Update in progress

Update in progress

For over a decade, Microsoft’s IP group has been one of the best in the business. But as the company’s culture and direction evolve, its billion-dollar team must now transition to a new approach

Building 8 on Microsoft’s sprawling campus HQ just east of Seattle occupies a significant place in company lore: the nondescript low-level office block was once home to Bill Gates and his management team. With the founder and senior executives having long since moved on, the site today plays host to the Microsoft IP group. Its location in Gates’s old digs is an apposite reflection of the vital contribution that intellectual property has made to the company’s commercial success.

Microsoft’s influence in the IP sector is almost unrivalled. The company touches every segment of the market: as both licensor and licensee; as an advocate for patent reform and the patent system in general; and as a patent prosecutor that has built one of the largest portfolios in the world to underpin its annual $11 billion R&D budget. In the smartphone sector in particular, it has become a licensing juggernaut, inking deals with some 33 different players in the Android universe.

Recent court documents revealed that in 2013 its tie-up with Samsung alone brought in $1 billion; and while the company remains tight lipped on just how much its Android licensing agreements are worth in total, a ballpark figure of $3 billion would not seem outrageous; while recent estimates have the sum at over $6 billion.

Whichever way you look at it, though, when you consider that a large chunk of any licensing revenue falls straight to the bottom line, Microsoft’s Android-related patent royalties are a big deal – and a testament not only to the IP team’s deal-making abilities, but also to its commitment to developing a wide-ranging, high-quality portfolio.

But change is in the air in rainy Washington State. Two years ago, the software pioneer appointed the third CEO in its 40-year history when Satya Nadella was promoted internally to replace Steve Ballmer. The new man in charge has made it his mission to foster a greater culture of cooperation with Microsoft’s traditional rivals – a strategic shift which has now filtered down to the IP team.

Erich Andersen, head of the Microsoft worldwide IP group

“We’re approaching licensing in a different way than we have in the last few years”

“I think that we’re approaching licensing in a different way than we have in the last few years,” confirms group head Erich Andersen. “Increasingly, we are focusing on collaborations and partnerships that involve business elements to them as explicitly part of the licensing discussions with other parties.”

Perhaps nothing exemplifies this new era of détente better than Microsoft’s truce with Google, which was announced in October and drew the curtain on the pair’s long-running, though often softly stated patent feud. Given the fierce enmity that hitherto prevailed between the two tech giants, the development came as something of a surprise, to say the least. But today, it appears that evolution – not revolution – is the new watchword at Microsoft.

Microsoft’s theory of change

Sometimes, the impact of a corporate changing of the guard can be overstated; at Microsoft, however, that does not appear to be the case. Almost immediately after taking over, Nadella announced that Microsoft Office would be made available on Apple’s iPad. Reportedly, this had already been in the pipeline for around a year, but it gave the new leader a way to quickly make his mark.

Nadella has since been busy knocking down walls, revamping the company’s image in Silicon Valley and making Microsoft, well, much hipper. “It’s like night and day,” say Valley denizens when asked how Microsoft has changed. “I mean, I have the Outlook and Excel apps on my iPhone, and they’re actually good,” quips one local lawyer. Spend time with the company’s engineers and they exhibit the same enthusiasm as their peers in Northern California’s tech hotbed: there is a new spring in their step.

In contrast, Ballmer – who took his bluster and billions south to Los Angeles to buy the city’s Clippers basketball team – had adopted a distinctly ‘in your face’ approach when building Microsoft’s business. During his tenure, the strategy was very much ‘Windows and Office first’ – the two software packages that still drive a large chunk of the company’s profits. Establishing their hegemony in the personal computing space was the overarching priority.

But that world has now changed. The rise of mobile means that the proportion of internet connected devices that run on Microsoft’s flagship operating system has dropped dramatically; and the sharing economy is also tilting the balance towards greater collaboration. As the transition from desktops to PCs continues, Microsoft has had little option but to move with the times.

The IP group, which sits within the legal and corporate affairs division, has not been immune to this flux. It has seen its own change of control, with Erich Andersen taking over the reins in July 2014 from Horacio Gutierrez, who had served as group head since 2006 and was recently appointed the company’s general counsel. Eschewing pithy one-liners, the thoughtful Andersen is not one to make bold statements that could rock the boat internally or create ripples in the market.

Micky Minhas, Microsoft’s chief patent counsel

Drafting using the European Technical Effect Standard is “a little bit more stable in terms of ensuring that we meet the patentability bar around the world”

Perhaps that is unsurprising, given that he is still just 18 months into the job; but his personality and background clearly make him a good fit with the latest incarnation of the Microsoft team. A 20-year company veteran, Andersen has previously served stints as general counsel in Europe and deputy general counsel of the Windows business. Immediately prior to moving to the IP function, he led the legal and corporate affairs division’s business development and evangelism team.

Throughout his career, Anderson has been firmly plugged into many different parts of the business, with a heavy accent on external collaboration. “I’ve spent a lot of time working with our product and engineering groups on partnerships with other companies,” he says of his various roles.

His current position is a natural progression to this, suggest two of his key lieutenants. “Horacio was phenomenal at establishing the fundamentals that you need in order to build a practice like we’ve built,” explains head of licensing Nick Psyhogeos. “I think the dimension that Erich brings is his deep experience within Microsoft in working across multiple organisations – his background working with the Office team and his background working with the Windows team.”

“Because Erich has spent the bulk of his career on the product side, he understands how IP can be used to enhance business value,” adds chief patent counsel Micky Minhas. “I think that’s probably the biggest shift we’ve seen with Erich.”

Figure 1. Breakdown of Microsoft’s US patent portfolio

Source: EnvisionIP

Figure 2. Top patenting focus for Microsoft

Source: EnvisionIP

The new old thing

Day to day, this translates into work on broader, often more complex agreements, where intellectual property is just one aspect of a much bigger whole. In early October, for instance, Microsoft and ASUS announced the expansion of an existing patent licensing deal; as well as a broad cross-licence involving ASUS Android phones and Microsoft software, devices and services, it heralded a new period of closer integration between the two, including pre-installation of Office software on ASUS’s Android devices.

This was followed in November by an even more remarkable alliance with long-time rival Red Hat. Under the terms of the agreement, Red Hat’s version of the Linux operating system will be made available on Microsoft’s Azure cloud platform. In return, Red Hat Enterprise Linux will become the preferred choice for enterprise workloads on Azure. Considering that Ballmer had once famously referred to Linux as a “cancer”, the deal makes quite a statement on Microsoft’s evolution under Nadella.

“The reality is that the market has changed to a point where we have a greater opportunity to do some collaborative things on a broader scale with other companies,” comments Psyhogeos on these new partnerships. This is driving the emergence of what he calls a “collaborative IP economy”. “Advances in technology – powered by the cloud in particular – married with the hunger of consumers for on-demand solutions such as Uber, Snapchat and Open Table, are putting companies in a position where – whether they realise it or not – IP is forming a larger dimension of their business strategy and growth,” he explains.

This in turn is having an appreciable impact on patent licensing. Microsoft’s executives insist that the company has always focused on partnerships; but in today’s multi-layered tech economy, these relationships have never been more important. “If you think of patent licensing specifically as a blunt instrument to acquire something in the near term, it really jeopardises your ability to do it over the long term,” says Psyhogeos.

Whatever shape it takes, licensing has long proved a lucrative endeavour for Microsoft. The company’s prodigious generation of royalties from the Android ecosystem is well known: while its own efforts to compete in the smartphone market may have failed to take off, systematic targeting of Android users has seen the likes of Samsung, HTC, Barnes & Noble and General Dynamics all sign on the dotted line.

“It would not have been successful by any measure for us to consider this as looking to license a few original equipment manufacturers opportunistically,” explains Psyhogeos. “It’s something that we looked at as an ecosystem approach, where we felt it was important to have not only our IP respected, but also the value of the implementation of our technology in those devices.”

Although most of the Android deals were brokered through amicable negotiations, Microsoft has not completely avoided the high-stakes litigation that has come to dominate the smartphone era. Its dispute with Google – which started out as a spat with Motorola (the search giant became involved after acquiring Motorola Mobility in 2011) – became one of the industry’s defining courtroom tussles and underlined the deep rivalry between the two businesses.

At the end of September, however, the hostilities ended as the pair announced that they had called off all pending patent litigation between them. They also announced that they had agreed “to collaborate on certain patent matters and anticipate working together in other areas in the future to benefit our customers”. Andersen declines to comment on the terms of the agreement beyond what was disclosed in the statement, but nothing reflects the new approach at Microsoft HQ more than the ceasefire with Google.

Figure 3. Microsoft patent breakdown by technology area

Source: EnvisionIP

Reaching a valuation

With this different approach and new corporate climate, however, is it possible that Microsoft may start to see a decline in the revenues that are directly attributable to licensing? As the terms of deals change and the focus shifts to getting company software and services onto more devices, the profit that can be chalked up to Andersen and his team could become more difficult to determine.

Maybe – but that would assume that all licensing agreements are the same, which clearly they are not. Many may still involve a simple cross-licence and high-margin royalty deal. Plus, the company has by no means exhausted its licensing opportunities. Android operators have captured around 80% of the smartphone market; so in the mobile sector alone, as more new players emerge in markets such as China and India, it seems likely that licensing opportunities will proliferate.

It is also wrong, as Andersen stresses, to assume that licensing success is gauged only by the revenue it brings in. “The way we measure success in our intellectual property business is really around business impact,” he says. “Clearly, we’re licensing IP – we license it for royalties and we make revenue off of that. But there’s another element of value that we increasingly receive in deals, especially with larger partners, which is some level of business impact that helps company strategy.”

If intellectual property is part of a deal that gets more Microsoft products onto more devices, that is obviously part of a bigger win for the company. And there is another aspect to such tie-ups which cannot be measured: the strengthened commercial alliances that result from putting an IP agreement in place. “It’s a slightly different conversation than if it were purely a commercial deal, but a lot of the fundamentals are the same,” explains Andersen. “You end up creating a relationship that has other impacts and other effects throughout other parts of the company.”

Portfolio planning

In many ways, the patent evolution at Microsoft reflects that taking place in the wider tech community. Its annual filings of new patents accelerated sharply in the early 2000s, at about the same time that its patent licensing programme was established under the guidance of then group head Marshall Phelps. While Phelps, who had driven so much of IBM’s early licensing success, laid the groundwork, it was Gutierrez who expanded the reach of the IP group, extending its influence into so many parts of the market.

Today, Microsoft has a portfolio of more than 58,000 US and international patents. According to analysis by EnvisionIP, of the company’s US patents – which number just under 30,000 – a little over 60% relate to software, with the rest comprising non-software related utility patents (26%) and design patents (13%).

Breaking the portfolio down further, around 15% are directed towards operating system software, which reflects the core Windows business. Just under 10% relate to server and cloud-based technologies – an area that might be expected to increase as Nadella continues to emphasise the importance of the cloud to the company’s growth.

Figure 4. Microsoft’s patent application filing trends

Source: EnvisionIP

The strength of Microsoft’s portfolio of software patents has placed the company at the heart of the debate on the patentability of computer-implemented innovations. In 2014 the US Supreme Court issued its ruling in Alice Corp v CLS Bank, a case that involved a patent for the settlement of complex financial trades. Although it did not directly mention software, and the patent in question related more to a business method invention, the case has prompted wider discussion on software patents.

There is no doubt that the question marks that such decisions have raised over Section 101 of the US patent statute, concerning patent-eligible subject matter, have caused great uncertainty over what exactly is patentable. For Microsoft, business method patents account for a relatively small chunk of its portfolio (approximately 6%, according to the EnvisionIP analysis). That notwithstanding, Minhas for one would admit that to some degree, he shares the fears about uncertainty over patentability encroaching on more than just business methods; and the Microsoft prosecution team has had to adapt in response.

Perhaps the greatest change relates to how patents are drafted. Several years ago Minhas’s team started using the European Technical Effect Standard as a template for more of the company’s filings. “It seems a little bit more stable in terms of ensuring that we meet the patentability bar around the world,” observes Minhas. He has also expanded the team’s technical capabilities, with engineers now representing one-third of the IP group; this has helped in identifying potential holes in Microsoft’s portfolio and predicting where technological advancements might be heading.

Minhas admits that the current trend lines around patent eligibility might ultimately lead to a reduction in the overall size of the portfolio: “How much smaller depends on the nature of the company and its innovations.” But it would seem unlikely – for now, at least – that Microsoft will lose its place on the patent arsenal leader board.

Microsoft on the issues

It is not only questions about patent eligibility that are creating uncertainty in the US market. Patent reform remains on the agenda, just four years after the America Invents Act was signed into law. New legislation may seem less probable in the current Congress; but with vocal lobbying from the tech community and many high-street businesses lined up in support, reform looks likely to remain on the radar for some time.

Although Andersen says that Microsoft is broadly supportive of the reform efforts in the House of Representatives under the Innovation Act and in the Senate through the PATENT Act, the company has been rather more muted than some of its tech counterparts – such as Google and Cisco – in calling for change. Any legislative package should strive for a balanced approach, he insists; although that would not appear to be an accurate description of the Innovation Act in particular, which has been criticised for undermining patent rights – particularly those of smaller businesses.

Microsoft was a founder member of the Partnership for American Innovation, a coalition of businesses – including Apple, Ford and GE – that aims to highlight the importance of intellectual property to the wider economy. The coalition has not taken a position on patent reform thus far, but the narrative it promulgates seems to be at odds with the kind of broad-based legislation that is currently under consideration.

Andersen maintains that there is no evidence that the US system is increasingly skewed in favour of the largest companies – a popular claim of reform critics. “If you look at the amount of money that we and Apple and Google are paying out in lawsuits, in damages, in licensing fees and things like that, it’s a lot of money,” he insists. “I don’t see any evidence that because we’re a big company, we’re somehow benefiting from the system in some special way.”

Litigation reform is the primary focus of those advocating further legislation and – like its tech peers – Microsoft sees its fair share of lawsuits brought against it by non-practising entities (NPEs). However, there seems to be little doubt that the assertion climate for patent owners in the United States has worsened considerably, particularly for standalone licensing businesses. Such is Microsoft’s reach in the market that this trend is also having an impact. The company has been one of the anchor investors in Intellectual Ventures (IV) since the world’s largest NPE was founded back in 2000. Microsoft has reportedly backed all three of IV’s fundraisings, even as many of its peers declined to invest. This is unsurprising, given that IV co-founders Nathan Myhrvold and Edward Jung are both Microsoft alumni. Although IV is an independent entity, the historic ties between the two are clearly strong. But supporting a licensing business in which patent assertion is a key revenue generator may seem to contradict Microsoft’s new collaborative, partnership-focused approach.

Andersen is clearly reticent to talk about the ties with IV, at first insisting that he has no comment to make on the NPE. But when pushed, he refers to the important role that such businesses play in the market: “We do believe that it’s important for the industry to have a secondary market and IV is one of those entities that exist in the marketplace to facilitate that.”

How to balance that relationship against the IP group’s strategic priorities and the company’s broader targets will undoubtedly test a team even as experienced as this. Like IBM before it, and many other tech players that have focused on patent monetisation, Microsoft originally tasted IP success as its wider fortunes faded. As it left its 1990s Windows pomp behind it, so its patent filings and licensing programme took off. But unlike Big Blue, which has been outstripped by a swathe of tech parvenus, under Nadella Microsoft’s slide might have been arrested.

The company’s prospects look as good as they have done for years; and while success is never assured in such a lightning-paced sector, the sense of optimism is palpable. But in the new Nadella era, Andersen and his team must continue to steer a multibillion-dollar licensing business that, in churning out deal after deal, has not always left the other side feeling warm and fuzzy. Evolution may be the key message now, but patent success is still all about survival of the fittest.

Richard Lloyd is the North America editor of IAM, based in Washington DC

Unlock unlimited access to all IAM content