Big Changes to Patent Law Coming. Is Innovation at Risk?

The U.S. House of Representatives and Senate have each passed similar versions of a bill that will make big changes to the patent system, with only conference committee changes standing in the way of it becoming law.  The America Invents Act makes several changes to the way patents are filed and protected, but the biggest one for small businesses and entrepreneurs is the change from the current "first to invent" system to a "first to file". Under the current system, if you invent a patentable invention, you have one year from the time you disclose it to file the necessary paperwork with the U.S. Patent and Trademark Office.  This time is typically spent improving the concept, working with collaborators, or speaking with investors who could help fund the project.  The new system takes away that "grace period" and gives to the first person to file the paperwork the right to patent the invention, regardless of whether they participated in the invention or not.

For example, an entrepreneur or small business might not have the necessary funds to file the patent on their invention in the first place (a patent can cost $15,000 or more to file).  If that inventor describes the invention to investors as it tries to raise the money, the investor would be able to file for the patent before the inventor had raised the money.  This will cause major changes to the way that entrepreneurs and investors interact with the investment community and would give a decided advantage to investors or corporations with deep pockets to trump the rights of individual inventors.  That will have the effect of stifling innovation rather than supporting it.

Any inventor or entrepreneur is going to have to reevaluate their processes and be much more careful with their intellectual property once this bill becomes law, which is expected in the near future.

M&A Series: What do I need in a term sheet?

A term sheet (after an NDA) is generally one of the first documents produced if you are buying or selling a business, and sets the tone for the negotiation.  It is not required, but can make the process much smoother because it raises disputes on the key terms much earlier in the process and determines whether you will be able to reach agreement on those before you incur the expense of negotiating the transaction documents.  The content and complexity of the term sheet will vary widely from deal to deal, but the length of the document is not what makes the difference.  The content as it applies to the particular situation of the transaction is what is important.  So what should be included?  The goal is to include just enough to cover the important deal points (such a lawyer answer, I know).  But here is what I mean. The term sheet is the agreement to agree, or the framework that will get you to the real agreements.  In many cases, the term sheet is non-binding (even if some provisions, like confidentiality, are), meaning there is no penalty if the deal does not go through for some reason.  In other cases, holding the parties to the agreed terms will be a critical part of getting through the due diligence process (to be discussed in a later post) to closing.  Either way, the term sheet needs to be specific enough so that the parties understand where they are headed as they embark on the diligence work, but within reason since the term sheet will be replaced ("superseded" in lawyer speak) when the final documents are prepared.  The larger the deal, the more provisions are generally going to be required; but for many smaller transactions, the goal is to keep it simple and straightforward.

Now lawyers will insist that they be involved in negotiating the term sheet, but sometimes this is done for the wrong reasons.  Many of them want to "lawyer up" the term sheet with a variety of legal provisions that will end up in the final documents (mostly to show that they are adding value).  Sometimes the legal provisions are critical to the deal and may need to be included (e.g. certain material business change provisions or legal conditions to closing).  But more often, legal "customary" provisions like representations and warranties and indemnification provisions will be negotiated with the final documents rather than at the term sheet stage.  The reality is that most of the key information in the term sheet will be business terms -- price, earnout terms, deal structure (cash/stock/assets), working capital requirements, status of employees, and the like -- with a few exceptions noted below.

That being said, I have had to renegotiate business provisions in term sheets after the fact because the the descriptions were too vague and the parties did not have the same understanding when the definitive documents were drafted.  For example, the calculation of an earnout (or payment of the purchase price over time based on earnings of the company after the closing) and net working capital requirements (how much cash has to be on hand after taking in to account certain expenses) are not only tied to very specific definitions, but poorly worded term sheets can provide either side with plenty of latitude to adjust the numbers any way that suits them.  In those cases, having a lawyer review your term sheet can prevent some drafting issues long before they have to be renegotiated, which costs the parties more time and money.

In addition to the business terms of the deal, we typically include the following legal provisions to help protect the parties form unintended consequences:

1. Exclusivity and Good Faith: an agreement by the parties to negotiate with the other party exclusively and in good faith in order to complete the proposed transaction.
2. Confidentiality:  in order to compete the transaction, each party will supply the other with confidential information that much be protected by the other party for a certain period of time regardless if the deal closes or not.  This provision must be specifically excluded from the non-binding nature of the agreement.
3. Non-binding:  if the parties intend the term sheet to be non-binding, as is common, then a specific provision must be included to prevent a legally binding agreement from taking place at this stage.
4. Material Changes:  a provision that bases the transaction on the accuracy of certain assumptions that, if not true at closing, give one or the other party a way to exit negotiations.

Again, there may be other provisions that you will want to include at this stage, but the best way to do that is to work with your attorney, which can prevent headaches down the road.

Attempts by States to Control the Internet Are Just Beginning

Last year, new privacy regulations became effective in Massachusetts, which required businesses to take a series of actions whenever they held personal financial information of Massachusetts residents.  The law had far-reaching implications because it could effectively cover businesses that had no other ties to the Commonwealth. Now California is making its own privacy grab by targeting the (somewhat dubious) privacy policies of Facebook and other social networking sites with the proposed "Social Networking Privacy Act".  Anyone who uses Facebook, Google, Twitter, and the like knows that it is difficult to control how your personal information is stored and used - or frankly, what each site's fluid policies even cover at any given time.  This has caused well-documented user confusion and angst, and has led to many privacy breaches.

But California is pushing privacy restrictions to a new level.  The Massachusetts privacy law, for example, regulated mostly back end processes and governed how personal information would be protected by the companies once it was acquired.  The difference here is that California's bill will affect how the companies interact with their California users, from requiring how the companies collect the personal information, to what they can do with it.  The bill would require Facebook and the others to change not only how they collect information from their users, but also what information can be posted by default, and how information can be removed.  One provision gives parents the right to remove information posted by "minors", meaning anyone under the age of 18 (a provision that I am sure would not exactly be popular with high school students).

The bill will likely not make it into law in its current form, partly because of this alliance of powerful opponents.  But it is clear that states are starting to take privacy issues very seriously, and, in the absence of a federal alternative, will still try to take action to protect its citizens.

M&A Series: How is the purchase of a company structured?

When a client asked if I would help him sell his business, he told me that he was ready to go and already had a buyer.  I followed that up with "is it a stock deal or an asset deal", and his face went blank. Most acquisitions are done with one of two structures:  either the buyer purchases all of the assets of a business out of the selling company, or the buyer purchases all of the ownership interest (i.e. stock, membership interests, etc.) and takes over the company, which can either continue as a subsidiary or can be merged into the buyer or related entity.  If the selling company is not a corporation or an LLC, then the deal has to be for assets.  Which one is right for your business?  Each has its pros and cons.

In an asset deal, the buyer is paying cash, stock, or other property for all of the assets that the seller uses in the operation of the business - everything from equipment, to Web sites, to trademarks, copyrights, and patents, to contracts.  The benefit to the buyer is that it does not have to buy any of the liabilities of the seller, or any bad assets for that matter.  For example, if someone has a claim to sue the seller for something that occurred prior to the sale, that will remain the seller's responsibility.  Likewise, if the seller has debt or other obligations outstanding at the time of close, none of that passes to the buyer unless expressly agreed (sometimes, the buyer will, as part of the purchase price, assume some outstanding debt or other obligations, like a real estate lease or mortgage).  Plus, the buyer gets a stepped up basis in the assets it is buying which will be advantageous when selling the assets later and for amortizing the assets over a period of years.  The down side to an asset deal is that everything that gets transferred has to be assigned.  For most of the basic assets of the company, that is easily done through a bill of sale.  But for certain contracts, capital equipment, vehicles, Web sites and other registered intellectual property, and leases, some sort of assignment has to be made, which may include getting consent from the current contract holder or entering into an amendment to the original contract.  That can often slow down a deal.  It is frustrating to all of the parties when a $25 million transaction is being held up because we don't have a signature of a landlord on a lease assignment (which does happen).

If, on the other hand, the buyer purchases all of the stock of the seller, in a way, it is simpler conceptually because you eliminate the need to transfer the assets.  The selling company still owns it all after the closing - the only change is that the company has new owners.  But in addition to keeping all of its assets, it also keeps all of its liabilities, even if they are not known at the time of the closing.  This may cause a bit of heartburn for the buyer, and may lengthen the negotiation process because there will be more focus on the representations and warranties and indemnification provisions in the final agreements (which I will cover is a later post).  On the tax side, the seller can enjoy significant tax benefits at capital gains rates, but the buyer loses the benefit of depreciation that it would have had in an asset deal.  The bottom line is that a stock sale benefits the seller more than the buyer.

Putting all of that together, sellers will generally push for a stock sale and buyers will typically want an asset sale.  But at the same time, either can be an acceptable structure depending on the nature of the deal.  That is just where the negotiation begins.

Launching ACQ&A - a New Series of Posts on Acquisitions and the Art of Selling a Business

After spending the last couple of months involved in a few acquisitions, and seeing what might be coming as the economy continues to improve slowly, I thought it might be helpful to talk about what goes into the sale of a company.  It is a mysterious process for many business owners who are doing it for the first time.  They are likely getting only one shot at selling a company, so it is important to go into the process with some understanding of what is coming.  A big mistake that many business owners make is jumping in without sufficient prepping and letting the process teach you valuable lessons (after it is too late). Because there is a lot to discuss, I will break this into several posts.  Over the next few weeks, I plan to cover term sheets (aka letters of intent, memorandum of understanding, etc.); deal structures; purchase price and earnout issues; representations, warranties, and covenants, and some other thoughts that might help you when you approach this milestone.  These posts will mostly deal with private company sales - public company transactions come with their own peculiar issues - but the concepts here will cover the vast majority of transactions out there.

So stay tuned!