Wednesday, September 14, 2011

These four threats against Android secured Motorola Mobility a $12.5 billion offer from Google

The way I see it, the driving force that led Google to offer $12.5 billion for Motorola Mobility (MMI) -- a 60% premium -- was a combination of serious threats that MMI made to Google. Those threats were perfectly legitimate and credible because the underlying business logic was reasonable and compelling, but the bottom line is that if Google had not offered to pay the price MMI demanded, there would have been four very near-term consequences that would have resulted in a disaster of catastrophic proportions for Android. Three of the four threats were also made in public. The fourth one was obvious to me from the moment I heard of the merger proposal, and an SEC filing now states it explicitly. It also becomes clear now that August 9 was a key date in those negotiations and apparently the point when MMI built maximum pressure on Google with those threats.

I'm more convinced than ever that Google's offer for MMI was driven by mutual weakness, not strength, and by MMI's threats against Android, not by a Google strategy to protect Android against the likes of Apple and Microsoft.

This isn't a defensive purchase in the sense of Google becoming strong enough to retaliate seriously against its strategic rivals (mutually assured destruction). It's defensive-defensive in the sense of merely attempting to prevent an exacerbation of the Android patent situation due to what MMI was going to do otherwise.

This wasn't about MMI telling Google: "buy us, and together we'll protect the Android ecosystem". This was more like MMI telling Google: "buy us, or else we'll immediately do three or four things that will make sense for us but be absolutely devastating for Android".

The four threats against Android with which MMI's shareholders forced Google to offer $12.5B

An SEC filing contains a section that describes the merger negotiations chronologically, a story that's obviously optimized for MMI's purposes (getting the deal approved and closed, and fending off shareholder lawsuits against the board), but nevertheless interesting. My conclusion from that document and other publicly available information is that Google felt forced to raise its offer from $30 to $40 -- in the conspicuous absence of any other formal bidder -- because, in the alternative, MMI threatened to do all of the following four things:

  1. MMI would have taken a royalty-bearing patent license from Microsoft, and possibly also settled with Apple.

    For MMI itself, it would have made all the sense in the world to settle litigation, especially where it's clearly on the losing track. However, the fallout for Android would have been nothing short of catastrophic. Relatively speaking, MMI was in a better position to defend itself than any other major Android device maker except for Samsung, which is in a comparable situation. MMI's likely capitulation would have been a disastrous signal and resulted in pretty much every other Android device maker's surrender on the patent front. It would have made it clear to everyone that Android infringes patents held by Microsoft (and Apple, if MMI had also settled with them, though that's always more difficult).

    In the SEC filing, there are multiple references to MMI's settlement thoughts. I'll go into more detail further below.

  2. MMI would have revisited its exclusive focus on Android and possibly adopted Windows Phone.

    MMI is the only major smartphone maker to build exclusively Android-based devices. However, there were some rumors about MMI developing a mobile operating system of its own. Those were denied. But on August 9 (I'll get to the importance of that date further below), MMI's CEO described Windows Phone as "an interesting option for us to consider" under certain circumstances.

    That open door for Windows Phone is likely related to the first item: MMI might have been considering a settlement with Microsoft that would have resolved the ongoing patent litigation as well as created a strategic partnership related to Windows Phone. MMI wouldn't have adopted Windows Phone only to settle the patent case. MMI's CEO made this subject to technical "capabilities" and a Nokia-like close partnership.

    I don't know whether Microsoft offers Windows Phone adopters sweeter business terms than others, but generally speaking, companies that have (or are in the process of forming) a commercial partnership find it easier to sort out legal issues -- such as intellectual property infringement -- with each other. Apple's dispute with Samsung is different from this because Samsung isn't an Apple licensee. It's an easier decision to sue a supplier than a customer. The idea of a combined Windows Phone partnership and Microsoft patent license also came up in a report on Samsung purportedly hoping to "lower the payment [under an Android-related patent license agreement] in exchange for a deeper alliance with Microsoft for the U.S. company's Windows platform, the Maeil Business Newspaper quoted unnamed industry officials as saying."

  3. MMI would have attacked other Android device makers with its patents to make their products more expensive.

    At the same August 9 event (I said before that it's an incredibly important date in this process), MMI's CEO talked about IP as being "very important for differentiation among Android vendors" and differences in terms of "potentially being able to collect royalties".

    I blogged about those statements the day before Google and MMI announced their merger agreement, in a post entitled "Motorola doesn't have a license to kill Android but can cause problems". In that post (again, just one day before the merger), I wrote:

    Some believe that Motorola Mobility may threaten with patent enforcement against Android in order to pressure Google to buy it. I don't know, but it's possible that this is one of the intended effects.

    I also talked about how the worst-case scenario for Android would have been for MMI to abandon Android in favor of other platforms because that would have made it easier for MMI to enforce patents against other Android device makers.

    Among Android device makers, MMI could have found many suitable targets for patent attacks. Most Android device makers are weaker than MMI in terms of patents (even though MMI is weaker than Apple and, especially, Microsoft). Also, MMI's patents are broadly-licensed in the industry because they had to cross-license with other established players at some point. In the Android space, however, there are plenty of late entrants who don't have a license from MMI. Outside the Android space, the only major device maker that didn't have a deal in place MMI was, apparently, Apple.

  4. MMI would have conducted a public or private auction of the entire company or large parts of its patent portfolio.

    The previous three points are all somewhat interdependent. In fact, the first three items can be seen as a package. This fourth item is structurally different, but it's worth mentioning anyway.

    While Google and MMI were negotiating, there wasn't any other formal bidder. In the second half of July, MMI shareholder Carl Icahn proposed that MMI explore alternatives for its patent portfolio, such as an auction of large parts of it. MMI's management, however, didn't want to sell large parts of its portfolio because it would have ended up with an operating company that wouldn't be able to defend itself. According to the SEC filing, MMI's CEO also told Google in July that "it could be problematic for Motorola Mobility to continue as a stand-alone entity if it sold a large portion of its patent portfolio".

    It seems that discussions between Google and MMI shifted pretty quickly to the idea of buying the entire company. The SEC filing explains that after Google made its $40-per-share offer, MMI's board concluded that it was better to try to finalize a deal with Google on those terms "rather than to conduct a private or public 'auction' of Motorola Mobility".

    In order to enable MMI's board to forgo the opportunity to solicit and entertain other offers, Google had to bid a massive premium and also address any other concerns on MMI's part.

    An auction would also have been threatening to Google:

    • If Icahn had succeeded in getting MMI to auction off a part of its portfolio, those patents could have been acquired by someone like Apple and used against Android device makers. Also, MMI would have been weaker and more susceptible to patent attacks.

    • If the entire company had been put on the auction block, it would have looked like the admission of a top three Android device maker that its strategy didn't work out well enough for that company to stay independent, and it's unclear whether another acquirer would have continued MMI's Android-only strategy.

    • Again, this fourth kind of threat comes with greater unknowns than the first three threats, which all by themselves would have been enough of a reason for Google to pay the price MMI's leadership demanded.

Now I'll go into more detail on the negotiations as they are described in the SEC filing and discuss the strategic situation of the two companies and the nature of those threats in that context.

Initial contacts in the aftermath of the Nortel patent auction

The deal background section of the SEC filing suggests that M&A talks between Google and MMI started right after the Nortel patent auction, which Google lost:

"In early July 2011, Andrew Rubin, Senior Vice President of Mobile at Google, contacted Dr. Jha, Chairman and Chief Executive Officer of Motorola Mobility, to request a meeting to discuss the purchase by some of Google’s competitors of the patent portfolio of [Nortel] in an auction conducted by Nortel in June 2011, and the possible impact of and potential responses to the purchase."

I know that those who believe MMI was Google's next best deal after losing the Nortel auction will view this as corrobrating their theory. And I don't deny that Google's failure to buy Nortel's patents was a very important event that is, of course, related to everything Google did since, including the MMI deal. But in my view, the logical connection is not that MMI was even a remotely equivalent alternative to the Nortel deal. Instead, the factual connection is that Google had lost the only opportunity to become a nuclear superpower in the patent wars, and it now had to develop a strategy for Android under the precarious circumstances it faced and continues to face on the patent front.

The timeline laid out in the SEC filing begins after the Nortel auction. If Google had looked at MMI's patents as an alternative, it would have commenced negotiations over an acquisition of MMI or its patents well ahead of the late June Nortel auction. If they had, it still wouldn't prove that MMI's patents are as useful as Nortel's, but if one assumed for the sake of the argument that those deals were alternatives to each other, earlier talks with MMI would have made business sense for two reasons:

  • Google could have told MMI's selling shareholders that if they demand too much, Google would rather spend the money on Nortel's patents.

  • With an offer from MMI, Google would have been in a better position to determine how much to bid for Nortel's patents: exactly up to the point at which accepting MMI's offer would have been preferable.

Even though Nortel and MMI both look like deals covering "thousands of wireless patents", there's a difference there that's as fundamental as the difference between night and day. Both Nortel and MMI had many cross-license agreements in place in the industry, and the best patents of both companies were related to industry standards and encumbered by FRAND licensing commitments, which make such patents commercially first-class but strategically second-class patents. They're great parking meters, but not suitable as strategic weapons. But the difference is bankruptcy:

Anyone who buys a company under non-bankruptcy circumstances, such as Google now trying to acquire MMI, has to honor all existing agreements and standards-related commitments to enter into new agreements on FRAND terms. However, if Google had bought Nortel's patents, it would almost certainly have taken the position that all existing agreements and FRAND licensing commitments entered into by Nortel were null and void since Nortel per se had ceased to exist. If you buy a company car out of a bankruptcy estate, you get the car and can do with it whatever you want. But if you buy the company as a whole, it will surely have an insurance contract in place for its car, and you'll have to honor it (until you can terminate).

I'm not saying that Google really would have been at complete liberty to use those Nortel patents. A court might have very well disagreed with Google after years of litigation, but there would have been an argument and at least some legal uncertainty over it, and that uncertainty, in and of itself, made those patents much more powerful. It was an unprecedented opportunity to buy such a treasure trove of standards-related patents with a chance to be able to use them as a strategic weapon. With MMI, there isn't even a shadow of a doubt that Google will have to honor MMI's contracts.

The potential legal uncertainty surrounding Nortel's patents had the industry at large concerned. Between late May and mid June, various major players filed objections with the bankruptcy court in Delaware. I downloaded filings from EADS, Nokia, Verizon, AT&T, Microsoft, Nokia, Qwest, and -- very interestingly -- Motorola Mobility.

Yes, on June 13, MMI fild a "limited objection" to a "sale of certain patents and related assets free and clear of all claims and interests". In other words, MMI wasn't against the sale as a whole, but it was against the idea of those patents being, all of a sudden, being unencumbered (in terms of being free of all past commitments). Here's one of the things MMI stated:

"As a precautionary measure, Motorola Mobility objects to the Debtors' Sale of Assets free and clear of all claims and interests to the extent such Sale limits Motorola Mobility's right to assert affirmative defenses in any lawsuit or other proceedings filed by any Successful Bidder based on any of such Assets."

Not only did MMI want to ensure that the ultimately successful bidder would have to honor past commitments but it also asked the court to ensure that if the ultimately successful bidder sold those patents on to others, they, too, would have to honor those past agreements and commitments.

With MMI's proposed sale to Google, all of that is a non-issue. MMI would have had to go bankrupt to make its patents comparably valuable for strategic purposes as Nortel's patents.

Even though MMI's patents weren't going to be an alternative to Nortel's, there's no doubt that Google's leadership felt a need to discuss the post-Nortel-auction situation with OEMs like MMI. I'm sure they were already frequently in contact about those issues with MMI and other companies being sued over Android, such as Samsung and HTC. The SEC filing states that in "meetings throughout early to mid-July 2011", the two companies discussed "intellectual property litigation and the potential impact of such litigation on the Android ecosystem". Google certainly has to address grave concerns among OEMs over Android's precarious patent situation all the time.

Patent-related due diligence

Apparently, it became clear at the early stage of those talks that MMI's management wanted to sell the company rather than just a large part of its patents. I mentioned the reason before: an MMI stripped of many of its patents would have had a hard time in this litigious industry.

The part describing the "early to mid-July" talks refers to both an asset deal and a share deal (sale of the company): "potential strategic options relating to the Motorola Mobility patent portfolio and Motorola Mobility, including the potential sale of Motorola Mobility to Google". But all subsequent references appear to indicate that the focus shifted to a share deal.

Nevertheless, the parties entered into a non-disclosure agreement under which Google could conduct "due diligence relating to Motorola Mobility’s patent portfolio".

Patent documents are public, except for the first 18 months during which newly filed applications are in stealth mode. But a due diligence with a view to an M&A transaction can go beyond what's publicly known and include access to confidential material related to, for example, ongoing litigation in which those patents are being used.

The fact that Google initially conducted a specific due diligence on MMI's patents still doesn't prove the strategic value of those patents. Also, it doesn't mean that Google's ultimate motivation to buy MMI for $12.5 billion was Google's assessment of the value of those patents. Instead, Google may very well have been disappointed by what it saw.

Settlement threats

On July 25, there was an MMI board meeting. That one had apparently been scheduled anyway, and MMI's board "discussed, among other things, the conversations with Google as well as the status of ongoing intellectual property litigation and the general prospect of Motorola Mobility's settling some or all of these litigation matters." While MMI is party to many patent lawsuits, that passage certainly wouldn't relate to a small "troll" lawsuit in East Texas that can be settled for a few million dollars. The two most important disputes that MMI's board talked about must have been the ones with Apple and Microsoft.

On July 28, the parties held a meeting "to discuss Google’s interest in Motorola Mobility, including its mobile devices and home businesses". At the time, Google indicated that, on a preliminary basis, it was "considering a per share purchase price range in the high $20s or low $30s". On August 1, Google offered $30. That would have been a certain -- but limited -- premium over the price at which MMI's shares were trading ont he stock market.

When MMI's board discussed this the next day, it didn't want to decide because its just-appointed financial advisors were just evaluating the proposal and in light of "other strategic alternatives that could hypothetically be pursued by Motorola Mobility, including the prospect of settling some or all of the intellectual property litigation". The board had its financial advisors convey that decision (a decision not to take a decision) to Google.

This is very important. It means that MMI basically told Google: "we know we can do a deal with you, but we can also settle with Apple and Microsoft". Like I explained further above, such settlements could make a lot of sense for MMI, but they'd be devastating for Android.

How the per-share price went from $30 to $40 on August 9, 2011 -- the "gunpoint day" in this negotiation

At this stage, MMI's board primarily wanted to drive up the price. It seems that Google was seriously interested, but it wasn't so excited that it was willing to pay $40 per share just based on what it thought MMI is worth. That's why MMI increasingly played the "buy us, or else" threat card.

On August 5, MMI's board held a telephone conference and decided how to respond to Google, which had indicated a willingness to improve the terms of its proposal but wanted a quick decision. After consideration "of a number of factors", MMI's board formally rejected Google's $30 offer. The first one of those factors was "the then current status of the intellectual property litigation and the prospects of settling some or all of the intellectual property litigation". Again, you can see the two alternatives: settle to the detriment of Android, or be bought by Google at an attractive price. MMI told Google that the price would have to be $43.50 per share -- a 45% increase over Google's $30 offer.

On August 7, 2011 these negotiations entered the decisive week. That day, the parties also talked about "the possibility that the definitive agreement might provide for a fee payable by Google under certain circumstances if the parties were unable to obtain the requisite antitrust clearances to consummate the merger." I discussed that break-up fee and the antitrust concerns it reflects last month.

I'm still convinced that this means concerns among shareholders about whether the deal could be blocked. But I now think there's even more to it. The $2.5 billion break-up fee is also meant to enable MMI to refuse to settle with Apple and Microsoft in the meantime, even though it may have offers on the table. There's a very significant probability that the ITC will bar MMI from importing Android-based devices into the United States due to Microsoft's complaint, with a formal target date set for March 5, 2012 -- long before MMI is going to have any chance of serious leverage against Microsoft. Now imagine a situation in which MMI loses that litigation and suffers serious damage to its business, but the deal falls through for whatever reason. In that case, they at least get $2.5 billion from Google to be better able to cope with such challenges.

MMI's strategy of threatening Google with those settlements clearly worked. On August 9, the most important day in this process (as I mentioned), MMI played the triple threat card. At 8:15 AM Eastern Time, MMI's CEO spoke at an Oppenheimer investor conference. That time corresponded to 5:15 AM in California -- several hours before Google's management went to work. MMI's CEO Dr. Jha said the things I listed as threats #2 and #3 at the start of this post: that MMI might adopt Windows Phone under certain circumstances, and that MMI might start to assert its patents in internecine wars against other Android device makers.

The way he stated those strategic options was certainly consistent with how a CEO would seek to reassure investors. But from Google's perspective, those were serious, public threats. Google probably even knew ahead of time that he was going to say those things. But after he spoke out publicly, Google cracked down and called Dr. Jha himself "to increase Google’s proposed purchase price to $37.00 per share". And later that same day -- and without any rival bidders -- "Google sent a letter to Dr. Jha increasing its proposed purchase price to $40.00 per share".

The next day, MMI's board accepted the offer. Over the following days, they hammered out the details of the agreement. On August 14, it was announced.

Settlement of patent lawsuits also listed among "business opportunity costs" due to the merger process

In the SEC filing, MMI also tells its investors that it's taking a risk by not settling ongoing IP lawsuits, which it isn't allowed to do under the merger agreement (at least it would risk that the deal falls through and that it has to pay hundreds of millions of dollars):

"Motorola Mobility has certain potential near-term intellectual property (“IP”) licensing opportunities and certain IP litigation risks that without the merger may have been able to be settled on favorable terms to Motorola Mobility and may be more difficult to settle on such terms after entry into the merger agreement. Further, if licenses are not entered into and litigation is not settled, Motorola Mobility’s position in these matters may be prejudiced if the proposed merger does not close"

The fact that MMI is restricted under the merger agreement with a view to settlements has also given rise to two motions filed by Apple, asking federal courts in Wisconsin and Florida to stay two lawsuits between Apple and MMI until the merger has been completed.

By making MMI's board an offer that it couldn't refuse, Google prevented settlements. I already suspected so on the day the merger agreement was announced.

Effects of the deal

We now know what won't happen due to the merger agreement. MMI won't settle with Apple and Microsoft for now; MMI won't adopt Windows Phone; MMI won't attack other Android companies; MMI won't auction off a part of its patent portfolio, or the company.

So what will happen?

Sometimes it feels like I'm almost the last man standing to say that Google's proposed acquisition of MMI is not primarily a patent purchase, and to insist that MMI's portfolio is certainly not the kind of protective shield that could take care of the Android ecosystem at large.

No matter what the original reason for talks between Google and MMI may have been, or what the parties say: if this goes through, it will result in the ultimate extension of Google's advertising-centric business model to the handset and tablet computer market. Google's vision for the information and communications technology industry is the same as its approach to digital media content: everything -- hardware, software, services -- should be free, or if it can't be entirely free, it should at least be sold at a zero or (subsidized) sub-zero margin, refinanced exclusively by ads that Google sells to banks, insurance companies, car makers, airlines, and so forth.

While the particular combination of my related views is a minority position at this stage (I didn't file a patent on it), I have seen credible people express skepticism concerning Google's ability to protect Android with those patents (a fallacy that I simply call "Fata Motorgana"), or even dismiss the overall quality of that patent portfolio. It's all too easy to believe that this was just Google's next best choice after losing the Nortel auction. But as I explained, comparing MMI's patents to Nortel's patent is like comparing apples to bananas.

Patents are part of the deal. I never said the value of those patents is zero. But those patents aren't a protective shield for Android at large.

The driving force for this deal was not that two parties joined forces from a position of strength, to accelerate growth of whatever. This is a deal between one player (Google) who has a lot of money but a platform (Android) with serious intellectual property issues and another player (MMI) who was losing out in the marketplace -- among the three major Android device makers -- to Samsung (which builds better products) and HTC (which builds products that are at least comparable, markets them pretty well and has a cost advantage) and, additionally, losing out in the courts, especially to Microsoft.

This is a deal under which a party that's losing the legal battle (Google) is buying one that was losing in the market as well as in the courts. If the transaction goes through, the combination of the two will create serious competition issues without solving Android's IP issues. MMI's patents are barely good enough that MMI could stay in business if it accepted license deals from stronger players. Google bought MMI to prevent the worst for Google's strategy, not to make things better for everyone else.

In a way, the $12.5 billion price represents protection money. But not in the way most people seem to think.

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