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March 28, 2014

Understanding the Economic Value of Trade Secrets

Glenn Perdue – March 28, 2014

The economic value of trade secrets, like other forms of intellectual property (IP), lies in the proprietary competitive advantage gained from use coupled with the exclusion of others from such use. But unlike the right to exclude others from using a patent for a limited period of time, which arises from a government granted monopoly tied to disclosure, the right to exclude others from the use of a trade secret arises from limited disclosure and reasonable efforts to maintain secrecy.

This article explores economic factors relevant to trade-secret development, reverse engineering, and misappropriation as well as the manner in which value creation is shaped by various legal requirements to maintain trade-secret status.

In Search of Proprietary Competitive Advantage
Human beings respond to incentives. This fundamental tenet of economics is demonstrated every day by business managers working to maximize profits by selling more, selling at a higher price, or reducing costs. But, of course, such efforts do not occur in economic isolation. With the exception of governments and a handful of monopolies, such as utility companies, most enterprises function within industries that include competitors vying for the same customers. As a result, sources of advantage should be viewed relative to those of competitors. 

If two competing businesses have an equivalent "advantage"—whether in the form of a production method, internally developed software, marketing information, or some other capability—then it's really not an advantage after all.  In such cases, these businesses achieved competitive parity in a particular area while neither gained an advantage.

Economics literature is filled with references to the notion that advantage should be considered on a comparative basis. Adam Smith makes what may be the earliest reference to this idea in The Wealth of Nations (published in 1776), while David Ricardo uses the term "comparative advantage" in On Principles of Political Economy and Taxation (published in 1817).  Ricardo's reference occurs in comparing the relative advantages that England and Portugal had in producing cloth and wine at the time.

While competitive parity along certain dimensions can be expected, business managers seek advantages that are proprietary, sustainable, differentiating, and financially material. When business managers identify such advantages, they may seek to protect the source of that advantage to extend benefits and justify further investment. 

Of course, advantages may erode over time as competitors come to understand one another's capabilities and develop their own sources of advantage. An apt analogue is found in weapons and warfare. Weapons tend to evolve over time in response to new weapons or defenses used by the enemy that may render earlier weapons less effective. In business—and on the battlefield—our actions are shaped by the measures and countermeasures of competitors.

Patents, copyrights, trademarks, and trade secrets play a central role in defining and protecting sources of proprietary competitive advantage sought by managers to provide benefits on the battlefield of business.

IP Economics and the Free-Rider Problem
Unlike tangible goods that are governed by laws of scarcity, information can be inexpensively shared and replicated. This creates unique economic circumstances for intellectual property and other information-based assets.

Protections afforded by patent, copyright, trademark, and trade-secret laws provide further —and often essential—incentives for developers of IP to make both initial and ongoing investments.  Absent such protections, investments in IP would decline (and, in some cases, not occur at all) due to the risk of others free riding on these investments. Speaking to this issue, Judge Richard Posner explains:

Intellectual property is characterized by heavy fixed costs relative to marginal costs. It is expensive to create, but once created the cost of making additional copies is low, dramatically so in the case of software, where it is only a slight overstatement to speak of marginal cost as zero. Without legal protection, the creator of intellectual property may be unable to recoup his investment, because competitors can free ride on it; and so legal protection can expand, rather than as the usual case with monopoly contract, output.

Judge Richard Posner, Address, Antitrust in the New Economy (Sept. 14, 2000).

According to Black's Law Dictionary, a free rider is "one who obtains an economic benefit at another's expense without contributing to it" or without "paying a fair price" for the economic benefit obtained.  Due to free-rider risks, the ability of an IP originator to obtain and enforce rights to exclude others from unauthorized or improper use is necessary if substantial business investment in IP is to occur.

As indicated by Judge Posner, the differential between the relatively high up-front costs needed to develop IP and the relatively low costs generally associated with replicating and using IP encourages free riding.  After all, free riders stand to gain the benefit of IP use without up-front investment risks.  As a result, IP protection is needed to encourage investments in developing IP that provides societal benefit that might not otherwise occur without such protections. In the case of trade secrets, these protections are granted based on economic value and secrecy. 

Trade-Secret Economics
Like the economics of other forms of IP, the economics of trade secrets are shaped by the means through which IP protection allows for proprietary benefits to be gained.  In the case of trade secrets, the Uniform Trade Secrets Act (UTSA), as amended in 1985, provides the following:

• Types of information: "Information, including a formula, pattern, compilation, program, device, method, technique, or process, that: . . ." (section 1)

Economic value: "derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable by proper means by, other persons who can obtain economic value from its disclosure or use, and . . ." (section 1(i))

• Secrecy requirement: "is the subject of efforts that are reasonable under the circumstances to maintain its secrecy." (section 1(ii))

• Protection period:  "Like injunctive relief, a monetary recovery for trade secret misappropriation is appropriate only for the period in which information is entitled to protection as a trade secret, plus the additional period, if any, in which a misappropriator retains an advantage over good faith competitors because of misappropriation." (section 3(a))

The excerpts above tell us that the information comprising a trade secret is to derive economic value from being a secret, that reasonable efforts must be made to keep it a secret, and that the period of protection is based, in part, on reasonable efforts to  maintain secrecy. It is interesting to note how competitive advantage unfairly gained through misappropriation becomes a basis for extending the period of protection in section 3(a). 

Based on this legal-protection framework, some rational economic considerations in the decision to develop or purchase a trade secret would include:

• Demand. Expected demand for the products, services, or internal capabilities  that would embody the trade secret.

• Protection period.  The anticipated protection period as impacted by the likelihood of competitive discovery through allowable reverse engineering or other proper means.

• Substitutes. The existence or expected development of acceptable substitutes that could diminish or eliminate competitive advantages provided by the trade secret.

• Investment outlays. The expected economic outlays to develop (or purchase) and protect the trade secret.

• Investment returns. The additional economic benefits expected as a result of trade-secret use such as greater sales, price premiums, or cost reduction.  These benefits should provide both a return of capital (i.e., a recoupment of investment outlays) and a return on capital that compensates for risk and the time value of money.

To the extent that a prospective trade-secret developer determines that investment benefits exceed the cost to develop and protect the trade secret, then it makes economic sense for development to proceed.  Of course, economic costs include the cost of capital, typically expressed as a discount or capitalization rate that reflects investment risks and market-based return expectations.  Similar economic analysis may also occur among those contemplating independent development, reverse engineering, or even misappropriation.

Economic factors associated with investments in reverse engineering are similar to those considered by a trade-secret originator with some slight differences.  Most obviously, the primary up-front investment being contemplated by a reverse engineer is the cost associated with identifying, understanding, and incorporating the trade secret of another through examination of the targeted product or service. In contrast, a trade-secret originator's primary up-front investment is the cost of initial development.  In addition, the likelihood of successful reverse engineering and the expected benefits such success could bring are rational economic factors to consider.

While successful reverse engineering may reduce the protection period for a trade secret, the owner of the trade secret and first reverse engineer may still share some continued economic advantages to the extent that the reverse-engineering exercise was not easy or cheap. This is because technically difficult and expensive reverse-engineering efforts still create barriers to entry for others that may lack the expertise and capital to engage in a similar exercise. 

However, to the extent that the market opportunity is attractive and reverse engineering is easy and inexpensive, other competitors will likely engage in reverse engineering, enter the market, and erode economic advantages associated with trade-secret use.  Under a scenario like this, where the trade secret is easily and legally unmasked by competitors, there is likely little or no IP value because there is little or no proprietary competitive advantage.

Looking at this through the lens of a prospective misappropriator, primary economic considerations would include the potential benefits of misappropriation as compared with the costs of misappropriation.  Such costs would include legal defense costs and potential payments for damage awards. 

Of course, a rational misappropriator will also factor in the likelihood of (i) being accused of wrongful conduct by the trade-secret owner, (ii) legal action being pursued, (iii) an ultimate finding of misappropriation by the court, and (iv) paying the trade-secret owner as a result of a legal settlement or monetary damage award.

Trade-Secret Value
Proprietary competitive advantages realized through the use of a trade secret can result in sales (or increased sales) of products or services, the ability to charge a price premium, reduced costs, increased market share, or other benefits.  While typically not a preferred way of generating returns from trade-secret investments, litigation involving misappropriation can also provide investment returns through the recovery of damages. As a means of generating investment returns, a trade-secret owner might also consider licensing or selling a trade secret—whether as part of a specific IP transaction or as part of a larger business transaction. These monetization approaches—internal use, litigation, licensing, or sale— are considered further in the discussion that follows.

Identification and definition. A typical challenge, particularly in a litigation setting, is identifying and defining the trade secret(s) at issue. By doing a better job with identification and definition, businesses can enjoy improved trade-secret awareness, management, and protection.  In turn, such improvements can assist management in monetizing trade-secret assets through any means. Companies with significant trade-secret assets may want to consider performing a regular IP audit that, among other things, assists with identification and definition.

Contractual protection. Central to the protection of trade secrets are (1) employment agreements that may include covenants not to compete, and (2) nondisclosure agreements that may limit the subsequent disclosure and/or use of trade secrets that may be divulged as a part of a business relationship.  Consistently obtaining these agreements from employees and business partners can positively impact trade-secret value as can the scope and enforceability of these agreements. Additionally, to the extent that a trade secret is licensed or sold, the licensing agreement and related protective provisions are important considerations in assessing trade-secret value. 

Business practices. Business practices that preserve secrecy are an important part of trade-secret protection. Such efforts often begin with obtaining appropriate protective agreements for trade secrets and other confidential information as discussed previously.

With new employees, orientation and training sessions that consider the need to protect trade secrets and confidential information might be provided while existing employees may receive continuing education on the topic.  Finally, departing employees may be asked (or required) to participate in an exit interview.  At this interview, employees may be reminded of the trade secrets and confidential information to which they were exposed during their employment, reminded of their nondisclosure obligations, and asked to return any confidential information in their possession. 

Other business practices that can contribute to the protection of trade secrets include the designation of confidential information, marking related documents accordingly, and  implementing reasonable physical and information security measures. 

Observing protective business practices can help prevent inadvertent disclosures and deter misappropriation.  In addition, following such practices can assist the trade-secret owner in obtaining a recovery (or better recovery) in litigation.  As a result, such efforts may also improve trade-secret value by allowing for better protection, a longer protection period, greater competitive advantage, and improved monetization opportunities.

Understanding the economic contribution. As a source of proprietary competitive advantage, it is helpful for IP owners to understand the manner in which IP contributes to revenues, profits, and business value. This understanding begins with identifying IP assets as discussed previously. And of course, the economic contribution will differ based on the manner in which the IP asset is being monetized.

If an IP asset is being used internally, the economic contribution may arise from additional revenues, reduced costs, market protection, or some combination thereof.  Understanding this value contribution might begin with a comparison of the expected economic contribution with and without trade-secret use. In addition to a comparative analysis of this type, a reasonable royalty analysis might be performed as a basis for isolating the economic contribution of the trade-secret asset.

If an IP asset is monetized through litigation, the most apparent economic contributions would arise from injunctions that extend market protection and any damage recoveries.  Trade-secret damage recoveries may be based on the actual loss suffered by the trade- secret owner, the unjust enrichment of the misappropriator, or imposition of a reasonable royalty. (See UTSA § 3; Glenn Perdue, "The Broad Spectrum of Trade Secret Damages," Intellectual Property Litigation, Vol. 23, No. 3 (Spring 2012)).  In addition to potential damage recoveries, other economic benefits associated with future deterrence might also be gained through litigation.

If an IP asset is monetized through licensing, an economic contribution is provided through the net royalty received for use of the IP by the licensor.  However, in the case of non-compulsory licensing, the issue of value is often viewed from the perspective of two parties, a licensor and licensee negotiating in an arm's-length setting attempting to arrive at a royalty arrangement that makes economic sense to them both. This real-world negotiation setting is, of course, the basis for the hypothetical negotiation setting described by the court in Georgia-Pacific Corp. v. United States Plywood, 318 F. Supp. 1116 (S.D.N.Y. 1970) and in University Computing Co. v. Lykes-Youngstown Corp., 504 F.2d 518 (5th Cir. 1974).  While University Computing was a trade-secret case, Georgia-Pacific was a patent case but is also used in trade-secret matters where a reasonable royalty is being used as the basis for damages. While the Georgia-Pacific factors are more exhaustive, both cases consider similar economic factors.

Other licensing considerations. The previous section (Trade-Secret Economics) identified five basic economic factors that a trade-secret owner might reasonably consider in making a trade-secret investment decision.  As illustrated below, these factors are also relevant to a prospective trade-secret licensee.

• Demand: A rational licensee considering investments to exploit a licensed trade secret would want to understand this key source of economic benefit. Of course, with a new product or service, demand is often difficult to forecast.  Demand-related uncertainties can result in lower up-front payments (if any) due to the economic risks this presents to prospective licensees. In situations where high levels of demand uncertainty exist, rational licensees tend to reject high up-front fees (or lump-sum royalties), which shift economic risk to them.  Instead, running royalties are typically used in this setting because they allow for shared risk in which both parties share in benefits—upside or downside—as the royalties are realized. 

• Protection Period: A rational licensee would consider the exclusive or nonexclusive nature of the license as well as the ease and likelihood of reverse engineering or independent development by a competitor. Because these factors impact the effective period of market protection, they may also impact the negotiated royalty rate, up-front payment (if any), and other terms of the prospective license agreement.

• Substitutes: The existence or expected development of acceptable substitutes that could diminish or eliminate competitive advantages provided by the trade secret are also key considerations to a rational licensee. After all, if acceptable substitutes exist (or soon will exist) and are offered at comparable prices, the proprietary benefit of the trade secret, and any trade-secret license, is diminished. As above, the presence of risks could result in a reduced royalty rate and up-front payment. 

• Investment Outlays: The expected outlay to license and effectively use the trade secret is considered alongside the economic benefits to determine whether licensing makes economic sense. 

• Investment Returns: A rational licensee would consider the additional economic benefits expected as a result of trade-secret licensing such as increased sales, price premiums, or cost reduction.

From the perspective of a rational licensor, the economic factors in a licensing decision include:

• Risk of Trade Secret Disclosure: A rational licensor would consider the risk of loss or diminished trade-secret protection due to disclosure by a prospective licensee.

• Risk of Competitive Loss: To the extent that the licensor competes, or plans to compete, with a prospective licensee, a consideration is the potential competitive loss that might occur due to the licensing arrangement. The licensor's ability to compete as a result of sufficient capacity, financial resources, and geographic coverage are also considerations in assessing this factor.

• Net Economic Benefit: A rational licensor would consider the net economic benefit obtained through a license.  For example, to the extent that the licensor is able to license to a business in a noncompetitive industry or in a geographic region that the licensor is unable to serve, then all licensing revenue is incremental in nature.  But in a competitive setting, the benefits of licensing will weigh against expected losses due to competition.

Proprietary competitive advantage is the key to IP value.  In the case of trade secrets, monetization can occur through internal use, litigation, licensing, or sale. While identifying trade secrets and understanding the means by which they create economic value is time-consuming, the effort is often necessary if these assets are important to the ability of a business to effectively compete and generate profits.

Keywords: litigation, intellectual property, economic value, competitive advantage, trade secrets, monetization, reverse engineering, misappropriation, economics, free-rider problem

Glenn Perdue – March 28, 2014