Jorge Torres, Class 16
For most of the last decade, I have been helping companies deal with intellectual property (IP), initially as technical advisor to the legal firm Skadden, Arps, Slate, Meagher, & Flom LLP and more recently representing clients in complex patent infringement lawsuits as an IP attorney. As I entered the Kauffman Fellows Program in the summer of 2011, I began developing a framework for thinking about venture investment in emerging companies whose business models have the potential to dramatically 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 contours of the major trends shaping the evolution of IP markets, and identify the ways that venture-backed IP-business of the future will disrupt IP markets over the next decade.
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 first was a landmark decision by the U.S. Court of Appeals for the Federal Circuit, and the second was the publication of a highly influential book on IP strategy by Harvard University Press.In 1998, the U.S. Court of Appeals for the Federal Circuit decided State Street Bank & Trust Co. v. Signature Financial.1 In that case, the court held that the U.S. patent laws permitted the patenting of business methods. Prior to State Street, 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 Federal Circuit’s State Street decision was game-changing not only because it placed the court’s imprimatur on business method patents, but also because the court’s timing was impeccable. Business method patents existed before State Street, but the Federal Circuit 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 is done. State Street transformed the public’s perception of the U.S. Patent and Trademark Office 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 Patent Office issued 7x more business method patents than it did in 2002 (3,649 vs. 494).2 In the same period, the Patent Office received an average of almost 11,500 business method patent applications per year. The number of patent applications received between 1998 and 2010 doubled overall,3 and the Patent Office is working toward reducing 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 after State Street, when Kevin G. Rivette and David Kline wrote Rembrandts in the Attic,5 a volume on IP strategy in which they argued that CEOs 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, Rembrandts got the business community to start focusing on unlocking the value in their patent portfolios. Some executives decided that selling portfolios on the secondary market was the best way to monetize that value. The ensuing decade saw transaction volume in the patent secondaries market explode, fueled 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 license and enforcement companies’ came to dominate the public consciousness of the patent system and IP rights more generally. State Street and Rembrandts in the Attic helped lead us to where we are today. Startups and established companies alike operate in a business environment awash in patents and capital invested in generating returns through licensing and enforcement. The ideas set out in 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.” The patent peril dynamic happens 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 developers, where practitioners exhibit a visceral rejection of patent rights and of the arguments defenders of the current 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 heklp them solve. I was motivated in part by my experience representing litigants in patent infringement lawsuits. Patent litigation is perhaps the most inefficient price discovery engine ever conceived. I realized that a business able to materially decrease the number of patent disputes that companies litigate, or to significantly 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 U.S. Congress, the latest culminating in the American Invents Act of 2011.8 Not only did the new laws fall short of expectations, each time, they made the operating environment for businesses more challenging. Attorneys, duty-bound to zealously represent their clients, 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 difficult cases, 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 entrepreneurship as a viable alternative to patent reform. Accordingly, 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 aim 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 managers 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 last decade have prompted a flight to quality as limited partners have allocated to the asset class. As TrueBridge 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 ten years.12In this fundraising environment, venture whitespaces stand out and increase the odds of getting funded; they also bode well for returns. A venture whitespace is an emerging area of innovation and entrepreneurship in which little or no risk capital has been invested and where there are fewer startups and investors clamoring for deals than in areas where venture capital is plentiful in comparison. The relative lack of competition for deals in venture whitespaces disciplines valuations, allows new entrants to scale quickly, and rewards first-movers able to execute successfully. By any definition, the IP sector is a venture whitespace. The combined market for legal services and transactions involving IP is more than $60 billion,13 and 2011 saw two transactions—Nortel’s sale of its 4G LTE patent portfolio and Google’s acquisition of Motorola Mobility—that together accounted for almost $17 billion in transaction value. Despite the size of the potential market opportunity, there are probably less than a dozen venture-appropriate startups in the United States 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 management startup founded in 2008 that does not sue others for patent infringement. Instead, RPX identifies and acquires patent portfolios that represent significant infringement risks to operating companies, usually those operating in the technology sector. Customers pay RPX a subscription fee in return for a license to the company’s entire portfolio. License in hand, operating companies are free to focus on innovating, and they spend less money answering claims of patent infringement.15 RPX attracted approximately $100 million in pre-IPO financing from venture capital firms Charles 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 capitalization of over $1 billion. One venture capital firm that backed RPX from the beginning saw a return of between 12x and 13x (unrealized as of June 2011).17 The RPX story is a critical proof-point that demonstrates how a non-litigation play in the IP sector can generate superior returns. As such, RPX, and the venture investors who backed it, have begun the process of socializing IP as a venture-ready area of investment.
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 firm to appropriate the value of all the patentable innovation embodied in a single product. For example, mobile handsets 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 componentized 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 can potentially 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, a market trend that includes the development of software tools for the organization 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 capacity and processing bandwidth, businesses will be able to quickly mine such databases, and the resulting insights will impact how they assess patent quality, when they choose to assert patents in court, and how much they pay for a license. 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 organizational 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 of 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 the 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 U.S. patents that account for the majority of patent value. The most successful entrepreneurs starting companies in the IP sector will then build companies that capitalize on one or more of the trends discussed above. RPX, for example, pioneered the defensive patent aggregator category, and it recently announced that it would offer its customers defensive 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 firms that underwrite similar coverage. As the sector develops and matures, we can expect to see more examples of this approach to growing IP-based businesses.
John Doerr recently asked his Twitter followers how they would fix the patent system and whether they favored banning or term-limiting software patents.20 This is a valid way of framing the question, and Mr. 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 United States, 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 last decade, the technology sector saw a flood of 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. The new IP business will disrupt business in three key ways: (1) bringing price transparency and transaction efficiency to IP markets, (2) enabling robust quantitative prediction modeling of litigation outcomes; and (3) 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 business deal with IP risk will benefit the most from the wealth-generation that entrepreneurship in this space will generate.
Jorge M. Torres
Jorge M. Torres is a Vice President at Silas Capital, a New York City-based firm that invests in early-stage consumer products and consumer internet companies. Prior to VC, Jorge practiced intellectual property law at Skadden, Arps, Slate, Meagher & Flom and at Fish & Richardson P.C. He helped startup Built NY monetize and enforce their IP portfolio, successfully defended Nokia in a series of patent infringement lawsuits, and was also part of the legal team that helped Microsoft overturn a $1.5 billion jury. Jorge is currently advising Context Matters and sits on the advisory board of the Organization of Latino Entrepreneurs. He holds a BS in molecular biophysics and biochemistry from Yale and a JD from the University of Pennsylvania Law School.