As IP lawyers, one of the most common types of dispute we see arises in the context of third party investment in a tech start up. What has usually happened is that the money has run out before the start up has started generating enough income to be self-financing.
There are many reasons why this happens. Frequently the start up will simply not have raised enough cash to have any realistic chance of getting to market: this is a particular problem in the UK tech investment market, where early stage investment can be particularly hard to find. Sometimes however founders have wildly underestimated how much cash they will need. Sometimes this is mere incompetence but not infrequently the insiders knowingly or recklessly misrepresent the likely costs involved: every traffic light is assumed to be green on the road to market glory. Of course it never works like that in practice.
Whatever the precise cause, when the cash runs out a wide range of rescue scenarios will often be explored. The problem that often arises is that the parties just can’t agree on the way forward: who should remain involved and who should not and the basis on which further investment should be made and by whom are frequent sticking points.
It is in this “High Noon” situation that the parties start to look at the weapons in their legal holsters, which can be deployed to enable them to get what they want. Often the contents of their legal holsters will disappoint. Neither a shareholders’ agreements nor a company’s articles are often much use when the investee company has simply run out of money: neither obliges further investment. A minority shareholder in a private company – which is what most investors will be – is often in a very weak position.
It is this situation that the start up’s IP rights come into real focus. Often they are the only asset of any real value which the start up has, so who controls what happens to them becomes the key issue.
Getting Control of the Start Up’s IP Rights
From the investor’s perspective the best position in to be in is to own the start-up’s IP rights on day one by virtue of having taken an assignment of them as a condition of investment. However this rarely happens in practice as founders are usually very reluctant to in effect sell their IP before its real market value has been realised through commercial exploitation at scale.
The next best thing – and an avenue often overlooked by investors – is for the investor to take security over the company’s IP: this can work well when the investment is made by way of a loan. A convertible loan note is an often used vehicle to allow an investor to advance monies by way of a loan but which then provides the lender with an option to convert the loan into equity on the occurrence of certain predetermined events. The loan so advanced can be secured on the company’s IP.
Taking Security over IP
IP rights (with the exception of rights in confidential information) are private property rights so security over them can be taken in much the same way as any other form of property. Security interests over intellectual property rights (IPR) come in two main types: legal mortgages and charges.
Legal Mortgage of IP Rights
A mortgage of IP is an outright transfer of the ownership of the IP, which has three basic elements (in addition to provisions relating to the loan and its repayment):
· An outright assignment of the legal title in the IPR to the lender.
· A right of redemption; that is, the right to have the legal title transferred back to the borrower once repayment and other obligations have been fulfilled.
· Pending exercise of the right of redemption by the borrower, some form of licence back from the lender to the borrower to enable the borrower to use the IPR in its business.
As noted above, this kind of outright transfer arrangement is rarely accepted by founders so that the only practical alternative is the charge.
Charge over IP Rights
Where the lender only takes a charge over the IPR then the legal title to it remains with the borrower but the lender is granted certain rights over it as security for the loan. The basic elements of a charge are (in addition to provisions relating to the loan and its repayment):
· The charging clause.
· A transfer mechanism to allow the transfer of the IPR in the event of default.
· A range of negative obligations on the borrower not to grant conflicting security or other interests in the charged IPR.
A common transfer mechanism for IP rights is the assignment in escrow: the intellectual property owner signs (but does not date) an outright assignment, which is then held in suspense until the lender dates it (to bring it into effect) on the occurrence of an event of default. Charges of IPR can, at least in theory, be either fixed or floating. However, floating charges are rarely granted over IPR, as most borrowers do not deal with their IPR frequently enough to make the greater flexibility they offer a material advantage.
Protecting the security
To get the full benefit of a mortgage or charge over IPR, the mortgagee or chargee (i.e. the lender) must register particulars of the transaction at Companies House within 21 days of the day after the charge or mortgage was created. Failure to do so results in the charge becoming void against a liquidator, administrator or creditor of the company, with the draconian effect that the lender loses its place as the first creditor to be paid after the costs of liquidation are met, and instead merely ranks alongside the ordinary unsecured creditors. Such an unfortunate lender will therefore typically only receive a portion (often only a very small portion) of the amount owed to it.
Registration at Companies House Necessary but not Sufficient for Registered IP Rights
In addition to registering the charge or mortgage at Companies House, the lender should, in the case of registered IP rights (such as patents, registered trade marks and registered designs) also register the transaction at relevant IP registries such as the UKIPO.
Failure to register the charge or mortgage at relevant IP registries will result in a bona fide purchaser for value of a later conflicting right in the relevant IP (for example an assignment or licence) taking free from the earlier unregistered mortgage or charge, providing that they did not know abut it[1]. Mere registration of the mortgage or charge at Companies House will not constitute notice/knowledge for these purposes.
Banks (and their advisers) sometimes fail to realise this and only register their charges at Companies House, an oversight which leaves them vulnerable to a complete loss of the value of the charged IPR.
Conclusion
Investors in tech start up’s should consider taking security in the start up’s IP as a condition of their investment. Doing so will often put them in the driving seat in the common occurrence of the funding running out before the start up becomes cash generative.
What Sonder & Clay can do for you?
Sonder & Clay’s accomplished IP Solicitors can help investors and start up’s manage IP rights in an optimum fashion. Please get in touch to book a consultation.
[1] Section 33(1) of the Patents Act 1977, Section 25(3) of the Trade Marks Act 1994 and Section 15B(2) of The Registered Designs Act 1949..
