July 01, 2018 Landslide

Corporate and Intellectual Property Considerations for Startups Seeking Venture Capital Funding

By Chris Sloan and Emily Brackstone

©2019. Published in Landslide, Vol. 11, No. 5, May/June 2019, by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association or the copyright holder.

Intellectual property (IP) is often the most valuable asset of a startup. Thus, identifying and protecting those IP rights is critically important for preserving and enhancing the value of the business. IP issues should be considered at each phase of the company’s life cycle, including when the company is formed, when it seeks to raise money from outside investors, and when it enters into key agreements with customers, suppliers, or strategic partners.

Startups are often short on cash at the time they face some of the most important legal decisions impacting their business. Due to this lack of resources, startup founders often attempt to handle legal matters on their own, resulting in mistakes or omissions that are uncovered later, often inconveniently during investor or buyer due diligence, and that must be resolved, usually at a greater expense to the company than if they had been handled appropriately at the outset. In some cases, these issues are significant enough to kill an important transaction altogether.

In this article, we will discuss certain IP matters that should be considered as the company is formed, as it commences business, as it seeks to raise investment capital from outside investors, and as it enters into key contracts.

Entity Formation and Structure

Some of the most important issues arise when the company is first formed. Accordingly, it is important for startups to structure and form the company properly to minimize potentially damaging issues among the founders, to ensure that the company’s intellectual property is protected, and to inspire confidence from potential investors during the due diligence process.

Choosing a Name for the Business

One of the first things that startup founders must do when launching a business is to select a name for the business. The founders must choose a name for their legal entity, which may or may not be the same as the trade name they will use in operating the business. Each state prohibits the formation of a new entity using the same name as an existing entity that has been formed or registered to do business in that state. The extent of these restrictions varies from state to state, so it is wise to check the availability of the proposed name in the specific state where the entity will be formed.

As noted above, the company may decide to operate using a trade name that is different from the legal entity name. If so, in addition to forming the legal entity, the company should also file an assumed name registration for the trade name in the company’s state of formation and the states where it will conduct business. Many states prohibit the registration of a new assumed name that is the same as an existing assumed name or legal name registered in that state. However, some states are less restrictive regarding duplicate trade names, so startup founders should be aware that just because a state accepts an assumed name registration for filing does not necessarily mean that another company could not later file an assumed name registration for the same name.

Startup founders often mistakenly believe that the company obtains trademark rights in the company name once they successfully use it to form the entity or register an assumed name. However, forming an entity or registering an assumed name does not create trademark rights. The converse is also true, i.e., possession of trademark rights in a name does not give a company the right to use that name as a legal name or registered assumed name. Trademark protection will be discussed in more detail later.

Founders are often well advised to take the availability of domain names into consideration when selecting a company name. As with legal names, the ability to lease a domain name does not result in trademark rights, and a separate trademark filing should be made if appropriate.

Contribution of Intellectual Property by Startup Founders at Formation

When the company is formed, the founders are typically issued common stock in the company in exchange for the payment of a cash purchase price (usually nominal unless the founder is self-funding the business) and the contribution of any intellectual property developed by that founder prior to formation of the legal entity. This contribution of intellectual property by the founders is important to ensure that the legal entity owns all of the intellectual property that has been developed by the founder pre-formation and that is related to the business.

Care must be taken to properly document the contribution of intellectual property by each founder so that it is legally effective. Generally, the assignment of intellectual property is included as part of the subscription agreement executed by the founder in connection with the issuance of his or her shares of common stock, either within the body of the agreement or as a separate exhibit. The scope of the assignment should be carefully crafted to be broad enough to cover all intellectual property developed by the founder that is related to the business, but narrow enough not to pick up other intellectual property that may have been developed by the founder related to other businesses.

In addition, depending on the type of intellectual property being assigned, the execution of an assignment may not be sufficient to perfect the transfer, and other steps may need to be taken to ensure ownership is effectively transferred to the legal entity. For example, if there is any registered intellectual property, such as patents or trademarks, not only should those be assigned by the founder/inventor to the legal entity, but the assignment document also should be recorded with the U.S. Patent and Trademark Office. Similarly, not only should any domain name registrations be assigned, but the account ownership for the registration also should be changed to the legal entity, typically through an online process.

Commonly, founders will work at a traditional job while they are developing their business plan and working for the startup on the side. If the founder is or has been employed at any point while he or she was developing intellectual property for the startup, any employment agreements, the employee handbook, and any other employment policies of the founder’s employer should be reviewed to make sure the founder’s employer does not have an ownership interest in the intellectual property developed by the founder during the term of his or her employment. This is especially true for founders who have worked in academic or medical settings, as the policies of those types of employers tend to be more aggressive regarding IP ownership.

If the company has concerns regarding the potential ownership of intellectual property by an employer, the founders may consider whether they should proactively approach the employer to obtain a release of the employer’s potential claim, as it is often better to identify and eliminate this risk before the company undertakes further investment in the development of the intellectual property. Doing so when the value of the company is minimal can be easier to accomplish than when the company is on the verge of taking on investment capital or has otherwise increased in value. If the employer is approached and tries to assert a claim of ownership, that is better to uncover earlier in the life cycle of the business. In that case, the parties may be able to negotiate an equity or royalty arrangement that is satisfactory and that will not impede investment in the business.

Assignment of Intellectual Property Developed Post-Formation

In addition to documenting the contribution of intellectual property developed by the founders prior to formation, the company should take steps to ensure that it owns any intellectual property developed by the founders and any other employees or independent contractors engaged by the company following formation. For the founders and employees, this is typically accomplished by having the parties execute proprietary information and invention assignment agreements. These agreements contain confidentiality provisions protecting company proprietary information and trade secrets, as well as invention assignment language covering any intellectual property developed by the employee.

In many cases, startup companies will engage independent contractors, such as software developers, to work on their products, rather than exclusively using their own employees for this work. Sometimes the company will enter into a written service contract with the independent contractor, but oftentimes companies will forgo a formal written contract signed by the parties in favor of a pared down scope of work document or even an informal e-mail chain. The lack of a written agreement with appropriate invention assignment language results in the company not owning the intellectual property developed by that independent contractor. Startup founders are often shocked to learn this, as it is natural for people to believe that when they pay for work product such as software they will own it. Unfortunately, under copyright law, that is usually not the case, except for work that is done by an employee (in the strict sense) who is acting within the scope of his or her employment. Most of the time, absent an express, written assignment of copyrights, the outside developer will own the work product, even in spite of what both parties may have intended all along. Thus, it is very important to secure a written assignment from each and every contractor working on the product or otherwise involved in the development of intellectual property for the business. This misunderstanding of the work made for hire doctrine is one of the most common and costliest mistakes startups make.

Use of Restrictive Covenants

For the founders and certain key employees, the company will likely want to go a step further than simply obtaining proprietary information and invention assignment agreements, in order to ensure that a departing founder or key employee is prevented from competing with the business and poaching the company’s employees and customers for some period of time following termination. Indeed, venture capital investors will often require the founders and other key employees to sign these types of agreements as a condition to obtaining funding if they have not been entered into previously. Founders are often reluctant to sign these types of agreements because they are the ones who have created and built the business, but it is very important to secure these types of restrictive covenants from the founders since they are well positioned to compete with the company if they become disgruntled or otherwise decide to leave. These agreements can vary in the length of the term and the geographic scope, and should be structured to comply with applicable law, which varies from state to state.

Technology Transfer Agreements

In some circumstances, an IP asset that is critical to the business is owned by a third party and is only available for use by the startup by means of a license agreement. The most common situation involves the commercialization of research conducted at a university. Most universities have a technology transfer department that is responsible for managing and commercializing all intellectual property created by university faculty and researchers. A startup desiring to build a business incorporating university-owned IP rights must obtain a written license from the university.

The terms of a technology transfer license agreement are critical to a startup’s ability to succeed and raise money. Obviously, the financial terms, such as the applicable royalty rate and minimum royalty commitments, are important. Care should also be taken to ensure that the fields of exclusivity and geographic territory are broad enough to encompass all current and future plans of the business, and to ensure that the license is not easy for the licensor to terminate. An otherwise well-negotiated agreement is of little value if the licensor can easily terminate or not renew it.

These same considerations also apply when the critical IP rights are owned by a business; if the business has no immediate plans to commercialize a patent or some software that it owns, it may be willing to enter into a license agreement with a third party.

Ongoing IP Strategy

Use and Misuse of NDAs

Startup companies often rely on their “secret sauce” to differentiate themselves in a crowded marketplace, rather than patenting their technology, either because they do not want to publicly disclose their invention or because their invention is not patentable. Even where patent filings are made, there is often other company information that is sensitive and highly valuable and that should be maintained in secrecy, such as business plans, customer lists, and other know-how.

Of course, the best way to protect company trade secrets and proprietary information is to limit disclosure to those who truly have a need to know the information. Before disclosing proprietary information, companies should consider whether the disclosure is strictly necessary or whether the sensitive information could be removed or redacted from the disclosure. Often, the disclosure of confidential information is not expected by the other party and is not required for the parties to conduct their business, so disclosure should be appropriately limited where feasible.

However, if disclosure cannot be avoided, the company should enter into written nondisclosure agreements (NDAs) with each recipient protecting the confidentiality of the proprietary information prior to its disclosure. The definition of what constitutes confidential information protected by the agreement should be carefully reviewed, as these agreements sometimes state that only information marked as being confidential will be protected, which may be more limited than what the startup company desires. In addition, the term of the nonuse and nondisclosure obligations contained in the agreement should be reviewed to ensure they are sufficient to protect the information being disclosed, with any information constituting trade secrets being protected by the agreement for as long as the information remains a trade secret under law.

Startup companies should note, however, that there are some exceptions to the general advice that the disclosure of proprietary information should be avoided without an NDA in place. The most notable exception to this general rule is disclosures made to venture capital investors. Most venture capital investors will not sign NDAs. Venture capital firms are approached by so many startups, many of which are working in the same industries on similar ideas, that it would create more legal risk to the venture capital firm to sign an NDA than it would for the company to proceed without one. Also, because venture capitalists look at so many companies each year, it would require the venture capital firms to expend a great amount of time and resources simply negotiating NDAs to look at companies they may not ultimately be interested in investing in. Accordingly, it is simply not practical in most cases for venture capital firms to sign NDAs, and startup companies should not ask them to do so since it can appear amateurish to even make the request. Nonetheless, companies should still do their due diligence on venture capital investors before disclosing any confidential information in order to ensure the investors are legitimate and trustworthy. Furthermore, companies can control the timing of disclosure of particularly sensitive information; sensitive trade secrets should not be disclosed until a term sheet has been negotiated.

Another exception involves discussions with key potential customers or strategic partners. Many startups have made the mistake of approaching a key party with an NDA before any discussions have taken place; it often makes little sense to the other party to sign one at that point in the process. Rather than allow lack of an NDA to be a barrier to an important conversation, the company should simply structure the presentation and discussion around less sensitive aspects of the business. If the discussion heads into an area that requires confidentiality, the company can suggest an NDA. At that point, the other party has sufficient information to decide that an NDA makes sense for both parties to continue the discussions at a deeper level.

Recognizing and Protecting IP Rights

One of the most common startup IP mistakes is failing to recognize its IP assets and then to take steps necessary to protect them. A company cannot protect what it does not know it owns, so formulating an intentional strategy is a key first step. A good starting point, beyond the scope of this article, is to have a basic understanding of trademarks, copyrights, patents, and trade secrets, so that the business is well positioned to recognize when it may have something to protect. This is not to say a company should file patents and trademark applications on anything and everything; a business can waste tens of thousands of dollars doing that. Some companies choose to aggressively file and pursue patent protection; for other companies, patent protection may not make sense as a key strategy, but trade secrets, trademarks, and copyrights may form the core elements. Whatever the strategy, the important point is that any intentional strategy is better than no strategy at all.

When dealing with something potentially patentable, waiting can be costly, especially with recent changes to patent law. If an invention has been publicly disclosed or offered for sale, under U.S. law the inventor has one year to file an application. In most other countries, there is no one-year period after disclosure. Accordingly, a startup with potentially patentable inventions should decide early whether to file at all, and if so, whether foreign protection is important. Put another way, if the company fails to decide, the decision might be made for it.

For trademarks, startups should conduct a clearance search to reduce the risk that they may unknowingly infringe on an existing trademark. The type of clearance search to conduct and the scope of the search should be discussed with a trademark attorney, but in general, the more important the trademark to the business, the more thoroughly it should be searched. If there is a conflicting mark, it is much better to learn about it early, before lots of time and money have been invested in that mark, instead of after receiving a cease and desist letter.

Trademark registration is also important, although if the mark is cleared for use, a U.S. registration can wait until the company has sufficient cash to afford the few thousand dollars that it will typically cost. Note, however, that like with patent law, the U.S. approach to trademarks is different than in other countries. In the United States, a company can own “common law” rights in a trademark that is unregistered but in use in commerce. In many other countries, registration is the sole basis for claiming trademark rights.

Trade secrets are protected by taking reasonable efforts to protect them. “Reasonable” is circumstance-specific, but in most cases trade secrets can be adequately protected by limiting access (virtually or physically, depending on the trade secret) to only those who need to know it to do a job, and only those who have signed an NDA. Labeling trade secrets as such can also be helpful in many circumstances. However, if a company fails to recognize that it owns a trade secret, and thus fails to take reasonable efforts to protect it, it can lose the ability to protect that trade secret.

Contract Mistakes

As discussed previously, a very common mistake is misunderstanding the “work made for hire” doctrine under copyright law. Most of the time, absent an express, written assignment of copyrights, the outside developer will own the work product, even in spite of what both parties may have intended all along. Typically, this will manifest itself at the most inconvenient time, such as in the midst of a dispute between the parties, or during due diligence by an investor or a buyer. These mistakes can be extremely costly to clean up in hindsight, but they are easy to address on the front end. All that is required is a simple assignment, signed and in writing, saying that the creator assigns all of its copyrights and other IP rights in the relevant work product.

Ownership of intellectual property is also sometimes an issue in customer or supplier agreements. In circumstances where a company may be developing a customized implementation of its proprietary software for a particular customer, the parties often negotiate ownership rights; the customer often has the same reaction described above, i.e., that if it is paying for the development of something, it should own it. However, ownership is usually the wrong way to approach this issue; it is impractical for the customer, and potentially devastating for the company, to give up ownership of any title to intellectual property related to the company’s proprietary product. In fact, the customer is usually concerned about a free-rider problem; it does not want to foot the bill for new development that a competitor or other party then enjoys for free. A better way to approach this conversation is to focus on providing a limited period of exclusivity, or discounted pricing for a period of time, or some other mechanism that allows the customer to mitigate the potential free-rider problem.

A related issue, specific to software, is failing to control the inclusion of third-party or open source products that are incorporated into the codebase. Some open source software licenses, notably GPL and Mozilla, have some very significant restrictions regarding intellectual property that can have very deleterious effects on title to other proprietary code. Those applications and libraries should only be used in consultation with an experienced software attorney. Even for more innocuous licenses, any software-based company should have strong controls and tracking mechanisms in place for any external components added to the code. No good chef would be unable to describe in detail the ingredients in his or her best recipes; software should be no different.

Barriers to Entry

A barrier to entry is any obstacle that limits or prevents others from competing directly with a company’s product or service. A company may have built the best “better mousetrap” around, but that innovation may be of little value if it is readily available to competitors. Intellectual property is a strong starting point for any examination of barriers to entry.

For example, a strong and well-drafted utility patent gives the owner the right to prevent any other party from making, using, or selling the patented invention in the territory covered by the patent. Potential competitors face a Morton’s fork: they must choose between the risk of a very expensive patent infringement lawsuit or the risk of a potentially expensive and uncertain research and development process in an effort to design around the patent, but with no guaranty of success in either case.

Even patent pending status has some efficacy as a barrier. Although the applicant has no rights to sue for infringement until a patent issues, until the examination of the patent is complete a competitor cannot know with certainty whether a patent will issue and, if one does, the final scope of its claims.

Another type of intellectual property that can serve as a barrier to competition is a trade secret. Trade secrets are economically valuable secrets that competitors cannot readily obtain through legal means. Put another way, a trade secret is the “secret sauce” behind some aspect of a business. It could be a formula, a process, an algorithm, a recipe, or any similar information that allows you to compete successfully but that is unknown to your competitors. As noted above, the owner must take reasonable steps to protect it; once that secret is public, in most cases there is little opportunity to protect it.

A strong trademark is another form of intellectual property that can serve as a potential barrier to entry. If a company has a well-established, recognizable, and distinctive trademark, then competitors have to spend more money and invest more time to establish their own competing brand.

In some instances, locking down key rights or relationships can also create a barrier to entry. Entering into key exclusive relationships with customers, distributors, suppliers, licensors, endorsers, or other strategic partners not only may be important steps for growing the business, but also, by definition, may mean that competitors cannot obtain those same relationships. Exclusivity may come with a cost, of course, but for certain types of relationships that cost may be well worth the investment.

When all else fails, winning in the market can be a barrier all on its own. If a company has a large number of loyal customers, then potential competitors will have to invest heavily in their own marketing efforts to attract those customers away. For companies that do not have a strong IP portfolio, often the best strategy is to build a really great product and then invest heavily and aggressively in marketing and customer acquisition in order to grab as much market share as possible as quickly as possible. Whether intentional or not, that strategy is entirely focused on using market share as a barrier to entry.

There is a common thread running among each of these: each requires a potential competitor to invest money and time to overcome, with no guarantee of success. There are many other potential barriers to entry that follow a similar theme. The more of those situations an entrepreneur can create, the better positioned they will be in terms of protecting their company’s competitive position, and the more investable their company will be.

Conclusion

Startup companies should consider the potential IP implications as they structure and implement their business arrangements and should develop a clear strategy regarding IP protection. Doing so will help ensure that the founders are maximizing the value of the company and are setting themselves up for success as they seek to raise investment capital and ultimately exit the business. The intellectual property developed by a startup is often its most valuable asset and accordingly should be handled with great care.

Chris Sloan is a shareholder with Baker Donelson in Nashville, Tennessee, and chair of the firm’s Emerging Companies group. He assists early-stage, high-growth businesses with business planning and formation, venture capital funding, drafting and negotiating vendor and customer agreements, mergers and acquisitions, and intellectual property protection.

Emily Brackstone is a shareholder with Baker Donelson in Memphis, Tennessee, and vice chair of the firm’s Emerging Companies group. She concentrates her practice in the areas of corporate law, mergers and acquisitions, and venture capital fundraising and fund formation.