Recoupling Founders with Their IP - Improving Innovation by Rationalizing IRC Section 351: Licensing vs. Assignment of Founders' IP in VC-Backed Startups.

• Author: Ganor, Mira
• Position: Intellectual property

ABSTRACT 493 I. INTRODUCTION 494 II. TRANSFERRING IP RIGHTS 496 III. PATENT LAW 497 IV. BANKRUPTCY LAW 499 V. TAX TREATMENT 502 VI. FOUNDERS ATTACHMENT TO INVENTIONS 505 VII. GETTING FUNDED WITHOUT IP ASSIGNMENT 508 A. Skype 509 B. Google 509 C. Square 510 D. Blockchain and SAFTs 510 VIII. PROPOSED REFORM 511 IX. CONCLUSION 512 I. INTRODUCTION

Conventional wisdom and common practice require that founders assign to the startup company all intellectual property rights that they individually own and that the company uses at a very early stage. (1) Without such assignment, the argument goes, the founders will not be able to secure venture capital funding. (2) Delaying transfer of founder IP to the startup company may have negative tax implications and other ramifications that could be expensive. (3) Thus, U.S. startup founders typically assign their IP rights to the startup company upon the company's formation in exchange for founder stocks. (4)

Anecdotally, however, this is not a complete description of the spectrum of tech-based startup IP allocation. Most notably, the Skype-eBay case was a success story of founders who retained personal property rights to their intellectual property. (5) The Skype story, however, is an example of a foreign startup company. This fact raises the question of whether different business culture, customs, and legal rules explain the different practices. Are U.S. entrepreneurs discouraged from retaining IP rights, and does it negatively affect innovation and social welfare? This Article explores the U.S. practice of early founder assignment of IP in the context of venture capital (VC) backed startup companies, the motivations for this practice, and its potential inefficiencies and suboptimal effects on innovation.

This Article argues that the U.S. tax rules, in particular Section 351, (6) potentially distort founders' decisions by motivating them to assign their IP rights to the startup company at an early stage. Seeking to avoid negative tax consequences, ex-ante, founders are incentivized to transfer the technology to the company rather than to keep the ownership of the IP separated from the business entity. The Article further argues that under certain situations, the premature assignment of IP may result in inefficient use of innovation and reduction of the total social welfare.

However, if, contrary to current common practice, the IP is kept separately from the startup company, and the company receives only a license to use the technology, then the use of the founders' IP may be more efficient. For example, should the company end up in bankruptcy, the founders can continue to develop and exploit the technology with no delay since the IP is not the property of the bankrupt company. on the other hand, if the technology is transferred to the company instead of being merely licensed to the company, a lengthy liquidation process can hijack the technology. until the bankruptcy procedures are resolved, the technology may not be put to use.

This Article further argues that the anticipated forfeiture of the IP from its original author discourages entrepreneurships. The decoupling of the idea from the inventor discourages innovation in two distinct ways. First, this Article argues that inventors are likely more capable and better motivated to advance their own invention than anybody else. (7) Second, the risk of a forced separation from the invention decreases the expected benefit from inventing ex-ante, thus demotivating the entrepreneurs.

The disturbing decline in new U.S. startup companies, (8) described as a "national emergency," (9) makes the case for lifting hurdles to entrepreneurship and amending legal rules that distort entrepreneurial choices and increase the cost of innovation. It should be noted that while a few of the concerns related to assignment of IP created by founders also encompass IP created by inventors who are ordinary employees; this Article focuses on founders because they create startups, which are important to economic growth, innovation and employment. (10)

The Article proceeds as follows. Part II delineates the process of founders transferring IP rights to startups. Part III describes relevant patent laws and their relation to assignment of founders IP to startups. Part IV outlines the special protections that bankruptcy law affords to IP agreements and demonstrates that both the VC fund and the founders can be protected in bankruptcy should the founders only license the IP to the startup. Part V explains the inconsistent tax treatment of IP assignment. It also shows the tax consequences of delayed IP assignment and the resulting bias against IP licensing. Part VI considers the special connection between the founder and their creation and the potential costs of decoupling one from the other. Part VII describes anecdotal evidence of successful startups that were not assigned all the IP created by their founders. Part VIII lays out this Article's proposed reform of the tax laws, which will eliminate the tax distortion and remove the incentive of founders to rush to assign their IP to the startup.

2. TRANSFERRING IP RIGHTS

   The creation of a startup is usually preceded by entrepreneurs pursuing a business idea. The conception of the startup--and often the invention of new technology, novel intellectual property and, potentially, even registration of patents authored by the entrepreneurs--drive the startup formation. To be sure, founders may be motivated by a desire to work together or generally wish to form their own startup without having formed a concrete idea about the contemplated business, but with the belief that a business idea will materialize once a concentrated effort by the new venture is in motion. However, the cost of forming a business entity will render this attempt at early formation economically prohibitive. A few states, including California, even have statutes encouraging entrepreneurs to start working on a new venture while still employed elsewhere. This is done by making pre-assignment of future inventions unenforceable, provided that the inventions are unrelated to the employer's business, are invented without the use of the employer's resources, and are created in the entrepreneurs own free time. (11) Furthermore, in the startup business cycle, funding by venture capital firms will come only after formation of the business entity and usually after advancement of the business; unless the founders are serial entrepreneurs with a proven record of success, investors will not be clamoring to fund their nascent venture without further work done by the startup. (12)

   This natural course of events leads to the startup company's use of technology that was created before its formation and that belongs to the founders. Thus, the need of transfer of technology rights from the founders to the startup arises so the startup owns the IP rights needed for its operations. Potential sophisticated investors, such as venture capitalists, will appraise the startup and usually perform an IP due diligence on the startup when evaluating the startup prior to any investment. owning clean rights to all the technology the startup needs for its business is important for its funding prospects.

   Generally, the founders can grant the startup rights to use IP in one of two ways: either by licensing or by assignment of full ownership. Licensing the IP grants a contractual right to use the founder's IP. The design of the license agreement may take several forms and may include restrictions and limitations of use in various degrees. The license agreements may provide that the founders who created the IP maintain rights to use and even license the IP. The rights granted to the startup may be limited in various scopes: by territory, by time, and by field of use. Such license agreements may or may not require future payment of royalties to the licensing inventors. The license agreement may be similar to license agreements that companies enter into with third parties that own rights to technology that the startup needs to use. (13) Assignment of IP, on the other hand, transfers the title and all the rights to the technology to the startup. The inventors may retain the honorary title as authors or inventors of the technology, but they will be prohibited from using the technology independently from the startup.

   To be sure, everything else being equal, the VC funds investing in the startup company will prefer more rather than fewer rights to the IP. However, as this Article argues, the founders of the startup are also affected by the transfer of IP rights to the startup and their willingness to transfer control over major decisions to the VC funds and to professional managers is likely to increase if they retain separate rights to the IP. A balancing compromise, which addresses these opposing interests, may well be an exclusive license agreement granted by the founders to the VC-backed startup with no restrictions but for an ipso facto clause that will cause the IP to revert to the founders in case of company failure. (14)

   The founders' choice between licensing and assignment of IP has implications on myriad aspects of their future rights and liabilities and implicates laws such as patent law, bankruptcy law, and tax law.

3. PATENT LAW

   Patent law is designed to encourage innovation by rewarding inventors with exclusive rights to use their inventions. (15) However, the assignment of the IP to the startup at an early stage likely lowers the expected reward from the invention, because business failure traps IP in the startup and the founders may no longer be able to use it. (16) Thus, the pressure to assign the IP to the startup may lower the incentive to innovate ex-ante. This diminished incentive effect is similar to the general problem with innovation in large corporate entities, which, as Mark Lemley points out, may break the "link between innovation and patent reward,"...