Technological Innovation and Intellectual Property

Andreas Panagopoulos sent a brief note on a theoretical paper on startups and innovation. In this model, the startup’s patents add value to an incumbent’s patent portfolio when the incumbent acquires the startup. There is a trade-off between the incumbent’s patents deterring entry and the acquisition prospects increasing startup value. Andreas write:

In modern hi-tech industries where technology is complex and cumulative, a new innovation is likely to infringe on existing patents. Hence, an entrant firm is under potential threat of litigation from a competing incumbent firm that has accumulated a patent portfolio. It is not clear, therefore, how entrepreneurial activities may be sustained in the same technological terrains as those of powerful incumbent firms.

In a model where an incumbent faces a sequence of potential startups and the incumbent’s chance of winning an infringement lawsuit increases with the size of its patent portfolio, we demonstrate a positive dynamic impact on the startup innovation that is generated by an interplay of takeover deals (out-of-court settlements) and carefully selected levels of IP protection. The core insight behind this result stems from the observation that the benefit of a takeover for the incumbent goes beyond commercializing the new innovation. This is because the incumbent capitalizes on the enhanced bargaining position that the current takeover will bring about in all potential future deals by incorporating the current startup’s patented ideas to its own patent
portfolio, which allows it to better barricade its technological territory, increasing its chances of prevailing in future infringement lawsuits. Since this prospect of future surplus for the incumbent hinges on the current takeover, a part of the surplus accrues to the current startup, enlarging its bargaining share in the takeover deal. We show that this feedback effect of future prospects on the current deal can motivate the startups’ innovation activities that would not take place without it, and as a consequence, increase the social welfare.

We emphasize that for maximum effect the level of IP protection should be selected carefully at a moderate level. The aforementioned increase in the startup’s bargaining share, being proportional to the marginal benefits brought by the last patent added to the incumbent’s portfolio, would be too small to be effective if the IP protection is too weak. An excessive IP protection, on the other hand, would accumulate the incumbent’s bargaining power too quickly, killing off the innovation incentives for startups prematurely. We illustrate this point further by way of computer simulations.

Not sure how this plays out in a world where any player (e.g., troll) can acquire patents that can be used as bargaining tokens…