This article focuses on the importance of intellectual property (IP) in startup companies to attract investment. Various examples of startup companies dealing with medical devices were also discussed. Much of a medical device startup’s assets, however, lie in ideas or concepts it hopes to develop into a commercial product. Patent protection often is considered a critical component of corporate transactions involving medical technologies because it can protect the significant upfront investments required for R'D and regulatory activities. Investors evaluating the IP of a target medical device company are attracted to a demonstrated awareness of IP and to a clean house as it relates to administrative issues potentially affecting the company’s intellectual property. A target company also may make investment more attractive by minimizing or eliminating contractual restrictions on the transfer of its IP. A startup company seeking its portion of investment dollars must pay attention to its IP: it must ensure that its technology is freely marketable without infringing third-party rights and that its IP portfolio is free of encumbrances and has the necessary protection.
Last year, many industries saw an overall increase in venture capital investments. The year also saw the largest number of acquisitions of venture-backed companies since 1985, and the number of initial public offerings last year was the highest since 2007.
As the economy improves, many expect financial activity to continue its upward trend. Increases in 2011 are expected in the number of startups, in overall venture-capital investment, and in acquisitions and initial public offerings of venture-backed companies. At least some of the increase is owed to potential acquirers looking to invest stockpiled cash. An entrepreneur can increase the chances that a technology-based startup will share in this year's investments by making sure that the company's intellectual property is in good order.
Most of our examples in this article will be about companies developing medical devices, but the principles apply to all technology endeavors.
Through the first nine months of 2010, the medical devices and equipment sector saw approximately 11.4 percent of all venture-capital dollars. In addition, one of the largest venture-capital investments of the year went to a medical device manufacturer, Trivascular Inc., which received a combined investment of $60 million.
In addition, bringing a medical device from concept to market can take a number of years and large amounts of capital. Much of that capital is spent on costly R&D and regulatory requirements. To cover these expenses, medical device startups frequently look to venture capitalists or angel investors for the needed cash.
Before spending their money, however, investors typically conduct a thorough investigation of the startup. Likewise, in the case of an acquisition, the buyer will conduct a due diligence investigation of the company.
A startup may have tangible or intangible assets. They may include tooling and machinery, personnel, a device or method that will be reimbursable by insurance companies, and even valuable relationships.
Much of a medical device startup's assets, however, lie in ideas or concepts it hopes to develop into a commercial product. The suitor therefore must evaluate those ideas or concepts. To do so, the suitor will look to one of the startup's most valuable assets, its intellectual property and to the IP of others in the technology area of the startup.
A Critical Component
Patent protection often is considered a critical component of corporate transactions involving medical technologies because it can protect the significant upfront investments required for R&D and regulatory activities. In addition, because many medical devices can be reverse-engineered relatively easily and inexpensively, a company's patent portfolio may deter copying by a competitor and protect the device's profit margin and market share.
Investors evaluating the intellectual property of a target medical device company are attracted to a demonstrated awareness of IP and to a clean house as it relates to administrative issues potentially affecting the company's intellectual property.
As to awareness, many investors want to see that the target company has in place and is following a prudent patent strategy, with respect to its own patents and the patents of others. Awareness of the competitive landscape is critical. Investors often uncover problem areas during their investigations. They may use the discovery of a problem—for example, a third-party patent that covers a critical component of the device—to place less value in a company during negotiations by pointing to the potential risk and expense of a lawsuit. Advance knowledge of problem areas and possessing defensible positions will help a startup maintain its value.
Suitors evaluating potential investment in a target company typically conduct a two-pronged IP investigation. First, suitors want to know that the target company is free to market its technology without infringing the IP rights of a third party. That is, the suitor may conduct what is known as a freedom-to-operate search to determine if another entity possesses a patent covering the target's technology. Second, suitors will examine the target company's patent portfolio to determine, among other things, if the target's technology is protected and if there are any issues affecting the enforceability of the target's patents.
To prepare for a suitor's evaluation, there are a handful of things a company can do ahead of time to make the investment attractive and also maximize the potential investment. For example, it can attempt to determine ahead of time if there are any obvious roadblocks to commercializing its technology.
Significant roadblocks to successful commercialization of developing technology can be a deal breaker, especially if there is a tangible risk of a lawsuit. In addition, identifying problems early in the product development cycle can have the added benefit of avoiding investment in a design that falls within the scope of another's patent. Early identification of these problems can allow for an opportunity to develop suitable work-arounds and minimize liability.
To ensure freedom to operate, a target company must search the patent literature. Occasionally, the search will return a clean bill from third-party threats. Often, however, a search will identify one or more problem patents.
A patent attorney can assist in evaluating the threats posed by any problem patents identified by the search. For example, the patent attorney can study a problem patent and find that even if the patent is asserted, it is likely that a court will find the patent to be invalid or unenforceable. The patent attorney also can study the patent and advise on a potential design-around or, if necessary, assist the company in securing a license from the patent owner.
Regardless of the advice a patent attorney may give on a particular patent, the target company should exercise caution when securing writings, e.g., attorney opinions, that characterize or disparage the intellectual property of another party. Occasionally, it is the owner of the problem patent that ultimately acquires the target company. A negative written characterization of a potential acquirer's patent could impact the deal in such circumstances.
For example, let's say that Acme Co. once started a program to replace a patient's damaged cornea with a tiny camera. During development, Acme secured patents directed to processing the camera signal into a form that could be sent directly to the patient's brain, but the program was discontinued because it necessitated invasive surgery with unjustifiable risks.
Later, XYZ Co. began developing a handheld device that could scan words on a page and transmit images directly to a person's brain. During a search, XYZ's patent attorneys discovered the Acme patent portfolio. To satisfy its board, XYZ asked the attorneys to write an explanation of why XYZ's technology would not infringe Acme's patents.
When Acme became interested in acquiring XYZ's technology, it discovered that XYZ did not have sufficient patent coverage. Acme's attorney determined that the portfolio of artificial vision patents provided some protection. Then Acme's patent attorney discovered the memorandum arguing that the Acme portfolio would not cover XYZ's technology.
Although he disagreed with the memorandum's conclusions, Acme's attorney feared that the memorandum could work against Acme's assertion of its patent portfolio to cover the XYZ technology. After all, if the developers of the XYZ technology themselves thought their design was different from that covered by Acme's patents, it could be difficult to persuade a judge or jury otherwise.
A House in Order
When evaluating the patent portfolio of a target, suitors are concerned with administrative issues that may adversely affect the enforceability or transferability of the portfolio and with the substance of the patents in the portfolio. With regard to administrative issues, the target company can take steps to minimize problems. For example, the company can implement procedures to ensure that the correct inventors for each patent are identified on the patent. Improper inventorship of a patent can have serious consequences, possibly rendering a patent invalid. Since inventorship is a legal issue, it is best to involve a patent attorney to resolve an inventorship question.
Inventorship issues can arise in collaborations with a third party. For example, a medical device company developing an orthopedic implant may partner with a chemical company to develop a suitable bone ingrowth coating for the implant. If an employee of the chemical company invented the coating, the medical device company must list both the employee and the individuals who invented the implant on any patent claiming both the device and the coating. Failure to list the employee on such a patent will likely render the patent invalid.
Advance knowledge of problem areas and defensible positions will help a startup maintain its value.
The target company also should ensure that all of its patents are properly owned with clear title. To do so, the company can include clauses in its employee agreements assigning all inventions to the company.
State laws may govern this situation, and the laws differ from state to state. There are some doctrines that, absent a written assignment, ownership of a patent lies with the employer. This, however, is not ironclad. For example, if the employee has made it clear to the employer that he wants to retain his inventive rights, for example by refusing to sign an express assignment of rights, then an implied contract may not exist even though the employee was clearly hired to invent. Thus, it is advisable to use a belt-and-suspenders approach with an assignment clause in an employment agreement and with an express assignment.
The company also may require its employees to expressly transfer (i.e., assign) ownership of individual patents and patent applications to the company. In the orthopedic implant example above, the target also could have secured appropriate assignment agreements (e.g., contracts transferring ownership rights) from the chemical company prior to collaboration, as well as specific assignments from the chemical company and its inventors transferring the rights to individual patents and applications. The target should record the assignments at the United States Patent and Trademark Office to provide public notice of its ownership.
Buyer beware: VW got less than it expected in a Rolls Royce deal.
A target company also may make investment more attractive by minimizing or eliminating contractual restrictions on the transfer of its intellectual property. The importance of IP transferability was highlighted by the $700 million purchase of Rolls Royce Cars by Volkswagen in 1998. Only after the deal closed did Volkswagen realize that the valuable Rolls Royce trademarks were owned by Rolls Royce PLC, the aircraft-engine company, and not Rolls Royce Ltd., the automotive manufacturer that it had purchased.
Upon further investigation, Volkswagen learned that the Rolls Royce trademarks were merely licensed from Rolls Royce PLC to Rolls Royce Ltd. under an agreement that terminated when Volkswagen acquired the automobile company. Thus, Volkswagen bought an automobile company and owned its factories, design, and equipment, but could not use the Rolls Royce name or the “RR” trademark. Volkswagen could not sell any cars under the Rolls Royce brand without risk of a lawsuit, and was forced to sell its cars under the Bentley name.
Learning from Volkswagen's mistakes, many acquirers now insist on verifying the transferability of a company's intellectual property.
In addition, a target company should ensure its IP house is in order by complying with the appropriate regulations of the United States Patent and Trademark Office. Failure to, for example, disclose required information, claim correct priority to previously filed patent applications, claim correct entity status (i.e., large vs. small), or pay the necessary maintenance fees, could adversely affect the enforceability of a patent. A patent attorney can provide the necessary guidance and assist companies in complying with the relevant regulations.
Potential suitors also are interested in the scope of a company's patent portfolio. Suitors value patents and patent applications that are filed early with broad disclosures. A target company also can increase the value of its IP by securing patent claims that not only cover its technology but also cover potential design-arounds. In addition, possessing claims that cover technology of a competitor, the potential suitor, or the suitor's competitor will increase the value of the target's intellectual property.
Let's say Heart Co. is in the business of developing treatments for cardiac ailments. Upon breakthrough testing by one of its engineers, the company identifies a new way of treating a valvular defect. Heart Co. files a patent application on a specific device and method for treating the defect, but decides to focus its efforts on developing a new pacemaker. The Heart Co. application eventually issues as a patent.
Valves-R-Us is a company focused on developing devices for treating heart valves. It has IP covering its products and methods but is unaware of Heart Co.’s patent because it was not monitoring the relevant patent literature. A number of years later, Valves-R-Us develops a product squarely within the protection of the Heart Co. patent.
Valves-R-Us is undergoing clinical trials for FDA approval but finds itself running out of funds. To raise additional capital, Valves-R-Us seeks investment from potential suitors. During a freedom-to-operate search, however, a potential investor uncovers the Heart Co. patent and declines to invest in Valves-R-Us. If Valves-R-Us was monitoring the relevant patent literature, it may have discovered the troubling Heart Co. patent and prepared a defensible position relative to the patent, perhaps a design-around or a license, since Heart Co. was not interested in commercializing the valve device.
Privileges and Confidences
It is important, too, that a company undergoing evaluation for a potential investment or acquisition maintain its confidences. Above all, the company should minimize communications with a suitor regarding its IP portfolio and protect any attorney-client privileges.
In addition, confidentiality may be maintained through the use of appropriate confidentiality and nondisclosure agreements. Such agreements protect the target company against improper use of information learned by the suitor during the evaluation process, and protect the potential suitor from being charged with improper use of sensitive information.
Target companies also should limit the distribution of sensitive information, to potentially avoid a scorned suitor from beginning a competitive program or targeting the company with its own patent filings.
Missteps of this sort crop up in the example of Acme and XYZ Co. XYZ not only may have sacrificed the attorney-client privilege afforded to the memorandum prepared by its lawyer, but also provided Acme with detailed explanations of its technology. Armed with the knowledge that XYZ has no patents protecting its technology, and perhaps no confidentiality or use restrictions on the information, Acme is able to freely begin a competing program and mine its patents to secure claims targeting XYZ. It's clear to see how Acme, a company with vastly superior resources, can begin to encroach on XYZ's technology.
As business around the country continues to improve and the credit crisis subsides, investments and acquisitions will increase. More investment dollars will be available to startups, but there will be no shortage of companies seeking those dollars.
A startup company seeking its portion of those dollars must pay attention to its intellectual property: it must ensure that its technology is freely marketable without infringing third-party rights and that its IP portfolio is free of encumbrances and has the necessary protection.