Patent Assertion Entity

Patent Assertion Entity (also known as a Non-Practicing Entity or, more pejoratively, a 'Patent Troll') is a company whose main line of business is making money by suing people. More specifically, a PAE acquires patents, not to create a product or service, but to enforce them against companies that are allegedly infringing on them. These entities don't invent anything or run factories; their primary asset is a portfolio of patents, and their primary activity is litigation. Imagine someone buying the deed to a small, unused alleyway and then charging every person whose window opens onto it a “trespassing fee.” That's the PAE business model in a nutshell. They leverage the astronomical cost of defending a patent lawsuit to extract settlements from their targets, who often find it cheaper to pay the “troll toll” than to fight a lengthy, expensive court battle, even if they believe they are in the right.

The strategy is a well-oiled, three-step machine: acquisition, assertion, and monetization.

• Acquisition: PAEs are hunters. They scour the landscape for patents, often buying them for a bargain from struggling or bankrupt companies, or from individual inventors who lack the resources to defend their own intellectual property. They particularly love broad or vaguely-worded patents, especially in the software space, as their ambiguity makes it easier to claim infringement against a wide array of products.
• Assertion: Once armed with a patent, the PAE identifies potential targets. This is often a numbers game. They might send out hundreds or thousands of demand letters to companies big and small, alleging that a common business practice—like using a scanner to email documents or offering Wi-Fi in a café—infringes on their patent.
• Monetization: This is the crucial step. The demand letter comes with a threat of a lawsuit and an offer to settle. Defending a patent infringement case can easily run into millions of dollars in legal fees. The PAE, knowing this, typically offers to make the problem “go away” for a much smaller, yet still substantial, sum (say, $100,000). For many businesses, paying the settlement is a painful but economically rational decision compared to the alternative.

For a value investor, PAEs are rarely seen as an investment opportunity. Instead, they are a significant risk factor that can erode the value of otherwise excellent businesses.

The activities of PAEs act like a tax on innovation and profitability, directly harming the companies you might own.

1. Draining Cash: The most obvious impact is the direct financial cost. Settlement payments and legal fees are a direct hit to a company's earnings and free cash flow. Money spent fighting a patent troll is money that can't be used for research and development, paying dividends, or buying back stock—all things that create value for shareholders.
2. Stifling Innovation: The fear of litigation can have a chilling effect. A company might shelve a promising new product or feature simply to avoid the crosshairs of a known PAE. This erodes a company's economic moat by slowing its pace of innovation and allowing competitors to catch up. It's a hidden cost that can cripple long-term growth.
3. Management Distraction: A CEO and their top engineers spending their time in depositions and legal strategy meetings are not spending that time creating value. This management distraction is a significant, if unquantifiable, drag on a business's performance.

When analyzing a potential investment, particularly in the tech or biotech sectors, it's wise to do a “troll check.”

• Read the Fine Print: Dive into the company's 10-K or annual report. The 'Risk Factors' and 'Legal Proceedings' sections are required reading. Companies must disclose significant lawsuits, and a pattern of litigation from PAEs should be a red flag.
• Assess the Industry: Some industries are troll magnets. Companies operating in fields with dense, overlapping patent rights (known as “patent thickets”) are at higher risk.
• Check for a Shield: Does the company have a strong patent portfolio of its own? A large collection of patents can act as a deterrent, as it gives the company ammunition to countersue—a strategy known as 'defensive patenting.'

Could a dedicated value investor ever buy shares in a PAE? It's highly unlikely. While a PAE might, on paper, have a high return on investment, its business model runs contrary to the core tenets of value investing. The philosophy of legends like Benjamin Graham and Warren Buffett is built on investing in productive businesses that create value for society. PAEs are purely extractive entities; they don't build better products or provide useful services. They simply transfer wealth from productive companies to themselves. Furthermore, their business is inherently speculative. Valuing a PAE requires you to guess the outcome of future lawsuits—a task fraught with uncertainty. Add in the significant regulatory risk (as governments periodically try to rein in troll-like behavior) and reputational damage, and you have an investment that is far from the predictable, durable, value-creating businesses that a true value investor seeks. For us, PAEs are best viewed as a hazard to avoid, not a stock to buy.