The secondary market in patents: help or hindrance for start-ups?

Though small and resource-poor by definition, start-ups are nonetheless possibly the most important part of the innovation ecosystem. They often take up the challenge to innovate in spaces that larger companies overlook or avoid. Many household-name companies had humble origins as start-ups, which won funding and eventually grew large enough to command the power and influence that they possess today. As with other creative and commercial businesses, most technology start-ups rely on intellectual property, as both an incentive to innovate and a means of protecting their most important business assets.

The key form of IP protection for firms operating in the technological space is the patent. Given their ubiquity and importance, patents are gradually being seen as another type of business asset, just like mechanical equipment, premises and company stock. It is only natural, therefore, that companies are beginning to trade patents on an informal but fast-growing secondary market. The secondary market for patents creates the possibility of liquidity for start-ups. For example, a start-up which needs a quick infusion of cash and which owns patents that have not proven to be commercially significant can raise money by selling its patents on the secondary market. As Colleen V Chien stated in her recent article “Startups and Patent Trolls” published in the Stanford Technology Law Review (2014), the secondary market also gives what she calls ‘patent trolls’ (and what we refer to in this article as ‘patent assertion entities’ (PAEs)) an opportunity to “feed the war chest” by buying patents in bulk. So, while the secondary market provides a path to liquidity for participants on the sell side, it also allows non-practising buyers such as PAEs to bolster the stockpile of patents that they can assert in infringement actions.

Figure 1. Venture-backed exits by year 2010-2014 Q3

Source: Thomson Reuters and National Venture Capital Association

* Includes all companies with at least one US VC investor which trades on US exchange, regardless of domicile

Patents are useful to start-ups even in the earliest stages of their growth, as intellectual property is an indispensable means of attracting investment. The key to the growth and success of any start-up is getting the right amount of funding at the right time – this is where venture capitalists (VCs) come in. Only a small proportion of start-ups funded by a given VC fund will turn out to be big winners, and this small proportion will cross-subsidise other companies in the portfolio which were unsuccessful in terms of being unable to meet their operational and financial targets, or which turn out to be lifestyle companies (ie, companies which achieve a sustainable level of profitability, but with modest growth that does not meet the expected high rate of returns for a big winner). VCs are thus the second set of protagonists in our story. Their investment decisions in start-ups are often driven by IP considerations, particularly in the tech sector. The question that we attempt to answer in this article is: are their exit decisions influenced by IP considerations as well? Specifically, if VCs recognise that, in the event of the failure of one of their portfolio companies, some value can be salvaged in a fire sale, will that influence them to invest in the company with the comfort of a safety net should things go wrong, rather than forgoing the risk of investment?

We aim to explore the opportunities that the secondary market represents for start-ups in terms of patent sales – in part because the existing literature on start-ups and PAEs engages only briefly with the idea that the secondary market also offers opportunities for start-ups and their VC backers to create value, and contains little detail. We focus specifically on the question of whether the possibility of a patent sale on the secondary market gives VCs the comfort of a safety net, spurring them to invest in a start-up about which they might have been in two minds initially. Our starting hypothesis is that the possibility of patent sales on the secondary market is unlikely to be taken into account by VCs – which, when deciding whether to invest, are more likely to focus on conditions existing at the time (as opposed to focusing on the possibility that a start-up may not meet its financial or operational targets). To test this hypothesis, we have conducted informal interviews with VCs in Silicon Valley.

We conclude our article with a brief inquiry into whether PAEs should have the right to enforce patents at all. They may have a legitimate interest in maintaining the value of the proprietary right that they have acquired; but given that they do not innovate, does their behaviour comport with the overall goals of the patent system? By combining a critical examination of recent studies of the relationship between start-ups and PAEs with original research which includes a third (and vital) participant in the innovation ecosystem – the VC community – we hope to make an original contribution to research in this area and possibly even to highlight further issues that might serve to expand the research agenda in this area of study.

Figure 2. Number of defendants in NPE lawsuits

Source: RPX database

Start-ups versus PAEs

While large companies dominate most patent-related headlines, there is evidence to suggest that at least some PAEs are specifically targeting start-ups. As reported in Chien’s abovementioned article, over 66% of unique defendants to PAE infringement actions are companies with revenues under $100 million per year, and over 55% of unique defendants have revenues under $10 million. By contrast, only 16% of companies with revenues under $10 million were unique defendants to infringement actions commenced by operating company plaintiffs.

Chien observed that the specific characteristics of small companies put them in an especially vulnerable position when faced with the threat of PAE demands. The settlement dynamics of the PAE-start-up relationship often force start-ups to pay PAEs’ demands rather than face the astronomical legal costs of a full defence in court, even where the PAEs’ demands are unfounded on patent law grounds.

Vulnerability of start-ups

The business model of at least some PAEs relies on the choice that a defendant must make between:

• paying the high legal costs of defending an infringement action; and
• paying the lower cost associated with settling the dispute out of court (which may nevertheless be substantial).

This cost differential is largely independent of the merits of the alleged infringement – in other words, even if the PAE’s infringement claim is not sustainable under patent law, a high cost will be associated with establishing non-infringement in court. So even if the patent on the basis of which the infringement action is being brought has no applicability to the defendant’s invention, the defendant may still be better off paying a settlement fee. This effect is amplified in the case of start-ups and other small companies, which have less capacity to absorb the costs associated with protracted patent litigation.

Start-ups and the secondary market

We introduced the idea that the secondary market also represents an opportunity for start-ups, as it offers them a path to liquidity in times of financial strain. The obvious benefit of the secondary market is that it provides a market for patent sales, enabling start-ups to monetise their patents. The cash infusion from a patent sale can help to support a start-up’s business and provide an alternative revenue source. However, we believe that there are two distinct scenarios in which start-up patent sales take place.

The first situation is when a start-up wishes to sell a patent relating to a technology that it no longer uses. This decision is based on business strategy – for example, the start-up might have reoriented its product in order to respond to market preferences. In this situation, the start-up can sell any patents that it no longer uses and attempt to make a profit from the technology that it developed. This sale has the potential to generate additional revenue, in which case it represents a considerable benefit to the company.

The second situation is when a start-up has been unable to achieve its operational or financial targets and is thus forced to shut down its business. Under these circumstances, the sale of its patent(s) may be used to help to repay creditors and, following a ‘participating preferred’ clause inserted in the majority of VC investments, also give some money back to VCs.

In this section, we consider whether VC backers take account of the possibility of a patent sale a priori as an alternative exit option and, if so, whether start-ups can use this fact to their advantage while negotiating. We have sought to answer this question by conducting interviews with prominent VCs around Silicon Valley and analysing their responses from the point of view of start-ups.

Figure 3. Distribution of significant impacts resulting from a PAE demand

Source: Colleen Chien, “Startups and Patent Trolls”, Stanford Technology Law Review

However, we recognise that the secondary market does not come without potential socioeconomic costs, as PAEs are active on the buy side. Thus, we briefly examine the question of whether the secondary market should be altered to exclude the socioeconomic costs incurred by the presence of PAEs, while permitting start-ups and other operating companies access to it as a means of obtaining liquidity (for start-ups) and strategically significant patents to be applied towards genuine innovation (for larger companies).

Start-up founders seeking VC funding must strike a compromise by giving up some of the ownership of their company to investors. The amount of control is typically a key negotiation point, as each party tries to acquire a bigger slice of the pie.

PAEs acquire at least some part of their patent portfolio from small companies, thereby providing them (and, more significantly, their investors) with the means to monetise their patents. Data up to the present indicates that patent sales usually represent a last-ditch option for start-ups. Consequently, while a patent sale is rarely a primary operational goal for a start-up, it can nevertheless be seen as providing an alternative exit option for VCs, apart from private acquisitions and initial public offerings (IPOs). VCs are likely to take patents and/or patent applications into account during the valuation process anyway – the logical next step, therefore, is to determine whether they see any value in the safety net provided by a possible patent sale.

Figure 4. How the venture capital industry works

The venture capital industry has four main players: entrepreneurs who need funding; investors who want high returns; investment bankers who need companies to sell; and the venture capitalists who make money for themselves by making a market for the other three

Source: Bob Zider, “How Venture Capital Works”, Harvard Business Review

Our hypothesis

VCs invest in early-stage ventures with the goal of exiting a few years later, monetising their investment with equity in the company (ie, shares that they can sell) and/or ongoing returns from the investment. Even though the sale of patents to a PAE might be seen as a last-resort exit, it might still be capable of positively influencing investment decisions and, consequently, driving investment in start-ups and innovation. We believe that either of the possible answers to this question is significant. If VCs indicate that the secondary market is important to them, it will pave the way for further study of the means through which the benefits of the secondary market can be optimised for start-ups. If, as we hypothesise, VCs show little interest in the possibilities of the secondary market, this should point towards the conclusion that some of the current speculation over the positive effects of the secondary market is overly optimistic.

In short, one of the major theoretical benefits of the monetisation of patents by PAEs is that it provides a new type of exit for VCs, in addition to the more traditional methods of exit from a venture capital investment (ie, through an IPO or M&A/private sale of shares).

However, our initial hypothesis is that the possibility of a patent sale in the secondary market is not a significant factor in a VC’s investment decision. We believe that this is likely to be the case for at least two reasons. First, VCs bet on the possibility that a company will be a big winner. They tend to invest in companies that they are optimistic about and are therefore unlikely to be concerned about salvage methods at this stage.

Second, the high returns of an IPO or M&A-based exit are unlikely to be matched by a patent sale, unless the patent commands an exceptionally high value (on par with the Google algorithm or a similarly groundbreaking and commercially significant technology), in which case it is less likely (though not impossible) that the company will be in such a weak position that a patent sale is necessary.

Research methodology

In order to prove our hypothesis and uncover other information relevant to determining the effect of the secondary market on VCs’ investment decisions, we conducted informal interviews with partners from VC funds in Silicon Valley. Our goal was to seek our subjects’ input on the relevance of patents in the VC decision-making process – specifically, on the question of whether the sale of a patent in the event of the business’s failure might be considered as a safety net.

We interviewed partners from three different VC investment funds in Silicon Valley – August Capital, Bloomberg BETA and Sierra Ventures. Although we conducted informal and relatively unstructured interviews in which we adjusted and refined our questions with the responses, we nevertheless framed each interview using the following questions:

• Does the fact that a company holds (or has applied for) patents affect your decision to invest in the company? If so, how?
• At the valuation stage, how much importance do you attach to whether the company holds (or has applied for) patents on its key technologies?
• To what extent are you aware of the secondary market for patents?
• If the company is not doing as well as initially expected and needs more operating capital, what options do you consider? Another round of financing, sale of assets (eg, non-core patents), patent licensing or any others?
• Would you consider the sale of a company’s patents a viable alternative exit strategy (compared to IPOs or private sale)?
• Of the companies you have backed in your career, approximately how many sold some or all of their patents to a non-practising entity (NPE) in the event of:
• bankruptcy;
• failure to achieve financial targets; or
• other circumstances?
• Of the companies you have backed in your career, approximately, how many sold some or all of their patents to an operating company in the event of:
• bankruptcy;
• failure to achieve financial targets; or
• other circumstances?

Our findings

Our hypothesis was borne out by our interviews with VCs, who generally expressed the opinion that the possibility of a patent sale on the secondary market was not a significant factor in influencing their decision to invest in a start-up. Their reasons closely matched those that we hypothesised. We have summarised the key points of each of our interviews in the boxes on pages 82, 83 and 84.

The primary reason for not taking secondary market sales into account correlated with the second basis of our hypothesis (ie, that patent sales on the secondary market usually take place only as a last resort, when the portfolio company is running out of money or is in the bankruptcy/winding-up process). Our interviewees all expressed the view that patent sales in such circumstances are almost never likely to be profitable – one interviewee specifically mentioned that a patent sale is unlikely to deliver the return that the firm expects of its portfolio companies in order to deliver the fund’s overall expected return.

Peter Wendell of Sierra Ventures observed that the best method of extracting commercial value from a patent of a healthy operating company is to cross-license the patent to other companies (most likely competitors) operating in the same space as the portfolio company in question. This idea holds an intuitive appeal – an operating company with a valuable patent is much more likely to be operating successfully, negating the need for a fire sale, and more likely to be in a stronger bargaining position against potential licensees than a failing company would be against prospective secondary market buyers.

The first basis of our hypothesis also found some support from our interviewees. James Cham of Bloomberg BETA specifically noted that the use of patents, in his experience, is becoming increasingly defensive and patents are thus becoming less important generally from a VC’s point of view. One interviewee noted that the VCs’ focus is primarily on the start-up team. Downside protection did not seem to be a primary investment driver for any of our interviewees. With respect to downside protection, our interviewees were all of the opinion that patent sales by companies in dire financial straits are unlikely to result in significant returns and so the downside protection offered would be minimal in any event.

However, there was a difference of opinion between our interviewees on the importance of patents at the valuation stage. Wendell, discussing an investment in the hardware space, saw patents as being an important business asset for companies in this sector, especially in disruptive technology cases. Though the sale of patents was not considered a viable exit option, patents were a major factor in the VC’s initial investment decision in this type of technology and a key means for the portfolio company to realise value and demonstrate its viability. On the other hand, Cham saw patents as commanding less importance in the investment decision than in the past and observed that the use of patents is becoming increasingly defensive. On this view, while patents still have strategic use in the event that a competitor is found to directly infringe the portfolio company’s patent or a portfolio company is sued for infringement and needs to make a counterclaim, VCs are unlikely to take much cognisance of patents in evaluating the overall health of a prospective portfolio company. David Hornik of August Capital also held that intellectual property is not a commanding factor in the investment process, rather being part of the mix that VCs consider when investing in early-stage ventures. Moreover, if a company fails, the sale of patents to a PAE is not seen as a viable last-resort option, due to the time and complex process that patent sales necessitate. According to Hornik, the amount that PAEs are willing to pay for a patent seldom justifies the burden of the sale process.

Relationship between patent assertion and innovation

While our study has shown that the returns generated by patent sales on the secondary market may not be enough to satisfy the VC backers of start-ups, there is no doubt that – at least in theory – the possibility of liquidity is one of the key benefits that the secondary market offers to start-ups. However, in our opinion, a problem with the secondary market is that PAEs are among the most active buyers. PAEs principally seek to leverage and extract money from defendants on the basis of the patents they hold, even though they typically do not commercialise those patents or partake in R&D-based innovation activities themselves.

The situation is complicated by the fact that PAEs often operate in a clandestine fashion, without making public either their patent portfolio or their relationship to any shell companies that they use, instead using licensing transactions that are protected by non-disclosure agreements.

The enforcement of patents by PAEs can reasonably be seen as necessary to protect the value of their patents. If PAEs are not prohibited from participating in the secondary market by buying and selling patents, they can justifiably claim that they must be permitted to preserve the value of their assets; otherwise, the value of the patent will diminish greatly if products using the patented technology are being sold in the market.

The question that we wish to raise is whether PAEs take advantage of the patent system by amassing large patent portfolios solely to bargain for higher fees on licensing agreements. We also might point out the natural counter-argument – that even if they are only bargaining for advantageous licensing agreements, they are simply operating under the rules of the market, enforcing a right to which they are entitled. If their business model consists of monetising the patents they have – even if it is just by mere sale and not by innovation or developing the patented technologies – it might be argued that this merely amounts to exercising a legitimate interest in the enforcement of proprietary rights in order to protect the value of business assets. However, this business model also raises questions about whether these practices are promoting innovation and whether they are in the spirit of the overall framework and purpose of the patent system.

Intuitively, it seems that the act of purchasing patents to do anything other than manufacture a new product or develop a new service does not accord with the traditional role of patents in our economy. The patent system developed in order to encourage inventors to produce innovative new products – it incentivises them to do this by granting them a limited monopoly to commercially exploit such products. The use to which PAEs put patents is arguably not in keeping with the original goals of the patent system.

We recognise that the conflict between a patent owner’s right to maintain the value of its patents and the question of whether the ownership of patents by PAEs has a negative impact on innovation is likely to be difficult to resolve. However, recent US judicial opinions have indicated at least a recognition of the idea that NPEs are likely to use patents in ways that the patent system did not foresee or incentivise (eg, the concurring opinion of Justice Kennedy in eBay v MercExchange, 547 US 388 (2006)). Legislative efforts in the United States to reform patent law have also looked at the general idea of curbing the power of PAEs to initiate litigation against defendants that are practising entities. We predict that this trend towards the recognition of a special status for PAEs is likely to continue and that more fetters will be put on their ability to initiate lawsuits and recover damages. Narrowly tailored judicial and legislative solutions are a better method of dealing with the problem than a more heavy-handed approach seeking to exclude PAEs from owning patents outright, which is likely to result in unintended consequences. While the form and content of legal solutions to the so-called ‘troll’ problem will no doubt continue to evolve, recent attempts at reform indicate a willingness on the part of the US Congress and the courts to act on the problem. We believe that a consensus is rapidly emerging over the idea that the ability of PAEs to enforce their patents needs to be fettered.