Patenting vs. Secrecy for Startups and the Trade of Patents as Negotiating Assets

The term “patent paradox” refers to the increased use of patents, despite being perceived as having limited stand-alone value as incentives to innovate (Hall et al., 2012). This phenomenon can be attributed to the array of roles patents may play. One role particularly relevant in this context is their use as bargaining chips by firms who employ many patents bundled into patent portfolios to gain a better hand in licensing negotiations, especially in industries where technology is cumulative (Hall and Ziedonis, 2001). As argued by Lanjouw and Schankerman (2004), patent portfolios endow such uses because patents confer “enforcement spillovers” that allow firms to exploit economies of scale, making it less costly to protect a patent when it is part of a bundle, in which case small firms like startups, that hold few patents, are at a disadvantage. In fact, for startup firms patents may even be a “liability” as they can invite infringement allegations from dominant firms with a portfolio of patents. Fear of evoking such highly costly legal disputes is known to force startups to redirect their research (Lerner, 1995) and may well have contributed to the tendency of startups to prefer trade secrecy over patenting as found in some studies, e.g., Graham et al. (2009). In a world of dominant firms and patent portfolios, is there a role for patents as incentives to innovate for tech-startups, or should these innovative firms, which play an outsized role in US net job creation (Hathaway, 2013), prefer secrecy instead? This is an important question because patents, unlike trade secrets, promote welfare enhancing diffusion and knowledge spillovers. The use of patents as leverage in licensing negotiations stems from ownership contentions that arise due to the inherent difficulty (especially in cumulative innovation) of confining bordering technologies. Due to such contentions, when licensing or trading a patent whose ownership is potentially disputed by the prospective licensee, a startup may not be able to reap the full value of its patented technology because the negotiations take place in the shadow of infringement litigation (Shapiro, 2003). Nevertheless, we argue that trade secrecy may not be the best resort. Instead, we show that overt ownership of technology through patenting, together with appropriate channels for ownership trading, can work better to incentivize startups’ innovation activities. Specifically, we present an equilibrium analysis of a dynamic model that clarifies when and how patents may outperform trade secrets in promoting startup innovations. In the process, we also provide some policy implications. Our main thesis is that when trading a patent its owner is potentially selling more than a monopoly right. Specifically, insofar as patents’ enforcing capacity spills over as mentioned above, when a patent is added to a patent portfolio it enhances the portfolio’s muscle in enforcing the rights of any given patent in the bundle. Such additional leverage correspondingly increases the portfolio’s ability to favourably barter a future technology transfer agreement against potential infringers. Thus, a transfer of patent rights does not only convey monopoly profits on the technology embodied in the patents’ claims (as trade secrets do), but also extra surplus from the patents’ capacity to affect future technology transfer negotiations. Therefore, when an innovator transfers a patent, even though its transfer price may not be able to capture the full monopoly profits (because of the risk of infringement), it may merit a markup reflecting the prospect of such extra future surplus. When a sequence of startups are expected to patent and transfer their technology to an incumbent, gradually increasing its future bargaining power, the dynamic feedback effects on this markup can be large enough so that the patent’s transfer price exceeds the value of a trade secret. In short, since patent portfolios do not only engender the threat