Patent Troll

Patent Troll (also known as a Non-Practicing Entity (NPE) or Patent Assertion Entity (PAE)) is a company or individual that enforces a patent against alleged infringers but does not manufacture the patented invention or supply the patented service. Think of a grumpy troll who buys the deed to a bridge he didn't build, and instead of maintaining it, he simply sits underneath, demanding a “toll” from anyone who tries to cross. In the business world, these trolls acquire patents, often from bankrupt companies or individual inventors, with no intention of creating products. Instead, their entire business model is to identify successful companies whose products might, even tangentially, infringe on their portfolio of patents. They then launch lawsuits or, more commonly, threaten to launch them. Because defending a patent lawsuit is incredibly expensive and time-consuming, many targeted companies choose to pay a “licensing fee”—which is really just settlement money—to make the problem go away, regardless of the merit of the claim.

The patent troll's strategy is a numbers game that thrives on the inefficiencies of the legal system. It's a simple, yet often effective, three-step process:

1. Acquire: Trolls buy up patents, often for pennies on the dollar. Their favorite shopping grounds are the IP auctions of failed startups or tech companies that are shedding assets. The quality of the patent is less important than its vagueness, as broad and ambiguous claims are easier to apply to a wide range of existing technologies.
2. Attack: The troll identifies target companies, usually ones with deep pockets or those in patent-heavy industries like software and biotechnology. They then send out a barrage of demand letters, claiming infringement and threatening legal action.
3. Settle: The troll's primary goal is not to win in court, but to secure a quick cash settlement. The settlement amount is strategically calculated to be just below what it would cost the target company to hire lawyers and fight the case. For the company being sued, paying the troll is often the lesser of two financial evils, creating a powerful incentive to settle.

For a value investing practitioner, understanding the risk posed by patent trolls is crucial. They are not just a nuisance; they are a direct threat to corporate profits and, by extension, your investment returns.

When a company is forced to pay a patent troll, that money comes directly out of its bottom line. It's an unproductive expense that could have been used for research and development, hiring new employees, paying dividends, or buying back shares. In essence, patent trolls act as a private tax on innovation. This threat can have several negative effects on a company's value:

• Reduced Earnings: Legal fees and settlement payments eat directly into profits, lowering a company's earnings per share (EPS) and depressing its stock price.
• Management Distraction: C-suite executives and key engineers get pulled away from running the business to deal with depositions and legal strategy.
• Stifled Innovation: The fear of being sued can make companies more risk-averse, causing them to shy away from developing new products or entering new markets. This erodes a company's competitive edge and long-term growth prospects.

As part of your due diligence, you should actively assess a company's vulnerability to patent trolls. Here’s what to look for:

• Industry Risk: Be extra cautious with companies in notoriously troll-heavy sectors. Software, consumer electronics, e-commerce, and biotech are prime hunting grounds.
• Legal Disclosures: Carefully read the “Risk Factors” and “Legal Proceedings” sections of the company's annual report (in the U.S., this is the 10-K filing). Vague language about ongoing litigation related to intellectual property (IP) can be a warning sign.
• Defensive Posture: Check if the company has a proactive defense strategy. Does it belong to defensive patent organizations like the LOT Network? Does it have a high-quality, focused patent portfolio of its own, or just a large quantity of low-value ones? A strong defense is a key part of a durable economic moat.

To be fair, some argue that NPEs serve a purpose. They can provide a way for small inventors or universities to get paid for their ideas when they lack the capital to commercialize or defend their own patents. In this view, NPEs create a liquid market for inventions. However, from an investor's standpoint, this potential benefit is vastly overshadowed by the systemic costs. The majority of patent troll activity is not about rewarding the “little guy” inventor but about exploiting the legal system for financial gain at the expense of productive enterprises. For an investor analyzing a target company, the presence of troll litigation is almost always a net negative.

Patent trolls are a real and unpredictable business risk. They can materialize out of nowhere, drain cash, and damage a company's long-term prospects. While you can't predict every lawsuit, you can and should evaluate how well-prepared a potential investment is to handle this threat. A truly great company not only excels at its core business but also has robust defenses against value-destroying forces. Ignoring the trolls under the bridge is an oversight that a prudent investor cannot afford to make.