William Wilson
Last year saw investors throwing record amounts of dollars into startups, but recent geopolitical events, an anticipated increase in interest rates and other factors are leading to a slowdown in venture capital financing.
Since the pandemic began, intellectual property assets have seen an increase in value and are increasingly becoming a focus for investors looking to spend their stockpile of dry powder. For startups, ensuring their intellectual property and commercial contracts are in order can be helpful in achieving smooth financing.
Waiting to tackle these issues during a financing could cause delays, result in time-consuming and expensive remediation, and, in the worst case, lead to lower valuations.
Below is a list of 10 intellectual property and commercial areas that investors look at during due diligence, and steps that startups can take to better prepare for these issues.
Ensure former employers cannot claim IP ownership
Investors are particularly concerned about startups having exclusive ownership of their intellectual property. This exclusive ownership often faces risks when a founder moonlights on their new startup while still employed by another company, especially if the former employer offers a competing product or service.
A founder should ideally begin working on their startup after ending all previous employment. They should ensure and document, if possible, that they don’t start any work on their new product or company on their former employer’s time, using its tools, customer lists or confidential information.
Founders should also carefully review any non-complete and non-solicitation provisions when starting a new company and hiring any former co-workers or vendors.
If a founder is developing a product or service that will compete with their former employer, they should carefully document the development process, and even use a clean-room software development methodology to ensure that the product or service was created independently of their former employer.
Document IP created by employees and contractors
The fact that a person is employed by a company is typically insufficient for it to secure any IP developed by the employee.
One of the easiest ways for companies to protect their IP is to have all employees, advisers, contractors, interns and other entities enter into written confidentiality and invention assignment agreements. Although these agreements are typically short and simple contracts that are not heavily negotiated, companies often fail to obtain them, which can result in them not owning key aspects of their IP.
Startups should also be cognizant of personnel located overseas and how local IP laws may affect ownership.
Carefully review IP filing deadlines
Investors like to see startups taking a thoughtful approach to IP. The best IP strategy is to file for federal protection as soon as possible.
Timing is imperative. Failing to do so could lead to the loss of valuable benefits, including the inability to obtain statutory damages for copyright infringement, or to prevent a competitor from using a company’s product name in another area of the country.
An inventor must file a patent application within a year of offering to sell an invention or first disclosure or public use of an invention, or they risk not receiving patent protection for that invention. While a startup may not always have the money to apply for trademarks or patents, there are more affordable ways to reserve an earlier filing date, such as filing a provisional patent application.
Be cautious when hiring
When hiring new personnel, startups should confirm that they are not bound by non-compete restrictions with former employers.
If newly hired personnel own any IP that could be used at your startup, you and the employee should clearly identify and define ownership of that IP and what the startup’s rights are for using it.
Additionally, new employees should not bring over any documentation or other proprietary information from their former employer, including login credentials for third-party software. Doing so can result in IP litigation from their former employer or its licensors, as we recently saw with Facebook.
Protect trade secrets and confidential information
Maintaining non-disclosure agreements (NDA) and documenting the measures you’ve taken to protect trade secrets demonstrates to investors a thoughtful approach to protecting your advantage.
Trade secrets are an important way to protect innovations that are often not otherwise protected by other types of IP law, especially for software or hosted services. Vital information, such as source code, know-how, customer lists and product plans, could be considered trade secrets.
It is important to ensure that trade secrets can be accessed by individuals solely to the extent necessary and pursuant to an NDA, which is more or less a trade secret license.
Avoid source code escrow
Landing the first few clients for a fledgling startup offering mission-critical software or hosted services can be difficult. Customers are often concerned about vendor stability and will seek contractual assurances that they will have continued access to the service in the event that the startup fails.
One way to ensure continuity of services is source code escrow. However, this does not come without risks. Permissive release events could lead to a loss of trade secret protection and significantly devalue a company’s IP assets.
Accordingly, a startup’s technology agreements should demonstrate to investors that source code is only released to the customer under a narrowly defined set of circumstances. It is important to remember that even if a company ceases to provide value, its IP could continue to do so — during an asset sale or acqui-hire, for example.
Be careful when sharing information with potential investors
Startups should be cautious when sharing non-public or other confidential information with potential investors.
While NDAs are the generally accepted avenue for sharing sensitive information with investors, investor-provided NDAs will often contain non-market residual clauses that are designed to allow the receiving party (usually the investor) to use and disclose certain information received from the disclosing party (usually the startup) without violating the NDA.
Investors typically argue that they review a large number of investments, and therefore they are only bound to the confidentiality obligations with respect to information retained in the unaided memory of an employee or other representatives. If the investor refuses to remove a residual clause or enter into an NDA entirely, a company’s best defense is to minimize its disclosure of sensitive information.
Inventory open source and third-party software early
While use of open source software can lead to greater flexibility and efficiency, investors can be concerned about the risk of litigation associated with failing to comply with these licenses.
Investors will often request a list of open source software used, and will sometimes engage a third party, such as Black Duck, to conduct an open source scan on the company’s products and services.
Accordingly, before engaging with investors, companies should create an open source policy and inventory and monitor their use of open source components and associated licenses.
Contracts should reflect the evolution of your products
Given advances in artificial intelligence, investors expect startups’ commercial and technology contracts to be evolving documents that are drafted to allow data to be used for product development flexibly.
It’s important to ensure your startup has broad rights in its customer agreements to collect and use data to further develop its technologies, train its machine learning algorithms and improve and create new products.
When drafting and entering into commercial agreements, startups should envision not just how this data and IP can be used for current product design, but also how it could be used for product development in the future. If a startup experiences strong customer pushback or restrictions from privacy laws, data anonymization often provides a valuable workaround.
Secure IT
While the legal diligence will often be light in early-stage financings, startups should anticipate questions about the security of their products and services.
There are many affordable ways to protect sensitive data and demonstrate a thoughtful approach to security until you’ve raised enough money to acquire robust security tools.
For instance, you can use basic data principles such as personal data minimization, access controls and anonymization. You should consider how outsourcing to a vendor may allow it to demonstrate security controls and avoid certain compliance obligations.
IP and commercial contracts can make or break your next funding round. Follow these steps to ensure loose ends don’t get in the way of your startup’s success.
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