Yahoo-Facebook: Brace for the countersuit

March 13, 2012, 1:22 PM UTC

By Roger Parloff, senior editor

FORTUNE — The patent suit filed yesterday by Yahoo against Facebook was effectively predicted last November by an analyst at MDB Capital, an investment bank that finances companies rich in intellectual property.

Now, in an interview with Fortune, that same analyst, Erin-Michael Gill, predicts that Facebook — which has not been caught completely flat-footed by the attack — will respond by countersuing Yahoo, asserting patents it has acquired in anticipation of this type of attack. Facebook, whose portfolio now includes at least 54 granted U.S. patents, has acquired 30 of those in the past two years, notes Gill, including 22 since August.

Nevertheless, Gill predicts, in the end Facebook will probably strike a cross-licensing deal that calls for it to cough up a “substantial sum” to Yahoo (YHOO), because of the number, breadth, and nature of Yahoo’s patents. Yahoo’s timing isn’t likely to hurt, either. The suit landed just weeks before Facebook’s anticipated IPO, which is expected to value the company at some $100 billion.

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What does Yahoo have on Facebook? “Here Yahoo is asserting 10 patents, covering a broad diversity of core functions and features of Facebook,” Gill says. “This is not the kind of thing where you would expect Facebook to say, ‘Okay, could we design around all these claims?’ or ‘Could we prove invalidity of all these claims?’ It’s possible, but fairly difficult. . . . Yahoo has wave after wave of claims here.” (Neither Gill nor MDB has any stake in either Facebook or Yahoo, he says.)

Yahoo’s patents, according to the suit filed in federal court in San Jose, California, cover inventions relating to “messaging, news feed generation, social commenting, advertising display, preventing click fraud, and privacy controls.” In a statement responding to the suit, Facebook said, “We will defend ourselves vigorously against these puzzling actions.”

Gill was first asked to assess the strength of Yahoo’s patent portfolio by activist shareholder Daniel Loeb’s hedge fund, Third Point, which has acquired more than 5% of the struggling search giant since September. Prior to becoming MDB’s chief intellectual property officer, Gill was a political appointee in the Obama administration reviewing the US Patent and Trademark Office’s strategy and operations. Early in his career Gill was a patent examiner.

Gill recalls doing an analysis of Yahoo’s patent portfolio. “One thing that jumped out at me was its applicability to Facebook,” he says. Third Point then put Gill in touch with Eric Jackson, a fund manager with long positions in Yahoo, and Jackson wrote a story in about Yahoo’s potential patent strength vis-à-vis Facebook.

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In February, Gill was also interviewed by blog TechCrunch about his analysis. Gill speculates that “when leadership change occurred” — former PayPal (EBAY) president Scott Thompson became Yahoo’s CEO in January, replacing Carol Bartz, who had been ousted last September — Yahoo must have decided to act.

Facebook has indeed, maintained that it was blindsided when it received Yahoo’s patent demands on February 27, the same day the New York Times broke the story. (Yahoo’s complaint acknowledges that it first notified Facebook of its claims on that date.)

Facebook’s statement yesterday stuck to that theme: “We’re disappointed that Yahoo, a longtime business partner of Facebook and a company that has substantially benefited from its association with Facebook” — apparent references to Facebook’s integration of a Yahoo News application into its site last November — “has decided to resort to litigation. Once again, we learned of Yahoo’s decision simultaneously with the media.”

It is common for young companies that experience explosive growth to find themselves vulnerable to patent challenges. The recent success of Google’s (GOOG) Android operating system, for instance, suddenly thrust that company into the midst of a mature mobile phone ecosystem for which it did not, at first, have adequate patent protection. This was apparently the driving motivation behind Google’s expensive decision, announced last August, to acquire Motorola Mobility — and its rich patent portfolio — for $12.5 billion.

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When Gill researched Facebook’s own patents, he says, he was surprised to see that, for a young company, it actually had some significant assets of its own to yield defensively against Yahoo, including one broad patent in particular — acquired along with eight others from Hewlett-Packard (HPQ) in February 2010 — that has been “referenced” 12 times by Yahoo in its own patent applications. When an inventor files a patent application, he must, by law, list all prior patents that might conceivably be relevant; IP analysts use these citations to get some rough notion of who is playing in who’s sandbox. Facebook also acquired 11 Walker Digital patents last August, and 11 Philips patents in December, according to Gill’s research.

Now, those moves look wise. “They’ve been anticipating this, trying to build up the right sort of portfolio to protect themselves,” he says. Still, Gill suspects that their portfolio is “not quite fleshed out to the point” where it could force a clean, tit-for-tat, cross-licensing deal, with no money changing hands.

With the IPO approaching, he predicts, Facebook will not want potential investors worrying about questions like, “What if it has to design around 10 patents? Will that mean a suboptimized product? A suboptimized user experience?” The company will likely be willing to pay a substantial sum to get this problem behind it and never have to worry about it again, he says. After the IPO Facebook will be in a better position to do “serious IP acquisitions,” Gill notes, to further shore up its portfolio for the long haul.

For more on how Facebook really works, buy the exclusive Inside Facebook story from Amazon here or from Barnes & Noble here. You can also read it with the iPad app for free if you are a Fortune subscriber.

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