In addition to providing legal protection, patents serve a disclosure function aimed chiefly at inventors and technology customers. However, the effect of this disclosure on capital markets has been left largely unexamined in the literature, creating a gap in understanding of how the capital markets digest the information in patents.
To understand the importance of the disclosure function, consider the challenge faced by firms that continuously invest in research and development. Research and development increase the information asymmetry between a firm and capital markets, leading to uncertainty about the firm’s value and future market position. This uncertainty can adversely affect an R&D-intensive firm by increasing its cost of capital and prompting underinvestment and undervaluation in the market. The pressure from capital markets eventually leads to sub-optimal R&D investment, as well as the sacrifice of long-term value in favor of short-term earnings. This issue is particularly important for publicly traded firms, which are more sensitive to market perception, and in which managers’ compensation is more likely to be linked to firm’s stock price.
In our study, we focus on patents and investigate whether and under what conditions patenting can mitigate the uncertainty for R&D-intensive firms. We concentrate specifically on the role of patent applications as standardized sources of disclosure about a firm’s innovations. To assess the extent of uncertainty about a firm, we measure the errors in analysts’ earnings forecasts. We assume that if there is more uncertainty about the value of a firm in the market, then there should be a higher degree of disagreement and, as a result, larger errors in analysts’ forecasts. In order to disentangle a patent’s legal protection benefits from its market disclosure value, we construct a model based on a quasi-natural experiment: the American Inventor’s Protection Act (AIPA 1999) requirement that patent information be disclosed within an initial time period. We provide causal evidence that information disclosure through patents does reduce uncertainty about the firm in the capital markets. Hence, by reducing uncertainty, patenting may serve as a strategic tool to mitigate the uncertainty costs of R&D activities.
Prior to the passage of AIPA, firms that applied for a patent were not required to disclose information about their application before the patent’s grant date. As of November 29, 2000, AIPA required the United States Patent and Trademark Office (USPTO) to publish all U.S. patent applications within 18 months of the first filing date. This exogenous shock was unlikely to affect the protection function of patents, as the exclusive rights of patentees to their inventions upon patent grant remained in place. However, the shock did have an impact on the information disclosure function of patents in applications. We take advantage of the exogenous variations in the disclosure effect of AIPA, based on pre-AIPA industry differences in filing-to-publication timing. In some industries, there is a shorter period between filing to publication, leading to a small AIPA disclosure effect. In other industries the period between filing to publication is longer, resulting in a bigger AIPA disclosure effect. This structure helps us to employ a difference-in-differences identification strategy, which enables us to investigate the causal effect of disclosure through patent applications.
We use financial analysts’ earnings forecast errors as a proxy for the uncertainty about the firm in capital markets. Our analysis shows that patent applications after the passage of AIPA, compared with the patent applications before AIPA, brought a significant reduction in the uncertainty about the applicant firm, i.e., fewer earnings-forecast errors. The effect is significantly larger for firms with greater R&D intensity and firms that increased their R&D intensity over the analysis period. However, we find that firms filing broader and more valuable patents benefit less from the disclosure function, as uncertainty about their earnings is reduced less. As a result, financial analysts assess the lower-value and narrower patents more accurately (with smaller errors) than broader and higher-value patents. This finding is consistent with the previous research showing that more novel and complex technologies are less favored by capital markets, as they are costlier to asses. This result presents a limit on the strategic use of patents to mitigate the uncertainty costs of R&D.
This study is relevant to measuring the benefits and costs of patenting as well as the value of information disclosure in R&D-intensive industries. Prior studies have identified the disclosure benefit of patents in facilitating the market for new technologies and helping inventors build on prior innovations. Our study adds to these findings by analyzing the effectiveness of patenting in mitigating the uncertainty costs of R&D.
This post comes to us from Ali Mohammadi at the Royal Institute of Technology (KTH) – Department of Industrial Economics and Management (INDEK) and Swedish house of finance, Mehdi Beyhaghi at the Federal Reserve Bank of Richmond, and Pooyan Khashabi at Ludwig-Maximilians-Universität (LMU), Munich School of Management, Institute for Strategy, Technology and Organization, Munich, Germany. It is based on their recent article, “Technology Disclosure and Capital Market Uncertainty: The Role of Patents,” available here. The views expressed in the post are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Richmond or the Federal Reserve System.