Spinning out - legal issues following invention

Materials World magazine
1 Jan 2010

If you develop a new technology, what happens next? A legal perspective is provided by Dr Alan Bates of legal firm Reddie and Grose, and Charles Fletcher of Taylor Wessing LLP, both in the UK.

On developing, say, a practical high temperature semiconductor, you may want to set up a new company. All you need to become the world’s first superconductor magnate is a backer with pockets deep enough to get the business off the ground.

The solution may be venture capital (VC). This is an all-embracing term describing investment in companies with growth potential that are developing novel technologies, or new applications of existing technologies. They are normally young businesses and, from an investor’s point of view, high risk, with about 50% of venture-backed companies failing to return their capital to investors.

Spin out companies seeking VC investment have a risk profile that banks would not conventionally lend to, as they usually have few assets beyond intangible, difficult to value – intellectual property (IP). Many materials science ventures do not have a product that is ready to sell immediately. There may be many years of development to undertake before going to market.

In attracting the right VC for your needs, you should have knowledge of their expertise as well as their money. You should approach VC funds with a track record in materials science ventures, who understand the opportunity provided and will provide access to their contacts and sector knowledge.

Patent power

A VC fund will want to see that the invention is potentially defensible. In the field of materials science, the most important IP right is, almost invariably, a patent. They can be granted for a new and non-obvious technological development. Therefore, at least one patent application needs to be filed.

Beyond a basic filing, the proposed patent filing and prosecution strategy will be of interest to the VC funds. You need to think about what to protect and where.

Ideally, as many different aspects of the invention as possible should be protected. Using the superconductor example, it is fairly obvious to protect the composition of the alloy, but how about the method of making it? Would a wire extruded from the alloy be protectable, or commercially valuable? What about a component using the superconductor? Do you have a new understanding of the material’s properties that would allow novel products to be developed?

It is relatively cheap to file a patent application in the UK, but patent protection is territorially limited. This means that protection in the USA can only be provided by a US patent and, likewise, protection in China only by a Chinese patent.

To protect an invention in every country may be desirable, but is usually prohibitively expensive. Fortunately, there are procedures allowing filing of an initial patent application in one country and use of this as a basis for foreign applications filed up to a year later that can claim the same ‘priority date’ as the initial application. There is also an international application system that allows further deferral of the decision over territories. Using these tools, major costs of filing patents in many countries can be deferred until up to two and a half years from the initial application. This time can be used to apply for VC to fund the, significantly more expensive, later stages of obtaining patent protection.

If the invention relates to mining or extraction, it may never be used in the first world. In this case, there may be little value in applying for, say, Japanese patents. Likewise, a materials processing invention may require large supplies of cheap electricity. If the raw materials can be economically transported to any country, then perhaps patents in countries with hydroelectric or nuclear power generation will assume greater importance.

A patent application needs to be filed before any aspect of the invention is publically disclosed. In a university setting, this often causes a conflict of interest with the academic obligation to publish papers. With this in mind, it is good practice to constantly evaluate your work prior to publishing to assess if there is anything that may be commercially important.

There are other forms of IP that may be of value when applying for funding. Does your product or process require proprietary software? If so, there are copyrights involved. Are parts of the invention based on long experience or ‘black art? Is there secret technical know-how? A VC will need to see that all forms of IP have been identified and protected.

Make sure you own the IP and that it is clearly registered in the company’s name. Many start-up companies fail to ensure that they own all of the relevant IP rights.

Identify hurdles

Some problems are not apparent when performing an invention at the laboratory scale. Is safety regulation likely to be an issue? Will a new medical device need clinical trials? Identifying and considering such issues before applying for VC funding is more likely to inspire confidence than if they arise for the first time during due diligence.

Bear in mind that VC investors are interested in growing the business quickly. Not only will they expect to have rights to certain information and a say in key decisions affecting the business, but they will often appoint directors to the Board. They will also be working towards an exit from the company, such as by trade sale or public floatation, typically within five years of their initial investment. The company needs to prepare for a cultural shift to focus on its business goals.

Try and talk to others who have been through the process. Before seeking VC money, it is worth familiarising yourself with typical equity investments. A good starting point is A Guide to Venture Capital Termsheets, produced by the British Venture Capital Association. Bring your own advisors on board as soon as possible – they can offer detailed strategic advice and may be able to introduce you to potential investors.

Different factors influence the amount VCs are prepared to invest at various stages in the lifecycle of a company. However, the omnipresent factors are:

• Management. Good managers can make a success of weak technology, and poor managers can make a mess of fantastic technology. As a potential manager of an early stage venture it is imperative that you inspire the confidence of potential investors and have a compelling business plan. Long-term VCs may demand that new executives be brought in.
• Under-served customer need. You must show a gap in the market for your product, and preferably the market should be a fast growing one with global potential.
• Defensible market position. Barriers to entry are essential. You not only need to adequately protect your own technology (with patent protection), but you should also consider whether any competing technologies could take your market.

Risk assessment
Before making the decision to invest, VCs will conduct a thorough risk analysis. There are two key types of commercial risk a VC investor will be faced with on any given investment – technology risk – does the technology work? and market risk – will people want to buy the finished product at the likely price? These questions must be answered in your business plan.

A VC’s due diligence exercise will be crucial in reviewing commercial risks and ensuring that they are getting what they think they are. This process will include market/competitor analysis and legal due diligence, which is likely to focus on IP, the trading arrangements, contracts, corporate structure, accounts, insurances, records and business plans will all be scrutinised. The business must be presented in the most favourable light and you should set up processes to keep the business shipshape from the outset – not just for governance, but to create the right impression with prospective investors.

Such risk analysis and fact-finding will be important elements of the VC’s post-money valuation of the company and the percentage of the equity it wishes to hold. These are the economic fundamentals of the deal that you should try to make as favourable to you as possible. The specific terms of the investment documentation, such as share rights and management incentives, can drastically alter the economics and you should seek advice in this regard.

Great science does not necessarily make good business. But if you have a useful technology, you have every reason to be optimistic about obtaining funding in any economic climate. However, give your approach some thought. In many cases, producing a commercially important invention is only the beginning.

Further information: Charles Fletcher