Is there a role for patents in the financing of new innovative firms?

At first glance the answer to the question posed in the title seems obvious, since such firms have few assets other than their ideas and inventions. Therefore, granting property rights to these intangibles would seem to ensure the ability of the new firm to grow without the threat of immediate imitation. A second benefit of owning patents is that they create a securable asset in an environment where few such assets are available, making obtaining external finance easier. In this survey, I look more closely at one of the posited benefits of the patent system for startups: the use of patents as a quality signal or security for obtaining financing when a firm has few ways of conveying information to potential investors or to protect them in case of failure. My conclusion is that although they do indeed function in this way in some cases, the need for a market in which to monetize the patent assets of failed firms has some downsides in the form of facilitating rent extraction that does not necessarily incentivize innovation.

In the first paper to obtain plausibly causal evidence of the positive impact on new firms of holding patents, Farre-Mensa et al. find that startups whose patents are granted average 55% higher employment growth and 80% higher sales growth five years later. These authors also find that follow-on innovation by the same firms is of higher quality and that venture capital funding is more easily obtained if they have granted patents. Graham et al. surveyed entrepreneurs and investors in the biotechnology, medical device, and software sectors, finding that both groups rated financing and improving exit valuation as moderately to very important motives for obtaining patents, more so for biotechnology and medical devices. The latter finding is consistent with much prior survey work on the importance of patents in various industries. The great majority of other studies of patenting and access to financing in startups finds a positive relationship, although unlike Farre-Mensa et al. none are able to fully sort out the difference between patents as a signal of a good idea and patents as a property right. As I report in my survey, it is therefore surprising that a relatively small share of startups patent, even when they are VC-backed. The most common reasons for not patenting reported by Graham et al. are costs and the desire to keep an invention secret. Not having a patentable invention is given as a reason less often.

In spite of the positive benefits of patents as exclusionary tools and for the securing of financing, many entrepreneurs and researchers critique the operation of the patent system with respect to new entrants on two grounds: 1) in the presence of cumulative innovation, the costs of licensing in the patented technologies on which the startup’s technology builds can be prohibitively expensive; and 2) the existence of a market for patents that enables sale of patents on firm exit has a negative impact on surviving firms.

The existence of a secondary market for patent and other IP assets is important for creating salvage values for investors in startups which fail, since the possibility of extracting some value from the failure reduces the cost of capital for the investment. The evidence to date shows that patent markets are in their infancy, or at least at the toddler stage, and that the main sellers in terms of numbers of patents are large operating companies rather than startups. The beneficial nature of patent markets or markets for technology presumes that the sale of patents on the ‘secondhand’ market occurs because the technology they protect is useful to a firm other than the one currently owning the patent. In an ideal world, the role of patent markets would be to allocate technologies to those best able to make use of them profitably and efficiently, enhancing overall welfare. However, the evidence on buyers in this market suggests that these patents are being purchased for a range of reasons, most of which do not involve actually using the protected technology.

There are at least four problematic factors: 1) the presence of some very low quality patents, whose assertion will do nothing for innovation, but which may be too costly to overturn; 2) the frequency of parallel invention, implying that the information in the patent was not used by a potential infringer; 3) bargaining threat points that lead to extraction of more than the value of the patented invention; and 4) actual returns to inventors or owners from the intermediaries in such markets are rather low, raising the question of how large an innovation incentive was created by the secondary market.

Who buys patents on these markets? The limited and selective evidence I survey suggests that startups are more likely to sell to (potential) users of their technologies when they fail, whereas the larger corporations are likely to be pursuing a more defensive strategy by selling to defensive aggregators or patent assertion entities.

The evidence on the overall impact of the patent system on startups, or indeed on innovation as a whole, is somewhat inconclusive. Patents do seem to help some startups secure financing, but at a high enough cost that many firms are discouraged from using them. In addition, the benefits to startups of the secondary market for patent assets are more difficult to discern. The reasons are not hard to find. First, the patent system is just that – a system, and evaluating its impact is essentially a macro-economic question for which we have little in the way of alternative universes, other than past history. Second, and related to the weaknesses of the empirical evidence on the functioning of markets for technology, is an absence of transparency in these markets. The information we have tends to be selective, often based on samples where the sampling methodology is less than clear, and a large number of licensing transactions go unobserved, except by the participants.

Bronwyn H. Hall is Emerita Professor of Economics at the University of Califonia, Berkeley.