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Why Coding Pizza Parties are a Bad Idea

February 23, 2016 posted by John Gregory

You’ve toiled away for years on your startup and you’ve worked really hard to land a big investor or to strategically position your technology startup for acquisition. You’ve just received an investment offer or an offer to purchase your startup for a king’s ransom, and then, while going through the due diligence process to close the transaction, the other side’s attorneys start asking a bunch of questions regarding whether your products or services have a clean intellectual property (“IP”) trail. “What the heck is an IP trail?” you ask yourself.

A “clean IP trail” means your startup owns or has sufficient rights in and to the IP contained in or used by your startup’s products or services. Sometimes this answer is simple – yes, because you are the only founder and you wrote all of the code your startup utilizes from scratch and the startup was your full-time job.

However, the above scenario is rarely the case in today’s tech startup scene. Here are a few common scenarios that may cause your technology startup to encounter problems when engaging with potential investors or acquirors:

  • Scenario #1: You write code or develop technology during the day for a large technology company, and your startup’s product / service is similar to the products / services offered by your employer, or are on your employer’s roadmap.
    • The problem:
      • At the outset of your employment with the large technology company, you likely signed a “Proprietary Information and Inventions Agreement” (or similar agreement). These agreements state, in essence, that any “inventions” you create during your employment (whether you are at work or at home) that are related to the employer’s business shall be deemed “work for hire” and 100% owned by the Company.
      • This means that your employer owns all the IP you created for your startup.
    • The remedy:
      • There are two possible routes, neither of which are good:
        • Approach your employer and ask that they assign to your startup the IP you developed for your startup; or
        • Ignore the problem and hope the employer / investor / acquiror doesn’t find out or care.
  • Scenario #2: An independent contractor develops part of your startup’s code, but there is no written agreement between your startup and the contractor, or the written agreement is lacking sufficient “work for hire” and/or “assignment” language.
    • The problem:
      • Unlike an employee who is hired to invent (in which case all the work they create automatically belongs to the employer), independent contractors own what they create outright unless there is a written agreement in place making clear the hiring company owns what is developed (either through “work for hire” language or an assignment).
      • If, during the due diligence process, it comes out that an independent contractor developed certain code and that code is not covered by an agreement making clear that your startup owns the IP, a savvy investor or acquiror will require that you remedy the problem.
    • The remedy:
      • In this case, you may have to approach the contractor and ask him or her to assign the “work product” he or she developed. Sometimes this is accomplished without a problem or cost, but it’s not uncommon for the contractor to understand his or her leverage and ask for an additional fee in exchange for his or her cooperation.
      • The other option is to re-write the code the contractor developed from scratch. This remedy can be time consuming and/or costly depending on the situation, and may even kill your deal.
  • Scenario #3: You invite your friends, who work at the largest technology companies in your area, over for a “coding pizza party,” with the goal of learning and/or writing new code for your startup.
    • The problem:
      • Essentially, this fact pattern implicates both Scenario #1 and Scenario #2 above. This means that the work developed during the pizza party is either owned by your friends’ employers, or your friends themselves.
    • The remedy:
      • Assuming there are no problems with your friends’ employers, have your friends sign a document that makes three things clear:
        • That the work they performed, to their knowledge, is not related to their employer’s line of business or expected lines of business;
        • That he or she did not use any time or material of his or her employer; and
        • That all work product developed during the pizza party is hereby assigned to your startup (that “hereby” language is actually important).
        • If your friends do not want to sign anything, understand that in order to demonstrate a clean IP trail, you will likely have to re-create the work they performed during the pizza party.

Now, if any of the scenarios above are present, the potential investment or acquisition is not automatically dead. Here’s what may happen instead:

  • If dealing with a potential investor, either your startup’s valuation will take a hit, or the potential investor will reduce the amount it is willing to invest; or
  • If dealing with a potential acquiror, you can expect to indemnify the acquiror for any issues they encounter in connection with your IP (above and beyond standard indemnification for similarly situated acquisitions) and that the purchase price for your startup will be subject to a substantial holdback (i.e., the acquiror will “hold back” a portion of the purchase price for a specified period of time, usually tied to the expiration of the statute of limitations, to ensure that no claims are brought against the acquiror in connection with your IP), and if any claims are brought, the sums expended by the acquiror to resolve such claims, including legal fees and costs, will be deducted from the holdback.

As you can see, it’s very important to be conscious of your IP trail at the outset of your product and service development. If you don’t, all the effort you put into landing that big investor or positioning your startup for a successful acquisition could be put at risk.