Prompted by the ever-increasing efforts to monetize intellectual property (“IP”) by both practicing and non- practicing entities, a recent trend has developed where private equity firms (“PEFs”) have made funds available to companies and law firms to assist in these monetization efforts. Under the new approach, the PEF makes available an amount of funds with a pre-set return for a portfolio of IP monetization efforts, whether through licensing programs, litigation or a combination of both. Because the portfolio includes multiple IP monetization efforts, the opportunities for financial success increase and the corresponding risk is diversified.

For decades, IP monetization has been the business model for so-called patent trolls, also referred to as non-practicing entities (“NPEs”) or patent assertion entities (“PAEs”). These entities do not manufacture, use or sell products or services embodying their patented invention, but instead only seek royalties for their patents either through licensing programs or patent infringement lawsuits. Despite the call for legislative reform and a Presidential commission on the issue, the financial success of this model has attracted investors to join and/or invest in this business model. The traditional model has been for investors to make funds available for a specific monetization effort, such as a single patent infringement lawsuit.

More recently, operating companies have turned their attention to IP monetization by exploiting the company’s existing IP or through strategic acquisitions, such as Google’s acquisition of Motorola’s mobile business arm. A number of these practicing entities with sizeable patent portfolios have determined that selling or licensing their existing IP may be a source of additional revenue either through licensing, sale or enforcement, particularly where the company continues to burden the ever increasing “maintenance fees” to the U.S. Patent Office to sustain the life of their IP. Indeed, a number of these operating companies have established business divisions or separate subsidiary companies focused on these IP monetization efforts.

One monetization approach has been to license or sell patents owned by the practicing entity that relates to its non-core technology. For example, an entity may decide that its business has turned its focus away from certain business initiatives, making the IP less valuable to the company, but potentially valuable to others. As a result, the company will sell that IP—most likely patents directed to that now non-core technology area.

A more profitable monetization approach has been to enforce a company’s patents against competitors in litigation to gain market share through injunctions (i.e., excluding a competitor from selling a product in the U.S. that infringes the company’s patent(s)) or reap large monetary damages from companies that utilize the operating company’s patented technology. One of the primary examples of this approach is the so-called “Smart Phone Wars.”

Whichever approach is followed, companies (whether operating or non-operating) sometimes do not have, or are unwilling to make, the resources available to pursue a licensing and/or an enforcement program that will yield a sufficient financial gain to justify the investment. This is particularly true where business distraction costs combined with outside counsel’s legal fees could potentially dwarf the revenues generated. A number of PEFs have responded to this issue by offering funds to companies and law firms to help pay for the investment needed (e.g., expertise of outside counsel) to pursue these IP monetization efforts.

One of the most recent trends involves a PEF establishing a fund for the law firm to pay for a certain percentage of legal fees and disbursements associated with IP monetization efforts in exchange for a pre-negotiated return based on the amount of funds used by the firm. This allows the firm to offer companies substantial discounts on their fees in exchange for the company giving up some of the upside in the event of a financial recovery. For example, a monetary recovery would be split among the PEF, client and law firm based on their respective pre-set negotiated percentages. The PEF gets paid a pre-set amount out of the law firm’s percentage. This arrangement is ultimately a win-win-win for all parties who took an interest and risk in the IP monetization opportunity.

Of course, should the monetization efforts fail, the PEF would lose its investment, the law firm’s compensation would be substantially reduced, and the client would have lost the cost of disbursements as well as costs relating to business distractions. While this adverse scenario is possible, it is unlikely, and this approach works best when all the parties participating in the IP monetization effort have skin in the game — i.e., the PEF having invested its capital, the client having invested the funds to cover disbursements, and the law firm having risked losing a large percentage of its legal fees. In order to minimize the risk, each of these parties will have evaluated and conducted their respective due diligence on the strength of the IP monetization efforts and have concluded that it is worth pursuing. With such due diligence in place, the likelihood of an adverse outcome should be well within an acceptable degree of risk.

The elegance of this model, from the perspective of the PEF, is that the risk, similar to other investments, is diversified and not tied to a single company, licensing effort or litigation, as was the case in past models. Instead, the risk is spread across several matters and IP monetization efforts such that a single monetization effort within the portfolio could by itself pay for the investment. For example, if there are three monetization efforts underway, two of those efforts could yield no revenues, but one could be large enough to cover the costs of the other two. Under this scenario, the PEF would obtain its expected return.

Such an outcome is not atypical, particularly where the appropriate cases are selected for investment based on the due diligence. In sum, this emerging business model affords PEFs with another avenue for investment with acceptable risk, while at the same time affording companies the ability to pursue additional revenue streams with reduced risk and investment. We expect this trend to continue and expand in the coming years.