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Not just the option to exclude: patent enforcement as a portfolio of options
We use a compound real options model to investigate the impact of product market characteristics on patent value by considering imperfect patent protection. Patent enforcement can be regarded as a portfolio of options. Once the patent lawsuit is filed, an alleged infringer firm (“challenger”) and an infringed firm (“incumbent”) pay for their ongoing litigation cost using operating cash flows from product market profits. We consider the challenger's strategy to exit the market during litigation due to shortage of funds, the incumbent's strategy to withdraw from value-reducing litigation or to force the challenger to exit the market by a threat to litigate, and firms' strategies to set up royalty payments to avoid a lawsuit, or to settle with each other after a lawsuit is filed. We distinguish between the effects of litigation and settlement on patent values and show first that settlement options raise patent values. By focusing on each firm's ability and willingness to pay for litigation costs, we find that product market characteristics such as the challenger's profit relative to the incumbent's loss of profits due to the alleged infringement (“gain-to-loss ratio”) has to be high enough for settlements to be possible. Settlements are also more likely in less volatile product markets, with more questionable patent validity, and when litigation costs are similar for the two firms. Our model generates new testable implications regarding patent values in a rigorous and comprehensive way.