What the Verizon Verdict Means for Vonage

The patent-infringement decision spells financial woe for Vonage and could stymie customer growth. It may also augur future legal headaches

by Olga Kharif

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.