The Entrepreneur’s Dilemma: Pre-Existing IP

So you and your co-founder have it all worked out.  You’re going to launch the next Web 2.0 business, raise a bit of venture capital and go public as soon as the markets re-open.  You’ve created an incredible software application and your partner, as a participant in an IPO during the last Internet boom, will contribute the capital.  You create a Delaware c-corporation, document each of your ownership interests, document your partner’s capital contribution and away you go.  The business starts to grow, you decide you’ve found a better outlet for your software, you take off with your intellectual property, the business is dead and your partner’s investment is worthless.  Huh?

The pre-existing intellectual property issue is one faced by many a start-up, and one which is ignored by just as many.  What to do?  Lots of options here, a few of which I address (at a very high level) below:

  1. Taxes – Putting aside ownership issues, if one shareholder contributes $1,000,000 in return for his common stock in an entity and the other shareholder contributes Bubkes ($0 for those that do not speak Yiddish) for his equal interest, the shareholder, which in essence received his shares for free, will pay taxes upon receipt of those shares.  Paying Uncle Sam a substantial amount on account of the receipt of illiquid shares is an unsatisfying result to say the least, but what if the non-paying shareholder were to contribute to the entity a software platform worth somewhere in the neighborhood of $1,000,000?  That’s all well and good from a taxation standpoint, but what if…..
  2. Trust – … the shareholder which coded the killer software application doesn’t fully trust his soon-to-be business partner?  (One obvious solution is for the non-trusting shareholder to run the other way as fast as he can, as a lack of trust at the outset often mutates into paranoia and extreme dislike when the going gets tough for the nascent business, but I digress).  If you throw the intellectual property into the entity pot and things head South as feared, your once-partner-now-enemy, as a 50% owner of the software, now has just as strong a claim to that property as you do.  This is what’s known as a “bad situation.”  Beyond co-founder issues affecting decisions regarding the software, you also have to be concerned with …..
  3. The Outside World – vendors, creditors, alliance partners or any other third parties which decide they don’t like something your new entity is doing.  In  this country, such disgruntled parties are free to sue your business.  And if you lose and don’t pay, they’re free to obtain a judgment lien against your business.  And if you still don’t satisfy your judgment, they’re free to foreclose on that lien and sell off parts of your business.  And if the software is an asset owned by the business … well, you can see where this is going.  So the tax benefits associated with this option are good, but the IP risk falls into the bad category.  So, after consulting with your attorney or reading this blog entry, you decide …
  4. It’s Mine.  … to heck with it, I created this masterpiece and I’m going to retain ownership over it.  You decide to keep everything in your name, and you’ll work with your tax advisor to avoid paying taxes on the initial issuance of equity to you (this is a topic for another day).  Many a founder, in making this decision, simply retains the intellectual property and assumes the entity has some sort of divine (and undocumented) right to use it (another issue for another day), but not you – your attorney has convinced you of the need to execute a valid license agreement with the entity laying out the terms of your license to the corporation, fees due and owing to you (if any), term of the license, etc.  This is all good and well until you realize (i) the venture capital investor who otherwise loves your business isn’t so hot on the idea of the most valuable asset of the business residing with one of the founders rather than the entity into which they are about to invest, and (ii) an aggressive plaintiff’s attorney, should they decide to not only sue the entity you’ve created but everything related to the entity in any way, may now name you personally in a lawsuit as the owner of the entity’s principal asset.  Ugggh.  On to Plan E, which has you…..
  5. New Entity.  … contributing your intellectual property into a new entity “IP Entity” which will license the software to the operating entity.  That takes care of the personal liability issues, but what about the irate VC investor?  Well, maybe you also decide that the IP entity will be the parent company of the operating company, so the VC can invest their funds into the IP company rather than the operating company and in so doing, gain direct ownership in the valuable software and indirect ownership in the operating company.  Eureka!  But of course this raises other issues, including, among others, your co-founder’s ownership interest (or lack thereof) in the new IP entity and the nagging tax issues described above.

So is there any take away here?  Well first and foremost, elementary as this may appear, address the intellectual property ownership issue at the outset.  Document intellectual property ownership, licensing (if applicable), contribution, etc. as precisely as possible when creating the entity with a partner and launching the business, as IP confusion and/or disputes become far more difficult to resolve as value is built up in the entity and investors start to come to the table.  If you want the simplicity of contributing software to a single entity, that’s fine and well – just make sure this contribution is clearly spelled out in the documents and, if you really want to get out ahead of potential pitfalls, include buy-back language allowing you to retake the software in certain, defined situations.  If you want your IP protected in a separate entity unbeknownst to creditors and other potential claimants, put a license agreement in place and consider ways in which you can get potential investors comfortable with the arrangement.

Avoiding Intra-Founder Headaches

Starting a business – at least the part which precedes the execution phase – is an exhilarating experience.  Excitement abounds as hockey-stick shaped revenue projections migrate from the pages of the business plan into cocktail party chatter.  And of course, the founding members of the business not only see eye-to-eye on all of the material issues affecting the company, but are in fact best friends for life.

The launch of any new business venture tends to put rose colored lenses over the eyes of the creators of the company.  The real world, unfortunately, tends to set in rather quickly once the honeymoon phase is over.  Minor disagreements between or among the founding partners often grow over time, sometimes reaching a point where these once-unified world beaters are no longer on speaking terms.  It’s at this point that many a founder surreptitiously approaches legal counsel to find out what they can do to fix this untenable state of affairs.  And more often than not, when said legal counsel learns that said founder failed to anticipate and work through any of said issues at the outset, a rather discouraging message is delivered – you’re stuck.

So how does one avoid this mess?  Let’s rewind back to the entity-creation phase:

  1. See a Lawyer.  Bring in a mutually-agreeable attorney while everyone still has a smile on their face.  That’s the right time to discuss both the good and the bad, and seek common ground on the litany of thorny issues which inevitably arise over time in growing a business.
  2. An Odd Board.  While there are myriad management issues to consider in launching a new venture, at a minimum shoot for a board of directors (in a corporation) or managers (in a limited liability company) with an odd number of members.  Deadlock between 50/50 founders can be deadly to a business, while 66% allows the train to keep chugging along.  If the business has only 2 founders and there are no other trustworthy candidates available at that time, at least make a gentlemen’s agreement to expand the board at some point in the future when a third potential board member presents him- or herself.
  3. Buy-Sell.  If you don’t know what these 2 words mean when so juxtaposed, ask an attorney.  Buy/sell agreements can take many shapes and forms, but at the root of it, these arrangements typically provide a mechanism for equity owners to either (i) retrieve equity upon the death of a founder (and compensate the estate), or (ii) extricate themselves from one another if they find themselves locked in a cage match.  Consider taking out insurance policies to fund obligations which may arise under these agreements.  These aren’t the happiest of issues to consider during such heady days, but they may well be the most important.
  4. Discuss money.  Just as you would in evaluating a potential spouse for marriage, try to gauge your future co-owner’s views on saving, spending and making money.  Who’s going to fund the entity?  How much money will we need to achieve profitability?  Are all owners equally willing and able to invest the necessary funds to reach that point in time?  If one founder expects the founder group to pony up $1 million during the course of year 1, it probably makes sense for the group to be made aware of this expectation.
  5. Sweat versus Cash.  If one partner plans to give money and one plans to give time (a/k/a “sweat” in the world of equity), what happens if the time-partner decides he wants his time back?  Does he give his 50% ownership stake in the company back as well?  What if this individual decides he wants to walk away with both his time and his equity?  Vesting equity, repurchase rights, options to purchase equity and various other methods exist for addressing just this type of situation.  What’s important here is that everyone gets on the same page at the outset.  A departed founder holding 50% of the equity in his or her former company can, in many instances, lead to the demise of the company.

These are but a few of many items to consider in creating an ownership structure which can promote both operating efficiency and peace among the founders.  Check back from time to time for more.