Strictly Business

This article was originally posted on business.com on May 1, 2012.

Investing in a new venture can be exciting. In addition to the potential to make a profit, many people invest in start-ups for the thrill of being involved with helping a fledgling company make its mark. The possibility of funding a breakthrough company is enough to get many investors enticed, committed, and involved.

However, it’s also a fact of life that many, if not most, start-up companies fail. Alongside that, some investment opportunities are fraudulent, being promoted by people only looking to swindle you out of your money and then move on to pursue other ventures (and victims).

This can be the case even if it appears on paper that the company has a fantastic business model, an intricate plan, or even an extensive list of key assets. While not all promoters of start-up investment opportunities are out to do such a thing, the smart investor needs to gather important information before considering investing in a business – good or bad.

• Determine if the Promoters are Legitimate: Conduct a Google search on the person promoting the opportunity. If the person is in the financial industry or works as a securities broker, check out his profile on brokercheck.finra.org. If you find any history of securities law violations, fraud, lawsuits, or criminal conduct, it should function as a huge red flag.  A history of bad conduct means the company is likely to continue with such actions in future endeavors.
• Ask for the Company’s Offering Memorandum or Financial Statements: If the company doesn’t have some kind of offering memorandum or due diligence packet, that’s a red flag, as it alerts you that the company either is unwilling to provide information to potential investors or simply lacks the patience to put in the work the goes into compiling such information.  That being said, a small company may not have the money to produce a formal offering memorandum; in this case, you should ask for its financial statements. These should be prepared by an outside accountant in order to provide some degree of independent verification. The reliability of such documents is further enhanced if they’re audited.  Finally, it’s also a good idea to require copies of past tax returns in order to verify their claims.
• Obtain a Copy of the Company Business Plan: A company’s business plan is the ultimate road map that will guide a company to success. Not only does it provide the main objectives of the company, it also tells you the demographic they’re marketing their goods or services toward, along with the resources it will take to accomplish the company’s plans.  Companies that take the time to prepare a business plan have demonstrated that they have put some thought into how they are going to use your investment to produce a profit.

As an investor, you should have an informal team consisting of a lawyer, an accountant, and an investment adviser (one who’s paid a fee to advise you, not a broker who receives a commission on the sale). Your lawyer(s) should specialize in business law – don’t use the family lawyer who wrote up your will.  Having a team can be very important to you, as an investor, in several ways:

• Negotiations between You and Company: If the deal is negotiated between you and the company, rather than a prepackaged securities offering made to a number of investors, a lawyer experienced in start-up finance can help you negotiate protections and better terms.
• Understanding the Contents of Legal Documents and Disclosure: Your team also will be able to help you understand both the economics and the legal terms of the transaction.  Having an investment team is important when it comes time to review the documents binding you to the start-up. If you don’t understand something, your team of advisers is there to help. You pay them to help you sort through confusing and complicated issues.
• Establishing Credibility: Having a team is not only smart for legal reasons, but it also lends you a level of immediate respect.  Parties without lawyers show they don’t take themselves seriously, or don’t have the means to prepare their documents in a professional manner.  In addition, if the other party drafted the documents without a lawyer, the documents will likely contain serious problems and key issues will be overlooked.

If you’re an individual with a high net worth, it’s beneficial to join an angel investing group. These are local organizations comprised of individuals looking to invest in promising companies.  Joining such a group is beneficial, as it allows you to compare your notes about the companies with other potential investors. It also allows you to invest more money as a group.

While investing in a start-up company can be a gamble, proper investigation and preparation, from researching the promoters to working with your investment team, will allow you to make smarter and more profitable investments. The better investments you make, the more likely you are to invest in that breakthrough company.

———————————–

© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Last December, I wrote a series of posts about what was – and remains – a hot topic in patent law:  patentable subject matter under 35 U.S.C. § 101.   The law on patentable subject matter often boils down to whether the invention is so abstract or such a product of nature that the invention is not patent eligible even if it meets the other statutory requirements of being new, not obvious and useful.  Since those posts, the Supreme Court has issued another decision further limiting patentable subject matter in Mayo Collaborative Servs. v. Prometheus Labs., Inc.  I believe that patent eligible subject matter is going to continue to be a thorny issue for many software, medical diagnostic and biotechnology inventions.  However, I believe that in the majority of cases involving mechanical devices, medical devices, and new chemical compositions, patent eligibility under § 101 is going to be a non-issue, that is most inventions in these fields will readily qualify under § 101.

In Mayo, the invention related to the discovery that a particular concentration of drug metabolites in the blood should be targeted by doctors when they prescribe a particular class of autoimmune drugs.  (A drug metabolite is a chemical formed when the body digests – i.e., metabolizes – a drug.  In the pharmaceutical industry, it is extremely common to identify metabolites and their concentrations during clinical testing).    In particular, each claim of the plaintiff’s patent included (1) an administering step that instructed a doctor to administer the drug to his patient (2) a determining step that told the doctor to measure the resulting metabolite levels in the patient’s blood and (3) a wherein step that described the target metabolite concentration and informed the doctor to adjust the patient’s dosage if the patient’s metabolite levels were outside of the target concentration.

Addressing the patent eligibility issue, the Court repeated the commonly recited proposition that laws of nature, natural phenomena and abstract ideas are not patent eligible.  The court then found that the heart of the invention — namely, the discovery of the relationship between the concentrations of certain metabolites in the blood and the likelihood that the prescribed drug dosage would prove ineffective or cause harm — was simply a law of nature.  Further, in the Court’s view, the three recited steps failed to “add enough” to render the claimed method a patent-eligible process.  The Court found that the first step referred to a pre-existing audience, namely, doctors that already administer the drugs, the second step merely told doctors to measure metabolites in the blood, and the wherein step merely informed doctors about the law of nature.  Accordingly, the Court held that the claimed process was not patent eligible.

In my view, the Mayo decision is problematic for a few reasons.  For example, while it’s easy to say that laws of nature, natural phenomena and abstract ideas are not patent eligible, it’s often difficult to apply this rule in practice and conclude when an invention “adds enough” to render a claimed method patent eligible.  Indeed, perhaps for this reason, the Federal Circuit had crafted a machine-or-transformation patent eligibility test in which a claimed process was generally patent-eligible if it was implemented with a machine or transformed matter, and patent ineligible if it was not implemented with a machine or transformed matter.  Additionally, in my view, the proper way to strike down the patent in Mayo was on obviousness grounds.  It has been known for decades that it’s important to measure drug metabolite levels and at the time of the invention at issue in Mayo, scientists knew that the metabolites at issue were correlated with drug safety and effectiveness.  Though the particular target levels were not known, the methods to test metabolite levels were old and there was clearly a motivation to use these known methods to find the target levels.

It goes without saying that how the lower courts will apply Mayo will be important for companies in the software, diagnostic and biotechnology industries.

———————————–

© 2012 Shane V. Cortesi — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

This last week, the Senate passed the “JOBS Act,” leaving it one step away from final passage by Congress and Signature by President Obama.  The JOBS Act contains a number of provisions which are aimed at reducing the securities compliance burdens of small companies and startups.  One of the major provisions within the JOBS Act is the so-called “crowdfunding” provision.

Crowdfunding has an enthusiastic following online and within the entrepreneurial community.  Obviously, that following is very excited about the bill’s Senate passage.  Unfortunately, I don’t think they should be popping the champagne corks anytime soon.  Before passing the bill, the Senate passed an amendment to the bill substituting a new version of the crowdfunding law by Senators Merkley, Bennet, and Brown in place of the one written by Rep. Patrick McHenry.  All signs point to the Republican leadership in the House conceding to the Senate’s amendment this week in order to get the bill to the president’s desk for signature as soon as possible.

And I believe the Senate’s amendment kills crowdfunding.  The replacement crowdfunding bill is significantly more complex and fraught with liability for issuers.  While even the McHenry approach had some degree of complexity, the Merkley version makes it look simple and straightforward in comparison.  Here are just a few examples of some of the differences that I think will sink the new crowdfunding law and prevent it from being of any practical use:

• In the new version, the exemption from registration only applies if the aggregate amount sold to any investor by an issuer (that is, ANY issuer) does not exceed certain caps, which vary depending on the investor’s income.  That’s right, if you use the crowdfunding exemption, it may not apply depending on whether your investors have invested in OTHER startups using the exemption — something you have no control over.  Hopefully, the SEC, in regulations, will provide a safe harbor for issuers to make this determination (both as to income and the amounts invested in other crowdfunding offerings), but you can never count on the SEC making anything simple. [Update 4/19/12: see comments below.  One commenter had pointed out that from first blush the limits may not apply in the aggregate.  However, a separate portion of the bill does confirm that the limits apply in the aggregate, but the funding portal will have the obligation to enforce this.  That said, there still may be significant consequences to the issuer if the funding portal fails fulfill their responsibilities.]
• In the new version, the offering can only be made through a registered broker-dealer or a new “funding portal” which also must be registered with the SEC and, apparently FINRA.  In the McHenry version, an issuer could use an unregistered “intermediary” but was not required to.  This additional requirement will greatly increase the costs of conducting a crowdfunding offering.
• The new version requires that the issuer of any crowdfunding offering of over $500,000 have audited financials, again significantly increasing the compliance costs on issuers.  It also prohibits any advertising to promote the offering.
• The Merkley amendment creates a new cause of action against a crowdfunding issuer, and its directors and officers.  Traditionally, in Federal securities fraud suits (at least those involving non-public securities), the plaintiff has to prove that the defendant acted knowingly or recklessly.  In any suit involving a crowdfunded company, the burden of proof will be on the defendants and they will need to prove they didn’t know about any misstatements nor in the exercise of reasonable care could not have known about the misstatements.  Good luck finding competent directors for your crowdfunded company.

In all, the statute that provides for the crowdfunding exemption expanded from 12 pages to 24 after the substitution of the Merkley version.  For a crowdfunding exemption to work, it must be simple.  Small companies cannot afford the significant compliance burdens placed upon them by the crowdfunding exemption that was passed.  Therefore, my prediction is that entrepreneurs will quickly find that the new exemption is too expensive to utilize and is more trouble than it is worth and that it will rarely be used.  As I’ve stated in the past, there are some significant practical obstacles to crowdfunding even with the McHenry bill.  The Senate’s solution certainly didn’t help.   Therefore, I believe the Senate may have just effectively killed crowdfunding.  I may be wrong; the SEC may implement the bill well through regulation and save crowdfunding.  Anyone want to take a bet that this happens?

———————————–

© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

The U.S. House of Representatives voted earlier today (March 8, 2012) to pass the Jumpstart Our Business Startups (JOBS) Act.  The bill is actually a compilation of six separate measures that have been proposed in Congress (and in some instances already passed in the House) which loosen securities restrictions on smaller companies.  Here are brief summaries of each measure:

The Reopening American Capital Markets to Emerging Growth Companies Act (H.R. 3606; the rest of the bills were added to this one).  This bill is also known as the “IPO On Ramp” and it creates a new category of company called an “emerging growth company,” which is defined roughly as a public company with less than $1 Billion in revenue.  An issuer that is an emerging growth company as of the first day of a fiscal year will continue to be one until the earliest of (i) the last day of the fiscal year during which the issuer had $1 billion in annual gross revenues or more; (ii) the last day of the fiscal year following the fifth anniversary of the issuer’s IPO date; or (iii) the date in which the issuer is deemed to be a large accelerated filer, defined by the SEC as an issuer with more than $700 million in public float. In addition, a company would not be considered an emerging growth company if it has issued more than $1 billion in non-convertible debt over the prior three years.  An emerging growth company would enjoy more lax regulation by the SEC.  For instance, the bill would allow emerging growth companies to defer compliance with Section 404(b) of the Sarbanes-Oxley Act until the company is no longer considered an emerging growth company.  Section 404(b) requires the company’s auditor to report on and attest to management’s assessment of the company’s internal controls, a requirement that carries high compliance costs. In addition, the bill would only require emerging growth companies to provide audited financial statements for the two years prior to their IPO rather than three years. The bill also exempts emerging growth companies from new corporate governance requirements within the Dodd-Frank Act, namely the so-called “say on pay” requirement and the requirement that public companies calculate and disclose the median compensation of all employees compared to the CEO.  The bill would remove restrictions prohibiting investment banks that underwrite a company’s IPO from publishing research on emerging growth companies and would  expand the range of permissible pre-filing communications to “qualified institutional buyers” or “accredited investors.”

The Access to Capital for Job Creators Act (formerly H.R. 2940).  As discussed in a previous post, this bill essentially removes the general solicitation prohibition on offerings made under Rule 506 of Regulation D.

The Entrepreneur Access to Capital Act (formerly H. R. 2930).  This is the “crowdfunding” bill, which I’ve discussed at length in the following posts: Is action forthcoming on a crowdfunding exemption to Federal securities laws?; Bill Creating Crowdfunding Exemption from Securities Registration Passes U.S. House of Representatives; What does the future hold for crowdfunding legislation?; Implications of the Pending Startup Crowdfunding Bill.

The Small Company Formation Act (formerly H. R. 1070).  This bill would increase the offering threshold for companies exempted from SEC registration under Regulation A from $5 million to $50 million. It would also preempt state blue sky laws with regards to such offerings if they are traded on a national exchange.   Regulation A is a little used exemption from registration that permits an exempt public offering using a type of “short form” registration.  It is rarely used for two reasons: (i) it has a limit of $5 million and (ii) there is no preemption and so the offerings are subject to blue sky laws.  This bill would eliminate both of these obstacles.

The Private Company Flexibility and Growth Act (formerly H.R. 2167).  This bill raises the number of shareholders a company can have before it is forced to go public from 500 to 1,000.  In addition, it also excludes employees from counting against this limit.  More details can be found on a previous post on this topic: Bill Introduced in Congress to Permit Private Companies to Stay Private for Longer.

The Capital Expansion Act (formerly H.R. 4088).  This bill raises the number of shareholders permitted to invest in a community bank from 500 to 2,000.  The issue here is that community banks are often forced to engage in expensive Exchange Act reporting because they have over 499 shareholders.  This bill would remove this expense for many of them.

The vote was lopsided and the White House has indicated that it is supportive, so the bill has a decent chance of become law.  That said, don’t let the lopsidedness of the vote fool you.  There is genuine opposition to these bills in the Senate that has been building for some time.  There are some significant concern that the legislation will increase the incidence of securities fraud, particularly for senior citizens.  Therefore, stay tuned.

———————————–

© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Recycling is generally considered a good thing when it comes to trash.  It helps the environment and conserves resources.  However, in the context of legal work, it is not such a good thing.  Of course, when I use the word “recycle,” I don’t mean recycling the paper that the legal documents are on.  I’m talking about recycling the actual words on the page.  When a client “recycles” their lawyer’s work which was performed on a previous deal and uses it in a new deal, the client is asking for trouble.

Let’s look at a hypothetical example: The founder of a startup has some friends and family invest in the seed round of the company, issuing stock to the investors.  He hires a lawyer to draft the documents and offering materials.  The work is done correctly and the offering of stock is completed without a hitch, and rather importantly, carried out in compliance with securities laws.  The lawyer’s bill came in at $5,000 and the founder is not exactly happy about it (it’s just for “paperwork” after all!), but he begrudgingly pays it.

A year later, the company is running out of money and needs to raise more capital, perhaps this time from a few angel investors.  The founder thinks to himself: “I’m in luck, since I have the documents from our last stock offering, I have what I need and I can simply recycle the old documents.  That way I won’t have to pay the bloodsucking (or some other expletive) lawyers to charge me more exorbitant fees for more paperwork.  It’s just changing the date on the form for heaven’s sake.”

So that’s what he does.  He takes the old documents, changes the dates and the names of the investors and takes in the new investment.  Unfortunately for him and the company, the capital raise is not done in compliance with securities law, causing the offering to be considered an unlawful sale of an unregistered security.  In addition, because the disclosure is a year old, certain events from the past year which would be considered material information are omitted, resulting in a potential securities fraud claim against the company and the founder.  Finally, because provisions in a previous buy-sell agreement or subscription agreement relating to rights of first refusal and preemptive rights are not complied with, there is a dispute as to whether the stock was validly issued.

These kinds of defects have real world consequences.  When securities laws are violated, investors essentially have a “put” option against the founder; that is, if the company fails and the stock is worthless, they can sell it back to the founder and go to court to force him to pay them.  In addition, the SEC and state securities regulators can bring an enforcement action against the founder.  The confusion over whether the stock was validly issued could result in expensive litigation for the company at a later stage, as competing groups of shareholders dispute the ownership of the company.  Even if none of these things happen, and the company continues to grow, if the company were to later seek VC or institutional funding or engage in an IPO, the due diligence will reveal the problems.   At this point, the VC fund or underwriter will either (a) force the founder to pay the VC fund’s lawyers (at high NY rates like $1,000 per hour) to painstakingly clean up the violations or (b) pass on the deal altogether.

The above story is hypothetical, but similar real life examples happen all of the time.  A startup may save some money upfront by doing its own legal work, but the costs down the line will usually end up much higher.  Therefore, trying to draft your own legal documents based on prior work by an attorney ends up being penny-wise and pound-foolish.

———————————–

© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

This post is the fourth in a series written by Nashville attorney Shane Cortesi on patent protection.

As I mentioned in my previous post on patentable subject matter under 35 U.S.C. § 101, the law in this area has been in a state of flux over the last few years, especially in the case of process patents.  This week, I’ll discuss recent § 101 cases in the software and life science fields.  The common theme in both fields is that enlisting the help of a creative patent attorney may increase a patent applicant’s chance of meeting the patentable subject matter requirement.

Patentable Subject Matter for Software Inventions

Because the heart of software-related inventions often involve only the tangential use of a machine, software-related inventions often present difficult patentable subject matter questions.  Fortunately,  recent Federal Circuit cases involving the patentability of software-related patents provide a helpful road-map to patentability of these inventions.

For example, in Cybersource Corp. v. Retail Decisions, Inc., the first claim of the patent was directed to a method of detecting credit card fraud between a consumer and a merchant over the internet.  In particular, the method relied on comparing the internet address information used for a particular purchase to internet address information used in previous transactions with the same credit card to see if the internet address information in the present and past transactions was consistent.  The second claim was directed to a computer readable medium (e.g., a disk or other data storage device) containing program instructions for a computer to perform the method.  The Federal Circuit invalidated the first claim, reasoning that the claim was directed to an abstract idea and that even if the internet could be viewed as a machine, it was clear that the internet itself could not perform the claimed method.  The patent eligibility of the second claim at issue, in my opinion, was a closer question.  The court first held that this claim was in reality, a process claim, instead of a machine claim, because the invention underlying the claim was a method for detecting credit card fraud – not a manufacture for storing computer readable information.  The court then found the claim failed to meet either prong of the machine-or-transformation test because the claim merely required the manipulation or reorganization of data (as opposed to transformation of data) and the incidental use of the computer did not impose a meaningful limit on the claim’s scope.  Thus, the court held that the second claim was also directed to non-statutory subject matter.

From a patent attorney’s perspective, perhaps the most important part of the Cybersource decision is the manner in which it distinguished an earlier case that found a software-related invention patentable subject matter.  In particular, in Cybersource, the court distinguished the instant invention from the patented invention in its prior Research Corp. Techs., Inc. v. Microsoft Corp. decision, which involved a method of creating digital images.  According to the court, the distinction was that unlike the invention in the instant case, the method found to constitute patentable subject matter in Research Corp could not, as a practical matter, be performed entirely in the human mind.  Consistent with this distinction, the Federal Circuit in the recent Ultramercial, LLC v. Hulu, Inc. decision upheld the patentability of an 11-step process of distributing copyrighted contents over the internet.  Significantly, the process could not be performed in one’s head but rather required intricate and complex computer programming and required the use of an internet website.  Thus, the claim drafting tip from these recent decision seems to be the following:  ensure that the claimed method cannot be performed entirely in the human mind and, to the extent possible, require the use of intricate and complex programming and the use of a machine.  Of course, care should be taken so that the required use of additional programming steps and/or the required use of a machine do not allow competitors an easy opportunity to design around one’s invention.

Patentable Subject Matter for Life Science Inventions

In my view, the following invention have been subject to the most amount of debate when it comes to patentable subject matter in the life sciences:  1) man-made organisms; 2) naturally occurring materials (e.g., DNA); and 3) the use of diagnostic methods.  Ever since the Supreme Court’s 1980 decision in Diamond v. Chakrabarty, which held that a man-made organism was patent-eligible, courts generally have held that man-made organisms and natural compounds in isolated form are patentable subject matter.  (An exception is that, due to the enactment of recent legislation, human organisms are not patentable subject matter unless they were claimed in a patent issued before September 16, 2011).  Consistent with this precedent, in July of this year, the Federal Circuit held that isolated DNA molecules constitute patentable subject matter in the case Ass’n for Molecular Pathology v. U.S. Patent and Trademark Office.

In my view, the more difficult patent eligibility questions in the life sciences arena seem to involve diagnostic methods.  For example, in Classen Immunotherapies, Inc. v. Biogen Idec, the three patents at issue were related to a method of reducing the risk of chronic immune-mediated disorders by choosing a particular immunization schedule.  According to the patentee, two of the three patents were infringed when a health care provider reads the relevant literature and selects and uses an immunization schedule that is of lower risk for the development of a chronic immune-mediated disorder.  Meanwhile, the patentee argued that the third patent was infringed when a person merely reviews relevant published literature, regardless of whether that person selects and uses an immunization schedule.  Reviewing the patentability of the three patents under § 101, the Federal Circuit held that the first two patents involved the physical step of immunization and thus were patent eligible.  Meanwhile, according to the court, the third patent was merely an unpatentable mental process.

Upon a careful review, Classen suggests that patentability under § 101 may often depend on the ingenuity of the patent attorney in drafting the claim, by, for example, including in the claim the recitation of a physical step or the implementation of a particular machine.  Indeed, the concurring opinion in Classen admits as much, stating:  “[E]ligibility restrictions usually engender a healthy dose of claim-drafting ingenuity.  In almost every instance, patent claim drafters devise new claim forms and language that evade the subject matter exclusions.”

Thus, as in the software field, enlisting the help of a creative patent attorney may increase the chance that a  life science invention will be patentable subject matter.

Finally, it probably goes without saying, but I’ll say it anyways.  Patent eligibility is a rapidly evolving area of the law and I encourage all that are interested to continue monitoring court decisions in this area.  Indeed, the Supreme Court will hear oral argument in yet another patentable subject matter decision in December and it will be important to hear what the court has to say on patent eligibility in the ensuing opinion.  The case is Prometheus Labs. Inc. v. Mayo Collaborative Serv. and the case involves the patentability of diagnostic patents.

———————————–

© 2011 Shane V. Cortesi — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

The U.S. House of Representatives recently passed the Entrepreneur Access to Capital Act (H.R. 2930), which creates an exemption from the registration requirements of the Securities Act of 1933, allowing startups to engage in crowdfunding (i.e. raising capital from a large number of investors over the Internet).  Action is still pending in the U.S. Senate.  While the actual usefulness of this new exemption will depend largely on how the SEC interprets it in implementing regulations, it’s worth thinking ahead about how such an exemption would actually work (assuming of course that the bill passes).  Here are some of my thoughts:

• The bill may (or may not) reduce the amount of legal fees a company would pay for its seed round.  It creates a new type of capital markets participant called an intermediary, which would typically handle the offering for a startup.  The intermediary itself would be subject to considerable regulatory oversight and would also carry a large amount of risk of lawsuits brought under the anti-fraud provisions of securities laws.  Therefore, the intermediary’s need for legal counsel will be considerable (as will the need for some form of E&O insurance).  These costs will be passed along to the startups who use the intermediaries.  Ultimately, it remains to be seen whether the intermediaries will be able to obtain economies of scale for these costs, or whether startups will be better off engaging in the offering themselves.  And of course, even when a startup does use an intermediary, not hiring legal counsel is a risky move, given that the intermediaries will likely try to shift as much of the legal risk to the startup companies as possible through contract.
• With numerous shareholders comes the potential for class action securities lawsuits, derivative claims, requests for books and records inspections, and other actions shareholders can take against management.  These actions are much rarer when a company is funded through a small number of sophisticated investors.
• Having numerous shareholders also increases administrative burdens on a company.  The company will need to administer shareholder voting, transfers of stock, and communications with investors.  For large companies with significant resources, this is not a problem, but for a small startup that raises $1 Million, the administrative costs associated with having many shareholders could start to hurt the company’s bottom line. One possibility is that the intermediaries themselves may step in and provide this service to crowdfunded startups on their electronic platform, permitting them to take advantage of economies of scale.
• We have no way of gauging how VCs will regard the attractiveness of investing in a company that previously used a crowdfunding offering.  Crowdfunding can be used for seed rounds, but eventually, many companies need to turn to VCs or other institutional or sophisticated investors for further funding.  Assessing a startup’s capital structure is an essential part of any sophisticated investor’s due diligence.  When they find that they’ll be investing in a company that has numerous unsophisticated investors as its existing shareholders, they may balk at going ahead with the transaction.
• Finally, we have no idea how undertaking a crowdfunding offering will affect the price of a company’s D&O policy.  A sophisticated investor will usually want some form of board representation, which means they will also want the company to purchase D&O insurance for their board members (if they haven’t already).  D&O insurance providers may regard a company that has used the crowdfunding exemption as a higher risk, and price the premium accordingly.

As you can see, there are some downsides to using crowdfunding as your source of seed capital (as opposed to an angel investor or some other form of accredited investor).  If this bill passes, it will be interesting to see how this plays out.

———————————–

© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

This post is the third in a series written by Nashville attorney Shane Cortesi on patent protection.

As I mentioned in my earlier article concerning the requirements for obtaining a utility patent in the U.S., in addition to being useful, novel and not obvious, an invention must constitute patentable subject matter under 35 U.S.C. § 101.  In this article, I will briefly discuss the historical context of the patentable subject matter requirement.  Next week I will discuss the application of the requirement in two fields where patent eligibility under § 101 is commonly an issue:  software and biotechnology.

35 U.S.C. § 101 contemplates four categories of patentable subject matter:  processes, machines, articles of manufacture and compositions of matter.  The statute provides:  “Whoever invents or discovers any new and useful process, machine, manufacture, or composition of matter, or any new and useful improvement thereof, may obtain a patent therefor, subject to the conditions and requirements of this title.”  Despite the broad wording of the statute, courts have engrafted exceptions to the statute such that at least not all processes and compositions of matter that satisfy the conditions and requirements of Title 35 (e.g., novelty and nonobviousness) qualify as patentable subject matter under § 101.

A good starting place to discuss the evolution of the patentable subject matter requirement is the landmark 1998 decision State Street Bank & Trust Co. v. Signature Fin. Group, Inc.   There, the U.S. Court of Appeals for the Federal Circuit held that a patent directed to a data processing system that relied on a mathematical algorithm for calculating the share price of mutual fund investments was directed to patentable subject matter.  In so holding, the court implied that any invention that produced a useful, concrete and tangible result was patentable subject matter and expressly rejected the proposition, held by some commentators, that methods of doing business as a class were unpatentable.

The State Street decision led to a tidal wave of business method patent applications being filed in the U.S. Patent and Trademark Office (USPTO) ranging from methods of training janitors to dust and vacuum using video displays to methods of using color-coded bracelets to designate dating status.  Because business methods are commonly invoked in practice without being described in printed publications, the USPTO was ill-equipped to assess the novelty and non-obviousness of business method patent applications using its traditional search procedures.  Criticism over business method patents began to mount.

Finally, in 2008, the Federal Circuit, sitting en banc, revisited the patentable subject matter requirement in the case In re Bilski.   In In re Bilski, Mr. Bilski’s invention was directed to a strategy of buying and selling commodities so as to hedge risk.  Significantly, the invention did not require the use of a machine at all, let alone any particular machine.  The Federal Circuit, speaking through Chief Judge Michel, set forth a new, bright-line “machine-or-transformation test” for determining the patent eligibility of processes.  According to the court, to qualify as patent eligible, the process must be 1) tied to a particular machine or apparatus; or 2) transform a particular article into a different state or thing.  The court further stated that processes qualifying under this test may nonetheless be ineligible if the process had no other utility than operating on the particular machine, the machine was insignificant to the claimed process, or the machine was not central to the process’s purpose.   Finding that Mr. Bilski’s invention met neither prong of the machine-or-transformation test, the court held that his patent was invalid under § 101.  In so ruling, the court made clear that a mere-field of use limitation (here, the limitation to the commodities industry) was insufficient to render an otherwise ineligible invention patent eligible.  Mr. Bilski then appealed to the U.S. Supreme Court.

On review, the Supreme Court reiterated that laws of nature, physical phenomena, and abstract ideas are not patentable. The Supreme Court then held that the Federal Circuit’s machine-or-transformation test merely provided a useful and important clue to patent eligibility under § 101, and, thus, was not the sole test for determining whether an invention is a patent-eligible process.  Reaching the facts at issue, the Supreme Court held that Mr. Bilski merely sought to patent abstract ideas, namely the concept of hedging risk and the application of the concept to energy and other commodity markets, and, thus, the invention was unpatentable under § 101.

In my view, the Supreme Court’s opinion in the Bilski case did little to clarify the law on patent eligibility under § 101.  After all, the opinion leaves open the issue of when a process is sufficiently abstract to render the process unpatentable.   Fortunately, for patent examiners and applicants, the USPTO has provided guidance on patent eligibility under § 101 to assist patent eligibility determinations in the patent application process.  In short, consistent with the Supreme Court’s Bilski opinion, the guidance from the USPTO states that the machine-or-transformation test remains an important clue to patent eligibility.  Indeed, according to the guidance, as of its publication on July 27, 2010, no court presented with the issue had ever held that a process that failed the machine-or-transformation was patent eligible under § 101.  Nonetheless, the guidance provides a number of factors, apart from whether the process transforms matter or relies on the use of a machine, that play into the patent-eligibility determination, at least from the USPTO’s perspective.

Finally, it’s important to keep in mind that whether the invention constitutes patentable subject matter is only a close question in a subset of patent cases.  Inventions in most industries (e.g., electronic hardware, medical devices and pharmaceuticals) will usually readily qualify as patentable subject matter.  The more difficult questions arise when the invention is a diagnostic method, a method of doing business or a program that can be performed in someone’s head.

Next week, I’ll discuss recent post Bilski decisions in the life science and software fields.

———————————–

© 2011 Shane V. Cortesi — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

This post is the second in a series written by Nashville attorney Shane Cortesi on patent protection.

As I mentioned in my previous article where I provided an introduction to patent protection in the U.S., there are 3 types of patents:  utility patents, design patents, and plant patents.  This article deals with the requirements for the most common type of U.S. patents, utility patents.

To obtain utility patent protection in the U.S., an invention must be new and not obvious in light of the prior art.   “Prior art” includes publications and patents published before the inventor invented his invention, certain patent applications filed before the Applicant’s date of invention, and public use and public knowledge before the inventor invented his invention.  In addition, a sale, public use, or publication by anyone (even the inventor himself) more than 1 year prior to the date the inventor filed his patent application can prevent an inventor from obtaining a patent.  Finally, in some cases, the granting of a foreign patent before an inventor filed his U.S. application and the prior invention of another in this country before the inventor invented the invention himself can prevent an inventor from obtaining a patent.

In my experience, the aspect of U.S. patent law that most surprises inventors is that their own public use, sale or publication more than one year before a patent application is filed can preclude one from obtaining a U.S. patent.  The standard is even more stringent when it comes to obtaining patent protection overseas because in many countries absolute novelty is the rule and any public disclosure prior to the filing of a patent application can prevent one from obtaining a patent.  Depending on the circumstances, I often find it advisable for an inventor to 1) file a patent application and/or 2) have third parties sign a non-disclosure agreement (NDA), prior to disclosing his/her invention to others.

In addition to being new and not obvious, an invention must constitute patentable subject matter under 35 U.S.C. § 101.  Outside of software and processes that can be performed in one’s head, inventions in most industries (e.g., electronic hardware, medical devices and pharmaceuticals) will usually readily qualify as patentable subject matter.  The more difficult questions arise when the invention is a diagnostic method, a business method or a program that can be performed in someone’s head.  The law on patentable subject matter in the United States is continually evolving, and next week, I will devote a multi-part series to what constitutes patentable subject matter.

Finally, the invention must be “useful.”  In other words, the invention must have a specific, substantial and credible utility.  In most cases, the utility requirement is readily met.  The more difficult questions arise when the invention relates to a chemical or biologic for treating a particular disease and there is little or no experimental evidence showing that the chemical or biologic is useful for treating that disease.

In my experience, I have found that preliminary patentability opinions are often helpful to inventors in determining whether to invest the time and resources in filing a utility patent application.  These opinions usually can be done at a fraction of the price of filing a patent application and generally consist of two phases:  a search performed by a professional patent searcher and an analysis performed by a patent attorney advising the client on the likelihood of obtaining patent protection in view of the search results.

Finally, please note that the above discussion concerning prior art relates to patent applications filed before March 16, 2013.   Due to a change in law, namely the enactment of the American Invents Act (AIA), the scope of “prior art” for patent applications filed on or after March 16, 2013 will differ.  I hope to explore the AIA in a multi-part series on this blog later this year.

———————————–

© 2011 Shane V. Cortesi — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Previous, I summarized the Entrepreneur Access to Capital Act (H.R. 2930), a bill which provides for a crowdfunding exemption to the registration requirements of federal and state securities laws.  The bill was recently passed by the U.S. House of Representatives, and now awaits U.S. Senate action.  In this post, I’ll provide some of my thoughts on what is to come.

Will it pass?

Predicting the future is usually a futile effort, but I do believe that this bill (or something like it) has a good chance of becoming law.  If you had asked me this same question a year ago, or even six months ago, I would have told you that it has no chance.  The political climate over the last few years has favored the tightening of securities laws, not their deregulation, due in no small part to the perceived excesses of the securities industry in the events leading up to the financial crash in 2008.  What I hadn’t counted on was the cumulative effect of three years of high unemployment on the political process.  Politicians are desperate for a solution to reduce unemployment and consequently legislation that promises to reinvigorate the entrepreneurial sector has found rare bipartisan support.  Of course, the Republican gains in the Congress in 2010 helped significantly as well, given that the need for business deregulation is an article of faith within the Republican party.  As a result of these factors, the House passed the bill overwhelmingly in a rare bipartisan vote.  The White House has also signaled that it supports the effort.  The only remaining piece to the puzzle is Senate passage.

The U.S. Senate could choose to take up H.R. 2930 itself, or proceed with its own version, the Democratizing Access to Capital Act of 2011 (S. 1791), which is sponsored by Sen. Scott Brown (R – MA).  S. 1791 is remarkably similar to the House bill.  Given the bipartisan support for the concept, I think it is highly likely that a crowdfunding bill will pass the Senate, though it will likely differ in small or major ways from the House legislation.  These differences will need to be reconciled in conference committee, and then the reconciled bill will need to be passed again by each house.  However, neither political party has drawn a line in the sand about any of the particular differences and most of them are rather technical.  Therefore, there currently aren’t any major impediments to a final bill being passed before the end of 2012.  My prediction, therefore, is that we will see a crowdfunding exemption passed into law by the end of next year.

How will its implementation affect its usefulness?

Assuming the bill passes, it must also be implemented by SEC regulations.  It is crucial to understand that the SEC has significant power to determine how useful a crowdfunding exemption could be.  If the SEC’s regulations make it difficult to use, then no one will use it and the effort will be for naught.  If the SEC issues regulations that are friendlier to issuers, then the exemption could be highly useful.  For instance, here are some open issues that will need to be addressed and could drastically affect the ability of companies to use the exemption effectively:

• How will income be measured?  The bill requires that investors invest no more than the lesser of $10,000 or 10% of their annual income.  It further provides that an issuer or intermediary may rely on a certification of annual income provided by an investor.  This leaves several unanswered questions: (1) How will income be measured?  By the previous calendar year?  By an average of several of the previous calendar years? (2) Will the investor’s spouse’s income be included? (3) Is the limit subject to each of the spouses separately or are the amounts invested by each spouse considered in aggregate towards the limit?  (4) Will the certification ask for any kind of documentation to establish the income of the investor or does the investor merely provide a number which the issuer or intermediary can accept without question?  If so, is it reasonable for an issuer to accept that someone in a low paying field claims he or she makes $150,000 a year?  All of these questions will need to be addressed by SEC regulations, and the more specifically it does so, the more beneficial it is for issuers and intermediaries because bright-line tests remove business uncertainty.
• What will be the permissible activity of intermediaries?  The bill establishes a new category of participant in the capital markets called an “intermediary.” No definition of an “intermediary” is provided in the legislation, but presumably an intermediary would operate a website which administers the crowdfunding offering.  The  bill specifically exempts intermediaries from the broker-dealer registration requirements under the Securities Exchange Act of 1934.  There are a number of unresolved questions: (1) What activities may an intermediary engage in?  Are they simply passive participants, or may they engage in active sales efforts?  (2) How may they be compensated?  Are their fees limited to flat fees to use their platform or can compensation be varied depending on the success of the offering (i.e. a success fee or a fee in proportion to the amount of securities actually sold)? (3) Finally, how will state broker-dealer registration requirements apply?  Will they be required to register as broker-dealers and their employees as broker-dealer agents with the states they operate within?[1]
• Will issuers also be permitted to conduct a simultaneous offering under Rule 506 of Regulation D to accredited investors?  The bill itself says that use of the crowdfunding exemption does not prevent an issuer from raising capital through other methods.  Therefore, a simultaneous Rule 506 offering will not preclude the use of a crowdfunding offering.  Unfortunately, the use of a crowdfunding offering may preclude the use of Rule 506.  Regulation D provides that other offerings conducted near in time to a Regulation D offering are considered part of the Regulation D offering (i.e. they are integrated).  Since a crowdfunding offering would not be in compliance with Rule 506 (because it was conducted via a general solicitation and the securities were offered to non-accredited investors), the Rule 506 exemption relied upon for the offering would be invalidated.  Unless the SEC alters the integration provisions of Regulation D, companies may be unable to conduct an angel financing round near the same time as a crowdfunding offering.
• The bill requires issuers or intermediaries to “take reasonable measures to reduce the risk of fraud.”  It will be up to the SEC to spell out what those reasonable measures are.  The SEC could leave it with a relatively subjective standard, or they could provide a safe harbor which contains a number of measures an issuer or intermediary can take that will assure it that it has complied with this requirement.  A safe harbor would be far more preferable to an open-ended standard, since certainty is required for any securities registration exemption to be truly useful.  The bill also requires that the issuer or intermediary require potential investors to answer questions demonstrating their understanding of the level of risk involved with investing in a startup.  It also requires an intermediary to conduct a background check on the issuer’s principals.  Both of these requirements could also jeopardize the usefulness of the exemption if the SEC does not provide a safe harbor or otherwise objective criteria for meeting these obligations.

As you can see, even if the crowdfunding exemption bill passes as is, there will still be any number of issues unresolved until the SEC fills in the gaps in the legislation through interpretive regulations.  These regulations could greatly facilitate the usefulness of this new exemption, or could eviscerate its usefulness, causing it to be used as often as Rules 504 and 505 of Regulation D.[2]

Footnotes

[1] This issue of whether state registration requirements apply to intermediaries is very complex and merits its own post.  This issue has been around for some time, because there is an analogous situation pertaining to Rule 506 offerings.  Some states require the officers who conduct a Reg. D offering to register as “issuer agents,” but such requirements may be preempted by federal law.

[2] Rules 504 and 505 are other exemptions contained within Regulation D.  They tend not to be used very often because, unlike Rule 506, there is no federal preemption of state registration requirements, subjecting offerings conducted under this rule to numerous state regulations.