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.
Due diligence is hard work. Doing it well will get your hands dirty.
Introduction to IP Due Diligence
Any due diligence exercise, especially IP due diligence, involves turning over rocks and seeing what is there. Intellectual property is notoriously difficult. IP assets for most companies represent most of the value of a company.
For startup companies, intellectual property assets represent the potential of the business. Patents, for example, represent the company’s potential products.
For more mature companies, IP assets capture the company’s success to date. Patents for a more mature company captures the company’s lessons learned from research and development. Similarly, trademarks capture the company’s investment in advertising and marketing. Often more valuable, however, are the trade secrets that the company develops in the form of their customer list and customer relationships, as well as the countless lessons of what does not work.
Intellectual property is difficult to analyze. It is ephemeral and hard to grasp. In certain situations, a patent may be worth billions, but most patents are worthless. The trade secrets are often hiding in plain sight and the CEO might not even recognize them.
In this post, we will step through a due diligence checklist. The process:
- Identify the intellectual property
- Make sure the IP assets are owned by the target company
- Evaluate the intellectual property for strength and weaknesses
- Make recommendations regarding the value of the intellectual property
In this post, we will cover the first two topics. The second topics are found in this post.
A diligence investigation can be done for any business transaction for a target company, especially mergers and acquisitions, equity investment in an early stage company, company valuation, or many other scenarios. Much of the IP due diligence process involves questions about IP protection, and some of those questions may require an opinion from IP counsel that might render some legal analysis.
However, most IP due diligence investigations are focusing on the business value of intellectual property assets. While a patent attorney might opine on the legal issues regarding enforceability or infringement, most of the detailed analysis are business-focused factors. Sadly, most patent attorneys are well-versed in legal issues regarding patent prosecution matters but have little or no real world business transaction experience.
What Intellectual Property Does a Target Company Have?
A target company’s IP 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.
Intellectual Property Comes from Conquering Hard Problems
When performing a due diligence investigation on a target company, one of the best ways to identify intellectual property is to listen to the stories of the company. The appropriate questions focus on the problems they had to solve and the difficult challenges they faced. The gems of intellectual property are the solutions to those problems.
The best intellectual property assets are ones where a company solved a problem that nobody had seen before.
This part of the investigation is trying to find assets created when an engineering team that had to create a huge amount of software because none was available, or a marketing team that tried endless taglines and advertising copy to find the one that resonated. These are hard fought intellectual property assets. But they are often overlooked because in hindsight, it looked so easy.
Two Main Categories of IP Assets: Technical and Business
Intellectual property assets fall into two main categories: technical and business.
The technical solutions to engineering problems get captured in patents and trade secrets. The technical trade secrets may be manufacturing processes, software code. However, the technical side of the house may also have IP assets in the form of a vetted and operational supply chain, manufacturing and design know-how, packaging and distribution, and other IP. When looking for IP, remember that anything a competitor would have to recreate or re-engineer is a valuable IP asset.
The marketing and business side of the house creates lots of intellectual property. In hindsight, taglines and marketing copy seem obvious and easy. In reality, marketing and salespeople spend countless hours brainstorming, testing and re-testing the message, and measuring the market response.
The single most valuable intellectual property is when a customer recognizes a problem they need solved, and the technical aspects of a product meets those needs. It is not enough to have a great technical problem if the customer does not get the message. And it is not enough to have a great marketing machine if the product does not meet their needs.
When doing an IP due diligence investigation, make sure you capture both technical and business IP. Do not just look at the patents and trade marks, but dig in to identify the valuable trade secrets and copyrights. Once we identify these assets, we will attempt to value them as part of our IP due diligence.
Four Types of Intellectual Property Protection
There are four types of protection for intellectual property assets, and every one of them is in a typical due diligence investigation:
- 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 and can be the most valuable assets of a company.
Trade secrets are protected by just not telling anyone and actively keeping others from getting the information. Typically, a trade secret is controlled when it is written down and access is restricted. In one example, a company’s manufacturing formulas should be kept behind an access-controlled or password-protected system.
Copyrights are critical for software, but also for website copy, advertising collateral such as brochures, graphics, and the like. Like trade secrets, copyrights are granted automatically at the time of creation. Copyrights can be registered with the Library of Congress, but that is not necessary in many cases.
Trademarks, like copyrights, do not need to be registered. But trade mark registration has an incredible amount of power when other companies attempt to piggy-back on your hard-fought branding.
Patents are the classic intellectual property asset. These must be filed by a registered patent attorney or agent, not an ordinary attorney. A patent gets examined by a patent examiner at the United States Patent and Trademark Office (USPTO), and once it is issued, a patent can be enforced against a competitor.
We will discuss each of these types of IP protection in more detail below.
Ownership of Intellectual Property
IP Ownership Checklist
IP ownership comes in two flavors: present ownership and future ownership.
The things to check:
- Does the company own each and every asset?
- Are any of the assets encumbered?
- Does the company own inventions created by employees, consultants, and advisors?
- Does the company own inventions from founders?
Ownership is Critical to a Due Diligence Investigation
One of the biggest IP issues, especially for startups, is ownership. During IP due diligence, we are worried about ownership of current assets, as well as rights to assets that are developed in the future.
For patents and registered trademarks, there are publicly accessible databases that show ownership of patents and trademarks. The patent assignment database is here. The trademark assignment database is here.
Note that patents are not published, typically, until 18 months after filing. During that period, they will not be publicly available in the patent assignment database. You will need to request the Notice of Recordation of Assignment from the patent owner.
If a company says that they have a license for a specific patent or trademark, it is good to verify the actual owner of the asset. Licenses of intellectual property rights are typically not available in the assignment database, and you must get a copy of the license to understand its terms and conditions.
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.
Checking for Encumbrances
When checking ownership in the assignment databases, look out for Security Interests. A security interest is a lien on the asset, similar to a lien on real estate. You want to investigate the security interest and understand the conditions for removing the security interest.
There are unscrupulous “angel” investors or commercial banks that slap security interests on intellectual property. This is a way for the so-called angel investor or bank to take over the intellectual property. A secured interest is a huge red flag, as the owner of the secured interest can grab the IP before any equity investor.
A security interest allows the holder of the interest to close down the company, take the intellectual property, and restart the company with a new set of investors.
You should never make equity investments in a company with security interests on their intellectual property. You will typically be junior to the interest holder and can get wiped out financially.
It should be noted that security interests are typically used for distressed financing. The lender considers the company to be a risky bet, so they are hedging their investment with intellectual property. It is always a deal breaker.
Ownership Issues with Patents
There are countless stories about IP ownership issues, especially in patents. A founder of a company was forced out, then decided to write a bunch of patents and license it back to the company. Essentially, the former-founder wanted to blackmail the company into hiring him back and giving him more equity.
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. Worse yet, the dirty little secret about accelerators, incubators, and coworking spaces is that your IP gets de-valued because of poor (or missing) IP-related provisions.
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.
I have also seen where “angel” investors write patents on their own for their portfolio company’s inventions. In one case, an “angel” investor went to a different law firm than was doing the company’s patents, and he had a patent written. He listed himself as the first and true inventor (which was dubious), and put the patent in a holding company, not the portfolio company.
I only found the stolen intellectual property when I did a patent search for his holding company and found the new asset. There are countless stories of stolen or “misplaced” IP that come from IP due diligence investigations.
What if 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. Ask these questions:
- 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.
Ownership of Copyrights and Trade Secrets
Copyrights are owned by their creator – a human being. In most employment agreements and contracts, works of authorship should be done on a “work for hire” basis. As part of a due diligence investigation, all employment contracts and agreements with outside contractors must be reviewed to ensure that the “work for hire” language is present. If it is, the company probably owns all the work product of these employees and contractors.
For trade secrets, the employment agreements and contracts for hire must include provisions that transfer ownership of this intellectual property to the company. Further, there should be a written employee handbook that outlines the processes and procedures for physical and online protection of company information.
If these agreements are not in place, the company might not own copyrighted software, their web content, their marketing materials, as well as any proprietary information considered to be a trade secret.
Rights to Future Inventions
It is absolutely essential that everybody connected with the company be obligated to assign their IP to the company.
Every employee, consultant, advisor, board member, and even angel investors must sign a Proprietary Information and Inventions Agreement with the company. This agreement automatically transfers their IP 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 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.
As an angel investor, you must require every founder to sign a Proprietary Information and Inventions Agreement before investing – without exception.
Second Half: Evaluating the Strength of IP Assets. How to Find a Realistic Patent Value