Risk Management

What Do You Know?

Tracking patent portfolios is not only critical for growth, it's necessary for survival.
Linda CormanJuly 1, 2006

When one of Mobility Electronics Inc.’s major customers decided to switch to a competitor’s product five years ago, the potential defection galvanized top management. Not only would it mean up to $10 million in lost revenue annually, says executive vice president and CFO Joan Brubacher, but Mobility held the patent on the product in question — a universal power adapter.

That fact didn’t sway competitor Comarco Inc., which Mobility immediately confronted. But it convinced the Scottsdale, Arizona-based company to launch a multi-million-dollar lawsuit. That ended in a settlement allowing both firms to use each other’s technology without licenses. It also convinced Brubacher to institute a formal process for managing patents — even though the managerial time commitment equates to a monthly expense of more than $60,000.

Until the Comarco suit, “there was no real process for determining which developments to patent and in which jurisdictions,” says Brubacher. “That litigation made us aware of how important intellectual-property diligence, not just the pursuit of patents, is to our business.”

As the Mobility example illustrates, keeping tabs on what patents a company holds, what they are worth, and whether anyone is encroaching on them may sound straightforward. But with millions of patents active worldwide, monitoring patent portfolios is a complex task — one to which many companies give short shrift. Part of the problem is that patent valuation is not currently required in any regulatory report. In addition, many companies — especially those with small but growing patent portfolios — have a false sense of security regarding these assets.

But several trends are converging to change those attitudes. For example, recent patent cases involving Ebay and Research in Motion have highlighted the practices of so-called patent trolls, companies that use patents solely as bargaining chips. At the same time, the risk that a patent dispute could cause a precipitous decline in a company’s value is increasingly. In April, for example, Momenta Pharmaceuticals’s stock slid 15 percent after an appeals court sent a patent dispute back to the U.S. District Court.

Global commerce means that patent infringement can occur anywhere, putting U.S. companies at the mercy of foreign courts. In some countries, says Ron Foster, CFO of FormFactor Inc., a Livermore, California-based maker of probe cards used in inspecting semiconductors, there is a “clear home-court advantage.” American companies, he adds, “better be able to protect themselves.” Foster knows of what he speaks: FormFactor sued Phicom, a Korean company that also sells probe cards, for patent infringement last year. Initially the Korean patent office backed the U.S. company, only to have an appeals court overturn three of the decisions. The Korean Supreme Court will now review the case.

Cease and Desist

Obviously, some companies are adept at managing patents. IBM, for example, has a global staff of 200 supplemented by a customized Lotus Notes database that tracks its intellectual property (IP) — assets that bring in more than a billion dollars a year in licensing fees. But for many companies, the process has taken a backseat to growing the business. In fact, only 31 percent of private companies in a new survey by PricewaterhouseCoopers have formal processes to manage their patents.

As basic as it sounds, effectively managing patents begins by centralizing the process. In many firms, there has been no one person or department assigned to track patents, says Robert Reilly, a valuation specialist at Willamette Management Associates. “That responsibility has been disseminated to individuals in plants, in the IR office, in engineering, and in the new-product-development office,” he says.

In early 2004, Mobility formed an IP committee, which includes the CFO, the CEO, general counsel, and the director of product management. The committee meets quarterly to review existing patents and new proposals, as well as potential infringements, says Brubacher, adding that any suspect products are analyzed by a team of engineers. Then, if a potential infringement is validated, the IP committee decides on a course of action — simple monitoring, an initial letter de-manding that the infringer cease and desist, or immediate legal proceedings.

At Cephalon Inc., a Frazer, Pennsylvania-based biopharmaceuticals firm, a patent committee with representatives from research and development, business development, sales, and commercial meets bimonthly to decide whether to maintain individual patents and, if so, in what countries, says vice president of IP Bob Hreubiec. Since maintaining patents is expensive, Cephalon also regularly prunes its portfolio for deadwood, adds CFO Kevin Buchi. He estimates it costs from $200,000 to $400,000 to protect a patent within the first three years, including filing, translation, and legal fees. “We constantly review and analyze to make sure we are getting the most value for our dollars,” he says.

Such analyses also allow a company to decide which patents it should let lapse and which it should acquire. At many companies, this effort is supplemented by outside patent-watch services that keep an electronic eye on filings and flag potential infringements. Other companies rely on outside counsel to keep them vigilant. At Ropes & Gray LLP in Boston, for example, clients have access to a spreadsheet tool that not only tracks costs associated with obtaining a patent but can also be customized to provide “a fine level of granularity” on the associated fees, says partner Edward Kelly. Those additional costs include maintenance fees required in the United States every four years and annual property taxes in foreign countries.

No One Valuation Method

Managing patent portfolios also means monitoring incremental incoming payments. Tracking licensing fees “is a very messy job,” says Kent Richardson, vice president of IP for Rambus Inc., a developer of high-speed interfaces. For example, if a patented product is broken in half or rebundled, it is not clear what portion of the original payment the licensee owes.

Visto Inc., a software developer for mobile data in Redwood City, California, requires that licensees submit monthly reports detailing the number of product users and what the licensee owes. CFO Stephen Anderson and a company attorney then review the reports and if the numbers differ substantially from the norm, Visto has the right to audit the licensee. “It’s sort of the honor system,” says co-founder and senior vice president Daniel Mendez, adding that Visto has never audited a licensee.

Often there are also royalty fees or other milestone payments associated with licensee arrangements, which present their own challenges. For example, sometimes regular royalty payments do not kick in until a licensee builds the patented technology into a product. Determining when that actually occurs is not easy, however. Also, royalty percentages frequently change over time. “And the licensees won’t remind you about patent payments,” says Michael Kayat, president of IP management consultants UTEK-EKMS.

To simplify its process, Rambus, which derives 80 percent of its income from royalties, doesn’t require licensees to pay for every chip on which its technology is used. As much as possible, it establishes licenses for which there are fixed quarterly payments that are not tied to usage, says Richardson. Fixed payments, which can be tied to a forecasted growth rate, eliminate accounting and auditing costs and provide predictability, he says.

Ultimately, patent tracking may be necessary for another reason: to determine market value. In fact, some authorities, like Kenneth Hautman, an IP lawyer with Hogan & Hartson, say courts could interpret Sarbanes-Oxley to mean that companies must track their IP’s value. However, the value of a patent can, at best, only be estimated, and there is no one method for arriving at a figure. “It’s extraordinarily tricky to value IP [in the absence of] litigation or if it’s not licensed,” says Marc Foodman, vice president of IP law at Avaya, a developer of communications networks.

The basic problem, says Gary Morris, a partner at Kenyon & Kenyon LLP, is that “there’s no definitive answer on how to do it.” The best method is known as the income approach, says Brian Blonder, managing director at consultancy FTI. But it has several variations, and to decide which is best companies must determine how they make money from their patents, he says. For example, if a company can charge a premium for a product because it has a patent, the value is derived from the difference between the price of the patented product and the nonpatented product.

The variation that’s most common, however, is the relief-from-royalty method, which Rambus used against Hynix Semiconductor in 2004. The method derives a value from what a company would have to pay in royalties to another company holding the patent if that company did not and is based on a revenue forecast and royalty rates paid for comparable transactions, says Matthew Pinson, managing director at PwC. In its case, Rambus asked the jury for between $108 million and $868 million based on what Hynix would have had to pay in royalties to Rambus between 2000 and 2005, according to court documents. The jury awarded $306.5 million.

Preventing Poachers

The payoff in tracking patents comes from flagging infringements — a task that should involve all employees. “Everyone needs to know that patents are valuable and must be protected,” says Reilly. “You don’t leave the warehouse door open.”

At Mobility Electronics, product-management teams are responsible for spotting infringements at trade shows and industry events, says Brubacher. But tips come from numerous sources. In late 2004, for example, a salesperson was told by a customer that Formosa Electronic Industries, a Taiwanese firm, was offering a product similar to Mobility’s. The incident was presented to the IP committee and a cease-and-desist letter was issued, and comparable letters were sent to a half dozen U.S. retailers carrying Formosa’s product. The case will go to trial later this year, says Brubacher, adding that “We were aggressive pretty quickly because their product showed up on store shelves.”

Linda Corman is a freelance writer based in New York.

Patently Obvious
The top 10 patent recipients for 2005
Rank Company Preliminary number of patents
1. IBM 2,941
2. Canon Kabushiki Kaisha 1,828
3. Hewlett-Packard Development 1,797*
4. Matsushita Electric Industrial 1,688
5. Samung Electronics 1,641
6. Micron Technology 1,561
7. Intel 1,549
8. Hitachi 1,271
9. Toshiba 1,258
10. Fujitsu 1,154
*Calendar year counts for 2005 for HP Development Co.;
includes 7 patents issued to Hewlett-Packard Co.
Source: U.S. Patent and Trademark Office

Taxing Truces?
The IRS considers cross-license agreements.

For decades, companies have sought to ward off patent-infringement lawsuits by signing cross-license agreements (CLAs). Now, much to the chagrin of these companies, the Internal Revenue Service is considering whether there should be tax consequences associated with such agreements. “Let’s just say, the IRS is ‘interested’ in [CLAs],” says Nicholas DeNovio, a partner with law firm Latham & Watkins and former deputy chief counsel (technical) with the IRS.

To garner more information, the Treasury Department and the IRS issued a notice in March requesting public comment on CLAs and outlining potential income- and withholding-tax consequences. Such agreements between U.S. and foreign companies give each the right to develop products without fear of being sued for patent infringement.

Several organizations, including the National Association of Manufacturers and the American Electronics Association, are voicing their concern that changing the tax treatment of CLAs will hurt the United States competitively and increase the cost of innovation. “These are just covenants not to sue,” says Dorothy Coleman, the NAM’s vice president, tax and domestic economic policy, adding that “foreign countries do not tax these agreements.”

Why the IRS is choosing to examine CLAs now is a mystery. But DeNovio expects that by early 2007 guidance will be issued on the subject, though not necessarily new taxes. Sometimes public-policy issues trump new taxation, he explains. But either way, he adds, “companies are looking for certainty in their tax position.” — Lori Calabro