By Sam Chafetz and Peter Brewer
Investing in a new company can be an exciting experience. An investor who is approached by a company that appears to have a unique market niche coupled with much enthusiasm can present a tempting prospect. However, this article discusses a few of the things about which the investor should be wary.
Is the promoter a crook?
This may seem to be an obvious question, but it is amazing how many investors are willing to accept the flimsiest of “evidence” as to the bona fides of the promoter of a concept and investment. It is easy enough to check the criminal record of an individual, but you must first make sure that you have the correct individual. Do not be afraid to ask the promoter for his/her date of birth, middle initial and social security number. Then have a competent individual (usually an attorney) or service do a background check.
If the promoter is not a crook, has the promoter previously run afoul of the securities laws?
One may not have had any criminal charges brought against him, but they may still have had a disciplinary action brought against him/her by either federal or state securities regulatory agencies. Again, ask for personal identification information and have a professional check for you.
Is the promoter complying with applicable securities laws in connection with the proposed investment?
The opportunity being presented to the investor is clearly a “security” under both state and federal laws, and may not be sold without either (i) a registration with applicable authorities or (ii) the availability of an exemption from registration.
It is unlikely that a start-up company will be in a position to afford a registration. Therefore, if the promoter cannot cite for you the exemption available for this offering, then he is either ignorant of the law (which is dangerous for the investor) or is flouting the law (which is even more dangerous for the investor).
Have you been provided a disclosure document that clearly describes the company’s governance regimen, the attendant business risks and the profit/loss sharing arrangements? It is not the norm for investments of any size to be made on a handshake and a verbal understanding. Though everyone wants to “partner” with someone they can trust, it works best when all the “rules of the game” are laid out plainly, and all of the known pitfalls are described adequately. Most importantly, it is necessary to understand when and how the investor may be called upon for more money (usually to save that which is already invested), or what benchmark must be met before any money may actually be distributed. If this kind of clarity is not provided to you as an investor, do not invest. Do not just take your neighbor’s word for the way the deal is supposed to work; rather, make sure it is understandable to you from the written materials provided to you. Also, make sure the investment vehicle is a “limited liability” entity, so that you will not have any personal liability.
Is it too late to file for patent protection?
The value of the business may lie in its market exclusivity. Such exclusivity can be acquired through the patent process. However, the patent laws of the United States generally provide only one year for filing a patent application from the time certain events occur. This grace period begins to run when the invention is first published, publicly used, sold or offered for sale.
In some instances, a small company may have already (i) shown its product at a trade show, (ii) presented its product or business model to a potential customer or to prospective investors without a non-disclosure agreement or (iii) ordered a quantity of its product to be manufactured. Any of these events can trigger the “one year bar.” Therefore, it is important for the investor to conduct due diligence to determine whether such time-sensitive events have already take place.
Of even greater concern, most foreign countries do not have a one year grace period. Thus, if any of the triggering events have already taken place in the United States without a patent application being filed; valuable foreign patent rights may have been lost.
Is there a risk of patent infringement?
Consideration must be given to whether the prospective company is selling a product or operating under a business model which may itself infringe a U.S. patent. Therefore, part of the investor’s due diligence should involve a search of the U.S. patent literature. Do not rely on the company’s broad statement that “there is nothing like it out there.” Just because the company in Mississippi hasn’t seen it before doesn’t mean that a patent application wasn’t published last week that could mature into a patent at any time.
Of even greater concern, the company may be aware of an issued patent or may have already received a cease and desist letter. This information should be flushed out, and a well-reasoned opinion of noninfringement or patent invalidity should be obtained from a registered patent attorney. Under the U.S. patent law, one's awareness of the existence and infringement of a competitor's issued patent may significantly affect subsequent legal liability. The courts have the discretion of awarding up to three times actual damages plus attorney’s fees in the event that infringement is proven to be “willful.” Willfulness may be shown by a failure to timely obtain a well-reasoned opinion from patent counsel.
Does the company own all of the rights to its technology?
It is not uncommon for start-up companies to arise as a result of joint-development engineering projects. These projects are sometimes the result of an agreement between one or more inventors and a university. Alternatively, a small company may collaborate with a larger company that has in-house R&D capabilities. Sometimes agreements may be entered into with outside advisors or even customers. In any event, the agreement typically divides ownership of any resulting intellectual property rights. The result is that the IP rights may be co-owned by multiple parties. This can affect the value of the company as an investment target.
An investor should also consider the identity of the inventors. Is one of the inventors an employee? The default rule is that ownership of an invention rests with the individual who conceives of the invention, not with his or her employer. There are exceptions such as when the employee was “hired to invent,” but part of determining ownership is making sure that assignments of patent rights are in place.
Finally, the most important thing for a prospective investor to remember is that if it seems too good to be true, it probably is not true!
Sam Chafetz is a shareholder in the Memphis office of Baker, Donelson, Bearman, Caldwell & Berkowitz, PC. Sam concentrates his practice in the areas of corporate, securities, mergers and acquisitions, and venture capital. He represents public and private enterprises and has counseled boards of directors of companies listed on the New York Stock Exchange, American Stock Exchange and NASDAQ. Mr. Chafetz has extensive experience in SEC and stock exchange regulatory compliance, capital formation from both public and private sources, shareholder rights and corporate governance and accounting, public disclosure and investor relations issues.
Peter Brewer is Of Counsel in the Knoxville office of Baker, Donelson, Bearman, Caldwell & Berkowitz, PC. Peter is in the firm’s Intellectual Property Group, and focuses his practice on matters relating to the procurement of patent, trademark and copyright rights. Peter is a degreed engineer, and is a registered patent attorney. He has prepared patent applications in a variety of technologies including hand tools, marine vessel design, medical devices, business methods, geomechanical modeling, subsea production architecture, hunting equipment, seismic devices and other technical areas. |