Facebook's Yahoo! Patent Problem

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NEW YORK (TheStreet) -- Facebook's planned initial public offering is the talk of the business media these days.

Everyone is swooning over how big it will be, how many millionaires it will create and how Facebook might continue to grow after its IPO.

I'm sorry to show up at the black-tie party wearing a Grateful Dead acid-washed T-Shirt, but what happened to Facebook violating a bunch of Yahoo!'s 1,100 patents in social and search?

I first wrote about this topic last November in Forbes.

As I pointed out then, Yahoo!'s patent trove has been an undiscussed part of its overall value -- although when you consider that Yahoo!'s "core business" is currently being valued at less than zero, it's hard to say that only the patents have been ignored.

Obviously, it can be difficult to assess the value of patents. Few believed that Motorola Mobility's patents were going to be worth $12.5 billion to Google or that Nortel's patents were going to be worth $4.5 billion to the consortium of players who bought it in July.

Yet several people I talked to last fall thought that Yahoo!'s patents were worth a significant amount and that Facebook might be the company most at risk if Yahoo! suddenly becomes more aggressive in defending its intellectual property. (To date, it has been passive and acquiescent on this front.)

Keep in mind that Yahoo!'s own board seems to recognize the value of Yahoo!'s patents. In October, The New York Times wrote the following in a story updating the state of Yahoo!'s deal negotiations:

"But Yahoo has also talked up some of its other assets, including more than 1,000 patents, including those for search and display advertising, that the company believes would fetch high prices."

I spoke with the two New York Times DealBook reporters who wrote this story after it appeared and both acknowledged that they believed Yahoo!'s board clearly sees value in the patent portfolio.

So where is the value?

One obvious area is in the whole social networking space. Yahoo! has several relevant patents in that area even though it is not known for social networking.

Are they enough to squash Facebook in a protracted courtroom battle? It's unclear, partly because Yahoo! has been so docile and conciliatory around patents. It's also unclear, because it's hard to assess a patent's value until it is tested in court.

So all I can go on is the word of several people familiar with the patents who believe there is significant value in Yahoo!'s social patents.

But what is Facebook's best answer to this potential legal threat? One possible answer might be the 2003 purchase by Zynga's Mark Pincus and LinkedIn's Reid Hoffman of a broad patent for social networking from the now-defunct SixDegrees.com social networking site.

Pincus and Hoffman reportedly own 0.5% each of Facebook. Hoffman's venture firm Greycroft also own about 1.5% of Facebook, so he has an incentive to use that patent to protect his Facebook investment from attacks from the likes of Yahoo! or others.

The SixDegrees.com patent was granted in 2001, long before Facebook was around. It has to do with the "method and apparatus for constructing a networking database and system."

Interestingly, at the time of the purchase, Hoffman and Pincus were worried about Friendster's new owners. They also expected that Kleiner Perkins Caufield & Byers and Benchmark Capital would outbid them.

Hoffman described the SixDegrees.com patent in a CNET story at the time as "central to this field."

We may never know, but it's possible that Hoffman's ownership of the patent is what allowed him to take such a big stake in Facebook (likely for cross-licensing it). Hoffman was supposed to be responsible for introducing Peter Thiel to Mark Zuckerberg, and both Hoffman and Pincus were part of the first financing round.

The second area where Facebook is potentially vulnerable from Yahoo! is search. Back in 2004, Yahoo! pushed Google to a pre-IPO settlement of cash and preferred stock. The deal had to do with the Overture patent relating to the GoTo.com patent 6,269,361. This was around the whole paid-search business model that AdWords/AdSense copied from GoTo.com.

Most people see Yahoo! as making a colossal blunder in agreeing to the deal. Even today, 96% of Google's revenues come from advertising related to AdSense and AdWords. Yahoo! should have played hardball but didn't.

But is Facebook in direct violation of the GoTo.com patent? Isn't it a social networking site and not a paid-search site? Well, Facebook is certainly making the bulk of its $4 billion in revenues from ads, and its display ads make money based on IP against which Yahoo! has a good claim. What's more, it's quite likely that Facebook could seek to expand into search in the coming quarters and years.

When you're doing 5% of the revenues of Google but are hoping to be valued at 60% of its valuation, it's logical to believe you might feel pressured by Wall Street to increase your revenue in the future. Going into search would be an obvious extension, especially with Google already expanding its search business into social. Whenever Facebook chooses to do that, Yahoo! can slam them.

Given all this, it makes absolute sense that Yahoo! would seek to strike a deal with Facebook now -- pre-IPO -- and for Facebook to agree.

We will see what happens. Increasingly, it seems like Dan Loeb's influence is growing on Yahoo!'s board. That's good news if Yahoo!'s investors want to see the company extract some value from Facebook aggressively. This will require Yahoo! getting very offensive, instead of trying to be everyone's buddy in the Valley.

In fact, if Yahoo! wanted to really play hardball, it would cancel the Microsoft search deal at the same time it goes after Facebook.

Microsoft gets free access to Yahoo!'s search IP as part of its Bing outsourcing deal. However, that goes away if Yahoo cancels the agreement (after a one-year tail period).

Microsoft owns 1.6% of Facebook, too. So, it would be forced to come back to the table with Yahoo! and try to work out a better deal for Yahoo! longs in such a scenario.

Don't expect Facebook to hit a $100 billion valuation without Yahoo! paying it a visit in the coming weeks.

At the time of publication, Jackson was long YHOO.

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