In my February 1, 2011 blog I made a case for not bothering to spend your money and time on ad hoc patenting and to ensure what patenting you do is was part of a well-conceived  and well-articulated strategy in support of your company’s business objectives. 

Ad Hoc Patenting

What’s the difference between ad hoc and strategic patenting?  Where to begin?  Ad hoc patenting means assessing each patent on its individual merits, usually in the context of a periodic company or product line patent review board where patent proposals are reviewed.  Commonly, there can be five possible outcomes of these reviews:  (1) outright rejection, (2) come back later with better information, (3) classify the idea as a trade secret, (4) write a defensive publication or (5) approve the idea and release funds to have the patent application written up by a patent attorney or patent agent.

Regardless of the outcome of the review, the critical issue is the means by which such decisions are made.  Since the patent review board will likely be heavy with technical members, decisions tend to be heavily weighted in favor of the “nifty factor” – meaning, “how nifty is the idea”?  Other considerations include educated guesses on the patentability of the idea and subliminally, whether the review board is wanting to reward good creative thinking by a valued employee. 

As I’ll attempt to show later, this bottom-up decision process results in inefficient use of scarce budget dollars, may be conducted according to varying criteria if there are multiple patent review boards and, worst of all, fails to link the decision to the support of the business objectives of the company.

Strategic Patenting 

Strategic patenting is a top-down process that begins with the senior managers of the company making explicit decisions about which products or technologies in which the company should spend its finite resources.  In most cases, the number of areas of emphasis should be no more than three to five.  I leave it to others to debate whether this is just defining core competencies using different words. 

The next part of the process may cause some angst in the company at large because management must inform the organization at large and key middle managers in greater detail, that the era of ad hoc patenting has come to an end.  This is a sharp ninety degree turn and organizational inertia will resist the sudden change in direction. Unanimity of purpose, patience and providing clear decision guidelines will be required by senior management to ultimately succeed in making the necessary course corrections without having too many people fall overboard.

The consequences of strategic patenting is that all patent review boards will first use the litmus test of whether or not the idea can be shown to directly support the company’s stated business objectives.  If it can’t be shown to do so,  then the options include: (1) abandon the idea, (2) write a defensive publication or (3) classify it as a trade secret.  Yes, this means that some nifty ideas will never see the light of day – a tragedy of epic proportions, especially to the inventor.  One caveat.  Let’s not throw our brains away. We should make sure that the revised patent review process still allows for significant innovations that don’t make the first cut to get a hearing.

The other bugaboo of ad hoc patenting is that the patent applications that are written up are typically narrow in scope.  The claims are basically confined to the steps/processes/ components/materials  the inventor found to work.  Instead, attempts should be made to include as many of the rejected alternative approaches in the claims so that the patent can’t be easily flanked by competitors using alternate means. The patent application is necessarily more extensive (and expensive) but this approach may erect significant barriers to entry.  A provisional “jumbo” patent application based on this concept will buy time (one year) while multiple patent applications which claim priority to the single provisional application can be filed.  This approach erects the classical patent “picket fence” consisting of a cluster of related patents.  As long as the company’s institutional memory (which is sometimes lamentably short) remembers the reason for setting up the picket fence in the first place, the company will choose to continue to invest in the maintenance of those patents and will be vigilant that other companies have not breached its perimeter.*

The bottom line is that by adopting strategic patenting a company does not have to spend more money on making patent applications and maintaining its portfolio in order to get a superior sustainable competitive advantage.

* A tip of the hat to Scott McBain for helping me clarify the jumbo patent application/picket fence concept.

In my first blog on the subject of patents over a year ago, I stated that the concept of a patent was so fundamental that it is specifically mentioned in the U.S. Constitution (Article I, section 8).  Naturally, when the Constitution was adopted in 1789, the world was vastly different.  The new United States had little indigenous industry, especially heavy industry, because its erstwhile colonial master, England, had forbidden industrial development in the colonies in favor of supporting British industrial exports to them.

From the perspective of the framers of the Constitution, encouragement of industrial development in the US was of utmost importance, since the economic independence of the US was a pillar of the political and military survival strategy of the new country.  Therefore, allowing inventors to have a temporary monopoly on exploitation of their inventions by granting them a patent was a logical and desirable policy. 

However, from the outset, a patent’s protection was a matter of geography and politics.  The patent served the inventor’s rights within the US, but there was nothing to prevent England, the US’s primary trading partner at the time, from ignoring these patents and commercializing these inventions – even to the point of exporting infringing goods to their former colony.  Because the patent granted the holder a monopoly to sell products based on its patent, but only within the US, US Customs had authority to impound infringing goods at the port of entry.  Unfortunately,  the US’s ports of entry were rather porous and US consumers had strong demand for imported goods since similar domestic goods were scarce to non-existent until well into the nineteenth century.  Strike One against the patent.

The “world” in the view of the US in the late eighteenth century, was the US, England and Western Europe.  Japan and China were closed off societies and essentially didn’t exist from an economic perspective.   Little of the industrial revolution and the vast technological leap forward it spawned seemed of little relevance to rest of the world from the insular perspective of the US.  And so it remained until the mid-Twentieth Century.  After a sustained post-war period of economic and scientific growth, Japan joined the exclusive club of economic superpowers.  Recently, and seemingly out of nowhere, China has achieved the rank of the world’s second largest economy after the US, having left Germany and Japan in their dust without even a fare-thee-well.  This is not our forefather’s world.

Let’s pause to catch our breath.  The upshot of all this change is that having patented something in the US no longer has the cachet it once had.  There is now a nearly limitless number of competitors outside the US who don’t give a fig about your patent.  I suppose one could go to the trouble and expense of filing patents in China, Japan and the European Union – as if that gave some reassurance.  The truth is, that filing for a patent in Japan is a decade-long process.  China?  Don’t bother.  The truth is that protecting our borders from infringing and/or counterfeit goods is like trying to bail the ocean.  One industry that comes to mind who consistently tries to enforce the patent rules is the pharmaceutical industry.  In their case, “enforcement” means mega-million dollar lawsuits that play out over years in the courts, not stepped up customs inspections.  For the most part, defense of a patent is prohibitively costly to individuals and many companies.  What monopoly?  Strike two against patents.

Well, fans, the count is 0 and 2 against patents.  Why spend the money on filing for a patent then?  As I stated earlier, under today’s circumstances, only select companies even spend a sou to protect their patents.  My former employers certainly did not.  Worse yet, why send good money after bad and spend money to maintain each patent over its lifetime (twenty years after the filing date)?  The answers are a bit surprising and nothing like the framers of the Constitution imagined.  Much current patenting is motivated by one of the following:

 1.      Technology companies, especially start-ups, try to gloss up their bona fides for the benefit of investors by filing patent applications.  Only occasionally do such companies draw a distinction among “applied for”, “published”, “allowed” and “issued”.  They are all typically touted as “patents”.  Dare I say “lipstick on a pig”?

2.       Large companies in various industries compete to acquire the largest number of patents or the most patents applications filed in a year for purpose of bragging rights.  An extreme example is China.  As a country, in 2011 they will  overtake the US (currently number one) in patent applications.   Who cares?   This is merely a manifestation of a national policy, not evidence of the blossoming of genuine innovation.   Overall, this policy results in substantial recurring costs for the patenter to maintain its large patent portfolio, which unfortunately, will include many worthless patents.

3.   Companies in many industries maintain a thicket of patents as trading stock to defend against infringement suits.  Instead of directly defending against infringement claims, such companies shake their sabers and assert that the other party is nearly certain to be infringing one of their patents.  The end result is commonly a cross-licensing agreement in which both companies promise to look the other way when it comes to infringement issues.

4.   Companies who are disinclined to reward their innovators with cash, knowingly subvert the patenting concept and agree to file patent applications on behalf of these inventors, regardless whether the patents have value to the company.   In short, patent awards become something like merit badges.  They are part of the company’s recognition and rewards program.

Do the examples above count as strike three?  No, not really.  Patents, if part of a well conceived intellectual property strategy, can become powerful tools to maintain a competitive advantage.  Foreknowledge of powerful patent portfolios often have a salutary effect on competitors  — either causing them to change plans or to request a license before proceeding.  The whole point of this blog is not to argue against patenting;  rather to urge companies to patent selectively and for reasons that directly support the business’s objectives, rather than fall into the trap of one of the four examples above. 

Sadly, a well-designed and well-implemented patent strategy is a rarity.  Partly this is the result of a lack of understanding of the concept.  More on this topic in subsequent blogs.

Most all of us in business at one time or another encounter non-disclosure agreements (NDAs).  “NDA” is synonymous with the terms “Confidentiality Agreement” and “Proprietary Information Agreement” and similar titles.  I’m used to using NDA, so I’ll use it.  Be sure you understand, everything I say about an NDA applies to the other synonymously titled agreements.

The concept and need for NDAs is relatively obvious and straightforward.  When two businesses (or two individuals, for that matter) wish to discuss matters that includes exchanging information they don’t wish to be publicly known, they usually enter into an NDA before doing so.  If you should have the misfortune of trying to create an NDA involving three separate companies, you will be at the job a long time.  This comes about because most companies have forms of NDAs with which they are familiar, and therefore are comfortable with.  The chances of three company’s standard NDA forms matching up in all key regards are nil.  Less than nil.  Remember, behind the curtains lurks each company’s cadre of lawyers whose job is to protect their company from any and all harm.  Junk yard dogs come to mind.

Company lawyers are tasked to look at what the business guys want to do and then advise them on how best to accomplish the goal.  Unfortunately, relatively inexperienced lawyers have a weak grasp of concept called “compromise”.  Also, they typically don’t fully understand what’s truly important to the company.  On the other hand, business-savvy and experienced lawyers can be surprisingly flexible and creative when it comes to solving tough problems that often arise.  You’ll get to know who these individuals are and would be wise to steer your legal work their way.

Enough lawyer-bashing.  Just what function does an NDA serve?  Briefly, they facilitate sharing of sensitive information by establishing a set of rules that set out (1)  the business reason for sharing such information, (2) the general nature of such information, (3) the definition of “confidential information” (in the context of items (1) and (2)) and (4) the rules for protecting such information.  Once finalized, the NDA serves to guide the parties’ behavior regarding confidential information exchanges and becomes the legal basis for claiming damages if one party breaks the rules.

In an ideal world, the decision whether or not to enter into an NDA should be made by a senior manager who has the most obvious vested interest.  The basis for making the decision rests on two fundamentals:  (1) Why it’s a good idea to accept the risk of deliberate or accidental disclosure of valuable information to third parties (the bad guys).  Frankly, if one can’t make a good case for the rewards outweighing the risks of disclosure, the NDA is a bad idea.   (2)  What type of information is to be disclosed?  In most cases, a senior manager is in a good position to assess the wisdom of disclosing certain types of information.  Information commonly called “insider information” is an example of information that is rarely shared unless the receiving party is directly involved in use of such information.  An investment bank or outside counsel commonly has a genuine need to know. 

If the decision is to proceed with an NDA, care must be exercised to avoid agreeing to protect information that isn’t really confidential.  For instance, what if your company already knew the information by developing it by itself or by receiving it non-confidentially from a third party?  What if the information is already common knowledge by having previously been disclosed to the public?  Such standard exclusions, and others, are routinely spelled out.

A potentially thorny issue is what is usually called the “standard of care” governing protection of such information from disclosure.  A useful work-around is to agree that such standard should be at least as strict as the receiving party uses to protect its own information of similar importance, but no less than a “reasonable” level of care.

Finally, how long should the receiving party’s obligation of protecting such information last?   Often, companies will try to make this obligation perpetual.  This notion is plainly nonsense because it’s almost impossible for information to be so important.  For instance, information on how to make atomic weapons has been public for decades.  And don’t even consider trying to cover up the existence of extraterrestrial aliens.  Most information is sensitive for, at most, three to five years.  Ten years is the longest period of confidentiality to which I’ve ever agreed.  What happens when the period of confidentiality ends?  Nothing.  Common sense says that the receiving party will continue to protect the information using reasonable care, even though the legal responsibility to do so is long past.  This is just an example of the old fashioned concept of business ethics.

In my earlier blogs of February 2, 8 and 16, 2010, I discussed the art of licensing.  The fact that it took me three blogs to provide a superficial overview of the topic should be a clue that licensing is a business transaction that evokes deep, primal emotions in the licensor (the party who is licensing its IP).  If you want to observe the irrational side of a company’s culture, just drop a hint about wanting to use their intellectual property.  You may be able to eventually strike a deal, but at the cost of a lot of time and attorney fees.

Now, why is this so?

 The answer may be that a piece of IP (let’s use a patent as an example) is viewed by a company as a valuable asset, similar to a stamping mill or a wafer fab.  This may, or may not, be strictly true.  So let’s just concede that the company strongly believes that their patent is very valuable.  However, I’ve never observed anyone getting nearly as emotional about a stamping mill as they do about one of their patents. There must be more to this tendency to assign more value to a patent than it deserves.

 Well, it may be that the company is small, technology oriented and aside from some leased office space and some computers, the patent is arguably the only thing of value that belongs to the company.  Now we’re getting closer to the truth.  If you’ve ever been cautioned about the danger of accidentally getting between a Momma bear and her cub, square that danger and you’ll get a sense of how dangerous small startups with only one good idea can be.  They will fight for their patent as if their lives depended upon it.  That’s because…well, it’s because it’s true.

 Or, perhaps you have a situation at the other end of the business spectrum in which the subject company is a technology leader in its market sector.  They have oodles of patents.  And, in their mind, each patent is immeasurably valuable because their company is the big kahuna and they have lots of lawyers.  If this latter example makes you think about the company that supplied my word processing software, it’s merely a coincidence.

 The previous examples are just markers on a continuum and many companies can be found in the interstices or perhaps in several places.  The point is that most companies who derive some part of their competitive advantage from their IP, patented or not, have a keen appreciation of the need to properly manage these assets.  The problem is that paranoia tends to creep into the picture because of numerous notorious examples of companies who got swindled by another company that saw an opportunity and took it.  The paranoia usually shows up when a company isn’t sure whom to trust, so it trusts no one.  Boil it all down and you find that this fear results in insanely complex license agreements that mostly consist of tortured provisions to deal with situations are extremely unlikely to occur.

 However, it’s because such unlikely events did occur that most contracts, licenses included, have several pages of so-called “fine print”.  Each section of fine print has its roots in some long ago lawsuit that is gone but definitely not forgotten.  Some of the lawsuits resulted from someone who deliberately took advantage of someone else (hence justifying some of the paranoia) but more often, the dispute arose from ambiguity in certain wording or from an imbalance in power or influence between the parties.

 Take for example, a common provision that, in effect, warrants that the agreement was jointly drafted and that neither party is to be considered the drafter.  In my experience, one or the other party is the drafter.  This is because someone has to provide a starting point for the negotiations.  Yet we pretend (and swear) this isn’t so because a court found that he who controls the pen controls the outcome.  There is some basis for this finding. That’s why I prefer to draft an agreement that is based on a term sheet (see my blog of July 3, 2010).  This mitigates the “power of the pen”.

 The bottom line is that versions of the same body (collection) of fine print is nearly universally used in contracts, whether short and sweet or long and complicated, because it’s easier to include them than it is to justify not including them.  And guess what?  Case law continues to accumulate, so the fine print will always continue to grow.

On February 21, 2010 I published a blog on this site entitled “Patent Trolls”, a class of “non-practicing entities” (NPEs), otherwise best characterized as blood suckers who destroy innovation, rather than promote it.  I thought I had at least captured the gist of the subject.  Little did I know that the law of unintended consequences was giving rise to a new class of Trolls.  This was news to me and inspired me to write a Part Two, which may be read by the two readers I know by name but maybe no one else.  A tip of the hat to the Indianapolis Star and Bruce C. Smith  from whom I have, um, borrowed big chunks of verbiage. I leave it to your imagination as to which of my prose has been appropriated and which is original.  Hint:  my prose is, je ne sais quoi, more erudite.

That said, companies have been recently sued by “whistleblowers” for allegedly using outdated or bogus patent numbers in a nefarious attack on consumers to limit competition.  We’ve all seen the fine print on products we buy:  “Manufactured under US patent No. x,xxx,xxx”.  This is not to be confused with “Reg US Pat Off” or “Patent Pending”.  These latter two marks indicate someone has submitted a patent application and hopes that someday it will issue.  In the meantime, they hope they influence everyone to take care against copying. 

In principle, a patent holder is only entitled to put a patent number on a product beginning when the patent issues and ending when it expires (20 years after filing).  This is considered fair warning against infringement and proof that an infringer had been notified.  A willful infringer is liable for triple damages in a successful patent infringement suit.  Continuing to mark a product with a patent number after the product is considered fraudulent and a restraint of trade.  Under previous law, the scoundrels were liable for a $500 fine for each class of product bearing fraudulent or bogus patent numbers. 

Unfortunately, the US Court of Appeals recently ruled in December that the $500 fine applies for each item so mismarked.   The consequences can be dire.   Consider stilt-maker Forest Group.  They were fined $7000 under this ruling.  Unfortunately, their sales were so low that the fine worked out to be a cost adder of $180 for products that retailed for $120.  Worse yet, consider Solo, a maker of drinking cups. In a recent suit they lost, they are liable for the false marking of 21 billion cup lids.  If they lose on appeal, their fine could be $10.5 trillion dollars.

Since the Appeals Court ruling, nearly 200 false marking suits have been filed in Federal Courts against more than 100 companies.  Only 40 such suits had been filed in the previous five years.  Egad!  What’s happened?  Well, it seems that under Federal law, a whistleblower is entitled to 50% of the fine.  Any private citizen can file such suits, regardless whether they have suffered any harm.  Ladies and gentlemen!  We have a new growth industry that does not require the amassing of a war chest like a traditional Patent Troll!  Let’s call them the Patent Marking Police” or “PMP”.  Add a vowel and you’ve got an appropriate nickname.

OK, what’s so hard about complying with the law and putting the PMPs out of business?  Well, in many cases it requires a change in stamping or forming dies.  In other cases changes to labels or packaging.  First, the patent holder has to be monitoring this situation.  Second,  even if they are monitoring, this costs money.  Finally, it’s not worth the trouble given the  history of enforcement.  A perfect setup for a train wreck caused by the US Court of Appeals. 

Fortunately, our diligent lawmakers are on the case.  Legislation pending in the House (HR 4954) would keep mismarking illegal while simultaneously moving to eliminate frivolous lawsuits.  This according to the author of the bill, Rep. Darrell Issa, R-California.  He further says that this bill is a common-sense effort that protects consumers from higher prices.  He should have added that it may help let the air out of the tires of the PMPs.

In the last edition on the subject of royalties, I managed to discuss license fees but not royalties themselves.  A set of standards for establishing royalties has been something of a Holy Grail.  But it’s not going to happen.  Oh, there have been scholarly studies of royalty rates.  These studies uncovered certain underlying principles, some of which I’ve found to be true in practice.  One principle is that royalty rates are lowest on innovations relevant to market commodities and highest on leading edge technology-related innovations.  

“Commodities” are products or services that compete in a market chiefly on the basis of price.  Commodities are usually produced in very high volumes and tend to be ubiquitous in our lives.  The list is endless: cereal grains, iron, pan-headed screws…you name it.  Commodities operate with razor thin profit margins and make up for it by volume. Logically, these types of products would have little margin available to absorb a royalty in the price.  However, if the innovation can improve the profit margin or propel the commodity into a higher priced market segment, a modest royalty may be affordable. 

Royalties on innovations in high technology products or services may be surprisingly high.  This fact can arise for a number of reasons:

• The innovation may allow entrance into a brand-new and highly profitable market.  Consider any number of the new biosynthetic and genetic technologies that exist but are rapidly evolving. 
• Perhaps the innovation is such that it changes the basis for competition in an existing market.  For example, the market for portable music playback devices essentially turned on a dime when iPods were introduced.  Bye, bye Walkman. 
• Or perhaps it creates an entirely new mass market that never existed and people weren’t asking for.  How about the trifecta of the iPhone, the App Store and the thousands of iPhone apps that sprang into existence in a twinkling?  One single app (“Tap Tap”) brings in US$1 million per month. 

The whole point of this paragraph is that licensing game changing innovations can support rich royalties.  From a licensor’s perspective, competitive issues created by licensing will figure in the decision whether or not to sponsor market development while profiting from it. 

Academics have also tried to shed a little more light on the above general observations by conducting royalty surveys that are then aggregated by various market segments.  During their research they frequently found that licensing practitioners were quite wary of disclosing much information and none with any specificity.  Even assurances that strict anonymity was to be maintained and that the summarized results would be shared by all participants was to little avail.  Why?  Competition of course.  I surely wasn’t keen on any competitor knowing my business, but I sure was interested in learning, by name, theirs.  Result: stalemate and the same old muddle.

There have been a few attempts to systematize the process of determining a plausible  and justifiable royalty rate.  For instance, one theory is that if a licensee is enabled to add totally new incremental revenue (presumably profitably) then it would be reasonable to propose that the licensee share oh say, 25%, of its incremental profit to the licensor.  Voila!  A win-win, no?  No.  First, it ignores human nature.  The visceral reaction to sharing 25% of the profits from a new product, in which I invested millions in engineering, marketing, sales and capital equipment to bring to market, will be immediate.  Secondly, any finance person worth their salary can make sure that you never show a profit on that product.  It’s all in how you allocate the overhead. 

OK, let’s try a percentage royalty correlated to the relevant market segment.  First of all, pick a percentage.  Sorry, no cheating.  This is a closed book test.  Besides, the answer is not in the books.  One has to realize that every situation is different:  different participants, different technologies, different products, different competitors, different market conditions …you get it.   There is a mind-bogglingly huge set of variables that makes each deal unique.

Besides, a percentage of what?  Of sales?  Of profits?  Units sold?  We all know that profits are a non-starter.  Fundamentally, the answer to the question ”of what?” depends largely upon whether the licensed innovation becomes, in effect, a discrete product in which the licensed innovation is the very core of its existence.  In such cases, it is customary to try to negotiate a royalty based on sales to the licensee’s customers, as evidenced by sales invoices provided by the licensee.  Adding up invoices does not lend itself to manipulation.  No fancy terms, this is a “percentage royalty”.

But what if the innovation only enables enhanced functionality or an added feature in an already existing product?  The same question applies if the discrete product in the first example is up-integrated into another product and becomes just another product feature.  This happens all the time in electronics.  Usually this problem is addressed by attaching a fixed amount of royalty to every unit sold by the licensee to its customers.  The fixed amount is generally influenced by how dominant the innovation is to the market value of the product using it.  This is called a “unit royalty”.  Again, this formula lends itself to easy audit. 

Just a final word on royalties.  What is the term (length of time) of the royalty period?  Again, the particulars of the specific deal will provide the answer.  The choices are: (1) for as long as the licensee uses the licensed innovation, (2) if the innovation is patented, for as long as the patent is valid (20 years from the date of its application filing), (3) for a fixed period of time or (4) until a fixed amount of royalties have been paid out by the licensee.  Cases (3) and (4) are then called “paid-up licenses”.

Up to this point in time, a large portion of the licensing topics have had a recognizable element of objectivity.  Take “Field of Use” for example.  The nature and extent of the limitations put into the field of use definition have, in principle, a direct relationship to your business strategy and your competitive environment.  If not, one is arbitrarily limiting the opportunity to monetize the value of one’s IP through receiving royalties.

The concept of a royalty is simple and there is not really in much dispute about the reasonableness of paying for access to and use of, someone else’s innovation – at least in the abstract.  That’s pretty much the end of the agreement.  It’s not as if there hasn’t been abundant research and published opinions on the subject.  In my humble opinion as a licensing practitioner, much of the disagreement about how royalties are established and paid result largely from two factors:  (1) the inherent mismatch between licensor and licensee when it comes to valuing the innovation and (2) the staggeringly large number of options for structuring how royalties are due and payable (and the means for avoiding the foregoing).

Well, the last two paragraphs are really intended to soften the blow of my admission that I can’t constructively add to the solution to (1) or (2).  Mostly, I’ll speak from my own experience about what has and hasn’t worked for me over the last two plus decades.  If negative examples can teach, then I suppose you might learn something from this edition. 

Let’s first look at the mismatch in expectations between licensors and licensees.  This phenomenon is most obvious when the licensor is an individual or a small start-up company.  Both entities are far too close to the subject (their innovation) to be tolerant when the licensee mentions during negotiations that their idea isn’t that important (read: “your baby is ugly”).  Whether or not the potential licensee’s opinion is true is irrelevant because in negotiations, the name of the game is to lower the other party’s expectations.  In addition, the start-up is threatened because the innovation may represent the whole premise of their company and, therefore, most of its value.  I call these companies “one trick ponies”.   Nevertheless, I learned to be scrupulous in maintaining control of and access to, proprietary information the start-up is generally required to share as part of the discovery process.  Naturally, all of theses exchanges are done under formal non-disclosure, or confidentiality, agreements.  However, this agreement is scant comfort to the start-up since, in their world view, large companies are all anxious to cheat them and have the financial resources to do so.  Hence, as a group, start-ups are a very litigious bunch. 

 By contrast, I have found that similar negotiations with large companies to be much less stressful regarding this issue.  This is partly due to the fact that I would usually be negotiating with a counterpart who doesn’t have a strong emotional connection to the innovation and partly due to the fact that he or she may not really understand the innovation.  Fortunately, my personal background lends me the tools to thoroughly familiarize myself with the innovation and how it could relate to my company’s business.  I always did my homework.  Another factor facilitated negotiations with large companies.  Experience.  I’ll have a crafty, wily, experienced negotiator as my opposite over a green and partially paranoid newby every time.  With experienced licensing practitioners, things go faster and less time is spent on non-issues.  I’ve had experiences where I had to effectively sit on the other side of the table to help out the other party when they were in over their head subject-wise.  If I hadn’t, chances are that the negotiations would have crashed.  Also, even though it sounds corny, I still believe in ethics and fair dealing.  Helping the other side sometimes is consistent with this philosophy.  Pardon me while I polish my halo.

When it comes to establishing royalty arrangements, the problem party is more often the larger company.  Unfortunately, they come pre-equipped with their own set of experiences and knowledge of the subject.  Individuals and start-ups tend to be a bit more malleable – oops, I mean cooperative – due to a lack of experience.  The royalty arrangement may have two components: an up-front license fee and a set royalty that is tied somehow to how the innovation is being commercialized by the licensee.

The license fee is generally justified by designating it as an up-front payment to provide revenue to the licensor while the licensee prepares to be bring a product to market.  There can be a two or three year lag in many cases.  Often the individual or start-up company genuinely needs near-term funding to continue their own development activities.  This is not necessarily a larger company’s motivation.  They sometimes view a license fee as an incentive for the licensee to proceed to market because some licensees never follow through with their plans.  The amount?  I have agreed to as little as US$25,000 and as much as US$500,000.  However, the more substantial the license fee, the more likely the licensee will demand that the payment be consider “prepaid royalties” which will be amortized according to some negotiated formula when royalties start to flow.  The formula is generally involves deducting a percentage of the royalty due until the licensee amortizes its earlier license fee.  After that point, the full royalty rate will be paid going forward.  In my experience, if I were the licensor, I wanted a large license fee and if I were the licensee, I wanted no license fee.  Sometimes I prevailed, sometimes not.

OK, this is enough on royalties for this edition.  The next edition will address the intricacies of actually negotiating a royalty rate and how they get calculated.

I’ve decided to backtrack somewhat and pick up where I left off in Patents – Part 2 (18 January 2010).  I was discussing “submarine patents”.  This time I’d like to discuss in more detail the concept of “Patent Trolls”.

Of course, the origin of “trolls” is in Norse mythology.  They should not be confused with their more charming cousins, the ogres.  In mythology, trolls were mean, ugly creatures who commonly lingered dangerously under bridges.  The modern incarnation is a Patent Troll.  They are still a little mean but no uglier than I and typically live in McMansions or penthouses overlooking Central Park.

Trolls are individuals or a company whose sole reason for existing is to legally extort money — mostly from companies who actually create things or activities that have economic value.  From companies, made up of people such as you and I, who contribute to the gross national product.

Unfortunately, the Troll’s extortion racket is legal. Most Trolls got started in the business by astutely observing that patent infringement is common.  Much of this infringement is unintentional but sometimes it’s deliberate.  Regardless, if I own a patent and discover that someone is making money by using IP covered by my patent (infringing) without my permission (license) or paying me compensation (license fees and/or royalties), the law says I can sue the infringer.  Moreover, I can elect to either (a) ask the court to order the infringer to stop infringing (issue an injunction) or (b) pay me damages.  “Damages” are real enough and are commonly determined by the court by calculating how much the infringer would have paid me to use my patent under a license, during the interval between day one and now.  And, if I can convince the court that the infringement was deliberate, the judge can triple the damages.  Of course, if the infringer doesn’t want to be barred from further infringement (stop selling or whatever), he must continue to pay me a royalty for as long as he continues to infringe or for the life of the patent, whichever happens first.

So what’s wrong with this picture?  Well, Trolls have also astutely noted that many patents go undefended because the legal costs to assert one’s patent rights are prohibitive to most private individuals and sometime for companies as well.  Consider the fact that prosecuting a patent suit begins at one million dollars (US) and allegedly now runs about fifteen million dollars – win or lose!  The company for which I worked for many years, almost never sued for infringement and almost never defended the numerous suits filed against it.  In the case of defending a suit, it was always cheaper to settle out of court. (I once asked our Chief Patent Counsel why it was that we spent money on patenting and keeping attorneys on the payroll.  He wasn’t amused.)   In fact, about 95% of all such suits in the US are settled out of court.

So, if you’ve absorbed the last two paragraphs, you may have already figured out how Trolls (who are sometimes less pejoratively referred to as “non-practicing entities” or “NPE”s out of respect and/or fear) make their living.  If you’re smart and have an amply-funded “war chest”, you buy up as many potentially valuable, but otherwise unexploited, patents as you can afford.  Then you go hunting for infringers.

A well funded war chest is essential because most companies who are sued for infringement have much deeper pockets than individual patent holders and can safely ignore such annoyances if they perceive that you are under funded.  However, if it is known that you’ve got the money for a long and expensive court battle, you become someone deserving of close attention.  It helps if you already have a litigious reputation preceding you.  Not too different from gunfighter’s reputations in the US’s old West.  Once an NPE has amassed enough out-of-court settlements and an occasional successful law suit, it then represent a credible threat.  According to Business Week, an NPE called Acacia Research has filed and settled 33+ suits in its eighteen years of existence and made US$69 million in 2009.  And what was their contribution to the advancement of science and technology or to genuine economic growth in the US?  Zilch.

These are dangerous time for high profile high technology companies.  Apple and Sony are numbers one and two respectively in being targeted for suits by NPEs.  In fact, it is estimated that 70% of infringement suits in the US are initiated by NPEs.  Poor Microsoft estimates that their percentage is about 80%.  In dangerous times, companies have traditionally  tried to mitigate their business risks by obtaining insurance.  But how to protect against NPEs?  Would you be surprised to learn that companies that perform a function similar to insurers against NPEs have sprung up?  Look at RPX www.rpxcorp.com and check out their business model.  Meaningful contribution to the economy?  Still zip.  Score another one for the free enterprise system.

In Part 1 of this series about licensing, I mentioned that licensing involved the licensor setting the rules for the use of the licensor’s IP .   Among these rules there may be a limitation on the field of use of such IP.  “Field of use” involves one or more of the following boundary conditions:

1. Geographical
2. Type of product in which the IP is used
3. The industry in which the IP is used
4. Customers
5. Unlimited

 Geographical limitations are the easiest boundary condition to define.  These include countries, continents, trade groups (NAFTA for example), states, provinces and other sub-national administrative entities.  However, these limitations only apply to where the licensee’s sales or leases occur, not where manufacturing or other work is conducted.  This makes sense, since a sale or lease is the transaction where the licensed IP is converted to cash or something else of value to the licensee.  Curiously, some licensors cling to the notion that the place of manufacture is included in the value equation of the licensee.  If the licensor won’t budge setting limits on where something is manufactured, then it is time to abandon the deal.  The licensor is so dense that you are sure to have problems in the future.

 The type of product and the type of industry the licensee applies its IP rights are often related.  Although it is not necessarily the case, it stands to reason that certain types of products are only applicable to certain industries.  An “industry” is can be hard to define because terms such as “telecommunications” or “computers” are impossibly broad.  The industry can be more easily interpreted if it is narrowed down to  “3G cell phone manufacturing or services” or “manufacturing or providing services to hand-held computing devices with wireless access to the Internet”, for example.

 Once in a while a patent is issued that is so fundamental that it is impossible to avoid having to acquire a license if one has ambitions to build products or services based on claims covered by that patent. For instance, a key patent for cellular telephony is held by QualComm.  If a product has the capability to communicate on a 3G cellular network, it likely has an integrated circuit. containing patented technology from QualComm and licensed by the integrated circuit manufacturer.  In another example, Land’s (Polaroid) patents on instant photography were so basic that Polaroid was able to convince the courts to order Kodak to cease its own manufacture and sales of instant cameras – at the cost to Kodak of hundreds of millions of dollars.  Ironically, even if these Land patents hadn’t expired, they’d be irrelevant because of digital photography.  Good luck in finding film or a lab to process it.

 However, most often the licensed IP is incorporated into another product as a feature or function, not a discrete product by itself.  This fact complicates life for the licensee because it makes determining a fair royalty rate and method for calculating royalties earned difficult.  More on royalties in the next blog of this series.

 Placing limits on the licensee’s sales to customers can be troublesome.  At times I have been presented with the demand that no sales to the licensor’s competitor’s customers are allowed.  The natural question becomes:  “Who are your competitors?”.  This question is harder to answer than one might think.  A follow-up question of “What happens if a customer of the licensee becomes a competitor to the licensor during the term of the license?” leads to further befuddlement of the licensor.

 Ironically, allowing sales by a licensee to one’s competitor may make sense.   Think about it for a bit.  If the technology is new and somewhat unfamiliar to the market, having more than one supplier tends to build credibility for the technology.  Also, having more than one supplier of a particular product is a source of comfort to large customers because it allows the creation of price competition.  Having more than one supplier may also encourage large customers to apply the technology more widely because they have mitigated the risk of a sole-source supplier.  In both of the just-mentioned cases, market development is enhanced.  Finally, it will always be true that no one licensor will ever be able to acquire the total available market world-wide.  The sheer impracticality of such a task even trumps most of the competitive issues that are created.  Therefore, receiving a royalty from competitors serving markets and regions that the licensor will never control is better than blocking a competitor but earning nothing.  I have been successful in convincing numerous clients to accept this common sense approach to market development and gaining access to inaccessible markets.  In most cases, the result has been success.

Conceptually, licenses are simple.  Basically, (1)  you assert, in writing of course, that you own a particular piece of IP (whether patented or not) and you describe it; (2) you state that you wish to allow a person (or business or whatever) to use that piece of IP; (3) you list the rules for using that IP and (4) you establish the basis for your compensation for loaning the use of your IP.

In practice, licensing can be tortuously complicated.  First of all, it is generally held that new IP doesn’t spring from nothingness.  Said another way, most often an invention is based to some degree upon prior inventions which have become widely known through patenting, publishing an article, giving a speech at a convention and so on.  Most of these previous inventions are classed as “prior art”.  Your invention doesn’t necessarily depend upon this prior art, but it may have been incorporated in your personal know-how and thus, helped inspire your invention.  Your invention is considered “foreground IP” or “foreground”.

On the other hand, some prior art may be integral to your invention by actually being deliberately or accidentally incorporated into it.  This is called “background IP” or “background”.  Background can be patents, know-how, trade secrets or mixtures of all three.  If you, the licensor, own this background, you must also grant the licensee a license to this background, since the licensee’s ability to use your licensed foreground depends upon having a right to also use the relevant background.  Frequently, the background is a little nebulous and hard to specify.  This problem is avoided by describing the background as “that IP owned by the licensor that is necessary for the licensee to practice the licensed foreground IP”.

Ah, but what happens if you, the licensor, have incorporated into your invention some background you don’t own?  An easy, but all too real example, is foreground consisting of either hardware or software that uses software licensed from a third party.  The dilemma is that your license grant to the licensee is worthless without the licensee having the right to use this third party software.  The solution is for the licensor to identify the third party software. It is the licensee’s responsibility to get a license.  In this case, the software licensor is typically keen to acquire a new licensee.  Unfortunately, and since the business world is an unfriendly place, acquiring background rights may sometimes be extremely expensive or impossible if the third party licensor of the needed background is a competitor of the licensee.

Frequently, a licensor must warrant (promise) to the licensee that “to best of its belief and knowledge the licensor warrants that the licensed IP does not infringe upon the IP rights of a third party.”  Sometimes, if the licensed IP is later discovered to infringe the rights of a third party,  the licensor must promise to do its best to get a license from such third party, or failing that, redesign its invention to avoid such infringement.  If those two options aren’t available, messy legal proceedings may result.

This edition of my blog has only managed to present a cursory look at how convoluted a license becomes because of the concept of foreground and background IP.  Yet to be covered are fields of use, exclusivity vs. non-exclusivity, royalties and much more.  These topics add further misery and opportunities for full-blown fiascos in the otherwise simple concept of a license.