**Issues Paper:**

**Small Business, Innovation, and Patent Policy**

Josh Lerner[^1]

NSTC Federal Policy Review

Priorities for Federal Innovation Reform

New firms have played a major role in fomenting technological innovation
in the United States, particularly in emerging economic sectors. Both
case study-based field research \[Jewkes, Sawers, and Stillerman, 1958\]
and large-sample analyses \[Acs and Audretsch, 1988\] have documented
that small firms make a vital contribution to innovation in immature,
relatively unconcentrated industries. These studies suggest that
entrepreneurs and small firms often observe where new technologies could
be applied to meet customer needs, and rapidly introduce breakthrough
products.

The 1990s have seen several dramatic illustrations of these patterns.
Two potentially revolutionary areas of technological
innovation---biotechnology and the Internet---were pioneered by smaller
entrants. Neither established drug companies nor mainframe computer
manufacturers were pioneers in developing these technologies. By and
large, small firms did not invent the key genetic engineering techniques
or Internet protocols. Rather, the bulk of the enabling technologies
were developed with Federal funds at academic institutions and research
laboratories. It was the small entrants, however, who were the first to
seize upon the commercial opportunities. The magnitude of the value
created is illustrated by Greenwood and Jovanovic \[1999\], who show
that a group of "IT upstarts"---firms specializing in computer and
communications technologies that went public after 1968---now account
for over 4% of the total U.S. equity market capitalization. While some
of this growth has come at the expense of incumbent information
technology firms, the new market value and technological spillovers
created by these new businesses is substantial.

Given the important role of small firms in the innovation process, an
important policy goal should be to address threats to their future
development. This is particularly true of threats that have been created
by misguided, if well intentioned, government policies. The area that I
believe deserves particular attention relates to the key mechanism for
protecting intellectual property, namely patents.

The U.S. patent system has undergone a profound shift over the past
fifteen years. The strength of patent protection has been dramatically
bolstered, and both large and small firms are devoting considerably more
effort to seeking patent protection and defending their patents in the
courts. Many in the patent community---U.S. Patent and Trademark Office
officials, the patent bar, and corporate patent staff---have welcomed
these changes. But viewed more broadly, the reforms of the patent system
and the consequent growth of patent litigation have created a
substantial \"innovation tax\" that afflicts some of America\'s most
important and creative small firms.

Almost all formal disputes involving issued patents are tried in the
Federal judicial system. The initial litigation must be undertaken in a
district court. Prior to 1982, appeals of patent cases were heard in the
appellate courts of the various circuits. These differed considerably in
their interpretation of patent law. Because few appeals of patent cases
were heard by the Supreme Court, substantial differences persisted,
leading to widespread \"forum shopping\" by litigants.

In 1982, the U.S. Congress established a centralized appellate court for
patent cases, the Court of Appeals for the Federal Circuit (CAFC). As
Robert Merges \[1992\] observes,

While the CAFC was ostensibly formed strictly to unify patent doctrine,
it was no doubt hoped by some (and expected by others) that the new
court would make subtle alterations in the doctrinal fabric, with an eye
to enhancing the patent system. To judge by results, that is exactly
what happened.

The CAFC\'s rulings have been more \"pro-patent\" than the previous
courts. For instance, the circuit courts had affirmed 62% of district
court findings of patent infringement in the three decades prior to the
creation of the CAFC, while the CAFC in its first eight years affirmed
90% of such decisions \[Koenig, 1980; Harmon, 1991\].

The strengthening of patent law has not gone unnoticed by corporations.
Over the past decade, patents awarded to U.S. corporations have doubled.
Furthermore, the willingness of firms to litigate patents has increased
considerably. The number of patent suits instituted in the Federal
courts has increased from 795 in 1981 to 1553 in 1993; adversarial
proceedings within the U.S. Patent and Trademark Office have increased
from 246 in 1980 to 684 in 1992. My recent analysis of litigation by
firms based in Middlesex County, Massachusetts suggests that six
intellectual property-related suits are filed for every one hundred
patent awards to corporations. These suits lead to significant
expenditures by firms. Based on historical costs, I estimate that patent
litigation begun in 1991 will lead to total legal expenditures (in 1991
dollars) of over \$1 billion, a substantial amount relative to the \$3.7
billion spent by U.S. firms on basic research in 1991. \[These findings
are summarized in Lerner, 1995.\] Litigation also leads to substantial
indirect costs. The discovery process is likely to require the alleged
infringer to produce extensive documentation, time-consuming depositions
from employees, and may generate unfavorable publicity. Its officers and
directors may also be held individually liable.

As firms have realized the value of their patent positions, they have
begun reviewing their stockpiles of issued patents. Several companies,
including Texas Instruments, Intel, Wang Laboratories, and Digital
Equipment, have established groups that approach rivals to demand
royalties on old patent awards. In many cases, they have been successful
in extracting license agreements and/or past royalties. For instance,
Texas Instruments is estimated to have netted \$257 million in 1991 from
patent licenses and settlements resulting from their general counsel\'s
aggressive enforcement policy \[Rosen, 1992\].

Particularly striking, practitioner accounts suggest, has been the
growth of litigation\--and threats of litigation\--between large and
small firms (see, for example, the several examples discussed in Chu
\[1992\]). This trend is disturbing. While litigation is clearly a
necessary mechanism to defend property rights, the proliferation of such
suits may be leading to transfers of financial resources from some of
the youngest and most innovative firms to more established, better
capitalized concerns. Even if the target firm feels that it does not
infringe, it may choose to settle rather than fight. It either may be
unable to raise the capital to finance a protracted court battle, or
else may believe that the publicity associated with the litigation will
depress the valuation of its equity.

In addition, these small firms may reduce or alter their investment in
R&D. For instance, a 1990 survey of 376 firms found that the time and
expense of intellectual property litigation was a major factor in the
decision to pursue an innovation for almost twice as many firms with
under 500 employees than for larger businesses \[Koen, 1990\]. These
claims are also supported by my study \[1995\] of the patenting behavior
of new biotechnology firms that have different litigation costs. I
showed that firms with high litigation costs are less likely to patent
in subclasses with many other awards, particularly those of firms with
low litigation costs.

These effects have been particularly pernicious in emerging industries.
Chronically strained for resources, USPTO officials are unlikely to
assign many patent examiners to emerging technologies in advance of a
wave of applications. As patent applications begin flowing in, the USPTO
frequently finds the retention of the few examiners skilled in the new
technologies difficult. Companies are likely to hire away all but the
least able examiners. These examiners are valuable not only for their
knowledge of the USPTO examination procedure in the new technology, but
also for their understanding of what other patent applications are in
process but not awarded. (U.S. patent applications are held confidential
until time of award.) Many of the examinations in emerging technologies
are as a result performed under severe time pressures by inexperienced
examiners. Consequently, awards of patents in several critical new
technologies have been delayed and highly inconsistent. These
ambiguities have created ample opportunities for firms that seek to
aggressively litigate their patent awards. The clearest examples of this
problem are the biotechnology and software industries. In the latter
industry, examples abound where inexperienced examiners have granted
patents on technologies that were widely diffused but not previously
patented \[see, for instance, Merges, 1999\].

It might be asked why policy-makers have not addressed the deleterious
effects of patent policy changes. The difficulties that Federal
officials have faced in reforming the patent system are perhaps best
illustrated by the efforts to simplify one of the most arcane aspects of
our patent system, the \"first-to-invent\" policy. With the exception of
the Philippines, all other nations award patents to firms that are the
first to file for patent protection. The U.S., however, has clung to the
first-to-invent system. In the U.S., a patent will be awarded to the
party who can demonstrate (through laboratory notebooks and other
evidence) that he was the initial discoverer of a new invention, even if
he did not file for patent protection until after others did (within
certain limits). A frequently invoked argument for the first-to-invent
system is that this provides protection for small inventors, who may
take longer to translate a discovery into a completed patent
application.

While this argument is initially compelling, the reality is quite
different. Disputes over priority of invention are resolved through a
proceeding before the USPTO\'s Board of Patent Appeals and Interferences
known as an interference. The Board will hold a hearing to determine
which inventor first made the discovery.

The interference process has been characterized as \"an archaic
procedure, replete with traps for the unwary\" \[Calvert, 1980\]. These
interferences consume a considerable amount of resources: the
adjudication of the average interference is estimated to cost over one
hundred thousand dollars \[Kingston, 1992\]. Yet in recent years, in
only about 55 cases annually has the party that was second-to-file been
determined to have been the first-to-invent \[Calvert and Sofocleous,
1992\]. Thus, the U.S. persists in this complex, costly, and
idiosyncratic system in order to reverse the priority of 0.03% of the
patent applications filed each year.

But this system has proved very resistant to change. At least since
1967, proposals have been unsuccessfully offered to shift the U.S. to a
first-to-file system. As recently as January 1994, USPTO Commissioner
Bruce Lehman was forced to withdraw such a proposal. While the voices
raised in protest over his initiative---as those opposing earlier reform
attempts---were led by advocates for small inventors, it is difficult
not to conclude that the greatest beneficiary from the first-to-invent
system is the small subset of the patent bar that specializes in
interference law.

It may be thought puzzling that independent inventors, who are generally
unable to afford costly litigation, have been so active in supporting
the retention of first-to-invent. A frequently voiced complaint is that
small inventors take longer to prepare patent applications, and hence
would lose out to better-financed rivals, in a first-to-file world. This
argument appears to be specious for several reasons. First, economically
important discoveries are typically the subject of patent filings in a
number of countries. Thus, there is already an enormous pressure to file
quickly. Second, the recent reforms of the U.S. system have created a
new provisional patent application, which is much simpler to file than a
full-fledged application. Finally, as former Commissioner Lehman notes,
many most vocal independent inventors opposing patent reform are
\"weekend hobbyists . . . \[rather than representatives of\]
knowledge-based industries\" \[Chartrand, 1995\].

As this case study suggests, the failure of Federal reform efforts is
due to several factors. First, the issues are complex, and sometimes
difficult to understand. Simplistic claims frequently cloud these
discussions. For instance, because firms use patents to protect
innovations, it is frequently argued that a stronger patent system will
lead to more innovation. Second, the people with the greatest economic
stake in retaining a litigious and complex patent system---the patent
bar---have proven to be a very powerful lobby. The efforts of the highly
specialized interference bar to retain first-to-invent is a prime
example. Finally, the top executives of technology-intensive firms have
not mounted an effective campaign around these issues. The reason may be
that the companies who are most adversely affected are small,
capital-constrained firms who do not have time for major lobbying
efforts.

Thus, an important policy concern is that we avoid taking steps in the
name of increasing competitiveness that actually interfere with the
workings of innovative small businesses. The 1982 reform of the patent
litigation process appears to have had exactly this sort of unintended
consequence.

**References**

Zoltan J. Acs and David B. Audretsch, \"Innovation in Large and Small
Firms: An Empirical Analysis,\" [American Economic Review]{.underline},
78 (1988), pp. 678-690.

Ian A. Calvert, \"An Overview of Interference Practice,\" [Journal of
the Patent Office Society]{.underline}, 62 (1980), pp. 290-308.

Ian A. Calvert and Michael Sofocleous, \"Interference Statistics for
Fiscal Years 1989 to 1991,\" [Journal of the Patent and Trademark Office
Society]{.underline}, 74 (1992), pp. 822-826.

Sabra Chartrand, \"Facing High-Tech Issues, New Patents Chief in
Reinventing a Staid Agency,\" [New York Times]{.underline}, July 14,
1995, p. 17.

Michael P. Chu, \"An Antitrust Solution to the New Wave of Predatory
Patent Infringement Litigation,\" [William and Mary Law
Review]{.underline}, 33 (1992), pp. 1341-68.

Jeremy Greenwood and Boyan Jovanovic, "The IT Revolution and the Stock
Market," [American Economic Review Papers and Proceedings]{.underline},
89 (1999) forthcoming.

Robert L. Harmon, [Patents and the Federal Circuit]{.underline},
Washington: Bureau of National Affairs, 1991.

John Jewkes, David Sawers, and Richard Stillerman, [The Sources of
Invention]{.underline}, London: St.Martins Press, 1958.

William Kingston, \"Is the United States Right about
\'First-to-Invent\'?,\" [European Intellectual Property
Review]{.underline}, 7 (1992), pp. 223-226.

Mary S. Koen, [Survey of Small Business Use of Intellectual Property
Protection: Report of a Survey Conducted by MO-SCI Corporation for the
Small Business Administration]{.underline}, Rolla, Missouri: MO-SCI
Corp., 1990.

Gloria K. Koenig, [Patent Invalidity: A Statistical and Substantive
Analysis]{.underline}, New York: Clark Boardman, 1980.

Josh Lerner, \"Patenting in the Shadow of Competitors,\" [Journal of Law
and Economics]{.underline}, 38 (1995), pp. 563-595.

Robert P. Merges, [Patent Law and Policy]{.underline}, Charlottesville:
Michie Company, 1992.

Robert P. Merges, "As Many as Six Impossible Patents Before Breakfast:
Property Rights for Business Concepts and Patent System Reform,"
[Berkeley Technology Law Journal]{.underline}, 14 (1999), pp. 577-615.

Miriam Rosen, \"Texas Instruments\' \$250 Million-a-Year Profit
Center,\" [American Lawyer]{.underline}, 14 (March 1992), pp. 56-63.

[^1]: ^\*^Harvard University and National Bureau of Economic Research.
    Mailing address: Morgan Hall, Room 395, Harvard Business School,
    Boston, Massachusetts 02163. Phone: (617) 495-6065. Fax: (617)
    496-7357. E-mail: <jlerner@hbs.edu>. I thank Paul Gompers and Jenny
    Lanjouw for helpful discussions. This paper is based on a work
    prepared for the conference "Understanding the Digital Economy:
    Data, Tools, and Research."