IP Unlocks Startup Valuation – Part I

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  • Chris Baxter - Managing Director, Patent & Trade Mark Attorney
  • Managing Director, Patent & Trade Mark Attorney

I’ve been working as a patent attorney since 2007 and investing in tech startups since 2009. Baxter IP advises thousands of startups each year and I manage a portfolio of 22 angel investments. Most have an IP position. Over the last decade I’ve been fortunate to work with a truly diverse range of investors from angel syndicate managers such as Kylie Frazer and Brendan Hill to VC firms, mid-market fund managers and many business angels. From mentoring startups on their pitch, advising them on their IP, judging pitch nights to investing in startups I’ve gained insights into how IP strategy can be used to unlock the valuation of startups.

No traction yet – what’s key?

It’s harder to raise capital pre-traction because investors are weighing up your opportunity against others where traction exists. Pre-traction, angel investors typically run through (normally in their mind) an extensive list of pre-conditions that need to be met prior to making an offer to invest. In my experience, the top pre-conditions for pre-traction investment are:

  1. The team: Do they have skills and expertise required in-house to execute and complete their next raise and beyond. Do the team members have what it takes to connect, communicate and persevere?
  2. The opportunity size: Investors typically invest in multiple startups. It’s no secret most will fail. Given this risk profile investors need one or two of the opportunities to do 20x plus in order to make the investment strategy worthwhile. Therefore, investors will generally only go into opportunities which in themselves could be worth $100m+ if they hit their target.
  3. Evidence in support of future traction: The most important thing in any business is users/customers. They drive cashflow, revenue, profit and valuation. So investors are looking for indications that strong traction will soon take place. Evidence of future traction may come from a variety of directions including the industry, the market, experts and most importantly from potential users/customers.

How does IP play into this stage?

As a stand-alone point, IP is rarely in the top three qualifying pre-conditions. IP considerations are, however, interwoven through them. How so?

  1. The team is typically where the IP initially resides as ideas, notes, mock-ups, prototypes, specifications and code. It’s essential that there is a clear lineage of ownership from the team members, including founders, co-founders, employees and contractors to the startup. This is normally achieved through written assignment. Ownership of IP is always on the due diligence checklist because investors want to see the IP controlled by the vehicle they are investing in. The bottom line? The chain of succession of IP ownership needs to be evidence-able.IP resides in more than just the statutory types of IP such as patents, designs and trade marks. IP also resides in copyright in code, confidential information, know-how (what works as well as what doesn’t work), product and process design, internal processes and systems that make a startup easier to use than the others, potential client lists, and other information that has been developed by the team and taken time to set up or put in place. Competitors who don’t have this IP are delayed and so IP should not be made available outside of the startup, unless there are commercial reasons to do so. Therefore, the recognition and care-taking of IP is important.
  2. The opportunity size is inversely proportional to the number of startups competing for it. IP can be used to carve out sections of the market that the startup can own for up to 20 years. This is the term of a standard patent. Opportunity in terms of profit also correlates with unit margin, margin, in turn, correlates with product/service innovation and brand. Product innovation and brand can often be protected with registered IP. So IP is useful in carving out sections of the market and in protecting unit margin, both which speak to the size of the overall opportunity for the investor.
  3. As the IP savvy know, all sorts of problems are created, including IP invalidation in most jurisdictions, if you disclose an idea to a third party prior to filing. The exceptions to the rule are if the disclosure occurred within a communication where there was an obligation of confidentiality, due to a confidentiality agreement for example, or if a grace period is used to obtain protection in target markets despite an earlier disclosure.In order to gain the necessary evidence in support of traction normally the startup needs to speak to third parties. The filing of a patent application first makes these discussions much easier. This is because, if there is an understanding or agreement of confidentiality in the discussions with those parties and it is breached, and the breach is unable to be traced, then at least the untraceable breach won’t invalidate the right to apply for patent protection. Traceable breaches do not invalidate patent filings per se. The exceptions mentioned above continue to apply.Successful businesses are copied. A startup will be forging a new market the hard way, from scratch, using investor(s) money. If they are successful at doing so, investors will want to know that the market share won’t be easily lost to the first or second copier that comes in, at say, a different price point.

Wrapping up, whilst IP may not be in the headline of a key pre-traction consideration, it’s crucial to unlocking the valuation the startup seeks. Investors want what IP enables:

  • to see ownership of the IP reside in the investment vehicle
  • to maximise the accessible opportunity size
  • to prevent losing market share that has been hard won, and
  • to see evidence in support of future traction and IP filed early allows this evidence to be collected with minimum risk.