5 ‘IP’ Mistakes Start-ups Should Avoid

By ANTONE JOHNSON

Venture capitalists, angel investors and start-up lawyers these days tend to be obsessed with “intellectual property,” or IP.

And for good reason: In the information economy, the core assets of a new venture are likely to be talented people, the IP they create, and little else.

To maximize future value, founders should try to lay a solid IP foundation even before a new start-up is incorporated. Here are five common mistakes to avoid:

1. “Contamination.”

Perhaps the single greatest source of IP anxiety in Silicon Valley stems from the fact that engineers and executives tend to build on what they know best when starting a new venture.

If a former or “day job” employer can lay any claim to the IP upon which a new start-up is built, that claim, however tenuous, injects risk into the venture. And that risk grows in magnitude over time proportionate to the success of the business.

A classic example is the so-called “Winklevoss Twins problem” made notorious by the movie “The Social Network.” Some degree of ambiguity regarding IP ownership may be inevitable, but if a sliver of equity must be granted to settle the dispute, it makes quite a difference if the “sliver” is in a company worth $1 million or $100 billion. In Facebook’s case, the settlement netted the Winklevoss brothers stock worth many millions of dollars.

Of course, such disputes are rarely litigated except when the new start-up turns out to be a big success, in which case everyone scrambles for a piece of it.

2. Mixing up what came from where.

IP rights ordinarily belong to the individual who creates the work unless the creation occurs as part of the person’s job, a so-called “work for hire.”

One common mistake is to use a non-employee contractor or consultant to produce work without obtaining the necessary assignment of IP rights to the client company.

After the contractor has been paid, the company’s leverage to coax him or her into signing more legal documents is more or less gone.

This all gets complicated, thanks to the natural fluidity of start-ups as business enterprises: A software developer may have started out tinkering with a side project during evenings and weekends, bring some of that knowledge or code to bear on a consulting engagement with a colleague who founded a startup, and ultimately join the team as a co-founder or one of the first employees.

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California Attorney General Kamala Harris recently announced an agreement with three of the largest online dating sites:  eHarmony, Match.com and Spark Networks (parent company of JDate and ChristianMingle, among others).  In much the same way Facebook reached an agreement regarding child safety with AG’s nationwide in 2008, it appears the dating sites agreed to some voluntary measures under pressure from AG Harris’s office rather than in response to any specific allegations that the services broke any laws. This action can be traced back to a widely publicized incident in 2011 in which a Southern California woman was attacked by a man she met on Match.com who turned out to be a registered sex offender.

In the agreement, which is called a “Joint Statement of Key Principles of Online Dating Safety,” the three major service providers agreed to the following:

Education:

• Provide safety and fraud prevention tips, along with periodic reminders to users.
• Display links to the safety tips from the homepage, on member communication pages, and/or in the footer on some or all Web pages.

• Employ a “rapid abuse reporting system” that acknowledges receipt of any consumer concerns or complaints received.
• Review profiles of members in an effort to identify fake profiles that may be used to perpetuate financial scams.
• Use tools and technologies to identify sexual predators, including checking sex offender registries when the providers possess the requisite information to conduct such checks, and, when identified, remove registered sexual predators from participating in fee-based services on their websites
• Not promote or publicize sex offender screening tools in a manner intended to lead members to assume that due to the providers’ use of these tools, meeting people online is any safer than meeting people any other way — i.e., avoid creating a false sense of security.
• Remind users that they bear responsibility for their own safety.

Cooperation with Law Enforcement:

• The AG will assign a liaison from the eCrime Unit to address any concerns about potential criminal conduct that providers may have.
• The AG and providers will continue to work together to ensure that law enforcement officials can quickly investigate and prosecute criminal conduct in California involving the providers’ websites.

The items of greatest substance are in the “Online Safety Tools” section.  The statement includes language acknowledging that it does not create any new rights of legal action or enforcement against online dating service providers.  Nevertheless, AG Harris stated in the release, “In the interest of protecting and educating users, I strongly encourage all online dating companies to adopt the same principles as these industry leaders.“

Why am I writing about this at all, given that it’s non-binding and only directly concerns three companies?  In the grand scheme of things, as articulated by AG Harris in her quote above, I think this agreement raises the bar for what will likely come to be considered the industry norm for user safety precautions in online dating.  (California tends to be a bellwether when it comes to Internet regulation; it is the largest single online population in the United States and also houses a large number of Internet and wireless companies.)  For any company hit with a lawsuit, large or small, being able to testify that it follows these principles could help defeat certain claims of negligence by showing the service meets the standard of care established by the largest players in the industry.  Conversely, any company that is not doing these things would presumably be put on the defensive in any litigation, forced to defend its failure to do “X” when site “Y” has been doing X for years.

The agreement is silent on the subject of mobile apps, which seems like an unfortunate oversight.  Without any guidance directly aimed at mobile dating and social apps, I would argue the parallels are clear enough that app makers should assume they will be held up to a similar standard sooner or later.  The disclosure aspects could be trickier with a mobile UI that offers less display room to work with.

The good news is that most of the items are common-sense measures that many of the largest online dating sites already had in place prior to the agreement — or, if not already in place, can be implemented at minimal cost.  For example, as I pointed out in my post about Path, there is really no excuse for a social site that encourages people to meet offline not to have some kind of “Safety Tips” information somewhere on the site, and a link to that page in the footer where it can be accessed from anywhere on the site.

The verb “to disrupt” in all its forms is rightly popular in the startup world.  To many entrepreneurs, few things are as personally satisfying (or as lucrative) as disrupting an entrenched, complacent, monopolistic, inefficient or stagnant market in ways that often empower consumers and producers alike.  Consumer Internet and mobile technology businesses continue to be rife with opportunities for disruption.

On March 8, 2012, the U.S. House of Representatives passed the JOBS Act, becoming the subject of much chatter at this year’s South by Southwest Interactive (SXSW) conference that began the following day.  This bill is the latest in a series of efforts and initiatives in recent years intended to disrupt the traditional methods and markets for investment in, and capitalization of, emerging growth businesses.  Boosters can be found all over the Web proclaiming a nascent crowdfunding revolution that will ensure prosperity for entrepreneurs and mom-and-pop investors alike. As a lawyer, advisor, investor, director and co-founder myself, I am an ardent advocate for entrepreneurs, startups, and the individuals and institutions that fund them.  Yet I simply can’t support crowdfunding in the form authorized by the House bill for reasons I’ll get into below.  To cut to the chase, I believe it would lead to disastrous consequences for minimal gain, creating perverse incentives that would enrich the most “ethically challenged” hucksters, deplete the assets of those who can least afford it, while continuing to leave the most attractive investments to financial institutions and high-net-worth individuals—traditionally, venture capital firms and angel investors.

My colleague at Gust Blog, veteran angel investor Bill Payne, has written a series of outstanding posts on the subject already.  If you’re new to the subject, I highly recommend reading this post by Bill, which is more balanced than mine, neatly summarizing the pros and cons, risks and benefits.  I’d like to supplement his pieces with my own perspective, developed as an in-house and outside lawyer for startups and investors over the past 15 years.  In the course of my career, I’ve counseled clients in matters ranging from $10K friends-and-family convertible debt seed financing for new startups to overhauling a Nasdaq 100 company’s financial disclosure controls and securities compliance as Chairman of the Disclosure Committee in the wake of the Sarbanes-Oxley Act of 2002.

First, it’s important to define what we do and don’t mean by “crowdfunding.” There are various ways of collectively funding new initiatives, such as pooling donations to a non-profit entity or facilitating collective sponsorship of creative projects as Kickstarter does.  There are also startups funded by a large number of individual angel investors or groups, all of whom meet the criteria for “accredited investors” under current U.S. securities law.  Those are all worthy pursuits that fall outside the scope of this discussion.

My definition of the type of crowdfunding contemplated by the JOBS Act — more accurately dubbed “crowd investing” — is the making available of equity shares in a for-profit business enterprise for investment in relatively small dollar amounts by a relatively large number of individual investors who do not meet the traditional “accredited investor” criteria.

Anyone in the securities industry will find this to be a familiar description.  It sounds virtually identical to something called an “initial public offering,” or IPO.  You can find Facebook’s regulatory filing for its upcoming IPO, known as a registration statement on Form S-1, on the SEC’s EDGAR website in all its 190 pages of glory.  (I previously published an analysis of the 22-page “Risk Factors” section in collaboration with Dan Rowinski of ReadWriteWeb.)  To “go public” involves filing this kind of registration statement under the Securities Act of 1933, subject to review by the SEC and amendment in response to its comments; preparing five years of historical financial information, to be reviewed and audited by an independent accounting firm and published in the registration statement; meeting both qualitative and quantitative listing criteria to be traded on a stock exchange; committing to governance standards such as having an audit committee comprised of independent directors; and committing to indefinite updating of the company’s public disclosures in the form of quarterly financial reports, annual audited financial statements with more extensive disclosure, and annual proxy statements in connection with the election of directors, as well as real-time reporting of significant events and transactions by insiders, among other things.

Crowdfunding involves offering the same kind of securities to the same kind of public buyers with precisely none of the above.  The lack of transparency is justified by limiting the amount of capital any one investor can lose, and/or the amount the company can raise, to figures small enough to meet someone’s arbitrary standard of relative harmlessness.  If that sounds reasonable to you, I’d be happy to confiscate $100 apiece from 10,000 readers to walk away a millionaire while leaving you with no recourse.  (Libertarians are understandably outraged when the government does that in the form of taxation.)

Securities regulation in the United States is a disclosure-based system.  The SEC does not pass on the merits of any particular investment per se.  The primary purpose of securities laws and regulations, and their enforcement, is to protect investors from fraudulent and deceptive practices in a situation of radical information asymmetry.  The people running a company know literally everything about it; outsiders know literally nothing except what is disclosed, either voluntarily or through government coercion.  Even then, as investors, we have no guarantee that what is disclosed by the company resembles the truth — a lesson bitterly learned through destruction of untold billions of dollars of shareholder value by Enron, WorldCom and their ilk.  Sabanes-Oxley was passed out of desperation when it became clear that even the very largest NYSE-traded companies with blue-chip auditing firms were able to get away with massive accounting fraud by reporting figures that were manipulated and distorted.  Our trust, as it turned out, was misplaced.

In the lexicon of economics, this is a variety of principal-agent problem in which a moral hazard exists for a company to take more risk than its investors would take under the same circumstances.  (If you find the term “moral hazard” muddies the waters, simply replace it with the concept of gambling with “other people’s money” rather than your own.  This very concept of spreading risk widely enough that it’s unrecognizable by the investors taking it turned out to be at the heart of the subprime mortgage crisis.)  There is no reason to assume that these problems will magically go away with respect to companies below a certain size, or raising an amount of capital less than $X, or in purchases of less than $Y from any single investor.  In fact, as I’ll explain, the risks are exacerbated and amplified by orders of magnitude as a consequence of basic economic principles and a recent U.S. Supreme Court decision.

One of the fundamental tenets of investing is that risk and return are positively correlated.  The more risky an investment, the more it must pay investors to find that risk acceptable.  The “invisible hand” of market forces described by Adam Smith makes this so.  Setting aside the theory, anecdotally, any early stage investor has examples of worthless stock written off after a bad investment as well as (hopefully) spectacular returns from the home-run hitters.  The portfolio approach followed by VCs and angels arrives at an outcome that should ultimately be a healthy rate of return in the long run at the cost of great short-term volatility and illiquidity.

Valuation of private companies is more of an art than a science.  Sophisticated institutional investors with decades of experience can and do regularly disagree about the fair pre-money valuation of a startup.  Nevertheless, existing securities law treats these investors as “grown-ups.”  Through exemptions such as Regulation D under the Securities Act, accredited investors can invest in a startup without putting the company through the onerous disclosure and governance requirements described above for public companies, which would be prohibitive.  The only reason this makes any sense is that investors typically have both economic incentive and bargaining leverage to conduct thorough due diligence reviews, negotiate protective provisions and investor rights, get a seat on the Board of Directors (or at least an observer seat, affording them access to the same flow of detailed inside information that the Board receives), and so on.  Even so, the best investors get it wrong much of the time, like Hall-of-Fame baseball players who still miss more pitches than they hit.

Small investors, as in crowdfunding, have neither the economic incentive nor the negotiating leverage to do any of the above.  They are therefore expected to make investment decisions involving the riskiest of investments in a near-total information vacuum.  Common sense suggests that in this kind of scenario, the little guys need more protection in the form of regulations mandating certain types of financial and other disclosure.  Unsurprisingly, the existing exemption most commonly used by startups (Rule 506 of Regulation D) requires exactly that!  The primary reason most startups won’t allow non-accredited investors (other than founders) to invest is that Reg. D requires them to prepare fairly extensive disclosure materials to be delivered to those non-accredited investors.  While less onerous than going public, it’s a headache that most early stage startups want or need to avoid.

A committed libertarian might shrug at all of this and suggest investors should be expected to bear risks and reap rewards on their own, keeping government out of it.  Regardless of the merits of that view, crowdfunding law as proposed would be a bizarre distortion that turns it on its head.  If investors are to be left to fend for themselves, it should logically be with respect to investments in the largest, Fortune 500-type companies that offer far more disclosure voluntarily and whose stock prices are far less volatile.  Instead, JOBS Act-style crowdfunding legislation is a form of targeted deregulation of the financial markets aimed exclusively at investors who by definition have assets or income placing them squarely in the middle class andare making investments so small that in reality they have neither the leverage nor the economic incentive to demand adequate disclosure by issuers.  An economics professor could hardly dream up a better textbook example of guaranteed market failure.  (Law professor Barbara Black has also written on the subject.)

Many investments become worthless.  People will make bad or uninformed decisions, or invest on the basis of misleading, deceptive or fraudulent information.  In the case of crowdfunding, when this happens, who will they blame?  The answer is not themselves; our culture simply doesn’t work that way in this litigious age.

What about intermediaries who could impose some order on the chaos, disclosure standards, and so forth?  The inherent trade-offs are insurmountable:  The more transparency and accountability required of issuers, the more the entire point of being crowdfunded disappears.  With a less transparent, unregulated market, more investors will inevitably be deceived, misled or defrauded.  This goes hand-in-hand with the liability question.  Securities litigation has been a thorn in the sides of technology companies for decades.  (It’s often jokingly said that a rite of passage for any publicly traded tech company is its first securities class action or derivative suit.)  For a private company, increasing the number of shareholders by orders of magnitude will also increase the probability of litigation by orders of magnitude, unless Congress acts to specifically shield crowdfunding issuers from liability.  So naturally that kind of immunity has been floated in some of the proposals currently on the table.  Without it, proponents argue, companies would be afraid to try crowdfunding.  Adding immunity to the mix takes a situation from bad to worse, where the nearly-unaccountable become totally unaccountable.  This starts to sound like sheer insanity.

It gets better.  Add the concept of adverse selection and we have the makings of a Microeconomics 101 final exam.  Adverse selection is the concept that “bad” inefficiencies result when parties have asymmetric information (see a pattern here?).  For example, people with enormous appetites gravitate to an all-you-can-eat fixed-price buffet while light eaters are more likely to stay away, costing the restaurant more than expected.  Such is the case with a funding mechanism that is designed from the ground up to leverage a large number of individual investors with minimal bargaining power under circumstances involving minimal disclosure, toothless corporate governance and little-to-no liability to shareholders.  What sort of business operators can we predict will be disproportionately drawn to using this kind of fundraising mechanism?

Finally, even if Congress were to refuse to limit or eliminate liability from securities litigation against crowdfunded companies, the U.S. Supreme Court might well do it for them under its recent AT&T Mobility decision.  To understand why, it’s important first to distinguish between individual lawsuits and class actions.  Litigation is expensive.  If I invest $100,000 in a company that deceives or defrauds me, it might well be worth suing individually, particularly if I can find a plaintiffs’ lawyer to take my case on contingency (e.g., 40% of the proceeds).  If I invest $1,000, not so much.  In the real world, this means companies will never get sued for securities fraud except (1) by individual shareholders with large stakes that make it worthwhile (usually hedge or pension funds), or (2) by numerous shareholders bundled together in a class action lawsuit—usually instigated by the lawyers, it should be noted, not the shareholders—on behalf of everyone similarly situated.

This individual-versus-class action distinction becomes critical in many contexts, including consumer protection and employment as well as securities, where there may be a large number of people with relatively small claims that wouldn’t be worth litigating individually but multiply out to a large total dollar amount.  States such as California, siding with consumers, have restricted companies’ ability to eliminate class actions in their contracts as AT&T tried to do in its cell phone service contract.  That is a controversial subject and a separate discussion in itself, but the point here is that the U.S. Supreme Court struck down California’s law in the AT&T Mobility case, restoring companies’ ability to require as a condition of doing business that customers agree to waive any right to class action litigation and/or agree to 1-on-1 arbitration with the company.  If you wonder who would ever insist on spending the time and money to go to arbitration for a $150 dispute with AT&T over a cell phone bill, you see exactly why this matters.

It’s far from certain whether the AT&T Mobility precedent will extend to matters outside consumer protection, such as securities litigation, but much of the legal community is mobilized to push things in that direction and test its boundaries.  We should expect contracts that involve high-volume, low-dollar-amount transactions to require a class action waiver in every conceivable setting unless and until the Supreme Court sets a clear boundary.  Crowdfunding is a perfect application for this change, and I would therefore be shocked if every subscription or purchase agreement for a crowdfunding deal under the new law (if it passes) doesn’t contain such a waiver.  That would have the practical effect of eviscerating any legal remedy for securities fraud against unscrupulous businesses using crowdfunding.

It should be clear by now that the very attributes that make crowdfunding an attractive tool for raising capital also comprise a disaster waiting to happen.  One person’s barriers to investment are another’s indispensible safeguards.  There is a cost to transparency and accountability which small enterprises are understandably reluctant to bear.  Nevertheless, eliminating those things while throwing the doors open to members of the general public who are less able to bear the complete loss of an investment than accredited investors, would have trouble valuing an investment even in the face of perfect information but in fact receive almost none (and of dubious veracity), and are left with no legal recourse if defrauded, seems like a dream come true for predatory con artists and hucksters.

Thanks to Pei Patrick Kuo for contributing to this article.  The original post appeared in Gust Blog.  Reprinted with permission.

Most startup lawyers have checklists (at least in their heads) and will interview a new client to gather a wide range of relevant information before moving forward with business entity formation, documentation and so forth.  Sometimes this is done in the form of a questionnaire.  I prefer a hybrid approach because founders come from all kinds of backgrounds, and while some may have a strong point of view on every question in the startup questionnaire, others want or need more guidance in answering the questions that call for decisions to be made.

I.  What’s in a Name?

Let’s start with your name.  Most new startups have a name in mind, or have even taken various steps to secure rights to the name, but some are on the fence or still developing a brand name when we first meet.  Don’t let naming issues stop you from incorporating and taking care of other legal housekeeping; a corporate name change is a simple matter that can be handled inexpensively, at least in business-friendly states like Delaware.

It bears mentioning that a startup’s corporate name doesn’t necessarily have to be identical or even similar to the product or domain name.  Historically, most bricks-and-mortar businesses were named after their founders, and large corporations often have a publicly traded parent company that holds all of the stock in many operating units that have familiar or famous names (e.g., AMR as holding company for American Airlines).  Even technology companies followed this tradition in the early years; for every IBM, Intel or Microsoft there was a Fairchild, Hewlett-Packard or Wang.

Assuming the company will be named after the product, the most common step founders have taken before we meet is to acquire one or more domain names.  As the consumer Internet has matured, it can be a major victory to acquire any decent-sounding name in the core .com top-level domain.  Nevertheless, many startups launch under a different (less expensive) domain such as .co, .ly or .to, deferring the expense of acquiring the coveted .com name until after a funding event.

It can be a painful and expensive mistake to acquire a highly valuable domain name intending to use it as the foundation for your startup’s new brand, only to discover that there are show-stopping legal conflicts.  In fact, some domains for which brokers would charge a fortune are virtually worthless, as I’ll explain below.

To cut to the chase, for the typical startup we work with from inception at my firm, there are four levels of name clearance needed to ensure smooth sailing:

1. The corporate name is available in Delaware (or other state of incorporation);
2. The corporate name is available in California (or any other state in which the company’s operations will be based)
3. One or more acceptable domain names are available that incorporate the brand name; and
4. There are no serious trademark conflicts with existing brands.

Most entrepreneurs focus on #3, and perhaps are also aware of the ability to search state business entity databases online (as with Delaware or California).  Perhaps they even know about the US Trademark Office online service called TESS that allows anyone to search the federal trademark registry for free.  In my experience, the most common traps for the unwary are:

• Nearly identical corporate names already registered in the relevant state(s)
• Identical names registered in other states or countries, for Internet businesses and others that cross boundaries
• Confusingly similar domain names that will divert valuable traffic if the service scales
• Perhaps most importantly, trademarks – whether or not registered – already in existence as of the date the startup begins doing business.

My trademark lawyer colleagues could write several articles on this last point alone.  Here is my shot at an abridged, TL;DR version:

• What you don't know can hurt you

  A USPTO trademark database search won’t reveal that company in Tajikistan that started selling an Android app six months ago under the exact same name you want to use for a similar iPhone app that hasn’t launched yet. 
  Trademark is a noun, not a verb. The legal action is called registering a mark. This can be done at the state, federal or international level (country by country). Territory matters, as does class of goods or services covered.
• In the US, actual use of a name, phrase, logo, tagline, etc. as a trademark in commerce is usually enough to begin accruing common-law trademark rights, regardless of whether the company registers the mark.  (Things work differently in many other countries.)
• That said, even if they were first to use a particular name, most businesses of any scale want to protect their brands by filing an application to register it as a federal trademark in the US, at a minimum, and possibly in other countries.
• You don’t know what the trademark registry doesn’t tell you – i.e., even if you diligently search the TESS database, it won’t reveal that company in Tajikistan that started selling an Android app six months ago under the exact same name you want to use for a similar iPhone app that hasn’t launched yet – which may not ever register the TM in the US, but may have common-law rights to the name.
• Similar-looking or –sounding marks are easily missed in a search:  Hyphens or other punctuation, deliberate misspellings, “C” vs. “K,” etc.
• Trademark law is notoriously subjective, and reasonable minds can differ about whether two names are confusingly similar, or whether two companies’ products are similar enough that having the same name is likely to create confusion in consumers, and so forth.

Alert readers may wonder why I’m discussing offense (enforcing your company’s exclusive useof a name) together with defense (determining the ability to use a name at allwithout getting sued).  Trademark law is one area in which the best defense truly is a good offense.  The process of searching for and registering your own trademark flushes out conflicting names, and may even reveal competitors you didn’t know existed, along with other benefits.

II.  Nuts and Bolts

So you’ve chosen a name for your startup, product, or both. Having covered all the bases to ensure that your corporate name is available, the domain name can be acquired, and the name doesn’t infringe any existing trademarks, now is a good time to look at the categories of intellectual property (IP) that are relevant to most startups.

Most traditional, bricks-and-mortar businesses have substantial, often enormous hard assets, such as raw materials and supplies, work-in-process, inventory, manufacturing equipment, real estate and more, as well as armies of employees. Tech startups are at the other extreme. The gulf has widened with the proliferation of social Internet / user-generated content and mobile application startups. (Instagram is a textbook example.) It’s possible to have a company with literally millions of customers (users) that employs only a handful of people, working in a small rented office, with hardware and software costing in the tens of thousands rather than millions of dollars.

Most of our early-stage startup clients fit this description. Even in purely online businesses, to scale from zero to millions of users:

• in the 1990s, an Internet company might have had to build a whole data center from scratch (as we did at Excite@Home — twice — only to ultimately shut them down in bankruptcy).
• In the 2000s, the company might rent space at a colocation facility; buy, install, provision and maintain its own servers, storage and networking equipment (as we did at MySpace, putting several new servers online per day); and enter into a series of contracts for ever-changing amounts of bandwidth.
• Today, it can sign one deal with a cloud service provider such as Amazon Web Services(AWS) to replace all of the above.

After eliminating all of these types of assets, what remains?  Intellectual property.  Second in importance only to talented people, IP in all its forms is the key asset comprising most of the value of any tech startup. Nevertheless, even industry veterans are often fuzzy on the definitions and boundaries between different types of IP and the ways they can be protected and exploited.  Hence this “Cliff’s Notes” refresher, to be followed by a discussion of why it matters.

1. Trademarks, which we touched on last week, are brand and product names, graphic logos, slogans, taglines, and other indicators of origin of the goods or services in question.  In the Internet era, trademarks and domain names are closely interrelated, and both can be or become extremely valuable.  (What do you suppose the market value would be of the trademark “Facebook,” its lowercase “f” symbol, or the Facebook.com domain?)
2. Copyright is the right to control reproduction and distribution of original works of authorship fixed in tangible forms of expression.  Every original work is automatically copyrighted under US law upon creation, whether or not registered (although there can be significant benefits to registration).  This includes website content and software code as well as the more obvious examples in media and publishing.
3. Patents are property rights granted by the government to exclude all others from making, using, selling or importing anything that uses or incorporates the patented invention (usually described as a new, useful and non-obvious method or process, described in enough detail that it can be reduced to practice).  Patents are highly technical, hard to get, and the process is slow and expensive, but for those who succeed, the payoff is a 20-year government-sanctioned monopoly over the patented technology.
4. Trade secrets are everything else that would be considered confidential or proprietary.  Trade secrets in the US are governed by state law, which can vary, but in general, can include anything from clever ways of solving technical or business problems to formulas, algorithms, internal pricing or financial data, or just about any other valuable business information, provided that it’s treated as confidential by the company.

Each of these categories is a deep subject that can be explored in a future post. For now, focusing on the early stages of getting a startup off the ground, it’s worth understanding the basics of the IP assets that are dumped into the empty receptacle of a newly incorporated business entity.  If all goes well, the value of those assets will grow geometrically over time to eventually be worth millions or even billions.

Here are a few key questions and observations that I offer to any newly incorporating startup:

• Who are the founders?  Has anyone already left the picture?  Were outside advisors, contractors or consultants involved?  Every person who has touched the new business in any way has a potential claim to related IP rights.  This may never amount to much if the business fails, but for a highly successful growth company, “minor” claims have a way of coming back at the worst time with more zeros.
• Second in importance only to talented people, IP in all its forms is the key asset comprising most of the value of any tech startup.
   One common mistake is to equate “IP” with “code”or other technical contributions.  At a startup, the concept of IP should be viewed expansively:  The business is new, the team is small, branding/UI/UX is in flux, and as a matter of practicality, anyone can have input on nearly anything, from business and marketing plans to product design decisions.  As an extreme example, that graphic designer or photographer who was paid as an independent contractor to create an image for the website may have also offered some input on other aspects of the user experience after reviewing a demo or mockup.  If that’s the case, without a proper contract in place, it wouldn’t necessarily be sufficient to take down the picture.  Get a contract, if only a simple one-pager, stating that everything the contractor produces on the company’s dime is the property of the startup.  This is often referred to in the creative community as a “work-for-hire agreement.”
• Who on the team, if anyone, is moonlighting, and how closely related is their work to the startup’s business and technology?  In general, if a startup team member is employed elsewhere, any work on the startup should be done on his or her own time, using entirely separate equipment and none of the employer’s assets (IP or physical) whatsoever.  Laws regarding IP assignments vary by state and this is an area that should be reviewed carefully with legal counsel if there are any concerns.

How does all of this translate into legal documents for the typical startup?  Apart from registration issues, which are beyond the scope of this post, there are three main tools commonly used:

• Non-disclosure Agreements (NDAs or confidentiality agreements) are used (some would say overused) for many reasons, but one of them is to maintain trade secret status when sharing information with external parties.  Proprietary information can lose trade secret protection if the company doesn’t make reasonable efforts to treat it as such.
• Stock Purchase Agreements with founders require them to assign all IP rights they may have already created or acquired (for example, code written or domain names purchased by the individual) to the corporation in exchange for their shares of founders’ stock.
• IP Assignment Agreements with founders, employees and consultants clarify ownership of all IP created going forward (the work-for-hire concept described above) and cover many other bases related to preservation of IP rights going forward.  These often go by a long-winded title such as “Confidential Information and Invention Assignment Agreement.”

III.  Contributing Value

I’d like to take a step back and discuss the significance of IP as a component of the overall value that founders intend to create as they grow the company.  The questions that arise most with respect to any category of IP at the earliest stages include:

1. How will this affect our chances of getting funded on favorable terms?
2. What kind of advantage will this create vs. our competitors?  Barriers to entry?
3. How much is it worth investing in cultivating and enforcing an IP portfolio?
4. Are there any rights the company risks losing if it does nothing to preserve them now?
5. What kind of risk do we run of being put out of business by others’ IP rights?

Later stage companies have some additional concerns:

1. What favorable impact could IP have for PR, marketing and investor relations purposes, or as an attraction to potential acquirors?
2. To what extent are we able and willing to assert proprietary IP (usually patents) as aweapon against competitors?
3. To what extent are we vulnerable to attack from competitors or patent trolls?  Is there anything we can do about it?
4. How much is it worth investing in international IP protection, if at all?
5. What is the risk-benefit calculus for developing and protecting proprietary technologies vs. buying or licensing them (“build vs. buy”)?
6. How much risk do IP issues in the aggregate pose to our business?
7. To what extent might proprietary IP rights be undermined by antitrust laws?

Nearly every point above is subjective, varies from company to company, and at its core is more of a business judgment than a pure legal question.  For this reason, among others, tech startups are well served by engaging a good IP lawyer early in the game to help develop overall strategy and call the plays rather than just execute them.

Starting with the first point, in general, IP assets of demonstrable value that are relevant to the startup’s business can only help when pitching investors.  This could include anything from a clever domain name in the coveted .com TLD to issued patents or patent applications that could serve as barriers to entry for potential competitors.  The only exceptions that come to mind are if the IP seems likely to provoke costly litigation, costs too much to develop, or taints the startup with some kind of ties to other ventures or people that give it a checkered past.  For these reasons, it’s helpful to do things right the first time and ensure that all relevant IP is properly disclosed and assigned to the corporation, as discussed last week.

Competitive advantage is an area in which many investors are justifiably skeptical.  Patents are the only way to legally exclude others from doing something similar, and then only if the method or system used infringes the claims of the patent.  (It’s often possible to “design around” a patent to operate a business that achieves similar results in different ways.)  As we’ve discussed, obtaining a patent can be a slow, costly and difficult process.

Most investors will assume that if the business plan is solid and a large market opportunity exists, there will be vigorous competition from other players.  In general, IP protection will do nothing to prevent others from independently developing something similar, copying the overall business model, targeting similar customers or end users, and perhaps even mimicking the product’s look and feel.  The most effective response is to beat the pants off the competitionthrough brilliant product design, superior technology, clever marketing, strategic partnerships, swift execution, and so forth.  (Easier said than done!)  This is not to suggest there is no legal recourse whatsoever, though.  The quicker the startup establishes a strong brand identity that “sells itself” through word-of-mouth and social media, earning goodwill in its name, the sooner it can effectively chase away knockoffs that try to use confusingly similar names, logos, or domain names.  If the startup develops a uniquely effective or efficient system to solve a business or technical problem, regardless of whether it ever seeks patent protection, that proprietary method can and should be treated as a trade secret.

The amount of investment in IP in any direct sense is generally small for early stage startups.  Measured as a discrete line item in a budget, it might be near zero.  But given the expansive definition of IP discussed previously, in fact almost everything done by most members of the founding team at a startup on a daily basis involves the creation of one kind of IP or another.  Here are just a few examples:

• Creating and revising a business plan (copyright, trade secret)
• Creating product mock-ups, wireframes, etc. (trade secret)
• Writing, debugging, testing and deploying code and scripts of all kinds (copyright, trade secret)
• Developing Web content (both the design and underlying code) (copyright, trademark)
• Building and populating databases of user-supplied information and content (copyright)
• Designing and producing marketing and PR materials (copyright, trademark)
• Financial, technical and operational plans and forecasts of all kinds (trade secret)
• Sales and marketing plans, lists of prospects, supplier and subcontractor relationships, pricing data, media buying plans and strategies, etc. (trade secret)
• Internal org charts, job descriptions, titles, resumes, compensation details and direct contact information for individual employees (trade secret)

At the earliest stages, direct IP expenses might include beginning the process of registering the company’s primary brand and logo as trademarks; registering copyright in any exceptionally valuable works of authorship before they are distributed to the public; and filing provisional patent applications for any proprietary technology that seems to be unique, original, useful, and of future economic value.

This leads to the next point about “using or losing it,” which can be a concern for some types of IP in some countries.  In the United States, a patent application must be filed no later than one year from the date the invention is first described in a publication, used publicly, or placed on sale; otherwise, any right to a patent will be lost.  The rules are stricter in most foreign countries, where the inventor must file a patent application on the date of public use or disclosure in order to preserve patent rights.  In practice, this leads many U.S. startups to ignore foreign patent protection in the early stages, only to learn that they’ve lost the opportunity altogether if they try to pursue foreign patents later when better funded.  (By 2013, the U.S. will transition to a similar system as a result of the Leahy-Smith America Invents Act (AIA) of 2011.)  Such a “first-to-file” system also applies for trademarks in most countries outside the United States, setting the stage for ugly disputes involving companies that invest heavily in building their brands domestically while deferring international trademark protection.

The possibility of being put out of business by a ruinous patent suit brought by a large corporation with deep pockets understandably creates anxiety among entrepreneurs.  Nevertheless, experience has shown this to be primarily a later-stage company problem.  Paul Graham explains:

We tell the startups we fund not to worry about infringing patents, becausestartups rarely get sued for patent infringement. There are only two reasons someone might sue you: for money, or to prevent you from competing with them. Startups are too poor to be worth suing for money. And . . . they don’t get sued by other startups because (a) patent suits are an expensive distraction, and (b) since the other startups are as young as they are, their patents probably haven’t issued yet.  [Large companies] win by locking competitors out of their sales channels. If you do manage to threaten them, they’re more likely to buy you than sue you.

IV.  More on Domains and Trademarks

One of the best values a young entrepreneur can absorb early on is the value of learning from mistakes, both your own and those of others.  I’m constantly amazed at the extent to which experienced entrepreneurs and angels are willing to share their accumulated knowledge and wisdom, including some painful battle scars, with others.  This bedrock of Silicon Valley culture is a prerequisite for the whole phenomenon of venture accelerators.  It’s the radical opposite of the prevailing culture in established or contracting industries, where all things proprietary or innovative are jealously guarded and information is shared on a “need-to-know” basis.  This spirit of “coopetition” is one of the things I truly love about the startup community.

In the same vein, lawyers learn from mistakes, both strategic and tactical.  One reason business lawyers tend to specialize is that it’s more practical to amass knowledge of pitfalls to avoid, and things that can go awry, in a given area of focus.  No human being can be equally knowledgeable about all things.  This is why experienced General Counsel know that the most important executive decision to be made at the outset of any new matter is whom to ask, or which firm to engage, to handle it.

In the startup world, we tend to be subject matter generalists but industry specialists.  I will freely admit that I’m not the lawyer to consult if your apparel business is facing a trademark dispute with counterfeiters in Vietnam, but if you’re starting a consumer Internet business, the road from private beta to millions of registered users is strewn with corpses that I’m happy to identify.  The kind of legal advice I find most personally rewarding helps new players steer clear of foreseeable disputes, avoid overinvesting in legal work to mitigate risks that are more theoretical than real, and invest wisely when the best defense is a good offense.

In an earlier section, I discussed some basic considerations in choosing a name for a new startup.  As you may recall, there are multiple layers of name rights that can come into play, including trademarks, domain names and corporate names.  Things get interesting when a company goes international, becomes a household name, or simply gets popular enough to attract a lot of traffic — which then attracts the squatters looking to monetize that traffic.  It’s an area in which investing early in more protection rather than less, optimistically planning for future growth, can pay dividends down the line.  Nevertheless, when a company is young and strapped for cash, filing trademark applications all over the world and defensively registering every potentially confusing domain name variant in every new top-level domain (TLD) to come along worldwide is not a realistic strategy in a world of competing priorities.

Most startups begin life as single-product, single-market businesses.  Let’s assume for discussion’s sake that it’s a US-based company using the same name for the corporation as for the product (e.g., MySpace, Inc.).  As we’ve discussed, it helps to start out as clean as possible with a brand name that’s available as a corporation, a trademark, and a domain name, with no existing conflicts.  The more “arbitrary or fanciful” the name (e.g., Yahoo!, Google), the less likely there is to be any trademark or domain conflict from inception.  Generic or descriptive names start out in crowded territory to begin with, are harder to protect, and face stiff competition from domainers for similar-sounding names (Widgets.com vs. MyWidgets.com, Widget.com, WidgetCo.com, and so on).

Of course the main disadvantage of going with a name like eBay or Yelp is that it starts out meaningless to the consumer.  The opposite extreme (Buy.com) requires no explanation but is a nightmare to obtain and protect.  My favorites are suggestive names like Twitter, Groupon,YouTube, StumbleUpon and so forth that strike a good balance, being highly suggestive yet not merely descriptive or generic.  Nevertheless, it’s worth noting that even generic or descriptive names can become imbued with what trademark lawyers call “secondary meaning” — that is, even if the name “Windows” is descriptive, after selling hundreds of millions of copies, its use in a computing context can only reasonably be associated with Microsoft Corporation.

So you’ve got a startup with a clever, well-thought-out name, incorporated and acquired the domain name under the most valuable .com TLD.  What next?

Trademarks

• File an application to register the trademark with the US Trademark Office.  Ideally you’ve already engaged a trademark lawyer to do a search to make sure someone else hasn’t already registered the name you have your heart set on, or something confusingly similar.  (Sorry, you probably can’t get away with MeTube or Googol.)  Regardless, as soon as the company starts investing real money in building brand awareness, it would be foolish not to protect that investment with U.S. federal trademark registration at a minimum.
• The process can take a couple years (usually less) but doesn’t require extensive legal work unless you run into a head-on conflict with another company that is willing to expend resources to oppose your use of the name.  In the mean time, the company can begin accruing common-law trademark rights (in the U.S.) by actually using the name in commerce, “as a trademark” (meaning a designation of origin).  It helps to use the TM symbol at least in the first place the name appears in any given page or document.
• International trademark registration is beyond the scope of this article.  Suffice it to say that trademark law is country-by-country (with a few exceptions such as the European Union).  For domain name enforcement purposes, the most urgent priority will usually be to get a trademark registration here in the U.S.

Domain Names

• A good problem to have

   The more your business scales, the more the price of everything will go up.
   There’s no reason to hold off acquiring domain names that are available for registration or sale at a reasonable price.  The good news is that domain name registrations are cheap.  The bad news is also that domain name registrations are cheap!  Domainers make a living buying low and selling high, in much the same way as real estate speculators.  If your name is generic or descriptive, it’s virtually certain that the domain name is already taken under the most valuable .com TLD.  Many times it will be “parked” at a site such asSedo.com and listed as available for sale.  In reality, everything is negotiable provided you can actually get in touch with the domain owner.
• It should be evident from this discussion that the best way to avoid overpaying for every conceivable variation of your brand name is to register them all first, paying the minimum price (“defensive registration”).  Once the business gains traction and appears on speculators’ radar screens, in all likelihood they will grab every close variant they can find, including typos and misspellings (eharmoney.com), punctuation variants (e-harmony.com), and so forth.
• What’s wrong with this picture?  Simple math.  Unfortunately, even if domains only cost $20 apiece, by changing a few characters it’s possible to come up with thousands of variants of a domain name.  This is particularly true with every new TLD that opens up.  (The recent introduction of .xxx is a good example.  That TLD is limited to sites in the adult entertainment industry as well as brand owners that wish to register defensively for obvious reasons.)
• The more your business scales, the more the price of everything will go up.  At a famous brand, high traffic site, even a small percentage of mistyped URLs will net a decent number of hits for an enterprising domain squatter.  That makes it more worth their while to register an ever-widening circle of similar domains in the hope of getting a payoff.

The Carrot And The Stick

• Like an emerging military power, the bigger you become, the more skirmishes are likely to occur at your borders.  As problems go, these are good ones to have, considering they come with scale and rapid growth.  Nevertheless, it helps to be prepared.  Fundamentally, there are three ways to obtain a domain name held by another party:  Negotiate to buy it, file a lawsuit, or pursue arbitration under the ICANN rules known as the Uniform Domain-Name Dispute-Resolution Policy (UDRP).
• Practically speaking, nothing beats simply negotiating to buy the domain for a modest price.  Although it may seem unfair to pay anything to someone who is taking advantage of your success, legal proceedings are expensive, time-consuming and stressful distractions from building your business.  In addition, a good settlement agreement will buy you some comfort in the future (e.g., an agreement not to turn around and squat a dozen other variants of your primary domain name).
• Litigation can be incredibly expensive.  Expect to pay six figures in legal fees for any trademark infringement lawsuit, or even more.  It’s rarely worth it for any startup.
• UDRP is often the only practical alternative for a company that is intent on reclaiming a domain from a party who is unwilling to sell it or insists on an unreasonable price.  Without getting into the gory details (which can be found here), it gives the brand owner an opportunity to make a case for abusive registration — i.e., that the domain name is confusingly similar or identical to your company’s trademark and that the current domain owner has no legitimate purpose for registering it.  This is a key reason why having a registered trademark is important.  UDRP is a “stick” to use against uncooperative squatters that is far less expensive than litigation.  The Chilling Effects Clearinghouse maintains an excellent FAQ with more information on the process.

A successful business in the Internet age will have to wage an ongoing war against domain name squatters, fought one battle at a time.  There is no practical way to prevent it altogether, but an up-front investment in trademark registration and the most obvious candidates for cybersquatting and typosquatting can save a lot of headache and expense if your startup turns out to be the “next big thing.”

This post was compiled from a series of posts at Gust Blog.  Reproduced here with permission.

Business risks are unfortunately never as interesting to review as opportunities.  It’s a well-worn joke among people involved in the financial disclosure process that the only people who pay any attention to the “Risk Factors” section of an S-1 or 10-K filing are lawyers:  Those who draft it and those who review it when suing the company years later.  It tends to be a mostly boilerplate section that goes on for page after page of legalistic CYA language.

Nevertheless, in Facebook’s case, when called upon to review and comment on the Risk Factors for an article in ReadWriteWeb, I couldn’t resist digging in.  There are a few exceptional risks in Facebook’s case, given its enormous size and position in the industry, that make it unique.  From a financial investment perspective, any “fully valued” stock has priced in continued growth and flawless execution, so many of the risk factors describe early warning signs of developments that could topple the stock from its lofty trading price.  Finally, drawing on personal experience at MySpace, I can relate all too well to the warning that “A number of other social networking companies that achieved early popularity have since seen their active user bases or levels of engagement decline, in some cases precipitously.”

You can find my commentary in part below, continuing with a link to the full article at RWW.  Thanks to Dan Rowinski for the opportunity to contribute to this piece.

Facebook’s Biggest Risks Explained

Facebook is about to jump into unfriendly waters. If founder Mark Zuckerberg thought the company faced fierce competitors in Silicon Valley, he is about to find that the denizens of Wall Street are not nearly so forgiving. There are risks to going public. How does the world perceive your company? Can the platform grow and maintain its edge? The trick for Facebook will be to balance the concerns of its shareholders with the need to push the boundaries of innovation. This is no easy task.

In its S-1 filing today, Facebook outlined a litany of risks for the company going forward. Monetizing the mobile user base in a system dominated by its competitors will be a major challenge going forward. Diversifying its portfolio away from its reliance on advertising will be a big task, one that Google has never quite figured out. We take a deep dive into Facebook’s risk factors below.

What Are the Risks?

Facebook’s risks are fundamentally tied to the fact that nearly 85% of the company’s revenue is related to advertising. When most of your assets are tied to one cash vertical, any fluctuations can lead to dramatic swings in performance. Facebook also has concerns with competition, global expansion, infrastructure and retaining top talent. Here is the summary breakdown from the prospectus, with the exception of some specific stock risks.

We enlisted Antone Johnson, founder of the Bottom Line Law Group to help with the analysis of Facebook’s risk factors. Johnson is a respected Silicon Valley lawyer who has spent 15 years representing technology and media companies. He was vice president of legal affairs at eHarmony as well as assistant general counsel to Intermix Media, which included serving as director of business and legal affairs at Myspace, culminating in the company’s $650 million sale to Fox.

Johnson on Facebook’s reliance on advertising:

“Main story here is the drop from 98% to 85% of revenue being generated by advertising. Obviously a good risk mitigation approach to diversify with revenue from virtual goods, etc. Again, mobile jumps out as an important theme; given they admittedly don’t make ad revenue from mobile users, this could be a significant headwind for FB in coming years as smartphones become near-universal and people become accustomed to using them as their primary means of accessing social media.”The rest of this risk factor is par for the course.”

Mobile

According to the S-1, around half of Facebook’s users access the website through mobile devices. Facebook has a robust mobile presence and it iterates its native apps constantly. As an advertising-based business, Facebook has a distinct problem here.

It does not serve ads in its mobile apps.

Facebook has 425 million monthly active users on its mobile platform as of December 2011. Mobile is rapidly becoming a replacement for personal computers and that threatens Facebook’s advertising model. The key for Facebook will be to turn mobile users into mobile dollars.

“They are forthcoming about the challenges,” Johnson said. “No revenue currently generated from mobile advertising; unclear how much mobile use could be monetized; failure to solve this puzzle combined with a dramatic shift toward mobile usage could be a serious problem for FB; and per the next risk factor, they don’t control the iOS and Android platforms. Frankly, if there were one thing that persuaded me not to invest in FB (given the growth assumptions built into current valuation), this would be it.”

Full article at ReadWriteWeb

Notice what is missing from this list of priorities:  The company itself – that is, a business entity, most often a corporation, that will own the entire business (however defined), issue equity to founders, take investment capital, enter into contracts, make sales, pay employees and contractors, and so forth.  I don’t fault entrepreneurs for relegating startup legal work to the bottom of their daily triage list; founders are spread incredibly thin.  Nevertheless, choosing to defer basic corporate housekeeping items can be disastrous in some circumstances, as when the failure to spend a few thousand dollars on legal fees to clarify IP ownership and equity arrangements comes back to bite a successful company to the tune of millions of dollars on the eve of a liquidity event.  To add insult to injury, the more spectacularly successful the company, the more costly the mistakes can be.  Every startup lawyer is familiar with variations on this theme and can recite cautionary war stories, but the Winklevoss brothers’ dispute with Facebook, made famous in the movie The Social Network, has become the iconic example.

There are countless related subjects, such as what type of entity to form and in what jurisdiction, how to handle equity compensation and vesting arrangements, determining titles and Board membership, and so on.  I’ve written extensively on these subjects, as have other lawyers, notably Yokum Taku and Scott Edward Walker.  For purposes of this article, I want to slice off one specific issue:  Which actual pieces of paper are required at what stage, and who should prepare them?

In the days before online document repositories and do-it-yourself sites such as Docstoc and Legalzoom, as a practical mater, the answer to the latter question was that early stage startups either went to a friends-and-family type lawyer to do the basic setup work, found their way to one of the handful of large law firms that have extensive experience representing venture-backed startups (such as my “alma mater” firm WSGR), or went without.  Serial entrepreneurs or those with close ties to the investment community would usually go straight to the big firm.

Founders now have more options, which is a double-edged sword.  It’s easier than ever to find example documents on the Internet, use a service to file your certificate of incorporation or trademark application, and so forth.  Entrepreneurs are quintessential do-it-yourselfers, but it would be a mistake to think that because these items and activities consist of documents, there is little to be gained from involving an attorney.  In much the same way a good primary care physician adds value by diagnosing illnesses and prescribing treatment, a good startup lawyer brings to bear professional judgment, perspective across many clients and deals, the wisdom of experience, and – near and dear to most founders’ hearts – a history of mistakes (often made by DIY clients or by other lawyers working outside their area of expertise) with lessons learned accordingly.

I will get into specific documents shortly.  For starters, let’s examine the question of who, when and what:

Who:  Find and engage an experienced startup lawyer.  The advantage of using documents you find online or through a document service is largely illusory.  Startup law firms have vast collections of documents, templates and examples to work from; this allows us to create most if not all of the standard documents in very little time, and at relatively little expense to the client.

When:  Ideally, involve a startup lawyer as early as possible upon deciding to start a new venture.  This is most urgent when more than one founder is involved, when “outsiders” touch IP related to the new business, or when the startup is engaged in a business closely related to the current or former employer(s) of the founder(s).

What:  The foundational corporate formation, governance, equity issuance and intellectual property assignment documents.  We’ll get into these in detail below.  Going without good advice in these areas can result in mistakes and messes that will need to be cleaned up later in the company’s life cycle – usually at much greater expense than it would have cost to do them right in the first place – and that doesn’t even count the cost of litigation, which can be orders of magnitude greater if a serious dispute breaks out.