Due diligence is essential for any business deal, and IP due diligence is shockingly left out of the equation for most angel investors and venture capital investors.
IP is left out for good reason: most patents are worthless.
This patent due diligence checklist helps anyone evaluate IP and patents – and weed out 95% of the patents that are worthless.
IP due diligence has two main components: does the company actually own the IP it says it has? Is that IP any good?
- Intellectual Property Definition
- The Right Due Diligence Matters
- Patent Ownership
- Patent Ownership Checklist
- Check Patent Ownership at USPTO
- What If Patents are Owned by Someone Else?
- Rights to Future Inventions
- Founders Must Sign Proprietary Information and Inventions Agreements
- Sample Proprietary Information and Inventions Agreement
- Encumbrances to Patents
- Design Around
Intellectual Property Definition
Intellectual property is any type of property that is not physical. This can be inventions, brand names, images, text, and audio/video materials. It can also be your customer list, a price list, methods of manufacturing a product, taglines and sales pitches, suppliers for parts, and many other things. For most companies, the hardest fought assets are intellectual property.
There are four types of protection for intellectual property: patents, trademarks, copyrights, and trade secrets.
By far and away, most of a company’s intellectual property is protected by trade secrets. Customer lists, product costs, supplier lists, employment contracts, payroll, and the like are kept relatively secret.
Patents can protect products sold by the company. Trademarks protect the branding and name recognition of the company, and copyright protects from someone copying your text/images/audio/video.
For startup companies, the biggest protection comes from patents.
The Right Due Diligence Matters
IP due diligence is pretty straightforward, but for some reason it is not done well in angel groups or by venture capital investors.
Angel groups tend to over-value IP, as if there is some magic in having a patent. Venture capital investors are on the opposite side of the spectrum: they do not give patents any weight at all.
Due diligence for IP (and patents specifically) is not that hard. It just takes a few rules of thumb and common sense.
Owning the IP is essential, and it is staggeringly often that a startup company does not own its patents.
In the US, patents are granted to the inventor – a natural person. That person owns the IP until they assign the patents to another person or corporation. If the patent is unassigned, the inventor owns the IP.
Startup founders often file patents before raising money. In some cases, they “forget” to do the paperwork that assigns the patents to their startup. The angel investors wind up owning the company but the founder owns the IP.
This leads to huge problems.
Sometimes, the clever founder puts the patents in a holding company and charges a license fee to their own startup.
This is a technique that all big companies use to avoid taxes. Big companies set up a patent holding company in a tax-advantaged location (Bahamas, Isle of Man, Ireland, Jersey, etc.) and “license” their IP to the operating company. The license fees are expenses against operating income, which is moved to a lower tax jurisdiction.
This is not a good situation if you are an angel investor in a startup because the founder is self-dealing. A founder can siphon off revenue for themselves and the angel investor will be cut out. The angel investor is helpless.
Patents represent downside protection for an angel investor, in the sense that an entrepreneur can license/sell the asset if the business does not succeed. In the case of a bankruptcy or receivership, the IP can be one of the assets that are sold to return money to investors.
Patent Ownership Checklist
Patent ownership comes in two flavors: present ownership and future ownership.
The things to check:
- Does the company own each and every patent asset?
- Are any of the patents encumbered?
- Does the company own inventions created by employees?
- Does the company own inventions from founders?
Check Patent Ownership at the USPTO
A company owns its patents when the assignments are on file with the USPTO. Patent assignments are public record and can be checked at https://assignment.uspto.gov/patent/index.html#/patent/search.
Every published patent application or issued patent should be checked to confirm that they are owned by the company.
If there is no assignment at all, the patents are owned by the inventors. In this case, an investor must require the inventors – every one of them – to sign an assignment. Without the assignments, the investor should never invest.
What if the Patents are Owned by Someone Else?
In many cases, patents are controlled by a startup but owned by someone else. This happens when startups license technologies from universities, for example, or when they finance their patents through a company like BlueIron.
When there is a license agreement, it is essential that the investors read the license agreement. Does the company have the right to buy the IP? What is the company’s obligations to the patent holder? Can the license be terminated by the patent holder? Does the company have the right to enforce the patents? Is there any patent enforcement insurance or assistance provided by the patent holder?
Most importantly, ask whether the investors have an option to purchase the IP. An option to take over the license agreement might give angel investors downside protection. Such a right would allow an angel investor to take over the IP and sell it off, hopefully recouping some of their investment.
Rights to Future Inventions
It is absolutely essential that everybody connected with the company be obligated to assign their inventions to the company.
The worst case scenario – which gets played out more than you can image – is where an engineer/founder/advisor/consultant independently gets a patent on an invention and turns around to “sell” the patent back to the company.
Every employee, consultant, and advisor must sign a Proprietary Information and Inventions Agreement with the company. This agreement automatically transfers their inventions to the company, even if they person refuses to sign an assignment.
The PIIA might be a separate, standalone document signed by every employee, consultant, or advisor, or may be incorporated into an employment agreement, consulting agreement, or advisor/mentor agreement.
Founders must sign Proprietary Information and Inventions Agreements
Founders are notorious for “forgetting” to sign employment agreements or agreements that transfer their IP to the company. When the founder is working solo out of their garage, this is not a problem, but when they take on investors, it is essential.
Some founders view their IP as their biggest accomplishment and most valuable possession, and they are very reluctant to part with it. In some cases, founders can be trying to keep their IP separate so they can keep “control” of things.
As an angel investor, you must require every founder to sign a Proprietary Information and Inventions Agreement before investing – without exception.
Encumbrances to the Patents
Like real estate, patents can be encumbered by liens. A lien or security interest allows a lender to take back the patents in certain circumstances. For a bank loan, a bank may place a security interest on a patent until the loan is paid off. In theory, if the loan is not paid, the bank will repossess the IP and sell it off to recover the loan amount.
It is essential for angel or venture investors to understand the terms of any security interest on the IP. The holder of the security interest is senior to equity investors in a liquidation. This means the security interest holder gets paid first and in full before the angel investor.
Patent enforceability tries to measure whether the patent can survive litigation. There are two sides to this: whether there are legal weaknesses to the patents, and whether there are business weaknesses to the patents.
There are countless legal ways a patent might not be valid, such as statements a patent attorney makes to the patent examiner or the exact language the attorney used to write the patent application. These kinds of issues are best handled by competent patent attorneys – preferably a litigator who knows how to tear apart a patent from the legal perspective.
However, the biggest aspect is the business weakness of a patent. The two questions to ask are: Are the claims detectable? Can a competitor design around the invention?
If the claims are not detectable, a patent is worthless.
Every patent has a set of claims in the back. The claims are set up with a list of “limitations” or elements of the claims. To see if the claim is detectable, go through each and every element of the claim and ask: “can I tell when a competitor does this?”
If there is even one limitation that is undetectable, the patent is worthless.
Lots of software patents are worthless, purely because there are elements that are undetectable. Any type of algorithm, blockchain, machine learning, artificial intelligence element is probably undetectable. We will never have access to source code to verify that they are using our algorithm.
Any type of manufacturing process is undetectable. If the claimed process is performed behind closed doors in a competitor’s factory, we will never have access to their production floor and their process equipment to verify infringement.
Things that are detectable are products that we can buy from our competitor, take it back to the lab, and analyze to verify infringement. If there is any limitation that cannot be verified, the claims are worthless.
There is a staggeringly high number of patents that fail this analysis – far more than fail because the attorney did something improper during examination.
If the patent is easy to design around, the patent is worthless. This question is trying to assess the business value of the patent.
When a patent is enforced, the infringer has two options: keep infringing and pay a license fee or change their design.
The simple question we are trying to ask here is: “what is the cost of changing the design?”
The cost comes in two parts: the fixed costs of re-engineering a new design and the market costs. The re-engineering costs are probably minimal in most cases, so the biggest factor is whether the competitor’s customers will want the claimed feature even with increased cost of the license fee?
Sometimes, the invention is so good that a competitor will reluctantly pay a license fee to keep the feature in their product. Other times, the competitor’s would gladly redesign their product to avoid paying the license.
When the competitor has other options for a specific feature or function of their product, the patent has no value.
The only valuable patents are ones where the cost to design around are so high that the right business decision is to pay the license fee.
IP due diligence can be as expensive as you want it, but anyone with a bit of business savvy can make some first pass evaluations of patents and intellectual property. It does not have to be intimidating and complex, just look at a few key issues and avoid the biggest pitfalls. If the patent fails the simple questions we asked here, it falls into the 95% of all patents that are worthless. If it passes, maybe it is worth putting more effort into the evaluation.