What Are the 5 Biggest Mistakes that Startups Make Regarding IP?

by Scott Edward Walker on August 18th, 2010

Introduction

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Below is a longer, more comprehensive version.

Question

My co-founder and I are getting some traction on our new site, and we would like to raise some money from angels to hire a marketing guy and for a couple of other projects.  One issue that has come-up is IP.  We don’t have any IP documents.  All we have are the corporate papers we got from LegalZoom.  Could you give us some guidance about IP issues.  What are some of the mistakes that you’ve seen startups make regarding IP?

Answer

For many start-ups, intellectual property (IP) is their most valuable asset.  Here are the five biggest mistakes I’ve seen startups make regarding their IP:

Mistake #1 – Moonlighting at a Prior Employer.  Startups must ensure that none of the founders’ prior employers have any rights to the venture’s IP because a founder was “moonlighting” while previously employed.  This is a particular concern if the startup is in the same space as a founder’s prior employer.  Even a founder’s use of a prior employer’s computer or telephone in connection with the new venture could be a problem.

Accordingly, each founder should carefully review any agreements with his or her prior employer (e.g., an offer letter/employment agreement, a confidential information and inventions assignment agreement, a stock options agreement, etc.) and the employee handbook to determine if there are any provisions that may give the prior employer rights to the startup’s IP.  Founders should also make sure that when they leave their prior employer they don’t take anything with them (e.g., electronic files, prototypes, customer lists, etc.).

Under California law (regardless of what the agreements or other documents say), an employee owns any “invention” that that he/she developed entirely on his/her own time without using the employer’s equipment, supplies, facilities or trade secret information, except for those inventions that either: (i) relate at the time of conception or reduction to practice of the invention to the employer’s business, or actual or demonstrably anticipated research or development of the employer; or (ii) result from any work performed by the employee for the employer.

Mistake #2 – Not Assigning to the Company Any IP Created Pre-Incorporation.  A common mistake startups make is not assigning to the company in writing all of the IP that was created or acquired prior to the company’s incorporation.  Any IP created or acquired by a founder (e.g., code or a domain name) prior to incorporation is typically assigned to the company as part of the founder’s restricted stock purchase agreement or subscription agreement.

Indeed, the IP is usually contributed or assigned by founders as full or partial consideration for the shares of common stock issued to them in a tax-free transaction under Section 351 of the Internal Revenue Code.  A problem arises, however, if one of the founders leaves prior to incorporation and takes his rights to certain IP along with him.

Another problem often arises with respect to IP created pre-incorporation by outside developers or consultants (i.e., non-founders), particularly if the developers or consultants are located outside of the United States.  The IP created often never gets assigned to the company at all either because there was no written agreement or because the company was not a party to the agreement (because it did not exist at the time).

Mistake #3 – Not Executing Confidential Information and Invention Assignment Agreements.  Once the company has been formed, the ownership of the IP should be protected by requiring all of the Company’s founders, employees and consultants to execute confidential information and invention assignment agreements.  Unfortunately, a lot of startups do not require founders, employees or consultants to execute this kind of agreement and run into significant problems with respect to IP ownership.

IP-ownership problems often arise in the context of an angel or VC financing, when the investors are unable to establish a clear chain of title to the startup’s IP as part of their legal due diligence investigation.  Chasing down third parties to execute invention assignment agreements in the context of a financing is not a prudent business approach.

Mistake #4 – Infringing on Another Company’s Trademark.  Another common mistake startups make in connection with their IP is infringing on another company’s trademark.  A trademark is a word, name or symbol etc. that is intended to distinguish a company or product (e.g., Google, Amazon, Zappos); in short, it’s a brand name.  A startup may not use a name or mark that is “confusingly similar” to a name or mark used by another company.

Just because a startup is able to register a certain domain name (or a corporate name in the State of its incorporation) doesn’t mean that it has the right to use a particular trademark.  This is a common misconception.  In order to have the legal right to use a trademark, a company must either (i) be the first to use the mark in interstate commerce or (ii) be the first to register the mark with the U.S. Patent and Trademark Office (USPTO), whichever comes first.

It is therefore very important that startups consult with IP legal counsel early on or, at a bare minimum, do a Web search and a search on the USPTO site to determine whether their use of a particular word or name will possibly infringe on another company’s trademark.  The last thing a startup wants is to start getting some traction and then get nailed with a trademark infringement lawsuit.

Mistake #5 – Not Developing and Implementing an IP Protection Strategy.  Finally, another big mistake that startups make (particularly technology companies) is not developing and implementing an IP protection strategy.  If a startup’s most valuable asset is its IP/technology, it is self-evident that reasonable steps must be taken to protect that asset.

Many entrepreneurs do not understand that IP protection comes in different forms, and one size does not fit all.  For example, “trade secret” protection may be a more effective method to protecting software than a copyright or a patent; or perhaps using all three is an even better option.  The bottom line is that founders of technology companies need to sit down with experienced IP counsel and identify all of their startup’s IP.  They then need to come-up with an effective, reasonably-priced strategy to protect their IP assets.

Conclusion

I hope the foregoing is helpful.  If you have any questions, please feel free to email me directly at scott@walkercorporatelaw.com.  Many thanks, Scott

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4 Responses to “What Are the 5 Biggest Mistakes that Startups Make Regarding IP?”

  1. Rtarasi says:

    In the early days of a start-up, pre-funding and therefore pre-cash compensation, what are the co-founders considered – employees, consultants, or something else? The Invention Assignment Agreements that I’ve seen always seem to be written for consultants or employees. Does that mean that you need to make the co-founders employees (through employment letters/agreements) or consultants (through consulting agreements), even if they aren’t receiving any cash compensation from the start-up? This question also impacts the founder’s stock purchase agreements, where vesting is based on “Continuous Service Status” which also typically is defined as being an employee or consultant.

  2. Co-founders are usually “employees,” as reflected in their respective titles (e.g., CEO, CTO, etc.); however, there may be certain situations where a co-founder is a consultant (though it is not recommended) – in which event, it would be prudent to have a consulting agreement to reflect the rights and obligation of the parties. Moreover, you can certainly have employment agreements with the co-founders, but that’s generally not done at the pre-funding stage. Indeed, there must be a certain level of trust and chemistry between or among co-founders to make the venture work. (The Restricted Stock Purchase Agreements generally serve as adequate protection.)

  3. Rtarasi says:

    Thanks for the quick response! Can I assume that if co-founders are “employees” but not paid salaries initially, that it doesn’t create any IRS compliance-type issues or require different or more frequent federal/state filings? I assume that when you actually begin paying salaries and therefore begin to deposit payroll taxes you begin those various filings?

  4. No, I would not assume that it doesn’t create compliance problems. Indeed, this is a tricky issue, particularly in California. Take a look at this article: http://bit.ly/bdEJpW