patent demand letters
PAEs

Patent Trolls Eat Startups First. Here’s What You Can Do About It

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The Changing Of The Enterprise Guard

Editor’s note: Leonid (“Lenny”) Kravets is a patent attorney at Panitch, Schwarze, Belisario and Nadel, LLP in Philadelphia, PA. Lenny focuses his practice on patent prosecution and intellectual property transactions in computer-related technology areas. He specializes in developing IP strategy for young technology companies and blogs on this topic at StartupsIP. Follow Lenny on Twitter @lkravets.

Patent assertion entities (PAEs or trolls) regularly engage in the practice of sending patent demand letters to unsuspecting startups and small businesses in preparation for going after much larger entities. A patent demand letter is typically sent by a patent holder to a company it believes is infringing the patent, and in the letter, PAEs offer a license to the patent. Typically, such demand letters ask for an upfront payment for past damages and royalties on sales going forward. Small businesses receiving such demand letters often lack the overhead necessary to determine and execute an effective strategy with which to respond, which can have serious ramifications on the operations and viability of a small business.

In a recent study entitled Startups and Patent Trolls, Professor Colleen Chien of Santa Clara University School of Law finds that PAEs have a strong effect on small companies and startups. Specifically, Professor Chien focused her study on the effect that receiving patent demand letters sent by PAEs has on these companies.

The findings of the study are based primarily on responses to a non-random survey of small tech companies and startups, as well as interviews with some key stakeholders. Of the 223 survey respondents, almost one-third (79) indicated that they had received a patent demand letter. Of those 79 respondents that received patent demand letters, 13 had revenue of under $100,000 showing how indiscriminate PAEs can be in their patent assertion campaigns. The study, using a comprehensive database of patent litigations developed by defensive patent aggregator RPX Corp., also revealed that at least 55 percent of defendants in lawsuits initiated by PAEs make under $10 million a year in revenue. In contrast, practicing entities (non-PAEs) only initiated patent litigation about 16 percent of the time against defendants making under $10 million a year.

Considering the expense of patent litigation, targeting companies with such small revenues would not ordinarily appear to be a wise strategy. However, such litigations against smaller targets, with less money on the line, allow PAEs to establish favorable royalty rates and run up a count of parties that have licensed prior to going after larger entities that will provide a more significant return. In this way, small business may be considered the appetizer to the large company entrée.

Troubling Effects

While patent litigation is expected to affect a business, the study’s finding that PAE’s use of demand letters against small companies can have a significant operational impact on those companies is troubling. Professor Chien defines significant operational impact resulting from a demand letter as being a business strategy pivot, product change, delay in hiring or meeting operational milestone, reduction in value of the company, and/or shutdown of the business.

Among the survey respondents, about half of companies making less than $100 million in revenue reported that receiving a patent demand letter had a significant operational impact, while none of the companies with revenues above $100 million reported any significant operational impact as a result of receiving a patent demand letter.

Based on responses to Professor Chien’s survey, several strategies appear to be prevalent in response to receiving a demand letter: 22 percent of companies “do nothing”; 18 percent of companies settle; and 35 percent of small companies or startups fight either in court or out of court. The average settlement cost is $340,000 among 12 respondents, the average in-court cost of fighting is $857,000 among seven respondents, and the average out-of-court cost of fighting is $168,000 among 18 respondents.

In some cases, creative settlement terms have included giving up equity in the company, as well as graduated licensing fees.  Though the survey’s sample size is fairly small, the numbers for in-court costs of fighting are similar to the findings of the American Intellectual Property Law Association Report of the Economic Survey for 2011, which found that for litigations with less than $1 million in controversy, the average costs through the end of discovery are $490,000, and the average costs through trial are $916,000.

It should be no surprise that with such a potential impact on the business from receiving a patent demand letter, the common reaction for many business owners is to become concerned about the effect the patent demand may have on their business and their ability to get funding. Many small businesses simply lack the knowledge and information necessary to properly address the threat of a patent demand to their businesses.

(Non)Response Ramifications

The result is that many companies still simply take a license in response to receiving the letter without fully understanding the ramifications of their actions, because it is often cheaper to take the offered license terms than it is to pay for legal analysis, negotiation and/or defense. Unfortunately, information about easy targets for patent assertion travels quickly among the PAE community in the absence of negotiated confidentiality agreements. Often, licensees of a PAE are even listed on the PAE’s website, giving the other PAEs a list of easy targets.

Those companies that respond without further research are putting themselves at a significant disadvantage.  Patents, and especially the claims of a patent, that define the legal scope of the patent are notoriously difficult to understand. PAEs take full advantage by providing little or no information regarding how the patent may apply to the targeted business. Furthermore, while there are obligations for a patent holder to perform a good-faith investigation of infringement prior to commencing a lawsuit, no such standard exists to merely fire off a demand letter to a target company.

Unfortunately, there is usually little reliable information that is freely available as to what a patent actually covers to help the company understand its potential liability. Since patent claims are often difficult to understand, companies usually do not have information about available prior art that may help show that the patent is invalid in the first place. Further compounding this problem is the fact that small businesses are often prohibited from discussing their strategies in responding (or not responding) to such patent demand letters in public by the license terms offered by the PAE. Thus, each company is left to fend for itself without understanding which strategy works best against the particular PAE they are dealing with.

As pointed out by Professor Chien, many of the currently proposed legal reforms do not address these problems that are unique to small businesses with limited resources to hire legal representation, such as their lack of relevant information and cooperation. While the new post-grant review provisions in the America Invents Act may help prevent “bad” patents from being issued or being enforced, this process may cost upwards of $100,000 to $400,000. Similarly, the proposed SHIELD Act may force patent trolls to pay the defendant’s legal fees, but the defendant must still first spend time litigating to invalidate or prove non-infringement, and then seek successful collection from the PAE.

Strategies For Dealing With Trolls

To address this knowledge and information gap, Professor Chien proposes “collective, self-help-based solutions such as joint defense efforts and industry association groups.” As she further commented for this article, “the costs of assertion have been driven down by PAEs, the costs of defense could also be reduced if companies worked together to promote their common interests, for example in invalidating a patent with which they are threatened.”

This is an excellent suggestion that may help reduce the attractiveness of small business to PAEs, but it relies on small businesses overcoming their reluctance to sharing information about being the target of PAEs. In fact, such public information about patent assertions is becoming more common on the technology blogs, and efforts to organize it and share it should be encouraged.

It is a patent holder’s right to enforce their patents against infringers and to choose who they target.  However, Professor Chien’s study confirms that in commencing attacks on companies, PAEs often choose to initially target companies that are not in a financial position to defend themselves. Returning to my appetizer/entrée analogy, since PAEs typically come after small businesses in preparation for litigation against larger entities, they are usually not looking for protracted battles with limited upside that may damage their chances against more lucrative targets.

For example, the threat of identifying strong prior art that is not yet of record in the patent (that may hurt the PAE’s chances against the more lucrative targets) may be an effective tool in responding to a PAE.  Therefore, small businesses need to understand the options and strategies available to them. Even a few hours of legal advice from a patent professional that understands the unique challenges of small businesses can be invaluable in formulating a strategy for responding (or not responding) to a patent demand letter.