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4 Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers professional and personal knowledge and understanding. The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more. For a list of available titles, visit our web site at

5 Patent Valuation Improving Decision Making through Analysis WILLIAM J. MURPHY, JOHN L. ORCUTT, PAUL C. REMUS John Wiley & Sons, Inc.

6 Copyright # 2012 by William J. Murphy, John L. Orcutt, Paul C. Remus. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) , fax (978) , or on the Web at Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) , fax (201) , or online at Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) , outside the United States at (317) or fax (317) Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at Library of Congress Cataloging-in-Publication Data: Murphy, William J. (William Joseph), Patent valuation : improving decision making through analysis / William J. Murphy, John L. Orcutt, Paul C. Remus. 1 p. cm. (Wiley finance series) Includes bibliographical references and index. ISBN (hardback); ISBN (ebk); ISBN (ebk); ISBN (ebk) 1. Patents Valuation. 2. Decision making. 3. Patents Accounting. I. Orcutt, John L. II. Remus, Paul C., III. Title. HF5681.P3M dc Printed in the United States of America

7 Contents Preface Acknowledgments ix xiii PART ONE Foundations for Patent Valuation and Decision Making 1 CHAPTER 1 Valuation Basics 3 What Is Value? 5 The Valuation Process 7 Identifying the Subject Matter of the Valuation 9 Valuation Misconceptions 12 The Three Basic Valuation Methodologies 16 Limitations on Rationality in Valuation and Decision-Making Exercises 20 References 20 Notes 21 CHAPTER 2 Patent Basics 23 What Is a Patent? 26 Anatomy of a Patent 32 Criteria for a Patent 33 Transferring Patent Rights 36 Nationality of a Patent 39 References 40 Notes 40 v

8 vi CONTENTS CHAPTER 3 Using Valuation Analysis to Improve Patent Decision Making 43 Patent Decisions 45 Maximizing, Optimizing, and Satisficing: How Much to Invest in Valuation Analysis 52 Preliminary Portfolio Valuation Audit: A Practical Valuation Technique 58 References 65 Notes 65 CHAPTER 4 Disassembly 67 Disassembly and Decision Trees 69 Using Disassembly to Develop Higher-Quality Data 75 Using Disassembly to Understand Data Better 84 References 86 Notes 87 PART TWO Patent Valuation Techniques 89 CHAPTER 5 Preparing for the Valuation 91 Understanding the Bundle of Legal Rights 91 Ownership Interest in the Patent 93 Description of the Patent Rights 99 Encumbrances on the Patent Rights 100 Understanding the Patent Rights Neighborhood 102 Exploiting the Patent Rights 103 References 117 Notes 119 CHAPTER 6 Income Methods: Discounted Future Economic Benefits Analysis 121 Basic Arithmetic of the Discounted Future Economic Benefits Analysis 124 Garbage In, Garbage Out: The Challenges Lay in the Inputs, Not the Math 131 Projecting Future Net Economic Benefits 133 Developing Projections from Analytical Analyses 143

9 Contents vii Estimating the Discount Rate 151 References 159 Notes 160 CHAPTER 7 Advanced Income Methods: Incorporating the Value of Future Decision Opportunities 161 Option Contracts and Their Value 164 Real Options 168 Valuing Patents Using Option-Pricing Insights 170 Using Decision Trees to Incorporate the Value of a Patent s Future Decision Opportunities 174 References 185 Notes 186 CHAPTER 8 Market Methods 189 Markets and Patent Rights 191 Competitive Exchange 198 Comparable Transactions 205 Alternatives to the Core Market Methods 207 References 214 Notes 216 CHAPTER 9 Cost Methods 219 A Few Accounting Principles 220 Cost of Development: Questionable Valuation Tool 224 Cost of Reasonable Alternatives: Establishing a Maximum Price 227 References 230 Notes 231 PART 3 Patent Valuation in Practice 233 CHAPTER 10 Pricing Patent Licenses 235 Payment Structures 236 Determining the Price for a License 246

10 viii CONTENTS Less Formal Valuation Techniques for Setting Royalty Rates 248 References 264 Notes 265 CHAPTER 11 Patent Infringement Damages 269 U.S. Legal Framework for Calculating Damages in Patent Infringement Cases 271 Lost Profits 275 Reasonable Royalty 285 Additional Patent Damages Matters 297 Answering the Sue or Settle Question 299 References 306 Notes 307 CHAPTER 12 Unlocking the Potential Value within Patents 313 Keeping Pace with Economic Changes 316 Patents as Collateral for Secured Loans 317 Securitizing Patents 325 References 333 Notes 334 CHAPTER 13 Valuation in Patent-Based Tax-Planning Strategies 337 Examples of Patent-Based Tax-Reduction Strategies 339 Transfer Pricing 344 Determining Transfer Prices for Patent Rights 348 References 358 Notes 359 About the Authors 363 Index 365

11 Preface We have a very simple goal with this book: to help inventors, entrepreneurs, executives, technology acquirers, technology managers, lawyers, judges, and anyone else who is part of the patenting process to make better patent decisions. Most readers of a book titled Patent Valuation are likely to appreciate that patented inventions are important. So, we are going to skip over the typical introduction to an intellectual property book that tells readers about the importance of intellectual property in particular, patents in a knowledge-based world. We assume that readers already know that patented inventions provide the foundation for modern economies and for many of the world s most successful companies. What many readers may not fully appreciate, however, is a more subtle but equally important reality that stems from two related concepts. First, making informed decisions about the creation, management, and defense of patented inventions can distinguish competitive success (and significant wealth creation) from competitive failure (and economic waste). For patents to achieve their value-generating potential, numerous actors performing a variety of functions need to make multiple decisions. For example, inventors need to decide which research projects to pursue and how much to invest in the research project. If a patentable invention results from the research project, the inventor needs to decide whether to patent the invention and, if the answer is to patent, how much to invest in prosecuting the patent. Decisions then need to be made about patent management. Should the patent holder use the invention, transfer it to a third party, or do both? If the patent holder seeks to transfer some, or all, of its patent rights, how should the transfer be structured and at what price? Overlaying all these decisions are equally important litigation decisions. Should the patent holder sue a potential infringer (and how much should it spend on the litigation)? At what price should the patent holder settle? When should an alleged infringer settle a potential lawsuit, and when should it defend? As the societal importance of patents continues to increase, so, too, does the importance of wisely making each of these various patent decisions (and thousands more related decisions). The second concept is that patent decisions can be significantly improved by recognizing that they can be quantified, compared, and evaluated. In short, patents and their related decisions can be valued and ix

12 x PREFACE are implicitly valued even if that valuation frequently goes unnoticed. Through an attentive and disciplined thought process, valuation allows a decision maker to determine the course of action that provides the most advantageous outcome. Despite its acceptance in other business settings, valuation has been slow to develop as a wide-ranging decision-making tool for patents. One reason (and probably the most powerful reason) for this failure to systematically employ valuation analysis to guide patent decisions is the common misperception that patent valuation is too difficult. Because most patent decision makers believe that valuing patents is an inherently difficult exercise, they often believe that it is foolhardy to invest much energy into valuation unless it is absolutely required, such as when licensing a set of patent rights. Such thinking could not be more misguided. On the one hand, it fails to appreciate the extent to which valuing patents can improve patent decisions. Moreover, the idea that patents are overly difficult to value is simply wrong. One of the most fundamental premises of this book is that intelligent valuation skills are accessible to, and should be used by, each of the various decision makers in the patent process. This book provides narrative descriptions of the various topics, illustrative cases, stepby-step valuation techniques, user-friendly procedures and checklists, and an abundance of examples that help to make patent valuation an understandable decision-making tool that can be deployed throughout an organization. OUTLINE OF THE BOOK This book is organized into three parts. Part One examines the foundations for patent valuation and decision making. Chapter 1, Valuation Basics, presents an overview of valuation and its role in decision-making processes. Chapter 2, Patent Basics, provides a review of patent law basics. Because patent rights separate from the underlying use of a patented invention are central to an invention s ability to generate value, it is critical to understand those rights when valuing a patent. Chapter 3, Valuation Analysis to Improve Patent Decision Making, provides an overview of the wide range of patent decisions that can benefit from valuation analysis and examines decision-making strategies that help to guide how much valuation analysis to conduct in a particular situation. With real-world applications in mind, this chapter also explains how valuation techniques can help to inform decision making without becoming tedious, overly burdensome endeavors. Chapter 4, Disassembly, explains how the basic task of disassembling a

13 Preface xi valuation problem into its component parts can often be the most crucial step for generating a useful valuation. Disassembly helps the valuator to identify the individual factors that collectively generate the overall value of the item being valued, generate a better understanding of those individual factors and how they interact to generate value, organize the information so that it can be dealt with in a manageable way, and identify and eliminate extraneous information that is not important to the valuation process. This chapter also demonstrates how to incorporate disassembly techniques into patent valuation analyses. Part Two provides the fundamental tools needed to value patents. Chapter 5, Preparing for the Valuation, details the preparatory work that should be done before launching into a thorough valuation exercise. Chapter 6, Income Methods: Discounted Future Economic Benefits Analysis, describes the basic discounted future economic benefits (DFEB) model for valuing patents. Chapter 7, Advanced Income Methods: Incorporating the Value of Future Decision Opportunities, seeks to expand on the basic DFEB model to incorporate the value of future decision opportunities. The basic DFEB model does not fully capture future flexibility and choices that are embedded in patents, but more advanced techniques (such as real options theory and decision trees) do. Chapter 7 explores the theoretical and practical applicability of these advanced techniques. Chapter 8, Market Methods, analyzes a number of the market methods that are used to value patents. This chapter also explains the strengths and weaknesses of these methods and how they can be effectively employed. Chapter 9, Cost Methods, explains the core cost methods for valuing patents and demonstrates how to make practical use of them. Part Three presents specific, practical scenarios that benefit from patent valuation. Chapter 10, Pricing Patent Licenses, examines how to structure and price patent licenses. One of the most critical times for valuing a set of patent rights is when patent rights are being transferred voluntarily, and licenses are the most common method for such transfers. Chapter 11, Patent Infringement Damages, provides an overview of U.S. law for calculating damages in patent infringement cases. The consequences of infringement litigation can be very material to a party, which makes understanding how patent damage awards are computed important to intelligent decision making in numerous litigation and nonlitigation patent settings. The potential net returns from bringing a lawsuit as well as the potential net costs from being sued for infringement should factor into a multitude of patent decisions. Chapter 12, Unlocking the Potential Value within Patents, considers the latent, capital-generation potential that exists within patents. Unlocking the potential value of patent assets to access investment

14 xii PREFACE capital is critical to the creation and growth of entrepreneurial firms. This chapter describes a number of emerging methods for extracting this potential value from patents and explains the intersection between traditional valuation analysis and these emerging practices. Chapter 13, Valuation in Patent-Based Tax-Planning Strategies, explores patent-based tax-reduction strategies and explains the role of valuation in these strategies.

15 Acknowledgments We could not have completed this project without our colleagues at the Intellectual Property Valuation Institute (IPVI), which is part of the Franklin Pierce Center for Intellectual Property at the University of New Hampshire School of Law. Our IPVI colleagues, in particular Gordon Smith and Professor Susan Richey, have provided us invaluable assistance and insights throughout the book-writing process. We have also received substantial support from UNH Law Assistant Professors Jon Cavicchi and Tom Hemstock, who are two of the best law librarians in the world. During our work on this book, we have had a number of talented research assistants who have provided us with thoughtful and generous assistance in researching and editing the book. They include Jeremy Barton, Jacki Lin, Ian Mullet, Sarah Rogers, and Joseph Young. The various decision trees that we provide in this book were developed using TreeAge Pro. We would like to thank TreeAge Software, Inc. of Williamstow n, Massa chuset ts (www. treeage. com) for providing us with a complimentary license to construct the decision trees for this book. The authors would also like to thank Professor Ray Friel of the law faculty at the University of Limerick, Ireland, for his welcome advice and encouragement. The authors would also like to thank the law faculty at University College Cork, Ireland, who sacrificed the 2011 elaw Summer Institute, an unexpected occurrence that fortuitously provided some much needed time for Bill to work on this book. Finally, and most important, we want to thank our families and friends for their support. Bill would like to thank his family, in particular Tyler and Kristen Murphy, who have had to listen to more about patent valuation than any two college students should. John would like to thank his wife, Corinne, and his children, Xavier, Alexandre, and Morgane, for all the sacrifices they made to allow him to work on this book. John particularly wants to thank Morgane, who became a regular at his office while he xiii