IP & crowdfunding: are 1,000 NDAs better than none?

Bill Payne , Angel Investor , Frontier Angel Fund

18 Jan 2012

Angels and venture capitalists will not sign non-disclosure (confidentiality) agreements just to listen to an entrepreneur’s funding presentation, or even to read the entrepreneur’s business plan.  Serial entrepreneurs understand this and write their plans without describing the “secret sauce.”  Investors will eventually want to validate the intellectual property (IP) prior to investing, but not just to hear about the opportunity.  After hearing an interesting presentation, these professional investors will engage with the entrepreneur in a process called “due diligence,” an exhaustive review of the business plan.  During this phase of the investment process, representatives of the investor group may agree to a non-disclosure agreement as part of their validation of the IP.

Crowdfunding is an opportunity for new small businesses (lifestyle companies) to raise capital from many different sources using qualified websites to facilitate the deal.  For “mom and pop” businesses, this may make lots of sense.  Unfortunately from what I read, crowdfunders expect to invest in the next potential IPO in which IP may play a huge role in the success of the company.  Validating the IP may become a roadblock to crowdsources participating as equity investors in high-growth companies.

IP takes many forms, but let’s just consider patents for now.  The validation of a patent (perhaps not as yet issued) requires demonstrating that the innovation is unique by an exhaustive study of the prior art (early patents and publications).  Validation also requires consideration of “freedom to operate,” that is, clarity that the product can be made and distributed without violating the IP rights of others.  Verifying that a new company has a unique product or service that cannot legally be duplicated quickly by reverse engineering by competitors is a legitimate concern of investors.

So, how will crowdfunding sources validate the technology for investment in interesting startups?  There seem to be a few options:

• Crowdfunding sources will simply not require new companies to provide any validation of competitive advantage facilitated by IP.  OK…but that certainly seems to increase the risk of failure for investors in this very high risk asset class.
• The entrepreneur will ask hundreds, if not thousands of crowd investors to sign non-disclosure agreements to allow investors to validate the IP.  Gee….think about the nightmare if an inappropriate disclosure is made.  Tracking down the individual who made the unauthorized disclosure would seem to be a daunting task.  In fact, just maintaining the non-disclosure documentation for hundreds of investors would be a logistical headache.  Are 1,000 non-disclosure agreements better than none?
• An independent facilitator will validate the technology and provide a non-confidential report to interested crowdsources.  Those with extensive experience in pursuing IP legal opinions understand that this is a time-consuming and expensive process ($10,000 to $50,000, or more).  Since crowdsources will be making small investments, the new company seeking funding will have to pay for these opinions.   Considering the legal liability, will these IP specialists complete these studies on a contingency (assuming their fees will come from the proceeds of the crowdfunding)?   I wonder.

It is the opinion of this writer that IP validation is simply one more strike against crowdfunding as a source of capital for high-potential, high-growth startup companies.

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