We usually talk about software patents when big tech companies sue each other or start talking trash on their blogs. I think we don’t always realize how much the growth of software and business process patents has transformed the culture of Silicon Valley and the broader tech industry, from the smallest young companies upwards.

Marty Pichinson at Sherwood Partners may understand startups in Silicon Valley better than anyone, since his company specializes in selling off their assets and unwinding their obligations when they fail. Sherwood has shuttered so many companies, most spectacularly when the big startup bubble burst in 2000, that it’s become known in the Valley as “the undertaker.”

Connie Loizos at peHUB recently interviewed Pichinson about the state of the industry. One observation in particular jumped out at me:

We’ve probably become one of the largest sellers of [intellectual property] in the country. We sell tons of IP, and as you know, the IP wars have started, so we play with the big guys, the little guys, and the in-between guys. During the last bubble, there weren’t as many patents. It was more ideas and URLs. So the business has matured.

While big companies and even bigger consortia of companies may come together to bid when patent portfolios of other big companies are auctioned off, shuttered startups usually wind up selling their IP to midlevel competitors in the same industry. “The bigger players are interested,” Pichinson says, “but they move slow, and we have a deteriorating asset and an obligation to the creditor [to get some money out of it], so we don’t have months to figure it out.”

Sherwood Partners’ web site includes a whole page devoted to Intellectual Property Monetization, touting the company’s skill at finding partners who will buy or license patents from startups in trouble. In one case study, the board of a lifecycle automation software company with $65 million in VC financing determined they would be better off selling off their IP than seeking an additional round of funding. Sherwood maintained the patent portfolio for two months while it liquidated the company’s other assets, then sold the portfolio to a competitor.

In another case, a wireless tech company was able to license their IP (with Sherwood’s help) and stay afloat with help from the proceeds. Patents can make the difference between staying in business, closing the company at a profit to all investors, or closing it at a loss.

As a consequence, developing and securing patents at company’s founding (or even before) have become routine, just like signing incorporation papers, raising a first round of funding and hiring the first group of staff.

Holding patents signals to potential investors that the startup’s founders are organized and serious; it prevents big companies or a slew of me-too competitors from imitating an idea, which could kill the company when still in the cradle; and it becomes one of the primary assets the company can trade on if it’s purchased outright or sold off piecemeal when it fails. One of those two scenarios is how the overwhelming majority of startups end.

In a very short time, patents have become a key part of the scaffolding of the tech industry. Eliminate them, as an asset class and value signal, and those structures needs to be rebuilt again, for better or worse. (At least patents have more substance than a clever domain name).

Very few people have argued — or at least, argued well — in defense of software patents. (Last week, I complained to Forbes/Ars Technica’s patent & tech policy expert Timothy B. Lee that “the intellectual ammo is all on one side.”) Now startup founder Michael Mace, CEO of Cera Technology* and a former executive at Palm and Apple, has written “The Case For Software Patents,” which is an effort worth reading, grounded in the history of the industry and the genuine problems facing small startups.

Mace argues that the most egregious sins associated with software and process patents — rows of empty offices in small Texas towns that serve as mailing addresses for patent-trolling shell companies, trying to generate money from nothing from suing companies until they’re paid to go away — can be solved by simply limiting the ability of non-practicing entities to sue for infringement. (I worry that posing a hurdle like this would be “solved” by companies doing the bare minimum to qualify as “practicing,” whether through clever accounting or creating Intellectual Ventures-style showrooms for inventions that will never be brought to market.)

More persuasive is Mace’s invocation of Applied Data Research’s Martin Goetz, holder of the first software patent (issued in 1968: the Computerworld headline presciently read “First Patent Is Issued for Software, Full Implications Are Not Known“), who successfully sued IBM for giving away a knock-off of ADR’s mainframe program Autoflow.

“That lawsuit,” Mace writes, “plus a related one by the US government, laid the foundations of the independent software industry by forcing IBM to stop giving away free apps for its mainframes… [Y]ou can’t say that software patents alone led to the birth of the software industry. But I think it’s clear that patents helped codify the value of software independent from hardware.”

So if we rewrite the history of the software industry through this lens, let’s say the industry has gone through the following phases:

1. The Mainframe Era, when IBM was effectively the only game in town;
2. The Birth of Independents, post-1968, when new companies began to form in offices and garages;
3. The Rise of the PC, when IBM, and the kids at Lotus, Microsoft and Apple took computers out of the office and made consumer software companies a real thing;
4. The Web Boom and Bust, when companies high up like Microsoft and Oracle began to worry about patents and form their positions on them, but small startups were more interested in foosball tables and shiny plastic pants (if you will forgive the caricature)
5. The Age of the Serious Startup, i.e., building post-boom companies like Google and Facebook that are serious about IP: essentially the world we have today.

“There is probably no industry outside of the startup industry,” Pichinson observes, “that begins companies in the most proper, prim way possible, including ensuring there are good law firms involved and the right accounting firms. That way, when the window of opportunity opens [for a potential exit], everyone is ready to go.” That culture is a product of this history. It’s created the order we largely take for granted.

Nilay Patel at This Is My Next argues in a new post that tech companies, analysts and media all need to think differently about the patent system. Instead of lamenting its brokenness and/or its necessity, arguing that it’s intellectually inconsistent or chastising utopians with hard-headed realpolitik, we should be working to develop new IP laws and licensing systems that will work. The entire industry deserves something better than on/off. The stakes are too high.

I’ll add a cultural argument to this. Google, Apple and Microsoft put together don’t dominate the computing industry the way IBM once did. So if the Supreme Court were to wipe out the patentability of software with the stroke of a pen, we wouldn’t suddenly revert to a new Dark Ages of code, or be caught up in the rapture of an open-source paradise.

But I don’t think we quite know what that world would look like, either. Nor do we know what further transformations the patent wars themselves might bring about in the years to come. They are only just beginning.

NOTES

* Try rewriting that from memory and not accidentally typing “Michael Cera.” I dare you.

Both Loizos’s and Mace’s posts are via TechMeme. I love you TechMeme.

Photo by Marius Watz used under a Creative Commons license.