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Google's Bid-for-placement Patent Settlement Cover-up

When Google acquired blogging startup Blogger in February 2003, nobody foresaw that two years later Google will earn the ignominious distinction of being one of the first corporations to fire an employee for blogging. In January of this year, Mark Jen a new Google hire was sent packing for a blogging offense. Mark Jen writes in his blog:

" i was terminated from google. either directly or indirectly, my blog was the reason. this came as a great shock to me because two days ago we had looked at my blog and removed all inappropriate content - the comments on financial performance and future products. for my next entries, i was very cognizant of my blogging content, making sure to stay away from these topics. i mean, as much as i like to be open and honest about communicating to users and customers, i'm not insubordinate. if i was told to shut down this blog, i would have."

Mark Jen is justly irate about the harsh treatment. Google did not have a blogging policy at the time, and Mark did his best to comply with the wishes of his superiors. Furthermore, Mark Jen was not a high ranking Google manager with important information to disclose; he had only just started work at Google. If Google's management wanted to avoid making an incidence of the Mark Jen case, it had plenty of options, but Google's management willingly embraced bad PR and proceeded with a response disproportionate to the offense.

(Update: July 10, 2008
In retrospect, I feel I exercised bad judgement in connecting Mark Jen's firing to Google's cover-up of its patent settlement with Yahoo. In fact, this article as originally published in April 2005 did not contain any reference to Mark Jens' firing, but I subsequently added the material. Mark Jen's firing was suspicious and made no sense, and it may have been prompted by motives I outlined in this article; however, I have no evidence that the firing was linked to Google's cover-up of its Yahoo deal.)

It turns out there was a very good reason for management's bizarre behavior. At the time of Mark Jen's dismissal, Google's management was playing a game of deceit to mask an ugly but not so well-kept secret. Management wanted employees to keep their mouths shut and firing Mark Jen, a new hire, was a convenient way of conveying the message without ruffling many feathers.

Google's ugly secret has quite a bit of history. The trouble started with Google's push for profitability. Google owned excellent search engine indexing technology all along, but it lacked a business model to extract profits from search traffic. Google's solution to the problem was the AdWords business model. The AdWords business model combines Google's search technology, text ads, and an ad-placement mechanism that allows advertisers to bid for the placement of ads (the bid-for-placement mechanism).

The bid-for-placement mechanism is a very important component of the AdWords business model. In the absence of the bid-for-placement mechanism, ad pricing can at best be inefficient. The bid-for-placement mechanism frees up extensive resources that would otherwise be required to set ad prices, and it allows Google to charge ad sponsors in proportion to the value Google is delivering to the sponsors. Thus, from a profitability perspective, the bid-for-placement mechanism is as valuable as Google's indexing technology. Unfortunately, Google did not own the rights to this important mechanism when it adopted the AdWords business model.

Overture Inc. a paid search specialist pioneered the bid-for-placement mechanism. In July 2001, the US patent office issued Overture a patent for the mechanism. Patent 6,269,361; also known as the '361 patent, essentially covered all AdWords like business models. Google needed access to the '361 patent in order to use AdWords, but it never managed to negotiate a licensing agreement with Overture. Consequently, in April 2002 Overture sued Google over patent infringement. Google was now operating with a loaded gun pointed to its head.

Overture started life as a paid listing search engine. The company was known as GoTo.com when it first began operations. Advertisers placed ads with GoTo.com and in response to queries the GoTo.com website produced a listing of ads ranked by the ad sponsors' bids for the search keywords. The GoTo.com website never made it big, and the company was forced to pitch the idea of bid-for-placement to outside search engines. The company even changed its name to Overture to better reflect its new business model.

Overture had a bit more success with this new business model. Under this new business model Overture signed up affiliates and managed their ad sales via its bid-for-placement system. Overture recognized the ad sales of its affiliates as revenue on its books and recorded the portion of ad sales that went to its affiliates as traffic acquisition costs.

The paid-search market took off in 2001, and Overture prospered in the rapidly growing market for a while. Overture earned $73 million on revenues of $667 million in 2002, but then a disturbing trend became apparent: Overture's traffic acquisition costs started spiraling out of control. Overture's traffic acquisition costs grew from 53 percent of revenue to over 62 percent of revenue in just the last three quarters of 2002.

Even after handing over 62 percent to affiliates, a 38 percent cut of ad sales for providing access to the bid-for-placement mechanism is hardly unimpressive, and reflects the revenue generating power of the bid-for-placement mechanism. Unfortunately, the 38 percent number was just an average, and not every affiliate was paying the same amount to Overture. Overture was increasingly growing dependent on fewer and fewer affiliates for more and more of its revenue. Overture's smaller customers were in decline as advertisers were concentrating primarily on highly trafficked websites. Overture's 2002 annual report reveals that Microsoft and Yahoo were responsible for 60 percent of Overture's revenue that year. This dependency allowed the big affiliates to claim bigger and bigger chunks of ad sales as their share of the pie.

The '361 patent was certainly very valuable, but the patent had not been tested in court. If either Yahoo or Microsoft walked, Overture could expect major layoffs and a severely weakened bargaining position with the rest of its affiliates. Additionally, one big setback in court could end Overture's game for good. Such risks implied a vulnerable market position, and pushed Overture's management towards seeking a buyer for the company. A company with well-diversified sources of revenue was Overture's best option. Such a company could handle setbacks in courts and bargain better with affiliates on account of its stronger finances.

Microsoft made a lot of sense as Microsoft was well-diversified and loaded with cash. There was some enthusiasm for acquiring Overture inside of Microsoft as well. According to Fortune Magazine, Chris Payne, a Microsoft manager, tried to convince Bill Gates to proceed with an Overture acquisition; however, Bill Gates did not see sufficient value in Overture and rejected the acquisition. Overture's value lay in its patent portfolio, and Bill Gates must have miscalculated the strategic importance of Overture's patent portfolio.

Yahoo was Overture's backup choice and it too made a lot of sense. Yahoo handled more web-traffic than anyone else, and with Overture's patent portfolio Yahoo could become what Overture wanted to be, but without the handicap of having to hand over vast chunks of revenue to affiliates.

Unlike Bill Gates, Yahoo was aware of Overture's potential. Yahoo had always outsourced its search functionality to outside search engines. With Google gaining prominence and no new search contenders on the horizon, Yahoo was in a tight spot. Yahoo realized that to be competitive in the search engine arena, it needed access to Google's intellectual property. Overture's claim on the core of Google's business model was just the bargaining chip Yahoo needed.

In July 2003 Yahoo acquired Overture in a mostly stock deal valued at $1.63 billion. This was an expensive deal as Yahoo's stock was not flying very high at the time. Also, Overture did not have anything valuable apart from the '361 patent. Yahoo and Microsoft counted for the bulk of Overture's revenue, and were it not for the '361 patent, Microsoft would have certainly walked. The deal was terrible news for Google as Yahoo was now in a position to cut a very tough bargain with Google.

Google and Yahoo settled the '361 patent dispute in August 2004. Google disclosed the settlement in an SEC filing just before its initial public offering (IPO). The relevant excerpt from Google's SEC filing states:

Overture will dismiss its patent lawsuit against us and has granted us a fully-paid, perpetual license to the patent that was the subject of the lawsuit and several related patent applications held by Overture. The parties also mutually released any claims against each other concerning the warrant dispute. In connection with the settlement of these two disputes, we issued to Yahoo 2,700,000 shares of Class A common stock.

At the time of the patent settlement disclosure, 2.7 million shares of Google represented roughly 1 percent of the company. Google estimated that the shares were worth somewhere between $260 and $290 million. This estimate was based on Google's proposed IPO price range of $108 to $135 a share, which was subsequently lowered to $85 a share. Interestingly, even the $290 million number does not represent any sort of adequate return on Yahoo's $1.63 billion Overture investment. Yahoo was licensing critical patents to Google at a critical time for less than one fifth of what it paid to acquire them.

Interestingly, Google never paid anything even remotely close to $290 million for the patents. Google quite successfully managed to muddle up the math by jumbling together the numbers of the patent licensing settlement with the settlement of a separate second dispute with Yahoo.

In the second dispute, Yahoo claimed a warrant it held in connection with a June 2000 services agreement between the two companies entitled it to 3.7 million Google shares. Google had issued 1.2 million shares in June 2003 to settle Yahoo's claims, but Yahoo wanted an additional 2.5 million shares.

Google's 2004 annual report has the settlement value pinned down to $229.5 million, and it sheds some light on how much was paid for what. The section about the Yahoo settlement states:

In the year ended December 31, 2004, the Company [Google] recognized the $201.0 million non-recurring charge related to the settlement of the warrant dispute [with Yahoo] and other items. The non-cash charge associated with these shares was required because the shares were issued after the warrant was converted. The Company realized a related income tax benefit of $82.0 million. The Company also capitalized $28.5 million related to certain intangible assets obtained in this settlement.

In the IPO filing the focus was on the patent dispute, but here the emphasis is clearly on the non-recurring charge related to the warrant dispute and "other items". Interestingly, the "other items" mentioned above do not include patent licenses (explanation follows), so out of the $228.5 million settlement $201 million had absolutely nothing to do with the patent settlement.

US corporations are required by law to follow generally accepted accounting principles (GAAP) put forth by the Financial Accounting Standards Board (FASB), and compliance to this requirement is assured by independent auditors. One fundamental component of GAAP is the matching principle. This principle requires revenues to be matched with the expenses it took to generate them, i.e., expenses relevant to the revenues reported are recognized in the same period as the revenues. Often matching expenses with revenue is not straightforward, and then the matching principle reduces to recognizing expenses when resources are utilized as opposed to when resources are paid-for or acquired.

For instance, if a corporation pays for a one year insurance contract at the start of its fiscal year, the corporation can not record the total cost of the insurance contract as an expense in its first quarter. The corporation will be availing of the insurance company's services over one year, so the insurance expense has to be spread over that time frame. To accomplish this the corporation capitalizes the insurance contract, i.e., the corporation records the insurance contract as an asset, prepaid insurance, on its books. Afterwards, the corporation records insurance expense in four subsequent quarters to write-off the prepaid insurance asset.

A patent license is conceptually somewhat similar to an insurance contract. A typical patent license grants the licensee the right to use a patent for a number of years, and if the licensee prepays for the license then it makes sense to capitalize the cost of the license. In fact, GAAP requires prepaid patent licenses to be capitalized. Google too was required to capitalize the patent license it acquired from Yahoo and expense it over time. However, the $201 million one time charge was something that was not capitalized; therefore, it had no relevance to the patent licenses Google acquired.

A $201 million payment for the warrant dispute makes perfect sense as this amount represents 2.36 million Google shares which is fairly close to the 2.5 million shares Yahoo wanted. Yahoo had zero incentive to compromise on its demands with Google's IPO so close, and Google's financial statements clearly indicate that Yahoo got what it wanted. Google recorded the rest $28.5 million as intangible assets on its books. Patents are capitalized as intangible assets; therefore, $28.5 million is all Google paid for the patent licenses it acquired from Yahoo.

Yahoo was also a participant in the patent licensing transaction, and it too was required to report the transaction. Yahoo needed to recognize revenue and under GAAP revenue is reported in accordance with the revenue recognition principle. This principle requires revenue attributed to a product/service to be recognized in the same period in which the product/service was sold/rendered, regardless of the exchange of cash. Under this principle, prepayments for services are recorded as liabilities and revenue is recognized against these liabilities when the relevant services are rendered.

The patent licenses Google acquired counted as service agreements under GAAP. Google prepaid for the patent licenses, so Yahoo was required to report the prepayment as deferred revenue, a liability. Yahoo's 2004 annual report states:

"The Company [Yahoo] agreed to dismiss the 361 patent lawsuits and has granted to Google a fully-paid license to the 361 patent as well as several related patent applications held by Overture. The Company allocated the 2.7 million shares between the two disputes, based on the relative fair values of the two disputes, including consideration of a valuation performed by a third party. A portion of the shares allocated to the patent dispute has been recorded as an adjustment to goodwill for the period that the patents were in effect prior to Overture's acquisition by the Company. The portion of the shares received for the settlement of the patent dispute which has been allocated to future periods has been recorded in deferred revenue on the consolidated balance sheets and will be recognized as fees revenues over the remaining life of the patent, approximately 12 years."

Yahoo divided the proceeds of patent licensing agreements amongst the goodwill and deferred revenue accounts. The twelve year remaining life of the patent mentioned in the annual report implies Yahoo allocated most of the proceeds from the licensing agreement to its deferred revenue account. Consequently, Yahoo's deferred revenue account ought to show a big spike if the proceeds from the patent agreement were substantial.

Yahoo reported deferred revenue of $224 million, an increase of $11 million over the prior quarter, in its Q3 2004 (3rd quarter of fiscal 2004). This was the quarter in which the settlement took place, and a substantial increase in deferred revenue was anticipated. Yahoo's deferred revenue was $192 million, $201 million, and $213 million in Q4 2003, Q1 2004, and Q2 2004, respectively. Considering these numbers, the $11 million increase in the Q3 2004 in no way represents a break from the obvious trend in Yahoo's deferred revenue account. The patent settlement value has to be insubstantial as there is no spike in Yahoo's deferred revenue.

Both Google and Yahoo's financial statements indicate that the patent licensing portion of the $229.5 settlement was no bigger than $28.5 million. Spread over the life of the patent the licensing fees are paltry, and it is simply inconceivable how Yahoo agreed to license its billion dollar patents for such a ridiculous sum.

Patent litigation is extremely expensive and Yahoo must have spent a good chunk of $28.5 million on legal expenses by the time of the settlement. This suggests the $28.5 million covers Yahoo's legal expenses associated with the patent litigation and does not represent any payment for patent licenses. Google compensated Yahoo for the patent licenses in some other way, and the company is not being forthright about the settlement terms.

Yahoo craved Google's intellectual property, but the terms of the settlement make no mention of Yahoo licensing any of Google's patents. Google could not expect to get away with hiding an IP licensing agreement with its biggest competitor; therefore, it is reasonable to assume that Yahoo did not get such an agreement. However, Yahoo had an indirect way of achieving access to Google's intellectual property.

Google's SEC filings mention a "fully-paid, perpetual license," but they omit the word non-revocable. Patent license terms often include non-revocable in addition to perpetual. Perpetual seems to indicate non-revocability but it really does not. It is unreasonable to expect Google's high-powered lawyers to miss the word non-revocable, so Google's license to the '361 patent is revocable.

Now all that remains is the question of the terms which if violated cause Google's patent license to become revocable. The only obvious term that makes sense was for Yahoo to have conditioned the revocability of Google's patent license on Google's not litigating against Yahoo. Such a condition puts Google on a leash, and effectively grants Yahoo the authority to use Google's patents with complete immunity. Of course, there are other possibilities, but again there was no reason for Yahoo to settle for anything less than unhindered access to Google's patent portfolio.

Settling on onerous terms with a competitor is not a crime, and Google did nothing wrong by settling with Yahoo. If Google had reported the transaction honestly there would be no problem at all, but Google didn't do that.

US regulations require corporations to disclose all significant business risks to investors. Before the settlement, Overture's patent litigation posed a threat to Google's business and Google did disclose that. The settlement removed the risk of litigation but by giving away the company's technical superiority it created a new risk. Google essentially traded one type of risk for another, and was bound to disclose the nature of the new risk. Google never did that, and in doing so ran afoul of US regulations.

Google's patent settlement disclosure on August 9 2004 was immediately followed by an IPO auction on August 13. Typically, investors don't care too much about pending patent litigation when investing in IPOs, but the timing of Google's patent settlement suggests Google's IPO was the motivation for the settlement and the ensuing cover-up.

US regulations prohibit companies from aggressively marketing their IPOs and compliance is assured by forcing companies into a quiet period. In the quiet period a company can disclose information about its business activities only via an SEC filing known as the company's prospectus. The goal being to prevent unsound businesses from pitching themselves to investors. This results in a substantial handicap. Additionally, new businesses have the problem of being restricted to raising funds from retail investors (individuals who buy/sell securities for their personal account) on account of their limited contacts. Retail investors constitute a small portion of the trading activity in the stock market, and are only willing to invest small amounts in speculative ventures. To raise a billion dollar or more a company might need to sell its IPO shares to tens if not hundreds of thousands of retail investors which is impractical at best.

Fortunately, companies going for IPOs don't have to worry about such problems; instead, they hire investment banks as underwriters and relegate these problems to investment bankers. Most of the big money in the stock market is controlled by institutional investors such as mutual funds, endowment funds, pension funds and hedge funds. Investment bankers deal with large institutional investors on an everyday basis and are able to market IPOs to such investors. In addition, they help companies price their IPOs by assessing demand and obtaining commitments from investors.

Investment bankers typically collect seven percent of IPO proceeds for their effort. Even better, investment bankers get to allocate IPO shares. As IPO shares are almost always underpriced and often experience a pop of 15 percent on the first day of trading, IPO allocation privileges are very valuable and enable investment bankers to handsomely reward their favored clients. This means the direct and indirect payoff to investment bankers totals around 20 percent of the value of IPO proceeds.

Google's IPO was atypical. Instead of letting its investment bankers control its IPO, Google tried to price and allocate IPO shares by an auction. Additionally, Google's investment bankers received only 2.8 percent of IPO proceeds instead of the usual 7 percent. Google's IPO was a very bad deal for investment bankers, but that was not the end of it. Google's IPO was the IPO event of 2004; the success of Google's IPO auction would have turned the IPO underwriting business upside down. It would have caused a flood of companies to embrace IPO auctions, and in the process threatened the very livelihood of IPO underwriters. Consequently, Google's investment bankers had powerful incentives to do their utmost best to sabotage Google's IPO auction.

Google's IPO auction turned out to be a complete rout. Towards the end of its IPO auction Google simply gave up and allowed its IPO underwriters to run the show like a traditional IPO and price its IPO offering. The company not only sold its IPO shares at $85 a share, well below the $108-$135 pricing range, but also reduced the number of shares it was planning to offer to 19.6 million from 25.7 million.

Google's investment bankers had to play a balancing game; they needed to sabotage Google's IPO auction but they also needed to preserve their credibility. This suggests, Google's IPO underwriters discreetly high-lighted risks stated in Google's prospectus to institutional investors. Google's Overture troubles were mentioned in Google's preliminary prospectus and constituted convenient ammunition. It must have been a straightforward job to hype Google's patent litigation risks to institutional investors, and scare them into seeking assurances as to an amicable settlement with Yahoo and steep discounts on Google's IPO auction pricing range.

Once the institutional investors became wary of Google's patent troubles, Google had to settle and cover-up in order to proceed with its IPO. There was no other option. The investment bankers couldn't have helped, as they couldn't simply tell their clients that they exaggerated Google's troubles and investing in Google was safe. Disclosure of the unfavorable terms was not a choice either, as that would have scared institutional investors even more.

Google's choice of proceeding with its IPO was suicidal. The patent settlement cover-up was always going to be an open secret. Mark Jen's wrongful termination suggests the details of the cover-up were widely known inside of Google, and Yahoo's managers knew of the cover-up from the start.

Google's future prospects are not good. By hiding risks from investors Google has exposed itself to shareholder lawsuits. Google can only hope that its stock doesn't take a nosedive; otherwise, Google can expect shareholder lawsuit hell. Shareholders are going to claim Google intentionally hid potential risks, and they are going to be right about that.

US securities regulators are a much graver threat to Google. Google flouted US securities regulations right under the noses of SEC lawyers, and SEC lawyers are not going to find that amusing in the least. Google's top management and its directors obviously knew about the cover-up, and regulators are not likely to want to miss a chance to fry some really big fish.

Interestingly, Google had no need to go through an IPO. Even before its IPO Google was profitable, and had access to all the capital it needed to expand operations. By simply staying private Google could have avoided the whole mess. Under this scenario, Google would have no obligation to disclose settlement terms. Even better it would have no incentive to rush the settlement in the first place. Google could have simply held-out for better terms. The pressure for an IPO was coming from the venture capitalists and employees. The VCs wanted to show impressive gains on their Google investments, and the employees wanted to cash out their stock options. Petty greed combined with extreme naivete and hubris seems to have led Google's management on the path to ruin.




by Usman Latif  [May 31, 2005]


Updates:

9 March 2006: Edited for clarity
31 May 2005: This document has gone through a number of revisions, and the original version as well as an older revision to the original are also accessible.

Links:

Discussion on this article at Mark Jen's Blog
Mark Jen's Blog Entry on his termination from Google
US Patent 6,269,361
Google's SEC filing S-1/A 08-09-2004
Overture Services, Inc. Form 10-K 2002 (annual report)
Google Inc. Form 10-K 2004 (annual report)
Yahoo Inc. Form 10-K 2004 (annual report)
Google's Ad Technology Tussle | Internetnews.com
Overture sues Google | CNET News.com
Yahoo to buy Overture for $1.63 billion | CNET News.com
Search and Destroy | Fortune Magazine
Google Ends Auction for IPO Shares | Washigton Post
IPO primer