Theoretical Perspectives on Patent Strategy

Deepak Somaya

Robert H. Smith School of Business

University of Maryland

College Park, MD 20742

Tel. 301 405 0333 Fax. 253 550 7736

Email: dsomaya@rhsmith.umd.edu

DRAFT

August 1, 2002

ABSTRACT

We seek to advance scholarship in patent strategy by presenting a set of organizing

theoretical perspectives to guide future research. The domain of patent strategy primarily

encompasses patenting, licensing, and enforcement decisions. Patent strategy also entails a set of

nested choices, where future opportunities are only available by building prior positions, which

thus become a source of dynamic capabilities. Three generic strategies are pursued by firms in

the patent domain – using patents to strategically “isolate” rent yielding organizational assets,

maximizing royalty revenues from patented technologies, and defending against patents owned

by others. In addition, patent strategy has an important organizational choice dimension, where

the organizational modes used in the commercialization of complex multi-invention products

have fundamental implications for the strategic use of patents by firms. I situate prior studies of

patent use in the context of broad theoretical framework presented in this paper, and suggest

avenues for further research into patent strategy.

Keywords: patents, intellectual property, licensing, firm strategy

JEL Classification: O3, K2, M2

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Theoretical Perspectives on Patent Strategy

1. Introduction

In a knowledge economy, the knowledge assets built and owned by firms are vital for

commercial success. Intellectual property assets like patents constitute an important category of

these knowledge assets, and are therefore of substantial interest to modern corporations. Recent

books in the popular business press (Rivette and Kline, 2000; Davis and Harrison, 2001) also

reflect this growing managerial interest in patents and their role in building competitive

advantage. However, research on patent strategy has proceeded on a somewhat ad hoc basis, and

there is a pressing need for organizing theoretical perspectives to motivate and structure this

emerging field.

We address this need by presenting both an analysis of the patent domain, as well as two

sets of theoretical motivations that are central to patent strategy. The domain of patent strategy

primarily encompasses decisions about obtaining patent rights, licensing patents, and enforcing

them. In turn, these decisions have a nested structure, so that some choices are only available to

firms if specific prior choices were made. Thus decisions about patents can help firms build

“positions” that become sources of dynamic capabilities in the long run (Teece, Pisano and

Shuen, 1997). While actions in the patent domain are essentially of a “non market” type, they are

nonetheless closely connected to the market strategies of firms.

These very connections are at the heart of patent strategy. One such strategy is the use of

patents as isolating mechanisms (Lippman and Rumelt, 1982; Rumelt, 1984) to shield valuable

rent yielding commercial assets of the firm from imitation. A second important strategy is the

leveraging of patents to maximize licensing revenues from the firm’s inventions. Third, firms

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must often devise effective “defensive” strategies to ensure that they are free to innovate and

operate in the marketplace despite numerous patents owned by others. These three considerations

seem to pervade the patent domain, leading us to label them as “generic patent strategies”.

In addition to this first generic set of strategies, patents also play an important role in a

second level of strategic considerations in complex multi-invention industries. In such industries,

products typically incorporate a very large number of patented inventions, which in turn, may be

owned by a number of firms. Since end products in such contexts can be produced by using a

number of integrated and non-integrated organizational modes, firms must first determine their

organizational strategy for commercializing products based on the relative merits of these modes.

An effective patent strategy is an important complement to this organizational choice, and can

help both non-integrated technology specialists and large integrated firms enhance their

competitive advantage.

Our focus on patent strategy is somewhat unique when contrasted with the long history of

“patent research” in management. This substantial and successful body of research has employed

patent-based variables as proxies in the study of innovative performance (Ahuja, 2000a;

Sorensen and Stuart, 2000; Ahuja and Katila, 2001), capabilities (Mowery, Oxley and Silverman,

1996; Stuart and Podolny, 1996; Ahuja, 2000b) and learning (Jaffe, Trajtenberg and Henderson,

1993; Mowery, Oxley and Silverman, 1998; Ahuja and Katila, 2001). By contrast, in patent

strategy, the phenomena being studied are “the patents” themselves, and their use as intellectual

property (IP) assets (or knowledge assets) by firms.

The rest of this paper is organized as follows. Section two of this paper defines patent

strategy and discusses its main characteristics. Section three presents three generic theoretical

perspectives on patent strategy – strategic isolation, royalty harvesting, and defensive strategy.

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Section four highlights the implications of patent rights for organizational choice in multi-

invention contexts. Section five discusses the implications of this paper for academic research in

patent strategy, and concludes.

2. Understanding Patent Strategy

Broadly, patent strategy can be defined as the pursuit of competitive advantage through

the acquisition and management of patents by firms. While a good understanding of patent law

would no doubt be useful in devising it,1 patent strategy is primarily a business responsibility that

is ultimately shouldered by the CEO. To clarify, patent strategy is not centered around the many

(clearly important) legal tactics and maneuvers practiced in patent law, but with the broader

strategic role played by patents in firms. A more detailed understanding of what I mean by this

can be obtained by focusing on three central features of patent strategy – its domain, its nested

choice structure, and its non-market character.

2.1 The Domain of Patent Strategy

The domain of patent strategy broadly encompasses three related phenomena – patenting,

licensing, and enforcement. Patenting refers to the gamut of actions whereby patent rights are

obtained, renewed and maintained around the world. While obtaining a patent typically involves

the “prosecution” of a patent application in the patent office, patents may also be obtained

through the market for patents, patent-owning firms, or exclusive licenses.2 The renewal and

maintenance of patent portfolios entails an active managerial process whereby the marginal costs

1 As a very brief primer, I note that patents are applied for at the patent office, where a technically informed patent examiner decides whether or not to allow the patent. Once the patent issues, it constitutes a (somewhat fuzzy) property right on the invention claimed in the patent for a fixed period of time (typically 20 years from the date of application). Patentees may exclude others from a wide range of actions – including, making, selling, and importing the invention – by enforcing the patent against such infringers in a court of law.

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and benefits of continuing to own the patents must be constantly evaluated. For example, Dow

Chemical saved over $ 40 million in maintenance costs when it eliminated roughly 25% of its

global patent portfolio that were not of business interest.3

Licensing encompasses both exclusive and non-exclusive licensing of a company’s

patents, as well as those arrangements for patent sharing that arise out of joint ventures or

strategic alliances. Within licensing, a distinction must be made between the instances in which

patent rights are licensed along with technology, and those in which only the patent rights are

licensed. The traditional licensing literature has tended to focus on the former “active” form of

licensing, however, it appears that the latter “passive” form has grown sharply in recent years. In

information technologies, firms like IBM have earned very substantial licensing revenues

primarily from this passive form of licensing ($ 580 Million a year over 1999-2001).4

Enforcement entails the use or threatened use of litigation to avail of the legal property

rights embodied in the patent. Since patents themselves are not very well demarcated as property

rights,5 patent litigation and its outcome is far from a routine matter. Indeed, most real

enforcement occurs in the shadow of litigation – in the detection of infringement, in notices and

other actions taken against alleged infringers, and the intensive negotiations and settlements that

occur both before and during patent suits.

Finally, as illustrated in Figure 1, patenting, licensing and enforcement are strongly inter-

connected, so that actions or opportunities in one area often affect firm behavior in others. For

2 An exclusive license would allow a firm to obtain a limited patent right (by product or geography), which can sometimes be very valuable. For example, Eli Lilly’s exclusive license to Genentech’s genetically engineered insulin (so-called Humulin) patents helped extend that firm’s franchise in the insulin market. 3 Davis and Harrison, 2001 (pp.145-46). 4 IBM 2001 annual report. IBM also makes very substantial income from sales and transfers of its intellectual property. 5 While patents issued by the patent office are generally assumed to be prima facie valid by the courts, evidence may be introduced at trial that undermines the validity or enforceability of the patent. Further, technical and legal

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example, enforcement opportunities thrown up by a change in legal standards may imply the

need to obtain and maintain more patents, and also enable firms to resist licensing and use some

patents in a more exclusive manner instead. Similarly, the recent spurt in business method

patenting (Allison and Tiller, 2002) has led to enforcement actions by firms like Amazon and

Priceline, as well as substantial licensing activity in these patents.

[Figure 1 about here]

While past research has not always studied the patent domains discussed above from the

perspective of patent strategy, it has nonetheless shed light on each of them. For example,

research has demonstrated the deterrent impact of prior patenting on the allocation of innovative

resources by companies (Lerner, 1995), and the growth of “defensive” patenting in systems

product industries like semiconductors as a result of stronger patent enforcement (Hall and

Ziedonis, 2001) and institutionalized cross-licensing (Grindley and Teece, 1997). In turn,

licensing has been shown to be more common in the presence of strong and clear patent rights

(Arora, 1995, 1997), and in the presence of competing technologies (Arora and Fosfuri, 1998).

Patent enforcement through litigation has also been studied in past research (for an early review,

see Lanjouw and Lerner, 1998), with most studies focusing on the decisions to file, prolong, and

settle patent suits (Lanjouw and Schankerman, 2001a, b; Somaya, 2002a, b).

2.2 Nested Choices in Patent Strategy

Patent strategy can be thought of as consisting of a series of nested choices. For example,

firms choose whether to apply for a patent, and having obtained them, whether to renew them,

and in turn, whether to license or enforce them. This pattern of choices is pervasive, not only

across domains, but also within each domain – patenting, licensing, or enforcement. The choices

judgments are typically involved in determining if the patent has been infringed, adding an element of subjectivity to

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are “nested” in the sense that certain options are only available if the necessary prior choices

have been made. Obviously, one can only enforce or license patents that have been applied for,

granted, and kept alive through renewals.

Further, while each choice opens up some opportunities, it often closes others. Thus, if a

patent is granted (and therefore published), firms are generally unable to protect the same

invention as a trade secret. Similarly, if a firm has chosen to license a patent, the terms of the

license would circumscribe its ability to enforce the patent on the licensee. Thus, firms must

continually make current choices by anticipating their future needs, taking cognizance of both

the opportunities opened up and forgone by their actions.

Each nested choice in patent management not only has an associated set of opportunities,

but also costs. Thus, obtaining and litigating patents is costly, both in terms of legal expenses as

well as organizational resources like the time and effort of key inventors and managers.

Similarly, it takes resources to find potential licensees, and to negotiate and structure licensing

deals with them. In some instances, the impact of these costs can be very substantial – e.g.,

reduced productivity from a star scientist, or a top management distracted by patent litigation.

Along with the opportunities foregone when certain choices are made, these costs imply that

firms can not simply keep all their options open, but must carefully consider if the value of

making a given choice exceeds both its pecuniary and opportunity costs.

While the costs associated with patent choices are often quite clear, the benefits of

choosing one set of nested patent opportunities versus another are often difficult to assess due to

inherent uncertainties about patents and technologies. For example, it is often unclear, a priori, if

an invention will turn out to be commercially successful, and therefore worth building a patent

fence around. Thus, at each stage, firms must make judgments about the likely value of patent-

the boundaries of the patent, and thus making them “fuzzy”.

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related opportunities kept open up (or closed) in the face of substantial uncertainty. This suggests

that many patent decisions could be viewed as the buying of real options (Dixit and Pindyck,

1994), and some recent research has sought to extend real options thinking into the patent arena

(Marco, 2000). Analogously, in the language of dynamic capabilities (Teece, Pisano and Shuen,

1997), these prior choices can be viewed as the building of asset “positions” that enable firms to

access future strategic opportunities.

The presumption in a real options view of patent strategy is that when the option is “in

the money” – for example, when technological and commercial uncertainties are resolved and it

is clear that a patented product would be a success – patent owners will exercise the option.

Typically, this would mean enforcing the patent right against others. However, as I have noted

earlier, it is often unclear what the outcome of patent enforcement will be, lending an element of

uncertainty to the “exercise-ability” of the patent option. One upshot of this is that patents that

are of higher quality, usually implying clearer validity and scope, are more valuable than weak

and shaky patents (Sherry and Teece, 2002).

2.3 Patent Strategy as Non-Market Strategy

The property rights embodied in patents are created by law and implemented by agencies

(e.g. patent offices) and the courts.6 Since the domain of industrial innovation and global

competition to which these rights are applied is both complex and constantly evolving, these

rights are often modified over time, as well as being applied in the specific context of each new

6 Within the U.S., in addition to Congress, the federal courts, and the USPTO, the Food and Drug Administration plays an important role in regulating patent extensions and generic entry in pharmaceuticals (an outcome of the Hatch Waxman Act). The International Trade Commission provides an alternative forum (to the courts) for the resolution of patent disputes relating to imports into the United States. In the international arena, patents are typically granted by national patent offices (with the exception of the European Patent Office) and enforced in national courts (even in Europe). However, several multilateral and bilateral treaties (the Paris Convention, the Patent Cooperation Treaty and the GATT TRIPS accord are the most important) and institutions like the World Intellectual Property Organization (WIPO) and the World Trade Organization (WTO) also govern these primarily national systems.

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technological invention. Firms can attempt to strategically influence both the broad direction of

patent “policy” as well as application of existing policy in the instance of a specific patent. Thus,

there is a substantial element of “non-market” strategy (Baron, 1995) in patents. Firms that

understand this non-market dimension often find that it is an important ingredient for success in

the patent domain. For example, even a small Maryland start-up called Fusion Systems could

successfully to forestall attempts by the giant Mitsubishi Corporation to surround its patents in

Japan and force a license to Fusion’s pioneering patents in high intensity ulta-violet lamps by

strategically using pressure from the U.S. Trade Representative (Spero, 1990).

While at some level all patent strategy is non-market in nature, a conceptual distinction

can be drawn between strategies that seek to shape patent policies and institutions, and those that

primarily operate within an existing non-market environment in response to market imperatives.

While acknowledging the importance of the non-market perspective in patents generally, the rest

of this paper will focus primarily on patent strategies of the latter type – i.e. where the role

patents play in commercial market success is center stage, operating within a largely exogenous

non-market context.

3. Generic Patent Strategies

While there are no doubt specific issues that arise in each domain of patent strategy –

patenting, licensing or enforcement7 – some important commonalities cut across all of them.

Three such generic theoretical perspectives are presented below – namely, strategic isolation,

royalty harvesting, and defensive strategy.

7 For example, patenting decisions are subject at least in part to the need for motivating the firm’s researchers. Similarly, litigation includes the tactical considerations of using the costs and uncertainties of going to court to one’s advantage.

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3.1 Strategic Use of Patents As Isolating Mechanisms

Patents and other forms of intellectual property have long been recognized as effective

tools to safeguard valuable organizational resources from imitation by rivals, or in other words,

as “isolating mechanisms” (Lippman and Rumelt, 1982; Rumelt, 1984). Similarly, in the recent

popular literature, the role of patents in enabling firms to “stake out and defend a proprietary

market advantage” has been characterized as “their most powerful benefit” (Rivette and Kline,

2000, p. 4). But how are we to understand patents as isolating mechanisms when at the same

time they are often licensed, which inherently implies (legal) imitation by other firms?

The central insight arises from the recognition that the technological exclusivity offered

by a patent can sometimes be far more valuable than the “technological value” accessible by

licensing the patent. Thus, patents over technologies at the core of a company’s business are

often relied upon for their ability to discourage competitive imitation, and even follow-on

innovation. Such patents could be used to protect related irreversible investments in (potentially

imitable) product development (Kitch, 1977), co-specialized complementary resources (Teece,

1986), and even follow-on innovations.

Patents are also often used by entrepreneurial innovative entrants, who are generally

lacking in other organizational resources, to keep better-endowed competitors from quickly

imitating them. In markets where a firm has established a proprietary standard, patents can be

used to prevent imitation (or reverse engineering) of the standard itself, and to deny rival

complements access to the virtual network built around the standard.8 In sum, the essence of

8 Patents on “connector” technologies that enable complementary products to work together are often critical to the execution of firm strategies in standards-driven markets. For example, Gillette has a number of patents on the interface between their blades and razor handles. Without these, Gillette would be hard-pressed to sustain its “cheap razor – expensive blades” business model, as other blade manufacturers would compete with Gillette in the blades market (even if their blades are not perfect substitutes for Gillette’s).

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strategic isolation through patents is that the protection they provide from imitation is more

valuable than any returns available from licensing the patent.

Ultimately, the reliance on exclusivity in these patents rests on a contractual explanation

– it is very difficult to write and enforce contracts that allow rivals to license-in the patent, while

retaining the isolating benefits of the patent at the same time. These contractual problems arise

because of the enormous uncertainties in the future benefits over which the contracts must be

written. In essence, such a contract would have to guarantee the level of rents that the patentee

would have earned absent the license – a calculation that involves so many unknowns in the case

of isolating patents as to render it infeasible. In turn, any open-ended licensing contract can be

used opportunistically to ends not intended by the patentee. Thus, isolating patents function as

unique non-contractible firm-specific assets, or resources, which are considered a central source

of competitive advantage for firms in the resource-based view (Wernerfelt, 1984; Dierickx and

Cool, 1989; Barney, 1991; Barney, 1996).

When patents can serve a strategic isolating function, firms will be keen to build a strong

position in such patents (e.g. by creating a “patent thicket” that is difficult to invent around), they

will obviously prefer not to license these patents, and they will enforce the patents aggressively.

Conversely, some patents are less valuable as isolating mechanisms because they are not central

to the firm’s commercial advantage and do not protect a broader source of rents beyond the

patented technologies themselves. If these patents are of any value to their owners, it would often

be for their potential to yield royalties from licensing.

3.2 Harvesting Licensing Revenue from Patents

The licensing of technologies is a much-studied phenomenon in the management and

economics literatures. For example, prior research has focused on such issues as the crafting of

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incentive compatible licensing contracts (Katz and Shapiro, 1986; Gallini and Wright, 1990), the

licensing of know how along with patents (Arora, 1995), and the design of appropriate

governance structures for technology transactions (Teece, 1986, 1988, 1989; Anand and Khanna,

1997; Oxley, 1999). However, the decision to license the patents, and the leveraging of patents to

maximize licensing revenues has received less attention in this licensing literature. Since leading

technology firms like IBM have, in the 1990s, transformed their licensing operations into major

income generators precisely through their proactive management of intellectual property, this is

an important lacuna.

Based on the discussion in the previous section, patents that do not serve a strategic

isolating function are natural candidates for licensing.9 However, to accurately assess the

isolation available from patents, one must not only consider whether rent yielding resources are

being protected by the patents, but also how effective the protection is. Thus, strategic isolation

would not be very effective when competing technologies are available for licensing from other

firms (Arora and Fosfuri, 1998). Similarly, if multiple technologies are competing to become a

standard (or dominant design) in the “preparadigmatic” stage of technological evolution, it may

be necessary to encourage adoption through licensing (Teece, 1986). Further, if the patent

position of the firm is itself not very strong, and can not be improved, rivals may be able to

circumvent the patent by inventing around or exposing the patent’s legal weaknesses.

Another instance where licensing is often used is if patentees need access to the unique

resources of other firms to successfully commercialize their patented inventions. For example,

early biotechnology start-ups lacked the marketing, financial, and regulatory resources needed to

commercialize their inventions, and often licensed them to established pharmaceutical firms as a

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result.10 Ultimately however, firms must evaluate if they are better off using the protective

umbrella of patents to develop their own capabilities, or licensing out the patents.

Having decided to license, either the patents alone or the patents with the associated

know-how (i.e. in passive or active form), firms can typically use their patent rights to maximize

revenues from these licenses. Clearly, such royalty harvesting will only be helped by the diligent

detection and pursuit of patent licensing opportunities – either where patent infringement is

already occurring or where there is interest in commercializing the patented technology. More

importantly however, the share of rents appropriated by the patentee depends in large part on

convincing the licensee of the value of the license. Two main metrics of value are of relevance

here – the alternatives available in the (licensing) market, and the expected returns if the patent is

enforced.

For example, if the potential licensee is already infringing the patent(s) and has invested

substantially in the patented technologies, there are few practical alternatives to licensing the

patent(s). Otherwise, firms could consider inventing around or licensing similar technologies

from other sources (and in some cases even abandoning the technological opportunity entirely),

which can substantially undermine the patentee’s bargaining position. Thus, royalties can be

maximized if the patents are obtained on alternative technologies, and by making it difficult for

firms to invent around the patent. In complex products, firms often patent extensively so that

even if any one patent can be circumvented, it is difficult to circumvent all the patents taken

together.

9 Sometimes, patents may be valued for strategic isolation in some applications (products) and not others. In these instances, firms may be willing to provide limited licenses to encourage other firms to pursue these other opportunities. 10 Genentech’s recombinant insulin patents were thus licensed to Eli Lilly, an established pharmaceutical firm in the insulin market.

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If alternatives to the patent(s) are not the binding condition, the expected returns to the

two firms from litigation constitute the relevant reference points in bargaining. Thus, the threat

of litigation, if credible, plays a central role in royalty harvesting strategies. At the same time,

patent litigation itself is so costly and disruptive for firms that a significant fraction of the

potential benefits can be dissipated in the process. Thus, the goal of patentees should be to

enhance their own bargaining position, and to convince potential licensees of the default

litigation outcome without actually incurring the full costs of litigation. In particular, firms can

demonstrate the seriousness of the litigation threat by taking concrete actions like filing a suit or

obtaining a preliminary injunction (without going to full trial), as well as by building a reputation

for aggressive enforcement.

In addition, firms should be aware that the outcome of licensing negotiations or litigation

with one firm often produces spillovers in other licensing opportunities. Just as a reputation for

enforcement or a positive court decision can help with royalty harvesting against other potential

licensees, a negative outcome in court (or in any given licensing negotiation) can be harmful.

Therefore, a clear and dispassionate appreciation of the patent’s legal enforceability is critical –

it would be prudent to accept less generous licensing terms if the patent itself is weak, and could

end up getting exposed in litigation.

3.3 Defensive Strategies with Patents

Thus far, I have focused on the strategic considerations of firms that seek to assert their

patents against others. But, how should firms respond when they are “on defense”, i.e. when their

rivals assert patents against them? In certain industries, the firm’s patents themselves can be used

as shields against patent litigation. The effectiveness of, and need for, such “defensive patents”

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stems inherently from the technological character of these industries, which involves the use of

large numbers of patented inventions in marketable products (and potentially, services).

In fast-paced high-technology industries, firms may have made substantial irreversible

investments dedicated to a specific technological opportunity even before it is known who owns

the relevant patents (due to patent issuance lags and confidentiality in patent applications). In

other contexts, like semiconductor manufacturing, highly capital intensive fabrication facilities

that use thousands of patented inventions could easily be held hostage by a single patent suit.

Since the captive investments and associated commercial opportunities in these cases can be very

large, the ex post willingness to pay and therefore the firms’ vulnerability to patent litigation is

also large.

The primary defensive strategy available to firms in such contexts can be described as

“mutual hold-up.” If threatened by another firm with patent enforcement, firms in these

industries will typically threaten to sue back with their own patents, thus preventing their rival

from operating in the marketplace as well. One fallout of using a mutual hold-up strategy is a so-

called “arms race” to obtain large portfolios of patents with which to threaten potential patent

enforcers (Hall and Ziedonis, 2001). Since it may be possible to invent around a single blocking

patent, the emphasis in such industries is typically on building a large arsenal of patents with

overlapping and complementary coverage. Often, firms with defensive portfolios will

preemptively obtain access to each others’ patents en masse through cross-licenses to mitigate

the uncertainties of future litigation (Grindley and Teece, 1997). In sum, defensive patents serve

the purpose of foiling attempts by others to use their own patents as strategic isolating

mechanisms or to extract exorbitant royalties, thus giving their owners the freedom to invent and

operate in the marketplace.

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Mutual hold-up is not the only defensive strategy available to firms however, nor is it

always effective. In particular, mutual hold-up is a weak defensive strategy against patents

owned by individual inventors or universities, who typically have no commercial operations of

their own that can be held up. An alternative defensive strategy that firms can use to overcome

this “asymmetric threat” is to invent around the patent, thus restricting the patentee’s claim to

past infringement alone. In other instances, they can preemptively make public their own

inventions, either through scientific publications or by filing an “invention disclosure” at the

patent office,11 so as to prevent others from patenting it later.

Firms will also often respond to patent enforcement by trying to render the patent invalid

or unenforceable. Patents can be invalidated by uncovering relevant “prior art”, or by proving

that the invention would have been obvious to anyone skilled in that field of knowledge. Even

valid patents can be made unenforceable if it can be shown that they were obtained through fraud

at the patent office, or were used for anticompetitive purposes in violation of the antitrust laws.

Finally, firms can also defend themselves against unwelcome patent litigation by credibly

threatening to cause financial damage to the patentee – by making the litigation extremely

expensive and inconvenient, by exposing flaws in the patent to other (potential or actual)

licensees, or by taking other retaliatory actions in the marketplace.12

4. Patents and Organizational Choice in Multi-Invention Contexts

The defensive strategy of mutual hold-up relates to a more general challenge in many

industries where multi-invention contexts are becoming increasingly common, i.e. where very

large numbers of inventions are typically combined in end-products. In semiconductors for

11 The advantage of preemptive disclosure through these mechanisms is that they are generally much cheaper than obtaining a patent.

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example, increasing miniaturization has made it feasible to manufacture massive electronics

systems on a single chip (so-called systems-on-a-chip or SOC), but this implies that very large

numbers of patented inventions must be combined in any single product (Linden and Somaya,

2002). Similarly, even as software products are becoming large and extremely complex, the

patenting of software inventions – hundreds of which may be combined in contemporary

software programs – continues apace. In biotechnology, too, an outpouring of innovation in

genomics, research tools, and other areas needs to be combined to bring new healthcare solutions

to fruition.

In practice, innovation in these industries comes from multiple sources – from within

large firms, from start-ups and specialized players, from firms outside the industry, and even

from universities and other research establishments – creating a tangled web of patent rights that

must be navigated for commercial success. The central challenge for firms in such multi-

invention contexts is two-fold. First, they must determine how the production of end products in

their industry can be most effectively organized, given the need to combine these large numbers

of inventions. Second, they must examine their own capabilities and patent assets to ascertain

what role they must play within this emerging industrial organization. Patent strategy will be an

important complement to the firm’s chosen role in the organization of production in the industry,

and must therefore be closely coordinated with it.

4.1 Organizational Modes for Multi-Invention Products

The combination of technologically separable inventions in multi-invention contexts can

be accomplished in a number of ways. Broadly however, these organizational alternatives can be

12 For example, Intel’s threat to withhold information about the next x86 generation from Intergraph when Intergraph filed a patent suit against Intel in 1998.

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divided to into integrated and non-integrated modes,13 where the essence of being integrated is

that internally available technologies are used within the firm to produce the final product. Note

however, that the firm need not own the patents on these technologies, so that there may be a

need for “passive” licensing even in integrated modes.

4.1.1 Integrated Modes

Integrated production of multi-invention products may be pursued using a number of

different approaches. A priori, given the nature of innovation in these industries, it would be

highly unlikely that a single firm can invent and patent all the technologies necessary to

commercialize the end-product. Integrated modes therefore entail alternative approaches to

obtaining both the technologies and the access to patents needed for commercialization. One

alternative is to use the markets for mergers and acquisitions to agglomerate the technologies and

patents available in other firms. Firms like Cisco Systems have championed this approach,

typically acquiring smaller innovative firms with technologies (and patents) that the company

wants access to. Similarly, in the agricultural biotechnology industry, a number of firms have

consolidated to bring together germplasm, genomic, and plant variety patents relating to specific

crops.

Integrated firms can also choose to develop all the technologies they need in-house. For

those technologies patented by other firms, in-house development may occur through

independent near-simultaneous invention with the patent holder, or even through reverse

engineering of the patented invention. If the in-house technologies have not successfully

invented around the patents owned by others, integrated firms will need to obtain access to these

patents. This could be accomplished in a number of ways – through patent pools, cross-licenses,

13 Intermediate modes like joint ventures and strategic alliances are also possible, but analytically these can be

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and other patent sharing arrangements. Note however, that these licensing arrangements are

passive licenses, involving only the patent right. Indeed, managers in industries like

semiconductors, where cross-licensing is rampant, primarily think of licensing as patent-trading,

rather than the transfer of technology or know-how. Importantly, reliance on such licensing

assumes a willingness to license on the part of others, an assumption that will be strongly

challenged if those patentees intend using a non-integrated mode for commercialization.

4.1.2 Non-Integrated Modes

Non-integrated modes primarily use licensing and component markets through which

specialized “niche” firms offer their patent protected technologies to integrating firms, who

combine them with others to make multi-invention end-products. Thus, non-integrated modes do

involve firms that integrate technologies into a final product, but the key distinction is that some

of these technologies are obtained across an organizational boundary either through licenses or in

“embodied” component form. In both cases, the relevant patent rights owned by the licensor or

component supplier also convey with the license or component.

In semiconductors, new “chip-less” firms are creating a market for integrated circuit

design modules that other firms can license and integrate into their own system-on-a-chip

designs. Similarly, a fledgling market in software components has also grown, where program

components written by third-parties are increasingly being used when developing software. In

turn, such markets often foster specialization in the industry, with technologically focused firms

populating these specialized niches. While such specialization removes the need for widespread

access to patent rights across the industry, it doesn’t remove it entirely. In particular, firms in the

accommodated as hybrid forms that combine some features of integrated and non-integrated approaches.

19

integrating “center” of the industry, as well as competing firms within each specialized niche,

would probably still need access to each others’ patents.14

4.2 Organizational Effectiveness and Choice

Ultimately, end products in multi-invention industries compete against each other in the

marketplace, and using a superior organizational mode can be critical for commercial success.

Therefore, firms are deeply interested in knowing which of the many integrated and non-

integrated organizational alternatives are the most effective in any given context. I have

discussed the advantages and costs of different organizational modes in greater depth in a

separate paper on multi-invention contexts (Somaya and Teece, 2000). The focus here therefore

is on the main conclusions of that analysis.

It is well recognized that integrated modes of organization are more effective when the

transaction costs of using markets are high (Williamson, 1991). Coordinated adaptation made

possible through managerial direction and the weaker incentives within firms help to overcome

the adaptation problems created by transaction costs in the market. In the non-integrated modes

discussed above, at least some transaction costs are Williamsonian in nature, arising out of the

need for specific investments and uncertainty in contracting. However, others can more easily be

understood as arising out of the systemic nature of technology, where technological

interconnectedness between different parts of the system creates the need for close cooperation

and coordination that is difficult to sustain in incentive laden markets (Teece, 1996). Sometimes,

these can be overcome by the widespread use of clear interface standards that facilitate the inter-

operability of different parts of the systems product despite the use of non integrated modes.

Thus, the absence of such standards is often an impetus to a more integrated approach.

14 Thus non-integrated forms do not supplant the structures of integrated production entirely, but merely break it

20

Although I have lumped licensing and components together as “non-integrated modes”,

there are obviously important differences between the two. In particular, components allow

inventors to more precisely control and monitor the use of their technology, which in turn lowers

transaction costs in the component market. However, in many contexts, the lack of clear and

robust interface standards between components and the integrated product (in other words, a high

level of technological interconnectedness) may mean that licensing – which allows integrators

some flexibility in modifying the licensed technologies or designs – is more effective than

component contracts.15

Another critical difference between licensing and components contracts is the extent to

which the transfer of tacit know-how is necessary. If a lot of tacit knowledge is associated with

an invention, it typically makes it more difficult to transfer the technology across organizational

boundaries and implement in a new organizational context. In addition, firms are hesitant to

share tacit knowledge with others if they feel that the knowledge may be expropriated. Thus tacit

know how, to the extent it is present in any licensing context, can add further impediments to

licensing transactions.

Thus far, I have focused on the advantages of integrated modes in building multi-

invention products. However, it is well known that integrated modes also carry the heavy costs

of internal bureaucracy and the burden of equity (Williamson, 1985). In other words, the

advantage of non-integrated modes is that market-based incentives spur efficiency within each

specialized component or licensing niche. By contrast, in integrated modes, market competition,

down to more manageable fragments. 15 Although I describe components and licensing markets as two distinct alternatives, in practice, the distinction is a often a matter of degree rather than absolutes. For example, in digital component markets like those for software components or semiconductor designs, the distinction blurs because the “components” are already information goods. However, even there, degrees of componentization and licensing are visible in the extent to which the underlying code or know-how (and the accompanying flexibility to modify and adapt) is transferred between firms in any given contract.

21

and thus incentives, operate only at the overall end-product level, which can subsume many

inefficiencies in components or technologies. Integrated modes can mitigate this drawback to

some extent by incorporating new market-driven technologies through mergers and acquisitions,

but these markets (for corporate control) are also generally quite inefficient.

The increasing size and complexity of products in many multi-invention contexts also

implies some other advantages for non-integrated innovation, in addition to raw incentives.

Integrated firms are typically less effective at experimenting with alternative technological

solutions than a heterogeneous market consisting of technology specialists. In other words,

integrated modes may have a disadvantage vis-à-vis non-integrated modes in the exploration for

path breaking technologies, even though they may be quite adept at the exploitation of defined

technological trajectories (Winter, 198x). When innovation in non-integrated modes is well

coordinated around effective compatibility interfaces, the external economies generated by

widespread experimentation can be formidable. Further, in multi-invention contexts, internal

production implies that organizations are constantly reinventing the wheel – reproducing

inventions that other firms have already made. It follows that substantial economies are available

by accessing external inventions through component and licensing markets.

Throughout this discussion, I have set aside the role patents play in determining

organizational effectiveness in multi-invention contexts. While the transaction costs in licensing

markets have often been studied (for a review, see Fosfuri, Arora and Gambardella, 1999), this

inquiry has tended to focus on the costs of licensing technology or know-how. In this literature,

patents generally ameliorate the transaction costs of licensing. Licensors are less concerned

about expropriation since they can rely on patent protection as a fall back, and this makes them

more willing to license their know-how.

22

However, other licensing costs that stem directly from patent protection also need to be

considered, which I have examined in recent research (Somaya and Teece, 2000). The upshot of

my analysis is that a lack of ex ante clarity about who owns the relevant patents, disagreements

over the value of patented technologies, and the patentee’s own desire to use patents as

instruments of strategic isolation can sometimes make non-integrated modes more cumbersome

than integrated modes. The passive licensing that typically accompanies integrated production is

often more efficient because access to patents are typically negotiated en masse and facilitated by

mutual hold-up. At the same time, patents can be critical to component and licensing specialists

attempting to establish themselves in the face of entrenched integrated firms.16 Thus, patents play

an important role in determining organizational success in multi-invention contexts, to which I

turn next.

4.3 Patent Strategies in Multi-Invention Contexts

In multi-inventions contexts, patent strategy functions as an important complement to the

organizational approach taken in commercializing end products. Thus, firms must first evaluate

organizational modes dispassionately and prospectively to determine which ones have the best

chances of success. In this analysis, it is important to recognize that non-integrated modes often

require inter-firm cooperation in building markets and standards institutions, and that sometimes

such cooperation may be difficult to achieve. Ultimately, firm strategy should be oriented along

an organizational mode that appears promising, with contingency plans for a few others.

For example, a firm could broadly pursue an integrated mode, with the knowledge that it

may need to open itself later to components markets in some specific technologies. If efficient

components markets do become a reality, it would generally be advisable to loosen the firm’s

16 In semiconductors, interview evidence suggests that niche players have relied heavily on patents to protect their

23

ties to the relevant internal technologies and make them compete in the components market, or

even spin them out as separate firms. Alternatively, if the firm determines that an integrated

approach continues to be promising, it can seek to boost its own technological capabilities

through the acquisition of specialized technology leaders.

We approach patent strategy in multi-invention contexts by examining, in turn, the

implications for technology specialists and integrating firms. If technology specialists expect that

a non-integrated organizational mode will succeed, their patents can play a critical role in

commercial success within their own technology niche. Patents are not only instrumental in

keeping integrated firms from replicating the niche firm’s technology and undermining its

business model, but also in helping the specialist build a strong position vis-à-vis all innovators

in that technology. Thus, the non-integrated firm should expect to use patents substantially as

instruments of strategic isolation, even though a limited amount of cross-licensing with other

patentees within the same niche may be unavoidable.

Sometimes however, it may become apparent that non-integrated modes will fail due to

the high level of transaction costs, and technology specialists must be willing to adapt by

consolidating with others or letting themselves be acquired to become part of an integrated

organization. Patents play an important role in transforming specialists into attractive acquisition

targets. A strong patent position can convince acquirers that it is not easy to imitate the

specialist’s inventions or obtain the technology from other sources. Thus the general lesson for

patent strategy among technology specialists is to build a strong isolating patent position.

By contrast, the patent strategy of integrated firms tends to emphasize the building of

portfolios, where quantity rather than “bullet-proof” protection is the watchword. If the

market position (Hall and Ziedonis, 2001). For a persuasive argument in favor of patents to enable a market in software components, see Lemley and O'Brien (1997).

24

integrated mode continues to be successful for these firms, their patent portfolios are valuable

defensive tools that help provide access to external patents. Of course, we can expect that these

defensive patent portfolios will not be very effective against isolation-minded technology

specialists. Therefore, a concerted strategy is needed to obtain leverage against such specialists

by targeted patenting within their technology niches. Similarly, if integrated firms are

considering the acquisition of a technology specialist, they should pay special attention to ensure

that their resulting patent position will at the very least prove adequate to obtain access to the

patents of other firms in that niche.

If an integrating firm decides to move towards a less integrated approach however, the

challenge lies in adapting its patent strategy to a more strategic isolating approach. Such a shift

would be critical for the new specialist businesses that the firm may now pursue, either through

spin-outs or through licensing and components markets. Strong isolation from patents can also be

valuable if the firm is able to define important interface standards for the industry using its own

technology, and retain exclusive use of its patents over those interfaces.

5. Discussion and Conclusion

In this paper, I have laid out a broad set of theoretical perspectives that are central to a

firm’s use of patents from a strategic managerial viewpoint. In many instances, I have

emphasized the strategic implications for firms that arise out of the theory, and thus, my

approach has been sometimes been somewhat normative. However, I am also interested in

setting out a positive description of firm behavior, which can in turn serve as a template for

research on patent strategy. I now turn my attention to these research implications.

25

5.1 A Framework for Research

The theoretical perspectives presented in this paper help provide a framework with which

to chart and build research within the emerging field of patent strategy. Although much past

research on patent use has not taken an expressly strategic approach, their strategic implications

are nonetheless palpable. As a first step, I attempt to classify this existing body of research using

the theoretical perspective(s) that they shed light on and the domain(s) of patent strategy

(patenting, licensing or enforcement) that they based in (Table 1).

[Table 1 about here]

It is evident from Table 1 that separate research projects have often shed light on the

same theoretical perspective in different domains of patent strategy. For example, five papers

have covered the use of mutual hold-up based defensive strategies in complex multi-invention

industries. One of these examined the patenting behavior of semiconductor firms (Hall and

Ziedonis, 2001), another studied the widespread cross-licensing prevalent in the same industry

(Grindley and Teece, 1997), while three others have researched the implication of these

strategies for counter-suits and other aspects of litigation behavior in computers (Somaya, 2002a,

b) and semiconductors (Ziedonis, 2002). Similarly, the strategic isolation perspective is informed

both by Lerner (1995), which looks at its consequences for patenting behavior in the shadow of

competitors’ patents, and by Somaya (2002 a, b), which study the resulting litigation outcomes.

The framework in Table 1 also helps to identify research using other theoretical

perspectives than those presented in this paper. One important set of studies fit broadly into the

realm of non-market strategy, although the emphasis of these papers has primarily been on the

influence of existing institutional features on firm behavior, rather than the shaping of patent

policies and institutions by firms. For example, one study focuses on the implications of

26

differences between patent examiners (Cockburn, Kortum and Stern, 2002), while another looks

at the use of reexamination (in the U.S.) and opposition procedures (in Europe) in patent offices

(Graham, Hall, Harhoff, and Mowery, 2002), and yet another examines the impact of preliminary

injunctions in patent litigation (Lanjouw and Lerner, 2001).

As Figure 1 illustrates, patent strategy is not only situated within an institutional and legal

context, but also seeks to influence this regulatory environment. However, with the exception of

two studies (Kortum and Lerner, 1999; de Figueiredo, 2002), which examine the pro-patent

changes in the 1980s and the passage of an electronic database protection law in the United

States respectively, research investigating how this regulatory environment is created has been

relatively scarce.

Table 1 also suggests a number of other areas where research has been lacking, and needs

to be pursued. Particularly glaring is the paucity of research that attempts to capture the

implications of particular strategies across different domains of patent strategy, although some

recent papers have attempted to bridge the patenting and litigation domains (Cockburn, Kortum

and Stern, 2002; Graham, Hall, Harhoff, and Mowery, 2002). Research focusing on the licensing

implications of isolating patents, and on the royalty harvesting perspective in both patenting and

litigation has also been somewhat sparse. In addition, more studies that examine the specific

challenges for patent strategy created by organizational choice in multi-invention contexts are

needed. Overall, my conclusion is that while research in patent strategy has made a promising

start, much still remains to be done. In particular, research that adopts a specifically managerial

perspective and puts patent strategy center-stage would be especially valuable.

27

5.2 Empirical Considerations in Patent Strategy Research

Empirical researchers face a number of challenges in crafting viable research projects that

examine patent strategy considerations. Here, I focus on three central issues, and based on the

theoretical framework presented in this paper and past empirical research, suggest some

approaches to addressing them.

First, patent strategies need to be translated into empirical questions that can be tested

using available data, which are typically from patenting, licensing, or litigation. Fortunately, pre-

existing theoretical and empirical models of firm behavior in each of these domains provide

valuable tools for this task. For example, Hall and Ziedonis (2001) use a traditional empirical

model of patent counts (Hausman, Hall, and Grilliches, 1987) as the base on which they build a

robust empirical test of patenting differences. Similarly, hypotheses about strategic isolation and

mutual hold-up were translated in the patent litigation context (Somaya, 2002a, b) by linking

these strategies to so-called asymmetric stakes theories of non-settlement in litigation from the

law and economics literature (Meurer, 1989; Lanjouw and Lerner, 1998).

A second concern that arises in empirical studies relates to the nature of the data typically

found in the patent strategy domain. Recall that patent strategy itself consists of a number of

nested choices that firms make sequentially. It follows therefore that the data available for

empirical work is itself a result of such choices, creating potential sample selection biases. For

example, patenting data is an outcome of firm choices on whether to patent or not, so that we

typically do not observe those inventions that the firms choose not to patent. Similar selection

processes operate on licensing and litigation data as well.

Making inferences based on such selected data is additionally complicated because firm

choices are typically made from a real options perspective, in the face of substantial uncertainty.

28

Thus, a simple fact like “more inventions in industry X are patented than in industry Y” can have

multiple interpretations. It would be tempting to conclude that patent protection is more effective

in X, but it could also be that more inventions exceed a threshold option value in X. Intriguingly,

this difference in option value may simply reflect the fact that more uncertainties are associated

with inventions at the time of patenting in X, making it sensible to retain the patent option there.

Ultimately, the solutions to working with such data lie in devising careful empirical tests that

account for the selection processes, and in interpreting the results with care.

Finally, another important challenge for empirical research is to craft appropriate

measures for the theoretical constructs presented in this paper. In many cases, the theories

themselves often suggest plausible measures that could be used in empirical tests. In past

research, the extent to which firms cite their own patent, which can be seen as a measure of the

firm’s commercial interest in building on the patented technology (and even patent fence

building), has been used as a measure of strategic isolation (Somaya, 2002a, b). Hall and

Ziedonis (2001) use the capital investment of semiconductor firms as a measure of their

vulnerability to hold-up, which would encourage them to engage in defensive patenting. In

patent litigation, the use of defensive mutual hold-up has been measured by the patentee’s

citations to the defendant’s patents17 as well as the existence of counter-suits (Somaya, 2002 a,

b).

5.3 Conclusion

This paper has presented a set of theoretical perspectives to understand patent strategy

from a managerial perspective. However, it clearly does not address all possible strategic issues

in this domain. For example, I have already pointed out that a non-market perspective would be a

29

valuable complement. In addition, I have approached firm strategy mainly from a decision-

making perspective, and consequently there is no discussion of the process by which these

strategies are developed and implemented. Finally, there is also little discussion of specific legal

tactics or institutional features. Although these are no doubt important in specific contexts, my

impression is that they are by and large secondary from a managerial viewpoint.

Another feature of this paper is that it examines patent strategy in isolation, without much

reference to other strategies that firms use to appropriate returns from their innovations. This

omission is intentional, and made in the interest of simplification. However, as illustrated in

Figure 1, I recognize that patent strategy must be situated within the broader appropriability

strategies of firms, where past research has shown that alternatives like secrecy, time to market,

and complementary commercial assets are also important (Levin, Klevorick, Nelson, and Winter,

1987; Cohen, Nelson, and Walsh, 2001). In addition, although I do not develop a theory of firm

strategy vis-à-vis intellectual property rights in general, the broad theoretical thrust I use with

patents is likely to transfer, albeit somewhat imperfectly, to other forms of intellectual property

as well.

In conclusion, I reiterate the importance of firm knowledge and knowledge-based

capabilities for competitive success in the new economy. Hitherto, the managerial literature has

placed much of its focus on the creation and recombination of knowledge, but strategies to

capture value from knowledge are also vital for firm success. Patents comprise an important

element of these appropriability strategies, particularly since the issuance and use of patents has

been growing rapidly in recent years, both within the U.S. and globally. Research in patent

strategy is thus an important and timely addition to our understanding of the sources of

17 These can be seen as a measure of the extent to which the defendant’s patent portfolio “reads” on the patentee’s own business activities, thus creating the need for reciprocal access.

30

competitive advantage in the knowledge-based economy.

31

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34

Figure 1: Domains of Patent Strategy

Enforcement Domain

Licensing Domain

Patenting Domain

OTH

ER A

PPR

OPR

IAB

ILIT

Y

STR

ATE

GIE

S

INST

ITU

TIO

NA

L A

ND

LE

GA

L EN

VIR

ON

MEN

T

35

Patenting Licensing Enforcement

Strategic Isolation Lerner (1995)Lanjouw and

Schankerman (2001a, b), Somaya (2002a, b)

Royalty HarvestingArora and Fosfuri (1998), Anand and

Khanna (1997)

Lanjouw and Lerner (1996)

Defensive Strategy Hall and Ziedonis (2001)

Grindley and Teece (1997)

Somaya (2002a, b), Ziedonis (2002)

Organizational Choice / Multi-invention Contexts

Lemley and O'Brien (1997), Linden and

Somaya (2002), Somaya and Teece

(2000)

Arora (1997), Somaya and Teece (2000)

Other Perspectives

Cockburn, Kortum, and Stern (2002),

Graham, Hall, Harhoff, and Mowery (2002), Kortum and

Lerner (1997)

Cockburn, Kortum, and Stern (2002),

Graham, Hall, Harhoff, and Mowery (2002), Lanjouw and

Lerner (1996)

Table 1: Classification of Prior Research in a Framework of Patent Strategy

Patent Strategy Domain:

Theo

retic

al A

ppro

ach:

Theoretical Perspectives