Launching a new business is a tremendous task, beset with trials and tribulations of all kinds. To succeed, it is incredibly important to have clear agreement among the founders on a variety of key issues, even before creating an entity. Agreement comes from having hard conversations during the early stages of formation, about issues such as roles and responsibilities of the founding team, decision-making, and dispute resolution. Addressing these issues at the beginning can reduce the likelihood of surprises and conflict down the road.
One question that shouldn’t be hard is whether founders should transfer ownership of any core intellectual property (IP) they hold to the new company. But imagine this scenario:
Alice, Bob, and Carol have been working on an app that will allow consumers to order produce from local farms. They think they are really on to something and want to launch a company. They are working with their attorneys to set up a founder’s agreement, but they’ve hit a snag. Carol developed the code underlying the new app for a personal project she was working on a year ago. Thus, she has pre-existing intellectual property that she will be contributing while Alice, and Bob will be contributing branding expertise and sweat equity. Carol is excited to begin this venture with Alice and Bob, but she also wants the ability to continue using her code for her personal project.
Alice and Bob know Carol is reluctant to transfer ownership of her IP to the company and don’t know what to do – should they insist that Carol assign her rights? Or just let it go?
What is a Founder’s Agreement?
A Founder’s Agreement is a contract that outlines the rights, responsibilities, and liabilities of each founder. It is designed to govern the business relationship between the founders and provide a blueprint for how the business will be run.
Often founders don’t believe they need a formal agreement until they are ready to seek funding or go to market. As a consequence, founders will frequently begin work on a business concept – developing inventions, devising a business plan, and beginning to build a product or technology with no formal business structure in place. In doing so, these founders are creating new IP. Thus, it is not uncommon for founders to own IP essential to the new business’ operation before forming the company.
Once a company is established though, founders should transfer this IP to the company. Typically, this is achieved through the Founder’s Agreement. In exchange for the issuance of their initial founder’s stock in the company, the founder assigns his or her IP rights to whatever IP is developed for or is core to the new enterprise.
Why Should IP Belong to the Entity and Not Individuals?
A company that does not own its own IP is inherently risky. Mission critical pieces of the business could walk off at any time, be it a trademark, customer list, or key patent. If this happens, the company will likely lose crucial time and money – battling with former co-founders for ownership in court, re-developing (non-infringing) IP independently that will allow the business to continue operating, or competing with former co-founders who are now selling or licensing the IP.
Investors understand how severely handicapped a business is when it doesn’t own the core IP it needs to operate and will typically not invest in these companies. Moreover, investors will want founders to have a stake in the success of the company. If a founder refuses to assign his or her IP rights, investors may worry that the founder is hedging his or her bets and not fully committed to the company’s success.
Why Don’t Founders Always Require Co-Founders to Assign IP?
There are many reasons why a business might not observe the practice of assigning IP to the company upon incorporation. Many young companies simply fail to appreciate the importance of doing so. Or in their rush to get started, they don’t stop to think carefully about the implications of valuable IP rights residing outside the company. Quite often, founders, like newlyweds, don’t foresee the possibility of parting ways.
But founder splits happen quite often and it is best to plan ahead. Sometimes, founders fear that discussing the issue with their co-founders will be awkward or that they don’t have the leverage to insist on assignment if they are not contributing IP themselves, only sweat equity. Finally, sometimes a co-founder is adamant about not assigning and the other co-founders simply concede.
What if a Founder is Reluctant to Assign?
A co-founder who is reluctant to assign his or her IP rights is perhaps the most difficult of the above obstacles to overcome. In most circumstances, allowing the co-founder to retain ownership while licensing rights to the company to use and practice the IP should be a non-starter. It is simply too easy for the company to become heavily reliant on IP rights that could be readily removed. One alternative is to insist on assignment, but offer to increase that co-founder’s equity share.
Another alternative is to insist on assignment, but agree to license back the technology so that the founder can continue to use the IP for their own purposes. If doing so, it is important to consider the precise scope of the rights that will be licensed back. For instance, should the co-founder be allowed to sub-license the technology to others or would this jeopardize the company’s interests? If the IP the co-founder would like to retain is tangential, not core to the company’s business, then licensing might be an option.
Unfortunately, sometimes, none of these options will work. In that case, it is best to part ways and disentangle that co-founder’s IP from the company’s IP as soon as possible.
What Other Special Considerations Should be Taken Into Account?
There are a few additional considerations young companies should be aware of. First, it’s important to understand who is a founder. It is not simply the group of people who ultimately agree to form an entity. Any person who touched the business during the early stages of conception and development may have a claim to related IP rights. Thus, it is important to ask: Are there any potential founders who have already left the scene? Any outside advisors or contractors who were involved?
Second, it’s important to consider whether any of the essential IP upon which the new company depends was developed by a founder who was “moonlighting”. In other words, its important to know whether the IP was developed by a founder who working on the business concept and related IP while continuing to work for another employer. If so, the former employer may own the rights to the IP, in which case the founder cannot assign the IP to the new company.
This is a serious risk that could easily lead to litigation between companies and should be evaluated as soon as possible.
So What Should Alice, Bob, and Carol do?
Since Carol’s code is essential to the new app, in order to protect the fledgling company, Alice and Bob should insist that Carol assign her rights to the code to the new company. Doing so, ensures that if they have a falling out, Carol can’t walk away with the code to begin her own competing business or threaten Alice and Bob with an infringement action for continuing to use the code in their app. A clear assignment of rights will also assure investors that the new company is well protected and has the necessary rights in place for long-term stability.
In exchange for assigning her rights, Alice and Bob can offer Carol a larger stake in the company. In the alternative, or perhaps in addition to a larger stake in the company, Alice and Bob can also negotiate a licensing agreement with Carol that will allow Carol to continue using the code in her personal project so long as her project does not unduly compete with or otherwise disadvantage the new company.
Identifying ownership issues and planning ahead can go a long way toward avoiding problems down the road. This is why the best thing a young company like Alice, Bob, and Carol’s company can do to protect itself is to start early and have these potentially difficult discussions amongst the founders about their interests, goals, and the value of their respective contributions to the enterprise.
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