Intellectual property issues are becoming increasingly important to venture capital investment decisions, speakers said at a recent American Bar Association webinar.
As defined by the US Securities and Exchange Commission, venture capital (VC) holds no more than 20 percent of its fund’s capital commitments in debt instruments, publicly traded security, foreign-issued securities and certain leverage portfolio companies, ff Venture Capital Managing Partner & Chief Financial Officer Alex Katz said at the 18 January webinar. It doesn’t borrow or otherwise incur leverage, or offer investors redemption or similar liquidity rights except in extraordinary cases. Such an investor represents itself as pursuing a capital venture strategy; it’s not registered under the Investment Company Act and is not a business, he said.
Investors in VC funds include wealthy individuals, family offices, accredited investors, institutions, hospitals, unions and others, said Katz. VC funds invest in all stages of a company’s growth, he said.
Due Diligence Different for Biotech, Tech Investment
Investment in biotech is intensely centred around IP, while in technology it is less so, said Wilson Sonsini Goodrich & Rosati LLP (San Francisco) patent attorney Vern Norviel. Technology products require many patents, which companies use as trading cards but which are often not exclusive, he said. The number of patents needed to market a biotechnology product is often fewer than 10, negating the need for trading patents or giving another company the right to make the product, he said. But because the funding required for technology innovations is frequently in the tens or hundreds of millions of dollars — while placing a drug on the market can cost $1.5-2 billion — investors often require total exclusivity and no patent trading, he said.
The diligence process for the two products is different, Norviel said. With tech companies, funders look first at market, pricing and sales, while in biotech, if a drug is shown to be effective, there is an assumption that there will be a huge market for it (or no market at all, if its fails), he said. The number one issue for investment in biotechnology is therefore exclusivity: VC funds will usually require that the patent owner be able to block others from using the patent and to show that no one else has a patent that could be used to challenge it or require cross-licensing.
Investors in biotech focus hard on whether the science will work, unlike with tech products such as apps, Norviel said. IP due diligence is much tougher for the life sciences because investors want to know what they’re buying and whether they can sell the product to a large company with freedom to operate (FTO) and stop others from competing, he said.
Hot topics in biotech investment diligence include IP ownership, Norviel said. Would-be investors have always examined patent assignment documents, but the investor community is now concerned about whether previous employers of significant employees, such as a university or another business, could lay claim to a patent, he said. Other areas of investigation include whether there are any employments contracts or consulting agreements in place that cover future investments; and whether there are grants or scientific publications that might reveal prior art, he said.
“Viral” Free Software a Worry for Tech Investors
Funding software and tech start-ups also raises IP concerns, said Katherine Gardner of Gunderson Dettmer Stough Villeneuve Franklin & Hachigian LLP (New York), who represents tech companies and venture firms.
One issue is the selling company’s use of open source software, Gardner said. Open source is provided under a licence under the Open Source Initiative which requires redistribution without payment and allows users to modify and create derivatives, she said. Some open source licences, such as the GNU General Public License, are considered “viral” or “copyleft,” meaning that licensees who use the code must licence their entire work to anyone who comes into possession of a copy. This worries VCs, Gardner said. Among other things, they will want to know how a company tracks its use of open source and whether it has policies in place to prevent misuse.
Employment-related issues are another key concern, Gardner said. There may be prior employees who claim to own the IP, or who may be violating a non-compete or other agreement, she said. Among other things, VC investors need to know whether the founders of the company seeking funding came up with their idea while working for someone else and whether they have assigned all IP they developed to the new company, she said.
Diligence for Multinationals
For enterprises seeking investment for a global business, there are additional IP-related considerations, said IP attorney Guillermo Carey of Carey Abogados (Chile). Among these are whether the company should separate its operational arm from its IP arm for tax purposes, he said. US ventures and VCs prefer to invest in US companies, but that could lead to 30 percent holding tax rates as opposed to less expensive rates in other countries, he said.
Other potential concerns are cross-border transfer of IP assets, and ensuring that when a patent licence ends, the local licensee can be stopped from continuing to use the technology, Carey said. In addition, the level of knowledge about IP risk is low outside the US, so providing reassurance about IP due diligence and warranties on IP is difficult, Carey noted.
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