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How to Spot Winners as Facebook (Nasdaq: FB) and Friends Fight Patent Wars

For big players like Facebook Inc. (Nasdaq: FB) and Apple Inc. (Nasdaq: AAPL), last summer marked a dramatic turn toward patent warfare in the world of technology.

Microsoft Corp. (Nasdaq: MSFT) and Apple in July 2011 spent over $4.5 billion at an auction on a portfolio of 6,000 patents.

Then in August, Google Inc. (Nasdaq: GOOG) purchased Motorola Mobility for $12.5 billion, gaining over 17,000 patents.

Facebook and Yahoo! Inc. (Nasdaq: YHOO) currently headline the battlefield. This spring, Facebook spent a whopping $550 billion on patents. Then Yahoo sued Facebook for patent infringement.

You should expect more lawsuits as many of the tech giants have a similar wartime strategy: The best defense is a good offense.

The plan is to snatch up as many patents as possible, then defend their plunder. The strategy effectively chokes out the competition, preventing the other guy from developing or implementing new technology because doing so infringes on patents.

But aggressive patent warfare leads to a big casualty: innovation. Technology investment buzzwords like creativity, growth, research and development take a sideline while companies lock each other up with litigation.

In fact, companies heavily participating in patent warfare doom themselves to fail. That's why investors should steer clear of the patent trolls.

Becoming a Monster: Patent Trolls

Patent trolls buy patents specifically to extort money from innovators. They are akin to a modern day mafia, according to the The Washington Post.

Patent trolls take advantage of the fact that litigation in any arena is typically a war of resources.

They sit atop their pile of patents, waiting to have a tenable enough argument that a company has been infringed upon. Then they sue.

The result? A patent troll suit can easily annihilate tech startups that simply don't have the resources to outlast a larger company in litigation.

Any tech company putting major effort into aggressive patent litigation should raise a red flag to investors. It is evidence of mixed-up priorities that scream failure.

For example, let's take a look at Yahoo.

Facebook (Nasdaq: FB) vs. Yahoo (Nasdaq: YHOO)

Yahoo sued Facebook in March for alleged infringement of ten of its patents.

"The lawsuit has drawn criticism," according to The Wall Street Journal, "as Yahoo historically has used its patents more for defensive purposes rather than suing its peers."

Facebook's response was both intelligent and decisive. It acquired several new patents, then filed an answer with the court denying Yahoo's infringement claims and counterclaiming that Yahoo is infringing on Facebook's patents.

Facebook's refusal to back down, coupled with its willingness to litigate, indicated that Yahoo's approach has backfired on multiple levels, said Forbes. Yahoo's focus on litigation over innovation has caused massive staff departures, stifled R&D, and drawn negative publicity.

On top of that, it's unlikely that Yahoo will prevail on its infringement claims in any significant way. The convoluted nature of patents in today's market makes a significant victory extremely rare.

In the end, the only thing Yahoo may have gained in its litigation against Facebook is the dreaded patent troll label, and patent trolls do little more than suck up resources.

The Economics of Patent Warfare Don't Add Up

One thing patent trolls fail to realize is just how costly their battles end up being.

For example, roughly 40,000 software patents are issued every year. With such a large amount of patents constantly being churned out, it follows that a software company has a slim chance of effectively monitoring infringement, whether it is protecting its own rights, or trying not to tread on the patents of others.

NPR's Lam Thuy Vo cites a study conducted in part by Christina Mulligan of Yale Law School. Mulligan examined how much it would cost companies to innovate without infringing:

"Even if a patent lawyer only needed to look at a patent for 10 minutes, on average, to determine whether any part of a particular firm's software infringed it, it would require roughly 2 million patent attorneys, working full-time, to compare every firm's products with every patent issued in a given year. At a rate of $100 per hour, that would cost $400 billion," wrote Mulligan.

Mulligan added, "For comparison, the software industry was valued at $225.5 billion in 2010."

With this data, we can comfortably conclude that a software company can't afford to regulate patents, even if it wanted to.

Additionally, since litigation can easily cost more than earnings, choosing to prioritize litigation can destroy a company from the inside out.

Smaller companies have to worry about hiring attorneys instead of building their startup, according to tech guru Brad Feld, reporting for The Washington Post.

The numbers game doesn't even work out for larger, public corporations like Facebook.

In a study out of Boston University School of Law, researchers found that between 1990 and 2010, patent litigation victims – mostly tech companies – lost half a trillion dollars and had to divert resources from production to litigation, according to The Post.

The Right Way to Fight the Patent War

Tech companies focused on aggressive patent litigation have their priorities dead wrong, and investors should beware.

The more time and money spent on litigation, the less spent on innovation – the lifeline of the tech industry.

Cut off the lifeline, and the company will dwindle and die.

"These patent wars incite a great deal ofvolatilityto the market for a particular stock and investors should be well aware," said Nick Daley, venture partner at Wasabi Ventures LLC. "Especially when you consider a software company such as Yahoo, where the product carries a high degree of intangible value and the impact is quickly recognized on the balance sheet. There is no reason to invest in Yahoo until they figure out how to function again, and the pending litigation is evidence of that search. More and more this appears to be a last ditch effort to save itself."

The best way for tech companies to tackle the issue is to minimize patent litigation.

Facebook may be struggling with some IPO glitches, but its response to Yahoo has been particularly smart. Its stone-wall strategy signals a wish to soundly defend its rights, but without being overly aggressive, according to Forbes.

Another tech company correctly handling the patent war is Twitter. In a recent blog post, it announced that it struck a new agreement with its employees "that will give legal rights to engineers and designers who develop a patent while working for Twitter," reports The Guardian.

Usually, employees' patents are completely owned by the company they work for; by giving employees some rights to their patents, Twitter's new policy diminishes its ability to use patents as a weapon.

Foursquare lauded Twitter's approach, and indicated an intention to follow suit.

Even though some critics question the success of Twitter's new plan, I find its attempt to directly discourage patent trolling a good sign for investors. Twitter and Foursquare have their priorities straight.

Bottom line: When it comes to the patent wars of Facebook and friends, stay away from the litigators and flock to the innovators.

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  1. Josh | June 20, 2012

    I enjoyed this piece. When discussing patents, and specifically patent litigation, very few people point out that it is the consumer that suffers, and all this takes place at the price of innovation. You did a good job bringing that aspect of it in as well.

  2. Anita Lambert | June 28, 2012

    ?I am a total zero when it comes to the stock market, but even I grasped all that is happening with
    these types of online business goings on. This is an excellent explanation of the incomprehensible!

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