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VENTURE
CAPITAL
Protecting
the Intellectual Core
of a Business
October
2001
By
Jon M. Garon for presentation
at MerchantBanc's Fall 2001 InfusionLab
The
fall apple harvest in New England evokes my memory of ripe fruit
and sturdy trees. The metaphor also serves to illustrate the importance
of healthy core management of a new company's intellectual property.
By planning early in the business cycle, a company can protect
the seeds of its business to weather the changing seasons. I have
identified five seeds that properly planted will yield the ripest
fruit, having the greatest impact on long-term financial health.
Seed One: The Idea
Every good business starts with a good idea. To grow, the idea
must be shared with others, including bankers, investors, and
suppliers. If the idea will work, then it will be valuable and
must be protected, using non-disclosure agreements and treating
the information as a trade secret. To protect the business at
the early stages of its development, the use of a nondisclosure
agreement is an essential. These simple agreements merely provide
that the business plan and other information will only be given
out on the condition that it will be treated confidentially. The
company acquiring the information cannot use this information
unless it becomes public information or a reasonable period of
time passes. Many venture capital firms refuse to sign because
they are inundated with so many proposals. A fund that does not
initiate its own projects may be worth the risk of unprotected
disclosure. Nonetheless, my own experience has been that the only
companies that refuse to sign non-disclosures will, in fact, go
on to use the profitable information it has, wherever acquired.
The
entrepreneur must be aware of the opportunities to promote the
new venture as part of the financial strategy as well. Many of
the early funding opportunities for new enterprises require that
no general solicitation or advertisement is made. The SEC regulations
include a prohibition from conducting a sales pitch at an open
forum or meeting. Overly enthusiastic business people might be
quick to talk about the great idea and the tremendous opportunity
for investment, but such an outburst can create significant securities
issues which hamper future growth. Enthusiasm is essential and
promotion appropriate, but both must be well timed.
Seed
Two: The Business Model's Form
Early business planning is as important as a good concept for
the long-term growth of the company. The best business choice
reduces tax liability, provides the founder protection from debts
in the event the business does not succeed, and maximizes the
flexibility for future growth. In most instances, this suggests
either a corporation or limited liability company (LLC). Both
provide alternatives that create legal entities separate from
the founders that can be structured to minimize tax liability,
and can be structured to fit the financing utilized by the company.
Although
a bit newer and less tested, the LLC has great flexibility because
each operating agreement - the document that serves as the business'
charter and rulebook - can be tailored to the particular management
and ownership structure. This is particularly important because
the interests of the participants change as the business matures
from stage to stage. Corporate stock cannot be as readily modified,
sometimes resulting in unintended payments or tax liability if
early termination or personnel changes occur.
For
venture capital supported ventures, the traditional corporation
remains the predominant favorite because a partnership structure
does not add value and the expectation is to continue to expand
the number of shareholders and the liquidity of the investment
as the company grows from its first incubation to a publicly traded
entity.
Start-up
entrepreneurs may be tempted to utilize "off-the-shelf"
corporate kits. While these are useful tools, the start-up business
should take care that any "off-the-shelf" solutions
actually fit the particular needs of the business.
Seed Three: The Business Model's Substance
The sale of dog food on the Internet became the archetype for
bad planning - a heavy, expensive to ship but low margin product
that could be conveniently purchased everywhere. Quite properly,
the era in which that business could be funded has long passed.
Venture capital is returning to start-up businesses, but only
with solid prospects of both short-term and long-term income.
A
good business model should be based on conservative financial
estimates and a large dose of skepticism. If the business is technology
based, there must be a clear, legitimate reason, that the technology
improves the current business opportunities. If the business is
Internet based, the Internet must provide some service that improves
the customer's experience. Traditional brick-and-mortar businesses
can supplement their activities with the Internet, so any newcomers
must add significant value. Finally, the business must serve an
existing need, one that is inadequately being filled, if possible.
(Hint, the US is aging rapidly - adult products for the aging
baby-boomers should no longer evoke either Penthouse or Depends.)
The
business model must include strong management. Particularly in
today's economy, venture capital investors are interested in assisting
those management teams that have demonstrated the ability to transform
a concept into both cash-flow and profits. The untested entrepreneur
should plan for a rapid expansion of the management team to add
the skills and experience necessary to instill confidence in the
business.
Seed
Four: The Three Business Names
The easiest time to identify an effective brand name is before
any investment has been made. Once a company begins to establish
its name, any change adds significantly to the cost and identity
of the organization. Today, a good name must meet three distinct
legal tests: the corporate name, the trademark, and the domain
name.
The corporate name is the name of the legal business entity. For
most small businesses today, that means a name that may be registered
as either a corporation or limited liability company. Any name
that is not confusingly similar to an existing business may be
registered. Most states allow the name to be reserved in advance
of the business filing for up to two months. While very simple
to file, it is a step that should not be overlooked.
The
trademark is the most sophisticated legal property involved in
naming the business. A good trademark allows the company to craft
its identity in the public. Trademarks may be registered either
with the state or federal governments, but federal registration
carries broader national protections. So long as the business
will be conducted in more than one state, a federal trademark
may be filed. The trademark may be filed prior to its actual use,
so the business can prepare the brand deployment.
Good
business planning must accompany the development of a trademark.
The more fanciful the mark selected, the greater the protection.
In contrast, merely descriptive or generic words will not be protected.
A trademark will also be denied protection if it is too similar
to an existing competitor's mark. Instead, the competitor can
bring legal action to stop the business from using its mark. For
a new business, an early trademark dispute can quickly sap the
company's resources and rot an otherwise healthy business.
In
today's world, the domain name has become as important as either
of the other business names. Tight integration of the domain name
and trademark strengthens both. If the trademark and the domain
name are unrelated, the company dilutes a good deal of its name
recognition. Although new, generic top-level domains such as .biz
(or co-opted country codes like .tv) now exist, consumer patterns
have not yet abandoned the preeminence of .com and edu. Failure
of Verisign to release abandoned .com names means that some of
the better possible domain names have not returned to the market.
Still, the earliest step in brand management requires that the
domain name, trademark and corporate names work together to create
a corporate identity.
Seed
Five: A Life-Cycle Strategy
Perhaps the unhealthiest aspect of the early E-Commerce boom and
bust was the focus on the exit-strategy. Corporate founders with
an eye to the exit strategy were inevitably fertilizing the ground
with the wrong nutrients for the wrong growth. Rather than strengthening
roots, these companies were focused only on the low-lying fruit,
so it is no wonder that they toppled. A good life-cycle strategy
plans for the various stages of a company's growth and does not
rush it from one stage to the next. Here are four examples:
First,
companies must plan for termination prior to IPO success. If the
financing encourages an inventor to sell her stock a week after
the major investor provides the cash, then the intellectual assets
of the company are lost, and everyone loses. In the earlier stages
of the venture, the investor, the inventor, and the manager each
bring different skills and resources to the table. These need
to be identified and valued, so the business does not end before
it gets started.
Second,
the company must establish meaningful benchmarks for the important
early stages of development, including prototyping, beta-test,
initial product roll-out, cash flow, and profits. A company should
anticipate the development stage where the products and services
are carefully tested and rolled-out slowly. It is easier to accommodate
1,000 disappointed customers than 1,000,000.
The
benchmarks predicted will help the entrepreneur determine whether
the business is intended as an exponentially growing venture,
destined for a public offering or a moderate sized, privately-owned
company that can sustain the participants for years to come. Both
are legitimate business models, but each has a very discrete investment
and growth cycle.
There
are many financial stages between start-up and public company.
Some of them serve the business far better than the public markets.
The company should incorporate these stages as choices in the
business models, and clearly identify when it is worthwhile to
move into the next stage in financing.
Third,
companies must plan their cash flow, not only their income. A
rapidly growing, successful company with high costs and low margins
will go bankrupt waiting for the net 30-60 day cash to come in.
Expanding sales will only hasten its demise. Cash flow management
will allow a growing company to grow rather than choke on its
own success.
Fourth,
inventors involved in creation of new business must plan carefully
regarding the nature of their own employment agreements with the
entity and their rights or interests in the invention separate
from continued employment. The particular arrangements can vary
greatly depending on the nature of the invention and the need
for continued participation of the inventor in the process, modifications,
and deployment of it. Adequate compensation, participation in
the corporate growth, confidentiality and agreements not to compete
with the company are all aspects of the relationship between the
inventor and the company. An inventor should not assume that he
will also control the company, and must structure the agreements
to provide reasonable protections and returns regardless of who
owns the business. Management skills are often quite different
than the skills necessary to create inventions for the company.
Successful inventors must protect their financial and creative
interests without overly limiting the growth and development of
the company.
Conclusion
A business grows because it has been planted in a field that allows
it to take root and well nurtured throughout its development.
Protection of the ideas and careful attention to the form and
substance of the business plan make for rich business soil. Good
choices regarding the name development and a long-term outlook
on the business strategies strengthen the roots and branches of
a company. Together, these steps nurture the business, giving
it a chance to grow. They will not guarantee success, but without
them, the seeds of good business ideas are often left to dry among
the stones.
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