The Lowdown on Patent Shakedowns

Intellectual property -- and protecting it -- is without a doubt a critical underpinning of corporate success and entrepreneurism in the U.S. today. Corporations depend on protecting their ideas to advance their business plans in a market unencumbered by unfair competition. Everything from Amazon.com's (Nasdaq: AMZN  ) one-click patents to Rambus' (Nasdaq: RMBS  ) memory inventions plays a pivotal part in the value investors place on shares.

But even a system put in place to regulate and encourage fair business and innovation can be manipulated to suit unintended purposes -- with destructive outcomes. While many businesses use patents and copyrights to protect their intellectual ideas as a defensive moat, others leverage patents for profit through active licensing programs. In the last few decades, many companies have found untapped value in patents they hold and have instituted licensing programs to escalate use of their intellectual property in return for high-margin revenue. What is far more controversial, though -- and damaging to investors -- are entities that take it to another level and literally extort fees from companies through intimidation and litigation.

The rise of the patent terrorists
A new term has been showing up more lately: patent terrorism. The harsh term refers to a legal entity that owns a patent or patents but neither develops products based on them or even retains the original inventor(s). Often, these organizations purchased the patents or swallowed companies that were going under to acquire the ideas, which is called patent trolling. These companies then scour the marketplace for other companies that may be doing business in areas related to the owned patents, and follow through with litigation to demand payment of license fees or royalties, or both.

On one hand, the business of licensing patents is a legitimate enterprise. The practice generates huge revenue streams for many companies around the world and has been standard practice for the likes of IBM (NYSE: IBM  ) and Texas Instruments (NYSE: TXN  ) for years. Yet there is definitely a code of conduct for the licensing of innovative ideas here in the U.S., and patent terrorists often cross this time-honored line.

There are a few practices in licensing patents that are considered legitimate in the business of technology. First, innovative ideas are recognized and paid for by companies if there is some form of return in kind. It is very common, for instance, for companies to execute cross-license agreements, where each company gets access to selective innovations of the other. Microsoft, for instance, has stepped up its efforts in the past year and is pushing for cross-license agreements.

Companies also tend to be willing to pay license fees to a patent owner if the ideas can give the company a significant boost in either time to market, profitability, or competitive advantage. Obviously, if there is a clear advantage to incorporating an outsider's invention into your own product or service, it's worth paying for.

In this case, inventors often provide more than just the legal stamp of approval to use a patent: They often provide consulting, design services, or other forms of technical assistance. This makes sense, because the more successful a licensed product is, the more royalty the inventor sees. Qualcomm (Nasdaq: QCOM  ) is one of the most recognized names that offered licenses for advanced CDMA (code division multiple access) technology in the 1990s in order to help wireless operators gain an edge on the competition.

Both forms of patent licensing are collaborations between two parties. Patent terrorism, though, doesn't include any element of either practice. Patent terrorists have no interest in cross-licensing because they produce no "products" themselves. They also often don't help the licensee with product development, because they usually don't hire the original inventor of the patents -- only lawyers. The typical legal action is more akin to a shakedown, with them often swooping in after a company has developed and sold so-called "infringing" products and trying to collect retroactive license fees.

Deep impact
Investors in companies that are on the receiving end of patent litigation know the costs that intellectual property suits can bring them, whether the claims are legitimate or not.

Investors in Research In Motion (Nasdaq: RIMM  ) have come to loathe NTP, a holding company that has dogged RIM for years over patents acquired from an inventor who has died. The company had spent tens of millions of dollars over the years fighting NTP, only to settle for $450 million and then see one of the patents at the center of the NTP lawsuit overturned recently.

There always comes a point when it makes more sense for a company to settle claims, even if they don't have merit. Public companies are in service to their shareholders, and sometimes "taking one for the team" means bowing to litigation pressures and settling suits to save the company significant legal costs and potentially damaging verdicts.

But the negative ramifications of patent shakedowns can go far beyond depressed stock prices. The aggressive practice of intellectual property lawsuits stifles innovation, in small and large companies alike. The cost of doing business in technology goes up dramatically when you have to pay out investor money to argue against uninvited lawsuits. Still, the practice seems to be gaining in popularity.

As an example, a recent ad in a popular telecommunications magazine announced the pending auction on eBay (Nasdaq: EBAY  ) for several mobile phone patents. A quick scan of eBay pulled up the chance to put in a $98 million starting bid on cell-phone patent 6,161,005, an invention that involves using a mobile phone for unlocking doors. Usually offered for sale by law firms, patents are dangled in front of buyers with the notion that any party that could put some legal muscle behind the patents could negotiate -- or sue for -- lucrative royalty or license fees far in excess of what was paid for ownership of the patent.

A call for reform
With dangerous precedents being set in the intellectual property area recently, many top technology leaders have called for reform in the patent system. In addition to the rising practice of patent-fee extortion, business leaders have for years lamented the proliferation of so-called "junk" patents, claiming that the U.S. Patent and Trademark Office is too liberal in granting rights.

If you want to understand more about the history of the U.S. patent system and current trends, I'd highly recommend reading Rembrandts in the Attic by Kevin Rivette and David Kline. The authors point out how the role that patents have played over the last several decades has affected businesses dramatically, and warn about some of the recent trouble brewing.

Regardless of where opinions fall on the current issues, however, it is important for investors to understand how the companies they own utilize and protect their inventions -- and what approach management has taken to deal with intellectual property disputes. Having to pay license fees can mean substantial reductions in product margins, so it's important to know whether a company is a licensor or licensee.

For more Foolishness on patents, see:

Fool contributor Dave Mock is considering licensing his intellectual strategy for guaranteed victory in any game of Twister. See... you really want to know, huh? He owns no shares of companies in this article but is the author ofThe Qualcomm Equation. The Motley Fool is investors writing for investors.


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