Guest post written by Fabio Marino and Teri Nguyen
Fabio Marino is a partner and Teri Nguyen an associate with McDermott, Will & Emery.
Long thought to be immune from the threat of patent litigation, startups have recently experienced a sharp rise in patent suits brought by non-practicing entities, sometimes mockingly referred to as “patent trolls” or simply “trolls.” A new study by Santa Clara University School of Law professor Colleen Chien suggests that recent patent reform legislation, aimed in part to reduce patent troll litigation, may have produced the opposite result, making startups a target for patent trolls.
Patent Trolls
Trolls are in the business of acquiring patents from individual inventors or small companies and using them to generate revenue through either licensing or litigation. Because trolls do not make products, they are largely seen as parasitical entities by many in the high-tech industry. A typical strategy of patent trolls has been to sue a lot of defendants (or even entire industry sectors) in the same lawsuit. This allowed trolls to litigate a single lawsuit, reducing their litigation expenses, while forcing defendants (which were often competitors) to share resources in defending the lawsuit. In part as a reaction to troll tactics, Congress enacted omnibus patent reform legislation know as the America Invents Act (“AIA”). The AIA made it illegal to sue multiple unrelated defendants together, and eliminated the trolls’ ability to attack entire industry sectors in a single suit.
The Rise of Litigation Against Startups
Traditionally, patent trolls have not targeted startups because they perceived them as not having the deep pockets that make the cost of litigation worthwhile. However, after the enactment of the AIA, the number of patent cases filed by trolls against smaller companies increased significantly. While the exact mechanism responsible for this development is still unclear, the timing of the increase in patent cases against startups relative to the AIA strongly suggests a causal nexus.
The passage of the AIA drove down the number of defendants named in patent suits, but also drove up the number of suits filed by trolls. This makes sense, since the trolls were forced to file separate suits, rather than a single, combined lawsuit. 2012 statistics show that trolls brought the majority of patent lawsuits filed in the U.S., 61% compared to only 45% in 2011. Interestingly, most of those sued were smaller companies based on the results of the Santa Clara study. In fact, the study also found that companies making less than $100 million annually comprised roughly 66% of the unique defendants named in cases brought by trolls and more than half of those defendants had less than $10 million in annual revenue.
Startups may be attractive targets for trolls because they are seen as vulnerable. For example, unlike large companies, startups often do not have with the financial wherewithal to defend against claims of infringement. Patent litigation is both expensive and time-consuming. According to the most recent AIPILA's Report of the Economic Survey, the average cost of defending patent suits with less than $1 million at risk is $650,000; the cost of defending patents suits with $1 million to $25 million at risk is about $2,500,000; and the cost of defending patent suits with more than $25 million at risk is over $5 million. Most startups simply cannot afford to foot these bills.
Additionally, litigation diverts the startup's limited resources away from developing its business. The cost of litigation alone (leaving aside any potential damages) may cause significant damage to a startup, including reductions in staff, changes to its products or services, or even a collapse of the business itself. The mere allegation that a startup uses patented technology of others can mar its reputation in the eyes of customers and investors, potentially driving down the value of the company.
Typically, a patent troll will offer a startup an opportunity to settle at the outset usually for a price which is lower than the cost of defending the lawsuit. Startups therefore must decide how to respond: ignore it, fight it, or negotiate. Each option has pros and cons. Let’s examine them one by one.
- Ignore?
The simplest strategy to implement is to ignore a troll’s demands and bet that the threat goes away since it is likely not in the troll’s best interest to pursue the litigation. This is, of course, risky if the troll decides to go through with the litigation. It is, however, a calculated risk, since trolls are ultimately driven by economics. It is also the cheapest option, at least in terms of legal expenses: the reported cost of ignoring an initial demand is approximately $2,400, far less than the cost of defense, according to the Santa Clara study. From a trolls’ perspective, whether a startup is worth pursuing to litigation will depend on revenue. The lower the startup’s revenue, the more appealing this strategy becomes.
- Fight?
Court battles are expensive and time-consuming, yet 35% percent of startups surveyed reported that they would fight back against trolls’ demands. This is indeed the most costly option, requiring on average $875,000 to $1 million to resolve. This could be a substantial portion of a startup’s annual revenue.
Before the AIA, startups were able to pool resources into joint defense groups and mount a common defense. However, the AIA has made it more likely that startups would have to go at it alone if sued. But opportunities may exist for the vigilant startup who investigates the plaintiff and discovers that it has also sued – albeit separately – other defendants. In that situation, it behooves the startup to consider creating or joining a common defense group.
- Negotiate?
Perhaps surprisingly, only 18% of responders considered settlement, that is paying a license fee to use the patented technology, as their primary strategy. Indeed, the average cost of settling was $340,000, roughly 13% of the company's annual revenue. However, when considering the stress and expense of a full blown lawsuit, and the startup's lack of leverage, paying only a fraction of the potential cost of a defense could be a viable trade.
Patent trolls, of course, are more than willing to settle. For the troll, an early “nuisance” settlement means money without having to actually prove the merits of the case or value of the patents. Importantly, this also means a recorded victory further legitimizing the patents, bolstering their perceived value and inflating their reputed threat against larger defendants. Realizing this can give a startup a stronger negotiating position. A startup with little revenue may be more willing to pay a higher royalty rate on that revenue. In a sense this may be a win-win situation.
Intuitively, if a startup chooses to settle, it is more cost efficient to do so at the outset. The most inefficient strategy is to fight first, incurring significant litigation expense, and then have to settle for no additional benefit.
Whether a startup chooses to fight, negotiate or play dead will ultimately depend on its stomach, constitution, and an understanding of what it has to lose. Any one of the strategies described above could be the right strategy under the appropriate circumstances. As a result, startups should consult with experienced counsel who understands the dynamics of troll litigation as soon as the threat arises to determine the most strategically sound option under the circumstances.
