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Got a Patent? Sell the Company!

by Basil Peters on July 26, 2014 · 2 comments

I Thought I Understood Patents

When I was CEO of my first technology company I thought I understood how patents worked. But it was only after managing a hedge fund for a few years that I began to appreciate the risks patent holders face.

Many entrepreneurs think that the real test of a patent’s value is whether or not it will be granted. But in my experience the real value isn’t known until you’ve spent years, and millions of dollars, defending that patent in your first infringement case.

It Takes Millions of Dollars to Defend a Patent

The legal processes associated with a patent can easily take a decade from beginning to end. If you file for a patent under the slow track method, you may wait two or three years just to get a patent granted. Once your patent’s granted, you may enjoy several months, or possibly a year or two, before someone infringes or challenges it. The ensuing court battle can easily take another two to five years. And if there’s an appeal, you may have to finance your legal team for another two to five years.

I’ve asked several patent attorneys what it would cost to go to trial to defend a patent against a major company.

None of them has given me a definitive answer, but they did say it could cost a $1 million just to start the process. Depending on the complexities, and how long the case drags on, it could cost as much as $10 million in legal fees to finish the lawsuit.

Even the Strongest Patents Can Lose Their Case

Hedge fund managers are always searching for situations where there will be significant moves in a company’s stock price. Especially valuable are situations where they can have insight before the actual move takes place. One strategy is to try to predict the outcome of patent litigation. The outcome often has a large effect on a company’s share price. A good recent example is the ongoing patent battles between Apple and Samsung over smart phones.

When I was running my hedge fund, some of the biggest patent cases we invested on involved technologies in the electrical and computer engineering area. Fortunately, my Ph.D.is in Electrical and Computer Engineering, and after a few years of watching these court cases, I started to get pretty good at predicting the outcomes. I developed a reputation among other hedge fund managers of having an impressive track record in predicting stock price moves based on patent litigation outcomes. When we got it right, we made some impressive money.

One of the first things I learned as a hedge fund manager, which I didn’t fully appreciate as a CEO, was that even when the merits of a patent case are clear from a technological perspective, a court decision can still go the wrong way for the patent holder. Surprisingly often, you can still end up losing your case even if you may have a perfectly valid patent and, no technological reason why you shouldn’t win.

According to PwC’s 2012 Patent Litigation Study, patent holders have a nearly 40% chance of losing their case.

It’s Almost More Important to Have a Good Lawyer than a Good Patent

Why do so many patent holders lose in court?

As I followed more patent litigation and developed deeper relationships with some of the high-profile litigators, it became clear to me that the relative skill level of the lawyers creates a significant probability that the final decision will go the wrong way for the patent holder.

According to the PwC study, patent holders have better success with juries than with judges. That might explain why the number of jury trials in patent cases has grown to 55.2% of cases in the 2000s from just 14.4% in the 1980s.

The entire concept of a jury in a patent trial has always seemed somehow wrong to me. I don’t see any way a jury could possibly understand most of the technical points in a typical technology patent unless they all had advanced degrees in the field.

I began to appreciate that it’s almost as important to have good lawyers as it is to have a good patent. This is probably part of the reason patent lawyers can charge such mind-boggling amounts to litigate patents – because the really good ones often win, even when they shouldn’t. While this is especially true in jury trials, even judges are susceptible to a persuasive argument by an exceptional litigator.

Big Company Attitudes about Small Company Patents

Later in my career, when I was running a venture capital fund, I saw firsthand just how vulnerable a small company is if they own a valuable patent.

While I was an investor in Brightside, the company showed it’s technology to one of the largest manufacturers in the world hoping to negotiate a licensing agreement. They’d done this under a very good non-disclosure agreement prepared by one of the biggest law firms in the country. But as some Brightside executives suspected later, this company must have taken Brightside’s technology and put it into production the same week it was shown to them. This was well before they knew whether they were going to license Brightside’s technology.

This happened because the big manufacturer knew the technology was valuable. But they decided they couldn’t delay putting it into production. So they built the technology into the next generation of their products immediately. Like a lot of big companies, their logic was that they would either agree on a licensing deal eventually or fight it out in the courts.

I suspect this big company knew that Brightside didn’t have enough money to defend their patents. Brightside got lucky – the company was sold to Dolby just a few weeks before the big company’s products appeared in stores.

This situation is not unique to Brightside. As a VC I saw this happen to several other small innovative companies; but none of them were as lucky to sell just before they knew their patented technology had been infringed.

An angel investor friend of mine described an experience that illustrates how some of these big companies think about small company patents. In a very similar situation, he’d traveled to Asia to meet with a big company that has infringed on one of their patents. In the meeting, one of the execs from the big company said “We big. You small. You lose.”

Investors Won’t Fund a Patent Battle

As a venture fund manager and an angel investor, one of the things I’ve seen consistently through my investments is that investors will almost never invest in a company where the use of proceeds is to fight a patent court case. Almost all investors are uncomfortable with the probabilities of success associated with a patent battle. The very uncertain outcome is something very, very few investors want to gamble on.

There are some companies who make a business out of fighting patents in court. They have an appetite for that level of risk and reward. This type of investor typically invests in companies whose sole purpose is to monetize patent portfolios. If your company ends up in the situation where this is your only alternative, the bad news is that you probably won’t get any money until after the court case – probably five to ten years later.

Don’t Have $10 Million in Cash? You Can’t Afford to Own a Patent

What all this means is that if you don’t have $10 million in the bank, and a board that is enthusiastic about spending a big chunk of that cash on lawyers, then you really can’t afford to own a patent.

The probability of having to defend a good patent is simply too high – and the costs of defending it are too great. The risk-reward ratio is just too high to make sense for a small company – it’s not a sound business, or investment, strategy.

The Optimum Strategy: File and Exit

As an M&A advisor I’ve come to believe that the optimum strategy for most companies is to file a patent application, and then start the exit process at about the same time.

When you apply for a patent you disclose your technology in great detail. During the early part of the process, it’s still confidential. At that point, your competitors can’t look at it and start to use it or design around it.

While the patent is still confidential, you can show it to a potential acquirer under an appropriate non-disclosure agreement (NDA). They’ll make their own determination about the probabilities that the patent will be granted; and more importantly, the probabilities the patent will actually turn out to be valuable.

In my experience sitting across the table from many potential acquirers, prospective buyers of small and medium-sized technology companies don’t seem to significantly discount the value of a patent before it has been granted. Buyers are smart. They understand how patents work. They know that there are probabilities attached no matter how good the patent is. They also know it could easily take a decade or more to know for sure.

The difference is that it makes a lot more sense for the big company to own the patent because they can afford to defend it. In a larger company, with many patents and products, the risk-reward ratio also makes a lot more sense. Their technology risk is diversified across their entire IP portfolio.

For all these reasons, if you have a valuable patentable technology, I am convinced the optimum strategy today is to file the patent and then start the exit process. In my experience, that’s the window of opportunity when patents have the best risk-reward ratio for almost every small company.

I’d be very interested in hearing similar stories on small companies’ patents and their exit strategies. If you have a lesson to share, please leave a comment below or contact me privately.

This video describes the same topic and is an excerpt from a talk I gave at a workshop on exit strategies sponsored by the Element8 angels in Seattle.

{ 2 comments… read them below or add one }

Dale B. Halling July 27, 2014 at 10:48 am

Very interesting points. I think your talk demonstrates that the problem in the US is that our patent system does not protect inventors and has become crony capitalist game. The problem for our economy is not too many people enforcing their patents, it is a lack of respect for people’s property rights in their inventions. The two main policies that are killing technology startups are the weakening of our patent system and SOX.

I disagree that unless you can afford to take a patent through trial, they are worthless. Patents are a barrier to entry. Like physical barriers to entry, there is no such thing as a perfect lock. The goal with a patent is to increase the competitors costs, time to market, and uncertainty, it is not to obtain a perfect lock.

Reply

Basil Peters July 31, 2014 at 10:22 am

Interesting points, Dale.

I didn’t mean to imply that patents are “worthless” until they have been tried in court. My point was that you never really know how valuable they are until they have been litigated.

Thanks for contributing your thoughts.

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