In a recent episode of HBO’s Silicon Valley,[1] the show’s fictional startup team encounters a setback when they’re sued just before their company is about to receive a major venture funding round. As the news of the suit spreads, once-interested VC firms back away, leaving the future of the company in doubt.

“A young startup with an IP lawsuit hanging over its head? I wouldn’t want to be part of that team,” says the company’s lawyer.

“Yeah… it just sounds really expensive,” the founder responds, reeling at the cost of fighting the suit.

“Welcome to the business, Richie.”

The story isn’t a new one — just days before its planned initial public offering in 2002, PayPal was served with a patent infringement lawsuit. The filing managed to delay PayPal’s IPO by a week, all the while “damaging the company’s reputation and raising doubts that it would ever go public.”[2] According to PayPal, the plaintiff had never before alleged a claim of infringement; thus, the suit must have been designed to “disrupt PayPal’s initial public offering.”[3]

Similar claims have made the news for years, featuring tech giants such as Google, Twitter, OpenTable, and GrubHub Seamless.[4] The general assumption is simple: patent trolls are tactically timing their patent demand activity to take advantage of the economics of funding moments, most notably the IPO. In “Patent Demands and Initial Public Offerings,” forthcoming in the peer-reviewed Stanford Technology Law Review, we sought to undertake the first empirical examination of this behavior, with the goal of shedding some quantitative light on the question: do patent trolls really target companies for demands near major funding events?

Patent trolls, known in academic and policy circles as “patent monetizers” or “non-practicing entities” (NPEs), are entities whose core activity involves licensing and litigating, rather than making products using their patent holdings. The favorable economics of patent lawsuits have allowed monetizers to extract settlements and licensing fees from companies, regardless of the merits of their infringement claims. In many cases, the merits have been dubious at best. Nevertheless, patent litigation is expensive, and settling is generally more cost-effective for companies than fighting in court. Reform efforts to curb this behavior are currently up for debate in Congress, but new information about the extent of patent demand activity is still surfacing.

Our study contributes to the evolving understanding of patent demand timing. Using a publicly available database, we gathered data on more than 550 U.S. product-producing companies that went public between 2007 and 2012. We then found contact information for legal personnel, most often the general counsel, at more than two-thirds of these companies. Each of these contacts received a survey asking about their company’s exposure to patent demands near particular funding moments: namely, the first venture funding round and the IPO. Patent demands include not just actual lawsuits, but also less observable behavior, including licensing demand letters and threats of litigation.

Responses from over 50 companies confirm the anecdotal belief — the IPO moment is a particularly vulnerable period for companies to receive patent demands. Almost half of all responding companies received patent demands either shortly before their IPO[5] or within a year following its completion, while only 10% received demands before the first funding round or in the following year. Unsurprisingly, the majority of these demands were issued by monetizers, with 80% of affected companies receiving monetizer demands in the year following their IPO.

Technology companies were hit particularly hard by demands focused around the IPO. In particular, no technology companies received patent demands surrounding their first funding round, but more than half did near the IPO. Once again, almost all of the demands originated from monetizers. These findings are in line with research detailing the disproportionate impact of patent demands on technology companies and the high proportion of monetizer lawsuits in which software patents are asserted.[6]

Although our sample size is small, the results show that monetizers are issuing patent demands near company IPOs — but why? In our paper, we offer a few possible explanations:

• The “leverage” theory — An IPO is one of the most public and vulnerable times in a company’s development, requiring the extensive disclosure of information previously unreleased to the public as it receives SEC approval and attempts to win over investors. The ensuing scrutiny makes a company uniquely susceptible to negative publicity that could adversely affect the company’s valuation, reputation, or interest in the IPO. Knowing that soon-to-be public companies are interested in minimizing risk factors, monetizers may go after these companies hoping they can extract a quick settlement with little probing of the actual claims involved.

This possibility of leveraging around a pressure point has an analogy in corporate takeover litigation. Nearly every large merger deal in 2014 experienced shareholder litigation,[7] and behind these lawsuits may be a similar attempt to gain leverage. In fact, in a study of securities class actions, Baker and Griffith note that an impending corporate event, such as a merger or an acquisition, is often the impetus for a hasty and swift settlement.[8] Similar logic may be at play when monetizers make IPOs a target.

Using the IPO for leverage could have even more troubling aims. A company might sue a competitor it deems a threat in order to reduce the competitor’s take from its IPO. Or, taking this tactic one step further, investors might attempt to manipulate stock prices either before the share price is set or shortly after the stock has begun to trade. Manipulating the price immediately before an IPO could make it easier for a potential investor to buy a stake in the company. After the IPO, an investor could short-sell a company’s stock and then initiate patent-related legal action, hoping to drive down the price.

This type of behavior is not just armchair theory, but a worrisome reality – a recent Wall Street Journal article described the actions of one hedge fund manager who is short-selling stock in pharmaceutical companies and then challenging the validity of their patents.[9] If a pharmaceutical patent really is weak, then society’s interests might align with those of the hedge fund manager, making it perfectly acceptable to profit from taking the risk of challenging a bad patent. One would have to be certain, however, that both interests align tightly and that no market manipulation concerns exist.

• The “full pockets” theory — Perhaps the most straightforward explanation merely examines the influx of capital a company receives after its IPO. After all, Sutton’s Law, which cautions doctors to first consider the obvious when making a diagnosis, is apocryphally based on a quote from a bank robber who said he robbed banks “because that’s where the money is.”[10] Certainly, a company with newly full “pockets” might appear to be a good target for a patent demand. And the theory fits well with our observation that more companies received demands after their IPO than shortly before.

Another explanation might combine both the “leverage” and “full pockets” theories. After an IPO, a company should be much wealthier — but still publicly vulnerable. Early market performance is heavily scrutinized and factors into a company’s long-term reputation and outlook;[11] thus, settlements that may be painful in the short-term may be necessary to preserve the long-term sustainability and success of the business.

• The “visibility” theory — Our final theory hinges not on the economics of the IPO moment, but on information asymmetries that may be bridged by a company’s IPO. The publicity that arises from an IPO could make a patent holder aware of a potentially infringing company, or the public SEC disclosures could provide the patent holder with the necessary information to determine whether infringement is taking place. The theory could therefore provide an explanation for legitimate patent claims near the IPO. If this theory were actually the dominant explanation for the observed behavior, however, we would expect both monetizers and product-producing companies to increase their demand activity near the IPO. Yet, in our limited sample, product company demand activity remains consistently low throughout all of the periods we sampled, while monetizer activity starts low and then rises sharply during the pre- and post-IPO periods.

Of course, a realistic explanation likely combines elements of all three theories. As such, our evidence indicates monetizers are not targeting companies solely based on the legitimacy of their potential claims. The economics of patent litigation — and the economics of the IPO moment itself — are helping to drive assertion activity during this period. Thus, the IPO remains a particularly precarious time for growing companies, and that should be cause for concern for startup founders, patent reformers, investors, and securities regulators alike.

ENDNOTES

[1] Silicon Valley: Runaway Devaluation (HBO television broadcast Apr. 19, 2015).

[2] Verne Kopytoff, PayPal Shares Up 55% On First Day of Trading / IPO Raises $70.2 Million for Online Billing Service, S.F. Chronicle, Feb. 16, 2002, available at http://www.sfgate.com/business/article/PayPal-shares-up-55-on-first-day-of-trading-2872553.php.

[3] Answer, Counterclaims, and Demand for Jury Trial, Certco Inc. v. PayPal Inc., Civil Action No. 02-094 (D. Del. Feb 04, 2002), available at http://www.sec.gov/Archives/edgar/data/1103415/000091205702004798/a2070244zex-99_2.htm.

[4] See, e.g., Telis Demos, Yoree Koh & Matt Jarzemsky, Twitter Raises Sights in Heady IPO Market, WALL ST. J., Nov. 4, 2013, available at http://www.wsj.com/articles/SB10001424052702303482504579177541101538338 (describing litigation against Twitter before its IPO); Erin Griffith, Amid IPO, One of GrubHub’s Risk Factors Just Got Riskier, FORTUNE, Apr. 4, 2014, available at http://fortune.com/2014/04/04/amid-ipo-one-of-grubhubs-risk-factors-just-got-riskier/?iid=SF_F_MPM (describing litigation against GrubHub Seamless before its IPO).

[5] “Shortly before” was specifically defined in the study as the period between filing the first version of Form S-1 with the SEC, officially declaring an intent to go public, and actually completing the IPO.

[6] See, e.g., Colleen V. Chien, White Paper for the Open Technology Institute, Patent Assertion and Startup Innovation, New America Foundation (2013) at 10-11 & fig.1, available at http://ssrn.com/abstract=2321340 (finding that 90% of technology venture capitalists have faced demands against a portfolio company); John R. Allison, Emerson H. Tiller, Samantha Zyontz & Tristan Bligh, Patent Litigation and the Internet, 2012 Stan. Tech. L. Rev. 3, 4 (2012), available at https://journals.law.stanford.edu/sites/default/files/stanford-technology-law-review-stlr/online/allison-patent-litigation.pdf (finding that Internet patents were 7.5 to 9.5 times more likely than other patents to be the subject of infringement litigation).

[7] Matthew D. Cain & Steven Davidoff Solomon, Takeover Litigation in 2014 2 tbl.A (working paper, Feb. 20, 2015), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2567902.

[8] Tom Baker and Sean J. Griffith, How The Merits Matter: Directors’ and Officers’ Insurance and Securities Settlements, 157 U. Pa. L. Rev. 755, at 778 n. 97 (2009), available at https://www.law.upenn.edu/live/files/102-bakergriffith157upalrev7552009pdf.

[9] Joseph Walker & Rob Copeland, New Hedge Fund Strategy: Dispute the Patent, Short the Stock, Wall St. J., Apr. 7, 2015, available at http://www.wsj.com/articles/hedge-fund-manager-kyle-bass-challenges-jazz-pharmaceuticals-patent-1428417408.

[10] Willie Sutton Rule, Investopedia, http://www.investopedia.com/terms/w/willie-sutton-rule.asp (last visited Apr. 20, 2015).

[11] See, e.g., Alexei Oreskovic, Facebook Stock Almost Hits IPO Price, 14 Months After Rocky Debut, Reuters, July 30, 2013, available at http://www.reuters.com/article/2013/07/30/us-facebook-ipoprice-idUSBRE96T1CI20130730 (detailing Facebook’s well-documented issues after its IPO).

The preceding post comes to us from Robin Feldman, the Harry & Lillian Hastings Professor of Law and Director of the Institute for Innovation Law at UC Hastings College of the Law, and Evan Frondorf, Research Fellow at the Institute for Innovation Law at UC Hastings College of the Law. It is based on their recent article, which is entitled “Patent Demands and Initial Public Offerings” and available here.