Patently Absurd

April 15, 2010

The topic of software patents has been getting a lot of coverage lately, and I think it is one that angel investors need to take note of, as it can — and invariably will — impact software companies in their portfolios. In the interest of full disclosure, I have been on both sides of the patent issue in my software career: as the sponsor of patent filings; co-inventor on patent applications (one still undergoing review); deponent for defense in litigation; and admittedly as an investor asking the question: “what sort of IP protection do you have?”

With the exception of the one instance being sued by a patent troll, I never gave the topic a lot of thought. When in small companies, I thought of patents as a fair way to provide some added defense in the ongoing battle against competitors large and small. When in larger companies, I accepted patents as part of the larger armory of legal tools that kept big competitors from suing each other into oblivion – a form of mutual assured destruction for the business world.

But that once instance with the troll was really, REALLY annoying. It taught me that there is a special class of company – typically small and unsuccessful at their core business – that doesn’t really value innovation, but instead sees the opportunity to use a legal instrument to build a business around. They are the bottom feeders of the technology world, and unfortunately their numbers are growing.

As an investor today, I often catch myself asking companies if they have any IP protection. In truth, I’m not all that biased by the answer, but want to know if the company has thought about it and how deep their innovations go. Essentially, the existence of a patent or patents tells me how the entrepreneur is looking at the market: a “better mousetrap” entrepreneur starts with IP, but a “change the world” entrepreneur starts with the customer and the business opportunity.

The reality is that for small companies – startups and even established SMBs – patents are an ugly trap. In a post earlier this week, Brad Feld talked about the various types of software patent plaintiffs, and referenced a previous post by his secret lawyer friend, Sawyer, entitled Why the Decks are Stacked Against Software Startups in Patent Litigation. I suggest that entrepreneurs give both of these a good read to understand the dynamics of the patent litigation process. Those who have been through patent litigation know that the answer is never as simple as did or did not infringe, because so many software patents are vague and over-reaching.

So litigation is the key, because without litigation a patent doesn’t have a lot of value. If a company wants to defend its patent, it will have to sue – or be sued. And therein lurks the struggle for the entrepreneur: many believe that a patent will help them attract funding and protect them from evil competitors – a magic talisman for startups. In practice, it often becomes a useless time- and money-sucking exercise that never comes into play, because to defend it costs more than the startup can afford. Entrepreneurs have to ask themselves if chasing alleged patent infringer is in their business plan, or even in their DNA. If you want to build great products and solve hard problems, you typically don’t start by hiring lawyers (apologies to my lawyerly friends).

Thinking about this issue, I tried to fit the dynamics into the ubiquitous 2×2 matrix, with company size (big and small) on one dimension, and patent strategy (defensive or offensive) on the other. The result left a void: large companies pursuing an offensive patent strategy (“offensive” meant here in the “aggressive” and not necessarily the “odious” sense). None came immediately to mind, but a recent NY Times article on Intellectual Ventures (IV) in the Seattle area provided a possible candidate. Admittedly, the IV strategy isn’t perfectly transparent, but they are very well funded and are attracting lots of customers and impressive revenues. For now, I take them at their word that they are trying to improve the marketplace for patent cross-licensing, and providing value to companies both large and small.

So we have a complete picture of the world:

 

On examination, I ask myself which of these strategies we (as an industry and body politic) really want to encourage through the issuance of software patents. With the exception of providing the software startup with some kind of short-term defensive tool during their earliest stages, I can’t see that any of these are more than manifestations of the inefficiencies inherent in the market today. And for the software startup, copyright and trade secrets should provide adequate protection while they raise money and enter the market.


Solving a Non-Problem for Angel Investors

March 25, 2010

Or, in this case, creating problems that didn’t exist before… Robert Litan of the Kauffman Foundation calls out a section of a reform bill passing through the Senate Banking Committee in the Huffington Post: Proposed ‘Protections’ for Angel Investors are Unnecessary and Will Hurt America’s Job Creators. It’s a fine example of legislators being horribly disconnected from the issues on the ground. Let’s hope this dies fast.


Who’s not writin’? John the Regulator

January 2, 2010

The Securities Acts of ’33 and ’34 established some interesting dynamics in the financing of private equity investments. At one end of the spectrum, we have funds (venture capital, buyout, distressed asset, mezzanine, and many variants). These are usually established as limited partnerships; restricted to at least accredited investors (individuals and/or institutions); and operate on a combination of management fees and carried interest. To date, funds have to date been mostly unregulated: the assumption being that if appropriate disclosures are made to a limited class of investors at inception, investors and fund management agree on terms, and the fund managers don’t run off to Brazil with the investor’s money, then everybody’s done their bit.

At the other end of the spectrum are transaction agents: variously called brokers, dealers, merchant and investment banks. These entities don’t typically manage money; instead they bring together investors and opportunities for a fee. Fee structures range from fixed amounts for capital formation advisory services and retainers, to a percentage of the capital raised. These organizations are very highly regulated: requiring testing and certification of the professionals; registration of the firms with an industry self-regulatory organization such as FINRA; indemnification and capitalization minimums; audits and other compliance measures. Not surprisingly, engaging an investment bank to raise startup capital can be prohibitively expensive. 

Somewhere in the wilderness between these two are “finders”: consultants, advisors, networkers and others who bring together investors and entrepreneurs for something in return. The securities industry has a less flattering name for these folks: “unregistered broker/dealers”, implying a level of sophistication that is usually absent. Instead, finders are often primarily engaged in some other business, but on occasion take remuneration for connection-making. Sometimes that remuneration is cash, sometimes equity. Irrespective, the law (sorta) says that if you want to be compensated for raising money for someone else, you have to be a registered broker or dealer. If found guilty of impropriety, the finder is not only subject to individual penalties (fines and presumably incarceration), but the transactions they have been involved with are forever tainted, and can trigger exercise of investor rights all the way through to an IPO. 

I’m fine with establishing a level playing field for private equity fundraising, but the current situation falls way short. The reason is simple: finders aren’t strictly policed, and as anyone who has been around private equity for a while can tell you, the rules aren’t very clear. Granted, the SEC is pretty busy with nuisances like Madoff, Stanford and Rajaratnam, but the lack of clarity in legislation means very uneven enforcement, often based on the priorities of regional SEC investigators. Finders who fall potentially under this restriction, then, never know if they have ridden into Dodge City, or Tombstone

So why should angels care? Theoretically, organized angel groups fall under this classification if they collect fees from any of the parties directly involved in the transactions: i.e., the investors and the companies. Practically, this has been enforced only in the case of success-based fees, no matter which party bears the cost (investor or entrepreneur), and regardless of whether the fee is flat or a percentage of the raise. This leaves the professionally managed angel group with limited options for revenue (hence, sustainability), and takes away the potential to align the interests of parties to the transaction from the outset. I’ll look at the implications in the next post.