IP nurturing: from conception to exit

By Joel Bock

What four letter word can get you into a great deal of trouble and may even cause people to stop speaking to you, yet can be freely spoken in all types of settings?

The answer is RISK.  It will create havoc for your company, cause investors and potential partners to terminate discussions with your company and end any aspirations for a successful exit at maximum value.

How so?

Let’s start with a familiar scenario.  Tech Co. has been growing aggressively and has captured a strong following in a new and promising market.  It is on the radar screen of a number of high‑profile VCs, private equity funds and Fortune 100 companies.  Tech Co. is at a crossroads, not sure if it wants to continue to grow at the same pace as it has for the last two years or if it would prefer to ramp its growth significantly and expand into new territories, venues and markets.  A second question that may arise, depending on its decision regarding expansion, is, if Tech Co. decides to shift into expansion mode, then does it look toward a VC raise, private equity financing, or a joint venture or other strategic relationship?  Speed is essential, as some of Tech Cos. competitors are making aggressive moves in the marketplace and looking to close a deal as well.

Timing is critical, as the first deal on the block is likely to be the largest with the greatest valuations and it will put the winning company in a leading market position.  Competition to “seal the deal” is fierce.  Tech Co. is positioned to win.  It has a top-tier management team, marketplace traction, a loyal following, a top-notch product offering.  What can go wrong?

What can go wrong is the failure to identify, quantify and mitigate intellectual property risk.  In other words, IP risk management.  Let’s explore those topics.

Identifying Intellectual Property Risk

As any company is conceived, built and grows there are a plethora of assets that are created.  Monetizing and realizing the full worth of those assets creates value for the company.  With technology companies and many low-tech companies, the assets that comprise a large percentage of the total value of the company are the company’s intellectual property assets.  These intellectual property assets range from patents, copyrights and trademarks to trade secrets, trade dress and source code, and everything in between.

How does a company identify its intellectual property risk?  The first step in that process is for the company to identify its intellectual property assets.  This step is not an exercise that takes place only when preparing for an exit; it is also not a project that is initiated only as part of a financing round.  This is an exercise that should begin at a company’s conception and should be an ongoing periodic review that is incorporated into a company’s regular business process.

Intellectual Property Assets

How does a company identify its intellectual property assets?  First, the company needs to understand its business.  Factors such as:   what distinguishes it from its competitors; what attracts customers; what gives it a competitive advantage in the marketplace; what are its product and service offerings; and what special skills does it possess, are key in helping a company to undertake such a task.  For example, having a particularly attractive, popular or commonly adopted business, service or product name can signal value in a particular trademark or trade name.  A company that develops computer software will likely derive substantial value from its software code, including source code and object code.  A company that designs, manufactures and/or sells electronic components or other consumer products may rely on its product composition and/or design for much of the company’s value.

Once this first step, of understanding what the company intellectual property assets include, is complete, the next step is to identify who created those assets and when they were created.  This next step is critical for identifying risk.  A lack of knowledge as to who created a company’s intellectual property can act as a big red flag to any potential acquirer or technology partner.  Integrally woven into the question of who created the intellectual property assets is the question of ownership of those assets.  There is nothing that can derail a potential deal more quickly than can the issue of questionable title to the assets being acquired or that are the subject of the deal.

Ownership of Rights

From the beginning the company should be certain to secure the ownership of the assets that are critical to the value of the company.  Whether dealing with employees or outside consultants, all personnel who work for, or provide services to, the company should be subject to agreements that provide for the securing of the ownership of the results of such work or activities by the company.  Employment and consulting agreements are examples of the types of agreements that should be in place prior to any work being undertaken.  These agreements should include provisions such as assignment of inventions, “work for hire” language when appropriate, disclosure requirements and a requirement to execute further documentation.  While obtaining such agreements is often not accomplished during the early stages of many companies, there are occasions when such failures can be rectified, including prior to significant work being undertaken, or prior to agreeing to engage such personnel for follow-up work or additional activities, or even prior to a round of financing and the payout of any stock options or other incentives.

Although a good starting point for a company to secure title to its intellectual property assets is employment and consulting agreements, follow‑up is certainly necessary.  While the employee or consultant may have agreed to assign rights to or transfer ownership of the results of their work or activities to the company, the actual documentation of the transfer of such results and the intellectual property rights in the work product should be completed.  This can be accomplished through assignment agreements which transfer all rights to the company.  Obtaining these assignments can be a precondition to eligibility for bonuses for employees or prior to paying or agreeing to send additional projects to any consultant.  As the delay between the date of creation and the date of the request for transfer to the company increases, so does the difficulty in obtaining such transfers.  Often the employee or consultant is no longer working for the company, has moved or the relationship has soured.  In those circumstances it is often difficult, if not impossible, to obtain documentation of the transfer of rights necessary to satisfy a due diligence inquiry.

License to Rights

It is always preferable for the company to own the rights to the intellectual property that has been developed.  However, substantially equivalent value can be derived as a result of a license to the intellectual property rights that have been created.  A license could take various forms, and provide various levels of rights relating to use of the intellectual property.  For the licensed rights to be substantially equivalent, an exclusive license would be necessary.  These are difficult to negotiate and are likely to be more costly to the company, including through upfront fees and higher royalties, than for a non-exclusive license.  There is greater value in an exclusive license, however, and often additional revenue opportunities through sub-licenses and other transfers of subsidiary rights.

The greater the uncertainty surrounding the company’s intellectual property assets, the greater the intellectual property risk to a potential acquirer or with respect to a successful exit and maximizing the value of the exit.

Protecting the Intellectual Property

Once the intellectual property assets of the company are identified, the next step is to ensure that the rights in those assets are properly protected.  This may be accomplished using a variety of strategies.  The bottom line is that a strategy should be undertaken and implemented.

Take the following scenario:   Tech Co. has just completed the development of a new digital audio player and the marketing team has come up with three possible product names.  What is the next step?  Prior to selecting a final name for the product, the company should undertake some diligence to see which name the company would more likely be able to protect and which is not already in use by another party.  After making such a determination the company should then undertake to protect the trademark through filing one or more federal trademark applications.  Failure to file applications for the mark may put the company at risk of losing some or all of its rights through third party use of the name, and could lead to the company having to expend significant capital and resources at a later stage to ascertain its rights.

Similarly, a company’s intellectual property rights could be forfeited or reduced in value should it fail to take the necessary steps to protect its technology and developments, either through trade secret protection or by filing patent applications.  The first step is to develop a strategy.  Once developed the company will have a better likelihood of being successful in securing its intellectual property rights than if it makes last minute decisions.  For example, the decision to forego filing patent applications on the company’s technology may be based on the lack of funds to implement a patent protection strategy.  However, such a decision should not end the desire and does not end the need for protection of the company’s intellectual property assets.  In such a situation the company should seriously consider implementing a trade secret protection program.  This will require establishing policies and best practices to maintain the confidentiality of the company’s technology.  The benefit is the creation of additional value for the company since the company’s technology will potentially achieve the status of trade secrets, which in some jurisdictions is entitled to a higher level of protection than general company assets.

Trade secrets do not require the filing of a particular type of application.  It is a form of protection that depends directly on the company’s ability to maintain the confidentiality of such information.  To accomplish this, the company should establish some policies regarding the secrecy of information and technology and maintain it in confidence.  Procedures should be established regarding access to information, how the information is to be distributed and to whom it may be shown.  The company should also have non-disclosure agreements in place anytime the company technology or confidential information is shown to anyone outside of the company.

For a software development company, its key assets are its source code.  Aside from being protected as a trade secret, source code is subject to copyright protection and could also be the subject of one or more copyright applications or registrations.  Filing for a copyright application prior to any infringement of the copyright provides companies with added benefits, including possible attorneys’ fees and statutory damages.  In the case of copyright infringement, the damages awarded to the copyright owner, if the infringement allegations are proven correct, could end up being very minimal, particularly where the infringement ceased after the claim was filed.  Where statutory damages are available, then damages could range up to US$30,000 per incident and per work and even greater amounts if willfulness is found.

How does a company obtain the assistance of its employees or consultants with respect to filing applications for the protection of the company’s intellectual property?  The first method is as described above.  Obtaining signed employment agreements or consulting agreements, as the case may be, which places such a requirement on employees and consultants, could prompt such assistance.  Additionally, the company can create incentive programs, where each of the inventors receives a bonus or company recognition for their efforts.  These incentive programs may include a first cash payment upon filing of a patent application naming an employee as an inventor and a second (usually larger) cash payment upon issuance of a patent.  Alternatively, plaques or some other form of recognition can be awarded to each employee who is named as an inventor on a patent.

Protecting intellectual property is not a one-time action; it is an ongoing process that must be adhered to and managed during all phases of a company’s existence, from conception through exit.  Of course the nature and extent of the protection will depend on various factors, including, for example, the company’s business, the market, product lifecycle, available cash, type of products, likelihood of infringement, ability to reverse engineer, and the company’s ability to enforce.  For example, a company in its earliest stages may file a limited number of patents covering its core technology.  A company in later stages of its existence may engage in a structured patent filing program where all advances in the development and improvement of its technology are protected through patent filings.  Depending on the nature of the company’s business and the market in which it operates a company may modify its patent filing program to address its concerns regarding competition and the ability to enter new markets to allow for growth and expansion of the business.  One type of program a company may want to implement is patent mining.

Patent Mining

A patent mining program is a program designed to provide a company with insight into the competitive landscape relating to technology being developed by its competitors and companies operating in markets that the company may have an interest in entering in the future.  This program is focused on identifying developments in technology, the people involved in developing the technology and patents covering the technology.  The information identified and obtained from searches, investigations and business forums is used to map out the landscape relating to the nature of the technology being developed, the people and companies involved in developing the technology and the scope of protection obtained or that may potentially be covered by the patents that have been filed.

The information obtained from the patent mining may be used to identify areas of technology where gaps exist.  This may afford a company an opportunity to develop and protect certain aspects of the technology where development efforts have been lacking or where the protection of the technology has left gaps.  Filing patents in these areas may provide the leverage needed to obtain a license to critical technology through cross-licensing programs.

Another benefit of such a program is that it provides a company with insight as to which areas to avoid based on the strength of its competitors’ intellectual property rights and difficulty in identifying open technology areas in which to develop products and a market.  The last thing a young company needs is a patent infringement battle on its hands.  The primary result of such a situation is a significantly increased burn rate, severe distraction to management and many key employees and uncertainty regarding its business.  Licensing is usually an option, but may change the economics so drastically that the business plan may no longer be viable.

Why spend time and effort on such activities when there may be no immediate payout based on the results?  It’s all about creating and enhancing value for the company and minimizing risk.  By engaging in these patent mining activities during all stages of a company’s existence, a company can plan for the future, provide the tools it needs to allow it to compete more effectively in the marketplace during various points in its lifecycle, and allow a company to avoid risks to the survival and growth of its business.  Equally, if not more importantly, effectively engaging in such activities will provide the tools for a company to enhance its value in the market, which will lead to bigger payouts at exit.

Policing Infringers and Enforcing Intellectual Property Rights

There is a saying that “intellectual property is only as valuable as the effort you place in enforcing your rights.” For the most part, this statement is a truism, although having filed for and obtaining protection for the intellectual property rights may often raise a sufficient threat to create value for a company.  Having intellectual property filings, registrations and issued patents will put many competitors and would-be competitors on notice of the potential risks that they would face should they attempt to enter the market, utilize certain technology or attempt to trade off of the goodwill of the company.

For young companies enforcement through litigation is not an option, and companies do not want to begin a fight that they cannot finish.  However, there are interim measures that can and should be taken to ensure that the rights that the company spent significant time, money and effort in protecting are not abandoned or diminished through inaction.  These measures may include sending correspondence notifying other parties about the company’s rights in the intellectual property assets and sending cease and desist letters.  As the measures taken escalate in severity, the need to continue with the enforcement efforts grows.  This enforcement path may eventually lead to litigation; however, it does not have to arrive there immediately and the delays may, to a certain extent, be controlled by the company.

Avoiding Third Party Intellectual Property Rights

As noted previously, with respect to patent mining there are offensive strategies that can be utilized with respect to identifying intellectual property rights belonging to others.  There is also a defensive strategy that can and often should be taken with respect to third party intellectual property rights.

The most critical defensive strategy is to avoid knowing or willful infringement of the rights of others.  To the extent that a company learns of another party’s intellectual property rights, for example in the form of an issued patent or trademark registration, it should be careful to investigate whether there is any possibility of the company infringing such rights.  This is usually accomplished through a “freedom to operate” opinion prepared by an outside law firm, but should certainly begin by an internal review of the company’s technology or practices.

Further actions that can and should be taken by a company, depending on the situation, include designing around, and obtaining licenses and indemnifications.  For example, if an analysis of another party’s patent indicates that there is likelihood that the product currently manufactured by the company, or that the company plans to manufacture, infringes or would infringe the claims of the patent in question, the company should work with outside patent counsel to design modifications to the product that would take it outside the scope of the patent claims and that would result in a product that does not infringe.

Alternative strategies where redesign is difficult or impossible include obtaining licenses to the necessary patents that would allow the company to continue making and selling its products or that would allow it to begin such activities.  Indemnification may be an option when the entire product is manufactured or supplied by another party or the components of the product at issue are being manufactured and sold by another party and the supplier of those components has deep enough pockets to provide some sort of risk mitigation benefit to the company.

Quantify the Risk

We know that risk exists on multiple levels in any organization and the same is true with respect to intellectual property risk.  But how risk is quantified and ranked depends on a multiplicity of factors.  Primary in such determination is the likelihood of the risk being realized.  Almost as important is the potential disruptive effect on the business of the company should the risk be realized.  The analysis requires in-depth review by the company of its business and the market and a careful and reasoned analysis by outside intellectual property counsel regarding the particular issue in play based on an in-depth knowledge of the company, its business and the situation being reviewed.

Risk Mitigation

When mitigating risk, the results of the quantification and ranking of the risk should be used to set strategy and direct the focus of the company so that the company’s assets can best and most effectively be utilized to put the company in a position to realize greatest value.

Throughout this article various ways of implementing an intellectual property strategy have been discussed.  Those strategies are valuable and should be considered and used to help shape a company’s intellectual property portfolio and establish best practices.

Conclusion

When considered from a systemic point of view, the best method for controlling intellectual property risk is to establish a sound intellectual property strategy, implement the strategy and maintain the strategy or modify it as appropriate based on the changing needs, direction and finances of the company.  Risk cannot be eliminated, but it can be controlled and minimized.  In fact, much of a company’s intellectual property risk can be mitigated with the right mix of care, planning and attention to issues and risks as they are identified and before they become real problems for the company.  Intellectual property strategy should begin at conception and should continue until the point of exit and beyond to create and obtain the maximum value from a company’s intellectual property.