Putting a value on technology patents
by Will Acworth and Mary Ann Burns
The futures industry has not had much experience with the issue of technology patents. FI therefore asked two experts to describe in a general way the kinds of issues that arise when companies are negotiating to use a patented technology or to settle a patent infringement claim. Edward Gold, an economist, leads the economics and strategy group in the Washington, D.C. office of PricewaterhouseCoopers. His views are his own and do not reflect the view of PricewaterhouseCoopers or its clients. Abram Hoffman is an independent consultant based in Washington, D.C. specializing in providing advice on intellectual property valuation. Neither Hoffman nor Gold has any involvement with Trading Technologies or the firms accused of infringing TT’s patents.
FI: Let’s start with the patent infringement issue and the potential cost of reaching a settlement and licensing the patented technology. What is the decision tree for a firm concerned about the potential liability for infringing a patent? What factors should the firm take into account in trying to come up with a value for licensing the technology?
Gold: When I think about trying to value intellectual property or determine a royalty rate for the rights to use intellectual property, I first try to assess what incremental value is created by the patented technology itself. How do you compare the world today with the technology to the world without the technology? To get to that incremental value, a firm accused of infringement should consider what its alternatives were at the time it began infringing and whether or not it had viable non-infringing alternatives.
If there was a very close substitute available from the beginning, the potential lost business for the inventor is relatively small. For example, in the case of two alternative “back office” software routines, the end-user might not care which method was used. The firm might have saved time and money by using some aspect of the patented technology rather than utilizing the alternative. If you spread that cost savings over the number of trades it transacted, you can estimate the benefits to the firm in the form of a value per transaction and that value can become the basis for setting a settlement figure.
On the other hand, if the firm did not have a good alternative, the firm should think about how much business it would have lost if it had not infringed on the patented technology. Where would the business have gone? Some trades might have used alternative in-house technology, some might have gone to a competitor down the road (who may or may not have been infringing), and some might have gone to the inventor. The profits from the fraction that would have gone to the inventor, in this case Trading Technologies, represents a key part of the potential damages.
Damages are not necessarily the same from firm to firm. One firm’s customers may be very different from another firm’s customers, and the fraction of business that would have gone to TT may be dependent upon the population of customers that the particular firm has.
FI: So the potential lost business is where you start the analysis?
Gold: Right. Start with the quantity and multiply it by the value of the business lost. Let’s assume that there were 100 trades dependent on the infringing software. Out of those 100 trades, let’s assume half of them would have gone to TT if the infringement had not occurred. Then 50 trades times TT’s profit per trade is a measure of the lost profits damages on those lost sales. In addition, in litigation of this type, a company found to have infringed would generally pay some royalty damages on the additional units. Other damage elements may also come into play, such as whether the actions in the market by the infringer led to the inventor earning lower profit margins due to lower prices.
Another way of thinking about setting a value on this technology early in the negotiation process is to ask yourself if you will be able to demonstrate that the patent is invalid, or that the claims related to you are invalid, or that you haven’t infringed. With respect to TT, that’s all unknown at this stage.
In addition, you may be able to show that your accused software brings more to the table than the TT technology, including potential improvements on the software. The number of the trades you have executed may have grown because of your innovation. In that sense, you may be expanding the opportunity beyond what TT’s technology could have created on its own.
FI: Why is that important?
Gold: That gives you bargaining power. A license is a sharing of inputs. In order to reach the final output, you need technology, people, capital, land and so on. You can’t make a final product without all the inputs to production. The question is how you divide up the profits among those inputs—every one has to be there in the end and each one of them in a sense is blocking. The technology person is only bringing one piece of that equation. The person who developed the customer list, the person who creates the distribution capability, the person who develops the product and carries the inventory takes on a lot of other business risks that the technology provider does not. This sharing usually results in the licensee actually getting the majority of the profits created by combining the inputs. The licensor goes away with a piece, but a piece that is smaller than half. How much smaller depends on the bargaining process.
FI: How should firms evaluate the potential damages arising from an infringement lawsuit and the potential value of a settlement?
Gold: One of the interesting aspects that I understand the Goldenberg Hehmeyer settlement provides is that the firm apparently does not have to pay the 10 cent royalty fee on any trades executed through TT software. The fee applies only to trades executed through its proprietary software. So GH has already thought about the decision to buy X_Trader. You can either buy the software directly, or license the technology and then develop software, or develop your own software (from scratch) and hopefully avoid infringing the TT patents. Assuming that the patents are valid, you will weigh how much it will cost to develop your own software to get around the patents, versus the cost of paying for the technology. TT software is an embodiment of TT patents, but it may be more than the TT patents. The whole package is what the customer sees. So somebody pays TT for the software, and built into that price should be the value of the patents. If TT wanted to collect a per-transaction fee, then it could contract with the users for a per-transaction fee. If 50% of the volume is already going through the TT software, then they have already paid for the patents on 50% of the volume.
FI: Given that we have litigation ongoing between TT and eSpeed, why would any other firm want to reach an agreement on the value of TT’s technology?
Hoffman: If you were to take a license on the technology as a potential infringer before the eSpeed litigation is finished you would pay royalties at least until that litigation is resolved. Alternatively, you might pay a lump sum covering both the past and future. If eSpeed proves the patents are not valid, you would no longer have a continuing obligation to pay royalties on the invalid patents. Unless the license provided for a refund (which would be unusual), you would be out what you paid up to that point. On the other hand, if the court upholds the validity of the patent but finds no infringement by eSpeed, that would not necessarily free you from paying ongoing royalties. Generally, infringement is determined on a case-by-case basis.
FI: Let’s turn to the transaction fee deal that TT is proposing to the exchanges. Is it unusual for the patent holder to approach a group of third parties and ask them to pay the patent holder to indemnify the alleged infringers from legal action?
Gold: This kind of setup usually happens when the parties making the payments are incorporating the technology into what they sell and passing it on. In effect TT is nominating its order entry technology as an industry standard. In the normal process of creating a standard, everybody has a say. TT is probably circumventing that process. I would ask, what benefits do the exchanges have to go along with this particular mechanism when they themselves are not accused of infringement?
FI: One aspect of TT’s proposal is that the fees would be permanent. What is your view of that?
Hoffman: Part of what makes TT’s threat credible and gives some credence to the notion that the fees should be permanent, rather than tied to the term of a particular patent, is the notion that there are 80 more patent applications in the wings. TT might say: “Maybe you might be able to fight one or two of them in the courts and succeed, but we will just haul out some others. So you should be willing to pay us for “peace in perpetuity.” Of course, you just don’t know at this point if those are truly innovations or just marginal improvements to existing patents. The value of the technology depends on what it contributes to the value of a product or service. Does it enable a new product or service? Does it enhance the volume of an existing one? Does it reduce the cost of producing a product or service? Without seeing what those patents are, it’s a threat that you cannot assess, whether these are just pieces of paper or revolutionary technologies. The 80 patent applications are like facedown cards—you really don’t know if they enhance TT’s hand or not. But note, if someone applies for both a U.S and a foreign patent on the same invention, the U.S. application becomes public after 18 months.
Gold: Once the agreement is entered into for 2.5 cents in perpetuity, what will be his incentive to do any additional innovation? If the exchanges are concerned about future engagements, they could insist on a commitment to future innovation, so that the price goes down if TT fails to produce a certain number of applications within a certain amount of time, or something along those lines. They might also insist on TT bearing the cost of defending patent suits brought by other inventors if they want peace in perpetuity.
Hoffman: You also need to think about what incentive there will be for anyone else to innovate. The fees generated under this proposal would not go into a pool and then be portioned out to all innovators. They are going to go to the one who got there first and snapped it all up. This basically provides no incentive to anybody else. In other words, what happens if the industry wants to change the standard to a new innovation created by someone else? If there is no structure to shift the royalties, then there is little incentive to innovate.
Reportedly there is a provision in the Goldenberg Hehmeyer settlement agreement that revokes the protection from litigation if GH customers assert their own patents or copyrights against TT. In other words, the license remains in force until you try to assert your own intellectual property against TT, at which point TT can haul out its patents and sue you. It does raise the question whether it provides a disincentive for others to innovate on top of TT’s platform or around the TT patents. The exchanges would still be paying TT the royalty on trades that no longer benefit from TT’s technology yet the vendors would probably have to indemnify their customer from a suit by TT. So the subsequent innovator has to overcome a double burden.
FI: Has TT taken it beyond the realm of patent law and put it in the realm of a business decision for the exchanges to make?
Hoffman: What I have to give TT credit for in terms of cleverness is the exchange fee as an alternative to suing people one at a time. One of the things going through his opponent’s mind when they consider settling is “I may agree to pay 10 cents a trade to settle this and avoid several million dollars in potential litigation costs, but in so doing, am I going to disadvantage my brokerage relative to some other brokerage using knock-off software that has not yet been sued? By the time they get around to getting the last piece of knock-off software, I’ve lost so much business as a result of having higher prices that it will be more costly to me in terms of lost business.”
TT’s approach, by going to the exchanges and proposing that the exchanges collect the fees for him, eliminates that sort of middle period where the brokerage that has settled and incurred these costs is at a relative disadvantage to one that has not yet settled and incurred these costs and that can still under-price the one that has taken the license. TT has essentially made it a level playing field in that regard. The downside of that is that people end up paying for it whether or not they in fact need it, or value it, or use it. The same issue is also raised by a uniform rate applied to all trades. There may be some traders, say arbitrageurs, whose trades critically depend on fast execution, whereas there may be others, say pure hedgers, who don’t necessarily benefit to the same extent from fast execution. So again there may be a class of customers for whom this innovation does not provide the same kind of benefits as for others. Level is not always fair.
FI: What do the courts consider unreasonable damages?
Hoffman: Generally the kinds of things that raise the hackles of competition regulators are license arrangements that are beyond the scope of the patent. Whether the patent holder was going sufficiently beyond the scope of the patent in time with this perpetuity kind of licensing and also scope in terms of charging a fee whether it is used or not and irrespective of the degree of use. If enough competition concerns are raised, this can lead to a finding that the patent holder is no longer entitled to enforce his patent as he attempted to stretch it beyond the scope granted by the Patent and Trademark Office. The bargain that you make with the PTO is that in return for getting a government-granted “monopoly” for a limited term, you have to describe your invention in sufficient detail for the world to understand what it is. That’s the trade-off. At the point at which it expires, you don’t have anything to say anymore. It’s now a public good. People can understand how far your property goes and understand the time limit. They can go around your property while you own it and trespass on what used to be your property after that right expires. That’s the choice TT made when it got a patent. When you make that choice you have to live with it. If you then try to renege on that by claiming more than you are entitled to either in scope or in time, the court can take away some of your patent rights.
FI: Who would challenge that in this case?
Gold: As long as the challenge is not frivolous, anyone that has been sued for patent infringement can challenge as a counter claim that the enforcement mechanism that the patent holder is using is overly broad. Under the right circumstances, even a potential defendant who has not yet been sued for patent infringement can bring a similar suit.
Will Acworth is the editor and Mary Ann Burns is the editor-in-chief of Futures Industry magazine.
