Secondary Patent Markets: A Possible Role for Startups

Prof. Robert P. Merges, University of California at Berkeley School of Law
May 17, 2012

The secondary patent market is red hot these days.¹   The focus, almost exclusively, is on the purchase and sale of large-scale patent portfolios.  Some of these transactions stem from technologies that are no longer considered strategically crucial to the selling company – often, in recent years, after a corporate acquisition.  Others are what might be called exit events for large, once-thriving companies.  The Nortel patent auction is a case in point, and the proposed sale of Kodak’s patent portfolio also fits this profile.

So far, there is little data on the overall economic impact of the secondary market.  Large companies are clearly using patent portfolios as a new weapon in various strategic contests, most notably in the mobile phone industry.  Here patent portfolios define and protect vast ecosystems; big companies with many patents use their portfolios to protect allies (such as handset manufacturers and application writers) and fend off competitors, as part of the larger contest for mobile phone platform dominance.  It remains to be seen just how effective patent acquisitions will be in this context.  The same can be said about the long-term effects on R&D and innovation – it’s too soon to tell what the overall impact will be. Industry members are watching, as are the regulators, of course, but as yet we cannot say whether the secondary patent market is just a new move in the same old competitive game, or whether it will affect the prospects of the big companies or the overall rate of innovation in the long run.

What About Startups?

One thing we can say for sure at this point is that the role of smaller companies, or startups, in the secondary market has been overlooked.  Most of the attention has centered on the big-company transactions.  This makes sense, since a story with dollar figures in the billions is intrinsically more newsworthy than one with figures in the mere millions.  Yet at the same time if we know anything about innovation, and economic growth generally, it is this: The real action is often in the small firms.  It is a truism by now that most jobs are created by small companies; that small startups move more nimbly and point the way to the future more surely than large incumbents; and of course, that tomorrow’s behemoth can be found, in nascent form, in today’s startup or smaller firm.

Which leads to a natural question: What impact, if any, might the secondary patent market have on smaller firms, on startup companies?

The answer is so far quite speculative.  There are even fewer data on startups than there are for large-company patent transactions.  What data there are, however, provide some intriguing hints.

Startups and Platform Industries

Mobile telephony is a good example of an industry that is driven by technical standards and a “winner take all” dynamic.  The reason, conventional wisdom by now, is that each user benefits from sharing the same platform adopted by many other users.  The more of us who buy an iPhone or an Android phone, the larger the market for iPhone or Android applications, the more applications are available, and the easier it is for us to share information between applications and phones.

Platform industries quite naturally converge on a few large platforms.  When these are proprietary – when the few dominant platforms are owned or controlled by large companies – this obviously limits the role that startup companies can play.  At the limit, there are very few startups at all.  This may be the case in very mature platform industries in which most of the complementary technologies and extensions of the dominant technology have been explored and exploited.  Telegraphy comes to mind; until the advent of the Internet, Western Union dominated this mature industry, and virtually every location where telegraphy made sense was connected to the Western Union network.

But there are many platform industries that are far less mature, and in which creative and innovative applications and extensions are still feasible and potentially lucrative.  In these, startups can and do still thrive.  Typically, a startup will try to position itself as the supplier of an independent, free-standing component that is easily integrated into the dominant platform.  So it is with various applications that run on the iPhone or Android.  Though this strategy often involves some level of cooperation with the platform owner, it is often viable, at least for a time.

Often, however, there is some logic to the absorption of the independent component into the main body of the platform.  When this is the case, the platform company faces a classic “make or buy” situation.  Does it try to recreate the success of the independent component maker, or simply buy a smaller component company outright?  Examples of both approaches abound: Consider the development of Internet Explorer at Microsoft (to compete with Netscape, the browser component of Microsoft’s operating system); and on the other hand the acquisition of Skype by Microsoft, or YouTube by Google (seen as the video component of search).

Patents as Drivers of Startup Acquisitions

The maker of a dominant platform that decides to acquire a smaller component company may be interested in technology, personnel, IP rights, or some combination of the three.  The Skype and YouTube acquisitions, for example, seem to have centered on technology and people (and brand name, too).  But there are plenty of examples of patent-driven acquisitions.²  In these cases, the acquiring firm usually has the full technological capability to make the component.  But one or more small, specialized companies may have pioneered or contributed to the development of the component – and have the patent portfolio to prove it.  In these cases, because of general technological diffusion, the dominant platform company may not need the expertise of the smaller firm in order to make and integrate the component into the platform.  In other words, the platform company may already possess the technological capability to make the component.  But the specialized smaller company may have some of the basic patent rights to it, and that is what the platform company is acquiring.

It is of course a short step from a full acquisition that is driven by patents, to the purchase of a group of patents (or even a single patent) unconnected to any other corporate assets.  Complete acquisitions, when driven by the patent holdings of the acquired company, thus appear simply as a special case of a more general strategy.  And in this strategy, the patents are the point.

The Case for the Patent Market

Taking all of this together, we can make out a case in favor of the secondary patent market – an argument that this market increases social welfare generally, and encourages startup companies specifically.  In industries characterized by dominant platform firms, the argument has these elements:

1. Patents represent actual contributions to a component of the platform.  They represent evidence that, even though the dominant (acquiring) platform firm may not need the startup for its technological capabilities, the patent(s) held by the startup represent real contributions to the technology, e.g., basic insights that have already diffused around the industry prior to the acquisition.
2. Given the propensity for only a few large platform companies to dominate, the patent-driven acquisition of a startup, or the acquisition of startup patents alone, represents an important payout event for the startup – an exit or partial exit that compensates the startup for its pioneering work.  Patents help a startup to be successful even when it does not beat the long odds and come to compete in the platform market itself.
3. Investors understand that patents add to the exit options available to startups and increase their investments in startups accordingly.  Though there is a cost to relying on patent-related exits (i.e., greater upfront expenditures to file for and obtain patents), the possibility of these exits adds to the prospective profitability of the startup – and hence leads to greater investment.

Of course, this is just an argument – a case in favor.  There is a counter-narrative that must also be taken seriously.  A startup that is a follower, and not a leader, might obtain patents that represent not pioneering contributions but clever instruments for holding up the dominant platform company.³   Or a platform company might be a true independent inventor, having in fact used nothing in any platform component that owes its origin to a startup company.  In these scenarios, the secondary patent market will not come off looking as good.

Only experience and empirical inquiry will determine the true value of the secondary patent market.  But it is important to understand that when it comes to platform industries, it is possible that the secondary market might serve some useful purpose, for startup companies in particular.