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Document Security Systems (NYSEMKT:DSS) and its soon-to-be-merged partner, Lexington Technology Group (LTG), just announced they are suing Facebook (NASDAQ:FB), LinkedIn (NYSE:LNKD), Broadvision (NASDAQ:BVSN), Jive Software (NASDAQ:JIVE), and Novell for patent infringement. As you can imagine, some of these cases will be high-stakes litigations with potential damages in excess of $1 billion.

If DSS/LTG can win any of these large cases, DSS's share price should at least triple. Will the share price go from $4 to $40 as was the case with VirnetX (NYSEMKT:VHC) following its Microsoft (NASDAQ:MSFT) victory? Anything is possible with IP companies.

IP licensing addresses a huge market, and according to the World Intellectual Property Organization 2011 report, the annual global IP licensing market has grown from $2.8 billion in 1970 to $180 billion in 2009. That figure should be well above $200 billion by now. There's a lot of IP pirating going on which should diminish in the coming years as patent holders claim their legal rights.

Revenue potential for Facebook litigation

I will initially focus on the Facebook lawsuit because of its visibility and Facebook's huge revenue stream. Facebook is expected to earn about $5 billion in 2012, and it appears that Facebook may be generating that revenue while using LTG's patented technology.

If Facebook agrees to pay LTG a 1.5% revenue based licensing fee, LTG could receive about $75 million in licensing fees, just for 2012. (A 1.5% royalty rate may be conservative when you consider that VirnetX is suggesting between 1% and 5%.)

According to Bloomberg, Facebook is expected to grow revenue by about 33% per year, so from 2012 on, LTG's licensing revenue from Facebook could rise at the same rate. For example:

If Facebook earns $5 billion in 2012, LTG could receive $75 million

If Facebook earns $6.5 billion in 2013, LTG could receive $99 million

If Facebook earns $8.8 billion in 2014, LTG could receive $132 million

If Facebook earns $11.7 billion in 2015, LTG could receive $175 million

If Facebook earns $15.6 billion in 2016,, LTG could receive $233 million

If Facebook earns $20.7 billion in 2017, LTG could receive $310 million

LTG's 2012 through 2018 potential licensing revenue: $1.024 billion

LTG is claiming that Facebook has been infringing since September 2006, so past damages are significant. Here's a breakdown of Facebook's revenue from 2006:

2006 revenue: $48 million

2007 revenue: $153 million

2008 revenue: $272 million

2009 revenue: $777 million

2010 revenue: $2 billion

2011 revenue: $3.7 billion.

Total Facebook revenue 2006 through 2012: $7.38 billion

At a 1.5% royalty rate, past damages would be $110 million. If willful infringement is determined, and treble damages are assigned, that figure could go up to $330 million.

DSS is currently valued at about $80 million, so it appears the market has not yet priced in these large lawsuits. If the Facebook lawsuit were to generate even half of the potential $1 billion in licensing fees, DSS's share price should at least triple. If LTG were able to receive a 2% or 3% royalty rate, the numbers become staggering.

This article will focus on the two merging companies, DSS and LTG, their patent portfolios, and the potential settlement outcomes.

Part One: Lexington Technology Group

LTG is a private company whose primary objective is to buy high-quality patent portfolios that generate large licensing and settlement fees. Its first investment was in a company called Bascom Research. Bascom Research owns the patents that allow companies to structure and use a social network. The Bascom Research patents could be at the very core of Facebook's and LinkedIn's businesses. These are the patents that Facebook, LinkedIn, and potentially hundreds of other companies are allegedly infringing upon.

For investors, the big question is whether or not LTG can monetize these patents. Here's my analysis:

LTG's 1st secret weapon: Kramer Levin

LTG's law firm, Kramer Levin, will be pursuing the lawsuits against Facebook and the other four defendants. In my opinion, LTG couldn't have chosen better litigators, primarily because of Kramer Levin's knowledge of Facebook's source code, which it obtained in the 2009 Leader Technologies versus Facebook case.

Source code is the human readable set of instructions underlying software. It basically tells the computer what to do but it does not do so directly. Instead, source code is typically converted into object code. As a result, electronic devices do not themselves contain source code, they contain object code. Because humans cannot readily read object code, a plaintiff usually needs source code to determine how it accomplishes its accused functions.

As you can imagine, defendants are not eager to produce their source code, which may be subject to trade secret protection.

Kramer Levin's access to Facebook source code is important for two reasons:

Number one: When Kramer Levin initially investigated LTG's patents, this source code had to be key in determining that LTG actually had a strong case against Facebook.

Number two: Knowledge of Facebook source code should give Kramer Levin a big advantage throughout the entire Facebook litigation.

Kramer Levin agreed to work on contingency at a relatively low rate. In my opinion, Kramer Levin's willingness to work on contingency while spending millions of dollars to prosecute this case is an endorsement of the law firm's belief in LTG's patents.

LTG's 2nd secret weapon: IPNav

LTG's lead advisor, IPNav, also operating on contingency will be pursuing the hundreds of other companies that are allegedly infringing on LTG patents with the intent of obtaining licensing fees from most of these companies.

Over the past eight years, IPNav has obtained over $600 million in IP settlements from over 500 different infringing companies, including Nike (NYSE:NKE), Symantec (NASDAQ:SYMC), and Schlumberger (NYSE:SLB). These guys have the experience and expertise to bring in hundreds of licensing fees for LTG.

Assuming a best-case scenario, let's say that IPNav successfully prosecutes 500 infringing companies at an average rate of $5 million per company. That would bring in a total of $2.5 billion.

LTG's 3rd secret weapon: board advisors Warren Hurwitz and Jeff Ronaldi

Warren Hurwitz is the cofounder of Altitude Capital Partners which has one of the most experienced and successful IP teams in the field. The company's patent infringement cases have generated settlements from companies including Research In Motion (RIMM), eBay (NASDAQ:EBAY), LG Electronics, and Nokia (NYSE:NOK).

Another strategic board advisor, Jeff Ronaldi, was the general manager at Imagexpo, a subsidiary of SPX (NYSE:SPW), which won a $60 million judgment against Microsoft. He was also a board member of SSL Services which won a large settlement against Citrix (NASDAQ:CTXS).

From my perspective, LTG has assembled one of the best IP litigation teams that I have seen. These are seasoned professionals who have proven their abilities to generate large licensing and settlement fees.

Low contingency fees validate patent strength

LTG stated during last week's conference call that the company would retain 65% of any settlement or royalty revenue. This tells me that Tom Bascom, IPNav, and Kramer Levin will be splitting the remaining 35%, or about 12% each (we don't know the exact division). Their willingness to work for low contingency fees only reinforces my belief that the key players, who understand this business and these patents, expect LTG"s patents to generate large settlements.

LTG's patents in the Facebook case

Only a patent expert can determine just how strong LTG's patents really are, but if you take a look at the four patents in the Facebook lawsuit, they appear relevant to Facebook's technology and beyond:

The 232 patent: Method and system for making document objects available to users of a network.

The 974 patent: Framework for managing document objects stored on a network.

The 241 patent: Method for users of a network to provide other users with access to link relationships between documents

The 971 patent: Method for searching document objects on a network.

According to a recent press release:

"Bascom's innovations cover the manner in which users and application developers on the Facebook platform make connections between 'objects' such as photos, people, events and pages - which is the very essence of Facebook's business."

Here's why I am betting on this patent portfolio

My investment premise focuses on the fact that most of these IP litigation heavyweights will only profit if the Lexington patents generate substantial settlement and licensing fees. I feel confident that all the key players investigated these patents thoroughly, and given their decision to join Lexington, it appears obvious that they believe the patents are strong. I have taken a long position largely based on these experts affirmations of LTG's patents.

LTG has proven its ability to buy quality IP at bargain prices

The software at the core of these lawsuits was designed by Tom Bascom and patented in 2001. According to a recent 8K filing, LTG bought these patents for $2.1 million cash. LTG's ability to find and buy a patent portfolio for $2.1 million that could ultimately generate up to $1 billion is a business model that I like.

LTG intends to expand its patent portfolio, and if it can do so with the same type of leverage that the Tom Bascom portfolio offers, investors should be rewarded.

Virginia's courts are investor friendly

These cases will be tried in Virginia courts which are famous for trying cases quickly. Vringo (NASDAQ:VRNG), whose share price has soared in the last few days, chose Virginia for this very reason. Also, as I mentioned in a previous Seeking Alpha article on Vringo, 67% of the rulings in IP cases favor the plaintiff.

With Virginia's rocket docket, LTG should be in court within a year, so I would expect Markman hearings within about nine months. Remember, 90% of all cases settle after the Markman, so this is an extremely important catalyst. A positive Markman ruling could easily boost DSS/LTG share price 50%.

Part Two: Document Security Systems

DSS is a developer and marketer of security printing technology, cloud computing data security, and radio frequency identification (RFID) systems. Its technology is patented and sold to large corporations, governments, and numerous financial institutions. Companies primarily use DSS security printing technology for preventing counterfeiting while government agencies use it for fraud detection and cloud integration.

Why LTG merged with Document Security Systems

Number 1: DSS has initiated a multimillion dollar lawsuit against Coupons.com which could generate a large settlement fee.

Number 2: According to IP Capital Group, DSS's patent portfolio contains at least $245 million inherent value.

Number 3: DSS is currently generating over $15 million per year in security printing technology, a rapidly growing sector.

Number 4: DSS provides LTG with immediate access to the equity market.

Number 5: As an operating business (as opposed to a nonpracticing entity), LTG will have the ability to demand injunctions, lost profits, and treble punitive damages. It really amplifies LTG's ability to increase profits through litigation.

Document Security Systems' patent portfolio

On May 15, 2012, DSS released the results of IP Capital Group's assessment of the company's intellectual property. The consulting firm valued the company's licensing market potential at approximately $245 million. This valuation is completely separate from the Coupons.com lawsuit.

DSS has over 50 patents and patents pending, many which are extremely relevant in today's high-tech world. The company is a dominant player in the anti-counterfeiting/brand protection market. Counterfeiting is a growing problem worldwide, resulting in over $1 trillion in global losses. Over $3 billion is spent annually to combat this problem, and according to Converting Quarterly, that number is expected to grow to over $79 billion by 2014.

DSS has established itself in some very important markets. For example, the US government mandated DSS technology to secure US Social Security cards. DSS has a history of protecting famous brands from counterfeiting, including Procter & Gamble (NYSE:PG), Pfizer (NYSE:PFE), Kellogg Company (NYSE:K), Pepsi (NYSE:PEP), and Coke (NYSE:KO). Also, DSS was selected by Deloitte as a fast 500 technology company for five years running.

DSS's secret weapon: John Cronin

John Cronin was IBM's most prolific inventor with over 100 patents to his name. His efforts helped turn IBM around, back when the company was in serious trouble, and he did this by helping IBM become a literal patent factory.

When IP Capital Group's John Cronin completed the valuation of VirnetX, the company's market cap exploded from $50 million to almost $2 billion. We have no way of knowing to what degree John Cronin's input contributed to VirnetX's success, but he is certainly a good man to have on your team.

It appears that John Cronin will be an IP strategist for DSS and should be able to help monetize the company's patents. He's been in this business for a long time and has proven his ability to help companies bring value to their patent portfolios.

Near-term catalyst: DSS versus Coupons.com lawsuit

DSS has initiated a lawsuit against Internet sensation, Coupons.com. DSS is alleging that Coupons.com had misappropriated trade secrets and breached confidentiality agreements with the company. I expect mediation to take place later this year, and a positive outcome would be good for shareholders.

Patrick White, CEO of DSS states:

"It is our contention that Coupons.com has utilized the copy protection technology which DSS provided to them for review under a strict nondisclosure agreement. Our research indicates that Coupons.com has printed this particular technology on billions of Internet generated coupons since 2006."

According to a recent Seeking Alpha article, DSS now seeks royalties from 2006 on, which could amount to $45 million per year, or over $2.20 per share.

According to the Silicon Valley Business Journal, Coupons.com has become the world's dominant digital printable coupon company, capturing about 90% of the market share in an industry projected to grow from 6 billion last year to $46 billion in 2015.

Coupons.com is growing fast with 2010 revenue at $50 million and 2011 revenue at $100 million. Coupons.com has created so much excitement on Wall Street that Goldman Sachs included it in a list of projected companies soon to hit the public markets with a big IPO. This would be good news for DSS because Coupons.com could be motivated to settle with DSS before the IPO.

This merger creates value for investors.

Overall, LTG could not have chosen a better partner. DSS owns valuable IP and can benefit from LTG's litigation expertise and experience. LTG can help DSS monetize its patent portfolio. And of course, DSS adds value to LTG for the reasons described above. This is the type of merger I like to invest in: where both companies complement each other and create a new entity stronger than each of the original companies.

Risks for investors:

Risk number 1: The big risk lies in the fact that we do not know whether these patents can generate as much revenue as expected. Just because experienced professionals believe in the patents, doesn't guarantee the outcome for investors.

Risk number 2: If the Coupons.com case does not bring in a large settlement, and LTG cannot provide sufficient cash, DSS may need to do a capital raise.

Risk number 3: It appears LTG has sufficient capital to conclude the Facebook/LinkedIn lawsuits, but if it were to acquire new IP, it may need to do a capital raise.

While these risks are real, I choose to maintain a long position. Since much of this team will be working on contingency, the cash burn should be minimized. But most importantly, their willingness to work on contingency is a strong vote of confidence for the patent portfolios. At this stage, I will defer to their judgment, maintain my long position, and watch the cases closely.

Conclusion

I like both these companies individually, and together they form an intellectual property powerhouse built on an established $15 million a year operating corporation. Based on the combined patent portfolio, in my estimation, the revenue potential exceeds $1 billion. If the new company prevails over Coupons.com, Facebook, and the other four defendants, and if it achieves its goal of generating hundreds of other licensing settlements, shareholders should be rewarded.

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Source: Facebook Lawsuit Could Send Document Security Systems' Share Price Soaring

Additional disclosure: I am long Lexington Technology Group, and if the merger is completed as planned, I will be long DSS.