What the Verizon verdict means for Vonage

Web-calling outfit Vonage suffered a major setback on Mar. 8 when an eight-person jury found it guilty of infringing on three patents owned by rival telco Verizon.

After a weeklong hearing in the U.S. District Court for the Eastern District of Virginia, a jury ruled that Vonage Holdings (VG) must pay Verizon Communications (VZ) $58 million in damages and a 5.5% licensing fee per subscriber per month. The damages and fee fell short of what Verizon asked for, and the jury said Vonage didn't infringe on two of the patents at the heart of the case. It also found Vonage was not willful in its infringement, helping Vonage avoid stiffer penalties.

Injunction Likely

Though Vonage avoided a worst-case scenario, the verdict is hardly something to cheer about. The company's stock fell 3.86%, to $4.85, an all-time low, the day the verdict was announced. The decision and expected injunction barring Vonage from using Verizon technology without paying the royalty fee are likely to take a big financial toll and push back profitability targets. They could also undermine customer confidence and make Vonage and other Web-calling providers vulnerable to other lawsuits.

While the damages will likely be subject to an appeal that could take as long as two years (most analysts think a settlement between the two companies in the meantime is unlikely), the injunction and the license fees are likely to kick in this year. An injunction hearing has been set for Mar. 23 and analysts expect an injunction to take effect in April. Vonage said in a statement that if the court imposes the injunction, it will seek a stay from the Federal Court of Appeals.

With an injunction in place, Vonage either will have to pay Verizon royalties or rebuild its network so that it doesn't using the technology in question"”or face a service shutdown. Both options are fraught with risks. Verizon's patents cover a range of features, from call-waiting to how Web calls are connected to traditional phone lines. So coming up with a so-called workaround won't be easy, say Stifel, Nicolaus (SF) analysts. Vonage does have some patents of its own. In July, it acquired three patents from Digital Packet Licensing, saying the purchase would help it fend off litigation from Verizon and other companies such as Sprint Nextel (S). The Mar. 8 verdict shows the patents weren't as potent as Vonage had hoped.

Perils of a Workaround

Even if a workaround is found, putting it in place could be disruptive. Witness Research In Motion (RIMM), whose customers temporarily lost service after a network upgrade originally designed to combat patent-infringement claims. In a statement, Vonage didn't address the prospect of technology alternatives but said, 'Vonage's customers should see no change to any aspect of their phone service.'

Analysts aren't so sanguine. Some of Vonage's 2.2 million customers may jump ship amid the potential for tech glitches and other turmoil wrought by the decision, says Jon Arnold, a principal at consultancy J Arnold & Associates. 'Subscribers will get nervous,' Arnold says. The company's subscriber growth is already shaky. In the fourth quarter, Vonage lured 36,000 fewer subscribers than in the preceding period. 'Their quarterly growth rate is [already] dropping, they are moving at a pace that's below the industry average,' says Stephan Beckert, director of research at consultancy TeleGeography.


If growth were to stall further, Vonage may take longer than previously expected to reach operating profitability. Before the verdict, Vonage expected to reach that milestone as soon as early 2008.

Appeals and network upgrades may also distract the company from its efforts to vie with rivals. The company had been considering offering wireless calling to better compete with cable operators (see BusinessWeek.com, 2/20/07, 'Coming Up: Vonage Wireless‾').

Financial Pressure Could Lead to Buyout

Meeting other financial goals will become problematic should Vonage be forced to pay Verizon licensing fees. Vonage has enough cash"”about $500 million"”to last three years, says Clayton Moran, an analyst with Stanford Financial Group. Damages alone will take a bite out of that sum"”never mind any royalty fees levied after an appeal.

Here's why: Last year, Vonage booked about $29 a month in revenue per subscriber line. Its direct costs per line, excluding marketing, averaged $8.20 per subscriber per month, and the company still had $286 million in losses last year. With the new license fee, Vonage's costs per line would increase by about $1.6 per subscriber, or almost 20%.

The Verizon case could also have implications for Vonage's ongoing litigation with Sprint Nextel, which alleges Vonage infringes on seven of its patents. Sprint's complaint, filed with the U.S. District Court for the District of Kansas, is set to go to trial on Sept. 7. That lawsuit is also demanding an injunction on the use of Sprint technology. In light of the Verizon decision, Vonage may not choose to risk another lengthy trial and instead settle, says John Rabena, partner at law firm Sughrue Mion in Washington, D.C.

Big Players Protect Turf with Patents

With its financial position corroded, Vonage, long rumored to be shopping around for a buyer, could finally become cheap enough for an acquisition by a cable company, or even a telco like Verizon, whose VoiceWing Web-calling service has so far failed to take off. Indeed, Verizon's 19-page complaint notes: 'Vonage's expanded marketing and advertising of its infringing services threaten to shift more customers and goodwill to its business at Verizon's expense' (see BusinessWeek.com, 5/5/06, 'Verizon's VoIP Offensive').

That's why this decision carries huge implications for the $4.4 billion U.S. VoIP-services industry as a whole. 'The message this sends to the VoIP industry is, if you build a patent portfolio, it helps you negotiate in these situations,' Rabena. The number of VoIP-related lawsuits mounted by telcos and other entrenched players could rise. According to the U.S. Patent & Trademark Office, there are 2,273 patents related to VoIP, many of them belonging to telecom old-timers like Verizon, AT&T (T), Motorola (MOT), Broadcom (BRCM), and Cisco (CSCO).

And that spells more trouble ahead for small Web-calling service providers looking to retain their foothold on the market. In his closing arguments on Mar. 7, Vonage's lawyer said, 'this case is about choice.' Thanks to the Verizon victory and other potential legal action in the future, the choices for Vonage will be far fewer.

Kharif is a reporter for BusinessWeek Online in Portland, Ore.

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