The United States Constitution provides that Congress has the power to reserve to inventors for a limited time the exclusive right to their inventions because this will promote the useful arts.

Owners and managers of small to mid size, and even large companies, often have doubts about the returns from investing in patents. Everyone will admit that engineers like to have patents on their resume and will allow that occasionally some idea is important enough to justify a patent; yet it is not unusual for a business owner, or manager to have doubts about the desirability of routinely patenting new products and new manufacturing techniques developed by the company. The purpose of this essay is to provide a rational framework for developing a budget for patents.

The principal use of patents for small to mid size companies is to differentiate their products from their competitors’ products. If a company develops a successful new product, its competitors will notice the success and bring out a competitive product to take advantage of the market demand created by the original product. If a patent has been filed on the original product the original product may lawfully be marked “Patent Pending.” A competitor reviewing the original product is thus placed on notice that if the product is copied it may well be covered by the patent when it issues.

Twenty years ago it was reasonably safe to infringe a patent because most patents were, on appeal, found to be invalid. Patents were viewed as monopolies which were not favorably viewed as a matter of public policy. In the ’70s the rise of strong foreign competitors which were utilizing U.S. technology resulted in a sea change. Patents became viewed as instruments to preserve the strong innovative advantage of the U.S. In order to promote a uniform treatment of patents within the federal court system, a new Court called the Court of Appeals for the Federal Circuit (CAFC) was formed in 1982. This Court hears appeals from all patent cases decided in federal district courts. The CAFC deals almost exclusively with patent and patent related cases. The judges are therefore experienced in dealing with the complexity of patent law and technology. The result has been a great increase in the likelihood that a patent will ultimately be held valid.

If patents are usually held valid, then infringing a patent involves considerable business risk. Patents typically take one to two years to issue, during which time they are not available to the public, making it difficult to assess the risk of infringement. Therefore a risk-adverse competitor will do one of two thing: either postpone designing a competitive product, or, after consulting patent counsel, design something very different.

Thus, even before a patent is obtained, it provides a one to two year marketing advantage, limiting a competitor from directly competing with a new product. This alone often justifies the cost of applying for patent protection.

Once a patent issues its scope or coverage is defined by the patent claims. These are one sentence statements of what the inventor believes is new about the developed product or process. A patent claim is broad if it covers a wide range of possible devices or methods. A broad patent, for example would be one covering all engines using the diesel principal, the laser principal, the electrostatic photocopying principle, etc. A narrow patent covers only a specific implementation such as a diesel engine utilizing a piston sealing ring having an elliptical shape, a diode laser employing a Germanium substrate doped with gallium, a photocopier utilizing a paper substrate on which an electrostatic image can be formed. Most patents have relatively narrow claims because at least the general concept for most products, or methods are old. You cannot get a valid patent on something that is old (lacks novelty) or is obvious (is not inventive).

If the product or process which is patented represents a real product at the time the application was written, the claims will generally cover at least the particular solution which the marketed product uses to solve a particular problem. Thus a competitor must choose a different approach to avoid even relatively narrow claims. Typically, the competitor can manufacture a product which is a functional substitute for the patented product. However, assuming the patented product is enjoying some market success, the customers of the original manufacturer will be looking for a product just like the original ones. If a competitor can’t supply a product just like the patent owners’, customers will be less likely to purchase its product. Further, the owner of the patent can argue through advertisement and sales representatives that customers should buy the patented product because of the features which the competition can not match.

For a product with significant sales the cost of a patent is typically a very small percentage of gross sales. Even a limited advantage, i.e. delaying a competitor’s entry into the market by a year, or preserving a unique feature which the competition cannot supply, will justify the investment in a patent.

A second motivation for obtaining patents is their use as bargaining chips. Patents are typically used as barriers to entry to particular markets and industries by preventing Free Riders from knocking off successful products without significant investment in product development and market development. It normally is the case that a given industry will have a limited number of competitors. If one competitor begins to enforce a particular patent against another in a particular market, they are often willing to settle a patent suit by trading licenses. Trading a license to settle a patent suit avoids expense in litigation for both parties, and secures a competitive advantage for both parties versus competitors–particularly Free Riders who have few or no patents and cannot expect to settle litigation on such favorable terms.

A number of competitors in a market often results in the total market expanding as a result of the collective advertising and promotion, innovation and available selection of goods. At the same time, patents prevent non-contributors from benefiting. Of course patents are an imperfect tool for excluding Free Riders, but a reasonable portfolio of patents improves a company’s position within an industry even when used passively to settle lawsuits. A related use of a patent portfolio is to make a suit by a competitor a two-way street. Whether the competitor’s suit relates to patents or not, a patent counterclaim can often be made. Settlement of a suit is often encouraged by both parties having downside risks. Litigation is an inherently uncertain process and before initiating suit a competitor must consider whether if suit is initiated a favorable outcome can be assured. The fact that the target of the suit has a portfolio of patents which could possibly be asserted will be a consideration which may prevent suit or result in a rapid movement toward settlement before litigation expenses mount.

A related use of patents is in a new industry where competitors are investing heavily in a new market hoping to bring a viable new industry into being. It often happens that the successful solution requires a combination of technologies from several or all of the companies in the new industry. This can result in a trading of patent rights such that several players will gain rights to sufficient technology to introduce competitive products. Thus when heavily invested in new technology, even if the key technologies are missed by your company in its investment strategy, a patent portfolio which even partially facilitates the eventually successful technology can be used to buy a seat at the table or obtain a royalty stream for the investors.

Cost justifying patents as bargaining chips or hedges to technology development programs is less immediate and generally requires a budgeted approach tempered by experience. Thus one to ten percent of R&D funds might be allocated to patents, with the precise number being based on industry norms and company experience. Patent expenses are similar in some ways to R&D, advertising, and insurance expenses which do not generally result in a clearly measurable immediate result but which over time make a clear and sometimes decisive contribution to a business.

A third justification for patents relates to selling a small to medium size business. Typically the most valuable thing about a business is the fact it is a going concern which knows how to successfully build and sell a range of products. However the purchase price must be allocated to various assets, and patents provide the most substantive of the intangible assets. Patent are routinely evaluated for scope and enforceability, and often a value of millions is often attached to a relatively small portfolio of patents which relate directly to the products being sold. Thus patents which apart from a going concern might have limited value, can have substantial value as part of a going concern. This is particularly true in terms of their contribution to product differentiation as discussed above.

A fourth use of patents it is as a tactical tool in developing a product to compete with a competitor’s patented product.

All these uses and economic advantages of patents are largely passive: the benefits of patent ownership accrue to the patent owner by the reaction of competitors or others to the existence of the patents, either in providing a competitive advantage in the marketplace, or in helping to avoid or settle litigation brought by others, or contribute to value in the sale of a business. Before discussing an active litigation strategy it is useful to consider the practice of collecting royalties based on patents. Although for many independent inventors and the general public, payment of royalties is the first thing that comes to mind when considering patents, obtaining significant revenues from patent licensing is in most cases of secondary interest, and cannot be counted upon.

Large businesses, universities and research institutions, and the rare independent inventor, and an occasional small company, can successfully exploit a patent portfolio to command substantial income based on royalties. However, in this realm the rule of ten applies. Out of every ten patents one might be licensable, out of every one-hundred patents one might return a substantial income, and out of one thousand patents one might dominate an industry. This reality is exploited by university foundations which obtain patents on university research and actively attempt to license the patented technologies. One major state university figures that out of thirty or forty ideas, one-half will be patented and of that half, a few will be licensed, but only one will yield significant returns. That one will pay for the cost of all the applications and licensing expenses for the rest. A recent book Rembrandts in the Attic discusses exploiting large patent portfolios as income producing sources which are often overlooked as profit centers.

Although patents can be a source of business income, the scale of patenting needed for reasonable likelihood of developing licensable technology is such that most medium and small businesses will not justify a budget for patents based on possible licensing revenue.

A patent gives the owner the right to exclude others from making, using, selling, or offering for sale in the United States, or importing into the United States products falling within the scope of a valid patent. A patent gives the owner the right to keep others from contributing or aiding and abetting, inducing, or acting as a accessory to an infringement. A patent gives the owner the right to prevent importation of products made by a patented process outside the country and the right to keep others from manufacturing a product in this country which can be readily assembled to form an infringing product in another country. A license is basically an agreement not to exercise these rights against someone in return for a royalty. A patent suit seeks to collect damages based on a trespass on the patent owners rights.

For most small and medium size businesses, litigation will be undertaken only for a clear business purpose. Litigation generally is expensive, and patent litigation is even more so. A typical patent case which proceeds through trial will require expenditures in excess of $500,000 for each litigating party. Rarely are potential damages so high that the certain litigation expenses and loss of management time and focus would not be more advantageously invested in new products and new markets. Nevertheless, litigation is justifiably undertaken to restrain a competitor who is damaging the market by selling inferior goods, taking customers, or destroying the economic incentives to innovation by copying a company’s products. A willingness to litigate can substantially increase the value of all patents held by increasing the perceived risks associated with infringement. An infringement action settled for a license can also supply a continual source of information about a competitor as they are required to report periodically sales of licensed products. Thus litigation is usually commenced for long term market considerations rather than short term prospects of recovering damages.

Whether for short term or long term advantage; whether to protect an emerging market or to make room in a developed one; and whether as an instrument of passive threat, or active enforcement; the U.S. patent is a powerful tool in the aid of a successful business enterprise, and the merits of developing a patent portfolio should be examined by every ongoing manufacturing concern.