SunRocket : Casualty of Patent War

Toni just posted a note on the Sunrocket and every point she makes is true!

Cable companies are encroaching the VoIP business turf; SunRocket was bleeding and without a major cash infusion, it was not going to survive for long, but the event that precipitated its demise was the patent war between Verizon and Vonage.

So what happened? Because of the Vonage-Verizon patent tussle, where the punishment for loosing the lawsuit was death, investors taste for VoIP companies dried up. In March/April, SunRocket, (the #2 independent VOIP company) was looking for $20-$40M series D funding, but had trouble closing the round; after the patent verdict, the whole sector had became untouchable. Vonage, Packet8, SunRocket , the whole group joined the bottom pool and without new cash and any possibility of getting new cash in near future, SunRocket died.

Without the patent sword hanging on its head, Sunrocket would have survived for another couple of years and then probably would have merged with another VoIP provider. After the Vonage verdict, it became a game of Russian Roulette with a fully loaded gun.

People very often ask me, are patents really worth having? Give me a good example of where patents (and not much else) mattered. I guess now there is a new poster child; Verizon vs. VoIP. The last I heard, the court had ordered Vonage to pay $58 million in damages for infringement, and a 5.5 percent licensing fee for the continued use of the patents. If the appeal fails, Vonage is toast.

Some say that the Verizon patents are junk patents and yet when the order came down from the court, it didn’t seem like a Junk order to me, the damages awarded had a lots of zeros in them!

Verizon patents crippled Vonage, one of its major VOIP challenger and summarily killed the second VoIP challenger without spending an extra dime. All other players in this sector are feeling the pinch. Hope this demonstrates the power of having the right patent.

The company that may survive is Packet8 , another independent VoIP company. It has a slew of patents and they are likely to be able to use this patent portfolio as a defense against Verizon and others.

A patent can work as a sword, a shield and, as in Verizon’s case, as a shot gun!

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Carried Interest Tax Debate and why should startups care?

Unless you were caught up in the iPhone hype or busy with the Paris Hilton saga, you are probably familiar with the “Carried Interest” Tax Debate in the VC community.

In a nutshell this is what the issue is and let me illustrate it with a concrete example:

Let’s say Frank wants to start a new venture fund; he calls his friends and other investors and raises $50M. Frank is the general partner and the other investors are limited partners. Frank’s compensation is some management fee, plus a portion of the “up side” of the fund. If the fund gains by 10%, he doesn’t get anything, but if it gains by more than 10%, he gets 20% of the increase, i.e., if the fund gains by 15%, Frank gets (20% of extra 5%) which is 1%. Different funds have different numbers and different thresholds, but the concept is the same.

Under the current tax code, the 1% that Frank gets (his “carried interest”) is treated as “capital gains” and it gets taxed at the rate of 15%.
Under the new tax bill that is afoot, the 1% will get taxed at the rate of personal ordinary income tax, which is about 35%.
The investors (limited partners) will continue to get taxed at the capital gains level of 15%, only the general partners (Frank in this case) gets taxed at 35% for his portion.

And why does Congress want to pick on Frank, the general partner here? They put forth two reasons: the first one, in a nutshell is “Frank made a lot of money and we want some of it”; and the second argument goes like this: “Hey, Frank didn’t put up his own money here; why should he get capital gains treatment, its all income to him! - lets get him.”

To show that this is all really asinine; lets take another example. Frank now wants to start a Pizzeria, he calls his friends and investors and they put up the money. They agree that the investors will own 80% of the business and Frank will own 20% of the business. Frank works hard and in a few years the pizza place is a great success. The pizzeria is sold for a handsome profit. Now for the questions - the 20% that Frank makes, is it ordinary income or is it capital gains?

If you get options at the company that you work for and if you hold them for a while and the options increase in value - is that ordinary income of capital gains?

In neither of the cases above, the person getting the “capital gains” tax rate, put up any of his own money. But we all know that in both of these cases, the increase in value is “capital gains”. All parties contributed to the success of the enterprise, they all took risks. Some brought in money, others brought in expertise, and some brought in know-how.

To me, these are simple partnership issues; if the underlying asset qualifies as “capital gains”, then for each of the partner; it is “capital gains.”

And what kind of logic is it to tax somebody more, just because they succeeded! Venture funds have contributed so much to the economy; they should be rewarded not punished. Moreover, the equity managers are generally in control of their own taxation, before the ink on the amendment is dry, there will be new methods devised, new Blocker Corporations setup to ensure that the carried interest gets treated at 15% (or even less) rate.

How does this affect the startups and emerging companies? It affects them directly. If Frank gets taxed at higher rate, he will either charge higher management fee or increase his carried interest so that he comes out even. And people who get less are the investors and that means they will be less likely to invest. The next time you have a Web 3.0 epiphany, you might not find as many people wanting to write you a check.

The place where the effect will be most directly seen would very likely be in “smaller markets”. The Silicon Valley, the southern California, the New England area, all of them will continue to get funding; managers will continue to manage, but when somebody wants to start a regional fund for North Carolina research triangle or for the Energy Corridor in Houston, the venture funds and the catalysts that make the funds happen, will be less likely to be there.

VCs have provided one of the most important economic engines in recent times; lets keep it moving and not burden it with more taxes.

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Internet Radio, Copyright, Copywrong and $$$

The end of the road for Internet Radio was near. The execution of the Internet radio by SoundExchange, the body that represents copyright owners, was to have been on Sunday.

And Dejavu happened on the way!

Go back about 5 years: In 2002, there was a royalty deadline looming and then a meeting between SoundExchange and small webcasters took place which made possible the creation and adoption of the Small Webcaster Settlement Act. Webcasting was a nascent industry, it needed nurturing, it needed a way to grow. So for independent webcasters with rev of $1.2M or less, a special deal was worked out. Great!

In 2007, we are exactly at the same place, minus the sanity of SoundExchange.

I understand the copyright issues here; they are kind of interesting but I am more fascinated with the business decisions.

The copyright owners, represented by Soundexchange, can do whatever they want with their copyrighted work. That’s the Copyright law. It says that they have to allow the internet webcasters to stream the music at a certain price. Soundexchange is willing to do it but unfortunately it wants to collect $1B first as administrative expense by charging $500/per channel under some ridiculous formula and wants royalty per song to be the same as a cup of Starbucks coffee. Under this formula RealNetwork owes them $200M/yr for “administrative expense”. They tweaked it a bit but the issue still remains.

SoundExchange wants minimum payments; Again for webcasters, its a non-starter. In almost all cases, if royalty rates that have been set are applied, the royalty amount due will be 3-5 times the revenue generated by the webcaster. Currently the webcasters pay ~10% of the revenue and it will go to 300% of the revenue.

This morning, Soundexchange realized that executing the internet radio also means that it will have to shoot itself in the foot. They announced that SoundExchange will not enforce the royalty hike on Monday but will try to work out some reasonable settlement.

This will drag on for a few weeks, some groups will work out a special deal, others will be subject to the new royalty rates, and it will be a huge mess!

Webcasting and internet radio is going to be huge but its not there yet. But I can tell you this with some confidence that the economics of webcasting, especially for small webcasters, is going to be the same as it is right now, for a long time to come.

Webcasters compete with satellite radios pay and about 7.5% as royalties. Webcasters should pay more because they do not have a subscription model but that number needs to be at 10-12%, with no minimum fees per channel. Who came up with channel thing anyway? I know that the comparison with the satellite delivery is not perfect, but its a good starting point as the basis for charging tariffs on internet radio.

If the internet radio is silenced in this country, many non-US broadcasters will try to extend their reach; that’s not copyright enforcement, that’s “copywrong”.

I fully respect and understand the copyrights owned by Soundexchange; I have counseled and litigated copyright cases, but this is not a copyright issue, this is a pricing issue; It is no different than setting the pricing for a widget correctly, so that it not only benefits the distributor, but generates sustainable revenue for the content producer.

And the solution is to follow the $$$ signs and optimize for the long term.

There is a revolution happening, and I want it streamed!

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Value of a junk patent and patent strategy of a company was awarded the patent number 7,200.413 by the U.S. Patent Office. It covers “Enhanced Directory Assistance�?, which will deliver keyword specific ad referrals based on user input on the phone.

If you look the lone claim (which defines the coverage and scope of the patent), it requires nine specific steps, each of which can be executed or bypassed. A few months ago, this patent might have had some inherent value but after the Supreme Court’s recent decision on obviousness and what is “patent worthy�?, I strongly doubt it if this patent can survive a spirited challenge.

Also this patent only has one claim, which is extraordinarily uncommon for a non-design patent and generally happens only if the patent offices trashes everything that is initially claimed and throws you a bone.

Some people might refer to patents like these as “junk” patents; they are very narrow and they are vulnerable to various legal attacks; so as a protect able IP component, they have limited value.

However, these patents do serve another important purpose, which is to get noticed by the investors. As soon as the enhanced directory assistance patent was granted, instantly added about $30-$50M to its market cap.

If were to be sued by another company that holds a geo-specific patent, would have the option of cross-licensing it’s patent as a trade.

The point that I am driving at is that building a patent portfolio is not just for creating a defensible IP barrier, but also to attract investors, and to have IP assets available for cross-licensing and bartering.

Some patents might not have inherent value, but they might have tremendous perceived value which is as important!

Patent strategy for a company is different depending on its gestation level, the technology it focuses on, and several other factors. A start-up might benefit from higher number of patents and a stable company might benefit from having more quality patents.

The key to success is to maximize the real, inherent value of the patent and take full advantage of the its perceived value in the market place.

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