Module 1: Foundations – The Setup & The Stakes
| Learning Concepts | Learning Objectives |
|---|---|
| Corporate Spin-offs and Technology Transfer | Explain the business and university policy justifications for internal project commercialization |
| IP assignment in employment | Identify the different ways in which employers have rights over employee-created IP |
| Founder motivations and entity formation | Identify personal and professional factors that motivate founders when working from within |
| Intial capitalization and sweat equity | Analyze an initial capitalization table, the implications of equity splits, vesting schedules, and impact of later investment on founder equity |
PARTIES
BigTechCo, Inc. (“BigTech”) is a very large, Silicon Valley-based, publicly traded, Fortune 100, hardware technology company with a considerable in-house research and development group. BigTech’s primary business is the manufacturing of central processing units for desktop computers and mobile devices. Like many large companies, BigTech frequently expands through acquisition of related technologies. It also develops its own technologies in-house and even has a special program that encourages and rewards employee entrepreneurial endeavors. Where the in-house developments are speculative or merely tangentially related to BigTech’s central line of business, BigTech will spin-off the technology into its own company to live or die on its own. Executives at BigTech believe this lets the technology compete in a free market as any other startup which can accelerate the technology and could create a nice return on investment for BigTech. As the technology develops, BigTech will sometimes buy-out the startup once the technology is proven thus bringing it back in-house, but frequently it will simply maintain its equity position in this new company and hold it as it would any other stock in its investment portfolio.
As part of BigTech’s investment portfolio it allocates approximately 15% of the total portfolio to high-risk venture capital investments made either in its own name or as part of a venture or angel investment group. Startups that arise through their own research are included in the 15% high risk allocation. BigTech’s Board of Directors is intrigued by the return on investment potential of this high-risk portfolio but is always worried about shareholder reactions to this portion of the company’s operations. Able is the Director of the BigTech Venture Group.
NewCo Tech Company, Inc. (“NewCo”) is a startup located in Madison, Wisconsin. NewCo was founded by Baker and Carter, both ex-employees of BigTech. Baker is an electrical engineer, with a Ph.D. from the University of Wisconsin (“UW”) and worked on new hardware projects at BigTech. Carter is also a graduate of the UW with a degree in software engineering. He worked on firmware and operating system architecture at BigTech. As part of BigTech’s research and development team they created a new software-based routing system that will make streaming on the internet significantly faster. While the technology works in conjunction with BigTech’s hardware, the system will actually work with any hardware. BigTech thought this technology would actually have a bigger impact if it were spun-off into its own company where it could work with BigTech and its competitors. In January of 2017, BigTech gave Baker and Carter a substantial severance package and permission to start NewCo.
Key Concept: Corporate Venture Capital
Large corporations often set up their own venture capital funds (creatively called: “corporate venture capital”, or “CVC”). They do so largely for two reasons: strategic fit and financial gain. Some companies prioritize one over the other, but all have internal policies related to how much each they will invest in. Portfolio companies that are a “strategic fit” are ones that will improve or expand the company’s current product/service offerings or operations. Other investments are made purely because the fund manager sees an opportunity to make venture capital returns (i.e., 10x at a minimum).
Universities have similar programs, but have very different goals. University Technology Transfer offices are most often concerned with commercializing technology that was built on-campus. This technology is often funded with federal grants, thus subject to the Bayh-Dole Act. In other cases, the University may have a contract with its Principal Investigators (“PI”s) that assigns any intellectual property developed at the school to the school. See the KeyConcept below on Employee Inventions. In these cases, the goal is find a commercialization partner for the technology and license the technology to the partner; sometimes the partner is a large corporation, sometimes it is a new venture started by the PI and/or the assistants and researchers that helped to develop the technology. Universities may also have a venture capital group that invests for many of the same reasons as CVCs: to support faculty entrepreneurship/commercialization, or purely for financial gain.
Resources
Harvard Business Review has a 2003 explainer on CVC.
You can read more about Technology Transfer and CVC (paywall) - Markman, Siegel, et al. Research and Technology Commercialization. Journal of Management Studies. Vol 45, Iss. 8. (December 2008).
FACTS
Baker and Carter, being alumni of the University of Wisconsin at Madison and with family in the area, have chosen to move back to Madison and start up NewCo. They sought out legal services from the University of Wisconsin Law and Entrepreneurship Clinic (“L&E Clinic”). In conjunction with the L&E Clinic, Baker and Carter formed NewCo Tech Company, Inc. a Delaware Corporation with its principal place of business in Madison, WI. They have rented office space at University Research Park and used part of their severance package to purchase the equipment they will need to finalize research on the system that they are calling NETWORKFUNCTION.
Baker will be the CEO and Carter will be the CTO. They will need to hire 3-5 engineers for research and 1 marketing officer to start doing customer validation. Together these 6 positions will each cost at least $100,000 per year plus equity incentives. The L&E Clinic is creating an employee option pool representing approximately 100,000 shares of NewCo.
Baker and Carter will forego salaries until NewCo is generating revenue; Baker will own 550,000 shares of NewCo and Carter will own 450,000. Their interests will vest pro-rata over the next four years with a 1-year cliff of 25% of the vesting interest. They valued their contributed assets of equipment and cash at $50,000 enough to get them a full year of rent, a small travel budget, and any additional equipment they might need.
Table 1: NewCo Capitalization Table
| Name | Date of Acquisition | Shares | Vested | Valuation | Share Price |
|---|---|---|---|---|---|
| Baker | 01/01/2017 | 550,000 | 137,500 | $50,000 | $0.05 |
| Carter | 01/01/2017 | 450,000 | 112,500 | $50,000 | $0.05 |
| Employee Option Pool | TBD | 100,000 | TBD | TBD | |
| Proposed BigTech | Date of Close | 165,000 | 165,000 | $132,000 | $0.80 |
The core technology of NETWORKFUNCTION was created at BigTech. Based on the employment contracts of Baker and Carter and intellectual property law, anything the two created at BigTech is the property of BigTech. BigTech has filed two patents and is claiming copyright over the core functionality that is NETWORKFUNCTION. The first patent covers the firmware implementation of the system (“P294”), the second patent covers the cloud architecture necessary for the system (“P573”), the copyright covers the software necessary for the system to operate (“C483;” together, all are “Core IP”).
Key Concept: Employee Inventions
Generally, companies own the intellectual property created by their employees in the course of their employment. However, the legal mechanism for ownership differs depending on the type of IP.
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Copyright: Under the “work made for hire” doctrine, if a work is created by an employee within the scope of their employment, the employer is legally considered the author and owner of the copyright from the moment of creation. No assignment is needed. This is why BigTech automatically owns the copyright to the
NETWORKFUNCTIONsoftware (C483) created by Baker and Carter. -
Patent: The default rule for patents is different. The inventor(s) are the initial owners, even if they are employees. To secure ownership, companies almost universally require employees to sign an employment agreement containing an “invention assignment” clause. This clause contractually obligates the employee to assign ownership of any inventions created during their employment to the company. Without such an agreement, the company might only have a “shop right”—a non-exclusive, royalty-free license to use the invention, while the employee retains ownership.
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Trademark: Trademark rights are established through use in commerce. The entity that uses a mark (e.g., a brand name or logo) to identify its goods or services is the trademark owner. If an employee creates a logo as part of their job (a copyrightable work owned by employer as a work-for-hire), the employer who then uses that logo on its products is the owner.
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Trade Secret: If an employee creates a trade secret (e.g., a confidential formula or process) within the scope of their employment, using company resources, the employer is considered the owner of the trade secret. This is almost always reinforced by an NDA signed by the employee.
IP-Related Contracts
Non-compete Agreements are restraints on trade that prohibit employees and former employees from working for competitors or in similar industries. The justification for such restraints is often based on IP considerations.
While many states permit non-competes in theory, there are states that outright prohibit them for non-Officer/founder/owner positions. In California, indeed even non-California employers seeking to restrain California (ex-)employees are prohibited from enforcing their non-compete.
Still others may restrict them from certain classes of employees such as line cook workers at a sub sandwich shop. For example, the state of Illinois prevents non-competes for any employee that makes less than $75,000 - $90,000 per year.
The University of Chicago’s “Innovation Policy and the Economy” has a recent (2012) article on the impact of non-competes.. The authors find that non-competes by and large hurt small businesses (including startups), but help large businesses. They propose that policymakers should weigh which they support more and adopt a non-compete policy that supports their interest.
Non-Disclosure Agreements (aka Confidentiality Agreements) compel one or both parties from disclosing information learned in the course of a relationship. The relationship could be employment, but it might also be a business deal such as a merger, manufacturing, or development agreement.
IP Assignment and Licensing Agreements require that one person assign ownership of their IP to the other party. Often these are signed at the start of an employment relationship and convey ownership of patents specifically. A license on the other hand gives a party the right to use IP, but does not transfer ownership.