CP solves perverse incentives

Some standards-based patent pools have adopted more complex formulas to discourage such behavior. For instance, the RFID patent pool alters the pro rata formula such that “half of the royalties are allocated to participants based on the number of patents contributed by each participant, and the other half are allocated substantially equally among participants.” By hinging fifty percent of all royalties on the pure number of members within the group rather than the number of patents within the group, this hybrid approach could limit strategic patenting behavior. However, this formula arguably results in an even cruder division of royalties than a purely pro rata formula.

A second type of formula adopted by some groups gradually apportions fewer royalties to patents over time. The DVD patent pool, for instance, allocates royalties to patent holders on the basis of how old their patents are. According to the group’s organizers, this formula was selected to encourage contributors to license new and valuable patent rights to the collective. This approach seems to assume that older patents are always less valuable than newer ones. As such, graded royalty sharing, like pro rata distributions, appears as a rough-and-ready approximation of patent value.

All formula-based groups charge a single decision-maker with the task of determining whether or not to include a new patent in the mix. As a result, the only way that a prospective innovator could influence his profits in a formula-based regime is by helping to define the standard around which a patent pool is organized. The MPEG-2 patent pool provides a helpful example of how this can be done. Between 1988 and 1994, the MPEG-2 standard was drafted and defined by an open working group of engineers and experts from over one hundred technology companies. Collaboration was coordinated by a standard-setting entity called “ISO/IEC.”

Once the first draft of the MPEG-2 standard was defined, several members agreed to allow two outside experts to identify patents that were “essential” to the technology. Entities that held one or more essential patents included many participants in the standard-setting group, including Columbia University, Fujitsu, General Instrument, Matsushita, Mitsubishi, Philips, Scientific-Atlanta, and Sony. These founding organizations agreed to a pro rata royalty division formula, and formed an independent limited liability company called “MPEG LA” to administer licensing and royalty collections. In this way, only organizations that participated in the standard-setting process for MPEG LA had opportunities to have their patented technologies incorporated into the final standard, and consequently, into the patent pool.

Although formula-based patent pools do not value individual patents carefully, their lack of precision may be compensated for over time: For instance, a formula that over-values roughly the same number of patents as it under-values could still satisfactorily value collections of patents in the aggregate. This possibility, combined with the open membership of nearly all such groups identified in this study, may offer a strong innovation incentive to patent holders who expect to contribute multiple patents to a single pool. In fact, such rough-and-ready rules may more efficiently encourage repeat players to innovate than would complex collective valuation procedures, such as voting over key decisions.