How to Build and Maximize Value in an IP Portfolio – The Key to Venture Capital Financing

The following article examines the issues a technology company must address in establishing an IP strategy that will enhance the value of its IP portfolio and its prospects for capital financing. Enhanced value can result, for example, from an increase in revenue and increased market share that results from a well planned IP portfolio. Check lists are provided which can benefit both start-up and more established companies as both need to protect and build the value of IP in core technologies that differentiate their technology from that of their competitors. While this article principally focuses on assisting start-ups to attract venture capital, the process of valuing and building core technology is the same for any size technology company.

I. INTRODUCTION It is no surprise that the current slowdown in the economy is resulting in a tightening flow of venture capital to fund start-ups. Even in a difficult market, venture capital financing is possible for a company with a strong technology and an experienced management team if the potential market is attractive. The ability of a start-up company to demonstrate market potential to the venture capital community cannot be accomplished, however, without building and constantly nurturing an intellectual property (IP) portfolio. The business plan and IP strategy of a start-up must therefore be planned and coordinated from the outset. Moreover, the IP plan should work in a tandem with a solid funding strategy.

Generally, a venture capitalist (VC) will not invest in a start-up company unless adequate steps have been taken to protect the company’s technology and, accordingly, the company’s market position or market opportunity. To the VC, IP is often an integral part of value creation in a technology-based enterprise. On the flipside of this equation, founders understandably want to maintain as much ownership of their company as possible. Often, the number one lever available to a founder in this regard is a strong IP portfolio and/or plan.

It is well known that patents, trade secrets, copyrights and trademarks can create advantages needed to establish a dominant market position and to achieve commensurate profits. In turn, this ability to establish a dominant market position translates directly to higher capital stock values and a greater reward for founders and investors. The challenge for a start up is to effectively communicate the potential advantages of what is often nescient IP protection. Often, with a start-up, patents have not been issued, the market and competition have not been wholly identified or proven, meaning the ultimate strength of the IP Portfolio is difficult to assess.

But it has been proven that a company’s IP strategy is likely to determine its future economic success and/or its ability to maintain that success. The recent surge in IP acquisitions and valuations is the only the latest testament to this fact.

But even for a start up, IP offers a differentiation between competitors, or solutions, and therefore it is often the key to quickly achieving significant market share and premium profits – or at least to being able to convey the possibility thereof. Valuable IP can include patented formulas, computer code and technical processes, as well as trade secrets, know-how, trademarks, and domain names. Indeed, a break-through product may derive its success from all such forms of intellectual property.

II. IDENTIFYING AND VALUING INTELLECTUAL PROPERTY

During the dot-com boom, valuations were sky-high and IP was almost an afterthought. Today, however, only companies with solid IP are able to raise money or achieve meaningful valuations. This is because VC’s are paying much more attention to IP and are taking much longer to assess their prospective investments. At the heart of such assessments is a full analysis of the IP protection that has been put in place, and whether there is a viable strategy for protecting core technology. As a result, a startup looking to successfully raise venture capital must be prepared to show that they have put in place IP protection that will justify the valuations they are seeking.

VC’s want to gain a thorough understanding of a start-up company’s business plan and the competitive landscape it is facing. Then they want to understand how the company intends to achieve its business goals given the competition that exists. They want to know the manner in which a company’s IP strategy protects the company’s potential markets. They question whether the core technology is protected and whether the company’s patents can be used to prevent competitors from using key technology.

In short, it is important to build an IP strategy in a way that is commercially relevant and that allows you to easily convey the commercial relevance of your IP strategy to a potential investor. It is also important for technology start-ups to understand the types of questions a well informed VC will be asking when assessing the start-up.

So what types of questions will a VC be asking? First, the well informed VC will focus on the market, with questions like:

  • What is the market for the company’s core technology?
  • Does the technology address significant problems in the market?
  • Does the company’s IP strategy lead to a sustainable competitive advantage?
  • Are patents and IP sufficient to create effective barriers to entry of the market by competitors?
  • Is there compelling technical and economic evidence to warrant building a business based on the company’s technology?
  • Are there competitive alternatives and, if so, is the market large enough to yield a significant return on the investment?
  • How much capital is needed to achieve a sustainable market position?
  • Are there other potential sources of capital beyond the venture capital?
  • How strong are the proprietary aspects of the technology including patent protection?
  • Docs the company have issued patents or patent applications on file with claims that cover the products and services the company intends to market, including anticipated products and services in anticipated markets?
  • Do third-party patents limit the company’s freedom to operate?
  • Does the company’s IP put it in position to negotiate a favorable cross-license with mature competitors, if necessary?
  • Does the company’s IP strategy support its proposed business plans and objectives?
  • Does the company’s strategy take into account its competitor’s likely course of action?
  • How can the company’s IP rights and prospective IP rights be used to enhance the company’s valuation prior to a liquidity event?
  • Are there any ownership issues related to the IP?
  • What further development of the technology and the IP position is needed?

A successful start-up must develop its IP strategy with these questions in mind. The more complete the answers, the higher the valuation and/or the greater ownership share the founders will be able to maintain.

III. IP AUDITS So how does the VC determine the answers to the questions above? Often, a VC will undertake an IP audit. To perform the IP audit, a VC will often hire a diversified and technically sophisticated IP legal team to analyze the IP strategy of a potential investment in the context of the above questions. The following details some of the important aspects of a typical IP audit.

(a) MAKE A LIST OF OWNED TECHNOLOGY How did the company protect its core technology? List patents, patent applications, trademarks, trademark applications and copyrights. Ensure that the company has established, adhered to Copyright and Trade Secret policies. Create accurate and complete patent, trademark, and copyright files. Search the records of the U.S. Patent and Trademark and Copyright Office and comparable organizations of other jurisdictions, if necessary. Similar searches in other countries would be necessary if the company filed abroad.

(b) DETERMINE SCOPE OF RIGHTS OWNED (i) Patents Chart the scope of issued patent claims in view of the market and competition. Determine whether patents have been filed for all patentable inventions of value and whether patent filings have been properly prosecuted. Make sure any renewal fees have been paid.(ii) Trademarks and Copyrights Ensure that the company has an established, adhered-to Copyright policy. Ensure applications have been filed for all of the companies’ copyrights, trademarks, and service marks. Make sure all fees and renewals are paid and/or filed. (iii) Trade Secrets and Proprietary Information Ensure that the company has an established, adhered-to Trade Secret policy. Look at whether trade secrets are being properly documented and whether the company has taken reasonable steps to protect their confidentiality. Ensure that the company uses confidentiality agreements whenever it discloses its technology to a third party. (iv) Enforcement Consider whether the company has been diligent in enforcing its IP rights and whether any potential rights may have been waived or may be the subject of legal or equitable estoppel. Gather all cease and desist type letters. Review all current and potential litigation. Close coordination between litigation and prosecution patent lawyers is the key to success in protecting a start-up’s intellectual property and raising capital.

(c) REVIEW IP LICENSES Review licenses from and to third parties to determine the company’s continued ability to use its technology and under what conditions. Assess impact of termination clauses, assignment provisions, fields of use or territory restrictions, royalty provisions, exclusivity terms, and unusual warranties which could significantly affect asset value or transferability. Employee and consultant agreements need to be reviewed for breadth and enforceability. Beware of “work for hire” doctrine. Is there documentation sufficient to convey to the company usable IP rights in works created by consultants or third parties? Determine whether the company has licensed or compromised any of its IP, and, if so, how and under what conditions. Review all licenses, assignments, distribution agreements and other commercial contracts that could convey any rights in the IP. Exclusive agreements, which transfer all rights to IP are of special concern. Non-exclusive arrangements should also be reviewed. They may make it impossible to grant exclusive rights in the future and may create unusual royalty provisions or may impose affirmative obligations on the company.

IV. TYPES OF IP WHICH SHOULD BE AUDITED (a) PATENTS Patents protect new inventions and grant exclusive rights to make, use, sell or offer for sale the particular product or process claimed. Patents are a significantly stronger form of protection than copyrights. Patents involve higher expenses than copyrights or trademarks. However, the relative benefits justify the expense and trouble seeking patent protection can involve. Patents can be obtained that cover a variety of products and services. Software and methods of business are patentable if they meet the essential requirements for a patent.There are certain key prerequisites for patentability, including “novelty” and “non-obviousness.” These and other prerequisites for patentability involve complex and detailed analysis. A key question to ask: is whether the technology that is the subject of the patent application is in the public domain? Prior to filing your patent application, it is essential that confidentiality and secrecy in relation to your technology be maintained. Failure to keep it confidential can prejudice patentability. Additionally, after a Copyright @2012 Procopio, Cory, Hargreaves & Savitch LLP www.procopio.com | 5 patent has issued, proper patent markings should be placed on products or it may be impossible to collect damages in any subsequent infringement suit.

(b) TRADEMARKS A mark is a word, name, symbol, or device or any combination thereof used to identify and distinguish goods or services and to indicate their source. A mark used on or in the sale of goods is known as a trademark. A mark used in the sale of services is known as a service mark. Trademark searches, public register searches and domain name searches can be carried out to gauge the strength of current marks owned by the company. If the company chooses a brand or sought trademark protection for a mark which is weak because of others’ prior uses, the valuation will often be lower. Even if trademark protection exists, policing of your trademark rights is important. Has the company moved quickly and decisively to protect its rights? Delays in doing so can prejudice rights in subsequent litigation. Ensure that proper marking and that the registered trademark warning appears on all literature which use the trademark, as well as the correct legal name of the owner.

(c) COPYRIGHTS In many sectors and particularly in the software field, copyright is perhaps the most utilized form of IP. Copyright prevents the copying of physical material. It is not concerned with the substance of the idea but rather with the reproduction of the form in which the idea is expressed. Check whether the software developers are employees of your company. If such employees create code or other copyright works during the course of employment, then the copyright in that software is the property of your company. It is different with third party contractors and consultants. If you use them to write software code or create other copyright works, you do not have complete rights unless the appropriate legal documentation is executed.

(d) TRADE SECRET AND CONFIDENTIALITY First, determine whether a trade secret policy is in place. Have there been proper and enforceable confidentiality and noncompete agreements? If there were prior disclosures of business secrets, such as ideas for a new product or financial information relating to your business, it is of crucial importance that before the disclosures, the recipient of the information signed a confidentiality agreement or secrecy agreement which provides sufficient protection from unauthorized disclosure or misuse by the recipient.

V. ADVICE FOR THE TECHNOLOGY START-UP It is important to note that in the venture capital world, turnarounds are much shorter than in typical long-term invested companies. VC’s will usually be interested in quarterly evaluations of performance, and will look to get a company up and running and hopefully take it public or sell it quickly. Copyright @2012 Procopio, Cory, Hargreaves & Savitch LLP www.procopio.com | 6 VC’s look for unique and proprietary technologies that are critical, such as in wireless, software, semiconductor, biotechnology, biomedical and pharmaceutical industries, and that can create new markets which are protected from predatory price competition and price erosion. VC’s will want to see that a prospective investment core technology is being protected in a way that is commercially relevant. So to get the attention of VC’s, a start-up should build and maintain a strong proprietary intellectual property portfolio. It is also important to maximize the patent protection of their technology in a way that makes it easier for someone about to invest in their technology to determine whether it is a worthwhile investment. The companies’ executives and boards of directors are encouraged to develop a consistent IP strategy intertwined with the business plan of the company. The IP portfolio should be built by filing broad patent applications early and often to build a fortress around the company’s core technology. There must be communication, not only between the IP attorney and the inventors, but also between the IP attorney and management – – including the marketing department and business plan visionaries to ensure that forward-looking patent protection is in place before there is a publication of research findings. A check list for doing so which summarizes both offensive and defensive strategy is attached and summarized below. This makes the selection of IP counsel a key decision in any start-up’s IP strategy. Not every IP attorney understands the business aspect of building a successful IP strategy in today’s competitive market. Moreover, not every IP attorney understands the importance of being able to convey the IP strategy in a manner that makes it easy for potential investors to understand. Litigation experience is also important, not only because it helps in writing stronger patents, but navigating a start-up through the critical early phases requires skills in litigation avoidance. But for the start up flexibility on costs, the ability to offer alternative arrangements, and a thorough understanding of the world of a start up, are also key attributes to look for when selecting IP Counsel. You IP counsel needs to be passionate about your startup company, really understand your technology and markets, and how to effectively build an IP portfolio for a start-up.

VI. PROTECTING CORE TECHNOLOGY Whether you are a large company or a start-up, obtaining patent protection is the key feature of any IP strategy. When building an IP strategy, a technology company needs to assess key aspects of its technology and its intended markets. In preparing patents and patent applications, the client and patent lawyer must collaborate to put in place a combination business and IP plan which should start by answering the following questions in Exhibit A.

VII. CONCLUSION Intellectual capital is recognized as the most important asset of not only many of the world’s largest and most powerful companies, but to technology start-ups it is the equivalent of the “equalizer.” It is the foundation and the hope for market dominance and continuing profitability. It is often the key objective in mergers and acquisitions. The focus on IP is critically important in today’s venture capital market in the United States. A start-up without a solid, readily definable IP strategy is unlikely to be successful in raising venture capital. In contrast, a start-up with a credible, well defined IP strategy can even find itself with some leverage when negotiating venture capital terms.

Noel Gillespie counsels clients on ways to build and enforce strategic patent portfolios that protect the client’s technology and markets so that they can achieve their business objectives. This process includes developing claim strategies that create market barriers and protect or create revenue streams. The process also includes preparation and prosecution of U.S. and foreign Patent Applications. In particular, Mr. Gillespie has extensive experience dealing with telecommunications companies, including companies involved with wireless, wired, and optical communications technology, as well as wireless health, health IT, medical device companies, analytics, and software/Internet companies. He can be reached at noel.gillespie@procopio.com or 619.515.3288.

Exhibit A Intellectual Property Issues — Protecting Core Technology

VIII. OFFENSIVE STRATEGY

a. Review Current Patents And Applications. Determine If Additional Patent Applications Need To Be Filed

i. Coverage Issues – The claims define the technology invented and the boundaries from which competitors will be excluded

1. What do the claims of the patents and applications on file cover? Will they protect sources of income?

2. What type of additional claims can be used, product, process, method composition, broad or narrow?

3. Will they cover the products processes or services you intend to market?

4. Will they cover anticipated products or services in anticipated markets?

5. If we claim methods of doing business – are there flow charts which describe software, hardware and internet implementation of each step in the business method.

6. You can file paper patents even where there is no actual product. Do not be constrained by current technology.

7. Brainstorm – what if you were a competitor trying to avoid the claims? COVER ALTERNATIVES

8. Make your IP plan conform with your business plan.

9. Make sure you own the patents and applications – clear title.

10. In making the above analysis, keep in mind that known prior art must be disclosed to the PTO to avoid a charge of inequitable conduct.

b. Continuously Identify Additional Improvements and Developments to file patents on.

i. Technology evolves, so identify improvements to current products or services.

ii. Identify new products or services – be forward thinking.

iii. Where is the technology going?

iv. What markets should be protected?

v. Identify future markets. Do not be constrained by current technology.

c. Identify Objective Factors Which Support Patentability

i. Was there a long-felt need for the invented technology?

ii. Was there a skepticism to solving the problems?

iii. Was there a failure of others?

iv. Was there commercial success?

v. Did prior art teach away?

vi. Document the above and use with the Patent Office or with Courts.

d. Establish Formal Mechanisms to Identify and Obtain Patent Protection on New Inventions and Improvements.

i. Engineers, programmers or scientists should keep dated and detailed lab notebooks.

ii. Invention disclosures should be prepared on new inventions.

iii. Schedule regular patent committee reviews.

e. Identify Potentially Adverse Parties having Patent Positions.

i. Who are the major players in each market of interest?

ii. What are their patent positions?

iii. If blocking can they be surrounded?

iv. Can you patent specific commercial uses?

f. Beware of Patent Bar Dates

i. In the United States, there is a one year “grace period” for filing. A patent application must be filed within one year of the first publication, public use, sale or offer for sale or your rights will be lost. Use NDA’s whenever possible. We must identify any one year bars!

ii. Outside of the United States, absolute novelty is generally required. In most foreign countries, a patent application must be on file in the United States or other treaty country before any publication, public use, sale or offer for sale.

g. Advantages of Obtaining Patents.

i. Patents are presumed valid and “clear and convincing evidence” is needed to overturn them.

ii. Patents provide the right to exclude competitors who trespass on the property defined in the claims by obtaining injunctive relief in a court of law.

iii. If a patent is infringed, damages can be recovered, including, lost profits or a reasonable royalty.

iv. If the patent is “willfully” infringed, damages can be trebled and attorney’s fees and costs can be recovered.

v. Patents may be useful as a bartering tool, as an aid in settling litigation, to raise capital or to avoid litigation.

h. Foreign Patent Protection.

i. Applications in foreign countries must be filed within one year of the U.S. filing date in order to retain priority in the U.S. filing date.

ii. Caution: EPO (European Patent Office), PCT (Patent Cooperation Treaty) and many foreign applications will be published 18 months after filing. These could act as bars to the inventor’s other patent applications.

i. Other Avenues of Intellectual Property Protection.

i. Copyrights

ii. Trademarks or Service Marks

iii. Trade Secrets: 1. Confidential disclosures (NDA’s) 2. Employment and Consultant Agreements

IX. DEFENSIVE STRATEGY

a. Identify Potentially Adverse Parties having Patent Protection (I-C above).

b. Patent Clearance and/or Design Around for Products to be Marketed.

c. Attorney Opinions re Competitors’ Patents/Applications to Avoid “Willful Infringement.”

i. The legal effects of attorney opinions.

ii. Evolving stricter standards by Court of Appeals for the Federal Circuit.

d. Financial Risks of Patent Infringement (mirror linage of I-E above).

i. Costs of litigation.

ii. Payment of damages (lost profits or reasonable royalty).

iii. Trebling damages for “willful infringement.”

iv. Injunction (Loss of R&D investment).

v. Payment of patentee’s attorney fees and costs in “exceptional” cases.

e. Possible Risk-Avoidance Strategies.

i. Indemnity agreements.

ii. Creating a fund if lawsuit is inevitable.

iii. Attorney, opinions may avoid “willful infringement” and “exceptional case” if infringing course of action is in good faith reliance on advice of counsel.

iv. Insurance (both offensive and defensive).

THE DANGERS OF RAISING CAPITAL THROUGH SOCIAL MEDIA

The use of social media for business, networking and personal purposes is increasing exponentially. Savvy entrepreneurs and businesses are using social media to market their products to a wider audience, drive traffic to their websites and increase sales. It’s hardly surprising that many of those same individuals and companies are turning to social media to fulfill their funding needs. However, in doing so, they may be inadvertently violating federal and state securities laws and putting themselves in a difficult situation.

You may have seen posts on LinkedIn, Facebook, or other social media websites requesting funding or suggesting a great investment opportunity. You might even have thought it would be a great way to raise money for your own business. What you are probably not aware of is that the primary method of raising money is by selling your company’s securities, which is a highly regulated practice. Federal securities laws generally prohibit any person from selling securities unless a registration statement covering the securities has been declared effective by the SEC or an exemption from the registration requirement is available. As you might imagine, registering securities in a public offering can be prohibitively expensive. Consequently, the only option most private companies have to raise money relies on certain limited exemptions from registration referred to as “private placements”.

Private placements are exactly that – private. A company seeking to raise money through a private placement may not offer or sell its securities by any form of “general solicitation” or “general advertising” and, in some cases, may only sell the securities to a limited number of eligible investors. Due to the restricted nature of these offerings they are not considered “public offerings” and, therefore, are not subject to the registration requirements.

What does this mean to the young company looking to raise money? It means what may seem like a harmless online post may in fact be deemed a “public” communication prohibited by federal and state securities laws. Although the law has not kept pace with social media, and there is no clear rule on what constitutes “general solicitation” or “general advertising”, securities laws generally prohibit communications regarding a stock offering published in any newspaper, magazine or similar media. Consequently, a widely disseminated online post that your company needs money is likely a prohibited communication.

What about posts in group forums on LinkedIn or to “friends” on Facebook you may ask? That is not quite as clear. A company may prove a stock offering was not based on general solicitation or advertising if the company or its principals had a pre-existing substantive relationship with the prospective investors. It may be possible for such a relationship to develop online. However, companies should be wary of making such an assumption. The SEC has stated that such a relationship is one that existed before the offering was contemplated and that enables the company to be aware of the financial circumstances or sophistication of the potential investors. While parties may develop such a relationship in an online setting, it is unlikely that merely joining a group on LinkedIn or adding a new “friend” on Facebook would, by itself, be sufficient for a company to understand all of the group’s members’ or friends’ respective financial circumstances or sophistication. The relationship must be substantive enough to ensure a reasonable belief can be formed that the potential investor meets the requirements to invest.

That are the consequences of these violations? First, the private placement exemption may no longer be available, resulting in the delay or even termination of your effort to raise capital. Second, the investors could have the right to rescind the offering, essentially giving them the right to demand the return of their investment at any time if they are not pleased with the company’s performance. Finally, the SEC could impose civil, and possibly criminal, enforcement actions against the company and its principals. Given these potential ramifications, it is in each company’s best interest to carefully consider what it, and its employees and agents, are posting online.

PREPARING FOR AN EXIT – WHAT TO CONSIDER WHEN SELLING YOUR BUSINESS

For the owners of most private companies, selling is a new and daunting process. Capitalizing on the value of the business in such a situation can be difficult for the unprepared. If you are considering selling your business, careful planning early in the process can help you ensure the process runs smoothly and ends with the best results.

1.   Know Your Goals

Before taking any steps, you should first have a clear understanding of why you are selling. A sophisticated buyer will question why they should buy your business if you no longer want to own it. It is important to be prepared to answer this question both for the buyer and for yourself. If your goal is to retire, you should have a firm understanding of how much money you will need to receive for your business to maintain the lifestyle you want during retirement. A qualified financial planner can assist you in making that determination. If your goal is not to retire, you should carefully consider how selling the business will affect you. Most buyers will require you to sign a non-competition agreement, prohibiting you from competing with the business for several years after the sale. If you cannot retire on the sale proceeds, can you afford to be out of work in the industry for several years? If not, you may need to negotiate an exit that provides for your continued involvement in the business after the sale or reconsider whether a sale to a third party is the proper exit for you. Other options include an installment sale to a key employee or succession planning to a family member.

2.   Understand your company’s value.

A realistic expectation of your company’s value is needed to make these tough decisions. While business owners typically have a general idea of their company’s worth, they may not have a firm grasp of its actual current market value. Obtaining a valuation from a professional source can provide you with a realistic expectation for your exit and help you negotiate proper value for your business based upon defensible information.

3.   Put your house in order.

Before proceeding to market, make sure your business is ready to go under a microscope. Potential buyers will typically conduct in-depth due diligence on your business before acquiring it. If their review uncovers any potential risks, they could be scared off or reduce the purchase price. By carefully reviewing your business in advance, you can identify potential weaknesses, eliminate red flags, alleviate a buyer’s potential concerns and maintain your bargaining position. Make sure your corporate records and financial statements are accurate and up-to-date, important arrangements are properly documented, your key employees are retained, lawsuits have been settled and there are no skeletons likely to pop out of your company’s closet.

4. Keep it quiet.

News of a potential sale may cause suppliers, customers or employees to look for opportunities elsewhere due to the company’s uncertain future, which can decrease the company’s value. It is important to maintain confidentiality by restricting disclosure of the proposed sale to those individuals needed for the sales process and requiring nondisclosure agreements when prudent.

5.   Stay focused on your business.

Selling your business can be a full-time job. Don’t forget that potential buyers will be scrutinizing the profitability of your business. If revenues falter or other concerns arise because you have not concentrated sufficiently on your business, buyers may seek to reduce your purchase price or back out of the deal entirely.

6. Learn and manage the process

Commencing the sales process, identifying the right buyer, negotiating the terms of the sale and closing the transaction can take longer than expected. Depending on the risk adversity of the buyer, due diligence alone may take 30 to 60 days, or in some cases longer. Understanding the sales process will allow you to be prepared, plan accordingly and start the process at the right time to maximize the marketability of your business. You should also identify upcoming issues, such the expiration of critical licenses, leases or other agreements, and be ready to deal with them. Don’t let surprises derail your transaction.

7.   Get the right help

Most business owners have little, if any, experience selling a business and find themselves negotiating with experienced buyers. Engaging professional advisors that are experienced in mergers and acquisitions early in this process will level the playing field, help maximize the value you receive for your business and ensure you are protected in the process. The sale of your business is not the time to hire a family friend or relative that is not an experienced mergers and acquisitions professional. The right professionals will guide you through the entire sales process and help you avoid common mistakes and pitfalls that can be difficult and expensive to fix in order to get your deal back on track.
It is never too early to begin this process. By taking the steps to evaluate your options, understand your company’s value, put your business in order and obtain professional assistance, you are strategically planning for the successful exit you want.

Jason Femrite’s practice focuses on the representation of both private and publicly held companies, funds and investment firms in a wide range of transactions from structure and formation to capitalization and finance, and sale and acquisition. Mr. Femrite’s emphasis is in the areas of mergers and acquisitions, private equity, corporate and venture finance, securities and general corporate matters. His experience in these areas includes the representation of both buyers and sellers in mergers, management buyouts, stock and assets sales and private placements. He also has significant experience in the areas of corporate governance and securities compliance for both public and private clients. He represents clients involved in many industries, including biotechnology, cleantech, action sports, financial institutions, automotive and manufacturing. Reach him at 858.720.6334 or jason.femrite@procopio.com.
January 2011
Copyright @2012 Procopio, Cory, Hargreaves & Savitch LLP www.procopio.com

THE RISKS OF USING “FINDERS” TO RAISE CAPITAL

Raising investment  capital  for  a  busi‐ ness  isn’t  easy  in  this  climate  and  most  entrepreneurs  are  willing  to  take any help they can get. Few entre‐ preneurs have sufficient personal con‐ tacts  to  fund  an  offering  and  when  they  are  not  an  attractive  candidate  for  the  venture  capital  market,  they  enlist  the  services  of  well‐connected  individuals  who  make  introductions  and open up  their contact lists. These  individuals who act as intermediaries  in  the  capital  raising  process  are  called “finders.”  The problem is these “finders” may be  acting as unregistered broker‐dealers.  The Securities and Exchange Commis‐ sion  (SEC),  the  Financial  Industry  Regulatory Authority (FINRA), as well  as  state  regulatory  agencies  highly  regulate  the  activities  of  broker‐ dealers.  In  the  past,  private  place‐ ments  involving  unregistered  finders  ran  little  risk  to  the  finder  or  the  is‐ suer.  The  SEC  rarely  investigated  or  pursued  finder  arrangements,  and  sought  enforcement  only  when  the  unlicensed match‐making occurred in  connection  with  much  more  signifi‐ cant wrongdoing.    This  has  changed.  Over  the  past  18  months,  the SEC has actively pursued  investigation and enforcement actions  for violation of the broker‐dealer laws  as  they relate  to unregistered  finders.   In  addition,  in  this  current  economic  climate  where  investors  in  private  placements  have  seen  their  invest‐ ments  sour,  or  at  best  their  path  to  liquidity  shut  down,  investors  are  bringing  private  actions  against  issu‐ ers to rescind their investments.   California  Corporations  Code Section  25501.5  gives  investors  the  right  to  rescind a  transaction when an unreg‐ istered  broker‐dealer  procures  their  investment.  If  the  investor  no  longer  holds the securities, he or she may sue  for damages. Pursuant to its authority  under an amendment  to Code of Civil  Procedure Section  1029.8,  the  court  may  award  attorney’s  fees,  costs  and  treble damages up to $10,000.  As a  result  of  the civil and  regulatory  exposure,  companies  seeking  to  at‐ tract  private  capital  have  wisely  re‐ considered  their  use  of  finders.  If  not  doing away with  finder arrangements  entirely,  they  have  tailored  their  ar‐ rangements to ensure  their  finders  fit  within  a  very  narrowly‐tailored  ex‐ emption from registration.   The “Finder’s Exemption” From Broker­Dealer Registration Section  15  of  the Securities  Exchange  Act  of  1934,  as  amended,  defines  a  “broker” as any person engaged in the  business  of  effecting  transactions  in  securities.  Section  15(c)(6)  makes  it  unlawful  for  a  person  not  registered  as a broker‐dealer to effect any trans‐ action  in  securities.  California’s  “blue  sky” securities laws essentially restate  the  federal  law.  Corporations  Code  Section 25004 defines a broker‐dealer  as any person engaged in the business  of  effecting  transactions  in  securities  in  California.  Under  Section  25210,  any  person  acting  as  a  broker‐dealer  must  be  licensed  by  the  Department  of  Corporations  unless  they  are  oth‐ erwise exempt.   Finders  argue  they  are  not  “effecting  transactions” in  securities, and  there‐ fore  are  not  acting  as  broker‐dealers,  when  they  facilitate  investments.  Finders  and  issuers  have  historically  relied  on  a  1991  SEC  no‐action letter  (Paul Anka, July 24, 1991)  to  support  this  position.    In  the  Anka  no‐action  letter,  the  SEC  blessed  a  “finder’s  ex‐ emption”  for  persons  that  merely  open  up  their  contact  lists  or  make  introductions  to  potential  investors.  The  SEC  found  it  important  that  the  finder  merely  furnished  his  contact  list of accredited investors and did not  negotiate or offer advice in the financ‐ ing. Although  the SEC looked askance  at  the  compensation  arrangement  where  the  finder was  paid  a  percent‐ age of the money he raised, it noted he  had  not  previously  arranged  invest‐ ments and agreed he would not do so  in the future.   JUNE 2009 JOHN P. CLEARY John P. Cleary is a nominee for the North County Bar Association’s 2010 Writer’s Award for the following article which appeared in the November 2009 edition of North County Lawyer Magazine. Copyright @2009 Procopio, Cory, Hargreaves & Savitch LLP.  All rights reserved. www.procopio.com │ 2 California  case  law  and  interpretive  guidance  from  the  Commissioner  of  Corporations also address the issue of  finders.  In  each  instance,  the  finder’s  exemption  has  been  narrowly  con‐ strued  to exclude most capital raising  efforts by unregistered finders.    Based  on  available  authority,  several  issues  must be  examined before  en‐ gaging a  finder. Each issue is relevant  to whether a finder will be deemed an  unregistered  broker‐dealer  for  pur‐ poses  of  regulatory  action  or  liability  under Section  25501.5.  The  determi‐ nation is not a balancing  test of  these  factors.  Rather,  violation  of  one  of  these  factors  will  render  the  finder  arrangement illegal.   1. Is the Finder Providing Services Other Than Simple Introductions? Black’s  Law  Dictionary,  Sixth  Edition,  defines  a  finder  as  “an  intermediary  who  contracts  to  find,  introduce  and  bring  together  parties  to  a  business  opportunity, leaving ultimate negotia‐ tions  and  consummation  of  business  transactions  to  the principals.” A per‐ son  loses  his  or  her  finder  status  by  taking any role, however minor, in the  ultimate  sale  of  the  securities.  The  finder’s  involvement  must  start  and  stop with making introductions.   Issuers  must  ensure  the  finder  is  not  involved in presentations to investors,  negotiation  of  transactions,  structur‐ ing  of  deal  terms  and  similar  activi‐ ties. Other activities that will render a  finder non‐exempt include:   • providing advice or recommenda‐ tions  about  the  merits  of  a  par‐ ticular transaction.   • providing  assistance  to  investors  in  completing  the  purchase  agreement,  subscription  agree‐ ment or other documentation.   • providing  financing  to  any inves‐ tor for purchase of the securities.   • providing assistance to the issuer  in  drafting  or  distributing  any  material  including  financial  data  or sales materials.   • introducing  the  issuer  to  com‐ mercial  banks,  lawyers  or  other  professionals  to  facilitate  the  fi‐ nancing.   • handling  the  funds  or  securities  involved in the transaction.   The  more  information  and  assistance  the  finder  gives  to  investors  or  the  issuer,  the  less  likely  he  or  she  will  maintain exempt  status. Even arrang‐ ing  meetings  between  the  issuer  and  prospective  investor  will  jeopardize  the exemption. Both issuers and  find‐ ers  are  well‐advised  to  ensure  the  scope  of  engagement  is  clearly  and  conspicuously  committed  to  writing  and followed in practice.  2. Does the Finder Regularly Engage in the Business of Facilitating Investments? As  the  SEC  first  made  clear  in  the   Anka no‐action letter, the regularity of  a  finder’s activity is crucial  to  the de‐ termination of whether he is acting as  a  broker‐dealer. Nothing is more  cer‐ tain  to  blow  the  finder’s  exemption  than engaging a person who regularly  acts as a finder.  Individuals who profess to be “profes‐ sional  finders”  may  be  successful  in  raising  money,  but  they  will  put  that  money  at  risk  and  expose  the  com‐ pany  to  the  potential  of  regulatory  action, fines, penalties, litigation and a  myriad  of  other  consequences.  If  an  issuer  is  looking  for  a  proven  finder,  the  only  safe action  is  to  employ  a  registered broker‐dealer or placement  agent.   3. Is the Finder’s Compensation Dependent on Success in Raising Capital?   It is  a  common misperception  among  entrepreneurs  and  finders  that  the  payment  of  a  fee  in  cash  or  equity  is  acceptable if  the  finder merely makes  introductions.    This  is  wrong.    It  is  a  myth  perpetuated  by  entrepreneurs  and finders who have not been caught.  It  is  verboten  to  pay  a  finder  a  fee  based  on  the  amount  of  capital  he  or  she is  responsible  for  bringing  to  the  company.  SEC  no‐action  letters  post‐ Anka  and  recent  guidance  from  the  SEC could not be clearer that success‐ based  compensation  is  the  primary  characteristic  of  broker‐dealer  activ‐ ity. Whenever  the  finder will be com‐ pensated  based  on  success  in  raising  capital,  he  or  she  has  the  “salesman’s  stake”  characteristic  of  a  broker.    In  the  SEC’s  view,  it  is  this  “salesman’s  stake”  that creates  the risk of unscru‐ pulous  activity  and  the  need  for  the  regulation  and  oversight  that  broker‐ dealer registration provides.  I have heard countless proposals from  entrepreneurs  and  consultants  seek‐ ing  to  avoid  the  success‐based  com‐ pensation  prohibition.  The  most  common  would  involve  hiring  the  finder  as  a  “consultant”  and  paying  him  a  “consulting  fee”  for  unspecific  business  purposes,  payable  if  and  when  the company achieves a certain  funding threshold.  No matter how the  arrangement is structured, if the fee is  tied  to  the  finder’s  activity  in  raising  investment  capital,  and  he  would  not  have  received  the  fee  absent  his  suc‐ cess in doing so, then it is not permis‐ sible.   The safest course is to pay the finder a  fixed  fee regardless of the outcome of  his  or  her  efforts  (for  example,  the  finder receives a $10,000 fee for mak‐ ing  the  introduction  regardless  of  whether  the  investor  purchases  shares).  This  of  course  requires  the  assumption of some risk on the part of  the  entrepreneur  in  the  event  the  in‐ troduction  does  not  lead  to  an  in‐ vestment.  If  practicality  requires  a  success‐based  compensation  ar‐ rangement,  the  only  solution  is  to  have  the  finder  affiliate  with  a  regis‐ tered  broker‐dealer,  essentially  be‐ coming  a  “back  office”  entity.  For  smaller transactions, this is not a real‐ istic  solution  because  the  finder  would  have  to  pass  the  relevant  li‐ censing  exams,  find  a  firm  willing  to  undertake supervisory duties over his  activities and he certainly would have  to  share a  portion  of  the  fee with  the  supervising firm.  The Consequences of Using an Un­ Copyright @2009 Procopio, Cory, Hargreaves & Savitch LLP.  All rights reserved. www.procopio.com │ 3 registered Finder Using  an  unregistered  finder  to  help  fund  a  deal  poses  significant  risks  to  both  parties involved.  The issuer will  face regulatory action by  the SEC and  state authorities, and may face private  actions by investors for damages or to  rescind  their  investments.  Using  an  unregistered finder will call into ques‐ tion  reliance  on  the Regulation D pri‐ vate  placement  exemption  and  be‐ cause  Section  25501.5  allows  inves‐ tors  to  rescind  investments  procured  through  the  use  of  unregistered  find‐ ers, the  funds  raised  will  be  at  risk  during  the  statute  of  limitations  pe‐ riod.    The  contingency  created  through  the  rescission  right  also  causes  accounting  troubles.  Finally,  if  the  investors  demand  a  legal  opinion  to close the transaction, the issuer will  also  have  a  hard  time  convincing  counsel to issue one.   Using an unregistered  finder will also  jeopardize future efforts to raise capi‐ tal. A common sanction sought by the  SEC  against  issuers  utilizing  unregis‐ tered finders is to bar the issuer from  conducting  Regulation  D  offerings  in  the  future. This, of course, could have  a  lethal  effect  on  a  start‐up  company  dependent on private capital.  In addi‐ tion,  some  regulators  have  at  least  informally  advised  issuers  that  the  use of non‐exempt finders will render  the company liable as aiders and abet‐ tors of securities law violations under  Section  20(e)  of  the  Securities  Ex‐ change  Act  of  1934.  For  emerging  growth companies planning to tap the  public  markets  in  the  future,  these  issues  will  at  best  be  spoilers  during  the  road  show  presentations  to  large  banks.   The  consequences  to  the  finder  also  are  severe. If  a  finder’s  activities  do  not  fall  within  the  exemption  from  registration,  his  or  her  agreement  with  the  issuer  will  be  wholly  unen‐ forceable  in  court.  As  a  result,  the  finder has no way to enforce payment  by  the  issuing  company  and  may  not  be  compensated  for  his  or  her  ser‐ vices.  In addition, non‐exempt  finders  are  susceptible  to  civil  and  criminal  penalties under both federal and state  law.