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No Protectable IP? Maybe No Funding

May 15, 2008
I was recently a presenter at a conference on raising investment capital for early stage and emerging companies. One of my co-presenters, John Ason, is an angel investor and the other presenter, Jonas Wang, Ph.D., is a partner in Sycamore Ventures, a venture capital fund.

In their presentations, both John and Jonas described their funding criteria, which was fairly textbook for an angel investor and venture capitalist. John invests in early-stage, pre-revenue companies where his technical and business background can provide some value-add to management, and Jonas invests in later stage opportunities, for example a B, C or D round financing.

What I found unusual about John's and Jonas' funding criteria was that they both require an investment candidate to have intellectual property that is patented (or patentable) as a condition to funding. That is, if a company seeking capital does not have patentable IP, neither John, nor Jonas, will consider the company as an investment candidate.

Quite often, early stage investors prefer investing in companies with exciting intellectual property, or the existence of unique intellectual property forms an important part of an investor's overall investment decision. However, this was the first time I had heard investors say definitively that they wouldn't even consider funding a company if it did not have patentable intellectual property.

This made a bit more sense to me with respect to Jonas, whose venture capital fund invests in only med-tech, biotech and pharmaceutical deals--companies whose success and failure rides on their scientific inventions and ingenuity. But the criteria made less sense to me with respect to John, who proclaims to be industry agnostic and has invested in deals that range from toys to new media and software.

According to Amy Goldsmith, a patent attorney with Gottlieb, Rackman and Reisman, P.C., investors prefer companies with patented (or patentable) technology for two reasons. First, in order to obtain a patent from the United States Patent & Trademark Office (USPTO), the governing body that issues patents in the United States, the company has to prove that its idea or invention is useful, new and that the technology is not obvious from what has been done before. In essence, the invention is prescreened by the USPTO to have good chance of being economically viable and that it is something that hasn't been seen in the marketplace before. Good news for investors.

The second reason investors prefer companies with patentable technology is that once a patent is issued, the company has the exclusive right to use that technology for a period of 20 years. That is, management can prevent any other person or entity from exploiting their technology for commercial gain, reducing or eliminating competition.

For an investor like Anson, who expects that only one in 10 of the companies he funds will ever produce a return on his investment, patentable technology is one of the principal ways he increases his odds for a successful exit. "Most of the companies I fund are two people in a kitchen or garage" claims Anson. The companies Anson invests in need every competitive advantage they can get to survive. A "keystone" or "fundamental" patent, business terms for very strong patented technology, keeps competitors out of the market.

As opposed to a company with an "execution" business model, where the company's success hinges on management's ability to execute their business strategy faster, bigger and cleaner than their competitors (and where, however, a competitor can easily jump into the market to compete), a company with a business model built around one or more pieces of patentable technology can stop everyone in its tracks that tries to duplicate its products or services.

Says Anson, "unlike an execution company, if a company with a business built around a keystone patent makes mistakes or even fails in the execution of its business plan, it can still survive."

Interestingly enough, Amy Goldsmith notes that she rarely, if ever, sees funded early-stage companies that have patents at the time of funding. The patent office is so delayed with respect to its evaluation of patent applications (according to Goldsmith, it can take three to four years for a patent to be issued), that companies are frequently past the early stages of their development by the time a patent is issued.

In lieu of having an actual patent issued or a patent application pending, Goldsmith suggests that VCs and angel investors may require funding candidates to retain a patent attorney to perform a "patentability search" prior to, or as part of, the investor's due diligence investigation. During a patentability search, the attorney researches the USPTO's database of issued and pending patents to see if someone else has previously applied for or received a patent for the technology in question. The result of the patentability search will determine whether a company has a good chance of obtaining a patent or if they need to scrap the idea and move on. Investors will rely on the results of this search when determining whether or not to participate in a deal.

John Anson is a bit more forgiving when it comes to requiring patentability searches or pending patents when he assesses a candidate for funding. Patent applications can be costly to prepare and often start-ups do not have the cash to pay for searches and applications. In this case, John relies on his extensive technological background to make his own determination as to whether the company's technology has a reasonable chance of obtaining a patent. He researches the USPTOs database much in the same way that a patent attorney would. This information is available to the public for free at the USPTO's website (www.USPTO.gov).

According to Dr. Wang in his presentation at the conference, the type of patent you obtain is also an important factor when investors assess whether they will make an investment in your company. The USPTO issues several kinds of patents, including design patents that protect the ornamental design of a functional item such as jewelry, furniture, beverage containers and computer icons; utility patents that protect the functionality of a given item; software patents; and biological patents.

However, according to Dr. Wang, investors have a certain amount of disdain for business method patents, which are a class of patents that disclose and claim new methods or processes for doing business.

Amy Goldsmith concurred with Dr. Wang's assessment. It seems that the USPTO previously issued a significant number of business method patents and, as a result, patent owners had difficulty enforcing their rights under the patents. Further, according to Anson, because the description of the technology or method underlying the patent becomes public information within 18 months from filing, competitors can study a company's business process and fairly easily design another process to go around the patented method. This actually puts the patent holder at a disadvantage as compared to never obtaining the business method patent at all.

The public's easy access to your technology when you file and obtain a patent strikes a nerve with some entrepreneurs. I spoke with an entrepreneur recently who was holding off on filing any patent applications until he achieved some commercial momentum with his invention. He feared that once the details of his invention became public that a company in some far reaching province in Asia may try to steal his technology. Instead, he was going to rely on keeping his invention a trade secret for the time being.

Says Goldsmith, "depending on how easy your invention is to duplicate, there definitely is some truth that if your invention takes off, certain companies will copy it." If you haven't filed in Asia for a patent protection to prevent your invention from being copied, you will have little recourse.

According to Amy, the problem of enforcing patents in Asia is improving, but still isn't great. "It will be another five to 10 years before we see a legal system that's capable of enforcing patents, but it is getting better."

My conversation with Amy Goldsmith was enlightening, and I learned a number of new things that would be important considerations for companies who want to protect their IP. These include:

* Budget. Make sure you have a budget in place to pay for searches and patent applications, which can start at $10,000.

* Timing. You only have one year from the use of an invention in commerce to file for your patent. If you're thinking of filing, give yourself enough time to do searches and prepare the application.

* Scrutiny. According to Goldsmith, nearly 99% of patent applications will initially be rejected by the USPTO. The applicant (or his or her attorney or agent) must then appeal to the USPTO in order to demonstrate why the invention is patentable. This second step to the patent application process can be costly and is an expense that will be in addition to the $10,000 fee for services related to the application process.

* Expertise. Given the high percentage of patent applications that get bounced by the USPTO after the initial filing and the fact that you cannot make changes to an application (except to fix grammatical errors), even if you have a technical background, it's in your best interest to retain patent counsel to prepare your patent application.

* Ownership. Patent applications can only be filed in the name of a person who invented the patent, not a company's name. Therefore, if your employee has created an invention for your company, then you need to have invention assignment language in an employment contract or have at will employees (those without an employment contract) sign an assignment of inventions agreement.

* Monitoring. Because the US system for protecting patents is one of exclusion-no one else has the right to use the technology--it is the patent owner's responsibility to make sure that others are not infringing on issued patent rights. It is prudent to put a system for monitoring your patented inventions in place and have a budget for enforcing your rights.

Interested in starting or funding a company that has a business model built around a piece of patented technology?

Got concerns about protecting your intellectual property?

Consider attending the seminar we are sponsoring on May 9, 2008, called "Patents & Trade Secrets: How to Protect Your Company's IP".

Amy Goldsmith will be our featured speaker. Details are included in this month's newsletter.
About the Author
Stephen Furnari is a securities attorney with Furnari Levine LLP. Though his Funding Blueprint workshops, Stephen trains entrepreneurs how to raise investment capital. To get a FREE copy of Stephen's Special Report Finding Your Match: The Art of Meeting the Right Investors go to http://www.AlternativeFundingStrategies.com.
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