I IP Assets from Early Stage Investment to IPO
Intellectual property (IP) rights (IPRs) are like any other property or asset of a business – they can be bought, sold, leased out (licensed) or mortgaged. Depending on the nature of the business and the IPRs they may be key assets of a business or just the “icing on the cake” when it comes to raising finance.
Whether the IPRs of a business are of interest to a financial backer also depends on the nature of the investment. Except in particular circumstances, a bank will probably give little weight to the value of IPRs when extending an overdraft facility. The bank is principally concerned with servicing interest through profits. In the case of a secured loan, the bank is likely to consider only tangible assets and real estate that can readily be sold at auction. Notwithstanding websites that purport to auction patents (and with the exception of copyright in popular works), IPRs cannot readily be auctioned or sold, in large part because they have no accepted uniform method of valuation. On the other hand, when it comes to raising seed capital and venture capital, IPRs are very important and sometimes critical. Viewers of the BBC television program “Dragon’s Den” may have observed a company that was reluctant to offer the putative investors world-wide rights under their international patent application. In this particular episode of the programme, this question over the extent of the patent rights on offer turned out to be a deal-breaker.
Going up the scale of financial investment, one can consider a trade sale of shares in a company to a larger company that may exploit a technology or idea or brand. Again IPRs are likely to be critical. At the top end of the scale, one can consider an initial public offering of shares (IPO). By the time a company considers an IPO, it is a well established business. Public investors may well expect the company to have exclusivity in its technology and brand. The corporate finance team promoting the IPO will need to have checked all the boxes in relation to the IPRs, but the public investor is concerned with the overall reputation of the company rather than this or that IPR. (One hears notorious tales from a century ago when poster campaigns invited the public to invest in newly formed companies purely on the basis of a patented invention, but that was a different age.)
Accordingly, our topic here lies in the phases between
raising seed capital (from angel investors and sometimes government sources) through to
initial rounds of venture capital or
an early stage trade sale.
By the time a company has been through these stages (or even skipped these stages) and is considering a private equity investment or an IPO, it is likely to have secured its IPRs and been through due diligence (sometimes several times) and is unlikely to be reading this chapter. The next section of this chapter considers the due diligence process. For the present, we are concerned with bringing the company to the point where an investor is sufficiently interested to require a due diligence disclosure, and the company is confident it can open its books and pass the test.
II Raising Seed Capital
It is an axiom that in an early stage, one is investing in the person and not the idea. Anecdotal evidence tells us that 99% of ideas never take off. It is the 99% perspiration and not the 1% inspiration that makes a good idea into a profitable business. For this reason, most new companies obtain their initial seed capital from directors and their families and friends – sources who know and trust the individuals.
Going beyond the circle of the directors and the bank manager, and with the directors financially committed to the enterprise (having “put their money where their mouths are”), from what other sources might an entrepreneur raise money on its IP?
II.1 Angel Investors
The term “angel” has long been used for individuals who finance theatrical productions. A wealthy individual may be prepared to put up a large sum of money on a West End production not merely as a speculative business proposition, but for the love of the stage. Today, individuals invest as business angels in a range of ventures, and in recent years there has been increased involvement in backing technology ventures. Wealthy individuals with an interest in technology also form clubs or loose networks to hear technology start-ups pitch for investment, and to spread the risks and rewards among their members.
Technology investors are typically interested in scalable ideas – that is ideas that, once proven, can quickly deliver rapid sales growth – rather than ideas which are limited by in their rate of growth by factors such as people and recruitment. Software and medical diagnostic kits are classic examples. Production costs are negligible, and manufacture can be ramped up in an instant. By way of contrast, many non-tech enterprises are at the other end of the scale. Restaurants and travel are examples. No doubt angel investors can be found for the right opportunity, but the proposition is quite different.
Highly scalable ideas are vulnerable to copying. Patent applications are vital. At investment pitches, a prospective entrepreneur will typically mention to the audience of potential investors that patent applications have been applied for, or an international patent application has been applied for, or a patent has been granted in this or that country. If not mentioned, it is a frequent question from the audience “have you applied for a patent and what is the status of your patent application?” The investor is merely seeking assurance that the proposed investment is protected. For reasons already mentioned, only occasionally will the investor be considering whether, in the worst case where the company folds, might there be an intellectual property asset that can be salvaged. Equally, an investor is typically unimpressed by an over-emphasis on the value of the patent or an expectation that an investment can be recouped merely by licensing the patent.
On the other hand, in many instances the business proposition may indeed be purely to license the technology. This is a very common model in the software and semi-conductor industries. The technology will be brought to market included in a chip or a mobile phone made by others. In these cases, the IPRs are critical. At the early stage, the patent may indeed be all there is, although this would be unusual. Even in the drugs, biotechnology or medical diagnostics industries, there is usually valuable know-how. But at this early stage, the technology is so far unproven, so there may not yet be any trade mark or goodwill.
III Beyond Seed Capital - Venture Capital
A venture capital investment is not unlike an angel investment, but is usually on a larger scale and with much less blind faith and much more business scrutiny and a thorough investigation of the IP assets as part of the “due diligence” disclosure and investigation (for which, see the next section of this chapter).
The company may by now have a more measurable worth, and the VC will propose to buy a significant share of it and probably appoint a director. For an initial round of funding the VC will typically not seek a controlling share, but perhaps not far short of a controlling share. The VC may well wish to buy much of the share of the angel investors, depending on who those investors may be and what, if any, involvement they have.
The VC will need to look more closely at the patent applications. Mere search reports and examination reports will probably not be enough. Equally, the review by the company’s patent attorney may not be enough. A brief independent review is likely to be required to verify not only that the objections raised by the various patent offices can be overcome, but that the scope of patent claims that can be achieved is satisfactory - i.e. that a third party will not be able to simply “design around” the patent. If there has been any shortcoming in the quality or scope of the originally filed application, it is likely to be identified at least by this stage.
All being well, the initial seed capital has brought the product through a feasibility stage and initial prototype stage and what is sought is development capital to bring the product to a production stage. Of course these are not clear divisions: some prototypes are enormously expensive, and some require expensive field trials to prove viability. There may be any of a number of reasons for seeking venture capital. For convenience, VC investors speak in terms of “Series A” and “Series B” funding. So far, we have been talking about a first round of funding (Series A).
If all goes to plan, the Series A funding sees the development through to the point where the product is production-ready, or the service is being offered to the public and is beginning to take off. A trade sale might be very feasible at this stage. Having proven the technology, the company might find a larger partner with a gap in its product line, manufacturing capability and the distribution channels to bring the product to market. Or if it’s a service, the larger partner may have the recruiting network to quickly ramp up the number of outlets, or the purchasing power to bring about economies of scale, or the franchising know-how, etc.
By this stage, the IP assets may have grown. In addition to national, European or International patent applications, and patents resulting from these, there may be:
a trade mark (or service mark), perhaps with associated goodwill if the mark has acquired a level of awareness in the marketplace or in the press or other media;
a website URL;
unregistered design rights;
software or other works of authorship.
Rather than a trade sale, the plan may be for independent organic growth without further funds, or another injection of funds may be required to put the product into production and commence sales and distribution. This may be referred to as “Series B”. Yet a further round of Series C funds may be required if problems have been encountered or there has been a change of direction, or in other unusual circumstances.
Research by Maucher Jenkins among technology start-ups shows a significant expansion of patent portfolios in the stages between initial seed funding and Series A or Series B venture capital funding. The chart above shows, for start-up companies with published patent applications (published in the company’s name), a breakdown of average patent portfolio size according to last round of VC funding. The numbers represent numbers of patent families (where a patent family may have a number of patents for the same invention in different countries).
The initial increase from seed funding to Series A funding coincides with the stage at which VC investors perform due diligence investigations onto a company’s IPRs. The VC wants to know: 1) whether adequate protection for the technology has been applied for in the relevant markets around the world; and 2) from the search reports issued by the various patent offices, whether the company’s inventions are indeed new, or whether in fact others have filed patent application first. Further portfolio growth is seen as a company progresses from Series A funding to Series B funding, by which time the product is typically through its prototype phase and about to enter production. This is an innovative stage when technical problems have to be overcome and the company has sufficient liquidity to patent the solutions to those problems.
IV. Summary of IP Assets
In summary, the investor (at whatever stage) is considering investment in a package that, in addition to the ability and commitment of the individual, and the business opportunity and any tangible assets, comprises:
the know-how, which may or may not be confidential1 and may or may not be a trade secret2;
the patent(s) or patent application(s)
copyright in works of authorship;
any registered and unregistered design rights; and
any trade marks, service marks and URLs.
 In the UK confidentiality is based on contract. Many common confidentiality agreements unnecessarily require information to be absolutely secret for it to be confidential.
 Some countries like France and Germany have laws to protect trade secrets even for information that may not be absolutely secret in the way required by patent law.