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Regardless of industry, the core principles of business remain the same. First, you find or develop a product or service that consumers want or need. Second, you market and sell the product. Third, you grow. In the process there are many variations, but the core concept stays the same. Yet there is a new concept of business that is beginning to develop, one that is volatile in nature and defies what we've been taught to believe about business. The industry in reference is intellectual property litigation, a highly promising yet risky industry of investment, one in which small investments and patience will be key.

The Importance of Patents

With large public companies there are many steps that must be taken to protect both the integrity of the business and also future sales. One of the most important areas of diligence on behalf of public companies must be in the issuance or acquisition of patents. It is an issue of import because these patents are what separate companies from one another, protect ideas, and provide exclusivity for a company to market or manufacture a product/service.

There are patents for virtually everything and anything that the mind can create, so long as the creation of revenue is imaginable. There are even "how-to patents, covering methods for how to swing on a swing, conceal partial baldness, and even crust-less peanut butter and jelly sandwiches. Hence, you probably infringe on patents every day, and that's exactly what several small IP litigation companies are hoping to prove (luckily against large corporations and not you).

The Rush for Patents and Intellectual Property

The tech super giant, Apple (AAPL), has patents for its glass staircase, in-store iPad stands, and even the packaging of its devices to complement its more technical IPs. This may sound strange, but it all goes into the process of protecting the company's identify and saving it from future courtroom dilemmas. The patent king, International Business Machines (IBM), accumulated an impressive 6,478 issued patents in 2012 alone, and it should be assumed that not all of those patents are "necessary" for the technology of the company to be protected. However, in this business environment, it's better to be safe than sorry.

Due to IBM's willingness to document all of its day-to-day activities with IP, the company is not often attacked for infringing on the technology of others. Yet, others are often not so lucky. Back in 2011, Google (GOOG) acquired Motorola Mobility for $12.50 billion in a deal that strengthened its IP portfolio by 17,000 patents. At the time, Google was in numerous pending lawsuits with various companies, including Apple, and Google was highly vulnerable due to its weak IP portfolio. The company has since been the victim of numerous high-profile litigations such as with Vringo (VRNG), a firm that is the quintessential example of the new IP litigation-based company.

Vringo: Attacking the Tech Giants

In the past, it was the juggernauts of the economy that were battling in high-profile IP cases. Today, the little man is succeeding against those juggernauts, and usually by only owning a fraction as many patents. The small company, Vringo, is attacking the industry without fear. The company has been awarded $30 million in past damages stemming from Google's AdWords platform. The battle between these two companies is far from over, as Google's recent "workaround claim has weighed heavily on Vringo's valuation, as of late. Yet the won $30 million in past damages, the company's unknown royalty, and its willingness to be relentless has also earned it the respect of other tech giants, and could create a door of opportunity producing consistent revenue.

The key point to remember regarding Vringo is that the litigation suit is still far from over, as there are still many unanswered questions. At this point, there's little denying that Google did infringe on Vringo's patents, and Vringo investors believe that Google still owes Vringo much larger revenues from past damages. Vringo shareholders care deeply about past damages because the small company could be negatively affected if Google makes changes to its ad system, as it would affect Vringo's royalty rate. In any case, there are many moving parts to this long suit, but fortunately, the length and relentlessness of Vringo has weighed in its favor in other potential suits. The company recently announced that it is in settlement talks with Microsoft (MSFT), proving that despite being a small company, other large companies are taking Vringo seriously and may elect to settle rather than embark on a very public journey filled with lengthy courtroom discussions.

Here's where the business of IP litigation companies gets tricky, and also smart: While Vringo claims "past damages" and seeks higher royalties, there is no proof that the company would have ever put into action its patents, or build a business around those patents. Vringo's underlying business is very small, thus suggesting that its true business surrounds IP infringements, or finding companies that have infringed on its patents. This can be very dangerous to large companies that can look back on the Google case as an example. Simply put, many companies don't want to go through the public courtroom scene, and it's cheaper to admit the wrong and pay a tiny royalty on one of its business segments to save on the legal costs, versus the alternative.

While a $30 million cost for a giant like Google may be small, it is a massive sum for a company like Vringo. As previously discussed, the fact is that Google can always make changes to its technology to avoid or to lower future royalty rates -- and realistically, if Google loses in its case then the costs are only pennies relative to its size in the market. On the other hand, Vringo has invested heavily into this case, and if it would have lost or not received the initial monies, it would have been disastrous. As such, it's a high-risk industry. Albeit, despite inherit risks, investors seem optimistic.

Over the last year, Vringo has traded flat though with much fluctuation, with large 30% swings in both directions. Looking back further to January of 2012, the stock has grown in value by more than 200%. It currently trades with a valuation of $230 million, which is greatly higher than its $85 million market cap in 2012. This shows the excitement and the potential gains to be had in this exciting industry. However, those holding over the last year have been frustrated, meaning this is not a space to build a portfolio around. It is although a good space of growth where you can capitalize with long-term investments in small amounts. After all, if these small companies do in fact win large suits, it will take but a small investment to return large profits.

How Can an IP Litigation Company Succeed?

For a company such as Vringo to be successful, it needs a patent portfolio, a good eye for the misuse of IP, and a legal team that's not scared to fight against the market's elite. Acacia Research Corp. (ACTG) has built a $1 billion company by implementing this plan and succeeding over a course of several years, seeing explosive growth over the last five years. During a period of five years the stock has returned gains of 370%, making it a market leader. During this same period, revenue has grown from $50 million to over $250 million, and while many quarters produce inconsistent growth, the company has continued to see improved fundamentals due to royalties and large one-time payments related to portfolio damages.

Acacia has returned loss during the last year, showing the volatility of an IP litigation company. Yet those who have invested for long periods of time, and in small amounts, have still been rewarded and are most likely used to the volatility. Acacia could be viewed as the model for what Vringo hopes to become -- and then there is a long list of smaller companies, such as Marathon Patent Group (OTCQB:MARA), that are in the beginning phases of litigation, but have a lot of promise.

Marathon is in the early phases of development; albeit, it is clearly a company that is in the business of patent litigation at its best, as its goal is to acquire patents being used freely by large companies. A couple of weeks ago, the company acquired a multi-casting patent from MOSAID Technologies, and in the press release it states, "The asset is a seminal patent cited by over 254 other patents that enables multicasting on Internet protocol networks." The company goes one step further to name companies such as IBM, Cisco (CSCO), Google, and Apple among many others that have reportedly infringed upon this patent.

If a small company such as Marathon Patent Group can go and acquire a patent that could garner the company many millions in revenue from patent infringements, then why wouldn't larger companies find and acquire these patents first? This is a good question, and the truth is that most large companies don't look for these small, seemingly meaningless patents. However, small companies -- like Vringo and Marathon -- do, and sooner or later this could force large tech companies to change their business practices. Now, the fact that Marathon acquired this patent and other companies cite it on many occasions should insinuate big revenue for the company, right? The answer is … not really. First, Marathon must perform research with its legal team to determine if it can successfully defend the patent in court, and prove wrongful infringement on behalf of another company. Thereupon, from 254 other patents to choose from, Marathon can pick apart the most damning cases that could return the largest royalties and revenue.

The Vringo case with Google has become a confusing ever-changing mess; but to understand how quickly one IP issue can change a company, just look back at Marathon's more promising IP suits. Keep in mind, this is assuming perfect execution and findings on behalf of the company. Marathon is alleging infringement in many industries within healthcare, including phosphate linkage. The company is pursuing Life Tech (LIFE), Roche (OTCQX:RHHBY), and Genentech for years of infringement and the billions combined in annual sales that were allegedly created from this technology. Then there are patents owned covering microarrays involving Affymetrix, Ilumina, and Agilent that also covers billions in annual and future sales. Once again, we can't say that the company will or won't pursue each and every case, or that it will even win these cases. But with a small market capitalization, if any of these companies settle it provides leverage against other suits (like seen with Microsoft and Vringo). Moreover, if cases go to court and the company is awarded a small 3-5% royalty on revenue, then it becomes substantial compared to the valuation placed on the company.

Conclusion

Marathon is among the first of companies that have set out to operate exclusively in the IP infringement space. Acacia Research Corp. has become a company of this focus and Vringo is well on its way, but more importantly is the smaller companies in the background that are acquiring widely used patents for very little. In many ways it is difficult to understand this process, and how the importance of patents is creating a new segment of the market. However, as we look back on history at companies such as Vringo, ParkerVision (PRKR), and Acacia Research, the early success of IP infringement cases has been highly lucrative. The question is whether or not it will continue.

My suggestion is to approach the space with caution, realize that it is an unconventional way of doing business, and also realize that smaller up-and-coming companies will trade volatile (much like Acacia Research Corp.) even if success is achieved. In that case, small long-term positions are best. You won't be able to judge the day-to-day performance of these stocks, and large swings (such as with Vringo) can occur with one filing from the alleged company. Thus make your investment with a long-term time horizon, and if you are right, then you might enjoy long-term Acacia Research Corp. like gains.

Source: A New Era Of Business Has Created Large Returns