July 20 (Bloomberg) -- Patents rarely make headlines, but they did this month when Nortel Networks Corp., the defunct Canadian telecommunications giant, auctioned off its patent portfolio and drew an astonishing winning bid of $4.5 billion from a group of companies that includes both Apple Inc. and Microsoft Corp.
The sale marks a watershed in the maturity of intellectual property markets and a dramatic shift in strategy for technology companies. Suddenly these companies are acknowledging that patents are a strategic asset worth billions.
Here’s an inside look at what happened -- and what’s at stake -- and remember, as you read this, that my company buys and licenses high-tech patents.
Most big tech companies inhabit winner-take-most markets, in which any company that gets out in front can develop an enormous lead. This is how Microsoft came to dominate in software, Intel Corp. in processors, Google Inc. in web search, Oracle Corp. in databases, Amazon.com Inc. in web retail, and so on.
As a result, the tech world has seen a series of mad scrambles by companies wanting to be king of the hill. In the late 1980s, the battle was for dominance of spreadsheet and word-processing software. In the late 1990s, it was about e-commerce on the emerging Internet. The latest whatever-it-takes struggle has been over social networks, with enough drama to script a Hollywood movie.
In each case, the recipe for success was to bring to market, at a furious pace, products that incorporate new features. Along the way, inconvenient intellectual property rights were ignored.
Copyrights Are Easy
Yes, copyright was almost religiously enforced. Copyrights are trivial to obtain (just type the “c” in a circle symbol), and software companies see them as essential to restraining piracy, which hurts revenue. Patents are a different story, however. It takes time for engineers to apply for patents and even more time if they diligently respect other people’s patents. So technology companies typically did neither.
In fact, many tech companies forbid their engineers from checking whether their products incorporate others’ patents. The practice amounts to an intellectual property version of “don’t ask, don’t tell.”
As tech giants commercialized ideas that had been pioneered by small companies and merged once-separate technologies into new products, they infringed other people’s patents. Personal computers took over publishing, photo processing, cash handling and a million other functions once performed by other companies’ patented products. Smart phones likewise displaced more specialized devices, such as GPS units and bar-code readers. When the TV commercial says, “There’s an app for that,” the “that” part is sometimes covered by patents the app creator doesn’t own.
Once tech giants got to the top, they realized that their cavalier treatment of patents had left them vulnerable. If you already control 90 percent of the market, your own patent portfolio does little for you. But outside patent owners sometimes show up and ask to be paid. Last month, the U.S. Supreme Court decided that Microsoft, the company I used to work for, must pay almost $300 million to a Toronto-based company called I4i LP, which claimed its patented technology was used in Microsoft Word. All tech companies face this sort of claim, and they’re not happy about it.
The biggest companies, which have always touted their brilliant innovations to justify the billions of dollars in stock options they pay their executives, have been in the odd position of attacking the patent system and publicly deprecating the innovations of others. Patents attempt to create a level playing field, but the last thing an 800-pound gorilla of a company wants is a fair fight. After succeeding in part by stealing other people’s inventions, they decry any inventors who have the temerity to ask for a share of the returns.
In Congress, lobbyists for every major semiconductor, software and Internet-services company worked for seven years to undermine the much-needed patent reform bill and to delay its passage. (The House and Senate each recently passed a version of the bill; they are now working to reconcile the two measures.)
Yet even as that was going on, a growing number of tech companies started to discover that patents might be useful after all. In 2009, Micron Technology, a major computer chipmaker, transferred about 4,500 of its patents to a renowned patent litigator in the hope that he could make some money on them. And in the past two years, Microsoft has sued companies that were using the Linux computer operating system and Android, Google’s mobile-phone platform, to collect on what it viewed as its share of the patent liability that is hidden in a lot of “free” software.
Attack by Apple
It isn’t just about the money; these are also strategic moves. Apple, flush with the iPhone’s success but understandably worried that it might wind up becoming the R&D outfit that prototyped ideas that made others rich, has recently sued HTC Corp., Samsung and others. Just last week, the company won a preliminary ruling from the International Trade Commission, which if upheld will prevent HTC from importing smart phones into the U.S., essentially wiping out its business here.
Microsoft and Apple could have sued Google; most of the disputed features are in Android code. Instead, they elected to sue Google’s customers as a way to avoid an all-out war with the search giant -- reminiscent of how, in the Cold War, the U.S. and the Soviet Union used to battle by proxy in places such as Vietnam. Oracle, buoyed by patents it got in its acquisition of Sun Microsystems, was less circumspect; it sued Google directly.
These tussles set the stage for Nortel to put on the block more than 6,000 patents and patent applications, which cover many features of current and future mobile phones, in an auction orchestrated by Lazard Ltd. Analysts at my company and elsewhere in the industry found that the patents were good, but what made them extraordinary wasn’t their quality -- it was simply that they were on the market and hadn’t been widely licensed. Just six months ago, the expected selling price had been $200 million to $400 million -- a lot of money, but still a pittance compared with the prize of being the biggest winner in the smart-phone business.
Google then made its move, tendering a public stalking-horse offer of $900 million that sent shock waves through the industry. Even stranger, its offer allowed Lazard to shop the deal for several months.
Many people were surprised that Google stepped forward; it has consistently been one of the most outspoken critics of the patent system, presumably because it faces enormous potential patent liability. Even its basic business model of advertising-supported search was first invented and patented by a company called GoTo.com, which sued Google for infringement in 2002. Google settled the lawsuit shortly before its initial public offering in 2004.
The amount of Google’s offer was unexpected, but the high price made perfect sense. Google has very few of its own patents; with Nortel’s portfolio, it could change the balance of power in the smart-phone industry. It could threaten to countersue any company that attacked Android, or it could even take a page from Apple’s book and go on the attack. Such potent ammunition in the battle for smart-phone supremacy could be worth far more than $900 million.
A third shocker was how Google structured its public bid. Neither I nor anybody I have spoken with can explain what Google was thinking. Had it simply waited for the auction, it easily could have won. Other bidders had much lower expectations and wouldn’t have had the time to get board approval for bids large enough to stay in the game.
Schemes and Counterschemes
Instead, the stalking-horse offer set in motion unprecedented scheming and counterscheming among strange bedfellows. Companies that normally fight one another, such as game-console rivals Microsoft and Sony and smart-phone rivals Apple and Research in Motion Ltd., pondered whether they hated the prospect of a patent-powerful Google even more. Investment companies like mine, which had been interested in Nortel’s portfolio for its potential financial return, decided the bidding was too rich for our blood, and dropped out. As the auction neared, rumors flew about who was teaming up with whom and how high the bids would soar.
Then, as the auction began, Google unveiled one more surprise. Its bids were numbers like $1,902,160,540. That’s a billion times Brun’s constant, which appears in the mathematics of prime numbers. And its successive bids were other mathematical constants, including one for pi billion dollars ($3,141,592,653).
Math geekiness, it turns out, doesn’t guarantee victory. A consortium of six other companies -- Microsoft, Apple, RIM, Sony Ericsson Mobile Communications AB and EMC Corp/Massachusetts -- won with an astounding $4.5 billion bid.
The result effectively retains the status quo. Google still has no strategic weapon to compensate for the patent liability inherent in Android, so the lawsuits will continue. Some in the industry think Google acted brilliantly; the company is no worse off than it was before, and it cost its competitors $4.5 billion. Others argue that Google was somehow snookered by Lazard into a disastrous strategy that has left its competitors better armed for the fight -- and more than a little angry. You don’t pay $4.5 billion for assets and then let them sit on the shelf.
More importantly, this sale validates the notion that patents will be a fundamental tool in the tech industry. They had been moving toward that position for years, but the magnitude of Nortel’s sale shows that they have arrived. Patents virtually define the pharmaceutical and biotech markets, and in the future they could play the same role for tech.
What’s next? The history of mergers and acquisitions suggests one possibility. Once upon a time in the clubby atmosphere of corporate America, hostile takeovers were rare; gentlemen just didn’t do such things. Then, in the 1960s, the hostile takeovers came to be accepted as a legitimate business tool. Similarly, the strategic use of patents now appears to be accepted in the technology industry. If that’s true, then Nortel is just the beginning.
(Nathan Myhrvold, the former chief strategist and chief technology officer at Microsoft and the founder of Intellectual Ventures, is a Bloomberg View columnist. The opinions expressed are his own.)
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