Thursday, 5th July, 2018

A guide to angel investing and IP due diligence

Investing in early-stage ideas can be a high-risk investment strategy. The crystal ball comes into play a lot, especially around intellectual property (IP). The cost of conducting thorough IP due diligence can be expensive, but there are some easy wins to be had.

Establishing a start-up’s IP position

IP is often the only asset a start-up owns and therefore should be carefully protected right from the start. Even for the larger corporates, the relative value of IP in the assets ledger of innovative companies has increased significantly over the last 20 years.

 OceanTomo SP500 2016

Establishing an IP position does not need to be an expensive strategy, but a strategy needs to exist. By solidifying the IP position, options for long-term competitive advantages are preserved for the next phase. The next phase could include better funding or an acquisition by a larger company, which can convert the budget-constrained IP of a start-up to stronger IP. But to do this, the IP position of the start-up must be preserved from the start. Whilst the first-mover advantage of a start-up is important too, these days copy product is able to be produced and marketed quickly. In addition, New Zealand start-ups are often underfunded to be able to give the first-mover advantage any real legs.  

Start-ups won’t have an exhaustive IP portfolio. Furthermore, protecting IP comes at an expense, something start-ups can’t always afford and something angel investors must realise. An angel investor can’t expect a start-up to have all of its IP tied up nicely. Often start-ups are coming to angel investors to raise money, some of which is intended to be used to better protect the IP.

The IP journey for a start-up

All new ideas start out as a trade secret. Trade secrets are IP and do not need to be registered or even written down. A trade secret may be:

  • a new product design

  • a formulation

  • an algorithm

  • a new business model

  • data that identifies holes in a market or that can deliver new services to a market.

These are all secret. If unique, they are a trade secret.

The best thing about IP in the form of a trade secret is that it’s free, which is great for a start-up. But some product or services cannot stay as trade secrets forever. Trade secret status is lost when someone else does the same thing independently, or reverse engineers a product or service, reliant on public information.

As an angel investor looking at the IP position of a start-up, it is important to ascertain that the:

  • start-up’s IP position is intact and that it’s not too late to improve on it (eg, if the IP is claimed to be trade-secret then has the start-up utilised non-disclosure agreements? When and what they have disclosed to the public? What they have kept secret?)

  • start-up has an IP strategy. 

Most hardware innovations are really hard to keep as trade secrets. For business models and software-based businesses, trade secret status can be easier to retain, but not always. Google’s proprietary search and ranking algorithm has been kept a trade secret. Now with big data backing-up the algorithm, Google’s search engine has a huge commercial advantage. Timing and scaling was critical for Google’s success, something which many start-ups don’t have the benefit of. At some stage, a decision needs to be made about whether trade secret protection is sufficient and can last long enough maintain its value to the business or whether other forms of IP are appropriate eg, patents, copyright, designs, or a combination of such. 

For most technology, it’s usually a decision between keeping all or part of the innovation as a trade secret or filing a patent. But patents need to be filed, if justified, before an invention is published or released commercially.  If a product or process is made public or commercially used, it’s usually too late to start the patent process.

The decision on the right form of IP needs to be made early and preferably before publication or commercial use of the subject of the IP. This decision is based on the: 

  • right form of IP and whether the start-up is eligible for it

  • cost of the IP versus the cost of not having it.

If it’s mission-critical IP, then the start-up needs to budget for and/or raise funds for it. 

Investor’s due diligence

In this section, we mainly focus on patents, as patents are the most commonly misunderstood IP.

So, you are told the start-up has a patent…sounds perfect! However, the investor needs to delve a little deeper.

  • Is it a granted patent, or pending patent?

  • What stage is the patent application at, and where has it been filed?

  • Does it have the ability to be filed into other countries still?

  • Has it been published, or the subject of the patent application disclosed?

  • Who was the patent prepared by? A specialist IP firm, or self-filed by the start-up?

More due diligence can be undertaken to determine whether the patent application is likely to lead to valid and commercial valuable protection. Costs to perform due diligence start to increase at this stage, so the amount the investor spends should be in keeping with the amount of money being invested.

Patents do not always equal valid IP. Early stage companies sometimes think they are onto something unique, or want to portray that they are, so they file a patent application with claims that are too broad. The patent application looks great on paper, but can lead to an invalid patent. Sometimes start-ups have enough resource to do a good prior art search and mistakenly file a patent on something they cannot patent ie, their broad concept is old. Be suspicious of these broad patents. 

But all is not lost. Often it’s concept product that is subject to the broad patent. Once the product is launched and receives market feedback, then it’s the improvements to the concept, or the minimum viable product, where the mission-critical IP resides—potentially in the form of a narrow patent, but still really useful eg, a patent for the wheel turns out to be old, but a tyre for the wheel is not. So patent the tyre, which will then stop others making a more user-friendly wheel.

For trade secrets, investors need to determine the following.

  • Is the secret new? If it is, who has seen it?

  • Is the start-up aware of its trade secrets?

  • Has the start-up taken proactive steps to protect its trade secrets?

  • Has the start-up used non-disclosure agreements and made it clear that its subject is secret?

  • Who is it in the start-up’s ‘cone of silence’? Who knows about the technology?

  • Can the trade secret stay secret, even when the product is in the market?

IP due diligence can be a daunting undertaking. But an IP specialist should make the process easy and keep the project to a realistic size relative to the investment.