Thursday 4 September 2014

Intellectual Property due diligence on start-ups: Part 2

The reality for most start-ups is that at some stage of their journey they'll need to get in front of potential investors who will want to shine a light on different aspects of their business, including their IP.

In part 1 of this series, I provided a checklist of the types of questions an IP specialist might ideally seek to answer when conducting IP due diligence. In the very preliminary stages of a discussion with a potential investor, a start-up may not be willing or able to answer these questions. More often than not, this will be due to budgetary constraints. For example, they may be raising capital to spend on a freedom to operate (FTO) search or to secure certain types of IP, or both.

I've been involved in IP due diligence work costing in excess of $100k for companies that are about to list, or as part of a sale and purchase transaction. The cost of getting it wrong and missing relevant IP issues in such circumstances can be very consequential and a large spend on IP due diligence is warranted. However, for start-ups, where the stakes aren't yet as high, a shoestring due diligence process is usually sufficient – one that looks for the low hanging fruit that may be rotten or that are export quality.

The three most critical IP due diligence questions I ask before investing in a start-up are:
  1. what IP have they already protected or can they still protect?
  2. do they have freedom to operate?
  3. do they own the IP they purport to have?
Even if the start-up is unable to answer these questions with certainty, it's still worth asking some high level questions. Here are nine quick areas to explore:
  1. Are the core value drivers in the technology protected by patents or by trade secrets?  You will want to know if their business model is going to rely on the trade secret route or the patent route. The trade secret route is potholed with risks that others may steal the secrets or independently derive them. The patent route is expensive. Perhaps they are a 'me-too' model company, in which case the only form of IP that may be applicable is brand protection and copyright.
  2. Have they had positive results from patentability searching? How much have they spent on this?  A cheap, low cost, but not very conclusive patentability search done by an IP firm may cost around NZ$1,500-$3,000. Depending on the technology, a thorough patentability search may cost NZ$4,000+.
  3. Have they done any FTO searching for IP rights of others in countries where the product or service will be used or sold?  An FTO search and opinion on infringement risks in the USA will cost no less than NZ$7,000 depending on the technology.
  4. Who has done the IP work?  There are good and not so good IP advisors around. For technology-based IP, it is important to ensure that the IP advisor is qualified in the same technical field as the technology in question. Many patent attorneys have degrees in software, electronics, biotech, mechanical and chemical engineering. They know the technology, know what it takes to design around IP protection, don’t need to spend hours being brought up to speed, know where to conduct prior art and FTO searching and may sometimes make valuable suggestions to improve the technology even further.

    AJ Park 500x284
  5. If the patent route is to be followed, find out what stage they are at and see if the spend per invention is at least the amount shown it the timeline below, at the appropriate phase of their protection process.
  6. If they are pre-provisional then a very important question to immediately ask is, 'have you kept your IP confidential?'  All ideas start off as a trade secret and this status must be maintained until the provisional application is filed if the patent protection route is going to be pursued.
  7. Some patents are filed as window dressing. Ask about earlier technology and if any searching for such has been done. Seeing the current state of the art will help you understand what their patent will never cover. A patent cannot protect what is already in use or published. For early stage due diligence and when the investment is low, you can take a low cost approach to figuring out the usefulness of a start-up's patent application. In fact the start-up may not be prepared to show you the patent specification. In which case, find out what advantages the start-up's technology has over the current state of the art.  Advantages may be a lower cost of manufacture, easier maintenance, better efficacy, better shelf life, easier to transport or to use, more features, safer, quicker, visually more appealing, better monitoring, more reliable, higher granularity etc.  If it has no advantages, then the patent application is likely to have little value.
  8. Be very wary of trade secret protection for technology. Trade secrets are vulnerable to theft, reverse engineering and independent design.  Ask if the trade secrets are able to be kept so forever. Know about the industry and any obligations for information to be revealed for public safety reasons. For example, food labeling requirements often result in the secret sauce being revealed.
  9. In the software or online space you can quickly check if the technology or product is old.  At a recent investment evening, I heard about a clever smartphone app. A quick search on the app store showed that the market was pretty crowded already. I was also able to find that the brand they had selected was going to run into trouble with an existing trade mark registration showing on www.iponz.govt.nz. You can also get onto Google patents and do free patent searching.  But if your investment is high then it pays to get a patent attorney experienced in the specific field of technology to do some searching for you. If they find an existing solution to a customer's pain point that is equally as effective as the technology of the start-up company, then the IP position of the start-up may not be strong.

The key message is that there are a number of pragmatic tools and high levels questions that can be used to assess the IP position of a start-up, not all of which involve high costs. Whatever you do, don't skip this step – it can yield useful and valuable information for investors and founders alike.

*This was originally posted on The Icehouse website.