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Patent Freedom to Operate Part 2: When Not to Seek a Freedom to Operate Opinion

"Patent freedom to operate" refers to whether one can conduct its business model without infringing another's patent rights.

“Patent freedom to operate” refers to whether one can conduct its business model without infringing another’s patent rights.

Part 1 of this series discussed the concept of patent freedom to operate (“FTO”) and why it might be important to analyze at the early stages of a technology-based startup.  There may be situations, however, where it might NOT be appropriate or your startup to invest resources in having an attorney analyze your FTO.  In particular, despite the benefits of an FTO opinion, hiring an attorney to perform an FTO search can be costly, and the results might not provide the benefits you’re looking for.  One should weigh the following considerations before deciding to whether (and how much) to invest in a FTO analysis.

(1) Time and Cost.  FTO analyses can be very costly, in terms of both time and money. An attorney needs to understand your product or service, conduct an extensive search for potentially problematic patents, and review those patents.  For potentially problematic patents, an attorney must closely read the entire patent, construe the elements of the patent claims, review the prosecution history of the patent (the documented application process), and apply the patent claims as construed to your product or service.  This process can easily cost tens of thousands of dollars, if not more.

(2) Ambiguous Patent Claim Language. Even a well-funded FTO analysis will not provide absolute certainty regarding whether you are in the clear. Patent claims are notoriously difficult to interpret—although a well-trained attorney can make educated guesses, nobody can be certain of how a court might interpret a certain claim. Accordingly, an attorney is likely to encounter patent claims where she cannot guarantee whether your product will or will not infringe.

(3) Unpublished Applications. It is not possible to identify all potentially problematic patents.  The PTO does not publish pending applications until 18 months after they are filed.  This means that even the most thorough searcher may not find certain applications that will ultimately pose a problem because they are not yet accessible.

(4) Changing Patent Scope. Even if potentially problematic patent applications have published, their claims may change during the application process.  Pending patent applications include draft claims that the searching attorney must analyze. It is not uncommon for these claims to change before the patent is ultimately issued. Since the attorney cannot predict how these claims will change, the effect of a pending patent application is very difficult to determine.

(5) Difficulty of Keyword Searching. It is also difficult to identify problematic patents because they may use different terminology.  Patentees are permitted to create their own terminology in describing their inventions.  Even if a patentee is not purposefully ambiguous with their terminology, patents may not use the accepted terminology in a field because that patent was filed before a particular market developed standardized vernacular. Accordingly, it might be hard to identify potentially problematic patents if they don’t contain the terms you use in your keyword searches.

(6) Do the results matter?  You might not want to know (or might not care about) the answer.  As we discussed above, willful infringes can face increased damages.  Therefore, some companies may decide to avoid becoming aware of problematic patents to limit the risk of being found to have acted willfully in infringing another’s patent.  This concern might be especially relevant in the information technology field, where it is common more numerous overlapping patents to relate to various aspects of accessing and transferring information via computers.  Accordingly, it might not be possible to design any product or service in the information technology field in a way that avoids any potentially problematic patents, an companies may make the business decision that a freedom to operate analysis does not provide any information that is relevant to their product design.

(7) Premature?  You should have an understanding of your potential product or service.  If you have a general idea for your actual invention, but don’t have a working prototype (or at least some idea of the specifics of your product or service), your invention is probably too early stage for a robust FTO analysis. You definitely don’t need to wait until your technology is finalized before you move forward with a FTO search, but performing a search too early is likely to be inefficient. You may have a strong business plan, or a general idea of how your invention will work, but you haven’t tested it yet. At this point, your design is likely to change dramatically. Since every patent claim has unique boundaries, even a small change in your design can have a big impact on whether you may or may not infringe a patent. Particularly given the ambiguities discussed above, an FTO search at this point may soon become obsolete if you encounter a technical or business obstacle that requires you to redesign your invention. At that point, you’ve spent a lot of time and money to procure an opinion that will not be very helpful in the long run.

Analyzing patent freedom to operate can be a valuable step in deciding whether to pursue a technology venture or how to design a particular product or service.  Startups should consider the above in deciding whether and when to expend valuable resources in addressing patent freedom to operate.  Being strategic in addressing patent freedom to operate can help one more efficiently obtain a more relevant and helpful analysis concerning patent infringement issues.

 

See Patent Freedom to Operate Part 1: Why Analyzing Patent Freedom to Operate is Important.

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Patent Freedom to Operate Part 1: Why Analyzing Patent Freedom to Operate is Important

"Patent freedom to operate" refers to whether one can conduct its business model without infringing another's patent rights.

“Patent freedom to operate” refers to whether one can conduct its business model without infringing another’s patent rights.

You’ve come up with an idea for the next big thing, and you want to start your own business. You know that intellectual property protection will be key in the success of your company. What should you do now?
Startups face two separate intellectual property (IP) questions. First, can I obtain IP protection to provide a competitive advantage for some aspect of my business? (Can I get a patent, copyright, or trademark?) Second, do I have freedom to operate? (Can I provide my product or service without infringing somebody else’s patent, copyright, or trademark?)

This 2-part blog post will discuss how and when you should consider hiring an attorney to perform a patent freedom to operate analysis. The first part will discuss what is freedom to operate and why a startup would want to get a freedom to operate analysis. The second part will discuss reasons that a freedom to operate analysis might not be right for your startup at this time. Although these posts will focus on freedom to operate assessments regarding patents, it is important to remember that freedom to operate will be an issue for other aspects of IP as well.

What is Freedom to Operate?
A freedom to operate (“FTO”) search (often called a “risk analysis”) aims to answer the following question: do your actions infringe somebody else’s IP rights? In a patent FTO search, the searcher assesses your product or service, then identifies claims within existing patents or patent applications that your product or service may infringe.
As an initial matter, let’s clear up a common misconception concerning patents. Owning a patent does not provide freedom to operate. Patents only provide negative rights—they allow the patentee to stop others from making, using, selling, or offering to sell your patented invention. Patents do not, however, give you any affirmative right to make, use, sell, or offer to sell your invention. Especially because there are so many issued patents in a given area of technology, Company A, B, and C may each hold overlapping patents. In this situation, each of the three companies may be unable to make and sell their products (they lack freedom to operate) unless they are able to negotiate a licensing agreement. Accordingly, freedom to operate can be a major concern for startups.

Why Analyze your Freedom to Operate?
Discovering late in the game that your new product infringes a competitor’s patents can be devastating. A startup may independently develop a new technology completely unique when compared to anything else on the market. However, somebody still may have a patent whose claims cover part or all of the invention. That person can then stop you from making or selling your product or service. Additionally, you might be liable for patent damages. Merely receiving a cease and desist letter from that competitor can scare away your potential investors.

A FTO analysis can help you determine whether you need to alter your product design before the costs of changing get too high. Performing a patent freedom to operate search gives startups an opportunity to identify paths for further development.

Additionally, an FTO opinion can help you understand your competitors’ patent portfolios or develop knowledge for future licensing negotiations. A freedom to operate search will uncover some inventions that are similar to yours, which may help you understand competing products in the marketplace. However, interpreting the limits of patent claims is very different from looking at marketed products. Accordingly, this benefit may be limited. Nevertheless, when engaging in future licensing negotiations, potential collaborators will want to know that your product has solid IP protection. A FTO opinion can help reassure these potential collaborators and encourage the negotiations.
Furthermore, for companies with the resources to defend a patent infringement suit, a written FTO opinion from an attorney can help avoid willful infringement penalties if your product is ultimately found to infringe another’s patent. It is important to note that an FTO opinion will not prevent a company from being sued for infringement. However, the opinion will help prevent the court from finding that you willfully infringed the patent, which may lead to increased damages (up to three times the value otherwise).

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Angel Investors II: Structuring the Angel Investment

Entrepreneurs have a number of options for structuring an angel investment.

Entrepreneurs have a number of options for structuring an angel investment.

This is part 2 of a 2 part series on receiving angel investments.  Once your company has decided to take on an angel investor, you have a couple of decisions to make.

Convertible Notes vs. Equity Purchase: What is right for you?

As discussed above, angel investors may be flexible in how the financing is structured. Two possible approaches a financing could take are convertible notes and equity purchase. The differences between the two are discussed below:

Convertible Notes

Convertible notes act like traditional notes, but grant the investor the option to convert the balance of the note into equity instead of seeking repayment at the choosing of the investor, or automatically upon a specified date. You do not need to value the company in order to execute a convertible note. These notes are also easier to produce than full-financing documents, resulting in lower legal costs. Convertible notes will often contain a provision specifying that the note will automatically convert into equity in the event of a qualified financing, usually defined to be the closing of a set round of a specific dollar amount or higher.  In that case, the note will convert to whatever type of equity is issued in that round of financing.

Equity

In this type of deal, the investor will purchase equity in the company in exchange for cash. The investors and entrepreneurs will agree on a set price that the investors will pay for each share of the company. This is how many financing deals are structured, and may be the preferred format for an angel investor.

One thing to keep in mind when structuring an equity deal is that convertible notes previously issued by the company may have an automatic conversion provision that will be triggered by this new round of financing.  If that is the case, the value of these notes and the corresponding stock that will be issued in exchange for them must be taken into account when valuing the company.  The two different methods traditionally followed in the industry to account for the convertible notes when setting the price of the new round are:

a. Convertible notes as part of the pre-money One choice is to include the value of the convertible notes in the pre-money valuation of the company. This is complicated, though, because the value of the convertible notes is determined by the price per share at which they will convert. The price-per-share is set by the new round of financing, which under this method is determined based on the value of the convertible notes. This method will rely on an iterative excel calculation to determine the price-per-share for both the convertible notes and the newly purchased shares.  One way to estimate this calculation is to simply subtract the amount of convertible debt (perhaps factoring in the discount or cap to calculate the purchasing power of the convertible debt) from the negotiated pre-money valuation.  Generally, this will result in a lower price and so will benefit the investors.

b. Convertible notes as part of the post-money. Another option is to factor the convertible notes as part of the new money coming into  the company. The investors and the company will decide on a price-per-share for the round based on a pre-money valuation of the company that does not include the convertible notes. This will generally result in a higher price per share, benefiting the company.

Compliance with Securities Laws

The SEC considers both a sale of equity or a convertible note as a sale of a security. As such, you will want to make sure that you meet one of the SEC’s private offering exemptions and that you file the necessary forms with the SEC and with the state in which the investor(s) reside. You will want to research the requirements for your specific financing directly on the SEC website and on state websites. Do not rely on general advice. Most angel investors will be accredited investors, making the exemption under Rule 506 available to you if they are.  Generally, you will need to file a Form D with the SEC within 15 days after the sale is made.  You may also need to make a notice filing and pay a fee to the state in which the investor resides within that time frame. Note that if you are receiving money from an angel syndicate but each individual investor will be writing a check you must comply with each investor’s home state filing requirements. Be sure to check out www.sec.gov and each state’s secretary of state website and http://www.NASAA.org to ensure that you comply with all regulations.  Also, note that the SEC requires that Form D be filed electronically. This will require access to the EDGAR database and may take multiple days to set up. Be sure to look into the securities filings early so that you do not miss the deadline.

In general, angel investors may be a good match for your company’s financing needs. Before agreeing to bring in an angel investor, though, be sure to assess whether this is the best fit for your company. Once you’ve made the decision to follow through with the financing, consider how to best structure deal to suit your company’s needs and be diligent in complying with necessary federal and state regulations.

Read part 1 of this 2 part series:  Angel Investors I: Should You Take Money From an Angel?

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Angel Investors Part I: Should You Take Money From an Angel?

 

"Angel investors" are typically high net worth individuals that invest in a startup at very early stages and prior to institutional investors.

“Angel investors” are typically high net worth individuals that invest in a startup at very early stages and prior to institutional investors.

This is part 1 of a 2 part series on receiving angel investments.  As your start-up grows, your company’s capital needs will be unique to your business. While some entrepreneurs may be able to bootstrap their companies, more than likely your company will need to seek outside investors at some point.  Many entrepreneurs start with gifts or loans from friends and family. There is also the possibility of incubator financing for the first $15,000 – $50,000.  However, after you’ve exhausted this money and your parents’ and Aunt Mildred’s generosity (or before you approach them if you don’t want to have to give financial updates at every holiday and family event), the company may want to raise a pre-VC round from wealthy individuals, also known as angel investors.

The prevalence of angel investors is growing. Angel investors are often more approachable than VCs. Many form syndicates and are looking to invest in start-up companies in their area. When deciding whether angel financing is the right choice for your company, there are a few things you should consider.

Should you take on an angel?

Since bank loans are becoming increasingly more difficult to secure, an investor may be the best choice for your financing needs.  There are a lot of positive things associated with angel investors:

 (a) Geography: Many angel groups look to invest in and promote local start-ups.  It may be easier to catch the attention of an angel group rather than that of a venture capital firm. Additionally, angel investors are likely involved in your community and may provide necessary introductions to help your company grow.

 (b) Size of investment: Generally, angels are looking to invest between $100,000 and $1,000,000. If your company needs more money than the incubator or Aunt Mildred can provide, but does not necessarily fit the specifications of a VC portfolio company yet, this could be a good option.

(c) Flexibility:  Angel investors may be flexible in structuring the financing deal.  This may be attractive to entrepreneurs that want to have a say in the deal terms.

However, depending on the individual, an angel investor may not make additional investments in a company, so it may not be the best choice if you believe you will need another round of financing in the near future. Furthermore, angel investors do not always have experience in the industry of your business, and so may require additional handholding throughout the partnership. Taking on an angel seed round may also make it more difficult to raise a Series A round from VCs. Because angel seed rounds are often based on a loose valuation process, Series A VCs may believe that the valuation of the company is inflated and may be hesitant to invest.

The decision to raise an angel seed round will ultimately be dependent on your company and its needs. For many start-ups, angels are a good solution for pre-VC financing.

 

See Part 2 – Angel Investors II: Structuring the Angel Investment

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Books for Entrepreneurs and Their Attorneys

We are often asked at the Entrepreneurship Clinic about good books for those starting their own companies and for attorneys aspiring to be better-versed on startup issues.  The following are resources we often recommend.

Finding a Repeatable and Scalable Business Model:  One of the most important things for entrepreneurs to understand is the importance of identifying their potential customers and understanding what those customers want.  The following books are essential texts for understanding the importance of customer discovery and development and validating one’s value proposition hypothesis before wasting resources building something that customer’s won’t buy.

Startup guru Steve Blank's best selling work on customer development.

Startup guru Steve Blank’s best selling work on customer development.

 

Business Model Generation by Alexander Osterwalder and Yves Pgneur walks you through the process of building your business model (note: different than a business plan).

Business Model Generation by Alexander Osterwalder and Yves Pgneur walks you through the process of building your business model (note: different than a business plan).

 

The Lean Startup by Eric Ries stresses learning what your customer wants before investing time and other resources in product development.

The Lean Startup by Eric Ries stresses learning what your customer wants before investing time and other resources in product development.

 

Steve Blank and Bob Dorf's step by step guide to developing customers and validating a business model.

Steve Blank and Bob Dorf’s step by step guide to developing customers and validating a business model.

Legal Basics for Entrepreneurs:  Entrepreneurs face numerous legal issues in the early stages and it is important for entrepreneurs to have a basic understanding of common startup legal questions (such as incorporation, IP, employment law, early stage financing, contracts) so they can be a smart consumer of legal services.  The following books are essential guides for entrepreneurs or attorneys seeking to become more familiar with startup legal issues.

 

The Entrepreneur's Guide to Business Law by Bagley and Dauchy has been required reading in our Entrepreneurship Clinic since day 1.

The Entrepreneur’s Guide to Business Law by Bagley and Dauchy has been required reading in our Entrepreneurship Clinic since day 1.

Not So Obvious by patent attorney Jeffrey Schox explains patent law for non-lawyers in plain language.

Not So Obvious by patent attorney Jeffrey Schox explains patent law for non-lawyers in plain language.

Equity Compensation:  Almost all startups rely on equity (such as restricted stock or options) to incentivize employees.  The following book provides a comprehensive, and plan language, explanation of the business, tax, and legal issues related to equity.

 

Consider Your Options by Kaye Thomas walks through equity compensation for startups, including restricted stock, options, tax issues, etc.

Consider Your Options by Kaye Thomas walks through equity compensation for startups, including restricted stock, options, tax issues, etc.

 

Venture Financing:  The goal of most startups is to attract outside capital in order to rapidly scale their business.  The following text by venture capitalists Brad Feld and Jason Mendelson explains the mechanics and substance of venture capital deals in an easy to understand way.  They also include insights from entrepreneurs and focus on which terms matter, and which terms don’t.

Venture Deals by Brad Feld and Jason Mendelson explains venture financing concepts in plain language.

Venture Deals by Brad Feld and Jason Mendelson explains venture financing concepts in plain language.

The Entrepreneurial Mindset:  The following book provides a great insight into the “entrepreneurial mindset” and can help entrepreneurs better understand themselves and those around them.  It also can help those who work with entrepreneurs to better understand their colleagues or clients.

John Gartner's profiles on success stories like Christopher Columbus, Alexander Hamilton, Andrew Carnegie, and Craig Venter depict "the Link Between (a Little) Craziness and (a Lot of) Success."

John Gartner’s profiles on success stories like Christopher Columbus, Alexander Hamilton, Andrew Carnegie, and Craig Venter depict “the Link Between (a Little) Craziness and (a Lot of) Success.”

Enjoy your reading!

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Startup Legal Lessons from the Biography of Steve Jobs (Part 5)

Walter Isaacson's bestselling biography of Steve Jobs touches upon numerous legal issues common to startups.

Walter Isaacson’s bestselling biography of Steve Jobs touches upon numerous legal issues common to startups.

This is part 5 of our series on startup legal lessons presented in Walter Isaacson’s biography of Apple co-founder Steve Jobs.  This post address issues with stock options.  On pp. 365-366, Isaacson describes the haggling between Jobs and Apple over his stock options when he dropped the “interim” from his CEO title in 2000.  The issue of valuing the strike price of options emerged again in 2001 when Jobs received another grant of stock options.  These issues led to an SEC investigation in 2006-2007 related to potential irregularities in the stock option grants to Jobs.  Issues with valuing stock options are a common problem for startups.

This post will provide a general overview of stock options and then discuss the importance of accurately setting the exercise price due to 409A.

Stock Option Basics

As described in “Consider Your Options” by Kaye Thomas, a stock option “is an agreement providing terms under which [one] can buy a specified number of shares of stock at a specified price.”  That specified price is the “exercise price” or the “strike price.”  For example, a company may grant an employee 10,000 stock options at an exercise price of $1/share.  The employee pays nothing and recognizes no taxable income on the grant of these options.  The employee can later choose to exercise the option by paying the exercise price.  For example, if after the stock options are fully vested, the company’s common stock has a fair market value of $5/share, the employee can “exercise” the options by purchasing 10,000 shares of common stock for $1,000 (10,000 shares at $1/share).

Benefits of Options

Stock options can serve as a tax efficient mechanism for giving employees equity exposure to a company.  Where as a restricted stock grant is taxed at the time of grant (assuming an 83(b) election has been made), stock options are typically not taxed at the time of grant.  This is helpful when the value of the company has increased such that the value of restricted common stock is no longer nominal and a recipient would have to pay a significant amount for restricted common stock (if purchasing outright) or in ordinary income tax (if not purchasing outright).

409A

While stock options can provide tax benefits, they can also present complexity and cost in determining the exercise price.  As you can tell from the above discussion, the exercise price is the price an individual will pay to exercise options and therefore has a significant economic impact on the option recipient.  Accordingly, a company may be incentivized to grant options at a lower exercise price in order to pass along more value to a recipient (or similarly to “backdate” the grant of options in order to grant them on a date when the company’s common stock had a lower value).  Under the current law, neither of these are advisable options.  The exercise price of a stock option must equal the fair market value of the underlying common stock on the date of the option grant.

This raises the question of how a company should value its common stock, especially at its early stages.  Company’s used to typically value common stock at 10% of the value of the preferred stock at the last financing.  That practice changed with the passage of 409A imposing significant regulatory hurdles and penalties for options granted at less than fair market value on the date of grant.  409A provides certain IRS-approved methods for startups to calculate the fair market value of option grants, thus shifting the burden to the IRS to show the fair market value was grossly unreasonable.

These approved methods include an independent appraisal (commonly called a 409A valuation), which is good for 12 months unless something impacts the company’s value (such as a financing).  These valuations cost anywhere from $2,500 to much more depending on the provider and the complexity of the company.  Another approved method is the illiquid startup appraisal, where the company has no imminent plans for an exit and a person with experience in valuations sets the value of the company.  See WSGR attorney Yokum Taku’s blog on setting the exercise price of stock options for more info.

Accordingly, startups should not take lightly the process of setting the exercise price of stock options.  At the early stages, when restricted stock can be issued at nominal value, restricted stock awards will typically be a simpler and more efficient way to pass along equity exposure to individuals.  As the company increases in value, options may become the preferred equity compensation vehicle, but startups should allocate resources to properly set the exercise price of the stock options and avoid any unnecessary problems under 409A.

As Apple found out, even prior to 409A, playing around with the exercise price of stock options can cause significant problems down the road.

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Startup Legal Lessons from the Biography of Steve Jobs (Part 4)

Walter Isaacson's bestselling biography of Steve Jobs touches upon numerous legal issues common to startups.

Walter Isaacson’s bestselling biography of Steve Jobs touches upon numerous legal issues common to startups.

This is Part 4 of a multi-part series examining the startup legal issues raised in Walter Isaacson’s biography of Apple co-founder Steve Jobs.  This post discusses how Apple has strategically used design patents to protect its user experience.

Throughout the Jobs biography, patents (both utility and design patents) are frequently referenced to show Apple’s innovation under Jobs. This prior post discusses the basics of design patents and how innovators are increasingly using design patents to protect the ornamental design of a product and therefore provide a competitive advantage.  Perhaps no company has been more effective at using design patents than Apple.  In fact, as of the Fall 2013, Apple has received over 900 design patents on its electronic products and over 30 design patents just on its packaging.  On page 347 of the Jobs biography, Isaacson describes how Apple would even use design patents to protect the packaging for its products.

One of the ways Apple has strategically used design patents is by filing multiple design patents on a single product.  Rather than seeking to claim the overall product design in a single patent, Apple focuses each patent on a discrete design aspect.  An example of this strategy can be seen in Apple’s protection of the design for the Apple Macbook Air.

Apple has used a series of design patents as part of its strategy to protect its ornamental design of the MacBook Air.

Apple has used a series of design patents as part of its strategy to protect its ornamental design of the MacBook Air.

Apple’s filed its first application for a MacBook Air design patent on January 4, 2008 and the PTO issued that patent, U.S. Patent D604,294, on Nov. 17, 2009.  While that patent has several figures, the following figure shows how this patent focused on the tapered clam-shell design of the MacBook Air:

U.S. Patent D604,294 focused on the tapered clam-shell design of the MacBook Air.

U.S. Patent D604,294 focused on the tapered clam-shell design of the MacBook Air.

The solid lines show required elements of the design where as the dotted lines show optional design elements.  Had Apple depicted the entire design with solid lines, a competitor could more easily evade the covered design by merely altering one aspect of the design.  Instead, Apple covers just a single aspect of its design in each design patent, and then seeks to cover the other aspects of the design in subsequent patents.  In the case of the MacBook Air, Apple filed numerous continuation design patents.

On Oct. 19, 2010, Apple received U.S. Patent D625,717 (claiming priority to the original filing date of Jan. 4, 2008).    This patent focused on the metallic color, the black keys, and the clam-shell shape of the computer.

Apple's U.S. Patent D625,717 focuses on the metallic color, black  keys, and clam-shell shape of the MacBook Air.

Apple’s U.S. Patent D625,717 focuses on the metallic color, black keys, and clam-shell shape of the MacBook Air.

Apple then received U.S. Patent D635,566 on April 5, 2011, which claimed the metallic color of the computer but made the color of the keys optional.

Apple's U.S. Patent D635,566.

Apple’s U.S. Patent D635,566.

Apple next received U.S. Patent D661,693 on June 12, 2012, focusing on the side port in the computer:

Apple's U.S. Patent D661,693 focuses on the side port.

Apple’s U.S. Patent D661,693 focuses on the side port.

Apple wasn’t finished.  On July 30, 2013 it received U.S. Patent D687,030.  That patent focused on the black keys and the appearance of the mouse pad.

Apple's U.S. Patent D687,030.

Apple’s U.S. Patent D687,030.

Note how most other features of the shape of the computer are not required elements of this claimed design.  Apple is likely not finished yet, and we will probably see another design patent on the MacBook Air design issuing in the next year.  While all of these patents likely receive the benefit of the parent patent’s filing date, Jan. 4, 2008, the 14 year term of the design patent starts to run upon issuance of each patent.  Contrast this with the 20 year term of utility patents that runs from the filing date of the first nonprovisional patent.  Accordingly, by filing continuation design patents in series, as Apple has done here, they can extend some portions of their design patent term because a new 14 year term starts to run upon the issuance of each new continuation patent (although that patent term will apply only to the specific design aspects covered in that new patent).

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Startup Legal Lessons from the Biography of Steve Jobs (Part 3)

Walter Isaacson’s bestselling biography of Steve Jobs touches upon numerous legal issues common to startups.

With the movie “Jobs” opening in theaters this week, we are taking a look at the startup legal lessons raised in Walter Isaacson’s bestselling biography on Steve Jobs.  Not surprisingly, given the dynamic history of the company Jobs co-founded and led, the book touches upon numerous legal issues encountered by Apple.  These legal issues, as presented in Isaacson’s book, serve as a useful framework for addressing some of the common legal issues faced by startups and entrepreneurs today.  This is Part 3 of a multi-part series.  This post discusses trademark issues in selecting a company name.

Selecting the “Apple” Name

Steve Jobs and Steve Wozniak selected the name “Apple Computer” on a ride from the airport to Los Altos.  Jobs was on a “fruitarian” diet and had just visited the “All One Farm” apple farm near Portland (where he used to spend weekends pruning the apple trees and seeking enlightenment).  On one hand, the name Apple Computer would typically be considered to be a strong name from a trademark perspective.  As discussed in this prior post,  the name “Apple” does not, by itself, suggest to the consumer the nature of the underlying business (making computers).  Accordingly, trademark law would consider the name to be arbitrary, and therefore highly distinctive.  Highly distinctive marks, like Apple for computers, receive greater protection under trademark law.

Selecting a name that is eligible for strong trademark protection is only half the battle when considering a company name.  Entrepreneurs should also make sure that their name does not conflict with any existing trademarks.  In the case of Apple Computer, it did.  Apple Corps, was the name of the Beatles holding company.  Apple Corps first sued Apple Computer for trademark infringement in 1978.  The suit settled with Apple Computer paying Apple Corps a modest payment and the parties entering into a “coexistence agreement.”  The Beatles would not produce computer equipment; Apple could not market any music products.

Apple Corps v. Apple (Not Just) Computers

Apple Computer’s business originally focused on “just” computers, but as we all know, it did not always stay that way.  This is a good example of a common mistake made by entrepreneurs, who are often unconcerned with an existing mark similar to their own in a seemingly unrelated field.  The experiences of Apple Computer, however, demonstrate how seemingly unrelated businesses can suddenly become related through changes in technology and business models.

On numerous occasions, Apple Computer sought to incorporate music-related technology or services into its products.  In the late ’80’s, Apple Computer introduced its Musical Digital Interface and in 1991, Apple Computer launched a Mac with the ability to play music files.  Apple Corps sued over both launches resulting in payments of millions of dollars by Apple Computer.  In 2003, Apple Computer launched the iTunes Store, and Apple Corps sued again.  The parties finally resolved these issues in 2007 with Apple Computer paying Apple Corps $500 million to acquire worldwide rights to the mark, and then licensing back Apple Corps the right to use the mark in connection with the Beatles.

While Apple had the resources to withstand these repeated disputes, it would be cost prohibitive for most startups to address a trademark dispute from a well-financed entity like Apple Corps.  While startups can change their brands, this is also cost intensive not only in terms of mechanically changing the brand but also in terms of the lost good will that a startup has built up with customers, investors, and other partners.

Performing a Preliminary Trademark Clearance

To avoid selecting a company or product name that conflicts with existing rights, entrepreneurs should at the very least conduct a preliminary trademark clearance.  The Entrepreneurship Clinic provides this trademark clearance checklist for entrepreneurs to make sure their name does not have any readily apparent conflict with existing marks.  One common misunderstanding among entrepreneurs is that just because a mark is not registered at the U.S. Patent & Trademark Office does not mean that another party does not have rights to that mark.  One can obtain common law trademark rights merely by using a mark in commerce.  Accordingly, even if your chosen company name does not appear on the U.S.P.T.O. trademark database, one also needs to check to see if that mark is nonetheless being used in commerce.  Once a company or product name has been preliminarily cleared, entrepreneurs would be wise to engage a trademark attorney who can perform a more thorough search on commercial databases covering additional registries and sources of information on possible uses of a mark.  While entrepreneurs often relish their status as risk-takers, selecting a company name is one area where taking on risk makes little sense.

 

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Startup Legal Lessons from the Biography of Steve Jobs (Part 2)

Walter Isaacson’s bestselling biography of Steve Jobs touches upon numerous legal issues common to startups.

With the movie “Jobs” opening in theaters this week, we are taking a look at the startup legal lessons raised in Walter Isaacson’s bestselling biography on Steve Jobs.  Not surprisingly, given the dynamic history of the company Jobs co-founded and led, the book touches upon numerous legal issues encountered by Apple.  These legal issues, as presented in Isaacson’s book, serve as a useful framework for addressing some of the common legal issues faced by startups and entrepreneurs today.  This is Part 2 of a multi-part series.

This post discusses the scenario of a departing founder.  As explained on page 61 of Isaacson’s biography, within two weeks of organizing Apple, co-founder Ron Wayne made the decision to leave the company.  He sold the entirety of his partnership interest to the other co-founders, Steve Jobs and Steve Wozniak.  Ron Wayne’s motivation to leave Apple was in part due to the personal liability he would take on as a partner in a general partnership (as discussed in Part 1 of this series, Apple was originally organized as a general partnership).

The departure of a startup founder, however, may not always go so smoothly.  It is extremely common for founders to leave startups.  All too often, these founder breakups can be fatal to a startup.  According to Harvard Business School Professor Noam Wasserman, roughly 65% of the failures of high-potential startups are due to “people problems.”

There are well-known mechanisms, however, that make it possible for a startup to survive a founder breakup.  These include:

IP Assignments

All individuals working for a startup should sign documents assigning to the company any intellectual property created by that individual arising from their work for the company.  This is typically accomplished through a Proprietary Information & Invention Assignment Agreement (commonly called a PIIA).  This document should be signed by an individual at the beginning of that individual’s relationship with the startup.  Proper IP assignment language should include the words “hereby assigns,” so that the language will act to automatically transfer IP rights from the individual to the company upon the individual creating that IP.

If the individual has created IP related to the startup’s business prior to entering a formal relationship with the startup (such as a founder who has been working on an idea prior to incorporation), then that individual should also assign to the company that individual’s IP rights already in existence.

Restricted Stock Agreements Implementing Vesting

As discussed in this prior post, vesting refers to a company having the right to repurchase an individual’s equity if that individual’s service terminates.  The company’s repurchase option lapses over time.  Vesting is typically implemented through a Restricted Stock Purchase Agreement (for a corporation) or a Restricted Unit Agreement (for an LLC).

Departing Founder Example

Let’s pretend Departing Founder owns 25% of the common stock in a startup.  Departing Founder has a falling out with his or her co-founders.  Departing Founder has not signed any documents assigning IP to the startup and does not have a vesting schedule in place covering his or her common stock.  Upon Departing Founder leaving the startup, her or she will likely walk away with (at least) joint ownership of any IP to which Departing Founder contributed, and the full 25% of the company’s common stock.  The startup will not have any exclusive rights to the IP jointly-owned with Departing Founder.  In addition, 25% of the company will be dead weight, which will certainly be demoralizing to the remaining team members still working for the startup.  This startup is likely doomed unless it can work out an agreement with the Departing Founder to claw back the IP and equity.

Now let’s pretend the same situation exists with Departing Founder except that proper IP assignments and vesting schedules are in place.  Upon Departing Founder leaving, all IP will remain with the startup.  The Departing Founder walks away with no rights in the startup’s core IP.  Additionally, the startup will have the right to repurchase the unvested portion of Departing Founder’s 25% of the common stock.  For example, if vesting occurred over 4 years with a 1-year cliff, and Departing Founder left just after the 1-year mark, the startup would be able to automatically repurchase 3/4 of the common stock held by Departing Founder.  Departing Founder would remain a shareholder of the company, but only for the 6.25% of vested common stock (1/4 of Departing Founder’s 25% of the company).  The repurchased common stock would return to the company’s pool of authorized but unissued stock.  It would be available to incentivize the remaining workers, or more likely to attract the talent needed to replace Departing Founder.

Release and Termination

If possible, it is also wise to enter into a release and termination agreement with a departing founder.  While Ron Wayne is at peace with the fortune he would have had he not left the company, other departing founders might experience seller’s remorse and make claims against a company whose value skyrockets after a founder leaves.  Ideally, a startup and departing founder will  resolve any possibility that either startup or the departing founder could have any claim against the other in the future.

Returning now to the Apple situation, Ron Wayne desired to return all of his partnership equity to his co-founders.  This is likely an anomaly, though.  As discussed in our prior post in this series, most startup entities will provide limited liability to founders.  Accordingly, most departing founders will not have the threat of unlimited liability (present with a general partnership) to incentivize the departing founder to relinquish their shareholder or member status.  With the proper legal documentation — including IP assignments and equity vesting arrangements — startups can survive the departure of a founder.

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Startup Legal Lessons from the Biography of Steve Jobs (Part 1)

Walter Isaacson's bestselling biography of Steve Jobs touches upon numerous legal issues common to startups.

Walter Isaacson’s bestselling biography of Steve Jobs touches upon numerous legal issues common to startups.

With the movie “Jobs” opening in theaters today, we thought it might be interesting to revisit Walter Isaacson’s bestselling biography on Steve Jobs.  Not surprisingly, given the dynamic history of the company Jobs co-founded and led, the book touches upon numerous legal issues encountered by Apple since its formation in 1976.  We can use these legal issues as a framework for addressing some of the common legal issues faced by startups and entrepreneurs today.  This is Part 1 of a multi-part series.

While Steve Jobs and Apple are known for thinking differently (as famously depicted in their 1997 “Think Different” ad), as a company, Apple has still encountered some of the same legal decision points common to today’s tech startups.  One example is the early choice of a form of entity for startup ventures.  On page 61 of the Steve Jobs biography, Isaacson explains that Apple’s three original founders — Jobs, Steve Wozniak, and Ron Wayne — established Apple as a general partnership.  Wayne wrote the partnership agreement, allotting 45% of the equity to Jobs, 45% to Wozniak, and 10% to Wayne, and requiring that expenditures over $100 receive approval of 2/3 of the partnership.

There are a few points to make here.  First, documenting these early agreements is a good idea in most cases.  It is important to note that in most states, a general partnership can be formed even without a written agreement.  The Revised Uniform Partnership Act defines a partnership as “an association of persons who carry on as co-owners of a business for profit.”  Therefore, if founders are working together in pursuit of a venture, they may be operating as a general partnership whether they know it or not.

Absent a written agreement, state law is going to dictate the specific equity and governance structure of the partnership.  This would be the same for other forms of entity as well, such as a limited liability company which is going to have an equity and governance structure imposed by state law in the absence of an operating agreement.  It is highly likely that this default equity and governance structure will not reflect what the founders have in mind.  So, put these agreements in writing — like Wayne did.  Unlike Jobs, Wozniak, and Wayne it is also wise to consult an attorney familiar with startups who can also establish industry standard mechanisms such as vesting.

Second, today, selecting to organize a tech startup as a general partnership would be highly irregular.  The reason is that in a general partnership, each partner is responsible for the liabilities of the company (whether or not that partner was involved in any way with the actions underlying the liability).  In other words, an individual partner in a general partnership could incur catastrophic liability through no fault of their own.  Accordingly, almost all tech startups will organize in a form of entity providing limited liability to the owners — typically a limited liability company, an S corporation, or a C corporation.   This prior post addresses the entity selection question for startups.  Indeed, according to its website, Apple incorporated on January 3, 1977, within a year of its initial organization as a partnership.

In fact, the threat of personal liability is one of the reasons for Wayne electing to leave the Apple partnership shortly after its formation.  According to Isaacson’s book, Wayne became worried about his personal liability for Apple’s debts when Jobs began planning to borrow money to grow the company.  He sold the entirety of his partnership interest to Jobs and Wozniak for $2,300, as reported in Isaacson’s book and by Wired Magazine.  We will talk more about legal issues associated with departing founders in our next post in this series.