USE OF INTELLECTUAL PROPERTY IN LAUNCHING AN INTERNET BUSINESS IN A HOSTILE SPACE. Robert Greene Sterne, Esq. Michael V. Messinger, Esq.

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1 USE OF INTELLECTUAL PROPERTY IN LAUNCHING AN INTERNET BUSINESS IN A HOSTILE SPACE Robert Greene Sterne, Esq. Michael V. Messinger, Esq. Copyright 2000 All Rights Reserved

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3 Biographical Information Program Title: Use of Intellectual Property In Launching An Internet Business in a Hostile Space Names: Robert Greene Sterne and Michael V. Messinger Position or Title: Attorneys Firm or Place of Business: Sterne, Kessler, Goldstein & Fox, P.L.L.C. Address: 1100 New York Ave. NW Ste. 600 Washington, DC Phone: Fax: rsterne@skfg.com and mikem@skgf.com Table of Contents I. RADICAL CHANGE...6 II. OWNERSHIP OF INTELLECTUAL PROPERTY...10 III. ANYTHING INEXPENSIVE...12 IV. IS PATENT PROTECTION WARRANTED?...15 V. COMPLEXITY...18 VI. COST...22 VII. HONE THE PROPRIETARY EDGE

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5 Introduction The purpose of this paper is to scrutinize the role of intellectual property in launching an Internet business in a hostile investment space. With limited resources on hand, many decision makers now find it necessary to deal head on with fundamental threshold questions concerning IP: why should IP be protected at all? If the answer is yes, then where should company resources be spent to gain maximum IP value add? In a hostile investment climate, the authors suggest three tactics that may help a company's intellectual property increase shareholder value at start-up and beyond. The three tactics relate to (1) ownership of IP, (2) using inexpensive protection of any IP that provides a competitive advantage, and (3) questioning whether patent protection is warranted at all. 5

6 Use of Intellectual Property In Launching An Internet Business in a Hostile Space 1 Robert Greene Sterne, Esq. Michael V. Messinger, Esq. 2 I. RADICAL CHANGE The investment climate for Internet-related business worldwide has changed dramatically since March, The shift has been pronounced for dot-com companies, and now 1 This paper describes intellectual property trends and issues at a high level. The paper was drafted in late December, 2000, on short notice to replace a previously scheduled speaker. Ideas presented in the paper will be further developed in an oral presentation by the authors in February, The authors are attorneys with the Washington, D.C. intellectual property specialty firm of Sterne, Kessler, Goldstein & Fox, P.L.L.C., Opinions expressed herein are solely those of the authors, and do not necessarily reflect the views of their law firm or their clients. The authors can be reached by telephone at (202) or by at rsterne@skgf.com and mikem@skgf.com, respectively. Copyright 2000, Sterne, Kessler, Goldstein & Fox, P.L.L.C., all rights reserved worldwide. 6

7 extends to telecommunications, computers, software, and wireless communications companies. At the beginning of the year 2000, investment capital was plentiful to the point of being almost unlimited. Business plans were not scrutinized for path to profitability, and lack of sales was not considered a detriment. Valuation climbed with each successive wave of initial public offerings (IPOs). A company could be launched without serious regard to intellectual property. Company officers had a measure of leverage over potential investors who often were in great competition to be allowed to invest. A comprehensive intellectual property portfolio was perceived favorably in funding rounds and liquidity events. This robust marketplace began to change in the spring of the year At the end of the year 2000, Internetrelated businesses face a very hostile investment climate. A great deal of money is still available in venture capital and other holdings, but no one now seems to want to invest. Some of our market-savvy clients advise us that it is the most 7

8 hostile environment to raise capital in over a decade. As a result, many fewer companies are even started. Existing companies find it harder to raise the next round of funding and even harder to have a liquidity event, such as, an initial public offering or double-pop buyout. Down rounds are now quite common. In some cases, no investment capital is available at all to an Internet business at any valuation. Businesses relying on revenue models based on web advertising or web traffic are increasingly hard hit. Internet software providers relying on licensing royalties or sales face stiff financial difficulty. Even Internet-related hardware vendors face greater scrutiny of their business plans and short-term revenue streams. Increasingly, Internet businesses are expected to show a much greater likelihood of increased revenues and short-term profit. The purpose of this paper is to scrutinize the role of intellectual property (IP) in launching an Internet business in a hostile investment space. Business owners face hard and conflicting choices in allocating available resources - 8

9 especially at start-up. Short-term intellectual property costs must now be weighed against competing priorities, such as, operating costs, labor costs, and even employee retention. Company decision makers have watched the strategic value of IP holdings rise throughout the Internet age. With limited resources on hand, many of these decision makers now find it necessary to deal head on with the fundamental threshold questions concerning IP: why should intellectual property be protected at all? If the answer is yes, then the follow-up question arises concerning where to spend company resources to gain maximum intellectual property value add. This paper describes one approach to handing these threshold queries. This approach may be effective for certain Internet-related businesses facing extraordinary constraints at launch. In a hostile investment climate, the authors suggest three tactics that may help a company's intellectual property increase shareholder value at start-up and beyond. These three tactics relate to (1) ownership of IP, (2) using inexpensive protection of any IP that provides a competitive 9

10 advantage, and (3) questioning whether patent protection is warranted at all. Each is considered in turn below. II. OWNERSHIP OF INTELLECTUAL PROPERTY Ownership of intellectual property related to an Internet company=s business plan takes on increasing importance in a hostile investment climate. Ownership of intellectual property and any issues in connection with freedom to operate need to pass the rigors of an intense due diligence analysis by a leary investor. An investor or buyer now has more leverage in a hostile space. A company cannot afford to have an investor raise clouds on title or potential encumbrances on use or practice. Such ownership issues can arise frequently and at critical junctures in a young company's life. IP due diligence analysis as part of a funding round or stock offering is now the rule. An audit of a company=s ownership rights with respect to domain names, trademarks, copyrights, trade 10

11 secrets and patents should clearly indicate that ownership rights squarely belong to the company. Employment agreements, assignments, and agreements with consultants need to document an assignment of or obligation to assign rights in intellectual property to a company. Key people in the company, including its officers, should be signed up in terms of IP. Freedom to operate concerns also need to be minimized. Any IP problems with a competitor, such as, an outstanding cease and desist letter or cumbersome license obligations, need to be resolved. Ownership and freedom to operate also need to be considered from the vantage point of the company's business plan. For many Internet-related businesses who have not established a profitable revenue stream, the company=s business plan is essentially what an investor or banker is buying. In this way, a company is better positioned against prospective buyers or investors. Proper handling and resolution of IP ownership and freedom to operate issues can 11

12 protect a company from a buyer who attempts to use a company's early intellectual property position adversely to devalue or short sell a company! This is a far cry from headier times in early 2000, where a seller sometimes could rely on or overcome an uncertain IP position and still drive up valuation! III. ANYTHING INEXPENSIVE Assuming the company owns IP that provides potential competitive advantage, what should it protect? For some companies facing hard financial choices, the motto may be "Protect Any IP that is Inexpensive to Protect." Trade secrets, copyrights, trademarks and domain names can be protected at a relatively small out-of-pocket cost to an Internet company. However, considerable in-house resources may need to be expended to obtain and maintain such protection. In the authors' experience, employee education is often very important in securing and maintaining trade secrets and copyrights. For example, to protect source code 12

13 using copyright and trade secret, a sound internal record keeping and archival system often needs to be developed and maintained. The ability to reliably access and retrieve dated versions of source code can be critical in asserting a copyright or license obligation. Registration of a company=s object code under the Copyright Office's "rule of doubt" approach (or even source code, if it is published) may be desirable in certain strategic situations. In such cases, moderate outside legal fees and filing fees associated with copyright registration may be required. Copyright registration of computer program code, while not required, can provide an evidentiary advantage and a practical advantage by further memorializing source code development. A company may also qualify for recovery of attorney fees and statutory damages which may be lost if registration is not timely made. Trade secrets may require reasonable security measures be taken and maintained. Employee education on maintaining the confidentiality of trade secret material, such 13

14 as, business plans, financial documents, and technical documents, may be necessary. In certain cases, trade secret protection may not be practical, however, where investors, directors, or other parties insist on distribution of company materials or even the business plan without securing confidentiality obligations and other safeguards. The importance of on-line commerce and marketing to many Internet businesses at launch may necessitate obtaining federal trademark right protection. The scope of a federally registered trademark is nationwide - which can be much greater than state trademark rights obtained for specific uses of the mark in commerce. We are also finding that the Trademark Office of the United States Patent and Trademark Office (PTO) is able to turn around and examine a trademark application within about six months of filing. Preparing and filing a federal trademark application for registration of an Internet mark on the Principal Register is relatively inexpensive. Total costs, including fees and attorney time for preparing a trademark clearance search and application, 14

15 averages around $2,000-$4,000. Barring exceptional difficulty or hurdles at the Trademark Office, prosecution and issuance of a trademark application can proceed for less than $3,000 as well. Given the national scope of the trademark right and the relatively prompt response by the PTO, obtaining a registered trademark is generally cost effective at the launch of an Internet business. IV. IS PATENT PROTECTION WARRANTED? When access to capital is difficult, obtaining patent protection may be problematic for many Internet-related businesses at the time of launch. Different factors cut in opposing directions. Factors weighing against patent protection are an overloaded U.S. Patent and Trademark Office which is very backlogged and delays examination, the legal complexity associated with preparing patent applications, and the cost of filing and examination. Factors in favor of patent protection are maintaining a company=s 15

16 proprietary edge in key IP, and protecting a company from investors and potential investors. Consider first the factors against obtaining patent protection as viewed through the eyes of some Internetrelated businesses at launch. The PTO is experiencing an overload in patent applications in Internet-related technology and business methods. The number of patent applications filed in the Internet space by large and small companies has risen faster in the last several years than in any other technology space. The attrition of patent examiners in the Internet space has been very high and continues to be a problem. The widened scope of eligible patentable subject matter in the areas of software and business methods has placed additional burdens on the PTO. All of this contributes to a significant delay in the initial examination of a patent application and its issuance for Internet technology. In this area is not uncommon for two years to pass before even the first initial communication on the merits is provided by the PTO. Three to four years from the time of filing may pass 16

17 before an Internet-related patent issues, if it issues at all. In contrast, business owners and decision makers face milestones and funding events on the order of months, not years. An Internet-related company may not even survive from the time an application is filed to the time the PTO picks up a case for the first substantive examination. One recourse the authors have found successful is qualifying a case for "special" status by filing a Petition to Make Special. Such a petition, if granted, can reduce pendency and handling of a case by 2-3 years. The Petition to Make Special process has been successful in the year In one case, the authors were able to obtain an issued Internet patent within one year of filing. At the end of the year 2000, however, the PTO appears to have heightened its standard for granting such special status. Our communications with the Internet-related areas of the Patent Office have indicated that Petitions to Make Special are going to be treated with greater scrutiny. In particular, Applicants may now be required to make even more remarks 17

18 characterizing references found in their search and distinguishing their claimed invention from the work of others. Such remarks can have significant estoppel issues later that narrow the scope of the claims of the issued patent. Among other things, these remarks are even more likely be used by a court to limit the scope of literal claim language and to bar the availability of equivalents. V. COMPLEXITY Trends in patent law have increased the importance and complexity of patent application drafting. This is especially true for companies at launch that rely on one or two patent applications to achieve a specific strategic aim, such as, credibility with potential investors. These companies may have little or no room for error. The legal requirements for an effective patent application are significant. 3 One requirement is that the level 3 A complete discussion of the legal requirements for a patent application is beyond the scope of this paper. Only a 18

19 of description must enable any person skilled in the art to make and use an invention without undue experimentation. See, 35 U.S.C. ' 112, first paragraph. Claims also need to cover all aspects of the invention or the disclosed subject matter may be dedicated to the public. See, Maxwell v. J. Baker, Inc., 86 F.3d 1098, 39 U.S.P.Q.2d (BNA) 1001 (Fed. Cir. 1996). In general, one current trend in patent law has been to increase the degree of detail that is required in the patent application. In this way, the public is put on notice of proprietary subject matter. Courts have increasingly read claim limitations more narrowly in light of specific examples and description given in a patent specification. This means patent applicants often must now add and claim many more embodiments and alternative designs to gain adequate patent claim coverage. One example of this is the interpretation of "means plus function" language to be limited to those few requirements are highlighted here for illustrative purposes. 19

20 specific embodiments recited in the specification. See, In re Donaldson,16 F.3d 1189, 1194, 29 U.S.P.Q.2d (BNA) 1845, 1849 (Fed. Cir. 1994) (When construing a means plus function claim, a court, as well as the PTO, Amust look to the specification and interpret that language in light of the corresponding structure, material, or acts described therein, and equivalents thereof, to the extent that the specification provides such disclosure@). A patent owner may also find it more difficult to extend the scope of literal claim elements to cover equivalents. Remarks made any time during prosecution history (so called "prosecution history estoppel") can bar coverage on any related claim equivalents. Indeed the Federal Circuit which handles patent appeals recently held en banc that any amendment that narrows the scope of a claim for any reason related to the statutory requirements for a patent will give rise to prosecution history estoppel with respect to the amended claim element. See, Festo Corp. v. Shoketsu Kinzoku Kogyo Kabushiki Co., 2000 U.S. App. 20

21 LEXIS 29979, 56 U.S.P.Q.2d (BNA) 1865 (Fed. Cir., Nov. 30, 2000) (en banc). Such a bar can impact litigation early. A district court now often holds a Markman hearing to determine the meaning of disputed claim elements. The scope of evidence which is considered at a Markman hearing varies from court to court and may be limited to intrinsic evidence only. Once a literal interpretation is decided, an unfavorable literal interpretation can result in a finding of non-infringement based on summary judgement. Litigators representing patent owners may find their hands tied as they are boxed in by limited description, narrow claims, prosecution history estoppel or all of the above. Design around options may also be available to competitors who have flexibility to rewrite code or alter functionality to avoid patent infringement. These trends (and others not mentioned here) drive the importance of adding additional embodiments in a patent application, numerous claims, and making sure the application meets strategic aims. A premium is then placed 21

22 in patent application drafting. This may make it difficult for some Internet-related businesses at launch to obtain an effective proprietary position with patent claims based on one or two patent applications. VI. COST Outside legal costs and the involvement of in-house resources can be relatively high in obtaining patent protection. In the Internet space, technological issues are often complex. Documentation describing software or product functionality in detail may not be readily available because of sparse staffing and very short product cycles. For many Internet-related patent applications, outside legal fees can run from $10,000 to $35,000 for preparing a single focused patent application. PTO filing fees can be around $1,000 which is even higher if excess claims are involved. The cost of examination is often equal to the cost of preparation and filing. 22

23 At launch, our experience is that senior engineers and technical officers face tremendous competing priorities for their time and energy. Time spent supporting patent preparation often comes at the expense of meeting software development tasks or other development milestones. Limitations on the availability of senior engineering personnel can negatively impact assessment of patentable subject matter and preparation of effective patent applications that cover a company=s strategic goals. In short, even obtaining patent protection is problematic for a constrained Internet-related business at launch. The very short event horizon of an Internet company in a hostile investment space may simply out run an overloaded Patent Office. The recent practical raising of the standard for obtaining special status makes it harder for timely issued patents to be applied to increase shareholder value. One or two patent applications construed narrowly may not result in a proprietary position that is sufficient to present a barrier to entry against competitors. Even the 23

24 initial cost of filing a suite of patent applications may be prohibitive. A decision maker under pressure at an Internetrelated company may be tempted to question, why bother? 4 VII. HONE THE PROPRIETARY EDGE Patent protection remains, however, one of the strongest legal mechanisms for protecting a proprietary edge. This can be critical to a company - especially an Internetrelated business entering a new space. Maintaining a proprietary edge for many companies includes patent protection for a company's business plan and core technology. In a hostile investment climate, a company=s business plan needs to withstand serious scrutiny. Filing for patent protection on all or part of a business plan (even if the 4 The authors do not mean to suggest that patent protection or patent issues should be ignored or that patent protection should not be sought. We are merely attempting to highlight the difficult trade-offs that some financially constrained Internet businesses may encounter at launch. 24

25 patent is not yet issued) can reassure potential buyers and help secure a strategic proprietary position. Further, an Internet-related company may be forced increasingly to expose its core business plan and underlying technology to a number of different investors. Investors come in different types. These investors include pure money investors, value add investors, strategic investors, and duplicitous investors. Pure money investors contribute money. Value add investors may contribute money directly but also add contacts, reputation, and/or leads to sources of capital. Strategic investors typically invest with a specific interest in the technology or business plan driving an Internet-related business. In one sense, strategic investors may even be favored as they are often a built-in customer for a newly launched Internet business. We are also aware of cases where individuals pose as investors but are actually acting on behalf of competitors. Such Aduplicitous@ investors may still gain access to a company=s core business plan and underlying technology. 25

26 Moreover, each of these investors in a hostile climate is increasingly reluctant to undertake confidentiality obligations or even sign non-disclosure agreements. Some of our clients have told us it is increasingly hard for Internetrelated companies at launch to wield leverage over investors. Filing one or two patent applications to cover a company=s business plan is then increasingly important even in a hostile investment space. Filing such applications prior to circulation of a business plan can provide a significant evidentiary and practical advantage in preserving the proprietary edge of an Internet-related business subsequent to launch. Such filings can provide an additional measure of protection for a company from investors - a far cry from the role of intellectual property in impressing investors at the start of the year 2000! Thus, one approach we expect to see for some Internet-related businesses at launch, even if financially strapped, is to file at least one or two patent applications on core elements of their business but not expend resources on seeking prompt examination. 26