Due Diligence

Startup IP due diligence

Maat goddess of due diligence
Maat – Egyptian goddess of truth

Startup investors know that they are mostly investing in just your IP.  So get your IP ownership situation under control before due diligence starts.

What does a startup investor get for his money? Startup companies are really just a bundle of information (usually ideas), people (founders, contractors, consultants), and things (tangible property, cash). A startup’s “things” will usually have minimal value. The people can walk out the door at any minute. So all that an investor may actually get for his money is some sort of ownership option in the information – the startup’s intellectual property (IP).  Prudent startup investors thus often conduct a fair amount of due diligence on this “IP”.

A startup’s IP can be viewed as being a mixture of alleged inventions (e.g. actual or potential patents), alleged copyrights, alleged trademarks, and alleged trade secrets.  At least some of this information may still only exist in the minds of the founders, contractors, and consultants. What is potentially real here, and what is not?

Sophisticated investors also know that according to our IP laws, unless actions are taken to protect the IP, the IP may either still belong to the individual that created it; or it may have become public domain.  Investors also know that startups often don’t fully understand IP law. Has that intriguing startup already accidentally lost its key IP?  Was it missing essential IP to begin with?  This is why investors want IP due diligence studies.

Some ways that IP can be missing or lost include failure to obtain written IP assignment contracts, inadvertently placing IP into the public domain, and reliance on IP owned by someone else.

Failure to obtain written IP assignment contracts: IP assignment agreements should be obtained from anyone who has materially contributed to the company’s IP. Don’t assume that just because you paid for something, your company owns that IP — you often don’t. Try to do these IP assignments upfront, because the longer you wait, the more leverage the other party has. For example, they could make unreasonable demands, or deny assignment altogether.

Inadvertently placing IP in the public domain: For patents, assume that anything you publish before a patent application is filed can be used against you, and be careful to update your patent filings as your technology advances. For trade secrets (i.e. important, not-generally known information which is often not patentable), take active steps to restrict access, require confidentiality agreements, and of course never publish this at all.

Reliance on IP owned by someone else: For patents, consider prior art searches to reduce the chances that you are infringing on other patents. Make sure you have listed the right inventors on any patent applications. For copyrights, check the status of your software licenses, and that you and your contractors are not copying other work. Avoid using names that might confuse customers from related companies, since this may cause trademark problems. For trade secrets, stay away from inside knowledge (not generally known in your field) that you or your contractors may have obtained from other companies.

Remember that from an IP due diligence perspective, if you can’t prove you did things right, the assumption will probably be that you didn’t.  So keep your documentation on file.

Contractor Copyrights

Contractor
Contractor

Want to pay a contractor to produce creative material for you, and then actually own the copyrights? Getting ownership of contractor copyrights is tricky.

Copyrighted material – be it text, images, music, or code, is important for many creative and commercial efforts. None of us have the time or talent to do all of this ourselves, and so it is natural to turn to experts to help provide this material.

We could hire employees for this purpose.  However, many projects are of limited duration, and alas, unlike “the good old days” where employees had no rights and could be hired and fired at whim, these days employees actually have rights and benefits. These include unemployment insurance, social security, tax withholding, and the like. No one wants to go back to the Victorian era, but at the same time, it can be a hassle to employ someone.

Contractors are often used to avoid this hassle.  Contractors are expected to deliver results, but to do so in their own way. We pay money, expect to obtain the benefit of the deal, and then no more hassles or obligations. This simple expectation breaks down when it comes to IP, however, and contractor copyrights are particularly tricky.

To somewhat oversimplify, if you want to pay someone and obtain ownership of copyrighted material in return, the following legal considerations can apply:

  • Under Federal law, full copyright ownership requires a “work for hire” agreement
  • “Work for hire” agreements may imply (and in California, can define) that the worker is an employee
  • Employees are legally entitled to various employee benefits
  • Contractors are not legally entitled to employee benefits
  • Absent an assignment, copyright ownership remains with the contractor
  • Copyright ownership assignments must be in writing
  • Copyright assignments that are not “work for hire” can be terminated by the author or heirs after 35 years

This creates interesting legal problems.  It is common to put “work for hire” terms in contract agreements. The idea is to automatically acquire full copyright ownership this way.  However, such “work for hire” terms can be inconsistent or even incompatible with the definition of “contractor”.  This can open the door to potential legal headaches.

In an alternative approach, there is no “work for hire” clause, but as part of the deal, the author-contractor agrees to assign all contractor copyrights to the work that you have paid for. This is not perfect either. Additional assignment paperwork is often needed, and Federal copyright law allows an author-contractor to petition to terminate this assignment 35 years later.

35 years is fine for most purposes, but what if you are thinking on longer terms? Here, efforts to work around the 35-year copyright assignment termination issue should be considered. One option is to contract with a corporation that in turn “work for hire” employs the author.

Non-disclosure agreements (NDA)

Non-disclosure agreements (NDA)
Confidential information

Non-disclosure agreements (NDA) can help preserve business trade secrets and other confidential information, but don’t expect your attorney to sign one.

Businesses often use non-disclosure agreements with their contractors, employees, product evaluators, and site visitors, as well as with other businesses such as suppliers, customers, potential partners, and the like.  These agreements are often required to establish diligence in preserving trade secrets.  If breached, such agreements may also be used, along with other suitable evidence, in subsequent legal action in state or federal court.

Although in some states, non-disclosure agreements are sometimes used as a backdoor form of a non-compete agreement (e.g. attempting to restrict an ex-employee’s employment elsewhere), this is not a universal practice. California, for example, disallows this sort of thing.

NDA typically include various clauses establishing:

  • Who is disclosing the information, and who is the recipient
  • The boundaries of the confidential information – what is and is not covered
  • Confidentiality obligations
  • When and/or how the agreement ends
  • Other legal provisions (beyond the scope of this blog)

Generally, NDA have carve-outs for publically available information and terminate either when information subsequently becomes available to others through no-fault of the recipient, or after a pre-negotiated number of years. Some examples can be seen here.

NDA can be particularly useful when you are working on an invention, but either have not filed a patent application yet, or else are continuing to work on improvements to the invention.  Here, if you want to work with vendors or contractors to produce components of the invention, NDA (and other IP rights agreements) can be important.

Attorneys, including myself, usually refuse to sign NDA.  Why is this?  The reason is that attorneys are already subject to strict state (and federal) attorney-client rules and regulations that require them to keep client (and potential client) secrets. In essence, by agreeing to talk to you, the attorney has already agreed to a standardized, legally enforced, type of attorney-client “NDA”.

Consider what would happen if this were not the case.  Clients would be afraid to even ask an attorney about their particular problems. Attorneys would be signing hundreds of NDA each year, each with different terms. The legal system would grind to a halt.

Professional investors (VC, Angels) usually also refuse to sign NDA.  Here, there is no duty of confidentiality.  However, the finance people control the money, see a lot of ideas they don’t fund, and usually don’t want any constraints on their future investments. This is where it is good to have your patent applications filed in advance.

Contractor ownership of IP

Agree on IP ownership in advance
Agree on IP ownership in advance

The ownership rules for copyrights, patents, and other IP vary depending on if the IP creator is an employee or an independent contractor.

In today’s world, the distinction between employee and independent contractor is often blurred, but legally, these two forms of working are very different.  As a result, whether you are working as an employee or independent contractor, or hiring employees or independent contractors, it is good to be aware of how these different types of work engagements impact IP ownership rights.

These laws can vary from state to state.  Consider California. Generally, work done by an employee for an employer, at the employer’ request, does belong to the employer. However the IP assignment process is not always automatic (patents, for example, generally need to be assigned to the employer in writing).

One of the reasons why California has a booming high-tech economy is that California labor code sections 2870-2872 mandate (with certain exceptions) that work that does not relate to an employer’s business (and is done with the California employee’s own time and materials) generally belongs to the employee. However, this section of California law may not protect independent contractors.  So if you are an independent contractor, you may want to negotiate this.

US copyright law (writing, art, software, etc.) also distinguishes between employees and contractors. For employees, copyright ownership for works made for the employer typically goes to the employer. However for independent contractors, absent a signed written agreement (such as a work made for hire agreement) that copyright ownership is being transferred, often ownership remains with the independent contractor.  So if you are hiring an independent contractor, absent a written agreement, just because you paid for something doesn’t automatically mean that you own it!

How to distinguish an employee from an independent contractor?  Generally, the difference is the amount of control.  For an independent contractor, whoever is paying can control the work result, but generally not how the work is done.  By contrast, even an employer who gives his employees freedom still has the legal right to specify how the work is done.

Regardless of work arrangement, it is always a good idea to work out the issues of who is going to own what in writing and in advance.  For employees, spell this out with a proprietary information and inventions agreement. For independent contractors, negotiate and sign an agreement on these issues before starting work. This topic often comes up in due diligence.

Open source software licenses for startups

BSD open source software suitable for startups
BSD open source license

Not all open-source software licenses are alike. Some are intentionally hostile for commercial use.  Choose wisely.  

Open-source software is a wonderful thing.  This community has given us a gift pack animal that everyone from individual hackers to the largest companies in the world can ride.  However, not all software licenses are alike. In particular, some of the most famous open-source software comes with legal obligations that can be hazardous for startups.  So if you are doing a startup, resist the temptation to immediately grab your favorite software and start hacking.  Instead first take a bit of time to look that gift pack animal in the mouth.

What’s Gnu? Back in the 1980s, Richard Stallman, who wrote the original and very influential Gnu OS open software license, had a deeply held opinion that in order to create an open software sharing community, it was necessary to “poison the well” for many commercial uses. This underlying hostility towards commercial applications is very evident in “The GNU manifesto”.

These “poison the well for commercial use” Gnu concepts in-turn influenced the GPL (General Public License), which Linux and MySQL use; along with a number of other popular open-source licenses.  Some of these open source license terms can negatively impact your ability to patent your software, as well as your other attempts to make your business profitable.

This problem scares investors.  Sophisticated investors now frequently include open source software questions as part of their routine, pre-funding, due diligence process. So yes, to avoid starving, this stuff matters.

Enter BSD: Not all software licenses have these problems. In the 1990’s other software experts decided that an open software sharing community could develop without also poisoning the well for commercial uses.  They developed the Berkeley Software Distribution (BSD) license (initially for their Unix-like operating system). The BSD license encourages sharing but does not usually limit commercial use or patents.

Although BSD type licenses and software are not quite as famous as GPL software, a large number of well-respected and highly reliable BSD distributions are available.  Like Linux, there are different flavors of BSD for different applications. Look into FreeBSD for large scale servers, OpenBSD for secure applications, and NetBSD for smaller-scale devices.  There are also BSD web servers (e.g. Nginx, httpd, Lighttpd), BSD databases, and many other BSD licensed open source applications.

Use your business model to pick your open-source software (license), and not the other way around.  Google’s main revenue is from advertising.  They could afford to base Android on GPL licensed Linux. They have to make Android available for a free download, but given their business model, this isn’t a problem for them.  By contrast, Apple has a business model based on selling closed devices.  Apple can’t survive with non-proprietary software. As a result, Apple chose to build iOS and OS X on a BSD foundation.  So pick the license that is best for your business (hint, think permissive or public domain).