Patent Trolls

Patent Trolls (also known as Patent Assertion Entities or PAEs) are the modern-day bogeymen of the corporate world, especially in technology. Imagine a grumpy troll hiding under a bridge, not to build a better one, but to demand a toll from anyone who crosses. That’s a patent troll. These are companies that don't invent, manufacture, or sell anything. Instead, their entire business model is built on acquiring Intellectual Property, specifically patents, often from struggling companies or individual inventors. They then lie in wait, scanning the market for successful businesses whose products or services might—even tangentially—infringe upon their portfolio of patents. Once a target is spotted, the troll emerges, not with a new product, but with a lawsuit or the threat of one. Their goal isn't to protect their own innovation (they have none), but to extract licensing fees or settlement payments from productive companies, turning the patent system into a tool for legal extortion rather than a shield for inventors.

The strategy of a patent troll is a simple, yet often effective, legal shakedown. It typically unfolds in a few predictable steps.

Trolls build a portfolio of patents. They don't conduct their own research and development; they buy patents on the cheap. Prime sources include:

• Bankrupt Companies: When a company goes under, its patents are often sold off for pennies on the dollar.
• Individual Inventors: An inventor may lack the funds to defend or monetize their patent and will sell it to a PAE.
• Broad or Vague Patents: They particularly love patents with broad, ambiguous claims that can be interpreted to cover a wide range of modern technologies the original inventor never even imagined.

With their arsenal of patents, trolls hunt for targets. They look for successful companies with deep pockets. They fire off demand letters to hundreds of businesses at once, alleging patent infringement for common business practices, like using Wi-Fi, scanning documents to email, or using a shopping cart feature on a website.

The troll’s ultimate weapon is the high cost of Litigation. Defending against a patent infringement lawsuit can easily cost millions of dollars, win or lose. The troll knows this and typically demands a settlement that is painfully high but still less than the expected cost of fighting the case in court. For the target company's management, paying the “toll” often becomes a purely economic decision, even if they believe the troll's claim is baseless.

While it might seem like a niche legal issue, the existence of patent trolls creates a very real and damaging drag on the economy and your investments. For a business, a patent troll lawsuit is a major drain. It diverts cash that could have been used for hiring, research, or expansion. It also distracts key executives and engineers, pulling them away from creating value to deal with legal battles. Over time, this stifles innovation, as some companies may avoid entering new fields for fear of attracting trolls. This directly erodes Shareholder Value. For an investor, patent trolls represent a hidden and unpredictable risk. A company you own could suddenly see its profits dented and its stock price fall due to an unforeseen lawsuit. It's a tax on innovation that doesn't appear as a neat line item on an income statement but can be just as costly.

As a value investor, your job is to understand a business deeply, including its risks. Patent troll activity is a significant qualitative risk factor to consider, especially for companies in the software, e-commerce, and electronics industries.

When analyzing a potential investment, you should perform some due diligence:

• Read the Annual Report: In the U.S., the 10-K report has a “Risk Factors” section. Companies often disclose ongoing litigation or the risk of future IP claims here.
• Check Legal Expenses: A consistent or rising trend in legal expenses on the income statement without a clear reason can be a red flag.
• Scan the News: A quick search for the company's name plus terms like “patent lawsuit” or “infringement” can reveal a history of tangling with trolls.

Not all companies are equally vulnerable. Businesses with a strong competitive advantage, or Moat, are often better prepared.

• A Strong Patent Portfolio: Companies that invest in their own R&D and build a robust patent portfolio can often countersue or use their patents as a defensive shield.
• A Strong Balance Sheet: A company with plenty of cash can afford to fight a troll in court and win, sending a clear message to other trolls to stay away. Weak companies are the preferred prey.
• Proactive Management: Look for management teams that are aware of the issue and take steps to mitigate it, such as joining defensive patent organizations.

Ultimately, while you can invest directly in PAEs (some are publicly traded), this is a speculative game that falls far outside the Circle of Competence for most value investors. It's far better to focus on identifying excellent, productive businesses that have the strength and foresight to swat these pesky trolls away.