Tech Lending: What Are IP Assets?
This article is the second in a series providing an overview of critical considerations for commercial lenders contemplating whether to finance a tech company and how such loans can be secured.
For lenders to fully understand and address the risks of investing in a business, it is crucial to understand the business’s assets and what steps the company is taking to preserve and leverage the value of such assets. This will allow the lender to determine what collateral might be available as security to minimize investment risk.
For tech companies, the most valuable assets are almost always intangible assets: the business’s proprietary information and intellectual property (IP) interests. This type of collateral is inherently difficult to value.
While there are particular valuation challenges common to all IP interests, not all IP is created equally. Trademarks, copyrights, patents and trade secrets require different value-preservation strategies. Lenders should be aware of these differences to accurately assess whether a business is taking appropriate steps to maximize and safeguard its value.
Trademarks are a form of IP that protects a brand’s identity and goodwill. The most common trademarks are names and logos, but other brand identifiers – like packaging, designs, or even sounds – can also be trademarked.
Securing appropriate trademarks is a fundamental step in an effective branding strategy and should be top of mind for all businesses, including tech companies. Registering trademarks is one of the essential steps a new business can take to build its brand value. While Canadian law does offer some protection to owners of unregistered marks, these protections are of limited use, especially to new businesses. For example, to successfully assert rights in unregistered trademarks, the owner will have to demonstrate that the public associates the mark with the company’s brand. By contrast, if a trademark is registered, the owner presumptively has the exclusive right to use it throughout Canada, and any use of the mark by another person in association with the same or similar goods or services, which causes public confusion, will be considered infringement.
Lenders and investors interested in the business should ensure they understand the company’s steps to protect its brand. Has it registered trademarks for its brand identifiers on critical products and services? Has it checked whether its brand identifiers are similar to any already used by other companies? Inadvertently utilizing a trademark which is the same or similar to a competitor’s trademark could result in confused customers and legal liability.
Copyright naturally arises in literary, artistic, dramatic and musical works upon their creation and without registration. Under Canadian law, computer code is considered a literary work. Tech companies’ most important properties involve copyright.
The most critical issue concerning copyright is ownership. Ordinarily, the copyright’s original owner is the work’s creator. The question of ownership becomes more complicated however, when a copyright work is created in the course of business. Canadian law provides a limited exception to creator ownership where works are created by an employee in the course of employment. In that event, unless there is an agreement indicating otherwise, the copyright in the work is owned by the employer. However, many tech startups’ early properties, in particular, are not created by employees per se but by the business’s founders or in collaboration with contractors. Investors must perform due diligence to ensure that copyright assignments have been properly executed and to identify whether the prospective borrower in fact owns the rights to the properties it claims. It is sometimes advisable to register copyright as evidence of ownership.
Further concerns arise when a company’s proprietary software includes source code developed by another party. Some open-source licences do not permit commercial use, while others require any use of open-source software to also be made open-source. Lenders should also inquire whether the business has secured appropriate licences and permissions for any third-party software or code used in its products before reaching conclusions about a product’s marketability.
A patent is a time-limited monopoly granted by the government. The patent allows the patent owner to exclude others from making, using or selling the patented invention, typically for 20 years from the filing date of the patent application. Patents are jurisdictional, meaning that a patent application must be filed and be granted in each country in which protection is desired.
Not all inventions are patentable. To patent an invention, it must be new, non-obvious and useful. It must be directed to patentable subject matter. For example, disembodied ideas, scientific principles and abstract theorems are not considered patentable subject matter. In the tech area, software-related inventions are a complicated and evolving area of law. While actual software code cannot be protected by a patent in Canada, the functional aspects of the software can be patentable, provided those functional aspects are new, non-obvious, useful and otherwise comply with the other legal requirements.
Businesses that intend to patent their inventions must be meticulous in safeguarding their invention at all development stages, at least until a patent application is filed. Investors in companies that depend on obtaining patents as part of their business model should ensure that the company has implemented robust measures to prevent unauthorized disclosure, especially prior to filing a patent application. Further, lenders should inquire as to whether the company has obtained proper advice regarding the patentability of the invention. Lenders should also inquire into how the company will adapt its business model (i.e., improvements) once the patents on its flagship inventions expire. Importantly, a patent provides the patent owner with an exclusionary right (i.e., exclude others from practising the invention). A patent does not provide the patent owner the right to freely practise the invention as other third-party patent rights may prevent this. In view of this, lenders should consider obtaining a freedom-to-operate opinion to determine whether the company has the right to freely practise their invention.
Trade secrets are a subset of every business’s confidential information. There is no statutory protection in Canada for trade secrets. Companies protect trade secrets by implementing measures to guard against unprotected disclosure. Companies that rely on trade secrets to obtain a market advantage must take deliberate, proactive steps for this strategy to be viable. At the least, the company should have appropriate confidentiality agreements with its employees and third-party contractors. It should also have robust physical and electronic data security protocols in place. If a company cannot demonstrate that it took effective steps to keep its information confidential, it will struggle to take legal action against a party that appropriates that information. Investors should inquire into the business’s measures to protect its information.
Of course, in practical terms, nothing works better than having happy employees. For this reason, a disgruntled co-founder or key employee is a big red flag.
Knowing how different kinds of IP work and how ownership interests are protected at law enables lenders to assess the value of a business’s intangible assets and overall viability. Lenders should proceed with caution if a tech company does not take appropriate measures to safeguard and maximize the value of its IP assets. The best idea in the world will not benefit a business that fails to protect it.
If you require assistance with any matter or question related to tech lending, please reach out to a member of our Financial Services Group. For further information on IP, contact a member of Aird & McBurney, our intellectual property boutique firm.
More articles in this series:
- Tech Lending: Why Are Tech Companies So Hard to Value? (airdberlis.com)
- Tech Lending: Due Diligence Issues (airdberlis.com)
- Tech Lending: Software as a Service (airdberlis.com)
- Tech Lending: How to Register Security Interests in IP (airdberlis.com)
- Tech Lending: Types of Debt for SaaS Providers (airdberlis.com)