How Tech Company Formations Are Different (Part 2 – IP)

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Forming a tech company is different from forming a non-tech company. Part 1 of this two-part post dealt with equity considerations, especially equity incentives and equity financing, that impact choice of entity and equity structure in tech startups. This installment addresses the second differentiating factor – intellectual property (IP).

IP is not unique to tech companies. Non-tech companies have valuable patents, copyrights, trademarks, and trade secrets. Content companies, such as publishers, are just as IP-centric as tech companies. Much of what is discussed below applies to these companies on formation, as well. But IP needs to be accounted for in every tech formation. The focus here is on pre-existing (pre-incorporation) IP, specifically patentable and copyrightable IP.

Where to start?

Fran and Jamie have an idea for a new technology they call Gizmoware. They want to start a company, Gizmo Labs, Inc., to develop and market Gizmoware. Fran, Jamie, and their lawyer need to answer three fundamental questions about pre-existing IP, i.e. any IP and IP rights that exist in Gizmoware today, prior to incorporating:

  1. Is there pre-existing IP?
  2. If so, who owns it?
  3. Based on that, how do we bring it into the company upon formation?

Is there pre-existing IP?

Gizmo Labs is a potential trade name and trademark. Gizmoware is a potential trademark. Neither exists as such today and neither is essential to the venture (i.e. if either name is unavailable, Fran and Jamie can always pick another). Patent rights or copyrights in Gizmoware, however, are essential. Whether such rights exist depends on whether Fran and Jamie have advanced Gizmoware beyond the idea phase, such that it is a potentially patentable invention or copyrightable expression (code, detailed descriptions, diagrams, etc.) of the idea has been created. It is beyond the scope of this post to define the threshold for copyrightability or patentability, but each can be crossed fairly early in the process. In my experience, one or both have usually been reached by the time the inventors/creators are ready to form a company. In other words, by the time of incorporation, some IP exists, which means that someone owns rights in it. For our purposes, let’s assume this is the case for Gizmoware.

Who owns it?

Current/Former Employer

Let’s say that Fran and Jamie met in 2017 at OldCo Inc., where Fran worked until 2019 and where Jamie still works today. They first came up with the idea for Gizmoware in 2018, when both were still employed by OldCo. In their minds, Gizmoware is unrelated to any OldCo technology or product. And let’s say that they have advanced Gizmoware beyond the mere idea phase, including detailed descriptions of how the technology will work and perhaps even a working prototype. Can OldCo claim ownership of Gizmoware?

That’s a seemingly simple question with a complicated answer. OldCo might contend that Gizmoware is not unrelated to its technology and its development fell within the scope of Fran’s and Jamie’s jobs there. If so, OldCo would own any copyrights in it under the work-for-hire doctrine (works developed by an employee within the scope of his or her employment are owned by the employer). If Gizmoware fell outside Fran’s and Jamie’s jobs, but Fran and Jamie used OldCo’s facilities, equipment, etc. to develop it, OldCo could claim still claim patent rights. Determining who owns the pre-existing IP is crucial and not always easy. The first place to look is the current or former employer of each founder/contributor. Also, Fran and Jamie may have assigned rights to IP created during their employment to OldCo via employment agreements.

This scenario is not uncommon: entrepreneurs working on their brainchild on nights and weekends while holding down day jobs. Not surprisingly, employees and employers can disagree over what is or is not within the scope of the job and what does or does not constitute use of the employer’s facilities and equipment. A startup lawyer knows how to screen for this, at least to determine whether the employer might have a claim. If so, depending on the strength of the potential claim, the new venture may not be worth pursuing.

Hopefully, Gizmoware is unrelated to OldCo’s business and Fran and Jamie worked on it at home, on their own time, and on their own equipment. A good startup lawyer would know how to screen for any potential IP claims by OldCo.

Other Contributors

Assuming OldCo has no rights in Gizmoware, could anyone else? Has anyone other than Fran and Jamie contributed to it? If so, what did they contribute, and is it enough to give them co-inventor or co-creator status? In other words, do they own any rights in the IP? This is another potentially complicated analysis. I’ve seen clients draw the wrong (legal) conclusions in both directions, i.e., both over-valuing and under-valuing third-party contributions. As a result, they might assume joint-ownership where there isn’t any or sole-ownership when it is in fact joint. Again, their lawyer should know what questions to ask Fran and Jamie to help make the determination.

Founders

Fran and Jamie, as individuals, own their pre-existing IP. Remember, Gizmo Labs doesn’t exist yet. Even when it does, even when Fran and Jamie are shareholders working on Gizmoware within Gizmo Labs, their pre-incorporation rights in Gizmoware don’t automatically accrue to the company.

If there is pre-existing IP, it is owned by someone. To get the IP into the new company, we need a documented transfer from the owner to the company.

Getting it into the company

Pre-incorporation IP

Without an express transfer (assignment or license), Gizmo Labs doesn’t own rights in Gizmoware IP that was created prior to incorporation. Assuming that the post-incorporation development of Gizmoware will build upon the pre-existing IP, Gizmo Labs needs to own those pre-incorporation IP rights (or at least have the license to use it). If it doesn’t own or license those rights, it will be infringing on them as it develops and commercialized Gizmoware. This is an issue even if Fran and Jamie are the only pre-existing rightsholders, as a dispute between them could turn into an IP ownership dispute that could threaten the company. This is why angels, VCs, strategic partners, acquirers, et al. are so insistent on the company having clean title to its IP. Even if an infringement claim or other ownership dispute never arises, there is a cloud over the title to the IP. For a tech company, that’s a ticking timebomb.

We defuse this bomb, or we prevent it from ever being built, by making sure that Gizmo Labs obtains all the rights it needs in pre-existing IP at the outset, as part of the incorporation process. We obtain whatever assignments or licenses the company needs from whoever owns those IP rights. In doing so, we ensure that title to the IP is clean and thoroughly documented.

Future (post-incorporation) IP

The same principles and strategies apply to IP developed after Gizmo Labs has been formed. If the IP includes patentable inventions, we obtain assignments of future patent rights from employees and independent contractors who work on it. We actually obtain assignments of all rights in all IP created in the course of employment, including patent and copyright rights. Even if the company owns the copyrights automatically under the “work for hire” doctrine, it’s good to have the assignment as a backup. For contributions by independent contractors, we use a three-tiered approach: 1) work-for-hire treatment if the work qualifies; 2) an assignment of rights if the work does not qualify as work-for-hire; and 3) an exclusive license in case the assignment fails.

IP Strategy

In addition to clearing rights in any pre-incorporation IP and having ongoing assignments of IP rights, Gizmo Labs, like all tech companies, should have a basic IP plan from Day One. At a minimum, this means thinking about what the IP assets of the company are going to be and how they are going to be protected. What will be patentable and what patents will be applied for? What will be protected by copyright? Where will copyright notices be placed? Which copyrights will be registered? What trade names and brands will be used? Which will be registered as trademarks? With whom should the company have non-disclosure agreements to protect trade secrets and confidential information? Gizmo Labs should develop a more comprehensive IP strategy in its early stages of the company and this strategy should be revised on an ongoing basis. I will explore IP strategy in an upcoming post.

Summary

Tech companies, whatever their ambitions, start out as small businesses. But forming a tech company is different from other small business formations in a few significant ways, mostly driven by equity and IP considerations. Tech companies will generally incorporate – the LLC form doesn’t work as well for them as for others because of the need to bring in outside investment. They may have equity structures and equity arrangements different from other small businesses. They will need to focus on their intellectual property much more intensely than most non-tech startups, including pre-incorporation and post-incorporation IP. A good startup lawyer understands these differences and knows how to work with tech founders to address them.