As more and more venture-backed technology companies falter, venture capitalists are finding that they can’t just let those companies go up in smoke. They need to squeeze every bit of value out of failed companies to keep their IRRs from falling into the red. Even if a startup is insolvent with no possibility of a return to its shareholders, investors who have representatives on the company’s board have a legal duty to maximize the value of the company’s assets. In either case, because most of the value of an early-stage company is in its intellectual property, both a determination of the value of IP assets as well as their preparation for sale is required.
Salable IP includes computer code, technical processes, know-how, trademarks and domain names. All of these are potentially subject to legal protection as copyrighted material, patentable subject matter, trade secrets, trademarks and service marks.
Valuing IP assets is different than valuing hard assets. Intellectual property can be used, and in some cases independently owned, by many people at the same time. Without diminishing your ability to use technical processes and know-how in your business, I can use them, too. Unless that IP is patented, we may both even own the right to do so independently of each other. These characteristics significantly effect the valuation of intellectual property.
To assess the value and potential sale of any IP asset, you need to understand the answers to three questions:
* Are you free legally to use it in the way needed and to transfer it to others for these purposes?
* Can you legally prevent others from using it, whether or not they are in competition with you?
The first of these three questions is beyond the scope of this article. The key to answering the remaining two-indeed a crucial step in preparing these assets for sale-is a process generally known as an IP audit. During the process, the investors’ legal team attempts to inventory all of the IP of a company, analyze it in the context of these two questions and take the necessary steps to clean up any problems to make the assets ready for sale.
Pay To Play
The cost and time required for an IP audit may vary greatly depending on the amount and type of IP in question and the degree of diligence required. For example, an audit for a biotech company with one unpatented product, no extensive commercialization and no other IP may be completed within two to three weeks for $10,000 to $20,000. A software company, on the other hand, may be a bigger project. Completing an audit for a developer with several programs covered by patents (and all of which have been marketed for several years with developed trademarks) could take several months and cost $50,000 or more.
It should be borne in mind that an IP audit done for liquidation purposes is likely to be different in degree and difficulty from the typical IP due diligence conducted by VCs prior to their investment. If the company has been operating for some time since the investment, all of those operations can materially affect the value of the IP, both positively and negatively. IP probably has been created, and deals transferring rights probably have occurred during that time.
In addition, as in the initial due diligence, the cooperation of the company’s employees is important, if not crucial. But in the liquidation context, key employees, if they are still around, are looking to their next job. They may be of little help or have a negative impact. For example, if a company’s IP assets are being sold as a single unit, the employees may want to go with the buyer; they would hardly be interested in maximizing value for the seller (the investors). Their equity in the company may even be of little concern to them, since they may be able to replace their ownership positions with the buyer.
An IP audit in these circumstances is a three-step process. Step 1 is to conduct an inventory. This may not be easy. Hopefully, the company will have accurate and complete patent files, as well as files for its registered trademarks and copyrights. If it doesn’t, it will be necessary to search the records of the U.S. Patent and Trademark Office as well as those of the Copyright Office. Those searches would cover only U.S. proprietary property, so similar searches in other countries would be necessary if the company filed abroad. Even if the searches are successful, the resulting records still won’t be as detailed as those that should have been regularly kept by the company, and they would cost several thousand dollars, at a minimum, to conduct. They may, nevertheless, be the best-perhaps only-alternative available in the absence of accurate record keeping by the company
The audit does not end with registered IP. Trademarks and copyrights do not need to be registered to have legal effect or value, and they frequently aren’t. It is a relatively common practice for small software companies to fail to register the copyrights for their software. In addition, there may be little or no evidence of know-how, unless it had been properly documented.
Finally, the company may have valuable IP that it licensed from others under contracts that need to be preserved through the liquidation process. I have frequently seen licenses (with questionable enforceability) that terminate not only on the actual filing of a bankruptcy petition but also on any liquidation of the company. The contract in the latter situation is probably enforceable, at least in many circumstances that would be of concern to venture capitalists. Commonly these licenses are also non-assignable. Unless you are able to work out an arrangement with the licensor in these types of cases, the company may find itself without key components of its products.
Know Your Rights
Step 2 in the IP audit is to determine a company’s rights for its IP. This raises two questions: What rights did the company obtain and what did it give away? For trade secrets, the audit will first look at whether they are properly documented and whether the company has taken reasonable steps to protect their confidentiality. A review will be made to determine whether patents have been filed for all patentable inventions of value and whether patent filings have been properly prosecuted. Analogous work will be done for the company’s copyrights and trademarks. The audit will determine if all IP fees and renewals have been paid and/or filed. The audit must also consider whether the company has been diligent in enforcing its IP rights or whether any of them have been waived. Because of the potentially broad spectrum of conduct that could be relevant, waiver of rights is usually not a black-and-white issue and its effect may vary greatly.
A key part of Step 2 is to review the contracts through which the company obtained IP. Licenses from third parties need to be checked to determine the company’s continued ability to use the IP in question and under what conditions. Termination clauses, assignment provisions, use or territory restrictions, royalty provisions, exclusivity terms, and unusual warranties could all significantly affect asset value or transferability.
Likewise, employee and consultant agreements need to be in correct form and enforceable. I have frequently seen instances where consultants were hired to create valuable IP, but the company’s agreements with those people were oral, on a standard purchase order, or documented as “work for hire.” None of these is sufficient to convey to the company usable IP rights in the work created by the consultant. In more than one of these instances, the consultants have tried to get additional compensation after the fact or hold up deals.
The other part of Step 2 is to look at whether the company has given away any of its IP, and, if so, how and under what conditions. All licenses, assignments, distribution agreements and other commercial contracts that could convey any right or interest in the IP must be reviewed. Exclusive agreements, which are in essence a transfer of all rights to the IP in question, are of special concern. But non-exclusive arrangements may affect value, too. They may make it impossible to grant exclusive rights in the future, create unusual royalty provisions or provisions imposing affirmative obligations on the company. I once used an exclusive distribution arrangement to prompt the sale of a multi-million dollar software business. For a seven-digit fixed sum and a modest ongoing royalty, the distributor was given the exclusive worldwide rights to copy and distribute the software. In this case there was no business left for the company in question, so the transaction was for all practical purposes a sale.
The third and final step in an IP audit is to clean up problems and prepare assets for sale. An inventory will be finalized. Patents may be filed for patentable inventions. Similar steps can be taken for copyrights and trademarks. Assuming there is an agreeable counterparty, contracts can be redone or renegotiated to cure problems and/or obtain consents to assignments. In the case of the consultants mentioned above, my colleagues and I we were able to negotiate and sign consulting agreements that resolved the IP title issues, but it was at an additional cost that was not insignificant when compared to the consultants’ original compensation.
As most buyers will require IP representations and warranties, careful thought needs to be given to what can be said. The importance of this last step cannot be overstated if the major investors are asked to certify these representations and warranties or an escrow is required to cover issues that may later arise.
The IP of any early stage company can have a significant real value that can be realized if the proper steps are taken. Indeed, in a real sense, the importance of intellectual property to a troubled company is a message to all investors that they should insist that all their portfolio companies keep their IP in proper order.
Thomas D. Halket is a partner at law firm Bingham McCutchen LLP. He is a member of the firm’s Commercial Technology Practice and is head of the practice group in the firm’s New York office. Halket has practiced law for more than 25 years, concentrating on computer, Internet and other technology transactions and representating technology companies.