertainties discussed above associated with buying the patent and aggregating it into his business model.  The seller, on the other hand, is much more inclined to believe that his patent falls into the 1 – 3% portion of profitable patents.  As such, the seller’s asking price will tend to reflect a much lower discount for the possibility that his patent may not be valuable.

Second, the value of patents is context specific.  For example, given its repository of patents and products, its know-how, its relationships, and such, IBM may be able to generate greater profits from a particular patent on a computer technology than, say, Cisco.  In this case, the patent at issue will be more valuable to IBM, that is, IBM will be willing to pay more for the patent, than Cisco.  Yet, the potential buyer may not be the one who can extract as much value from the patent as would the patent’s ideal commercializer.  In this case, the price the potential buyer would be willing to pay is less than the price the ideal commericializer would be willing to pay.  The seller of the patent, on the other hand, will tend to focus more on the possibilities of his patent in its most valuable context, and thus value his patent more than the potential buyer does.

Third, these days, most technologies are systems that combine patents and know-how from many different sources.  As a case in point, Steve Jobs has made a point of noting that the iPhone incorporates technologies from 200 patents (see for example this article). What can we then say about the portion of the iPhone’s value that is attributable to any one of those 200 patents?  It’s tough to say.  However, the seller of one of those 200 patents will be more inclined to believe that his patent is the make-it-or-break-it piece of the system and thus value his patent more than would a disinterested buyer.

Fourth, patents are a lot more valuable when they are aggregated into portfolios.  Many patent buyers already own other patents in the same area as the one being offered by the seller.  The patent at issue would be much more valuable when included as part of the potential buyer’s portfolio – due to all the classic risk diversification issues.  However, since it is the prospective buyer that owns the portfolio, it is he who would realize the extra aggregation value of the patent, not the seller.

Fifth, in most cases, only a portion of the value of the final product to which the patent contributes is attributable to the patent at issue.  That is, much of the value that inventors attribute to their patent is value that should be actually be attributed to complementary assets (in addition to any other patents, such as the 200 in the iPhone example just described) required to make and sell the technology to which the patent contributes.  This issue in particular intrigues me, because my view on the matter has been steadily changing over time.  When I first started working with IP, I thought patents were tremendously valuable.  However, after working with several start-ups and observing the success and failures of many more, over time I have appreciated more and more how much more it takes than just a patent to create a successful technology.

In particular, commercializing the technology that embodies the patent at issue involves two sets of issues, technology issues and market issues.

The technology side of the business involves all the issues surrounding whether or not the technology will yield a viable product.  Coming up with a viable product generally requires combining the right patents, with the right materials, in the right way, using the right know-how, all of which must be funded by an investor.

Furthermore, technologies today often require larger ecosystems in which they operate.  Take solar energy, for example, once you have a system of solar panels that will generate power, you need to find the land to put it on, build the infrastructure that surrounds and supports the panels, build roads to transport workers to and from the infrastructure, lay cabling that will transport the energy created by the solar energy system  to the electricity grid from which users can access it, etc.  In this case, one of the patents that contributed to the solar panels is just a very small piece of the technology ecosystem that enables the patent to eventually provide users with power.

The market side of the business involves all the issues surrounding whether or not the technology can be provided to end users at a price the users would be willing to pay for the technology.  The market side of the business thus requires that all the manufacturing, fulfillment, marketing, and sales costs, together with the funding of all these activities involved in creating the product and getting it to users, can be achieved in a reliable and cost-effective manner.

Consider an inventor who comes up with a patent that contributes to the next generation iPod, iPhone, or iPad.  Suppose that next generation device ends up generating $10 billion for Apple.  How much of that $10 billion is attributable to the patent?  Well, the product might end up being a phenomenal success, but most of the value is attributable to the hardware-software ecosystem, reputation, sales channels, etc. that Apple has erected over the decades it’s been in business.  Suppose the patent at issue in its next best use after the Apple device would be in an analogous Google version of the device, and suppose that the product would end up generating $2 billion for Google.  Well, then we know right there that $8 billion of the $10 billion generated by Apple is attributable to Apple’s IP (ecosystem, reputation, sales channels, etc.), and not the patent at issue.

Returning to the value created by the technology system embodying the patent at issue, once you account for all the complementary assets that are required to make the technology system successful, inventors will probably discover that their patents are not worth nearly the amount they think they are.

Conclusions

The question was: Why does only a small portion a patents make money for their inventors?

At least part of the answer is two-fold.  First, given the amount of uncertainty surrounding the rights a potential buyer is getting from buying a patent, together with the uncertainty surrounding the resources required to get the patent in-house and adapted to meet his needs, the buyer is almost always better off either working around the patent or pursuing some other investment project altogether.  And second, if a buyer does decide to purchase a patent, most of the value generated by the technology embodying the patent is attributable to assets other than the patent at issue.  In other words, in most cases, there are better opportunities available than those offered by a given patent, and even if the patent at issue does provide a one in a million opportunity, most of the success (value) of the final product embodying the patent is attributable to assets other than the patent itself.

Much of the uncertainty surrounding the rights a potential buyer is getting with the license or purchase of a patent is resolved either when a patent is litigated or it is designated as a standard.  The explains why a large fraction of the patents that have generated income for its owners are patents that have been litigated or designated as standards.

In most cases, it requires less uncertainty and/or fewer resources to work around a patent than to license or purchase a patent.  That is, most patents are not essential.  This explains why many of the patents that have been successfully commercialized are truly unique inventions, that is, those for which no good substitutes or work-arounds exist.

I will conclude by saying that just because a patent does not generate income for it’s inventor does not mean the patent has not contributed to the base of knowledge.  Ideas and inventions provide building blocks for later ideas and inventions, and just because a patent hasn’t provide income for its inventor doesn’t mean it hasn’t contributed some way to furthering the well-being of society. (Corny, but true.)