The preceding analysis raises a critical question. How did we know what other goods to consider as substitutes? What if consumers switch to plain- vanilla hammers if the price of the patented grip hammer is increased?
What if they switch to mallets or screwdrivers or electric staplers in response to a price increase? Or perhaps consumers would be willing sim- ply to buy some sticky tape and wrap it around the grip instead.
116 INTANGIBLE ASSETS
Because the patent holder is a temporary monopolist, it may be illus- trative to look at what the Horizontal Merger Guidelines (jointly issued by the U.S. Department of Justice and the Federal Trade Commission) say about defining the market in which a monopolist can profitably operate.
Including or excluding products using the guidelines’ market test can inform us about the availability of substitutes. It states:
A market is defined as a product or group of products and a geo- graphical area in which it is produced or sold such that a hypothetical profit-maximizing firm, not subject to price regulation, that was the only present and future producer or seller of those products in that area likely would impose at least a “small but significant and nontransitory”
increase in price, assuming the terms of sale of all other products are held constant. A relevant market is a group of products and a geo- graphic area that is no bigger than necessary to satisfy this test.1 In our example, could the hammer maker with the patented grip impose a “small but significant and nontransitory” increase in the price of its ham- mers that would not result in a loss of sales so great as to offset the profits gained? Can the monopolist raise the price a little and not lose money by an offsetting reduction in sales? If so, then nonslip-grip hammers may be their own market. Noninfringing alternatives still may exist, but they are proba- bly less likely than if the monopoly test fails. In other words, if the patent holder cannot pass this test by raising the price, then the patented good more likely faces competition from noninfringing alternatives. In our example, nonslip-grip hammers may be part of the larger hammer market, as some consumers who do not value the special grip will switch to other substitutes, such as the (now) even relatively cheaper regular hammers.
Economists wrestle mightily with market definition. In practical appli- cations it requires accurate data demonstrating how consumers will respond. Although the market definition test is not dispositive—in part because of imprecise terminology (how small or significant, how long is nontransitory?)—it still may be helpful to examine what products satisfy the test. Can a product constrain price in a significant and non-transitory way? If so, then that product is in. We keep adding products and expand- ing the market definition until the answer is no. That relevant set of prod- ucts gets us thinking again about acceptable alternatives.
Patent Review and Substitutes
Readers may be asking: But doesn’t the patent review process itself deter- mine if something is a substitute? The answer is yes, partially. The review
Intangible Assets and Litigation 117
of prior art helps eliminate what we might think of as the clearest substi- tute inventions. For example, in the case of a hammer, suppose that the nonslip-grip patent application specified a certain type of neoprene rubber, shaped into a mold to accommodate fingers. If the same type of grip had been patented for, say, garden implements, it could prevent the subsequent hammer grip patent application.
But setting aside this review of prior art, the patent process really can- not perform an economic analysis. There are substitutes in the public domain (plain hammers) and substitutes that might employ a noninfringing technology to achieve the same result—for instance, patented liquid hand- grip lotion used in combination with a regular hammer. (Both achieve the desired effect: the ability to hammer without losing one’s grip.)
Because noninfringing substitutes almost always exist at the margin, patent attorneys usually seek to write the claimed structure of a patent as broadly as possible. Method patents are a different story. Sometimes the structure is patented by someone else or is in the public domain and some- one gets a patent not on a structure itself but on the use of the structure (e.g., chemical Z used against solid tumors). In that context, a new use (chemical Z as hair regrowth cream) would not infringe the use patent, but still would infringe the structure patent, if one was still in force.
Back to Panduit
The third prong of the Panduit test concerns the capacity to capitalize on the patent. In a lawsuit, this criterion helps determine what percentage of the infringer’s sales the patent holder reasonably could have expected to have made, had the infringing product not come into the marketplace.
Outside of litigation, this criterion can go a long way in explaining the bar- gaining position of a patent holder whose patent is up for sale. Suppose that an individual inventor holds the hammer grip patent. Alone, he is unable to market and manufacture a hammer than incorporates his grip technology. Without landing a deal with a hammer manufacturer the patent is virtually worthless. However, now suppose that non-slip hammer manufacturer A is bargaining with another manufacturer, B. Further sup- pose that market studies have shown that consumers strongly prefer the patented grip that A sells. In this scenario, the patent would certainly be worth more.
The fourth criteria of the Panduittest contains the notion that the plain- tiff needs to be able to provide a reasonably accurate estimate of the profits that would have been made had the infringement not taken place. If we extrapolate this concept to valuation, it is equivalent to saying “Projections for the profits attributable to this patent need to be reliable.” Wild specula-
118 INTANGIBLE ASSETS
tion of lost profits is not acceptable to a court; neither should it be to a good valuation. Projections that take into account historical performance, the riskiness of the cash flows, the financial condition of the company, and char- acteristics of the market are some of the ingredients required to do the valu- ation right.
Relating Panduit to the PIE-B
It is hoped that at this stage, readers can relate the Panduitcriteria to PIE- B’s dimensions: If demand for the asset is greater, economic benefit is greater.
If there are no acceptable substitutes for the asset, then ownership of the ben- efits is more secure. (The opposite, of course, is that the features of the asset are not unique: Properties are shared by many owners.) If the owners of the asset can exploit demand, then economic benefit is greater. And, last, the less speculative a calculation of profit, the more certainly economic benefit can be calculated.