Describing patents as real options.

• Author: Cotropia, Christopher A.

1. INTRODUCTION II. CURRENT LITERATURE ON PATENTS AS REAL OPTIONS A. Real Options Defined B. Economics Scholarship on Patents as Real Options C. Law Scholarship on Patents as Real Options III. AN INITIAL STEP-DETAILED DESCRIPTION OF PATENTS AS REAL OPTIONS A. A Patent's "Option Price" B. A Patent's "Exercise Price" C. A Patent's "Expiration Date" D. Value of Asset Underlying the Patent E. Additional Complexity -A Patent as a Series of Embedded Options IV. BENEFITS TO DESCRIBING PATENTS AS REAL OPTIONS A. Defines New 'Macro Patent Elements" 1. Patent Troll Problem in Option Terms a. Too Low an Option Price b. Too Low an Exercise Price 2. KSR and a Heightened Nonobviousness Standard in Option Terms B. Describes Patents Like Industry Views Technological Development C. Presents a New Theory of Patents V. CONCLUSION I. INTRODUCTION

   A fairly robust economics literature exists which analogizes patents to real options. Real options create the right, but not the obligation, to purchase the underlying asset at a defined exercise price. (1) A patent is like a real option, economists say, because it allows its owner to choose between exclusively commercializing the patented invention sometime during the patent term or foregoing commercialization altogether. (2) Economists have taken this analogy and used real options analysis to place specific values on patents. A few economics articles have gone a step further, identifying some policy implications from the real options description of patents. (3)

   The legal literature is a bit behind in using this analogy. A few scholars have engaged in the same valuation exercise as economists. Russell Denton and Paul Heald, for example, previously set forth a state of the art discussion of how to value patents using options analysis. (4) Shaun Martin, Frank Partnoy, and Michael Abramowicz have taken the second step, arriving at definite policy conclusions based on a real options view of patents. (5)

   This Article continues the use of real options in patent law by taking a step back. The Article proceeds in three parts. Part II describes the concept of real options and catalogs the existing economics and law literature discussing patents as real options. The Article then lays a foundation for previous and future discussions by describing in detail how patents are like real options. Specifically, Part III identifies the particular patent doctrines that make up the common components of a real option--the option price, the exercise price, the expiration date, and the value of the underlying asset. This descriptive analysis is a necessary first step in developing a robust theory of patents as real options--a theory that can have specific patent doctrine implications. Part III also describes how patents can be defined as a series of embedded options. From here, Part IV discusses some implications of using real options theory in patent law, and provides a preliminary taste of the benefits of using real options theory in patent law. Real options analysis allows both patent problems and patent solutions to be examined in terms of "macro patent elements"--elements defined by the operational components of a real option. Real options theory also facilitates viewing patents the same way industry views research and development projects--as real options. Finally, there is promise in the underlying enterprise--using the concept of real options to articulate a new theory of the patent system.

2. CURRENT LITERATURE ON PATENTS AS REAL OPTIONS

   1. Real Options Defined

      "A real option is the right, but not the obligation, to take an action (e.g., deferring, expanding, contracting, or abandoning) at a predetermined cost called the exercise price, for a predetermined period of time--the life of the option." (6) It is called an option because it gives the holder just that--an option to do something, but not a requirement to act. The term is modified by the term "real" to distinguish it from a financial option. This means that the option is on an investment project, as opposed to a financial instrument. (7) Instead of the options granting the right to buy a stock, bond, or some other underlying security at a set price during a set time period, a real option concerns the same type of right regarding a capital investment or project with a more fluid time to expiration. (8) And, as with financial options, there are "call" real options that give the option holder the right to purchase the underlying asset at an exercise price, and "put" real options that give the option holder the right to sell the underlying asset at an exercise price. (9)

      Examples of financial options abound and are probably the most recognizable. (10) Purchasing the right to buy 100 shares of Microsoft stock at $100 a share over the next year is a typical financial option. This would be a call option, in that the owner of the option can exercise the option by actually buying 100 shares of Microsoft stock at $100 a share during the defined period.

      A real option operates in a similar manner, but considers a managerial decision regarding the allocation of resources. An example of a real option would be the decision to purchase a fleet of flexible fuel vehicles for your package delivery business. (11) Buying such vehicles gives your business the flexibility to purchase either gasoline-only fuel or a gasoline blend with up to 85% ethanol (E85). (12) Such flexibility allows the business to shift its fuel purchasing based upon the price of regular gasoline and relative fuel efficiency. In addition, at some time, the options these vehicles provide will become obsolete. Either E85 is no longer available, and the option expires, or the cost differential between the two fuels becomes negligible, and the option becomes valueless.

      The value of these options--both financial and real--is in the flexibility they provide. (13) The owner of the option can decide whether they want to buy Microsoft at $100, or purchase gasoline or E85. And the option holder has the full term of the option over which she may make this decision. This flexibility does come at a price--the price of the option. Accordingly, real options "giv[e] the investor access to a greater range of potential outcomes on the upside, while containing the exposure on the downside. This effectively truncates the left-hand tail of a performance distribution, creating a performance distribution curve that is skewed to the right, yielding asymmetric payoffs." (14) Options therefore become valuable when the value of the underlying asset is uncertain at the time of the option's purchase. (15) The greater the uncertainty over time as to the value of the asset covered by the option, the more valuable the option. (16) This is why there is a growing body of literature that suggests managers should consider capital investments in term of real options. (17)

      All real options have certain commonalities. As described above, these common features include a purchase price (the cost of buying the option), an exercise price (the cost of exercising the option and obtaining the underlying asset), and a time at which the option expires (an expiration date). (18) A call option, with some of these components labeled, is graphically depicted below.

      [FIGURE 1 OMITTED]

   2. Economics Scholarship on Patents as Real Options

      The concept of real options has had "a huge impact on academic research" in economics. (19) Real options theory has allowed economists to take into account "management's flexibility to adapt ... to unexpected market developments', (20) when valuing capital-investment projects. (21) This allows one to take the tools financial options theory provides-mainly valuation tools-and apply them to "real investment analysis." (22) The literature has applied the theory of real options to various forms of investment activity. (23) The concept appears in many finance textbooks. (24)

      The main use of real options theory is to value flexibility--that is, the value of strategic resource allocation decisions. (25) The decisions--essentially the options--available to a company can be characterized as real options and defined in terms of value by real option elements such as the exercise price or expiration date. Essentially, "[t]he real options approach seeks to scientifically explain the evaluation of intangible assets." (26) For example, using a real options approach, a company can define the value of the ability to close and then reopen a natural resource mine or the value of purchasing a flex-fuel vehicle, as discussed above. (27)

      Real options theory has also been used descriptively--to explain the way in which companies are behaving. A company's investment behavior can be observed to see if it falls in line with "real options reasoning" (ROR). (28) That is, real options theory allows an investigator to determine whether "decision-makers implicitly (or explicitly) respond to the value of the right to preserve decision rights in the future in their investment choices." (29)

      A natural area for economists to apply real options theory, both to value corporate decisions and to explain them, is technological development. The real option "to [d]efault during [s]taged [c]onstruction ([a] [t]ime-to-[b]wild [o]ption)" fits most research and development projects. (30) Research and development of a new technology typically occurs in stages, with current research facilitating follow-on research and the eventual launch of a commercial product. (31) At each stage, the company can default (abandon) the development process. (32) An R&D dollar spent today is, essentially, the purchase of a call option on the resulting technology or future application. (33) For example, economists have used real options to value research and development decisions in the pharmaceutical industry. (34) They have also used ROR to describe retrospectively the research and development decisions companies make. (35)

      An outgrowth of the economics literature...