Editor’s note: Walter E. Daniels is a founder of and principal in the Research Triangle Park law firm of Daniels Daniels & Verdonik, P.A.

RESEARCH TRIANGLE PARK, N.C. – Intellectual Property (“IP”) issues occur in three stages in most venture capital transactions.

In the first stage the want-to-be venture-backed company (the “Company”) presents its business plan and provides a lot of general information about the Company to the venture capital firm (the “VC”). During this stage VCs generally will not sign confidentiality agreements, so it is important that the Company withhold information which would constitute trade secrets or would destroy its ability to secure important patent protection at a later time.

The second stage begins when the VC becomes interested in moving forward with the investment transaction and a term sheet is negotiated and executed. The term sheet may contain confidentiality provisions, or a separate non-disclosure and non-use agreement may be signed, but either way at this stage formal confidentiality obligations on the part of the investor are put in place.

It is at this point that formal “due diligence” begins and the Company will be asked to provide information pursuant to a “due diligence checklist.” The due diligence checklist will be several pages long and will, in the IP realm, cover such items as: all foreign and domestic patents, copyrights, and trademarks owned by the Company; claims or threats of claims of infringement on others’ patents, copyrights, trademarks or other proprietary rights; license agreements for patents, copyrights and trademarks running to and from Company; and secrecy, confidentiality and nondisclosure agreements. Addressing the checklist list indirectly requires analysis of the status of the IP rights of the Company, and in some respects, that of third parties.

The third stage involves documentation of the deal. Most venture capital investment transactions are based upon a principal document called a Stock Purchase Agreement or a Securities Purchase Agreement. In each such agreement there is an article, generally five to fifteen pages in length, that sets forth detailed representations and warranties, known in the trade as “reps,” of the company in which the investment is to be made. In some instances certain significant stockholders make reps as well.

Overall the subject matter of the reps will often mirror the subject matter of the due diligence checklist, with the exception that reps will be more comprehensive and designed to ferret out problems and force those making the reps to either disclose the problem or stand behind the statement that there are no problems. Within the rep article there will be one or more sections dealing with the IP of the Company, which sections will, of course, be of particular importance to a high tech company.

While the purpose of this article is not to address the intricacies of investor versus company positions on representations and warranties, the following general observations, which are taken from the perspective of one who represents the Company, are important:

  • IP issues come up in sections other than those titled “Intellectual Property,” particularly those related to ownership of property in general, those related to contracts and those related to employees.

  • Beware of broad language that is ambiguous and overbroad…do not hesitate to offer clarification language if necessary, either in by changing the agreement text or by providing notice in the schedules of exceptions.

  • Reps should be addressed clause by clause. Always err on the side of disclosure because the logic is that you can’t be liable for concealing that which you have disclosed. Also, VCs have a good track record in dealing with problems, but they don’t like to deal with surprises. (Also, keep in mind that the “Disclosure” representation (also known in securities law parlance as the “10(b)(5) rep” because it is derived from the definition of securities fraud set out in that section of the 1933 Securities Act), will provide a catch-all for any material fact that was not elicited in the specific representation and warranty provisions.)

  • It is natural that programmers and engineers would prefer not to deal with legal issues; nonetheless, make sure that senior technical management personnel are involved in the process and that they, in turn, interview their staff with respect to the appropriate inquiries.

  • Beware of the implications of clauses that state that the Company has “sufficient” assets to be able to conduct its business. This type of language could be tantamount to a backdoor patent indemnity with respect to unknown patents held by third parties that later may pop out of nowhere and be deemed to be “necessary” for your business.

  • Sometimes VCs use the due diligence process and the review of the schedule of exceptions as a basis for lowering the valuation of the Company and changing the terms of the transaction after the term sheet has been executed.

  • Quite often different reps contain overlapping provisions. Some counsel for venture firms do not like cross references in disclosure schedules which identify exceptions to reps, so it often the case that repetitive disclosures of exceptions have to be made.

  • Reps serve to allocate business risks among the parties but, as a general business principle, one should be careful not to represent and warrant items that are outside the control or knowledge of the Company; otherwise, the Company becomes an insurance company for normal business risks. Lawyers on both sides of the transaction should recognize that allocation and acceptance of risks ultimately become business issues. It is appropriate to advise one’s clients about the risks then let the clients make the decisions about the risks they are willing to take.

  • The Company, and sometimes its officers, directors and principal shareholders, will have to stand behind the reps; failure to be accurate could lead not only to loss of the benefit of the deal, but also to additional personal financial exposure. In some instances the making of a misrepresentation in the context of a securities transaction can constitute securities fraud in addition to being a breach of contract.
  • The time to address matters encompassed within the IP reps is long before the term sheet is signed. If serious problems exist at the transaction stage, it may be too late to correct them. Sometimes it is difficult for entrepreneurs to focus on these issues early in the process of building a company, but it is the role of venture capital and IP counsel to work with their clients to make sure that adequate preparations are made, including, in some instances, performance of technology audits, and addressing loose ends that might be identified thereby.

    Daniels Daniels & Verdonik, P.A. has been serving the legal needs of entrepreneurial and high technology clients for more than 20 years. Walter Daniels concentrates his practice in the representation of rapidly growing companies, most of which are technology-based. He serves on the Board of Directors of the Council for Entrepreneurial Development and the Statewide Advisory Board for the North Carolina Small Business and Technology Development Center. Questions or Comments can be sent to wdaniels@d2vlaw.com