SPEAKER 1: I'm delighted to introduce our speaker today, Marshall Phelps. I clicked on the website of the Intellectual Property Hall of Fame just this morning. And it says, Mr. Phelps put intellectual property on the corporate map. He forced senior managements and Wall Street to regard IP not as legal overhead, but as a profit center.
He's also been called "the legendary Godfather of intellectual property," quote/unquote. And by the way, Mr. Phelps was in the inaugural class in 2006 of the Intellectual Property Hall of Fame.
Now backing up on his resume, Marshall received his undergraduate degree from Muskingum College in Ohio, went to the Stanford Graduate School of Business-- and here I pause at the next part of the resume-- came to Cornell Law School where he graduated with his JD degree in 1969. After clerking, Mr. Phelps went to IBM. And he was there for almost 30 years, first in antitrust then, and especially in intellectual property, but also government relations international affairs.
He turned IBM's remarkable portfolio of intellectual property, which was not doing much as a profit center, into over a $2 billion a year gold mine, perhaps, might be called. Serving as vice president for intellectual property and licensing, and essentially revolutionizing how IBM did its business. In 2000, Mr. Phelps retired from IBM, becoming chairman and chief executive officer of a private equity venture firm.
So this is an astounding career. But the next chapter was actually yet to come. Mr. Phelps was doing a deal with Bill Gates. And as part of the negotiations and terms, Mr. Gates invites Mr. Phelps to join Microsoft, eventually as corporate vice president for intellectual property, policy, and strategy. And his task there-- not that I'm putting words in his mouth-- but most simply was to revolutionize the way that Microsoft handled its intellectual property. So the word "revolutionize" comes repeatedly in this recap of Mr. Phelps' career.
He's just very recently retired from his role at Microsoft, but still serves as a consultant for the company, and has joined Waggener Edstrom's Worldwide Global Public Affairs Advisory Council, where he will provide strategic counsel to clients on a range of issues affecting business, government, public policy, and the public debate.
In addition to his time here today, we're delighted to announce that he will be our feature speaker at our Cornell Law School annual alumni luncheon in New York City on January 29, which will be at the Helmsley in the city. After today's lecture, you're invited to attend the book signing and reception in the foyer of Myron Taylor Hall. It's our great privilege to welcome Marshall Phelps. Thank you.
MARSHALL PHELPS: Thanks.
SPEAKER 1: Thank you.
MARSHALL PHELPS: I'm going to try to do this not behind this thing. It's very formidable. Also took my coat off.
I have been lately working for a company that had to pass a rule that you had to wear shoes in the cafeteria. So I'm used to a rather informal atmosphere. So I hope you don't take that personally. So I took my coat off, in any event.
I was telling Dean that school has changed radically since I was here. In 1969 at Cornell, for those of you who are historians, was probably the worst year in the school's history. The Black Studies building was burned to the ground. And there were six attempts to burn the law school down with kerosene-soaked hay bales in the tower. I don't pass that on for any reason.
But it was it was a tough time. And that was the year when the Willard Straight Hall was taken over by students with guns. And you've probably seen some of the pictures of that. But it was an interesting time.
We didn't have a graduation here at the law school, particularly. We had a cocktail reception in the same place we're going to have one this afternoon. Lasted about 15 minutes. Disappointed a lot of parents who spent a lot of money. But that was the time.
And the other thing about the school was quite different is how bright it is. This room is Exhibit A. This used to be the dingiest, most forbidding-- first of all, we weren't allowed in here. You could only come in here on very special occasions. And you had to kind of genuflect at the door.
I'm not sure what all the rules were. But you rarely got into this place. The library didn't have lights on the stacks, if you can imagine. If you look at the top of the library stacks, there are parallel lights. And the floor was made of cork that had turned kind of a dingy dark brown. And it was literally-- you walked in there at night. And the only lights were those table lights. And you kind of had to feel your way around to where you wanted to sit.
And that was kind of it. The outside wall of the far side toward College Town of this place is now that wonderful lit courtyard that you have there. And so the whole place is quite different. We used to live in the-- basically a dormitory over here in the law school. Play squash in the thing and eat in the cafeteria and not leave this building for six months at a clip.
We were not well-rounded. Let's put it that way.
So anyway. Enough of that. I thought I was going to talk about really some of the issues that I have been living with for a couple of decades on intellectual property and what that means for strategic innovation. And really more in an observational sense, I don't want to read a speech if I don't have to. I would encourage this to be as interactive as you all want to make it or not.
There are no bad questions. And there are bad answers. So don't at all be worried about disrupting anything.
I'm not going to use PowerPoint, which is a special form of heresy for somebody coming from Microsoft, I realize that. But I'm not going to do that. And I'm just actually going to just talk, if you will. And I do hope we can make this some somewhat interactive.
This whole issue of intellectual property that many of you may not realize is a very old one. One of my classmates in this Hall of Fame that the dean talked about is Victor Hugo. Victor Hugo is responsible for copyright law in the world. If it wasn't for Victor Hugo, you wouldn't have that.
And he was pressing the French to adopt that originally. But that's where all that came from. This has been around for a long time.
In the United States, it's reflected in Article 1 of the Constitution. For those of you who are constitutional scholars, you'll find it in there, believe it or not. Not necessarily covered in law school. But it's in there.
And there is a mandate in the Constitution to promote useful arts. And the output of that has been an intellectual property system in the United States. We tend to focus mostly on the patent system.
By the way, anybody know who the first commissioner of patents was in the United States?
MARSHALL PHELPS: Thomas Jefferson. Which you probably didn't know. Anybody know the only president to ever get a patent? Who wants to take a guess? Abraham Lincoln. Yeah.
Both of those are kind of important for a reason. I'm getting ahead of myself on three pages into this. The United States was trying to democratize all kinds of systems when it formed itself. And one of them was the intellectual property system.
The closest one we had as a model was Britain. And Britain's intellectual property system was basically a grant from the King for a limited monopoly tool to the grantee, if you will, almost done as a favor. But a hugely expensive proposition.
The framers of the Constitution wanted exactly the opposite. They wanted to democratize it. And if you think about the inventors in the 18th century, in the 19th century, the Thomas Edisons of the world, the Elias Howes of the world, and all of that. These were people who were poor as church mice, who quit school, to market their inventions and provide sustenance for their families, quite frankly.
Steve Jobs and Bill Gates would be the current analogs of poor people who did the same thing. That's a joke, folks. But that was the idea.
So our patent system at the time was wildly less expensive than what was available in Europe. To the point that about three years after it was in effect, the United States had as many patents existing in this country as Britain had in its. And Britain, of course, was a much bigger country at the time, and was the ground zero, if you will, of an Industrial Revolution. And yet here is where the United States was.
I think, if I can get the number right, well, I won't find it. Oh, by 1860. Yeah. By 1860, we had seven times the number of patents that Britain had. By 1860. And our populations were roughly equal at the time. So it was a huge success.
Oh, by the way. You could even get free postage on a patent application in the United States at the time. Postage was a big deal in those days, right? Somebody had to ride a horse from wherever you were to Washington, DC to deposit that thing. That was a big deal.
Today you call up FedEx or UPS, and you get it there. But free postage strikes you as kind of a kind of a homely example. But it was it was a very big proposition in the United States.
And so we had this democratized patent system the debates that you hear, those of you who follow this crazy stuff today about patent reform and all this stuff, and there was a huge article yesterday in the New York Times-- and I won't embarrass any of you who didn't read it-- about what's going on in the US Supreme Court right now over an issue of patent law, really come down to this issue of little companies versus big companies and who can afford to play in the system and who can't. That's really what it's all about.
And the echoes of what the framers of the Constitution were trying to do versus the system we where we are today are very much in effect. Why is that? Because today if you were to try to get a patent for yourself, about the cheapest you could do it in the United States is $25,000. That's about what it would cost you.
Now maybe if you're your own patent lawyer, you can do it cheaper, but you're probably going to write a crappy patent. But $25,000, you ought to figure, that might get you a patent in the United States, should it ever issue. Oh, by the way, it takes a minimum of 3 and 1/2 years to get it issued. By the way, you know how long it takes in Japan to get a software patent issued, by the way? 14 years.
Now in my industry, how good is a patent that gets issued 14 years later? It's totally useless. Totally useless, in general.
And so even 3 and 1/2 years, we live in internet years. What's an internet year? It's three months, right? Roughly speaking.
So these time frames and these lags and all of that are kind of the administrative issues that you see being played out right now. How to speed that up, how to make the system accessible to those who otherwise wouldn't be able to afford it. And oh, by the way, are we out there patenting air in this world right now?
And the current debate on patenting air happens to do with something called business method patents, where people literally have gone out and patented their back offices. Take something from desk A, take it to desk B, and then take it the desk C. And you go get that patented. Now that has happened.
And there's a famous case in the '90s called State Street Bank, which allowed that kind of thing. And since then they've been besieged by these kinds of patents which are leading to all kinds of issues in front of the Patent Office. And there's a famous case that's being heard-- was heard Monday-- called Bilski, which is one of the persons who's applying for a patent. And oh, by the way, what does that patent do? It allows you to financially predict weather cycles to hedge your commodities bets, if you will. And there are people who think that that kind of stuff isn't the kind of technology the framers of the Constitution were really talking about when you go apply for a patent.
So that's a big debate going on right now. I would urge you to watch all that. It'll come out in the spring when they publish those opinions.
But those of you who read the articles yesterday realize that Ginsburg and Roberts and Scalia and some strange bedfellows were all on the same side beating the living hell out of the lawyer for Bilski on whether or not this kind of stuff should be patented at all.
So anyway, the thesis that I've been arguing is that the patent system is really-- and the democratization of it-- is really kind of fundamental to the competitiveness of the United States, and always has been. Take my industry. It's the software industry. The software industry in the world is a $2 trillion-a-year business. That's pretty big, by the way.
There was no software industry in this world 25 years ago, those of you who think about that. When did we get a software industry? June 23, 1969. I was still here.
IBM unbundled software, which meant it separately priced for the operating system for its mainframe computers. Why did it do it? Because the Justice Department was going to sue the hell out of them in anti-trust if they didn't. So they did that.
And so today you have a $2 trillion industry of separately priced software. And I'm not even mentioning open source and some other business models that also exist in this, and the Twitters of the world that make no money, or the Facebook's of the world that make no money. But they are out there on the hope that someday they will.
But anyway, that's what my industry is. You know how many businesses happen to be in the software industry? 1.5 million companies in this world.
They have 15 million workers. And they pay $1 trillion in taxes to governments around the world. I will argue-- open source, closed computers, whatever they are. You got Steve Jobs on the one extreme. And you've got the open source foundation on the other. And God knows what.
None of those could exist without intellectual property protection. You might say that makes no sense, because they're anti-intellectual property on the open source side of it. And the answer is, no, they're not.
Everything they make is copyrighted. Everything. You want to get a trademark suit real fast, just go put the Red Hat logo on something of yours and watch how fast the trademark suit hits you. Another form of intellectual property, right?
All those companies rely on trade secrets, trade dress, all those kinds of things. Again, not patents for the moment. But certainly forms of intellectual property that you can command attention for. So that's my industry.
I can make a pretty good argument that if you don't have intellectual property, countries-- I'll do the whole nations now-- that don't have good structures for this have a excessive incentive to copy and steal. And on the other side of the equation, countries and companies that have protections pull back from those kinds of countries that are on the other side of the ledger.
Exhibit A-- China. China two years ago, not China today. We can get into that, what's happened in China. Those of you who read the International Herald Tribune will notice yesterday had a front page article on the new legal structures in China and how well they are working. And indeed, they are. But let's just go back two years,
China is the second largest personal computer market in the world, only slightly behind the United States. China is the 23rd largest personal computer software market in the world. What do you think makes up the difference between 2 and 23?
Oh, come on. This is not a hard question. Somebody take a real risk here.
MARSHALL PHELPS: Piracy. Sure. That's just computers.
I'll tell you another-- well, sort of a funny story. There's a company called Icos. Icos is in Bothell, Washington, which is just north of Redmond.
And Gates asked me to go up and see these guys, because he was on board. And they were making drugs for erectile dysfunction. I said, Jesus, this is a hell of an assignment.
So I'm up there visiting this company. And Bill's argument was they don't know anything about intellectual property. And he was exactly right.
Now they came up with a drug called Cialis. This is the one where you see the people in the bathtubs up on the mountaintop, just like home. Right? Not my house, anyway. But somebody's house, I guess. But anyway, that's the drug that they make.
The day they announced that drug, counterfeit copies were available in India and China. The day-- the very day they announced it in the United States. Now that's 2/5 of the world's population that's lost to you as a market, if you think about it. If you just want to think about it in business terms.
Right. A copy of Windows, all 53 million lines of code in Vista-- which is somebody's going to argue at least a million or two lines extra, I'll give you that-- is available in China for under $1. In the United States it's probably 75, 80 bucks. But you can get counterfeit copies for under $1.
That kind of takes the marketing initiative away from companies. If you were to ask Sony what they think about China on some of that stuff-- and I'm not trying to pick on China. I'm a big China fan. I was a Chinese history major ages ago.
But just to give you an example of how widespread this problem is. There is an automobile that General Motors is building called-- they were building in Korea, a small version of the Chevy. In fact, it was called the Chevy. C-H-E-V-Y.
And they had the whole thing on a database, which was stolen by China. And the exact same car was built using the specs out of the database that was stolen from South Korea, except for one thing. Instead of C-H-E-V-Y, the car was called C-H-E-R-Y. And they changed the aluminum logo on the front of the car. with a V to an R. That's the only difference in the car.
Now, they didn't have a whole lot of R&D expenses that went into that. Right? So say what you want about General Motors, they had a competitive disadvantage in that particular case.
So there are people like me who go around the world trying to convince countries that the better way to act is to step up to these kinds of issues and put the legal systems in place that will allow you to do so. And I'm happy to say that of all the countries in the world that have done this recently and done it very well, China is first and foremost. They have set up 50 different administrative courts around the country to deal with intellectual property issues alone.
So yay for them. And I think we're going to see a lot of success on that score. Certainly other companies have benefited from doing this. Korea, dirt poor, had a per capita income 20, 30 years go of under $100 a person. Today it's $12,000 a person in Korea. South Korea is just phenomenal. I would argue that one of the reasons for their success is a lot of investment that flowed into that country, because they changed their legal systems to support fairly strict regimes to protect the investment of people who wanted to invest in the country, which means fairly strict protections on intellectual property and things of that nature.
And I have talked about China. Do you know that there are more Chinese patent applications than there are in the United States now? Probably don't. But there are.
And most of them are now coming from Chinese citizens themselves. So this whole situation in China has done a complete 180 since I've been talking about this. So my point is that you're seeing quite dramatically that IP rights have had a major influence on the way the economies of the world are developing. And that's at the macro level.
Let's go to the micro level. Micro level are companies. Some of you are business school students. Some of you are law students who are going to advise the business school students at some point in time. Or think you are, anyway.
If you ask an executive today whether intellectual property is really important, they would say, oh, yes. Absolutely. And boy, do we manage that well?
How do you manage it?
We give it to the legal department.
Oh. Give it to the legal department. And what's the legal department do with it? Is the legal department a profit center?
You should hope not, by the way. The answer to that is, God help us if it is. Right? But so it isn't, normally speaking, a profit center.
So you take something that is an asset of the corporation. And you give it to the lawyers to manage. And they're going to manage it as lawyers. That's what they should do.
They're going to say, well, we're going to file 100 patents this year, whatever. We know what the cost of that is. So they're actually-- legal departments are an expense function. They're not a profit center.
And we know what that takes. We've got six patent lawyers who work on that. We've got some engineers who help that process. We know it's going to cost. And we'll go get patents on that.
And the CEOs are happy. All right.
Flash backwards to when I was in this place, or when I was in business school. Intellectual property is taught-- was taught, present company excluded now-- on kind of a read, speeds, and feeds basis. A patent was for 17 years. Now it's 20. But it was 17 at the time.
And here's what you do to get a patent. A copyright means this-- a life of a copyright is the author's life plus whatever the period of time was then. What is it? 70 years now, plus the author's life, the blah, blah, blah and that kind of stuff. Here's what a trade secret is.
That's what we learned. And that was OK. If you go to business school, you didn't learn anything about this stuff. Wasn't even covered. Right?
Why is that? Well, if you look at a balance sheet of a corporation 25 years ago, 30 years ago. And remember, all these folks now are running corporations or major law firms or accounting firms, whatever. The makeup of a balance sheet of a corporation was 80% physical assets and 20% non-physical assets. Right.
So those of you who are accountants, property, plant, and equipment. If you added it all up, it's 80% of the value of the corporation. Today that is totally reversed. It's the other way around.
80% of your assets are non-physical assets. 20% are physical. In the case of Microsoft, it's probably 5% are physical.
Why is that? Microsoft rents most of its buildings. Doesn't even pay for the buildings. It's got 100,000 employees, mostly in rented buildings.
So they don't even show up on the balance sheet. So Microsoft's got this really skinny balance sheet in terms of property, plant, and equipment. And yet you'd be a fool not to argue that Microsoft's value isn't more than what's represented in that balance sheet. Probably 95% of the value of Microsoft is not showing up on the balance sheet.
Now what about executives today who get out of school? They were trained in that world. Right? So they get into a corporate setting. And they see their CFO. And they know what Wall Street expects of them. By the way, you think Wall Street understands this stuff? No. No way. Not even close. Right?
They're all from the world that you get judged on and you manage what you can measure. And if you can't measure it, it doesn't exist. And that's the world today for most of the CEOs and boards of directors who pay lip service to this whole thing.
So what does a CEO think about when he thinks about his company or her company? They think about their sales. They think about their R&D. They think about of all things, those antitrust lawyers, what their market share is. They think about market penetration. They think about morale of employees.
You think they're really thinking about what's my patent profile look like? Any of that kind of stuff? No, they're not.
Flashback to IBM in 1992. IBM was a company that existed with full employment, was making all the money that was to be made in the computer industry throughout the '80s. Missed a couple of turns of the crank, and by 1992, was down to 100 days of cash.
It was about to go bankrupt. It would have been the largest bankruptcy in the history of the United States at the time. As it was in 1992, IBM laid off 205,000 employees. That's out of a total of 400,000.
That's a big layoff, even by Detroit standards. But in 1992 coming from IBM, it was unheard of. Major shockwaves through this country.
So in comes a new guy by the name of Lou Gerstner. Lou Gerstner is many things, including a friend of mine. But he didn't understand intellectual property very well.
What did Lou Gerstner think about intellectual property? He thought of it the way most CEOs think about it in operational terms. It's a negative right.
What do I mean by a negative right? Means I have the ability to stop you from doing what I'm doing. I've got a pattern here. You can't do it the same way. Or you can't follow my patent without violating it. And I can stop you.
Why does Lou Gerstner think like that? Lou Gerstner had come from-- anybody know the history of Lou Gerstner at IBM? There was a book on this-- two of them, actually. Barbarians at the Gate, some of you may have read. And there's another one called The Cookie Wars. Cookie Wars is the more interesting of the two books, believe it or not.
Lou came from being CEO of Nabisco. What does Nabisco do? Makes cookies and crackers.
Nabisco had just lost a major patent suit over one patent with a company called Procter and Gamble. The patent was how do you make soft chocolate chip cookies. And some kind of a process. Don't ask me.
Procter and Gamble won. Nabisco lost. Nabisco had to shut down its cookie line for soft chocolate chip cookies.
So Lou arrives at IBM. That's his knowledge of what an IP system is for. By the way, today I will guarantee you that nine out of every 10 CEOs you scratch will say exactly the same thing-- just that.
Meantime, IBM's down to 100 days of cash. And one of the things I did was say, I think I can make you some more money. We've got this giant patent portfolio. And you're giving it away, IBM, for basically nothing. Well, why was IBM giving it away?
Well, IBM was giving it away-- by the way, that just means licensing other people for nothing, and cross-licensing back and forth with no money changing hands-- because it had signed a consent decree with the US government in 1956. Antitrust case. Same with AT&T. The two biggest development labs in the world-- IBM and Bell Labs-- had signed consent decrees that basically said the same thing. You'll license everybody under fair and nondiscriminatory terms, and blah, blah, blah. The rest is history.
IBM couldn't really charge for its intellectual property portfolio-- albeit, it was imbalanced with everybody else in the world-- because of the consent decree, and because IBM was a monopoly at the time. And had it done so, it would have been regarded as a further tax on the industry. It would have cost IBM even more antitrust trouble than it was already in. So IBM was licensing everybody.
And by the time Lou Gerstner arrived, there were about 1,820 cross license agreements spread throughout the world. So on the second day in office, Lou Gerstner called me on the phone. And the conversation, which I sort of kind of put in the book, but not really, went like this. The opening statement was, what the hell do you think you're doing?
Now I didn't even know who it was on the other line, which is part of the problem. So my answer was, about what? And who is this?
It turned out it was Lou Gerstner, who was the CEO. And he says, you're out there licensing everybody. What the hell do you think you're doing? You're licensing our competitors to use our intellectual property. Blah, blah, blah.
So I was about to explain the consent decree, which is not a happy conversation to have with a new CEO, first of all, because the second thing is, why haven't you gone to amend the consent decree after all these years. And I didn't have a good answer to that.
So we were trying to think about what we would do to explain the way business now was starting to have to interrelate with itself. And by the way, these trends have continued. And today it's called open innovation. But the point is the same as it was then.
So we took a laptop computer. We've all got one around here. There's a whole bunch of them in this room. And we pried the top of it off. This happened to be an IBM version. Those, except for the Apple that I'm looking at here, they all follow an IBM architecture. It's an IBM architecture that was developed around 1979, 1980.
And every single laptop, but for the Apple ones, follow that architecture. So you would think that IBM's intellectual property position would be strongest for its own architecture. That's what you would think. Right?
So we pried the top off the thing. And we took a whole bunch of toothpicks. These are grown men sitting around in an office. Actually grown men and women.
And we were cutting little red flags out of construction paper, just right out of first grade. And we were making little flags-- somebody had the Glue All. Somebody had the construction paper. And somebody had the toothpicks. It was a three-person operation.
And we're cutting, and we're making little red flags. It's an absolutely true story. And then somebody had the job of gluing the red flags onto the guts of the computer in areas where we found the intellectual property of other companies that we had licensed in our own architecture computer. And we stopped at 150 red flags, because we ran out of room. Not because there weren't other pieces of intellectual property that mattered.
But you can think about this in your own mind. It's a pretty good visual impact kind of thing. And we took it in and plopped it on Lou's desk and said, here's the deal, Lou. This is why we have to license the intellectual property of others. And to do that, we have to trade our own and license it back the other way.
Lou, being smarter than the average bear, picked that up in about 30 seconds. And we were off to the races. Lou said, OK, what are you going to do with all this?
And I said, we're going to make you some money. Because we've got this imbalance now in our intellectual property portfolio and everybody else's, which we ought to start realizing. And at the end of the day, we were making over 2 billion bucks a year doing it. And by the way, those of you who are from the business school, it cost me $36 million a year to do that.
Now that makes you very popular with the CFO of your company. Very, very popular. And for those of you who are wondering, well, how do you get your company to do this kind of thing, the answer is, you do it by example. So you go find somebody who's in deep trouble. And you say to them, I'll bet you I can make you some money and make you a hero, if you give me x, y, and z.
In our case, we went to the guys who make the chips in IBM-- the microelectronics people-- who were going out of business, by the way, along with everybody else. And we said, we'll make you some money. How much can you make? Well, I don't know. We'll make you $25 million if you'll give me electron microscopes and some engineers.
We actually made them $48 million in the first year. Made them very, very happy, because it's $48 million and went right to the bottom line. Now how much revenue do you have to generate to make $48 million in profit is the way you need to think about this. Don't think about it as $48 million.
Think about, Jesus. I would have had to sell $500 million worth of chips to make that $48 million. That's the way you have to think about this. So they're very happy about that.
But what do you think happens the next year? The finance people don't forget about that $48 million. They put it back into your plan for the next year with a little extra kicker on there just for yucks. Right?
So the next year, it's not $48 million you have to make. It's $55 million. All of a sudden, though, that particular business-- engineers and the like-- are your best friends, because they're scrambling to figure out a way to help you do that. And quite frankly, that's the easy way. If you talk to companies that say, I have no idea how to start doing this or any of that kind of stuff, that's the kind of model you try to take them down.
Microsoft. Now, Microsoft doesn't need cash. You're going to find this hard to believe. But Microsoft throws off a billion dollars in cash a month-- free cash. That's after all the bills are paid. There's a billion bucks a month. It's been a billion dollars a month for the last 15 years. Right?
If you went to Bill Gates and you said, I want to adopt the IBM type of program, the lawyers would say, you're out of your mind. That's just another tax on the industry. We're going to get killed if we tried something like that.
Well, what does Microsoft need? There's actually a point to this story, which I'll get to. I realize it's a bit of a shaggy dog story.
But Microsoft need relationships. Now Microsoft grew up in a soggy corner of the United States not known necessarily for high tech. There's an airplane company there.
And Microsoft grew up in suburbs of Seattle all by itself. It became extraordinarily wealthy. Since it's the wealthiest company in the world, A-- for sure they're the smartest people in the world. That's the way they think. And they don't need anybody else.
And so they kind of grew up in an iconoclastic, leave me alone, I can-- those of you who are students of this kind of stuff, there were antitrust hearings in the United States Senate involving Microsoft. Microsoft shows up. And some executive who will go unnamed stood up and said, you know, the problem we have, Mr. Senator, is that our current attorney general is stupid. One might argue that that's kind of a stupid thing to say in front of the cameras in front of the US Senate that has oversight committee over that attorney general. But that's a story for another day.
What does Microsoft need? A course in civility. Give you that.
But the other thing they really needed were relationships. And they need it very badly. When I joined Microsoft in the year 2003, Microsoft had absolute not one single license agreement with another company in the world. Not one. They had had one with Fujitsu, which had expired. But but for that, zero. Nada.
Now one thing you can say about license agreements-- and we talked about the 1,826 that IBM had in 1992 and 1993-- is that those are 1,826 companies that do not suit each other, because they have a commercial relationship. Now Microsoft today has 550-plus of those kinds of relationships with other companies. Now that means that there are 550 companies that aren't going to go out there and sue each other over minor commercial squabbles because they're in constant contact and constant communications with each other going forward.
And that's kind of the way that the world is going, because the world has now figured out-- companies have figured out that they can't do everything-- I'm way off my speech, by the way. They can't do everything themselves.
So Microsoft spends-- who wants to take a guess? How much money on R&D? Go ahead. Who wants to take a guess? More than any other company in the world. The answer is $9.5 billion. That's a lot of money.
Now R&D is a crappy process. By that I mean, you cannot program innovation. You can't point to somebody and say, you're going to be innovative today. It just doesn't work like that. You're going to invent xyz today. It doesn't work like that.
So you spend all this money. And you hope to God some flowers bloom at the end of the day. But it's a lousy process. And at the end of the day, you end up with a lot of stuff that isn't going to be terribly useful to you. Now I know you're going to tell me that with 53 million lines of code in Vista, there can't be anything that's left out. That's what you're going to tell me, especially my friend over here with the Apple computer.
And the answer is, there are things that don't go into Vista or Windows. I'll give you an example. And this is one of the differences that a company like Microsoft is on on this open innovation world that we're in now in. Predictive traffic software. Any of you have a Garmin or a TomTom or any other-- do it on your PDA, that's Microsoft software. It's embedded in Microsoft research.
It isn't going to go in Windows. Hard to believe, but it isn't. So what did we do with that stuff? We spun it out of Microsoft and formed a company to make-- long and short-- called Inrix-- I-N-R-I-X-- which now has about 550 employees in Kirkland, Washington. And they're doing very well selling that software to TomTom and Garmin and companies of that nature.
But that's an example of the way this world is going, and a recognition that no company-- I don't care how big-- can go it alone. I would also argue that but for and without which intellectual property systems, you couldn't have this world. Why is that?
Because I couldn't draw up a licensing agreement to license you my intellectual property if I didn't have some rules. You as the receiver wouldn't dare take anything from me without rules, because you'll say, aha. You're just playing Lucy with the football. That's what you're doing. You're going to let me have that stuff. And then you're going to sue me for misusing it in some way, shape, or form.
And the receiving end you want those rules just as much as I want to give them to you on the giving end. That's the way corporate America is now working, and the way the world is working. Well, is that true for other industries? Or is that just Marshall with high tech and all those little thousands of inventions that are in every product?
And the answer is the same. Think about the drug company. Think about big pharma. Big pharma today is operating under a failing business model, those of you who are looking about for future employment.
What's the failing business model? They all rely on kind of giant blockbuster achievements on the front end. Billion dollar achievements, by the way, is what they're looking for. Right?
You know how hard it is? We just talked about how hard it is to program R&D. How hard do you think it is to say to a group of scientists, next year on June 23, you have to have a blockbuster. Got to be worth a billion dollars.
Doesn't work that way. They've run out of blockbusters. So what are they doing? What's the business model now with pharma?
They're going buying little pharmaceutical companies, little developers all around the world-- not necessarily in the United States, by the way-- who are working on very interesting little things that they can do by themselves that don't work so well in a programmatic large corporation model. That's what they're doing.
What about the airline industry? Think about that example, I suppose, to some level. Boeing's Dreamliner. Someday we'll all fly on one of those things, if they ever get it out the door.
But what do they do with that today? Think about how that thing is made. The wings are made by-- anybody know? Mitsubishi Heavy Industries in Japan. The fuselage is made by an Italian company. It's assembled in South Carolina. The engines are made in Great Britain and in Cincinnati.
They're all put together on some kind of a funny looking 747, and flown to Seattle, Washington-- to Everett, Washington-- excuse me, and they're put together by Boeing. What is Boeing? It's a systems integrator. It's not making airplanes any more.
It's doing product design, product test, systems integration. You and I better hope that they're sharing one hell of a lot of intellectual property with their vendors so that the wings work with the fuselage, and so that we can get on that plane and have some security-- assuming the pilots are sober-- those of you watching today's news. They hauled a pilot off a United Airlines plane today in London, England for being drunk. So those of you who fly from London to Chicago have something to worry about, because that was the leg the guy was on. But anyway. I digress.
That's the way the world is now working in this kind of interrelated model. And my argument being that it's intellectual property and the proper use of that that makes it possible.
So having said all those nice things, let me spend a minute on what are some of the issues that I see coming up. And for that I have to fast-forward a long way here. There are really kind of four things I wanted to talk about just really briefly about what I see are the issues. One, of course, is I wanted to tell you a little bit that this happy little economic engine in the United States is in some degree of duress and stress and is fluttering.
If I just wanted to take the high tech-- my world, advanced technology-- and if I pick a year-- 1999. 10 years ago. We were operating in the United States at a $30 billion trade surplus on high tech.
Anybody want to guess what it is today? It's a $53 billion dollar trade deficit. And this is an industry that we invented. Right? This is the computer industry operating at that kind of a deficit.
My friends at Apple Computer over here, or somebody like me who has an iPhone-- very proud of my iPhone. It runs some Microsoft software. That's how I can do it with a straight face. And it's a great machine. That phone isn't made in the United States. It's made in Taiwan, which is perfectly fine. But I'm just trying to make the point that that's how you get to have a $53 billion trade deficit.
So there are a whole bunch of things going on that I don't think are very helpful. One of them is. Venture capital. Venture capital in the United States is starting to dry up. It is. I'll read you something from New York Times.
Venture capital is running at the lowest level in more than a decade. Let me give you some numbers. In 1999, VCs invested $52 billion in 5,400 startups in the United States. Pretty good numbers. By 2009, VCs were investing $12 billion dollars in 2,000 companies-- a 77% decline in venture capital in this country in 10 years.
Where's that money going? A lot of it's going to foreign startups, by the way, which we should talk about culturally. Because one of the good things about the United States is we have a culture of failure.
What do I mean by that? It's almost a badge of courage, a badge of honor, if you failed as a VC in the United States. And in fact, you rarely find a successful VC who hasn't failed at something. 1 out of 10-- rule of thumb-- 1 out of 10 VC deals actually work. By that I mean stay in business. 9 out of 10 fail. That's a pretty healthy failure.
If you go to other countries, they all say, well, I want to be like the United States. Why can't we have Silicon Valley or 128 and Boston in my country? Say, fine. How are you going to get there?
Well, we do government funding for our VCs because we don't have a VC industry. So we fund startups. Thailand, Malaysia, you can go down the list. That's what they do.
Can they fail, you ask the government. Oh, no. They can't fail. Why can't they fail?
Well, we're using taxpayers' money. If they fail, we'll be criticized. Well, I've got news for you. If you can't fail, you can't succeed.
And so that's one of the few advantages we have in this country is that we can have this culture of failure, and it's OK. But as I say, the numbers are going down.
If you look at what this really means-- if you go look at FedEx, Intel, Microsoft, Apple, Amazon, Yahoo, Genentech, eBay, Google, just to pick some you might have heard of-- those were all VC-started and supported companies when they began. Those six or seven companies I mentioned are a huge slug of the US economy today. And you're not seeing them anymore. At least the way things are going right now. So that's number one.
Why is VC money not available? Because you can't have IPOs anymore. What's an IPO? An IPO is initial public offering. It's a financial event that gets the VCs paid back, gets the starters of the companies paid back, and all of that kind of thing.
We're not having IPOs anymore in this country. So I'll just give you some numbers on that. And this is exactly in the last few years. Between 1991 and 1997, there were 1,353 venture-backed IPOs in this country. But between 2001 and 2008, the numbers fell to 392. A 71% decline, even with throwing in an extra year of 2008.
Worst of all, the last quarter of 2008 and the first quarter of 2009. You know how many IPOs there were in the United States? Zero. Flat out zero going to market.
So if I'm a VC, and I am, and I have no possibility of a liquidity event going forward, what are the odds of you as a small startup coming to me getting money? Good? Bad? How about zero? How about I'll charge you for the time? I mean, that's kind of where we are on that.
So let me give you a third one. Government regulation. Now look. There is a time and a place for everything. And government regulations is one of them.
And you'd have to be a fool to argue against government regulations in the face of what we have seen in the Enrons of the world, and what we see in the AIGs of the world, and things of that nature that cry out for regulation. But we've got to be smart about it. So Sarbanes-Oxley. Any of you heard of Sarbanes-Oxley?
If you have, raise your hand so I don't wear you all out. OK. Sarbanes-Oxley. Mike Oxley. He's a really nice guy. And if you ask Mike how Sarbanes-Oxley got such a head of steam, he will tell you that it was written at a time when Rome was burning. And he's exactly right. It was on the heels of WorldCom, the heels of Enron, and all of that stuff that Sarbanes-Oxley was passed.
Now the estimate out of the Congressional Budget Office-- you hear a lot about this in the health care debate right now-- was that Sarbanes-Oxley would cost small companies $91,000 a year to comply with-- small public companies. $91,000. Steep. But $91,000, maybe you can survive that.
You know the actual cost is? $4 million. So I'm a small company. I'm public, small company. I've got $10 million in revenues. And now I've got a $4 million accounting bill for Sarbanes-Oxley on an annual, ongoing basis.
What do you think that does to my earnings per share? It craters them. This is a huge problem.
So what we haven't figured out in the United States is how to stage things so that the small folks-- look. $4 million means nothing to Microsoft. It means nothing to IBM. Means nothing to General Electric. It means nothing even to General Motors.
But it means a hell of a lot to a small tech thing up here in the Cornell Tech center, whatever, that $4 million bucks. It's a real inhibitor to going public and getting funding. So there is that problem. I'm just saying we need to be smart about that.
Fast circle to this whole patent debate. We've got to find a way to make the patent office accessible to small companies on a faster and cheaper methodology than we have today. There's no reason that Joe's Garage should pay the same for a patent as IBM. Absolutely no reason.
And we ought to be able to go back to what the framers of the Constitution counting on and figuring out that's something to do with it. So we talked about Sarbanes-Oxley.
Let's see what else. I had one more than I really wanted to cover. And that's kind of an interesting one. It's the lack of failure of all of this to manufacturing in this country.
We don't make anything anymore. And it's a sad chain. We are great on designing. And we are great of thinking about things. But we don't make anything, quite frankly.
And you can see this in the balance of trade numbers every month. You can see it in the decline of the US dollar every month. Dollar is now worth-- what's a euro? Buck and a half, right? I can remember when the euro was $0.75. That wasn't that long ago. Four or five years ago. Right? So this is all reflected in how you get into that kind of a situation.
So I go back to kind of finishing up with the US patent office. Here we have a patent office that is struggling-- Patent and Trademark Office-- is struggling to keep its head above water. You would think we'd want it to be as competitive as we could get it. And yet, in the last couple of years, the US Congress has diverted $752 million away from it to pay for their pet projects, whatever they may be at the time. So we are underfunding that office.
Meantime, by the way, the office that has the most patent applications in front of it right now is China. We are now number 2. And they've done that in a couple of years. Yeah.
AUDIENCE: I think this might be a good time to raise this point, that there seems to be not as much evidence maybe that the cause and effect relationship is between patents, say, or IP, and success in the market, or innovation.
MARSHALL PHELPS: Right.
AUDIENCE: It seems the reason that the United States, when we weren't doing very well with inventions, we were pirating everything. And then once we get kind of good at it, then we start putting the IP in place as more of a mercantile kind of protection. And perhaps that explains why China hasn't done that. And now once they are getting successful at it, not because of IP, but just because they got successful anyway, now they put IP in place to protect themselves from us.
MARSHALL PHELPS: You know, that's a terrific observation. And it's probably impossible to prove either way. It is true that the United States was one of the great pirate nations of all time. And so every time we get self-righteous about all this, we should remember that we basically stole everything from Britain. Textile industry, patterns for textiles, all that kind of stuff we basically took.
And you're right. It wasn't until we started to get good at this stuff ourselves-- although I will say that there is a pretty clear cause and effect between at least establishing the ability to file patents and protect them before the US invention stuff all took hold. Because if you think about it, the Thomas Edison's of the world and the Elias Howe's of the world and the Singers of the world, and all of that kind of stuff were a good 60, 70 years after all of this stuff happened and when the Constitution was written.
So we did have the mechanics in place to do this. I think your point about being what the US was at the turn of the 18th century is exactly right. We were-- as China today does-- China would say the same about Vietnam, by the way. And they would make the same arguments going downstream from where China is as they see themselves today.
It seems to be the way the world is. I'm not contesting that. But I am saying that as the world gets more and more sophisticated, we're all going to sort of have to play by the same set of rules kind of thing, I think to be ultimate. Because it's a matter of investment. If you have $10, and you're going to invest it in a business, are you going to invest it in a business that you have a chance to get your $10 back or not?
It's a very simple discussion to have. If I say to you, I'm going to put a software factory-- pick a country-- in North Korea, I have no chance of getting my intellectual property protected. Am I going to do that? There's no way in hell I'm gonna do that.
AUDIENCE: But the answer to that question that I was making is relative to how much Microsoft makes on selling the OS. If the answer to that question is, yes, I'll get $11 back, I'll probably do it. I don't need to get $1,000 back for $10. If Microsoft made $1.50 instead of $1 in China on the OS--
MARSHALL PHELPS: The actual answer to that is $3.
MARSHALL PHELPS: No. I'm paying you a compliment. You're correct. What it has forced companies to do is have tiered pricing. You can't have the same price for something. The worst example of this-- I hope I don't offend anybody-- is Abbott Laboratories.
Now what's Abbott do? It's a drug, big pharma, right? It has one of the drugs that manages AIDS. Well, what's the country with the worst AIDS problem in the world per capita? It's Thailand.
Abbott Laboratories-- and you could see the discussion in the executive suite-- refused to come up with a tiered pricing model. So they were charging the average Thai a whole year's income-- annual income per capita-- to get the drug to keep them alive. Well, what do you think the government of Thailand did? They voided Abbot's patents. Took all about two minutes to figure that out.
Set up a generic factory to make that molecule. And Abbott gets exactly-- how much do you think they make from Thailand? Zero.
Now if Abbott had come up with a different pricing formula that said for developing countries that meet this model, we're going to charge 10% of what we charge in the United States, they'd still be there. You can hear the discussion in the executive suite. I've been in them.
We can't have two-tiered pricing. It'll be a slippery slope. Everybody will follow the price down. That'll be the price around the world. And we'll be out of business. The shareholders-- translated, I'll be fired. And that's the way the discussion takes place.
But your points are all valid, and very good ones. So let's see. How did I want to end this thing up here real quickly? Because I'm clearly running out of time.
I wanted to-- this is somebody coming from two of the largest companies in the world-- make a plea for kind of a return to concern over the small businesses and starting small businesses in this country for a number of reasons. One is, that's where-- and it isn't existing small businesses, believe it or not, in spite of what the press says. It's new small businesses that create all the jobs in this country. And that's what we really have to have an engine that allows that to happen.
And my thesis of my argument is, we are making that engine too difficult and too expensive for startup small businesses to have to deal with. We are putting tax in the roadway in terms of a patent office that is opaque and very difficult for them to get to. I feel better that one of the guys I hired and worked for me for years is now the commissioner of patents. And that may make, hopefully, a big difference.
But that is a problem for this country. And my final thesis is, and the reason that's important is that is because it has shown that it can be an engine of sustained economic development in this country. And I do believe that. And if I didn't believe that, in spite of the very valid points, every other country of any commercial merit has basically followed the US patent system.
They have one perturbation between first to file and first to invent, which is not part of this discussion here. But other than that perturbation, they are all following the US model. And we've got a pretty solid country here.
But we do have real economic issues in this country. And this is all part of it. And it's not what you hear in the debate going on in Congress, by the way.
So with that, I'm going to stop, because it's 1:30. And I think I'm supposed to stop, aren't I?
SPEAKER 1: You are supposed to stop. And we are supposed to thank you for being here.
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One of the nation's premier authorities on intellectual property strategy, Marshall Phelps discusses his views on the value of IP in technological progress, economic development and individual and small business entrepreneurship.
His remarks reviews the historical development of patent policy in the United States, discusses the current era of open innovation and the benefits of collaboration, and compares IP strategies that other countries like China and Korea have successfully employed to aid in their economic development.
Marshall touches on the paradigm shift that occurred at Microsoft toward institutionalized IP collaboration and cooperation under his leadership, and introduces the new book he co-authored,
Burning the Ships: Intellectual Property and the Transformation of Microsoft, which provides a detailed and candid account of what one analyst has called "the biggest change Microsoft has undergone since it became a multinational company."