In the course of working with venture capital and private equity firms, we often see intellectual property and licensing-related pitfalls at prospective portfolio companies. Such pitfalls can result in restrictions on the company’s operations and profitability, reduced flexibility to undertake certain liquidity events and, consequently, impairment in the value of the investment.
Investors should maintain a heightened awareness of these common issues in order to limit risks in new and follow-on investments, while at the same time containing transaction expenses. After all, most of these problems can be readily identified and cured during targeted due diligence. In some instances, however, the cure may necessitate a re-pricing.
The value of many technology companies largely is based on their IP assets and scientific personnel. A company with weak IP protections may be unable to enter the marketplace without infringing the rights of others or preclude competitors from entering the marketplace, thereby decreasing the value of the company’s business.
Assignment of IP Rights. Investors should always verify that inventors have assigned their rights to the company and that assignments have been recorded with the applicable patent office. In the U.S., each co-inventor holds an undivided interest in a patent as a whole. If an inventor has not assigned his or her rights to an invention that inventor may freely assign his or her rights to a third party. Investors also should require that all employees and consultants with access to or involvement in the company’s IP routinely execute an assignment of inventions agreement that also requires them to disclose confidentiality obligations to, as well as IP rights held by, former employers.
Third-Party Restrictions on IP Rights . A common oversight by companies and their investors is the failure to assess the restrictions imposed by former employers, universities and government funding sources on the company’s IP. Investors should understand applicable university IP policies, the period of time the founder was subject to that policy, and whether any company IP was developed during that period. Similarly, investors should evaluate the restrictions imposed under government loans or other financing arrangements. Some foreign governmental loans prohibit or impose significant penalties on the transfer of IP to another jurisdiction, which could preclude the reorganization of a foreign company as a Delaware corporation or the off-shoring of IP to a low-tax or no-tax jurisdiction. A lien search is also useful to verify whether the company has encumbered its IP.
Freedom to Operate. Freedom to operate in the marketplace is critical to the commercial viability of a company’s products or services. A company may inadvertently infringe on third-party rights even when the rights that it owns or licenses cover the intended application of its technology. A patent confers only a right to exclude others, not an absolute right to practice a technology. Hence, investors should determine whether the company’s activities currently or potentially infringe on third-party rights. In some circumstances, investors may also require an opinion of counsel confirming that the company has adequate freedom to operate.
Patentability Analysis. Additionally, investors should consider assessing the strength of any existing patents and patent applications to gauge if the company will have the desired monopoly for its technology and the corresponding ability to exclude others from the marketplace.
The Fundamentals. Investors should also ensure that the company has a comprehensive approach to protecting proprietary information. All employees should execute agreements requiring non-disclosure of confidential information both during and after employment. The company should also require all customers, suppliers and collaborators to sign non-disclosure agreements before allowing them access to sensitive information. In addition, the company should subject all key employees to agreements on non-competition, non-hire of employees, and non-solicitation of customers during and for a reasonable period after employment. If non-competition agreements will be sought from employees after commencement of employment, some states may require a cash payment, salary increase or equity grant as consideration for entering into such agreements. Investors should consider the impact of any such payment or grant on the value of their investment. The attendant dilution from equity grants, if significant, could warrant a repricing.
When reviewing license and collaboration agreements, investors should pay particular attention to the scope and duration of the licensed rights, the ability to sublicense and assign, due diligence obligations, royalty payments, and rights to terminate the license. Such provisions frequently impose restrictions on financings or a sale of the company, and may contain undesirable provisions that must be assumed by a buyer of the company.
Narrow Scope of License. A licensor may restrict the field of use of licensed rights in order to retain certain rights for itself, to license other indications to a third party, or simply to limit the risk that the licensed IP will not be fully exploited. A license with a very narrow field of use, however, may not provide the licensee with sufficient rights to develop and commercialize its products. Such additional licenses may require license fees, royalties or milestone payments that are economically prohibitive.
Non-Competition Provisions. Licenses with non-competition provisions not only limit the exploitation of the licensed rights to a specific indication or territory, but also preclude the licensee from practicing any other IP rights outside of such indication or territory. Such provisions frequently conflict with proposed sale transactions where the buyer is already developing a product in the field or territory that is restricted by the license agreement.
Sublicensing Restrictions. Restrictions on the right to sublicense in-licensed IP may be inconsistent with the company’s contemplated business model if, as is typically the case, the company will not have the resources or the desire to fully commercialize products itself. The license should define when sublicenses are permitted, how sublicense income will be shared with the licensor, and the extent to which the sublicense will survive after a termination of the primary license agreement.
Diligence Obligations. Licenses often contain diligence obligations which, if not met, could result in the termination of the license or loss of exclusivity. Licensors sometimes define diligence obligations subjectively with “best efforts” or “commercially reasonable and diligent efforts” standards. Such standards are ambiguous and can be hard to enforce. Instead, objective milestones that must be achieved within a certain time frame (like commencement of clinical trials) could be used. Such provisions can be risky to the licensee since they may not take into account unforeseen factors that could prevent their achievement. When milestones are used, investors should confirm that they are clear and unambiguous.
Royalty Issues. Royalty terms, in addition to the royalty rate itself, may substantially impact the economics of the license. For example, a license that does not permit the licensee to deduct a portion of the royalties paid to others from the amounts due to the licensor (i.e. “anti-stacking” provisions) could lead to additional unanticipated costs, where the commercialization of the contemplated product requires multiple licenses from third parties. Other royalty provisions that impact the economics of the license include the requirement to pay royalties beyond the life of the licensed patents; royalty obligations on products developed by the licensee using licensed research tools or processes; royalties that reach through to sales by the licensee’s downstream sublicensees; and royalties that are based not only on the patented component of the eventual commercial product, but also on non-licensed active ingredients of such product.
Change of Control and Assignment Provisions. Investors should assess change of control or assignment provisions that require the consent of the other party, as such provisions can restrict or delay a sale of the company.
Termination Without Cause. The right of a licensee to terminate a license without cause may cause significant product development delays and economic loss for the licensor. Consequently, licensors frequently impose the payment of penalty fees in connection with such a termination. Such penalties, however, may be unacceptable to a potential buyer if it wants to terminate the license after the acquisition.
Input on IP Strategy. A licensee should seek the right to prosecute the licensed patents and improvements as well as the right to bring third-party infringement claims to ensure that it can maintain the strength of the licensed patents.
An understanding of how these issues affect a particular company will permit investors to make adjustments to the company’s valuation or to structure the investment in a way to avoid associated risks.
James T. Barrett is a partner at Palmer & Dodge and co-chairs the firm’s VC and Private Equity Group. Betty Lo Cualio is an associate in the firm’s Business Law Department. Joshua M. Thayer, a partner in the firm’s Business Law Department, contributed to this article.