IP Strategy for Startups

By Ian Maxwell

Here are two very true statements

1. A startup should have a patent portfolio
2. Startups can rarely afford to properly invest in a patent portfolio

With this fundamental paradox in mind, this article describes some of the options that startups have with respect to IP strategies that most effectively balance the costs and benefits of patenting.

But first, why do startups need patents? There are a number of reasons and not all of them are obvious.

1. Most obviously, a startup with strong patent protection will have higher “exit” value, i.e. the value when listed on a public market or sold in a trade sale. This higher value is a premium paid for a startup with high gross margins resulting from some degree of patent-enabled monopoly protection for its products and services.
2. These same higher margins, based on patent-enabled monopoly rights, also mean that startups with good patent portfolios receive more “contribution margin” from their early sales, and hence may need to raise less investment funds in order to further promote their own growth by investment in R&D, marketing and company enablement.
3. For investors in startups, typically venture capitalists, patent portfolios also represent “downside” protection. Even if a startup a venture capitalist invest in happens to fail (runs out of cash or breaches debt covenants), the company’s patent portfolio can sometimes be sold, licensed or enforced, in order to recover some of the original investment. A Venture Capitalist only gets to share in the profits when the whole fund is profitable, hence it is very important to get capital back from the startups that fail since this helps a fund, in its entirety, creep towards “profitability”. For a startup this means that seeking investment from professional investors usually means committing to creating a patent portfolio.
4. In a similar vein to the last point, a patent portfolio represents downside protection for founders and staff of a startup as well. This means that, even if the business fails, the startup may have value to an acquirer (say a competitor) because of the patent portfolio; this can afford founders and management (who have to negotiate such deals and be rewarded for doing so) some exit value. Often, for non-founding staff, such a transaction may mean the business continues to operate (albeit with new owners); this outcome may offer them continuity of employment if they want it.
5. In many cases a startup does not end up pursuing the original business plan. As a startup develops, it finds new opportunities, encounters problems, and has to deal with a rapidly changing and competitive commercial environment. By having a patent portfolio a start-up has more strategic choices when a change of direction is required. An extreme example of this is an operating startup (building a product or service) shifting to becoming a licensing company. Another example is a move into a new product space, yet where the technology requirements are still underpinned by some of a startup’s existing patent portfolio.

The people who normally make the decisions about how much is spent on patents in startups are the founders and management. Normally these guys have a moral dilemma. On hand they want all the patents they can have, for all the reasons listed above. But on the other hand they want to minimize how much their stake in the startup is diluted at funding rounds, and they do this by raising lower amounts of capital or by focusing their expenditure on accelerating early revenues. Both of these objectives can be achieved by reducing expenditure on patents because this is an area of high expense, and also where the impacts of under-investment are not always realized until some years later. This is where a startup board-of-directors, with professional investors as directors, needs to pay close attention and influence management decisions where they can.

In terms of building a strategic patent portfolio in a startup there are also a couple of shortcuts available.

1. A key one is to seek licenses to external patent portfolios – these can be owned by larger operating companies, or by any number of the so-called “patent banks”. Most start-ups can negotiate license deals without upfront payment, so these types of deals have minimal cash impact. The benefits of licensing patents are numerous but one good reason is to establish a foothold in the operating space such that larger competitors cannot so easily bully the startup, which is easier to do when the startup does not have granted patents. Another reason is to “prime” the patent “pump” of a startup – patents beget invention and other patents; by licensing-in, the process of crafting a patent portfolio can be accelerated within the startup. One of the key issues for startups is that patents take so long to get granted, typically three years or longer. By licensing-in a startup can have a real and defendable patent position much earlier in its life-cycle.
2. A new model that is emerging in the U.S. is a form of “outsourcing” of startup patent portfolios. Acacia Research Corporation, for example, will purchase patents of a startup and provide a “lease back” license. This enables a startup to get the benefit of the commercial monopoly granted to it by its patents, without tying up all the capital required to build and maintain a patent portfolio. For Acacia Research the benefit is that they get to seek patent monetization opportunities for the patent portfolio outside of the field of practice of the startup. I expect many new and diverse models for outsourcing of startup patent portfolios to emerge over the next few years.

On a tactical front there are many ways to reduce patent budgets. Here are some of the key approaches:

1. Take great care when using large attorney firms. These typically have high fees and also many practiced ways to extract money off their customers. One example is high mark-ups on foreign filing activities through associates.  Where low-cost introductory work, like drafting of provisional applications, is offered, ensure there is a clear understanding of the charges for later work.  
2. Work only with patent attorneys who are experts in a specific area of activity. This leads to more attorney-focus and feedback, and often better results at lower costs. Shop around for the best attorneys, not the best attorney firms. Often, for example, a canny startup may have three vaguely unrelated areas of patenting and use three attorneys from three different attorney firms rather than three partners from the same firm.
3. A startup should have its own IP manager, possibly part-time, to manage a portfolio and even to do the first drafts of patents. This saves a lot of money and also ensures that the administration load (which can be very large) does not distract the key employees. Such IP managers can also directly manage foreign associates. Another benefit of a professional IP manager is to ensure due process, such as proper assignment of inventor rights to the company, are in place. Many startups are an administrative mess, and this only becomes apparent when a third party is doing critical due diligence in, say, an investment round or an acquisition of the startup; in these cases a failure to have rigorous administrative processes for patent matters can be fatal. 
4. Carefully choose countries (jurisdictions) where patents will be pursued. The number of jurisdictions should be minimized to save costs, but in careful fashion so as not to destroy enterprise value. Sometimes, from a financial point of view, the smaller jurisdictions can be ignored because they do not impact exit value. Often U.S. patents are a must-have because trade sales are common to U.S. corporations. Decisions are often made based on the importance of patents to the business, for example, a “foundation” patent may be broadly filed across many jurisdictions whereas a less valuable patent might only be filed in the U.S. and the BRIC countries, or the specific jurisdictions of delivery of a start-up’s products or services. Germany is sometimes chosen as a jurisdiction of choice because it is a great place to enforce patent rights, whereas to a startup the rest of Europe just looks like a lot of filing costs.
5. Often start-ups also face key choices in timing. There are means within the patenting process to delay or accelerate the full examination of patents. Fast examination is great from the point of view of getting granted patents and increasing enterprise value. But it also means earlier and higher patenting costs. It’s a balancing act that has to be well considered.
6. In some contested areas of technology, or where the proposed products are marginally inventive, it is sometime a good idea to drop all of the early product and technology ideas into a “placeholder” patent application on behalf of the startup, with the intention of filing a large number of divisional patents at a later date. This approach reserves the right to protect a number of potential invention claims, but potentially comes at a price of early and incomplete disclosure, limiting what can be subsequently claimed. As in all things “patent”, it is a balancing act which is best navigated with the benefit of experience; if you don’t have it, then get some advisers that do.

What does a startup do when it has granted patents and it finds a third party infringing its patents? My advice is to seek assistance from a litigation funding company; these guys are becoming interested in patent enforcement actions for startups, but typically only where infringement has been happening for some time, and a hefty damages liability has accrued.  If these entities are interested in financing and pursuing the infringer, a startup may get the benefit of reduced competition (if the process is successful and the infringement was in the direct area of practice), and they also may get to share in the financial proceeds of any such enforcement. Very few startups have the resources, both financial and in management time, to directly manage the process of enforcing their patents.

Insurance against patent infringement is also available.  Historically start-ups would only insure against infringing patent rights of others (if they insured against IP risk at all), but now it is possible to obtain cover against the risk of a start-up’s own patents (and other IP) being infringed.  Of course, enforcement insurance won’t help if the infringement has already started, so it’s necessary to insure, and start paying premiums, at an early stage.

In the modern era of patent “portfolios” it has become clear that a single patent holds much less value than in previous eras. In the liquid market for patents (as embodied by the world of non-practicing entities) a single patent often has little value because a party looking to monetize a single patent might be blind-sided by some hidden prior art which invalidates the claims of that patent. There is so much prior art in the world that it is virtually impossible for patent examiners to thoroughly test novelty and invention. As a result companies must now choose to either operate without patents, or develop large patent portfolios with at least 20 or more patents.

For startups the decision to patent, or to not patent, is often influenced by how “open source” the area of commercial activity is. For example, in some areas of smart phone apps, say games, a vast majority of companies operate without a single patent. Having said this, in this same area there are a small number of patent companies extracting huge rents via enforced licensing from these same majority of companies who do not have their own patents. Which one would you rather be?  In other areas, e.g. drug discovery, the idea of operating sans-patents is unthinkable.

In most areas of startup activity the smart money is on having patents, and the smart move is figuring out how to finance the creation of a patent portfolio.  At a high level this can be understood by realizing that startups are typically moving into “white space” areas of technology, and this is exactly the space where high-value patents can be obtained. A failure to get finance for the patent budget is an implicit admission of flaws in the value proposition of the startup, either in the choice of the area of technology and commercial opportunity and/ or in the skills and know-how of the entrepreneurs and investors.

[This post originally appeared at Accordia IP.]