Member News: IP Considerations When Forming a New Company

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Intellectual Property Considerations When Forming a New Company

By M. Craig Tyler, Partner, Wilson Sonsini Goodrich & Rosati

For any new company, its intellectual property (IP) is one of its most valuable assets. Conversely, a dispute over the ownership or right to use founding IP may spell the end for a start-up in its infancy or, worse, may derail a shining moment of company success, such as a sale or IPO of the company. Indeed, the announcement of a large acquisition or IPO often generates the publicity that attracts IP claims from all directions. This article outlines several best practices that new start-ups should employ to secure their IP and protect themselves from claims of misappropriating another company’s IP.

IP Basics

There are four types of IP: patents, copyrights, trademarks and trade dress, and trade secrets.

Patents give their holder a right to exclude others from practicing an invention. They are issued by the government following an examination process. Patentable subject matter includes devices, systems, and methods of doing or making something. Patents are assignable in writing, and while recording an assignment with the U.S. Patent and Trademark Office (PTO) is preferable, it is not mandatory.

Copyrights protect original works of authorship and are created automatically when a work is “fixed” and federal registration confers additional benefits. Copyrights can protect, for example, literary works, musical works, and sound recordings. As with patents, copyrights are assignable in writing, but recording is not mandatory.

Trademarks and trade dress protect brands and designations for the source of a good or service. Trademarks are generally logos or short phrases, while trade dress refers to a distinctive shape or arrangement of a product or location that indicates who or what is making or selling a product or service. Trademarks can be created by use, but registration with the state or federal government will strengthen the protection.

Trade secrets are created under state law, and typically protect matter that might be patentable subject matter. Trade secrets are protected by state law, but almost all states, the District of Columbia, Puerto Rico, and the U.S. Virgin Islands have adopted some form of the Uniform Trade Secrets Act (UTSA). Trade secrets must have economic value derived from the limited knowledge of the secret and must be the subject of efforts to maintain secrecy. Like other types of intellectual property, they can be assigned in writing, but there is no centralized assignment recordation body.

As a starting point, we recommend taking the following 11 steps when forming a new company:

1. Identify who (exactly) is contributing the IP and what (exactly) they are contributing

The source of all IP on which the company is founded must be documented. Classify each type of IP.  Identify in writing who is contributing which ideas and IP, and how the ideas and IP will be contributed (i.e., by assignment or by license). Make sure all of the finders agree about the contribution of IP in writing.

If the start-up is going to be founded using IP that belongs to one or more of its founders, verify the founder’s ownership. For patents and patent applications, verify that the founder is listed as an inventor on the patent or patent application. If the founder is not an inventor, verify that the assignment of the patent or patent application has been recorded with the PTO. If a person who is not one of the founders is listed as an inventor on a patent or patent application, determine whether that co-inventor still has an interest in the patent. Determine whether there are other assignees with interests in the IP (i.e., an ownership interest or a security interest). Co-ownership of a patent will impact the start-up’s ability to assert or license the patent. Further, for each piece of IP, discuss with the founders whether there are any individuals who are not listed as inventors or co-creators who might assert that they should be listed as such in future litigation. Because there is no centralized registration or recording body for trade secrets, more effort is warranted to verify that any trade secrets used by the start-up have been assigned via contracts between the assignor and assignee.

If the start-up is going to license IP from a third party, confirm the third party’s documentation of its IP creation and ownership. The documentation should show, for example, the date and circumstances of the IP’s creation, the names of the people who created the IP, and the date and manner of the IP’s assignment. If the third party received its IP via assignment from a fourth party, ensure the third party’s ownership of its IP has been recorded in a centralized recordation body.

2. Categorize each component of founding IP

Each component of founder IP must be categorized into one of three areas: (1) developed and owned by a founder, (2) licensed or otherwise obtained from a third party, or (3) obtained from or otherwise available in the public domain. This is important because the category will help determine which steps a start-up will have to take to protect itself from litigation.

3. Confirm the company’s ownership of—or rights to use—all founding IP

For IP that the founders contribute, confirm in writing that the company either has ownership of the IP through assignment or an exclusive license to the IP. For IP that is being licensed or otherwise obtained from a third party, confirm in writing the company’s right to use the IP through an exclusive license to the IP or IP purchase. If only a non-exclusive license is available, recognize that the IP may also be used by a competitor.

For IP obtained from the public domain, document the public source of the IP to prevent future misappropriation claims. If the IP is open source software or other “open” IP, recognize that such IP generally has specific licensing requirements, such as the General Public License (GPL), that demand careful consideration. For example, the GPL is referred to as a “copyleft” license, meaning that any works derived from a work licensed under the GPL can only be distributed with identical terms as the original work. In short, this means that if a start-up obtains software code subject to the GPL and modifies the code for the start-up’s purposes, the start-up must make the modified code available under the GPL. The risks and costs of violating the GPL or similar licenses can be substantial. Thus, a start-up that uses open source software should consult knowledgeable outside counsel and technical experts, especially if a third-party supplier is involved.

4. Vet any potential third-party claims to the founding IP

For each source of IP that has been identified, vet any potential third-party claims to the IP. The most common sources of third-party claims are prior employers, investors, or collaborators. This may be an uncomfortable topic for the founders, and it is often easier for counsel to vet these issues with the founders individually. To the extent that potential third-party contributors or owners are identified, steps must be taken to obtain full ownership and/or mitigate any future claims (such as sending a letter confirming the difference between the IP belonging to the third party and the IP that will be used by the company).

5. Search and return confidential information

All founders and early employees should search for any confidential information belonging to previous employers or other third parties, and return all materials found or delete/destroy any such information (for example, if included in emails, texts, or other electronic media that is difficult to “return” to the prior owner). Even if documents or other materials may not otherwise be trade secrets under the law, the use of such documents from a former employer may constitute unfair competition. It may be helpful to create a checklist for each founder and early employee to certify that they have searched their computers and files to check for documents from previous employers and destroyed or returned any confidential information. This certification should be part of an employee agreement. Performing this step will allow the company to prove it was founded on a clean state, and not based on IP belonging to a founder’s prior employer.

6. Secure patent applications for the founding IP

Securing patent applications for the founding IP is a smart step for any new company, and not just to enforce against would-be infringers. For start-ups, pending and issued patent applications often will validate the core IP to potential investors and customers. Further, they can be used as evidence of independent development against future IP claims. However, be mindful of two unexpected sources of future IP claims that patent applications can create. First, make sure your patent applications are free of IP and nomenclature that is similar to that of any previous employer. Even if the technology is different, similar nomenclature may make it appear to a judge or jury that the patent application claims IP derived from the previous employer. Second, make sure the patent application does not broadly claim IP that gives a third party an opportunity to allege that they contributed to the patented invention. A contributor of even one element of one claim may be entitled to co-inventor status and joint ownership of the entire issued patent.

7. Use new nomenclature in company documents and source code

Be careful not to use nomenclature that is similar to that of previous employers in product documents, marketing literature, and source code (e.g., variable names). Similar nomenclature will be the first thing opposing counsel looks for in any IP-related litigation, and it can look bad to an unsophisticated jury even if the technology is quite different.

In addition to using new nomenclature in source code, instruct the start-up’s programmers to structure newly written source code differently than preexisting source code used by previous employers. Investigators use numerous techniques to detect when source code has been misappropriated for unauthorized use. These techniques vary in sophistication, but depending on the technique, the use of even the most carefully obfuscated misappropriated source code can be detected. The most simple of these techniques involves comparing the plain text source code or assembled binary machine code of a suspected program to the original. However, more sophisticated techniques may rely on the metadata attached to assembled programs, disassemble compiled binary source code into higher-level assembly code, reconstruct source code structure and naming conventions using metadata, and divide compiled code into segments for comparison to the original code using hashing algorithms. Depending on the technique used, a suspicious previous employer may be able to definitively detect the use of their source code or pseudocode. Further, even if definitive proof cannot be obtained with these techniques, preliminary results showing a substantial likelihood of misappropriated source code may be sufficient to support a lawsuit in which discovery may be used to uncover more definitive proof. Accordingly, writing new source code with new variable names and different structure may be a useful technique to avoid even the unintentional copying of work performed for a previous employer.

8. Document independent/internal development

Technology developers should keep careful notebooks or other records of their work, so that the company can prove independent development if challenged in a lawsuit. Source code should be entered and maintained in a source code repository with version control. Even non-technical founders and employees, especially in sales, must be advised to keep notes and records of the source of any confidential information that they use in the course of their work, such as customer lists. Proof of independent development can be used in court to quickly defeat a claim that the company took shortcuts and used third-party confidential information or information from a prior employer. At the end of the day, if your company cannot prove that information was developed internally without the use of your competitor’s information, the jury may assume the worst.

9. Employees/independent contractors must sign formal IP-related agreements

All employees, especially independent contractors, must sign formal agreements properly assigning all IP rights to the company, agreeing to keep the company’s IP confidential, and promising not to disclose to the company any confidential information from a former employer. These agreements must be put in place as soon as possible, prior to inventive work on behalf of the company. Some states have specific language that must be used for invention assignments to be effective, so consult with counsel on the wording.

10. Execute formal non-disclosure agreements

Never discuss the company’s IP, trade secrets, or confidential information with a third party without executing a formal non-disclosure agreement (NDA). While covered subject matter of patents, copyrights, and trademarks enjoys protection regardless of secrecy, maintaining the secrecy of trade secrets is a critical element of enjoining the misappropriation of trade secrets and recovering damages. As defined in the UTSA, a trade secret is information that (1) derives independent economic value from not being known to or ascertainable by others, and (2) is the subject of efforts to maintain its secrecy. This second element makes it critical to secure NDAs from suppliers, distributors, and employees. Unfortunately, for some other potential partners, particularly investors or parties interested in acquiring a start-up and/or its IP, securing an NDA may be easier said than done. This problem is known as the “disclosure paradox” and stems from the fact that a party interested in acquiring IP cannot evaluate IP without viewing confidential information. Typical NDAs cannot solve this paradox because NDAs generally only protect against the disclosure of confidential information to third parties, not the use of confidential information by the receiving party. Indeed, no potential investor or buyer will agree to the use of confidential information before knowing what it is, because the potential investor or buyer may already possess the idea. Signing an NDA with a covenant against use might expose a potential investor or buyer to a misappropriation claim for using an idea it already possessed. Accordingly, VCs and other investors often will be reluctant to sign such agreements, so a best practice is to work with counsel on the proper level of detail that can be shared without an NDA.

11. Naming/branding should take into account trademark considerations

Selecting a company name and product names should take into account existing trademark and tradename searches, which are relatively inexpensive to commission. Nothing slows a new company down more than expensive trademark disputes, which can be easily avoided if you do your homework.

There is also the question of whether to register your trademark. In the United States, you do not have to register—using your trademark in connection with your goods or services is all you need to do to secure trademark rights. However, if you do not register with your state or the federal government, your trademark rights only extend as far as the geographic scope of your business’s operations at any given time.

Importantly, not all trademarks are created equal. There are five categories of trademark strength, and the category that your company’s name fits into affects your ability to defend your trademark against infringers. Below are the five categories of trademark strength. You should devise a business name that is fanciful or arbitrary, if possible.

  • Fanciful or arbitrary marks – Such marks are completely made up, which means they had no meaning before they were used as trademarks. This is the strongest type of trademark. Examples include Exxon, Xerox, and Kodak.
  • Arbitrary marks – Such marks are common English words used out of context with the goods and services to which they are being applied. One famous example is Apple for a computer company.
  • Suggestive marks – These marks indirectly refer to the goods and services they are associated with, but require some imagination. Examples are Greyhound buses and Chicken of the Sea tuna fish.
  • Descriptive marks – Such marks describe the goods and services to which they are being applied. These marks are considered weak and not entitled to registration and protection unless you can show that consumers associate them with only one company. This typically happens after marketing and advertising for at least five years. Examples include Sharp for televisions, Digital for computers, Windows for windowing software, and International Business Machines for computers and other business machines.
  • Generic marks – These marks are not protectable because they describe a whole group of goods or services. Examples include “smartphone” or “social network.”

Conclusion

Starting a new business can be a challenging and exciting endeavor. When a business is just getting off the ground, concerns about litigation in the distant future may be unwisely set aside. However, a start-up that understands the IP that undergirds its business and secures ownership or licenses to that IP will be better positioned to avoid litigation and allegations of trade secret misappropriation. As Ben Franklin famously wrote, “An ounce of prevention is worth a pound of cure.”s