This commentary in the Genomics Law Report’s ongoing series Bench to Market is contributed by David W. Dabbs, Robinson, Bradshaw Hinson, P.A.

You just spent the last five years of your life working virtually 24/7/365 to build your company into one of the most respected firms in its field. Three years ago you barely could raise enough money to fund payroll and rent. Now you barely have enough time to run your business because of all the meetings with investment banking firms that want to talk about taking your company public. You hear rumors about competitors going public, and your outside investors and board members tell you to strike while the iron is hot.

You wonder what it would be like to run a public company and how it will affect your lifestyle. Based on the valuation ranges under discussion, your net worth (on paper at least) makes you feel like you just won the lottery. Serious people are saying that you could be the “next Google,” and you wonder what that would be like. You imagine yourself ringing the bell on the New York Stock Exchange.

You decide to have dinner with an old college friend, who is the chief financial officer of a public company, to share your news (against the advice of counsel). What she says makes you think.

You ask her how much stock you should sell in your IPO, and she tells you that you will be told not to sell any stock. You wonder why, especially given that your private equity investor plans to sell part of its investment, and she tells you that public investors will view the sale of stock by you as a sign that you do not believe in the future of your own company. You ask her why the same rules don’t apply to your outside investor, and she laughs and tells you that they just don’t.

Your friend asks how your company is doing financially, and you tell her that you have turned the corner and are hitting your stride. Part of the reason for going public is to reduce the amount of company debt, which is significant. In terms of your company’s financial projections, virtually all of the investment bankers believe that it is reasonable to expect double-digit revenue growth every year for the immediate future.

Your friend needles you about these projections. How is a company that struggled to pay expenses less than one year ago suddenly worth hundreds of millions? What are the assumptions used to project such rapid revenue growth, considering the novelty of your industry and product. She asks what you would say to investors in your IPO if you did not meet these projections. You tell her that everyone understands the developing nature of your industry and the risks involved, and that only those investors who “get it” and are “in it for the long term” will invest. She shakes her head and laughs again, and this time it bothers you.

She asks you why your company is going public, and you tell her that everyone—your investors, investment bankers and outside directors—tell you that now is the time. You are getting pressure from your private equity investor, who invested over four years ago, to find a way to liquidate its investment. Although you have a good working relationship with them, you complain that they are “just about the money.” You want new investors and more flexibility to manage your business. You also need to find a way to reduce or refinance the significant debt that your company has accumulated. Going public, you think, will establish your company as the industry leader. Plus, you know how excited your employees will be.

As dinner ends, your CFO friend apologizes and says that she needs to get back to the office to work on her company’s next quarterly earnings announcement and SEC filing, which are due in two weeks. As she stands up to leave, she gives you a serious look and tells you that going public isn’t for everyone. You press her to be more specific, and she sits back down and tells you the following:

• First, don’t get caught up in the moment. For most companies, the buzz of going public tends to fade away quicker than one might think. After that point, you and your management team will be left to deal with the demands and scrutiny that come with being public. You will be required to think about disclosing every significant development in your business, both good and bad, shortly after it occurs, even if there are legitimate business reasons for keeping it quiet. You and your management team will spend an enormous amount of time dealing with being public—preparing press releases, public presentations, and public filings; responding to questions from the press and investors; and meeting with analysts and large investors who can be demanding, probing, self-centered and sometimes uninformed, and who can have a significant effect on the price of your company’s stock. Simply put, she says, no one wants to be public for the sake of being public.
• Don’t fall into the trap of going public without defining your goals and considering your alternatives. Is your goal to find liquidity for investors, pay down debt, or establish a liquid market for your stock? If liquidity for investors is your primary goal, are there other buyers out there? Will being public help you raise more capital? Will having a publicly-traded stock help you acquire other companies? Where is your company in relation to where it needs to be, and how exactly will being public help?
• Stop thinking about going public as an opportunity to get rich. Your investors may look at it this way, but for you and your management team, it will be the beginning of a new and extremely challenging era. Because public investors tends to frown upon the sale of a significant amount of stock by insiders, you may not be in a position to sell much stock until years after an IPO. If personal liquidity is your goal, going public may not be the answer.
• Finally, quit thinking about going public as a goal. The process itself can be educational and eventful. But after the dust has cleared, being public can do as much harm as good. If your company hits a bump in the road, being public can make it worse. A negative development affecting your company’s stock price could well result in litigation regardless of whether anyone did anything wrong. She asks you whether your company is ready for that.

As your friend stands up to leave, she tells you that going public is an option available to very few companies and a sign of tremendous success. She says her point is to be careful and to approach the decision seriously just as you have approached every other major decision involving your company. Although going public can be exciting, being public is a challenge. Knowing, accepting and planning for this reality can make all the difference.

This commentary in the Genomics Law Report’s ongoing series Bench to Market is contributed by Matthew S. Churchill, Robinson, Bradshaw Hinson, P.A.

The last few articles in the Bench to Market series discussed capital raises and licensing-out arrangements that facilitate an entrepreneur’s commercialization of a new product or process. To obtain capital or a licensing arrangement, an entrepreneur must often share a business plan and confidential information about the proposed product or process with potential investors or licensees. The entrepreneur should insist upon binding non-disclosure agreements that prohibit both the disclosure and misuse of such information, before disclosing any such valuable information.

While some inventors may hold intellectual property rights, such as patents, to protect their proprietary information, many entrepreneurs rely on trade secret protection early in the commercialization process. See our recent article, “Can You Keep a Secret?” Non-disclosure agreements are fundamental to trade secret protection, as they demonstrate that inventors have taken reasonable steps to hold their valuable proprietary information in confidence.

These agreements, however, are binding only on the parties who actually execute them. Certain venture capitalists and strategic investors may resist signing non-disclosure agreements as a policy matter or for fear that they may interfere with alternative projects or in-house development activities. Thus, entrepreneurs may need to develop “teasers” that provide basic background information on their product or process without disclosing sensitive proprietary information so that potential investors and licensees understand the benefits and burdens associated with executing a non-disclosure agreement.

To be effective, a non-disclosure agreement must identify the appropriate investor or licensee legal entities that are intended to be bound by the agreement. Those investor or licensee parties should also be responsible for breaches of the agreement by their affiliates and by any accountants, attorneys or other representatives to whom they provide information. Some non-disclosure agreements go one step further and require signers to obtain a separate non-disclosure agreement in favor of the entrepreneur from any affiliate or representative who is provided confidential information.

Non-disclosure agreements should carefully define the confidential or proprietary information subject to the agreement. If there are exceptions to the prohibitions on disclosure or use, they should be precisely and narrowly defined. Common exceptions include (1) information generally available to the public through no breach of the non-disclosure agreement, (2) information that was known by the recipient prior to disclosure by the entrepreneur, (3) information obtained by the recipient from a third party who is not bound by a confidentiality agreement or other obligation of confidentiality, and (4) information independently developed by the recipient. Exceptions (2) and (4) are subject to potential abuse by recipients; many confidentiality agreements eliminate exception (4) altogether and require that the recipient provide written evidence demonstrating the existence of prior knowledge to satisfy exception (2).

Although the main point of a non-disclosure agreement is to prohibit improper use and disclosure of the information, that prohibition is not in fact total. For example, the recipient considering an investment will “use” the proprietary information in assessing the potential investment, and so the agreement should not prohibit that use. Where an entrepreneur seeks assistance in commercializing a product or process, the use restrictions must be carefully balanced to permit necessary commercialization activities without allowing the entrepreneur’s know-how and proprietary information to become part of the public domain. Simply describing a permitted use as “commercialization” is overbroad and subject to abuse. The parties must think through the commercialization process carefully to define the circumstances under which proprietary information can be disclosed to others.

The entrepreneur also needs to think about what happens after the recipient has evaluated the confidential information provided. Agreements should permit the entrepreneur to require the return or destruction of proprietary information in a recipient’s possession at the entrepreneur’s request. But the return or destruction of documents may not be enough, since the recipient of the information still knows it. To cover that issue, the agreement should require recipients to maintain the confidentiality of such information for a lengthy or indefinite term.

What happens if the recipient violates the prohibitions in the agreement and, for example, discloses the information to another party? The usual legal remedy for breach of an agreement is to sue for money damages. But in a case such as this, it could be impossible to determine what the damages are—how can one value the potential value of proprietary information that could be a bonanza or could be a bust? The alternative is to provide an acknowledgment by the parties that breaches of the agreement cannot be cured by monetary damages alone, and that equitable remedies such as temporary restraining orders and injunctions are appropriate to restrain breaches. Then, if the recipient is breaching the agreement, the inventor can go into court and obtain a court order that will stop the recipient in his tracks. Some people may violate their agreements, but they will think long and hard before violating an order from a court.

Entrepreneurs should also consider whether to include a covenant that prohibits solicitation of employees, sometimes called a “no-poaching covenant.” Potential investors who gain access to start-up businesses may decide to pass on an investment but to offer employment to talented employees with whom they interact during due diligence. A tailored employee non-solicitation provision will protect the entrepreneur from employee raiding.

Confidentiality agreements are generally a precursor to more definitive investment or licensing agreements entered into after due diligence has been completed and a plan for commercialization has been developed. Entrepreneurs generally seek to include in these preliminary agreements language that disclaims any representations and warranties with respect to the proprietary information to be disclosed during due diligence. Such representations are warranties are more appropriate in the context of definitive agreements when the business arrangements and related representations and indemnities can be spelled out in detail.

While well-crafted non-disclosure agreements provide entrepreneurs with legal and equitable remedies for improper disclosure or use of proprietary information, the agreements alone may not be effective to stop “bad actors” from potentially harmful disclosures. Therefore, entrepreneurs need to undertake their own diligence about potential recipients of proprietary information to confirm that such persons are professional and respected participants in the marketplace.

Over the last year or so, however, Beth has moved from core asset to affirmative liability. She has missed critical internal and client meetings, and may go days without responding to calls or e-mails. According to her direct reports, she’s become largely invisible to them as well. You have no hint of what may be behind the situation.

And what about her behavior when she is in the office? Colleagues report phone calls hastily concluded and the laptop shifted or shut whenever they appear. Has some personal vice taken over? Is she shopping herself to competitors, or even planning her own competing startup?

Convinced you’ve met every expectation that fairness and friendship impose, and tumbling rapidly from anxiety to paranoia about the risks the situation poses to the company, you’ve spent a sleepless weekend pondering your options. It’s now inescapable: Beth has to go, now.

Can you terminate the problem employee? Terminating anyone, and particularly a key senior employee, can be a minefield. Rather than attempting first to track down Beth, you call Angie, your outside employment counsel. Angie has a checklist of issues, and the two of you need to work it through. Angie first establishes that Beth is based at your company’s North Carolina headquarters. She reminds you that employment law varies widely from state to state, and that the answers to the issues may vary dramatically if Beth were resident in your California, New Jersey or Florida offices.

You first confirm your prerogative to fire Beth under these circumstances. In North Carolina, the default rule is that, absent an employer-employee contract (which could be created by a personnel handbook—as discussed below) or collective bargaining agreement, employment is “at will.” This means that either party may terminate the employment at any time and for any lawful reason. Many employment contracts restrict the rights to terminate and require notice or other procedural steps the employer must take before it can terminate (e.g. board of directors’ approval).

Happily for you at this stage of the analysis—though less so later— Beth has no contract, and there are no union issues.

Angie reminds you that your company’s personnel handbook addresses discipline and termination. Reviewing it, you see that it outlines a three-step disciplinary procedure for performance-related deficiencies: an initial notice to be given orally; a second notice to be given in writing and placed in the employee’s file; and termination as a third and final step if the deficiencies persist. You are relieved when Angie reminds you that the company has, in the provision itself, effectively reserved the right to deviate from the three-step procedure as it deems appropriate. Angie also points out that the title page of the handbook proclaims in boldfaced, capitalized type that nothing in the handbook creates any form of employment contract or disturbs the “at will” relationship.

Angie next works through with you the terms and covenants in the agreements between your company and its various investors. These sometimes impose or imply restrictions on the company’s ability to terminate key personnel. Satisfied that terminating Beth will not offend any lender or investor, and that your board of directors need not be consulted in advance of the decision (although you are already sweating over the questions you know you’ll face from the board in its aftermath), Angie and you shift the analysis from “can you terminate Beth” to “how to terminate Beth.”

How to terminate the problem employee. Angie’s first recommendation is that you communicate the termination decision to Beth as fast as reasonably possible. If Beth suspects she is about to be terminated, Angie explains, she may pre-emptively complain that her performance problems are the consequences of, for example, physical or mental ailments or job-related harassment. Such a complaint creates a risk that termination—even though the employer had settled on it before learning of the complaint—will provoke claims of discrimination and retaliation under state and federal anti-discrimination laws.

Angie next observes that Beth’s inaccessibility raises some practical concerns. Ordinarily, termination occurs in a face-to-face meeting, allowing the employer both to announce the decision and to review attendant issues. With Beth’s availability for such a meeting uncertain, Angie suggests that you and she devote the next few hours to preparing a written termination package. The package will include:

A short letter notifying Beth of her immediate termination.

Angie stresses the need, in the letter and in all other communications with Beth on the subject, to be clear, consistent and truthful. She explains that you owe Beth no detail about the company’s reasons for terminating her— a simple statement to the effect that “we have concluded the decision is necessary under the circumstances” is sufficient—but any attempt to explain the decision, including in response to questions from Beth, must be accurate. Yielding to the impulse to soften the message by, for example, characterizing the termination as the result of “elimination of the position,” or assuring Beth that her performance was no factor in the company’s thinking, invites litigation when, as it inevitably will, some version of the truth makes its way to Beth.

The letter will require Beth to immediately turn over her laptop, Blackberry, any physical files, and any electronic storage media containing company information. The letter also directs Beth to sign and return a copy of the letter with these items, and by doing so affirm that she possesses no company information (other than, of course, what is in her head—see below) and has not, at any time, disclosed or used company information other than as authorized by the company.

Noting your raised eyebrow, Angie answers the question before you ask: no, none of these measures can ensure that Beth retains no proprietary information. She goes on to explain that the only way to provide a reasonable measure of confidence that Beth will not use proprietary information to the company’s disadvantage is:

A proposed severance agreement offering Beth significant severance benefits in exchange for signing a noncompetition, nondisclosure and nonsolicitation agreement.

With no contract in place with Beth, she is as free to begin work for your competitor following her termination as you are to fire her, a prospect that freezes your blood. Angie explains that, while there are some constraints on Beth’s ability to use your proprietary information for the benefit of a competitor, including Beth’s own startup should she go that route, your best protection by far is a comprehensive agreement keeping her out of the market for a period of time (the noncompetition feature) and prohibiting her from soliciting other employees to join her elsewhere or from using company information elsewhere.

You note that Beth must still provide any new employer with a written summary of the nonsolicitation and nondisclosure provisions (the required summary is to be part of the agreement) even after the noncompetition period expires. Angie explains that this requirement will tend to enlist new employers in the cause of enforcing these provisions; North Carolina law, like that of many states, could permit your company to sue a competitor that ignores violations.

The agreement will also contain a release of any legal claims against the company, and will liquidate Beth’s rights as a shareholder of your private company.

To obtain such an agreement now, however, you will have to buy it in exchange for whatever combination of cash and non-cash consideration (e.g. post-termination health benefits) proves sufficient to persuade Beth to accept the restrictions. Recognizing glumly that Beth holds most of the cards in this negotiation, you also make a mental note never again to extend an offer of hire or promotion to any key position except on condition that the candidate sign one of these agreements before he or she can assume the role.

Once these documents are in shape, Angie will have them both couriered to Beth’s home and sent there by overnight mail (Beth lives only five miles from the office, but Angie observes that overnight mail transmission will create a paper trail establishing by inference when the company finally settled on termination). She also instructs you to have your IT department immediately cut off Beth’s access to company systems, as well as her Blackberry service. You are to instruct your administrative head that, if Beth shows up at the office, she is to be escorted to a conference room, instructed to wait until you arrive, and watched to ensure she does not access company systems (by, for example, using someone else’s terminal) or records.

Angie suggests that Beth will very likely insist on meeting with you. This meeting should include Angie, with Beth invited to include her own legal counsel. She also cautions you that you may be in for a long legal battle to restrict her from capitalizing on what you view to be proprietary company information unless you can convince Beth to sign the severance agreement.

Now comfortable that you’ve developed a comprehensive plan of action, you begin to make the necessary calls within the company as Angie begins drafting the termination letter and severance agreement. It will be a long time before you’ve fully processed your personal reaction to this difficult situation, but you’re now able to begin to trade exhausting worries over what to do about Beth for constructive thinking about what to do after Beth.

Unfortunately, fundraising is a difficult, frustrating and lengthy process for most entrepreneurs. The path to financing does not end with a strong patented technology, a solid business plan and model, and an experienced and talented management team. Of course, a company that lacks any of these things likely will go unfunded. But in most situations, even a well positioned company needs the requisite relationships to make a financing happen, and it must navigate cumbersome federal and state securities laws to ensure it remains legally compliant.

Before an entrepreneur hits the road looking for money, he or she should be familiar with some basic legal principles applicable to raising capital. A new company must be cautious and thoughtful when seeking investments. As we explained in our earlier post on Raising Private Capital, every offering of securities must comply with the registration requirements of federal and state securities laws or qualify for an exemption from these requirements. Many companies structure private equity investments to comply with the Rule 506 exemption promulgated under Regulation D of the Securities Act of 1933, because it is the only federal exemption that preempts state securities laws and allows a company to raise unlimited amounts of money. As a result, it is a very attractive exemption without many of the restrictions and limitations imposed by other exemptions.

The Rule 506 exemption, however, limits both the universe of potential investors that a company may target and the means by which it may reach these investors. First, securities may not be sold using general solicitations or advertising, including through newspapers, magazines, mass mailings and media broadcasts or at seminars or similar events. A company and its agents may solicit an investment only from a person with whom they have a “pre-existing, substantive relationship,” which the rules define as a relationship established prior to the offering and of sufficient quality that the company reasonably believes the offeree has adequate financial sophistication, experience and expertise to properly evaluate the risks and merits of the investment. Second, a company should solicit investments only from “accredited investors” that satisfy certain income, net worth or asset tests. If non-accredited investors are included in the offering, the company faces substantial and burdensome disclosure requirements that make compliance both difficult and costly.

Once you have a solid grasp of the legal framework, it is important to understand how much capital you require both initially and over time, and how this capital will be used in the business. This will affect your potential sources of financing and will drive your fundraising efforts. Smaller amounts of capital (e.g., under $150,000) typically can be pieced together through friends, family and grants.  After this “seed” capital, companies often look for additional funding from “angel” investors (i.e., high net worth individuals). If the company will be capital intensive, either at commencement or at some point in its early development, it may require financing from venture capital funds, which typically have minimum investment amounts (e.g., $1 million – $2.5 million). These are the typical investor categories for a start-up business, but every company is different and may attract capital from a variety of alternative sources. Please remember that the same securities laws apply whether you’re asking your neighbor for a $15,000 loan, looking for $500,000 from a local angel network, or soliciting $10 million from a syndicate of venture capital funds.

The bottom line: raising capital requires a strong network for both legal and business reasons. But how does an entrepreneur establish such a network? A good place to start is by forming a relationship with an attorney, accountant, consultant or other service provider who has experience and expertise in your industry. These professionals may be able to put you in touch with others who can assist your company either operationally or financially. A good service provider can help you refine your business plan, build a management team, identify potential investors and advisory board members, introduce you to strategic partners and, potentially, help you locate investment bankers or placement agents for larger capital raises.

You should consult with other executives, entrepreneurs, scientists and academics in your field or industry for advice and referrals. You should also understand and become involved in your local business community. If you are a part of or near a research university, pay a visit to its technology transfer office and seek advice. In North Carolina, for example, in addition to strong research institutions there are active trade organizations (e.g., Council for Entrepreneurial Development, NC Biosciences Organization), incubators (UNC’s “Launching the Venture,” First Flight Venture Center, the Triangle Startup Factory), quasi-government agencies (e.g., the North Carolina Board of Science & Technology, the North Carolina Biotechnology Center), and other groups (e.g., the North Carolina Small Business and Technology Development Center) whose mission is to commercialize science and technology and encourage entrepreneurship. They actively mentor young companies and provide helpful resources. You simply must get involved and meet people. A financing can arise from an unlikely source, and so never underestimate the contacts and referrals that your involvement will generate.

This commentary in the Genomics Law Report’s ongoing series Bench to Market is contributed by Mark O. Henry, Robinson, Bradshaw & Hinson, P.A.

Last week in the Bench to Market series, we discussed the license-out business model as an alternative to raising capital for the commercialization process. Because the business idea is “your baby,” however, you are likely reluctant to let go of it so early in its journey. Instead, you may prefer the challenge of finding the money to bring your idea to market yourself.

We discussed earlier in this series the government funding that may be available for science and technology related research. Unfortunately, this source of funding does not pay for the expenses of commercialization. Thus, once you have maxed out your credit cards and fully drawn the home equity line your spouse warned you not to set up in the first place, you are likely to turn to the private sector to raise capital.

Naturally, the first place you will look for money is from the people you know best. As a school kid you learned it was easier to ask friends, family and neighbors to support your fundraisers than complete strangers. Looking for equity investors is no different. Pitching your business model to complete strangers such as angel investors or venture capital funds can be intimidating and frustrating; however, what may be less obvious is that asking your family and friends for an investment may implicate federal and state securities laws.

A common misperception is that securities laws apply only to the stock of large public corporations traded on an exchange. But Section 5 of the federal Securities Act of 1933 (the “1933 Act”) and most state securities laws prohibit the offer or sale of any securities without registration, unless there is a specific exemption from the registration requirement. For a private company that has not previously registered the sale of securities, registration refers to the process of filing with the U.S. Securities and Exchange Commission (the “SEC”) to go public. This is an onerous process that is not a viable option for an early stage company, and thus it is important to find an exemption.

The statutes define “security” very broadly. For example, a “certificate of interest or participation in any profit-sharing agreement” or an “investment contract” would each meet the test. One famous case considers whether interests in an orange grove constitute securities (though for you Eddie Murphy fans, orange juice futures are not regulated by the SEC as securities but rather by the CFTC as commodity derivatives). Generally any equity interest in a corporation, limited liability company, limited partnership or other business entity would be considered a security when the investor is relying predominantly on the managerial efforts of others to generate profits. Thus, if you and two of your fraternity brothers get together in a garage and form a company to sell personal computers and each of you intends to be an active part of the business, the equity interests you receive at formation are not “securities” under the federal and state securities laws. When you solicit money from your neighbor who is not an active part of the business, however, the equity being offered is a “security” and the sale of that equity (in fact, even the “offer” to sell that equity) is subject to the securities laws.

The good news is that just because an equity instrument is a “security” does not necessarily mean registration is required. The federal securities laws provide for several registration exemptions depending on the nature of the security or the nature of the transaction in which a security is sold. Equity securities in a company generally do not qualify for any of the security-specific exemptions. Instead, most issuers of equity securities must look to the transaction-specific exemptions. The most common exemption is Section 4(2) of the 1933 Act, which exempts transactions by an issuer not involving a “public offering.” Factors examined in determining whether a Section 4(2) exemption is available include (1) the number of offerees, (2) the pre-existing relationship of the offerees to each other and the issuer, (3) the number of units offered, (4) the size of the offering, (5) the manner of offering, (6) the information disclosure or access involved, (7) offeree sophistication, and (8) the absence of redistribution of the securities.

Unfortunately, this exemption does not always have clear, specific guidelines for determining whether it applies. The sale of equity on a one-off basis to your father, who is the chief executive officer of a major securities brokerage firm, is unlikely to be a “public offering.” On the other hand, buying an infomercial on late night cable television and hawking stock to anyone who calls your 800 number is a problem. In between those ends of the spectrum, things can be confusing. To bring some clarity to the issue, the SEC has over the years issued specific safe- harbor exemption rules. Among other things, these rules include limits on the aggregate amount of equity that may be issued and describe the types of investors who may be involved depending on their wealth and financial sophistication.

Prospective issuers of securities must also consider the laws, rules and regulations in each state where securities are offered or sold. Most states have laws that are similar to the federal scheme, though it is important to carefully review and consider the individual state laws as there may be important differences.

Another over-arching consideration when soliciting investments from your friends and family are the general anti-fraud laws. Both the federal securities laws and most state securities laws impose liability on any person who offers or sells any security where there is fraud, an untrue statement of material fact, or an omission to state a material fact necessary to make statements not misleading. This standard applies to all offerings of securities, both public and exempt private offerings.

If all of this is making your head spin, you are not alone. A careful securities analysis can be costly and time-consuming, and thus you may be tempted to skip this step during early stage fundraising efforts. This can be a costly mistake. Remedies for breaching federal and state securities laws include, among other things, (1) rescission of the purchase, (2) an injunction on the offering, (3) damages, and (4) government fines. In addition, improperly documented and conducted securities offerings can hamper future capital raises with funds or other institutional investors when the stakes are higher.

This commentary in the Genomics Law Report’s ongoing series

The drive to create something new and useful is an almost universal trait of entrepreneurs. This passion, however, is not always accompanied by the same enthusiasm for managing the more mundane tasks of taking an idea from a research lab or academia and making it available in the marketplace. In addition to the fundamental need to raise capital, the commercialization process requires a number of time-consuming and less glamorous steps, such as forming a company, hiring employees, establishing accounting systems, drafting contracts, securing appropriate facilities and, if all goes well, marketing and selling products and services. The process can often be frustrating, difficult and even infuriating at times, particularly for scientists or researchers. So, what can an entrepreneur, who wants to maintain her day job as a professor, physician or other professional but doesn’t want her valuable innovation to sit idle, do?

One option that has gained popularity is the “license out” business model. Under this approach, an inventor takes the initial steps of creating a new product or process, but then passes the torch to a third party to use the underlying developments to make the products and services available to the appropriate market. The inventor is relieved of the burdens of commercialization but continues to retain ownership of her work, putting her in a good position to profit from its market value (albeit with the lion’s share of any such profit generally going to the business partner who takes on the commercialization responsibilities).

While this approach sounds simple and straightforward, there can be traps for an unwary inventor. A threshold concern is that an inventor can license only those rights she has the right to license. That sounds obvious, but inventors are surprisingly prone to overlook this concern. If software is involved, the inventor should carefully consider whether her software incorporates licensed third-party software or open-source software. If a new product is involved, the inventor should consider whether her invention is merely an improvement to an underlying invention owned by a third party. Purporting to license rights that are actually owned by a third party is a sure recipe for disaster.

Assuming the inventor actually has the right to license something of value, the first key decision will be the selection of an appropriate business partner to commercialize the technology. Sometimes the inventor will be aware of the likely candidates because of familiarity with the applicable industry. If not, technology transfer offices, venture capitalists, industry experts and attorneys can be useful resources to identify and vet potential business partners. It should go without saying that the “one stop” shops advertised on television are often not the best choice for a business partner.

Once a business partner is selected, the primary task shifts to preparing and negotiating the license agreement. The license agreement will often be the only contractual tie between the inventor and the business partner, and it contains the critical terms governing the relationship. Licenses can vary significantly, depending on the exact relationship the parties choose to create, and so the inventor is likely to be poorly served by simply downloading and using any type of “industry standard” license. (The license agreement is sometimes accompanied by a services or R&D agreement pursuant to which the inventor agrees to provide ongoing services, but that arrangement is beyond the scope of this article).

The heart of almost every license arrangement is defining the scope of the license grant. In a typical license, the inventor grants the licensee the right to use all of the inventor’s intellectual property rights in the new product or process, so that the business partner will have the legal authorization to make, commercialize and sell products and services incorporating those licensed intellectual property rights. The typical license would cover patents, unpatented inventions, proprietary know-how, copyrights and related documentation.

Assuming the inventor is willing to grant such a license in all of her intellectual property rights, there are still several decisions that must be made to define the scope of the license grant. First, is it exclusive or non-exclusive? In an exclusive arrangement, the inventor restricts her ability to allow anyone else to use her technology, and grants all of her rights to the business partner. Whether to grant exclusivity is something that must be carefully weighed by the inventor, although she should expect that her business partner will usually require it as a condition to making the investment. The inventor should negotiate protective provisions to ensure that the technology is actively marketed and that she has termination rights in the event that her expectations are not satisfied. If the license is non-exclusive, the inventor may not have the same concerns because she retains the discretion to license the technology to other partners if she becomes dissatisfied with the performance of the initial business partner.

Another issue is whether the license grant extends to all “fields of use.” For some technologies, this will not be an issue, because the new products or processes can be used only in a certain industry and the related intellectual property rights would have no relevance outside that particular industry. It is not uncommon, however, for an invention to have potential application in two or more industries, and a single business partner may not be best situated to take advantage of the commercial opportunity in each area. Instead, an inventor may desire to grant exclusive licenses to different business partners, with each license covering a specifically defined field of use. The drafting of field-of-use definitions is often heavily negotiated and requires precision to avoid future disputes.

The type and amount of consideration to be paid to the inventor are of course other critical components in the license agreement. Although the inventor may not plan to be significantly involved in commercializing the underlying technology, she expects to be fairly compensated for her contribution to the venture. The most common economic structure for licenses is the payment to the inventor of a royalty calculated as a percentage of the sale revenues or profits generated from the licensed technology. Various metrics can be used as the basis for the royalty calculation, including unit sales, gross sales, net revenues, and net profits. The percentage to be paid to the inventor can differ depending on the industry and the value and novelty of the licensed technology, and may fluctuate based on volume of sales. Because the data underlying such royalty calculations are under the control of the business partner, the inventor generally receives some form of audit rights to facilitate monitoring and confirmation of the royalty calculations.

Some inventors may prefer to negotiate a fixed payment amount, often through some combination of fixed upfront and periodic cash payments. This approach may be particularly attractive if the inventor is concerned about the challenge of monitoring the performance of the business, or if the technology is not being incorporated directly into the end product or service being sold to customers. The fixed payment has the additional benefit of discouraging any business partner from “parking” or “mothballing” the technology, which conceivably could be in its best interest if it gains access to another comparable technology under more favorable economic terms, including a replacement that it develops on its own. From an economic perspective, the fixed payment structure is more similar to an outright sale of the technology than a typical license, since the payments do not vary based on the success of commercialization; however, it is more favorable to the inventor than a true sale, since she will retain ownership of the intellectual property rights and will be better protected if problems arise.

Another approach is to combine a traditional sales-based royalty with a minimum payment (generally calculated on an annual basis). Typically, the minimum royalty is not an unconditional payment obligation and the consequence of the business partner’s failing to meet the minimum royalty thresholds is termination of the license grant. If this type of arrangement is properly negotiated, it can combine many of the benefits of a traditional sales-based royalty and a fixed-fee payment. The arrangement can provide the inventor with the expectation of a minimum annual payment while she retains the right to participate in the upside of successful commercialization and the right to terminate the arrangement if commercialization is unsuccessful.

The fact that the inventor will retain ownership of the technology raises other issues. In many cases, the inventor will have obtained (or at least applied for) basic intellectual property protection for her new product or process before seeking a business partner. However, the parties will still have to allocate the responsibility and costs of pursuing intellectual property protection. Deciding the appropriate scope of protection and allocation of costs can be particularly difficult in seeking patent protection, since it is not always clear where patent applications should be filed or what specific patents claims should be pursued, and the cost of prosecuting patents can be significant. Finally, the parties must decide who will control enforcement actions against alleged infringers.

In negotiating the license, the inventor also must take into account the evolving nature of technology. The likelihood is that any licensed product or process will be improved and enhanced as it moves towards commercial availability. Depending on the relationship of the parties, those improvements may be made by either the inventor or the business partner. The parties will need to negotiate the ownership of any such derivative works, improvements and enhancements to the technology. In any event, the inventor should insist that royalties be calculated with reference to sales of all products or services that are based at least in part on the underlying technology, even if the commercially available products or services have been significantly enhanced by improvements or additions developed by the business partner.

Finally, the inventor will need to consider the downside—what if the project goes badly off course? For example, what if the resulting product sold by the business partner is defective and injures consumers or what if another company claims, after development is completed, that sale of the developed product would infringe its patents? Parties typically allocate these risks through negotiated indemnification provisions. As a starting point, the inventor will generally request that the business partner provide comprehensive indemnification against any claims that might be brought against the inventor arising from the business partner’s commercialization of the technology. The business partner may reasonably request that certain claims be carved out from its indemnification obligations, and may even require the inventor to provide indemnification in certain circumstances.

We have mentioned only the typical key issues in this post. License agreements can be lengthy and complicated and will contain a host of other provisions that are important and can affect the relationship between an inventor and the business partner. It would be a mistake to view the license structure as a quick and simple answer to commercialization. On balance, however, the license model provides an attractive alternative to an inventor who wants to remain at her current position or continue to act primarily as a generator of new ideas while passing along the responsibility of commercializing the fruits of her labor.

We discussed earlier in the Bench to Market series the selection and formation of the legal entity that will own the technology and carry on the business of the founders. In connection with this formation and prior to engaging with investors, contractors, and others, the founders of the new business should establish clearly the terms of the venture as between themselves. They need to consider carefully and come to agreement on the ownership, management, and other important aspects of the business. Ultimately, through their discussions and with the aid of an attorney, the founders should have a set of legal documents that completes the formation of the entity, reflects clearly and with precision the terms of the venture, and prepares them to operate the business in the market without disruption. Below is a summary of key terms of the venture arrangements that the founders of any new business should establish with each other.¹

Ownership

The founders need to make the threshold determination of who owns the legal entity and in what percentages. If the entity is a corporation, this determination will dictate the allocation of profits and control of the business. If the entity is a limited liability company, the founders will have the freedom to set up procedures for control that need not reflect the ownership percentages. Ownership percentages typically are derived from the value of the respective assets contributed by the founders to the business. This value is easily determined when the founders contribute cash; however, a founder may contribute intellectual property, services, or other intangible assets, and in those cases valuation becomes more difficult and potentially contentious. If a founder receives an ownership interest in exchange for services (i.e., “sweat equity”), it may be appropriate to condition the ownership on the satisfactory completion of those services.

Ownership interests issued to the founders usually will be of the same class or type, such as common stock if the entity is a corporation. The founders may, however, create different classes of interest to provide for various rights and preferences as between themselves. For example, one of the founders may receive a “preferred” interest, which entitles him or her to priority in the distribution of profits from the venture.

The founders also should consider whether to create an equity compensation plan, through which the company may grant ownership interests to employees, contractors, and even the founders themselves in order to establish incentives for the performance of services to the company. Important considerations include: (i) the percentage of the company’s ownership allocated to the plan; (ii) the types of equity granted under the plan, such as options, restricted stock or “phantom” shares; and (iii) the conditions to vesting of rights to the equity, such as length of service or achievement of performance milestones.

Management and Governance

The founders must also decide who will be responsible for and have authority over management of the business as well as the structure of the management arrangements. While governance structures vary depending on the type of legal entity, this normally requires the designation of the following in the case of a corporate entity: (i) a board of directors (or managers in the case of a limited liability company), which oversees the affairs of the business; and (ii) officers (e.g., a chief executive officer), who manage the day-to-day operations of the business. Often the founders themselves fill these roles at the onset of the venture, as the founders’ need for and ability to pay qualified outsiders persons may be limited. The respective rights and duties of directors and officers should be carefully defined, including the terms of their authority, meeting dates and protocols, and removal arrangements.

In most businesses, the owners themselves, acting in their capacity as shareholders or limited liability company members, will reserve to themselves certain important decisions and delegate to the directors or managers other decisions. In a corporate structure, for example, the officers typically have authority to take routine, everyday actions on behalf of the business while the board of directors must vote on more significant, non-routine decisions; the owners would reserve to themselves the most significant decisions, such as a potential sale of the business. It is thus important for the founders to determine exactly what vote is needed by the owners to take an important action. A simple majority of the applicable voting group is normally authorized to take most actions; however, it may be appropriate in many situations to require a greater vote or to give the minority owners a veto over certain actions.

Transfer Restrictions

When starting a venture, the founders, who know each other well, voluntarily choose to associate with each other. Thus, to prevent being compelled to carry on the venture with other persons, the founders should consider whether to restrict each other’s ability to transfer their ownership interests. For example, a founder may be prohibited from transferring his or her interest without the consent of the other founders subject to certain qualifications. Alternatively, the other founders may have a right of first refusal in connection with any proposed transfer, i.e., a right to purchase the interest on the same terms and conditions offered to the potential buyer or on other terms that are agreed upfront.

Exit Events

Of course, for many founders, the ultimate goal of the venture is an “exit event,” such as a sale of the business to an established company or an initial public offering. While an exit event may seem only a distant hope at the onset of the venture, the founders would be prudent to consider and determine at the start such important issues as who can decide when an exit event occurs and upon what terms and conditions. This foresight should enable the founders to minimize disputes as the business grows and to increase the likelihood that they will realize their long-term expectations.

Most exit events will require the approval of the directors and owners, and as set forth above, the founders should be clear as to what vote is required. Also, the founders should consider providing for drag-along rights, which facilitate a sale of the company by entitling the majority owner to require the minority owners to sell their interests on the same terms and conditions as the majority owner, and tag-along rights, which protect the minority owner by entitling the minority owner to sell his or her interest on the same terms and conditions as the majority owner.
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¹When there is only one founder, most of this discussion is not applicable, as all ownership and control of the venture will typically belong to that person. Many of the issues presented will apply, however, if and when a sole founder desires to bring another person into the venture.

There are two key issues to consider when evaluating trade secret protection: what type of information can an entrepreneur protect and what does she have to do to protect it? In general, any information can be a trade secret if (1) it is non-public information that has value because it is not publicly known and (2) the holder of the information is taking adequate steps to hold it in confidence. Trade secrets can include things as diverse as business plans, business contacts, financial analysis, inventions, formulas, designs and methods.

Non-public Information. The first prong of this test may seem obvious. Publicly available information cannot be a trade secret. And even non-public information does not qualify as a trade secret if there is no value in keeping it secret.

However, the requirement that trade secrets be non-public can actually present difficult choices in choosing between the maintenance of a trade secret and the public disclosure of information in a patent application or issued patent. Assume for example that an inventor develops a novel and complex method of making genomic sequencing more efficient. Whether the entrepreneur should pursue a patent or trade secret approach—or even a combination of the two—will depend on the specific nature of the invention and the commercial realities.

The first question to ask is whether secrecy will really be an option. Would the novel method have to be disclosed to commercialize it or could the entrepreneur practicably commercialize the development by keeping the method secret while using it to provide sequencing results to customers (including researchers, individual consumers or patients, and healthcare providers)? Would users, payors, regulators or other stakeholders demand to review and understand the method to confirm its validity? Even if secrecy is a viable option, is it a better option than patent protection? It is important to remember that there can be a wide gap between the relative ease of filing a patent application with broad claims and actually obtaining a meaningful patent. Is the new method unique enough that the entrepreneur has a chance of obtaining a broad patent or would any granted patent likely be so limited that competitors could avoid the patent by “inventing around it”? Does the entrepreneur have the resources to pursue and maintain patent protection?

Even if it is clear that patent protection is the best long term choice, there may be twists and turns in developing the best strategy. In some cases, trade secret protection may be a useful way to augment patent protection. For example, if an inventor files a patent application in the United States, there will be a limited period of time (generally eighteen months) during which information in the application is not publicly available and can be treated as a trade secret. If this provides a meaningful head start for the business, it may be able to have the best of both worlds: short term trade secret protection and long term patent protection. In other cases, trade secret protection may be a necessary first step in obtaining patent protection. A patent is barred if the invention is in “public use” or “on sale” for more than a year before the patent application is filed, so it may be essential to keep any early stage prototypes and customer testing confidential to avoid losing the patent option.

The “no public information” requirement will also limit trade secret protection for information that can be easily “reverse engineered” by legal means. For example, an inventor may view the design of her product as confidential and proprietary. But if any purchaser of the product can reconstruct the design merely by measurement and observation, that trade secret will be lost.

Adequate Protection. The second prong of the trade secret test is often the undoing of entrepreneurs: the requirement that the trade secret owner take reasonable steps to maintain the secrecy of the trade secret. Much of this is common sense. Confidential information must actually be held in confidence. This means the trade secret owner should keep the written or electronic documentation of the trade secret in a secure place, limit copies and avoid unnecessary disclosure. It accomplishes nothing to stamp documents as “CONFIDENTIAL” and then carelessly leave them lying around accessible to anyone who takes the time to look, and the entrepreneur will run an unnecessary risk that the trade secret will be lost if it is stored in unencrypted form on a laptop that is not password protected.

Confidentiality agreements are critical. The starting point should be enforceable agreements with every employee and contractor involved in the business. Beyond that, it is important to require third parties to sign confidentiality agreements whenever they need access to the trade secret. This can encompass a diverse group of people, including potential investors, suppliers, customers and service providers.

Finally, timing is everything. In trade secret law, it is important to remember the oft-quoted adage that “you can’t shut the barn door after the horse escapes.” Once a trade secret has been publicly disclosed, the trade secret protection is permanently lost and cannot be resurrected by tardy attempts at secrecy. There is no substitute for the entrepreneur paying careful attention to trade secret protection at a very early stage of the business’ life.

Brand protection on the Internet begins with selecting and registering a “domain name.” Domain names are akin to virtual street addresses on the Internet, where the registry or “top level domain” is the name of the street and the string to the left of the “.” in the domain name is the ‘second level domain name.” Thus, “genomicslawreport.com” is the unique address for our site, consisting of the second level domain “genomicslawreport” registered on the popular “com” street. Anyone in the world can find us and no one else publishing there. We have grown jaded about this technological marvel, but a consequence of the domain name system is that every business should want to be sure that it preemptively registers domain names that support its brand and take reasonable and prudent measures to assure that others do not unfairly profit from the goodwill residing in that brand by registering domain names that impersonate, mimic or denigrate the brand or that sell counterfeit products under the brand name.

In the early days of the Internet, most companies were slow to register domain names. Journalists and enterprising pirates registered famous trademarks in the dot com registry, depriving the brand owner of an address on this Internet Park Avenue and ultimately forcing brand owners into litigation or expensive settlements to gain ownership of a domain name that included their flagship brand(s) in the dot com registry. The important lesson taught by these early mistakes is, as soon as you select your company’s name and the brand names of its principal products, register them as domain names in the dot com registry. Secondary registrations may redirect to the web site identified by the primary domain name, so there need only be one web site, but all brands should be registered. The Internet has evolved since those early days, but cyberpirates are still at work. Moreover, social media sites have become important tools for marketing, and all allow for some form of name or “handle” registration. Preemptive registration on social media sites may also be advisable. It is always better to reserve your name than to wage an expensive legal battle later to reclaim it.

Sometimes, through bad luck, poor planning or lack of execution, a third party ends up owning the desired domain name. This has happened often enough that the entity that ultimately assigns domain names through its administration of the Domain Name System (known as “ICANN”) adopted a set of rules known as the Uniform Dispute Resolution Policy (“UDRP”) to assist legitimate brand owners protect their brands. The UDRP provides for a relatively inexpensive, rapid and fair method whereby persons with trademark rights may force the transfer of ownership of a domain name registration from a person without any legitimate interest in the name and who registered and uses the domain name in bad faith. Congress has also passed a law (the Anti-Cybersquatting Consumer Protection Act or “ACPA”) that provides slower, more expensive but more expansive relief to the brand owner. Both the UDRP and the ACPA protect trademarks, whether registered or not, but for legal and practical reasons, both make it easier to protect registered marks than unregistered ones. Thus, the second lesson of brand protection on the Internet is to register the trademarks that one uses as or in a domain name.

Owners of famous brands have discovered that the creativity and perseverance of domain name pirates is well-nigh inexhaustible, and that these pirates will register multiple variations of the brand name, not only in the dot com registry but in the other 20 “generic top level domains” and even the 250 or so “country code top level domains.” The time and expense needed to preemptively register all brand names and their common variants in all of these domains and to monitor and launch UDRP proceedings against all comers has been likened to the amusement park Whack-A-Mole® game in its seeming futility.

Brand owners have to adopt more sophisticated and cost effective strategies. We believe that most businesses need only register in the dot com registry. Within that registry, a business should engage a monitoring service to look for both use and misuse of its brand. A wise brand owner will want to know if third parties are seeking to register variations of its brand. He will want to know if his brand is discussed on social media sites such as Twitter®, Facebook® or LinkedIn®. Armed with such knowledge, the brand owner may intelligently pick the fights over maliciously registered domain names to match her need and her budget.

There may be a looming exception to our general recommendation that new companies register only in the .com registry. ICANN is circulating a draft set of rules to allow the creation of an unlimited number of registries and top level domains. As now written, any company or group of companies trade groups or just interested “communities” could apply to form a new registry which might be restricted to the owners, members of the industry or community or could be unrestricted. For example, a consortium of genomics companies could apply to be assigned and operate a top level registry known as “dot gene” and strive to make that “street” the preferred address for genomics companies and research organizations. There has been a great deal written about ICANN’s proposal, chiefly negative outcries from large brand owners and their counsel, but one should not ignore the possible allure of such a registry for companies operating in a specialized market such as genomics.

Trademarks (and their siblings, “service marks”) are a valuable form of intellectual property. In the United States, trademark rights begin to accrue from the moment the name or mark is used in commerce on the goods or in connection with the offering of the services the mark identifies. The “common law” right so created is the exclusive use of the mark to identify the identified goods or services within the geographic territory in which the goods or services are sold or offered. The trademark owner may obtain the assistance of the courts to enforce this right and to claim monetary damages from an infringer.

If the owner takes the next step and registers his trademark with the U.S. Patent and Trademark Office (USPTO), then several additional rights are his: he may sue in federal court; all persons are presumed to have actual notice of his trademark, so that all subsequent adopters of an infringing mark, no matter what the geographic market, do so at their peril; he can avail himself of international treaties to extend the protection of his registration to other countries; he is presumed to be the lawful owner of his mark in the U.S.; his application and registration can easily be discovered through a simple computer search of the records of the USPTO (and thus avoided by others); and, after five years of continuous use of the mark, his rights become “incontestable” with respect to most grounds for challenge.

The exclusivity awarded a trademark extends not just to the exact mark and the exact goods identified by it. A trademark owner may exclude others from adopting any mark that, when actually used or applied to be registered, is so similar to the first mark as to likely cause mistake, confusion, or error with respect to the origin, sponsorship, or quality of the goods or services identified by the mark. Thus, protection extends to variations in sound, spelling, and meaning of the mark and also to variations in the design, function or purpose of the product so identified, as long as the total impact is to create a likelihood of confusion between the products.

This exclusivity runs both ways. Before a company adopts a new trademark, it should retain the services of a trademark lawyer to engage and interpret a full search of existing “common law” trademarks, pending trademark registration applications, and trademarks registered with the USPTO and state authorities. In this way, the company can be relatively certain that the chosen name for its new product will not inadvertently prove to be a legal killer. The trademark attorney who performs this clearance task will then be ideally positioned to assist the company in registering its new mark with the USPTO and foreign countries as appropriate.

In return for these protections, the law asks only that the mark be distinctive, i.e., that it be capable of identifying only the owner’s product and distinguishing it from those of others. A mark must not be “merely descriptive” or generic. A merely descriptive mark is one that primarily communicates a function, quality, or purpose of the product supposedly identified, such as a “smart phone” or a “personal genome analysis.” Although a merely descriptive term may, over time, acquire distinctiveness through relentless marketing, a “generic” term never can become distinctive, since it is just the standard term used by the public to identify all products of that type. Thus, entrepreneurs should resist the temptation to adopt a product name that describes or names the product. The temptation is understandable; the greater the novelty of a breakthrough product, the greater the temptation will be to give it a name that informs the public just what it is the product does. Although there are times when this approach is useful or even necessary, in most cases it will mean the adoption of a name that has no protectable trademark rights.