For most of the last decade, I have been helping compa-nies deal with IP, initially as technical adviser to the law firmSkadden, Arps, Slate, Meagher & Flom and more recently representing clients in complex patent infringe-ment lawsuits as an IP attorney. As I entered the Kauffman Fellows programme in the summer of 2011, I began developing a framework for thinking about venture investment in emerging companies whose business models have the potential dramatically to improve the ways in which IP, including its associated risks, is priced, bought and sold. In this article, I develop the conceptual details of venture investment in these IP-based businesses, explore the con-tours of the major trends shaping the evolution of IP mar-kets, and identify the ways venture-backed IP businesses of the future will disrupt IP markets over the next decade.
Background
During the early part of my career, there were two events that, in retrospect, did much to shape the way companies manage and mitigate IP risk today.
The firstwas a landmark decision by a US court and the second was the publication of a highly influential book.
In 1998, a US appeal court, in State Street Bank & Trust Co v Signature Financial1, held that the US patent laws permitted the patenting of business methods.
Prior to this case, there was some doubt regarding the legal status of business method patents. Serious legal opinion considered business methods to be no different from algorithms or laws of nature – outside the scope of patent protection.
The court’s decision was game-changing not only because it placed the court’s imprimatur on business method patents, but also because the timing was impeccable. Business method patents existed before the State Street case, but the court issued its decision in the midst of the dot.com boom – just as entrepreneurs were learning how to use the internet to remake the way business itself was done.
The case transformed the public’s perception of the US Patent and Trademark Offce from an executive branch backwater into the land of milk and honey. A flood of patent applications followed the decision, many claiming exclusive rights in business methods.
In 2010, the office issued seven-times more business method patents than it did in 2002 (3,649 against 494),2 while the officereceived an average of almost 11,500 business method patent applications per year.
The number of applications doubled between 1998 and 20103 and the office aimed to reduce its backlog of unexamined applications to fewer than 650,000 by the end of fiscal year 2011.4
The second landmark event occurred several years later, when Kevin Rivette and David Kline wrote Rembrandts in the Attic,5 a volume on IP strategy in which they argued that chief executives were ignoring some of the most valuable assets their companies owned – their patents.
By illustrating how top-performing companies used sound IP strategy to outperform their competitors, the book prompted the business community to focus on unlocking the value in their patent portfolios.
Some executives decided that selling portfolios on the secondary market was the best way to monetise that value. In the ensuing decade, transaction volume in the patent secondaries market exploded, fuelled by capital invested into private partnerships and publicly-traded companies whose operations consist entirely of licensing and enforcing patents.
The variously termed “patent trolls”, “patent sharks” or, less derogatorily, “patent licence and enforcement companies” came to dominate the public consciousness of the patent system and IP rights more generally.
The court case and the book helped lead us to where we are today. Start-ups and established companies alike operate in a business environment awash with patents and capital invested in generating returns through licensing and enforcement.
The ideas set out by these two landmarks, along with major trends in technology, several of which are discussed below, played a large part in creating what I term the “patent peril dynamic”.
This dynamic comes about when risk overtakes opportunity as the primary lens through which managers frame and solve complex business problems involving IP.
Originally, it was an article of faith that strong IP rights were an essential incentive for innovation and a necessary ingredient in a modern, property-based, free-market economy. Not anymore.
Today, the patent peril dynamic dominates the way managers of companies of all sizes think and act when it comes to IP risk. In some communities, the key stakeholders view patent rights as a chief impediment to – rather than a central requirement for – the progress of innovation.
This view is especially prevalent among independent software devel-opers, where practitioners exhibit a visceral rejection of patent rights and of the arguments defenders of the cur-rent system use to support the status quo.
Metaphors from the Cold War such as “arms stockpiling” and “mutually assured destruction” have achieved currency at the highest levels of corporate decision-making, and they influence how managers solve problems involving IP.
Indeed, we now live in a world where companies at the top of the technology industry can, and do, openly question the role and proper functioning of the patent system,6 while their leaders vow to wage “thermonuclear war” against competitors who infringe their IP.7
An investment thesis for IP
This is the environment in which my clients operated in 2009, when I starting thinking about the ways capital formation and entrepreneurship could address the business problems they called on me to help them solve.
I was motivated in part by my experience representing litigants in patent infringement lawsuits. Patent litigation is perhaps the most ineffcient price-discovery engine ever conceived.
I realised that a business able to decrease the number of patent disputes that companies litigate, or to accelerate the disposition of those that are litigated, would capture a unique and highly lucrative market opportunity.
As a patent system insider, I was also aware of the limits of patent reform. I have seen several attempts at legislative overhaul to the patent statutes work their way through the US Congress, the latest culminating in the America Invents Act of 2011.8
Each time, not only did the new laws fall short of expectations, they made the operating envi-ronment for businesses more challenging. Attorneys, duty bound to represent their clients zeal-ously, were given new legal ambiguities to exploit in making their cases.
Courts faced increased burdens in divining the intent of congress to resolve the most difficultcases, and the corresponding costs imposed on litigants rose.
The clearest beneficiaries of patent reform were patent lawyers, who were best positioned to untangle the legal uncertainty that invariably followed congressional tinkering with the patent laws.9
As I transitioned into venture capital, the loudest calls for reform seemed to come from the most successful early-stage investors in consumer web companies.10
Curiously, none of these investors raised the possibility of entrepre-neurship as a viable alternative to patent reform. Accord-ingly, I focused my thinking in that direction.
My aim is to develop an investment thesis grounded in the principles and values of early-stage investing with the goal of increasing the number of companies founded each year tackling the most pernicious problems technology companies face related to IP.
This iteration of my research presents a framework for thinking through the major issues that helps investors identify emerging companies with the most potential to disrupt the IP markets.11
IP and venture capital
As readers of this journal are well aware, fundraising has become more competitive for all except the money man-agers who possess the most successful track records, work from the most highly-regarded platforms, and invest in the most attractive sectors.
Poor returns over the past decade have prompted a flight to quality as limited partners (investors) have allocated capital to the asset class. As True Bridge Capital reported in its summer 2011 analysis of the industry, a clear trend in the fundraising market has been a concentration of capital with the very best firms– those that have been able to generate attractive returns and distribute capital to limited partners, even during difficult periods such as the past 10 years.12
In this fundraising environment, venture “white spaces” stand out and increase the odds of being funded. They also bode well for returns.
A venture white space is an emerging area of innovation and entrepreneurship in which little or no risk capital has been invested and where there are fewer start-ups and investors clamouring for deals than in areas where venture capital is plentiful by comparison.
The relative lack of competition for deals in venture white spaces disciplines valuations, allows new entrants to scale quickly and rewards first-moversable to execute successfully.By any defnition, the IP sector is a venture white space.
The combined market for legal services and transac-tions involving IP is more than $60bn13 and in 2011 two transactions – Nortel’s sale of its 4G LTE patent portfolio and Google’s acquisition of Motorola Mobility – together accounted for almost $17bn in transaction value.
Despite the size of the potential market opportunity, there are prob-ably fewer than a dozen venture-appropriate start-ups in the US with IP-based business models.14
Growing the number of companies in the IP sector through venture investments in emerging companies will present several challenges. One obstacle to growth is the idea that investing in IP is synonymous with bankrolling patent trolling.
However, that belief is misguided, as shown by the emergence of RPX Corp, a patent-risk manage-ment start-up founded in 2008 that does not sue others for patent infringement.
Instead, RPX identifiesand acquires patent portfolios that represent significantinfringement risks to operating companies, usually those operating in the technology sector.
Customers pay RPX a subscription fee in return for a licence to the company’s entire portfolio. Licence in hand, operating companies are free to focus on innovating, and they spend less money answering claims of patent infringement.15
RPX attracted approximately $100m in pre-IPO (initial public offering) financingfrom venture capital firmsCharles Rivers Ventures, Index Ventures and Kleiner Perkins Caufield& Byers, and from other investors.16
When it went public less than three years after its founding, RPX had garnered a market capitalisation of over $1bn. One venture capital firm that backed RPX from the beginning saw a return of between 12 and 13-times (unrealised as of June 2011).17
The RPX story demonstrates how a non-litigation play in the IP sector can generate supe-rior returns. As such, RPX, and the venture investors who backed it, have begun the process of socialising IP as a venture-ready area of investment.
IP megatrends
Several key trends are highly relevant to business-model development and opportunity recognition in the IP space.
As innovation has become more open and technology more complex, it has become difficult for a single firmto appropriate the value of all the patentable innovation embodied in a single product.
For example, mobile hand-sets can, and often do, contain thousands of patented technologies that must work together seamlessly. None of these technologies comes from the mind of a single engineer working at a single technology company – rather, as engineers have componentised hardware design, technology companies must source innovation from many places simultaneously.
Increasing technological complexity and changes in the process of product design have fractured the ownership of patent rights in products made by companies operating in disparate industries.
Businesses that innovate in high technology, biotechnology and other areas that are evolving rapidly must navigate patent thickets – and sometimes they must transact with one another.
Fractional ownership of all the rights companies need to do business has increased the supply of patents that could fall into the hands of a competitor or a firm whose sole business is licensing and enforcement.
Over time, courts are asked to resolve more disputes, and the landscape of property rights starts to resemble an “anticommons”18 populated by too many rightsholders unable to trade efficiently with one another.
Another important trend is “big data”, which includes the development of software tools for the organisation and analysis of massively large and complex data sets. Currently, patent databases are for the most part proprietary, disaggregated and incomplete – advances in big data will enable large databases hosted in the Cloud that will contain information on every patent ever issued, litigated, bought and sold.
Armed with increased storage capac-ity and processing bandwidth, businesses will be able to mine such databases quickly, and the resulting insights will affect how they assess patent quality, when they choose to assert patents in court, and how much they pay for a licence.
Big data will transform the practice of IP law itself into an activity informed more by analytics and less by the vagaries of human judgment.
Later on, as big data tools achieve broader adoption, businesses of all types will integrate insights gleaned from patent analytics into a wider portfolio of organisational decisions.
Closely related to big data is the convergence of IP and financial services, which is already in its early stages and which has the most transformational potential. Data scarcity accounts for the opacity of today’s IP markets and the fact that price discovery remains more an art than a science.
Those markets will become more transparent when large caches of patent data and the analytical tools required to mine them come online. In much the same way that data analytics firm Risk Management Solutions models the key risk drivers for perils such as earthquakes and hurricanes, insights from patent-data analytics will help investors pinpoint the small fraction of issued US patents that account for the majority of patent value.
The most successful entrepreneurs starting companies in the IP sector will build companies that capitalise on one or more of the trends discussed above. RPX, for example, pioneered the defensive patent aggregator category, and it recently announced it would offer its customers defen-sive patent insurance in 2012.19
The insights the company has gained through its IP market-making activities should allow it to price risk more rationally, giving it an advantage over competing firmsthat underwrite similar coverage.
As the sector develops and matures, we can expect to see more examples of this approach to growing IP-based businesses.
Looking ahead
John Doerr recently asked his Twitter followers how they would fix the patent system and whether they favoured banning or term-limiting software patents.20
This is a valid way of framing the question, and Doerr is not alone among venture investors troubled by the current state of the patent system in focusing his attention on software patents.
However, focusing on IP rights in software, or on reforming the patent system through legislative and judicial fiat,necessarily limits the debate. Indeed, in the US, patent reform is synonymous with new legislation and new avenues of judicial advocacy aimed at reversing the chilling effect the reformers believe patents have on innovation.
Venture investors and entrepreneurs who have entered the debate of patent reform are especially taken with the notion of repealing statutory patent protection for software, to the point where the elimination of software patents is used as a panacea for all that is wrong with the patent system.
Legislative reform and judicial advocacy surely have their place – congress and the courts will always be the source of major shifts in law and policy in the IP sector. But the pace of change at these institutions is glacial, and it would be a mistake to overlook ways new venture formation can quickly change priorities, realign interests and solve the world’s most pressing problems.
In the past decade, the technology sector saw a floodof patents and liquidity invested in patent licensing and enforcement. Should more venture investors start identifying and supporting the best emerging businesses in the IP sector, the next decade will see less focus on patent reform and more energy devoted to entrepreneurship.
That would be a good thing.The new IP business will disrupt the landscape in three key ways – bringing price transparency and transaction effciency to IP markets, enabling robust quantitative pre-diction modelling of litigation outcomes, and facilitating the seamless transfer of IP risk among capital markets participants worldwide.
If they are successful, these companies, and the investors who back them, will replace the patent peril dynamic with something else. Although it is difficult to know what this will be, I think it is safe to say that those who get involved in remaking the ways businesses deal with IP risk will benefit most from the wealth-generation that entrepreneurship in this space will generate.
This article originally appeared in Volume 3 of the Kauffman Fellows Report, Spring/Summer 2012, www.kauffmanfellows.org/vision-journal.aspx. Reprinted with permission from the Society of Kauffman Fellows.
Notes
1 State Street Bank & Trust Co vs Signature Financial, 149 F.3d 1368 (Fed. Cir. 1998), www.ll.georgetown.edu/federal/judicial/fed/opinions/97opinions/97-1327.html
2 US Patent and Trademark Office, Class 705Application Filing and Patents Issued Data, www.uspto.gov/patents/resources/methods/applicationfiling.js
3 US Patent and Trademark Office, US Patent Statistics Chart CalendarYears 1963-2010, www.uspto.gov/web/offices/ac/ido/oeip/taf/us_stat.ht
4 Gene Quinn, Kappos Sets Goal of 650,000 Backlog by End of FY 2011, IPWatchdog, 7 December 2011, ipwatchdog.com/2010/12/07/kappos-sets-goal-of-650000-backlog-by-end-of-fy-2011/id=13684/
5 Kevin G Rivette and David Kline, Rembrandts in the Attic: Unlocking the Hidden Value of Patents (Cambridge, MA: Harvard University Press, 2000).
6 See David Drummond, When Patents Attack Android, The Official Googl Blog, 3 August 2011, googleblog.blogspot.com/2011/08/when-patents-attack-android.html
7 See Bloomberg News, Apple Seen Hurting Shareholders Pursuing Jobs’s Patent War: Tech, 28 December 2011, para. 1, www.bloomberg.com/news/2011-12-28/apple-seen-hurting-shareholders-with-jobs-s-thermonuclear-patent-war-tech.html
8 See US House of Representatives Committee on the Judiciary, America Invents Act of 2011, judiciary.house.gov/issues/issues_patentreformact2011.html
9 See Bloomberg News, New Law Creates a Demand For Patent Specialists, New York Times, 9 October 2011, www.nytimes.com/2011/10/10/business/new-law-creates-demand-for-patent-specialists.html
10 See, for example, Brad Feld, Another Day, Another Patent Troll, Feld Thoughts Blog, 7 November 2011, www.feld.com/wp/archives/2011/11/another-day-another-patent-troll.html; and Fred Wilson, More Patent Nonsense, A VC Blog, 26 February 2010, www.avc.com/a_vc/2010/02/more-patent-nonsense.html
11 This article has been adapted and expanded from an earlier piece published in the October/November 2011 issue of Intellectual Asset Management.
12 TrueBridge Capital Partners, “State of the Venture Capital Industry: Market Analysis Summer 2011,” 3, www.truebridgecapital.com/NewsResearch.aspx
13 Charles T Huang, Charles River VC, a $300m Investor in Intellectual Ventures, Says Patents Are Huge Market, Not a ‘Dirty Word’, Xconomy | Boston, 4 May 2011, www.xconomy.com/boston/2011/05/04/charles-river-vc-a-300m-investor-in-intellectual-ventures-says-patents-are-huge-market-not-a-%E2%80%9Cdirty-world%E2%80%9D/
14 Figure derived from informal interviews conducted by the author during the summer of 2011 with VC investors, entrepreneurs, IP attorneys, patent portfolio brokers and patent valuation experts.
15 For more information on this aspect of the RPX business model, see Defensive Aggregation Service, www.rpxcorp.com/index.cfm?pageid=19
16 This estimate is based on the disclosures set forth in the RPX S-1 filed wth the US Securities and Exchange Commission on 21 January 2011, www.sec.gov/Archives/edgar/data/1509432/000119312511012087/ds1.htm#toc
17 Mark Boslet, VC Reaps Benefits frm Intellectual Property Investing, Reuters Venture Capital Journal, 51, no. 6 (June 2011), 2. Available from www.vcjnews.com/ or files.parsintl.com/eprints/23165.pd
18 Michael A Heller, The Tragedy of the Anticommons: Property in the Transition from Marx to Markets, Harvard Law Review, 111, no. 3 (1998): 621; Michael A Heller, The Gridlock Economy: How Too Much Ownership Wrecks Markets, Stops Innovation, and Costs Lives (New York: Basic Books, 2008), 1–22.
19 John Letzing, “RPX Corp to Offer Form of Patent Litigation Insurance,” The Wall Street Journal, 29 November 2011, online.wsj.com/article/BT-CO-20111129-715502.html
20 John Doerr, @johndoerr, 8 July 2011, twitter.com/#!/johndoerr/