The Business of Inventing: A Case Study
DAN Tedesco noticed two things while standing in front of the vending machine down the hall from his desk. First, the machine was once again sold out of Snickers bars and, once again, still held a stack of Mounds bars. Secondand this was the thing that bothered himSnickers bars and Mounds bars both sold for the same price. On this particular day this seemed particularly wrong.
Incongruity is the mother of invention. Dan Tedesco is an expert in something called "revenue management." He works at Walker Digital, the parent company that created and spun off Priceline, the reverse auction company. Priceline's original focus had been on selling seats on airplanes that would have otherwise stayed empty. Prospective travelers offer to buy seats between, say, Chicago and Phoenix at some price that they are willing to pay. Then the airlines flying between Chicago and Phoenix survey the offers from different buyers and decide whether they have seats that look like they will otherwise go unfilled and whether the offers look attractive. If it looks like accepting an offer will produce some additional revenue (the plane is flying in any case, with or without customers in seats), the airline sells a seat at the offered price. Consumers think of Priceline as a way to fly on the cheap. But airlines think of Priceline as one component in their broader programs for revenue management. Tedesco knew all about those programs.
Why couldn't you use revenue management to make vending machines more profitable? Why should candy bars, chips, and the other products in vending machines always sell for fixed prices rather than in response to the preferences of the local market that the vending machine serves? Many new vending machines have microprocessors; why not use the machines as point-of-sale devices in an overall revenue management system? Tedesco went back to his office with a candy bar that he didn't really want and began thinking about these questions.
Tedesco works in an environment that takes such questions very seriously. His business card says that his title is "Inventor." Walker Digital has developed a set of procedures to help inventors determine whether questions such as Tedesco's have answers that might lead to useful inventions.1
The first step in the Walker Digital process involves making a quick determination as to whether the inventor really has a new idea. Have other people been thinking, talking, or writing about applying revenue management to vending machines? If so, even if it is a great idea, it may be difficult to protect. Walker Digital is not interested in business ideas that are just going to be copied as soon as they are introduced. Instead, Walker is interested in inventions that are unique enough to receive patent protection.
In the course of assessing the "protectability" of his potential invention, Tedesco surveyed the structure and the state of technology in the vending machine industry. His objective was to determine, first, whether the idea looked viable from the 35,000-foot level. For example, if he had found that digitally controlled vending machines were having a hard time finding acceptance and that the industry was moving back to mechanical machines, that would have been a cause for concern (and perhaps an indicator that there was another potential invention lurking in the background).
What Tedesco found was reassuring. Microprocessors were being used in increasing numbers of vending machines, but the focus was on bringing down costs, on performing basic accounting, and in some cases on enabling purchases against a debit card rather than requiring change. In other words, the vending machine industry was still thinking of the machine's function in the same way that it had for the last fifty years, as a dispensing and collection device. Nobody was thinking in terms of the machine as a point-of-sale device within an inventory and revenue management system. So, Tedesco's insight might really be a new one, which is to say a protectable one.
Having established that the potential invention was worth a closer look, Tedesco's next step was to arrange a "knockout" search. At Walker Digital the small group of inventors is complemented by a small group of top-notch patent attorneys. Since the potential value of an invention depends both on its solving a business problem and its being protectable, attorneys and inventors work together as a team from the outset. At Walker there is no throwing an invention over the wall to "legal" to start the patent process; the legal and business objectives are pursued in parallel. The purpose of the knockout search, which involves an average of 10 hours of patent and literature searching, is to uncover any prior art that might weaken or constrain the invention's patentability and value.
Dan Tedesco's vending machine idea made it through the knockout search without a hitch. That meant it was potentially valuable enough to bring before the entire group of inventors at Walker for consideration, brainstorming, and critiquing. The working group of inventors, led by founder Jay Walker, is small, numbering between a half dozen and a dozen people. The size varies as inventors move from the working group out to individual projects and back and as the group looks at different technologies and businesses.
The inventors are generalists who have acquired lots of specific knowledge over time. They proceed by asking questions. Why hasn't revenue management been thought of before in the vending machine industry? How is ownership and control of vending machines distributed: who would make the buying decisions? How would the cost of the management compare with the expected revenues?
The objective is not to answer all the questions but instead to ensure that there are no immediately negative answersno slapping of a palm against the middle of a forehead. The questions, of course, also push and extend the inventor's thinking. If the questions raise only interesting possibilities, and if the impact and value of the invention looks large enough, the group authorizes further investment in developing and patenting the invention. Everybody at Walker Digital, attorneys and inventors alike, has an equity stake in the outcome; everybody wants to develop a portfolio of inventions that builds value, and nobody wants to waste time on marginal inventions.
Tedesco received authorization to proceed with developing his potential invention. This meant weeks of intense research and work to define the scope of the invention, develop and describe an implementation, and evaluate the business case behind the invention's use. The research required analyzing the structure of the vending machine industry and understanding current revenue flows and bottlenecks. The analysis looked both for horizontal applications across the different industry segments and for rich, vertical starting points. Tedesco looked beyond U.S. practice to understand how the vending business works in Japan and other countries where vending applications are radically different than they are in the United States. He focused on understanding how the patent would become an opportunity for Walker Digital to make money.
The research took about a month. Tedesco had been working with the patent attorneys assigned to the team from the outset; now it was time to develop the disclosure statement that would be used as the foundation for the patent. The research team had been continuing its search for prior art and for possible evidence that the invention might be obvious. At Walker Digital the average amount of time invested in patent and literature research for a patent application is 26 hours, in addition to the time spent on the knockout search. Outside of Walker the average amount of time spent searching for prior art related to an invention is more like 8 hours. The investment that Walker makes in its research is a reflection of its focus on protectability. Walker intends to make money by enjoying a protected monopoly on important ideas. It wants its monopoly position to be a sure thing.
Walker Digital constructs its invention process around the fact that the U.S. patent system grants patent rights to the person who is the "first to invent" something, rather than first to file a complete patent application. This means that Walker moves quickly once it has an interesting idea. It also means that Walker is careful to document each step of the process, starting with the initial idea and going forward. All documents are notarized. If it looks like it will take more than a few weeks to define the claims that will be made in the patent and to reduce the invention to practice, Walker will sometimes file a provisional application, which requires only a description of the invention but does not require claims. The purpose of the provisional application is to establish an early filing date to support the other evidence that a Walker Digital inventor was, in fact, the first to invent.
In the case of Tedesco's vending machine invention, the Walker team was able to prepare an initial patent application after several months of work. But filing the application, complete with claims, was in no way an end point. Walker Digital is a business methods laboratory. The company's value is tied to the value of its inventions. That value is determined, in part, by ensuring that inventions can be protected. Protectability is what drives the company's focus on rapid development of inventions and of patent applications. But the other key determinant of an invention's value is its scope and its ability to either increase a business's revenues or decrease costs. Walker Digital wants inventions that are not only protectable but that also have a big impact.
It would be very unusual to have developed the maximum scope and impact of a new business method in just a few months. So, after the initial application filing, Tedesco continued to study the vending machine industry. He also began looking hard at the more general issues associated with revenue management in retail sales. He began thinking about ways to sell slow-moving inventory, or inventory that is reaching the end of its shelf life, by changing things other than price. What would happen if, instead of dropping the price, you offered package deals that bundled slow-moving products with ones that were in more demand? In other words, the initial patent application was not an end point but a beginning. Dan Tedesco had a lot more work ahead of him.
A Business Method Laboratory
Dan Tedesco and the company that he works for, Walker Digital, approach business method patents from a different direction, with different objectives, than Amazon, Signature Financial Group, and most other companies that we have looked at in the preceding chapters. Walker is not selling books or managing funds but is actually focused on inventing new ways to do business. Its inventions center around the way that networks, distributed computing, and encryption create new opportunities to access and use information. Tedesco's vending machine invention is a good example: the key to the invention was the realization that the vending machines with microprocessors (and perhaps with an address on the Internet) have access to information that is not currently being put to productive use.
At Walker Digital the process of invention is not a complement to the primary business; it is the business. Success is measured in terms of the company's ability to create inventions that can be spun off into new companies or that can be licensed to other companies and perhaps traded for equity in those companies. Patents are central to the Walker Digital strategy: Walker is counting on receiving a limited monopoly that protects its exclusive right to exploit its inventions.
Monopoly is a familiar game for Jay Walker, the company's founder and driving force.2 As a student at Cornell University he took on the task of mastering the Parker Brothers game of that name and, within a couple of years, won the world championship. To describe the situation using one of Jay Walker's favorite metaphors, he unraveled the DNA of Monopoly. Naturally, he decided to profit from his research, and so, continuing the metaphor, he published a book that contained the DNA sequencing for Monopoly, titled 1,000 Ways to Win Monopoly Games. One might have expected Parker Brothers to see such a book as free promotion for the gamea good thing. But instead the company reacted as if Walker really were publishing Monopoly's DNA sequencing and, before the book appeared, sued Walker to stop publication. Walker hired attorneys and fought the suit, arguing that Parker Brothers was attempting to exercise prior restraint against his right to publish freely. He won the case and ended up using the proceeds from the book to pay for his legal expenses.
After graduating from Cornell, Walker started a number of publishing ventures, including a magazine that focused on coupons and other promotions for retail businesses. It seemed that every time he got a new idea, he started a new business. By the early 1990s he had started more than a dozen of them. Some didn't work out, but others, such as the businesses that grew from his idea about ways to automate magazine subscription renewals, made a fair amount of money.
In the early 1990s Walker began reading about encryption and the truly revolutionary invention by Ron Rivest, Adi Shamir, and Leonard Adleman of a way to exchange encrypted information without first exchanging encryption keys. (This is the RSA public key cryptography algorithm, U.S. patent number 4,405,829. I provide an overview of this algorithm and its uses in Part III as part of the description of electronic signatures.) Walker had been thinking about casinos, and it struck him that encryption provided a way to create a hand-held casino that would be immune from cheating and deception. But along with this insight came a problem: his model for making money from his ideas had always been to build a business around them. He wasn't going to open a casino. Besides, it seemed to him that the idea of encryption was so powerful and had the capability of transforming so many businessesnot just casinosthat he felt suddenly overwhelmed by opportunity. He could not possibly start and successfully manage the scores of businesses that corresponded to all the applications that he could see for encryption. Was there some way to ride above the details of all these individual businesses and make money just by developing the ideas? Walker began reading up on patent law. In an interview with Strategy+Business published in mid-2000, he described what happened next:
In short, when Jay Walker understood that he could patent business methods, he realized that he had found just what he was looking for: a way to own a new business idea, such as the idea to apply revenue management to vending machines, just like he could own a car or land. If he could own enough really critical, valuable patents, it would be just as good, maybe better, than owning a lot of midtown Manhattan. In the past year Walker Digital has applied for around 150 patents, each one a piece of conceptual real estate located somewhere between Montana and Park Avenue.
The most well-known Walker patents are the ones associated with Priceline. In the case of these patents Walker fell back to his old model of starting a business as a way of getting a return from his inventions. Walker describes this as a kind of bootstrap strategya way to generate some immediate cash flow while he waits for his other investments in inventions to mature. The intent over the longer run is to demonstrate to established businesses how they could benefit from the inventions. Once Walker Digital sells a company on the value of a new invention, Walker and the partner company can work together to find ways to cooperate and share in the upside. The options range from equity partnerships to simple licensing agreements.
In summary, Walker Digital is playing a long game. It typically takes two to three years to receive a patent, and in most cases Walker Digital will want to wait until the patents are in place before beginning the sales, demonstration, and negotiation process. Full patent protection increases Walker's leverage in negotiations about licensing and ensures that anyone who decides to simply copy the ideas and infringe on Walker's patents will be facing treble damages. It's just like Monopoly: you want to make sure, if possible, that you have hotels built on Boardwalk and Park Place before the other players land on them.