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Startup, Venture Capital and Intellectual Property Due Diligence

Introduction

For the entrepreneur, the development of a startup can be a heady time. The entrepreneur may have a great idea that has revenue potential, but the entrepreneur needs funding in order to develop and commercialize the idea. The development of the idea can be tempered by the inability to find financing. When the idea involves different types of Intellectual Property (patents, copyrights, trademarks and trade secrets), finding financing to develop the idea can be gruelling and frustrating. The financing world offers a number of financing opportunities. One of them is venture capital. Venture capitalists provide financing to riskier and unproven startups. In exchange for the needed capital to fund the startup, the venture capitalists usually demand startup’s shares. Unfortunately, since the recent recession, venture capitalists have a healthy scepticism when a startup has primarily Intellectual Property assets. The due diligence is critical for both the entrepreneur and the venture capitalists. If both parties pay attention to the due diligence, the ultimate relationship will benefit both parties - the startup will obtain financing and the venture capitalists will get an opportunity of a successful investment.

The Homework Phase

The entrepreneur must strive to make the current status of the startup and its future potential attractive to the venture capitalists. Before the entrepreneur even begins to search for venture capital, the entrepreneur has to have a good idea of at least three issues: (1) What business plan will the startup operate under; (2) What assets will the startup need to operate; and (3) What organizational structure is required for the startup to accomplish its goals. The formulation of the business plan and the assets needed to operate often go hand in hand. The entrepreneur should have a clear idea of what the goals of the startup will be and how those goals will be accomplished. Once the goals are identified, the role of Intellectual Property assets can be assessed.

The entrepreneur should identify startup’s assets by conducting his own due diligence that consists of the following: (1) Asset Audit where the entrepreneur identifies each of the types of Intellectual Property assets that will be owned or developed by the startup; (2) Value Investigation of the Intellectual Property assets, including researching market impact, the risk of third party development and the risk of infringement; and (3) The Asset Audit and Value Identification should be as extensive and detailed as the venture capitalists due diligence that will be discussed below. The entrepreneur should also take steps to build a strong organization before approaching venture capitalists. Building a strong reference list will add credibility to the startup. Many startups are long on innovation but short on skilled management. The startup can address this problem in two primary ways. First, the startup should build an active advisory board. Second, the entrepreneur should identify the startup’s key personnel and document their relationship to the startup through employment agreements and shareholder agreements, where appropriate.

The Matchmaking Phase

While most venture capitalists prefer to invest in startups with operating history, a select few will invest in the entirely new startup. Venture capitalists usually concentrate in a specific area such as pharmaceuticals, electronics or biotechnology. Some also focus their efforts in certain geographical areas. Each side must do a lot of dating before finding the right match. Venture capitalists receive thousands of business plans each year. They cull out those proposed startups that have very little chance of success. On the other side, an entrepreneur will pitch to dozens of venture capitalists before finding the one that will fund the startup. When the venture capitalists have a basic knowledge of the startup’s industry, the match between venture capitalists and the startup has a better chance of success. Once the right match is found, the parties can enter into courting phase.

 The Courting Phase

During the courting phase, the parties need to learn more about each other to insure that a formal relationship between them will be a comfortable fit. The parties should focus on the exchange of reliable information. The venture capitalists will require the entrepreneur to provide as much information as possible. The more reliable the information provided by the entrepreneur, the more comfortable the venture capitalists will feel during the courting phase. The courting phase is made up of four stages of due diligence.

Due Diligence Stage 1

Due diligence compels a thorough investigation of a number of factors that will affect the success of the enterprise. Initial due diligence involves the following steps: (1) Identify the Assets. The entrepreneur should provide the venture capitalists with a list of Intellectual Property assets that are vital to the operation of the startup. From that list, the venture capitalists can determine the scope of the investigation process. (2) Verify Ownership of the Assets. The venture capitalists will want to search the title of each Intellectual Property asset. The venture capitalists will also want to investigate foreign registration and contingent rights. (3) Ensure the Assets are Free from Encumbrances. Encumbrances on Intellectual Property assets can range from potential infringement claims to grants of security interests. The venture capitalists will want to determine if the startup's Intellectual Property assets infringe on a third party's rights. The venture capital group will need to know whether and to what extent the entrepreneur has granted third parties the right to use the Intellectual Property through licences, distribution agreements, and the like. Likewise, if the startup will depend upon a grant of use of the Intellectual Property belonging to another, the venture capitalists will want to examine the documents pertaining to the grant. The venture capitalists will want to search the appropriate records to determine if the startup has granted security interests in the Intellectual Property to anyone.

Due Diligence Stage 2

Once a general overview of the Intellectual Property assets has been completed, the investigation should then be tailored to the type of Intellectual Property. Each type of Intellectual Property has its own special issues. As a result, due diligence requires adapting to the specialized nature of the type of Intellectual Property involved.

For patents, due diligence should include: (a) Review of all present and past issued, pending and abandoned patent applications in Canada, the Untied States and foreign countries; (b) Examination of all patent searches conduced by or on behalf of the startup; (c) Review of all prior art for each present and potential patent; (d) Confirmation that the startup is current with all maintenance fees; (e) Evaluation of the scope and nature of any transfer of rights to and from the startup; (f) Analysis of any present or threatened infringement actions; (g) Review of all agreements between inventors and the startup, including assignments, licences, joint development agreements and government patents and grants; (h) Review of research and development records in laboratory notebooks; and (i) Review of any freedom to operate opinions involving critical technology.

For copyright, due diligence should include: (a) Review of all copyrighted works created, commissioned or acquired by the startup; (b) Review of all copyright registrations; (c) Evaluation of any work-for-hire agreements; (d) Analysis of any present or threatened infringement actions; (e) Evaluation of the scope and nature of any transfer of rights to and from the startup; and (f) Examination of the records of the Canadian Intellectual Property Office and the United States Copyright Office to determine if the startup has granted a security interest in its assets.

For trademarks, due diligence should include: (a) Examination of all trademarks and service marks used by the startup; (b) Examination of all pending applications for trademark registration in Canada, the United States and in other countries; (c) Examination of all pending Intent to Use applications; (d) Examination of all trademark registrations in Canada, the United States and in other countries; (e) Identification of the products and services that are covered by pending trademark applications or registrations; (f) Examination of the manner in which the trademarks are being used; (g) Review of all quality control manuals, files or guidelines relating to the goods or services sold under the marks; (h) Review of all licensing agreements; (i) Review all written opinions regarding the ability to use the trademark;

For trade secrets, due diligence should include: (a) Obtaining an inventory of all material trade secrets used by the startup; (b) Determination of the individuals who know the trade secret; (c) Determination of the steps the startup has taken to keep the trade secret a secret. For instance, security procedures and policies, non-disclosure agreements, white rooms, employment agreements, and exit interviews; (d) Evaluation of all agreements for the use of the trade secret by anyone other than the startup.

Other Issues: Stage 2 due diligence will include an examination of auxiliary issues that might affect the profitability of the startup such as Internet Assets and Human Capital. For Internet assets, due diligence must be fashioned by the extent to which the startup will use the Internet. Many startups depend upon an Internet presence. Therefore, no checklist would be complete without determining the schedule for renewing domain names and if the components of the website (graphics, text, overall impression) have been properly protected. The venture capitalists will also want to review the startup's Human Capital. The startup's key personnel will be an essential component of its success. Therefore, the venture capitalists should identify the key personnel and examine any agreements between them and the startup such as: (a) Employment Agreements; (b) Non-competition Agreements; and (c) Assignments. Interviews with the key personnel may give the venture capitalists insights into the workings of the startup that cannot be gleaned from reviewing documents and searching databases. The venture capitalists that end their due diligence here, may not have the entire picture. Therefore, many venture capitalists go on to verify everything they have learned so far.

Due Diligence Stage 3

The venture capitalists should take another look at the results of due diligence and verify everything. Verification can involve various activities such as: (a) Searching appropriate databases to identify rights; (b) Examining registration materials first hand; and (c) Interview key business and technology staff as well as past employees and consultants. The venture capitalists should search the appropriate records to verify the startup’s corporate existence and to determine whether the startup has granted any security interests in its assets to third parties. Once all of the information has verified, the venture capitalists can then complete the final stage of due diligence.

Due Diligence Stage 4

The last stage of due diligence involves the interpretation between the documents and the future success of the startup. The documents alone will not tell the whole story. The venture capitalists will want to understand the relationship between the Intellectual Property assets and how they are used in the startup. This can involve: (a) Identifying the startup's products both in existence and under development and how they relate to any patents or trade secrets; (b) Determining how critical the Intellectual Property will be to success of the startup; and (c) Evaluating the startup's management in terms of experience and potential. Once the venture capitalists complete this final analysis, they can make an informed decision regarding funding the startup.

The Prenuptial Phase

Once due diligence has been completed and the parties determine that they can go forward with the relationship, they enter the prenuptial phase. During this phase, the parties define the structure of their relationship. In a successful venture capital relationship, both parties understand the rules. Thus, the written agreement between the venture capitalists and the startup should: (1) Define each and every assumption and expectation; (2) Clearly set forth any expectations regarding the progress of research and development and marketing of the startup’s products or services; (3) State the stages at which funds will be disbursed over time; and (4) Provide disincentives for key personnel to leave the startup putting the entire venture at risk. Once the parties have a written document to describe their relationship, the startup can receive the financing.

The Wedding Phase

Once the venture capitalists and the entrepreneur have reached an agreement, the marriage can be a happy one. However, as with any marriage, both parties must continue to work together in order to keep the relationship functioning. Ongoing disclosures on both sides aid in the progress of the relationship. Both sides should also be aware of and plan for a few situations that may derail the happy relationship. Founder's disease occurs when the entrepreneur, who is good at innovation but not so good at day to day management, becomes discouraged and leaves the enterprise. The parties should have incentives in place to keep the founding entrepreneur in a position where he can do the most good. The possibility of a change in circumstances, such as a change in laws or a shift in projected market conditions may eviscerate the success of the startup. If so, the parties should have an exit strategy for the liquidation of the startup.