High stakes battle waged over search technology patent.

Every time someone types "head shots" into Yahoo Inc.'s search engine, Terry Frick's photography shop appears at the top of the computer screen.

His popularity didn't get him there--he paid for it.

"I have made so many tens of thousands of dollars from Yahoo it's not even funny," said Frick, who began advertising his Burbank business on the Web in 1999. "I make $8 for every $1 I spend."

Frick's online advertisement, which offers customers two rolls of portraits for $195, is one of a growing number of ads designed to reach users of Web search engines. Last year, they made up 40 percent of the $9.6 billion Internet advertising market, up from 35 percent in 2003, according to the Interactive Advertising Bureau.

But the popularity of this advertising method has prompted expensive legal challenges, as search engines vie for a larger slice of the market. At the center of those disputes is Yahoo, which claims to have acquired a patent that protects the business method behind paid search advertising, stemming from its purchase of Pasadena-based Overture Services Inc. Those patent claims have been challenged in a federal suit by FindWhat.com, a second-tier search engine company. Last week those claims were left unresolved after a federal judge in Los Angeles declared a mistrial in the infringement case.

A lot remains at stake. Should the patent be invalidated, analysts expect more companies to start offering paid searches, challenging the dominance of Yahoo and Google Inc. (Google is paying Yahoo an undisclosed license fee as part of a separate patent infringement case that was settled last year.)

Should the patent be enforceable, Yahoo would be empowered to sue other search engines that offer, or plan to offer, paid searches that they claim do not infringe on Yahoo's patent. With a patent, Yahoo could also generate more revenue in licensing fees.

"Overture figured out a way to monetize search results," said Jim Friedland, senior research analyst at SG Cowen & Co.. "If you are a retailer trying to sell plasma TVs and you bid for the words, 'plasma TV,' chances are someone wants to buy it. That's a very high return. You can see how you can generate a higher return on your marketing dollars."

Pay-per-click

Exactly how paid search results work helps explain why they have become so profitable for both advertisers and search engines.

The paid results, usually identified by labels such as "sponsor results" or "sponsored links," are different from regular search results, which are usually free to companies whose links appear on the computer screen.

They typically appear above or on the right-hand side of the regular search results, which are derived by using a mathematical algorithm that may take into account, for example, how often other users click on a site. And their placement relative to other paid results is the consequence of a bidding process, not a fee set by the search engine. Moreover, unlike banner ads, an advertiser pays only if a computer user clicks on its advertisement.

"You have no control (with regular search results). It's in the hands of an algorithm: whereas, with pay-per-click advertisements, if you're willing to pay more than the next guy, you'll show up ahead of them." said Jonathan Smith, founder of Peak Placement in Sylvan Lake, Mich.

(In the case of Yahoo's search engine, companies may pay a fee to be included in the regular search results but that comes with few guarantees of placement.)

Companies have proven willing to pay much more for sponsored links. Budgets for paid search advertising can be $500 to $1 million a month, said Matt Spiegel, president of Resolution Media, a Chicago firm that helps companies effectively advertise on the Internet.

And paid search listings make up a growing share of online advertising budgets, more than 30 percent on average. Advertisers like the idea that they only pay for someone interested in clicking on the link, whereas a typical banner ad will only draw interest from 0.5 percent of those Web surfers who view it, Spiegel said.

"There's no question that a search is better than a typical banner rate," he said. "You're paying for qualified visitors on your Web site. The response rates on banners aren't as high, and you're simply paying for the display of that banner."

Advertisers also prefer the bidding process because they get to determine how much they're willing to pay. The price for the bids is market-driven, ranging anywhere from 75 cents to $50 per click on a single key word.

For the search engines, the profit margins are especially high in paid advertising because the automated bidding process does not require thousands of sales people, said Greg Stuart, chief executive of the Interactive Advertising Bureau. "A marketer goes online, puts in a credit card, chooses a keyword he or she wants to target, and you're in business with advertising," he said.

Challenges

The growing popularity of paid search advertisements is a big reason for Yahoo's success since it purchased Overture in 2003. The company saw its net income jump to $840 million last year from $238 million in 2003 as its revenues more than doubled to $3.6 billion.

Paid search advertisements now account for 40 percent of its marketing revenues, which in turn account for nearly 90 percent of total revenues. Other sources of its marketing income are its banner ads and various subscription services, such as Yahoo personals.

Despite that growth, Yahoo is facing a number of legal and business challenges. For one, there is the explosive popularity of the Google search engine, whose growth has come almost entirely from paid search advertising.

"Google is gaining share on Yahoo," Friedman said. "Google is the most popular, in terms of number of searches and in terms of revenues."

Google has been able to sell paid search ads by creating a slight variation on Yahoo's business method. On Yahoo, the highest bidder gets the first listing on the paid search results; on Google, the highest bidder must also have the most clicks on its advertisement to end up at the top.

In 2002, Yahoo sued Google for patent infringement. The two sides came to a settlement last year when Google agreed to pay licensing fees with 2.7 million of its shares (worth $300 million at the time).

That same patent, called the "System and Method for Influencing a Position on a Search Result List Generated by a Computer Network Search Engine," became the subject of last week's trial, which began when Overture sued FindWhat.com in 2002.

Overture alleged that FindWhat.com had infringed its method of selling paid search advertisements. The patent, Overture, and later Yahoo argued, was issued to Overture's predecessor name, GoTo.com, in 2001. Yahoo sought an indeterminate amount of damages and wanted a judgment stopping FindWhat.com from infringing its patent and to find the patent valid and enforceable in a court of law.

In a counterclaim, FindWhat.com alleged Yahoo's patent was invalid because the paid search process and model had been publicly available more than a year before the company obtained a patent.

A core issue: whether the Yahoo patent covers the general, paid search advertising process. That issue is expected to go to trial again on June 24. If it does not. other search engines could simply tweak their processes and offer paid searches without legal challenge or having to pay license fees.

Should Yahoo ultimately lose the case, analysts expect more players to jump into the paid search niche.

"If they lose, then they won't be able to stop others, and others can jump into the market and could compete with them," said Nell Smith, an intellectual property attorney at Howard Rice Nemerovski Canady Falk & Rabkin PC, whose search engine clients have been watching the recent court battle in Los Angeles.

AMANDA BRONSTAD Staff Reporter