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Intellectual Property and the Venture-Funded Startup

One of the most commonly used buzzwords by the media and investors is the term “startup,” which is generally used to describe an entrepreneurial venture with the goals of rapid growth and immediate impact on a market. Although startups typically aim to disrupt a market through innovation, startups also sometimes refrain from pursuing intellectual property (IP) protection due to limited funding or other possible reasons. However, despite potential costs, startups can benefit from obtaining IP rights. Not only can IP protection potentially block others from negatively impacting the startup, it can also be seen as valuable property rights by investors. A startup can even potentially monetize IP rights through licenses or sales.

To enable growth and expansion into new markets, a startup may seek funding from investors, such as venture capital from venture capitalists (VCs). More specifically, venture capital is a type of private equity provided at early stages of a startup, which appears to have potential for high growth. When selecting startups for investments, VCs typically do not view patents and other forms of IP as an indication of the strength of a startup’s technology, but rather as an underlying asset of an overall investment.[1] In some cases, a young company may have as much as ninety percent of its value tied into intangible assets, such as IP.[2] Accordingly, VCs often look at a startup’s IP rights as a safeguard against uncertainty associated with investing and tend to prefer when the IP of prototypes produced by the startup is protected.[3] VCs want to make sure that a startup owns its IP to avoid potential lawsuits or risk of lawsuits that can often arise. This includes checking to see that the startup itself, not the founders, owns the IP rights. Because VCs often look at a startup’s IP portfolio as an important step when deciding whether or not to invest, the startup can increase chances of receiving initial funding, as well as the overall amount received, by pursuing IP protection.[4]

At the same time, it is important to recognize that all forms of IP do not present equal value to a startup. More specifically, focusing upon patents and trademarks, each type of IP protection can protect different aspects of the startup and have different associated costs with obtaining them. Therefore, VCs may value a startup’s patents and trademarks differently as discussed below.

Patents

A patent represents a set of exclusive rights granted to an inventor or assignee for a limited period in exchange for a detailed public disclosure of an invention.[5] While requiring the public disclosure of the invention can allow others to understand and build upon the invention, the patent also benefits the owner of the patent by providing rights to exclude others from making or selling the invention for a limited amount of time. Although a patent can create a monopoly limited in time for a given invention, the patent also affords the owner with the right to lease or sell rights to the claimed invention to others.

There are two types of patents: (i) utility and (ii) design. A utility patent is the more common type that is available to those who “invent[] or discover[] any new and useful process, machine, manufacture, or composition of matter, or any new and useful improvement thereof.”[6] Startups aiming to protect new functional aspects of a product can pursue protection via a utility patent. For example, a mobile application developer may use a utility patent to protect her unique way of operating an application. Utility patents can be further divided into two subsets: (i) products and (ii) processes.[7] Products represent a group that includes machines, compositions of matter, manufacture, computer-readable media, architectural designs and buildings, food products, biological matter, etc.[8] Conversely, a process is “an operation or series of steps leading to a useful result.”[9] In order for a process to be patentable, the process must be either “tied to a particular machine or apparatus,” or “transform[] a particular article into a different state or thing,” and cannot simply correspond to an abstract idea or mental process.[10]

Patents for protecting processes have recently become more controversial after the Supreme Court held in Alice Corp. v. CLS Bank International that claims about a computer-implemented, electronic escrow service for facilitating financial transactions are abstract ideas ineligible for patent protection.[11] With help from the media coverage of the Alice decision, many people believed that the decision made software ineligible for patent protection. However, subsequent decisions by courts and the Patent Office have further clarified that software can still be patented in a limited manner.[12] For many software-based startups, the ability to patent their ideas has not changed much in view of the Alice decision. Now, software-based inventions face more scrutiny, but nevertheless may still be patentable. For example, with respect to user interface (UI) patents under Alice, claims directed to graphing a curve on a user interface were found to be patent-eligible while a claim directed to building and displaying a user interface was not patent-eligible.[13] Thus, as one example, displaying functional aspects of a UI were found patent-eligible. Therefore, in contrast to the understanding of many, software based startups should still consider patent protection for their business.

Returning back to patents generally, the other type is a design patent that can protect “any new, original and ornamental design for an article of manufacture.”[14] Unlike a utility patent, a design patent protects a non-functional design and must be “inseparable from the article to which it is applied, and cannot exist alone merely as a scheme of ornamentation.”[15] For example, the same mobile application developer who sought utility patent protection for the functionality of an application may also seek design patent protection for the design of the application, such as a novel UI layout.

When considering IP protection, a startup should consider whether to pursue utility patents, design patents, or both. Traditionally, startups that pursue and obtain patent protection are often viewed more favorably by investors. Particularly, patent protection can make a startup appear to have long term growth prospects and can encourage VCs to increase the startup’s valuation.[16] In fact, startups that obtain patent protection prior to receiving VC funding often receive more financing overall from investors.[17] The investors may view the patent protection as security that the startup is less likely to fail.[18] Additionally, patents have been viewed as a positive signal for valuations to offset potential weaknesses, such as an inexperienced founding team, lack of high profile VC funding, and the startup being in early fundraising rounds.[19] The correlation between patents and funding does not appear only in one technological area, as the effect has been seen in both the biotechnology[20] and the semiconductor industries.[21] Further, when a venture-backed startup reaches the initial public offering (IPO) stage, the ownership of patents is reflected in the speed at which a company makes it to an IPO[22], the performance of the business[23], and longevity of the business after IPO.[24]  

Trademarks

A trademark is an identifiable mark, such as a sign, logo, design, or expression that distinguishes products or services of a particular source from those of others.[25] A trademark can be obtained and owned by an individual, company, or any legal entity through use and maintaining exclusive rights over the trademark. A trademark is only effective in a class associated with a particular field of commerce in which the trademark is registered.

Startups should factor the differences in protection provided by trademarks and patents when pursuing IP protection. Particularly, a startup that serves the general public directly is more likely to benefit from trademark protection to protect the connection with consumers. This differs from startups that operate upstream and tend to sell technology to other businesses. These startups may benefit from patents that can exclude others from making or selling their patented technology.

VCs often access a startup’s trademark protection and potential plans before investing. Although patent protection can indicate the value of a startup’s technology, trademarks can show the overall plans of the startup, including strategies for marketing and growth goals.[26] Trademark applications (or registrations) can indicate the industries in which a young startup operates (or intends to operate).[27] However, the correlation between trademark applications and the value of VC-backed startups is not linear.[28] The relationship between trademark applications and the value is more like a bell curve, which may indicate that a startup with too many trademarks and trademark applications has spread itself too thin or cannot focus upon a particular path.[29] Similarly, a lack of trademarks may show that a business is not yet ready for a commercial product.[30] These are a few considerations that a startup should consider when pursuing trademark protection.        

Conclusion

For a nascent startup, IP protection can serve as a powerful tool for protecting potential growth as well as helping to secure venture funding. Both patent and trademark protection are correlated with increased venture funding and likelihood of business success. Although obtaining IP has associated costs that may be off-putting to startups, the investment generally has a positive return when viewed against future fundraising and longevity. Having a solid IP portfolio can also help promote a future sale of the startup.



[1] Daniel Hoenig & Joachim Henkel, Quality signals? The Role of Patents, Alliances, and Team Experience in Venture Capital Financing, at 2 (Feb. 24, 2007), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2180406 (hereinafter “Hoenig & Henkel”).

[2] Mary Juetten, Do Venture Capitalists Care About Intellectual Property? Forbes (Aug. 11, 2015, 10:23 AM), http://www.forbes.com/sites/maryjuetten/2015/08/11/do-venture-capitalists-care-about-intellectual-property/#86706af2f290 (hereinafter “Juetten”).

[3] See Hoenig & Henkel, supra note 1, at 2; David B. Audretscha et al., Financial Signaling by Innovative Nascent Ventures: The Relevance of Patents and Prototypes, 41 Research Policy 1407, 1407 (2012).

[4]See Juetten, supra note 2.

[5] See Frequently Asked Questions: Patents, WIPO, http://www.wipo.int/patents/en/faq_patents.html (last visited Aug. 17, 2016).

[6] 35 U.S.C. § 101.

[7] See Caterpillar Inc. v. Detroit Diesel Corp., 961 F. Supp. 1249, 1252 (N.D. Ind. 1996), aff’d, 194 F.3d 1336 (Fed. Cir. 1999) (“Three of the four classes of utility inventions—machines, manufactures, and compositions of matter—may be grouped into ‘products,’ leaving products and processes as the two general categories of [utility] patents.”)

[8] See generally Donald S. Chisum, Chisum on Patents, § 1.

[9] See Id. at § 1.03 Process (citing NTP, Inc. v. Research in Motion, Ltd., 418 F.3d 1282, 1318, 1322 (Fed. Cir. 2005), abrogated on other grounds as recognized in Avid Tech., Inc. v. Harmonic, Inc., 812 F.3d 1040, 1047 (Fed. Cir. 2016)).

[10] In re Bilski, 545 F.3d 943, 964 (Fed. Cir. 2008), aff’d but criticized sub nom, 561 U.S. 593 (2010).

[11] Alice Corp. Pty v. CLS Bank Int’l, 134 S. Ct. 2347, 2354 (2014).

[12] See generally Michael S. Borella, Patentable Subject Matter after Alice: Best Practices for Responding to 35 U.S.C. § 101 Rejections, 14 Snippets 1 (Winter 2016).

[13] See Ex Parte Fuller, et al., No. 2013-000762, 2015 WL 3467122, at *2 (P.T.A.B. May 28, 2015); Ex Parte Klish, No. 2013-000814, 2015 WL 4608168, at *1 (P.T.A.B. July 29, 2015)

[14] 35 U.S.C. § 171.

[15] U.S. Patent & Trademark Office, Manual of Patent Examining Procedure § 1504.

[16] See Joern H. Block et al.,Trademarks and Venture Capital Valuation, 29 J. of Bus. Venturing 525, 527 (2014) (hereinafter “Block (2014)”).

[17] See Jerry X. Cao & Po-Hsuan Hsu, The Informational Role of Patents in Venture Capital Financing, at 5 (June 8, 2011), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1678809 (hereinafter “Cao and Hsu (2011)”).

[18] See id.at 2.

[19] See Hoenig & Henkel, supra note 1 at 6-8, and 37; David H. Hsu & Rosemarie H. Ziedonis, Resources as Dual Sources of Advantage: Implications for Valuing Entrepreneurial-Firm Patents, 34 Strat. Mgmt. J., 761, 772 (2013) (hereinafter “Hsu & Ziedonis (2013)”); and Sebastian Hoenen et al, The Diminishing Signal Value of Patents between Early Rounds of Venture Capital Financing, 43 Research Signal 956 (2014)

[20] See generally Joel A. C. Baum et al. Don’t Go It Alone: Alliance Network Composition and Startups’ Performance in Canadian Biotechnology, 21 Strat. Mgmt. J. 267 (2004)

[21] See Hsu and Ziedonis, at 764 (2013), supra note 23.

[22] See Tobey E. Stuart, Interorganizational Endorsements and the Performance of Entrepreneurial Ventures, 44 Administrative Science Quarterly 315 (1999).

[23] See Christian Helmers & Mark Rogers, Does Patenting Help High-Tech Start-Ups?, 40 Research Policy 1016 (2011).

[24] See S. Wagner &I. Cockburn, Patents and the Survival of Internet-Related IPOS, 39 Research Policy 214, 223 2010).

[25] See Protecting Your Trademark: Enhancing Your Rights Through Federal Registration, USPTO, (Jan. 2016), available at https://www.uspto.gov/sites/default/files/BasicFacts.pdf.

[26] See Meriam Brahem et al., What Drives Trademarks Registration Among Tunisian Clothing Firms? An Economic Investigation, 6 Int. J. Intellectual Prop. Mgmt. 1, 2 (2013).

[27] See Philipp G. Sandner & Joem Block, The Market Value of R&D, Patents, and Trademarks, 40 Research Policy 969 (2011); Sandro Mendonça et al., Trademarks as an Indicator of Innovation and Industrial Change, 33 Research Policy 1385 (2004).

[28] See Block (2014), supra note 20, at 535.

[29] Id.

[30] Id.

 

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