SOFTWARE BUSINESS MODEL

Posted on November 26, 2007 | Filed Under Finance & Pricing 

SOFTWARE BUSINESS MODEL

LEGAL STRATEGIES FOR STRIKING DEALS

The general legal strategy is to have credibility in all communications with potential investors such as the business plan, presentations and due diligence. Some elements of credibility will add value to your business while others will help avoid a discount on value. The key action points covered in this presentation are:

  • Feature intellectual property as a key value.
  • Design your capital structure to look normal.
  • Try to avoid unconventional financings and business transactions.
  • Demonstrate an understanding of current software licensing trends and their impact on revenues.
  • Address the legal issues in international markets since such markets are an increasingly important source of revenue.
  1. FEATURE INTELLECTUAL PROPERTY AS A KEY VALUE
  1. Be prepared to demonstrate that the company owns its software products. Problems with this issue can kill a deal.
  1. Pitfalls in Development

The relationships described below will be carefully examined by a potential investor. Be prepared to answer questions and demonstrate that such situations have been properly handled.

  1. Duties to previous employers. The work of one or more software developers may be tainted relative to a former employer even if there was no written employee confidentiality and invention assignment agreement with the former employer. Key factors from a legal point of view are: (1) the similarity of the product line of the former employer and the new company, (2) where the developer did the development, and (3) whether any of the former employer’s proprietary technology was used. These factors differ from state to state.
  1. Use of contractors/consultants. An employer must obtain written assignments of all

right, title and interest in all software work product. Otherwise, under the U.S. copyright law, the contractor will own the software even if paid for by the company. Also, determine if consultants are tainted by prior work for other clients in the same technology area.

  1. Use of university technology. A contracting company needs to identify and follow the

University’s policies and procedures for commercially exploiting the technology. Rights are likely to be nonexclusive so speed to market is very important.

  1. Use of federal government technology. Obtaining such technology seems to take forever and may result in acquiring vaguely defined nonexclusive rights. Vagueness is generally not good. Investors want to see crisply and clearly defined rights.
  1. Assignment or license. At the time of company formation, founders may consider hedging by licensing rather than assigning ownership of software to the company. There is significantly more value to a potential investor in a company with “ownership” of its key asset.
  1. Independent development. Independent development is not a defense to a patent infringement claim. It is a defense to copyright and trade secret claims.
  1. Featuring IP as a key value.

1. Major forms of intellectual property protection for software products are patent, copyright, trade secret and trademarks.

2. Consider global protection not just U.S. protection. Copyright protection is easy and inexpensive to implement on a worldwide basis. No action is needed. Enforcement is always an issue. Patent and trademark protection are more expensive to secure and action is needed for implementation.

  1. Investors look for at least the beginning of a patent portfolio for key products.

1. Patent protection (as well as copyright) provides statutory protection which means no signed agreement is needed to implement protection. This is very important because of the mass market sales trend in software.

2. It is estimated that about 8000 software related patents will be issued in the U.S. during 1996 and that about 20,000 software related patents will be issued in the U.S. during 1993-1996. Even if a person is philosophically opposed to patents for software-related inventions, it is prudent to consider patents at least for defensive purposes when establishing the intellectual property strategies.

3. Pitfalls – offer for sale and public disclosure bars. A “bar” is an action or event that means patent protection is no longer feasible. An “offer for sale” of an invention can occur even if the invention has not been reduced to practice and even if a nondisclosure agreement (“NDA”) is implemented. An NDA will prevent the public disclosure bar from being triggered. In the U.S. there is a one year grace period for both the offer for sale and public bars. Other countries have a public disclosure bar and no offer for sale bar, but have no grace period.

4. Following are estimates for planning purposes of costs of filing patent applications and prosecution in U.S. and elsewhere. Keep in mind that there are two stages, filing and prosecution. It would be a rare case in which the PTO says “good job,” here is the authorization for the patent. There is usually several exchanges between an examiner the patent author during the prosecution stage which causes added expense.

a. Drafting and filing the application:

In the U.S.: $4,500-$10,000 for attorneys’ fees (for simple to moderate cases); $10,000-$23,000 for attorneys’ fees (for complicated cases), plus $500-$2500 for Patent Office filing fees and drawing fees.

In foreign countries, after filing first in the U.S.: $4,500-$6,500 (in a country where translation of the U.S. application is required); $1,500-$2,500 (in a country where no translation is required): $7,800-$8,800 (in the European Patent Office).

b. Prosecution costs: In the U.S.: $1,000-$10,000 (without interferences, appeals or extraordinary proceedings). In foreign countries: $3,000-$5,000, without opposition being filed by third parties.

c. The general approach is to file a U.S. patent application first. The U.S. filing provides a 12-18 month hedge for filings in certain other countries. This provides time to make an initial commercial viability determination of the product.

d. Estimated time from filing to issuance in the U.S. for software related inventions is 2-3 years. First office action can be anticipated in about 18 months. A patent may not be enforced until issued.

5. Business plan credibility – “The Company has consulted with a patent attorney concerning filing of several patents in the U.S. and other important markets which will be funded from the proceeds of the financing.” Compare this approach to “I haven’t done anything.”

D. Trademark use can be an early area of legal exposure. Plan ahead for this visible symbol of the business so time can be spent on positive marketing activities. Words that describe a product may be good from a marketing point of view but may have little protection as a trademark. Do not go to a lawyer for the first time on the day before going to the printer with promotional and packaging materials containing the selected trademark. Avoid the need to have to explain to a potential investor why a trade name or mark is being changed.

E. Make sure the product and packaging have proper intellectual property markings (©, TM, ®, etc.) as a key indicator of intellectual property credibility. Ask an intellectual property lawyer to review these items before they are out in the market.

F. Investors will observe how well a person uses business discipline in enacting nondisclosure agreements for products and other sensitive information. There is no such document as a “standard NDA.” They are all different and must be read and possibly negotiated. Some are labeled “Confidentiality Agreement” but say that everything disclosed to the recipient is confidential but nothing disclosed by the other party is confidential. There is often a balance between maintaining confidentiality and having opportunity. Be flexible but firm on select terms related to confidentiality provisions. A balance is needed.

II. DESIGN THE CAPITAL STRUCTURE TO LOOK NORMAL

  1. Keep it simple. Both investors and the public market like a simple capital structure.

B. Standard Pattern.

Authorized   Outstanding

10 million c/s(founders)  2-4 million c/s (founders)

4 million p/s   1 million c/s (stock plan)

Immediately   25 million c/s   8 million c/s and equivalents

Prior to IPO    4 million p/s

  1. If all goes according to plan, based on overall company value and the desirable per unit share price, about 8 million common stock equivalents (common stock, preferred stock plus options) are generally outstanding moving into the IPO stage. Working backward from this stage, it generally means that 2-4 million common stock (“c/s”) are issued in the founders round and 1 million c/s are reserved for the stock option plan.

The number of shares outstanding at the time of an IPO is driven by:

  • company value at IPO
  • amount to be raised in the IPO
  • IPO per share range
  1. The “pattern” for the business value at the time of the IPO can be reached by forward or reverse stock splits. For example, if a company has a market valuation at IPO time of $120 million, it would not be feasible for 40 million shares to be outstanding. A reverse stock split is needed. No one likes reverse stock splits from excess dilution which reduce the number of units held and, therefore, potential return from the IPO. On the other hand, forward stock splits are welcomed since they add units to holdings.
  1. Keep the c/s price as low as possible as long as possible to provide greater stock incentives to attract and keep key employees. Tax and state corporate laws generally require option grants to be made at current fair market value.
  1. Using preferred stock (“p/s”) is a way to keep c/s at a lower price. A 5-10x value ratio

(p/s to c/s) is generally acceptable to avoid bargain pricing for tax purposes. This is not guaranteed but is common practice in the Silicon Valley.

  1. If you try to use c/s to raise large amounts of capital, there is usually a material dilution impact. Compare raising $1 million in c/s priced at $0.25 per share to using p/s priced at $1 per share.

Shares Outstanding    New Ownership

Prior to Financing  After  Percentage

$0.25 c/s    4 million (100%) 8 million 50% each

$1.00 p/s    4 million (100%) 5 million 80% founders

20% investors

3. Reward the entire software development team with stock incentives not just the Vice President, Engineering. Inequities in stock holdings and other compensation will be very visible at the time of an IPO and can create a potential destructive force. This is part of leadership and management.

  1. Use of S Corporation/Limited Liability Company (LLC). The benefit of electing S corporation tax status is to avoid double taxation. An S corporation is taxed like a partnership. A LLC can also be taxed like a partnership but does not have the eligibility restrictions of an S Corporation. The LLC is not generally perceived as an investment vehicle with the possibility of traditional liquidity events.
  1. An S corporation may not have two classes of shares outstanding (as opposed to merely authorized). Other eligibility requirements are:
  • No non-resident aliens permitted as shareholders
  • No corporations as shareholders
  • No more than 35 shareholders
  • All shareholders must elect to be an S corporation
  1. The S corporation’s tax year (calendar year) is truncated if p/s is issued.
  1. Only C corporations and non-corporate investors are eligible for the Qualified Small Business Corporation capital tax break. A loss of lower capital gains rates on S Corporation stock is not likely acceptable to investors. This benefit of this QSBC tax break is that if the stock is held for at least 5 years, 50% of any gain on the sale on exchange of stock may be excluded from gross income.
  1. With respect to LLCs, an acquisition of an LLC generally may not be done on a tax-free basis and the expenses of formation are higher than for forming a corporation.
  1. There are pitfalls of hedging on the timing of forming corporation to save on expenses. The longer you hedge the more difficult it is to keep the founders price at a minimum level if a financing is imminent.
  1. The best reason for using a Delaware corporation at startup is the ease of dealing with the Delaware Secretary of State in financings and other transactions. Otherwise, there is probably no compelling business reason to have a Delaware corporation at the outset if operations are in California or a state other than Delaware. Delaware law benefits are of the most value to public companies. About 75% of California corporations which go public reincorporate in Delaware at the time of the IPO.
  1. A Delaware corporation will result in taxation in Delaware as well as the state of operations.
  1. Many provisions of California corporation law are applicable in any event if primary operations of a private company are in California and at least 50% of its shareholders are here. A corporate name doesn’t otherwise become available for use in California because the business has been incorporated in Delaware.

3. The advantages of a Delaware corporation are:

  • p/s protective provisions are primarily defined in the certificate of incorporation rather than certain protections being required by statute.
  • more flexibility for directors and officers to act without shareholder approval.
  • slightly more protection of directors and officers from monetary liability to shareholders.
  • more flexibility with respect to implementing anti-takeover provisions.

III. AVOID UNCONVENTIONAL FINANCING & BUSINESS TRANSACTIONS.

  1. Conventional financing pattern.

1. Pattern is succeeding rounds of p/s which are sold at higher prices in each round and which have superior rights over prior rounds of p/s financing. P/s is convertible into c/s (initially at 1-1) and, at a minimum, has liquidation and dividend preferences. Depending on one’s leverage, the p/s will likely have other features to benefit and protect the investor.

2. Even if a “bootstrap” financing is needed, keep in mind what venture capital investors may want. Avoid small p/s financings because of the statutory veto authority over future financings. Cal. Corporations Code §903 requires approval of the initial series of p/s (even without voting rights) of a new round of p/s if the new p/s will have superior rights to the existing p/s. Also avoid using c/s at a price that inflates value too quickly. Again, a general approach is to keep the c/s price as low as possible as long as possible as an incentive to attract and retain key employees.

3. Avoid debt service–go for equity or at least debt which is automatically convertible into equity upon a successful event. A short term loan secured by proprietary intellectual property could result in disaster.

  1. Comply with federal and state securities laws. The general rules are that: (1) full disclosure

must be made to prospective investors, and (2) offerings of securities must be registered with applicable authorities. The rules apply to both offers and sales. “Debt” is a security unless the lender is in the business of lending.

  1. Must make full disclosure regarding material matters. Usually done primarily through the venture’s business plan.
  1. Must register all securities offerings unless an exemption from registration is available. Lawyers always look for exemptions based on the dollar amount of the offering and/or business sophistication of potential investors. Requirements differ between federal and state law.

3. An investor has a money back guarantee if securities laws are not followed. Legal opinions regarding exemptions are not possible if securities are sold without regard for such laws. An opinion may be required in venture capital investments or an acquisition.

4. Multi-state offerings require compliance with the laws of each applicable state.

C. Pitfalls in contract financings such as software development or license agreements.

  1. Distribution, license and other commercial relationships will have an adverse impact on future financings if too much is given away in terms of revenue generation or the ability to compete. A strategic partner is often a likely acquirer unless the initial commercial deal is so “sweet” to the partner that there is minimal value left to be acquired.

2. In a development project, if ownership cannot be acquired, the company needs to be granted the scope of license rights needed for commercial exploitation. Any right not expressly granted in a license is reserved so the company does not have the right if the agreement is silent on the activity. The right to prepare derivative works is a key right that is often missed.

IV. DEMONSTRATE AN UNDERSTANDING OF CURRENT SOFTWARE LICENSING TRENDS AND THEIR IMPACT ON REVENUES

A. Licensing and deployment must be market driven to fit current computing environments – network, distributed processing. Client-server is a key trend in business computing.

B. Understand the licensing impact on revenues. How was pricing established? The market size and ability to obtain and sustain a share of revenues in the market is a key factor to potential investors. There are price points for many types of software (not just mass market software) and these points are generally moving downward. Concurrent, floating, enterprise, site licensing all have various meanings and related revenue impacts.

C. Do not assume there is a standard meaning. Consider and define licensing rights and related revenues for a distribution model.

D. The mass market trend and competitors’ actions may force a move to shrinkwrap (as opposed to signed licenses) sooner than ever before. This shift is also driven by the platform and pricing. The goal is to speed up deals and revenues while maintaining a fundamental level of protection.

E. Be prepared to address how the Internet can be or is used for in marketing and distribution. Early on, the Internet was thought to be a great equalizer, a way for small software companies to avoid the shelf space/cost of distribution problem. Today, with the proliferation of World Wide Web sites, the problem is how to get people to a Company’s Home Page to learn about products.

V. ADDRESS THE LEGAL ISSUES IN INTERNATIONAL MARKETS SINCE SUCH MARKETS ARE AN INCREASINGLY IMPORTANT SOURCE OF REVENUE.

  1. International revenues comprise a high percentage of revenues for many software companies.
  1. Try to create channels in parallel not domestic first and international later. Do not wait until your domestic market is “fully developed” because the global window of opportunity may be closed. A World Wide Web home page is an immediate window to international business.
  1. Demonstrate knowledge of dealing with critical international issues to support credibility of revenues in the business plan and discussions with investors.

1. Making the right choice of a foreign partner is crucial as a practical matter. Does the prospective partner have distribution capability and enforcement clout in the territory?

2. Create the right type of legal relationship to avoid unexpected tax and other liability (distributor, sales representative, OEM, etc.). A vaguely defined relationship is also bad business.

3. Learn about international payment mechanisms such as the letter of credit to create certainty for revenue streams. Avoid the open account method until at least a track record of payments is established. The point of changing to open account is also vulnerable.

4. There is also always the risk of non-enforcement of intellectual property protection in foreign markets. It will usually be necessary to enter foreign markets; because competitors are there and practical actions can minimize risk. The right foreign partner with practical clout can help protect intellectual property.

5. Withholding and other tax planning issues are very important economic factors. Foreign tax credits are not likely usable in the early stages of a company so withholding taxes on royalties could have revenue impact. A gross-up is the likely solution. The ROC and Singapore are market countries without a U.S. tax treaty which means there is a 30% withholding tax on license revenues. The solution for mass-market software is to “sell” units since withholding tax is not applicable to sales.

6. Most commercial software, particularly mass market software, is currently exportable to major market countries under the U.S. export controls except for software containing a file encryption feature. There is much discussion about relaxing export controls on software with file encryption features but it hasn’t happened yet.


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