A large measure of the value of technology startup rests in its intangible property – the unique ideas, talents and vision of the company's founders and employees. It follows that an Intellectual Property audit should be an integral part of any startup's planning and development. An Intellectual Property audit is required not only when contemplating a merger and acquisition, but as a means to ensure the expansion and long-term survival of the startup. It is critical to take measures to foster and protect Intellectual Property assets from the beginning of the company and throughout its growth. Inadequate documentation of the discovery and development of innovations, or not taking proper measures to keep this information confidential, may forever preclude the possibility of obtaining a patent for a technology or a business method and thereby preclude possibility of excluding competitors. Likewise, not obtaining confidentiality and nondisclosure agreements, validating the title to Intellectual Property assets, or making proper notice of Intellectual Property rights can hinder the assertion of patent, trademark, copyright, and trade secret rights against infringers. These failures may spell the death-knoll for a startup, because investors recognizing these flaws will decline to offer funding to a startup that cannot protect or license its own proprietary technology. As the startup progresses through its early stages of funding, and the decision is made to make an IPO, or it becomes a target for a merger and acquisition, then the documentation and exclusivity of Intellectual Property assets will be of paramount importance in the valuation of the company. Moreover, the results from the Intellectual Property strategies adopted will determine the return on the investment to angel investors, venture capitalists, and the founders. Founders and investors of technology startups who ignore the importance of their IP assets risk joining the ranks of the “dot-bombs” so prevalent recently.
Growing Importance of Patents
An Intellectual Property audit entails systematic evaluation of the ownership, status and value together with the recording of the information on a database, or a cataloguing of a company's Intellectual Property assets. Intellectual Property audits have long been mandatory to meet the due diligence requirements for mergers, acquisitions, or other transfers. An audit creates a balance sheet of IP assets and liabilities, including for example, defects in IP ownership or potential IP infringement claims. Intellectual Property audits are also triggered by licensing agreements, changes in company ownership, or a sizeable influx of capital investment. Today, Intellectual Property audits are part of an ongoing self-evaluation that all technology companies should conduct to manage, maximize, and control Intellectual Property assets.
The Limits of Copyright Protection
The Copyright Act of 1976 in the USA, and the Copyright Act of 1985 in Canada, extended copyright protection to computer programs. Copyright protects the tangible expression of a computer program source code, object code, or non-literary components, such as a video game display. Copyright registration is a relatively inexpensive and simple way to ensure that legal remedies are available against unapproved copying. Copyright protection, however, does not extend to processes or methods of operation underlying the tangible computer program. Thus, while copyright can protect software against literal copying, it does not protect against reverse engineering or independent discovery to achieve the same result. Therefore, it may be relatively simple for competitors to write a program that duplicates the function, but does not infringe the copyrighted software.
Patent Protection of Software and Business Methods
In 1994, in Alappat case, the U.S. Court of Appeals for the Federal Circuit held that the practical application of a mathematical algorithm transformed by machine to produce “a useful, concrete, and tangible result” was patentable. Alappat marked the end of a long-standing doctrine that mathematical algorithms in computer programs were only patentable if they produce some physical transformation or were applied to a process step. Four years later in State Street Bank & Trust Co., the Federal Circuit held that a business method was patentable. Applying the same reasoning as in Alappat, the court concluded that so long as useful, concrete, and tangible results are obtained, a computer program incorporating a mathematical algorithm is patentable subject matter. State Street ended a second long-standing doctrine that business methods were unpatentable. Recently, on June 28, 2010, the U.S. Supreme Court in Bilski case reiterated principals established in the Alappat and State Street cases. (In Canada, however, software per se, or business methods per se, still is not patentable subject matter.) Alappat, State Street, and Bilski have enormous implications for startups producing software or exploiting eCommerce methods.
Because the two doctrines that previously excluded software and business methods from being patentable have been set aside, there has been a flood of patent applications in the U.S. for Internet business methods. Notable examples of issued patents include: CyberGold's patent covering the practice of paying consumers who view ads on the Internet; Priceline.com's patent covering online reverse auction methods; and Amazon.com's patent for one-click electronic commerce methods. These companies presumably now have the right to prevent competitors from using the particular business method embodied in their patented software, as in Amazon.com, Inc. v. Barnesandnoble.com, Inc., or to use the patent as the basis for forging a licensing agreement. The advantages of patent protection lie in the broad scope and exclusivity in the rights given to the owner, as compared to copyright. Unlike a copyright, a patent can extend to the underlying process and methods embodied in software. A patent gives the owner the right to exclude others from making, using, offering to sell, or selling the invention. This applies even to those who independently arrive at the same method or use reverse engineering.
Patents thus have an edge over copyright protection, especially where it is difficult to show improper copying. A patent also gives the owner a significant market advantage for an extended period (twenty years from the date of filing of the patent application), or until better technology is invented. These broad rights, while a benefit to the patent holder, also raise significant new costs and risks for technology startups. Before issuing a patent, the U.S. Patent and Trademark Office (USPTO) reviews the application to ensure proper subject matter, utility, novelty, non-obviousness, and adequate disclosure of the invention. The costs of obtaining a patent are substantially higher than copyright registration, taking two to three years and costing several thousand dollars. Within limits, however, these costs can be delayed by making a provisional patent application. Patent infringement litigation is expensive, typically requiring the plaintiff to both prove infringement and rebut the defence that the patent is invalid. Additionally, as more Internet business methods patents are issued, it may become increasingly difficult to avoid infringing a patent. It follows that the characterization of Intellectual Property assets and risks plays a pivotal role in helping a startup to decide the extent to which Intellectual Property assets should be protected.
What Are Investors Looking For?
Protected Innovative Ideas
A strong Intellectual Property portfolio helps attract and secure financing from investors. Investors want proof of exclusive and effective IP rights. Patents, for example, should provide a well-defined description of the startup's core technology and exclusive market advantages. Patent, copyright, and trademark also represent potential sources of revenue from licensing agreements. At minimum, a patent portfolio provides some assurance to investors that the startup's core technology is not infringing on another company's patents, although this is by no means guaranteed. For these same reasons, an Intellectual Property portfolio also increases the valuation of a startup when it is time for the founders to execute their exit strategy, by making an IPO, or agreeing to a merger and acquisition by another company. At the IPO stage, before purchasing or recommending shares, analysts and the consumers look for innovative technology, the security of its market position, and the potential for growth. Alternatively, large corporations may find it more efficient to purchase a company having innovative technology protected by patents, rather than attempt to invent around a patent in-house. Or, two companies of equal size may form a strategic joint venture with cross-licensing between them. A strong patent portfolio may signal an attractive buy-out opportunity by entities prospecting for high-technology companies that are considered to be undervalued because of their unused or unrealized IP assets.
Conversely, unprotected Intellectual Property assets may signal the risk of an increased burn rate on investment capital due to Intellectual Property litigation, and thereby negatively impact the credibility of a startup's balance sheet. Intellectual Property assets that are not protected or not properly licensed indicate significant risks to a potential investor. Without a patent, for example, the startup cannot exclude competitors from copying or reverse engineering products or processes entering the public domain. Moreover, the U.S. and Canadian patent law provides a mere one-year grace period within which to apply for a patent after publishing, selling, or offering to sell an invention. Therefore, a decision not to patent early on can have serious and irrevocable implications for a startup's long-term growth potential and value. Consider the consequence of a larger competitor, for instance, holding a patent for a technology or business method that is critical to the survival of a startup company. Internet business methods and associated computer programs are particularly susceptible to patent infringement because they may comprise hundreds of potentially patentable features. Owning a patent, however, does not eliminate the risk that significant investment capital will be burned up in litigation against infringers – or the costs to defend against infringers’ inevitable assertions that the patent is invalid. It is estimated that the average cost of legal fees for a single patent litigation suit at $1 million. In addition, a lawsuit places large demands on the time of senior employees to produce documents, to be examined and cross-examined, attend hearings, and consult with legal counsel.
Moreover, large companies may be motivated to use Intellectual Property litigation as a strategy to test the strength of funding behind a startup. That is, a large competitor infringing the startup's patent may wish to see if it has the financial capacity to tolerate litigation – or instead will agree to accept a small licensing fee simply to stop litigation expenses. On the other hand, fear of the uncertainty and potentially high costs and damages arising from IP litigation can steer competitors out of a patent holder's market entirely. Filing a lawsuit against an accused infringer may even dissuade customers from buying or licensing the accused's product out of fear that future parts, warranties, and services will not be available. The subsequent increased sales revenue to the Intellectual Property owner may pay for the costs of litigation, and thus provide little motivation to settle. The potential for huge damage awards can also make large companies a target of litigation by smaller companies with proprietary Intellectual Property. The possibility of winning a large damage award has even lead to the formation of entities whose principal business is to exploit patent positions in litigation.
Licensing agreements containing indemnification and warranty clauses also present risks. For example, a contractual obligation to pay legal fees or damages incurred by a licensee against a third party who successfully proves patent infringement could easily exceed the value of the entire license. On the other hand, a startup company may have insufficient bargaining power not to assume these risks when negotiating a licensing agreement. None of these risk scenarios particularly appeal to investors who want to see their capital grow the business and not pay for Intellectual Property litigation. Both the founders of technology startups and investors, therefore, need to be armed with accurate information about the value of their Intellectual Property assets and the potential costs of defending those assets. The risks that the startup will infringe another's protected Intellectual Property, and the costs that could entail, are all important factors in making an investment decision, or in deciding in which direction to take the company. An IP audit improves the likelihood that strategic decisions to properly account for the benefits and risks associated with Intellectual Property assets can be made.
The founders of startups are frequently so focused on actually developing their product that the seemingly more “mundane” business aspects of the venture are set aside. One prime area of neglect is documenting Intellectual Property assets and deciding how to protect those assets. An Intellectual Property audit can help re-focus attention on what the startup's competitive edge is and how it can be protected. An Intellectual Property audit provides four distinct classes of objective information in this regard.
Identify All Intellectual Property Assets
Key issues in any Intellectual Property audit is identifying the IP subject matter, how it works, and how it is manifested in a startup. The type of Intellectual Property that the startup creates and that needs protection depends on the purpose and scope of the startup. For example, while a technology-based startup will focus mostly on patents and trade secrets, a startup providing consumer products will emphasize trademarks, and a startup producing entertainment media will stress copyright protection. Unfortunately, many startups frequently fail to monitor, and therefore underestimate, their Intellectual Property assets. For example, software may have fallen into disuse after completing the specific project for which it was designed. Logos and other branding may appear on products, letterheads, business cards, or in advertisements, but never have been registered as a trademark. Even if no longer critical to the startup, well documented IP assets may be sold, licensed, or used as the basis for joint business ventures.
Identify Problems With Ownership
Questions about the validity of ownership of Intellectual Property will invariably arise in sales transactions, licensing agreements, or during Intellectual Property litigation. It is therefore critical for the startup to be able to trace its chain of title of ownership back to the conception of the invention by its own employees. That is, was the Intellectual Property solely created using company resources on company time? The failure to obtain assignment agreements may give former employees, contractors, or third parties a claim to the ownership or joint ownership of the startup's IP assets. For example, absent an express assignment agreement, all the inventors named on a patent retain an undivided interest in the patent, and can exploit its exclusive right for profit without accounting to the other co-inventors. Similarly, independent contractors and consultants retain copyright ownership of software and associated written material, absent an agreement stating otherwise. Conversely, when hiring a new employee, it is important to investigate the previous employer's assignment and non-competition agreements to ensure that the new hire is not in violation of previous agreements, and is able to assign the rights to any new inventions.
Identify Defects in Title or Enforceability
Analogous to real estate transactions, the failure to record an assignment or transfer of interest in an Intellectual Property asset can create a defect in title. For example, under the U.S. and Canadian patent law, a second assignee to a patent takes superior title over the first assignee if: (1) the first assignee fails to record within three months of ownership or before the second assignment; (2) the second assignment was taken in exchange for valuable consideration; and (3) the second assignee was without notice of the first assignment. A similar rule exists for the assignment of trademarks. Likewise, an unrecorded transfer of copyrighted works is void against a subsequent bona fide purchaser who records.
In anticipation of Intellectual Property litigation or licensing, it is important to ensure all formal requirements have been followed to allow lawsuits and damage recoveries against potential infringers. For example, although copyright registration is not required, it establishes prima facie evidence of a valid copyright, is a prerequisite for filing lawsuit against an infringer of U.S. and Canadian works, and allows the collection of lawyers fees and past damages. Similarly, registration creates prima facie evidence of the validity and ownership of a trademark, and entitles the mark owner to damages from an infringer.
Proper notice of Intellectual Property rights must be made to ensure that full remedies under the law are possible. For example, although not legally obligated to mark a patent, an owner, under the U.S. and Canadian patent law, can collect damages only from the point in time an infringer had actual notice of patent rights. Moreover, the patent holder is obligated to ensure that licensees also properly mark goods produced under a patent. Since 1989 in the USA and since 1985 in Canada, copyright notice is no longer a prerequisite for copyright protection, but notice is still valuable in that it eliminates the innocent-infringer defence.
Actual notice is a prerequisite for obtaining damages and lost profits for trademark infringement. Finally, failing to observe certain post-registration formalities may result in the loss of Intellectual Property rights or the levy of fines. For example, maintenance fees for utility patents must be paid three and one-half, seven and one-half, and eleven and one-half years after patent is issued in the U.S. and annually in Canada – failure to do so is deemed to be abandonment of the patent after a six-month grace period in the USA and a twelve-month grace period in Canada. Within three months after copyright registration, two copies of the work are to be deposited with the U.S. Copyright Office. Likewise, within six months of trademark registration, proof of use of the mark in commerce must be sent to the USPTO, and registration must be renewed every ten years. Domain names can be renewed for up to ten years. Trademarks can lose their distinctiveness and hence legal protection, unless measures are taken to prevent a mark from becoming generic.
Identify Unprotected Assets
An audit may also identify key IP assets that can and should be protected. Technical staff may not appreciate that many seemingly obvious inventions are in fact patentable. History teaches that often an innovation has applications in areas totally unrelated to its originally intended purpose. For these reasons, the decision to patent may be delayed for an extended time after the invention is made. It is therefore critical to document dates for the conception and reduction of the invention to practice, and all development and testing done in between these two milestones. If proper measures are not taken to keep the invention secret, the opportunity to patent may be lost forever. Procedures to maintain secrecy of information do not merely apply to patentable subject matter. A trade secret can be anything not generally known and provides a commercial advantage. For example, customer lists, market surveys, or even negative information – that is, knowing what not to do – can also be a trade secret worthy of protection.
Intellectual Property audits may vary considerably in scope. A full-blown audit is required if the startup is planning a merger or acquisition, seeking venture capital or financing, or changing Intellectual Property counsel. A more scaled-back process is appropriate for periodic audits. Periodic audits serve several functions. They reduce the time and cost to perform a full-blown audit when the need arises. They alert the startup of changing laws and force an evaluation of the law's impact on Intellectual Property assets or policies for characterizing and protecting IP. For example, when the U.S. Supreme Court in Feist Publications,Inc. v. Rural Telephone Service Co. ruled that the mere compilation of facts, in unoriginal form, was not copyrightable, this dramatically changed the Intellectual Property valuations and protective measures used by database service companies. Additionally, the Court's ruling in Community for Creative Non-Violence v. Reid, that independent contractors in the U.S. own the copyright for works created for companies outside the confines of “work made for hire”, emphasized the need to obtain intellectual property assignment agreements. State Street's overturning of the business methods exception to patentability, as discussed above, created new opportunities for protecting Intellectual Property assets in the areas of Internet and eCommerce.
The audit itself is normally conducted through the joint efforts of business and technical management and lawyers. In-house managers may already be aware of the startup's Intellectual Property assets, or be in the most efficient position to collect information. A team with broad expertise in sales, marketing, technology and manufacturing, human resources, and law is also needed to collect and organize the data. Furthermore, the committee members should be senior and experienced enough to understand the company's long term goals, and the purpose of the audit, so as to allow them to collect and evaluate the proper information. Armed with the IP audit, upper-level management may then determine a strategic use for Intellectual Property assets.
The audit should start with preliminary notices to all personnel involved in the audit to emphasize its importance and benefits to the company, and to allay apprehension associated with being audited. Next, interviews should be conducted with technical, legal, and human resource personnel to help identify and collect pertinent information, including licenses, research and development reports, employee and contractor confidentiality and assignment agreements, and employee invention disclosure statements. In addition, the status of patents, copyrights, and trademarks, and applications thereof should be documented. Trade secrets, and the measures currently used to protect those secrets, should also be collected and documented. Once collected, the audit information is entered into a database. At its most basic, the database would include the owner of the Intellectual Property asset, class of asset, the inventors or authors, when the asset was created or acquired, the asset's status (e.g., pending or issued patent, registered copyright, trademarks, domain names), on-going maintenance issues (e.g., payment of maintenance fees for patents, collection or payment of licensing fees), and the expiration or renewal date of the asset.
The Intellectual Property committee should now be in a position to analyze the database and create a report. There may be advantages at this point to involving outside counsel to provide expert advice on the legal issues such as the patentability of inventions, or the potential for infringement, acquisition or licensing. Additionally, the confidentiality of the database and report is protected if it can be designated as lawyer-client privileged communication. Intellectual Property assets should be considered in light of current and future revenues and the expansion of products or services. This will likely require an examination of competitor's market position and their Intellectual Property assets, prior art which may prevent the patenting of company inventions, the ownership of Intellectual Property assets, and the potential for infringement, both against and by the startup.
The committee should evaluate the startup's current procedures for identifying and protecting newly arising Intellectual Property. For example, do the scientists and engineers responsible for research and development conscientiously fill out invention disclosure forms? Is there sufficient motivation for employees to do this? How are invention disclosure forms evaluated? Do inventors or sales staff routinely obtain legal clearance before submitting professional publications or presentations at public meetings or tradeshows? The committee should also assess hiring and exiting procedures for technical and management personal. Do incoming employees sign the appropriate non-disclosure, assignment, and noncompetition agreements? Do exiting employees understand their obligations not to disclose trade secrets to future employers or engage in direct competition against the company?
Finally, based on the detailed analysis and report created by the IP committee, upper level management should decide how existing Intellectual Property assets fit into the goals of the startup. Depending on its importance, the startup may wish to implement different strategic approaches for protecting and using Intellectual Property assets. Further, more than one of these strategies may be applied to different IP assets at the same time.
What to do With the Results
Many startups are misinformed about what is and can be protected – an Intellectual Property audit should help rectify that situation. Equally important, however, is making informed decisions about what should be protected. It is important to adopt a strategy that matches the startup’s direction of growth, recognizes the competition, and yet is still cost-effective. Strategic decisions may be made more difficult due to the evolving nature of Intellectual Property laws. In turn, this emphasizes the need for an on-going evaluation process. For most startup technology companies, capitalization and cash flow are critical ingredients – an Intellectual Property strategy should support the stage of development that the startup is in and help lead it into its next phase of growth.
A startup may decide, for example for financial reasons, not to patent anything for now. However, in order not to lose the right to patent in the future, that means not publishing, presenting information at conferences, revealing the invention at a tradeshow, or placing a product embodying the invention into the public domain. Because the U.S., unlike Canada, has the first to invent regime, a well-documented record showing when the invention was conceived and reduced to practice is critical for establishing the company's rights over a competitor who invents second, but files a patent application first. A determination of priority is made in an interference proceeding, where the USPTO examines evidence such as laboratory notebooks and the testimony of witnesses. It is therefore important to have systematic procedures for disclosing and documenting the development and testing of inventions, and yet still maintain the secrecy of the invention.
An invention disclosure program should be put in place – it may be desirable to set up a reward system to motivate compliance by employees. A standardized invention disclosure form should be developed for the startup. Research notebooks and test results should be dated and witnessed by a person who can understand the technology described in the notes, and who is also under an obligation to keep the information confidential. Witnesses should also be used to confirm working prototypes or the initial conception of the invention. An invention disclosure program also helps clarify who the inventors are. This is important when applying for a patent and arranging the assignment of Intellectual Property rights to the startup. As mentioned above, the court established in the U.S. that a work made for hire is an exception to the general rule that copyright vests in the author. In the context of software, however, courts have differed in deciding what constitutes a work made for hire. It is therefore critical for employees, contractors, and consultants, when hired, to sign invention assignment agreements.
Procedures and policies to protect inventions as trade secrets are critical because the right to sue for the misappropriation of a trade secret is lost if the trade secret holder is not reasonably vigilant in their efforts to protect the secret. For example, documents that contain trade secrets should be labelled as such and kept in a secure location. In general, the amount of effort spent on protecting the secret should bear a reasonable relationship to the relative importance and value of the secret. Reasonable vigilance also includes obtaining contractual obligations from individuals not to reveal startup secrets. There should be a clear company policy communicated to all employees, at the time of their hiring, to keep material confidential by using physical measures, such as locking documents and prototypes away, and restricting access for non-employees. Employees, contractors, and consultants should be required to sign non-disclosure agreements. Upper-level management and technical personnel should also sign non-competition agreements or covenants not to compete (CNTC). Visitors should be required to “sign in” and wear visitor identifications. As part of signing in, the visitors should be required to sign non-disclosure agreements.
There are several limitations, however, in the extent to which measures to maintain a trade secret can protect inventions. Measures to protect trade secrets do not prevent competitors from gaining the information by legitimate means, such as independent discovery or reverse engineering. This differs from patent ownership which allows the exclusion of all others from practicing the invention, even if it is arrived at with no knowledge of the patent. Many eCommerce methods may be particularly difficult to maintain as trade secrets because methods of selling a product or service, by their very nature, must reveal at least the general method involved to a broad audience of prospective purchasers. An employee's general knowledge cannot be claimed as a trade secret. To do so would overly restrict an employee's ability to make their livelihood in their chosen field if they subsequently leave the startup. Although CNTCs are more likely to be enforced against a former employee than trade secret law, significant problems can arise if a CNTC was made after employment has already commenced.
In addition to the strategies discussed above, the startup may elect to patent only those core products or processes vital to the startup's business. As mentioned above, however, the costs of obtaining a patent are not trivial. Moreover, what may seem to the inventor as a single invention is often viewed by the patent office as a combination of several distinct inventions. And because the patent office allows only one invention per patent, what initially looked like the costs for one application may end up being several. In addition, for a startup uncertain about the novelty of their IP, it is especially advisable to have a thorough patent search done by a professional search firm or law firm. A patent search should reveal those inventions that are similar to the company's and thereby allows a more informed estimate of the scope of exclusive market that a patent would give. For example, a search revealing nothing close to the startup's invention suggests that a patent could establish a large area of market exclusivity, and therefore be highly valuable. Conversely, a search that reveals several patents surrounding the startup's invention may mean that only a patent of narrow scope will be possible. Nevertheless, a narrow patent might be critical for showing investors that the company can practice the invention without infringing on someone else's patent. And patents can also be valuable bargaining tools if the startup is accused of infringing another's patent - an offer to cross license patented technology is often part of an acceptable settlement solution.
As noted above, protected IP can also generate income through licensing agreements. A patent greatly strengthens a startup's bargaining position for obtaining a licensing agreement because the patent holder can prevent reverse engineering or independent discovery of the invention. To ensure a steady future income from licensing, however, it is critical to make valid agreements that protect the Intellectual Property asset being licensed and not place the startup at risk. For example, a licensing agreement may limit the use of software to a single computer; retain title in the IP to the licensor; specify no copying except one copy for backup purposes; or require the licensee to keep copyright, trademark patent, and other legal notices on the product. Licensing agreements should also contain provisions requiring the licensee to maintain the secrecy of the invention with respect to third parties and not to allow reverse engineering by the licensee or third parties. In addition, the agreement should have provisions excluding or limiting any warranties and indemnification of the licensee.
In addition to seeking patents on inventions vital to the startup's business and exploiting licensing or cross-licensing opportunities, the startup may choose to make offensive use of its patents and other protected IP assets against competitors, and seek Intellectual Property protection and enforcement in the international arena. Developments in areas of technology critical to the startup should be monitored continuously by in-house counsel or a watch service. When potential infringers are identified, they are contacted to initiate a licensing or cross-licensing agreements. Alternatively, inventions which are not critical to the future development of the startup may be sold for profit. If a licensing arrangement cannot be made, then litigation to stop infringement is initiated. A startup's senior management needs to consider the decision to litigate very carefully. As mentioned above, the high costs of litigation involves not just money, but the consumption of time and distraction of both technical staff and upper level management. On the other hand, royalties or damages awards by courts against an infringer can be very lucrative, and greatly strengthen a startup's market position.