This article is the fourth in an ongoing series on Due Diligence. To learn more about performing due diligence quickly and effectively, download this free eBook today Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies or purchase our books at Amazon.com.
We all love toys, new ideas, shiny new baubles.... Part of the fun of investing in early stage companies relates to the joy we get in trying out new products or imagining how the world will be a better place when a new medical device comes to market. But you have to look beyond the prototype, ignore the flashy product demo, and really dig into the technology before you write that check!
What does it mean to “really dig into the technology”? Are we talking about doing a full code review on a software product? Or, performing a full Freedom To Operate (FTO) review on a medical device company’s Intellectual Property (IP)? Some investors would say you need to dig this deep. But there is a huge cost in this level of effort in both time and money. And we can’t afford those costs for such early stage investments.
So what is the right balance of effort given our level of investment and stage of company. This is the time where we try to differentiate between:
A technology which is not yet a product
A product feature which may never become more than an add-on for someone else’s product
A complete product or product concept that can build a substantial company
And, it’s also the time where we need to understand a company’s IP ownership. Does the company own the IP or is it owned by a founder or a University? And, are we talking patents or trade secrets when it comes to IP?
Q: Christopher, let’s start with the high level technology assessment. How do you determine whether the technology will result in building 1) a substantial company, 2) an add on product, or 3) just another feature?
Humans don’t like change. There is a lot of inertia in the familiar and comfortable status quo. To convert users, new products usually need to be significantly better/faster/cheaper than the incumbents. A rule of thumb often cited is that to really galvanize customers and drive adoption, the new product must be clearly and demonstrably 10X better, faster or cheaper than the current state of the art.
And the things that make the product better cannot be subtle things that only a tiny minority of power-users would care about. It has to be a fundamental improvement. A good way to plumb the depths here is to be very alert to discussions of “features.” Entrepreneurs love to talk about product features, but it is customer benefits that matter. A good diligence practice is to force the founders to talk only in terms of true customer benefits and then ask yourself if those benefits even remotely approach a 10X improvement for the typical user. If not, you may be a bit short of the mark.
With products in the life sciences it is a little different, but the concept is the same:
Would this new device, drug, tool or therapy advance the standard of care in a fundamental way?
Is it good enough that the average users’ actual benefits (patient outcomes, practice economics) would be significantly improved?
Is it enough to the customer to overcome the inertia and risk of abandoning the safe and familiar status quo?
Would insurers pay for this?
Would regulators approve of this?
Q: Talk to us about Technology Risk. What are we looking for at this early stage in the company’s history?
It depends somewhat on the type of product. Due to its intangible nature, software is a lot quicker and easier to fix than hardware with fixed designs and long lead times. But in either case you are looking for a smart overall product architecture that is going to scale well. A great way to test that is to ask how much would need to be re-written in order to handle a 100-fold increase in customer traffic. If it is just a matter of adding additional servers with no material changes to the design, you are probably looking at a scaleable software product. With devices, ask about how hard it would be to cut materials cost in half or what it would cost per unit to build at large scale to uncover key design and knowledge gaps.
An important element of technology risk is the issue of product management. Markets and customer demands evolve constantly. No competitive product can stand still. Successful companies need very strong product management and clear guiding principles. Assessing the strength of the team in this area is essential, and a good way to do that is to have a discussion about the product road map.
Is there even a roadmap?
Who wrote and owns it?
What’s on it?
What was left off?
How far does it go into the future?
What are some specific examples of things that the team said “no” to upon arriving at this roadmap?
A company that can really hold their own in a detailed product roadmap review has a lot less technical risk than one that cannot.
Q: How important is the technology team? Do you have any issues with technology development being outsourced?
The more tech-centric a company is, the more important it is to have technology skills on the founding team or at least in-house as employees. For a company that is competing on its technology (e.g. software algorithms, bio-sciences, engineering), going to market without strong skills on the team is going to market with missing core competencies. A basketball team that knows how to play basketball will always beat one that needs help from consultants on every play.
In situations where technology is a key enabler, but not the absolute basis for competition, it is possible to outsource your technology, using for example, an on- or off-shore software development firm. But when doing diligence on these kinds of situations, great care must be taken to review product roadmaps, assumptions about funding, and speed with which products will reach development milestones.
The simple fact of life is that companies with outsourced tech teams get worse “gas mileage” with their funding. They move slower and cost more to run because they have to pay margins to a 3rd party firm. They have to communicate and coordinate remotely with developers who are not living right there in the trenches and hearing first hand what the customers are saying. This is a problem. It is not an insurmountable disadvantage, but when doing diligence, you must be aware that it is a significant risk and build plans with extra time and money buffers built in. These companies do not implode spectacularly, they bleed to death. They are constantly behind on milestones and keep having to raise more money, each time with a slightly weaker story on progress, until they just cannot raise any more.
Q: With software, it’s very common to use open source to accelerate development. What are the issues you need to be aware of with open source?
Incorporating open source software can deliver big time savings and quality enhancements. It is often some of the best tested and most well-understood and actively-developed code around for certain functions. Often it makes very little sense to write from scratch what you could incorporate from a well-respected open source project.
However, just because open source software can be used for free does not mean it does not have restrictions. Open source software is not given away, it is licensed to the user. Even the most mild open source licenses will impose some requirements, such as the requirement to give attribution to the open source project in your software credits. It’s no big deal to do this, but if you don’t do it, you are in breach of the terms of your license and every IP non-infringement warranty you give your customers is false.
Some of the licenses on open source projects go much much farther than breached terms and include terms which embody very strong philosophical viewpoints, such as the notion that all software deserves to be free, and modifiable. These licenses are sometimes referred to as “copyleft” or “viral licenses” in that they impose on the user of the code the requirement that the entire product be licensed on the same terms as the open source component. (The best known examples of these kinds of licenses are the GPL and LGPL licenses.) Unknowingly incorporating code bearing this requirement without the proper packaging care could mean that you are required not only to give your product away for free, but to make the source code available as well.
It is fairly easy to avoid these kinds of license terms, but only if someone who understands the issues is paying attention and tracking the details. If you create a vacuum where engineers who do not have familiarity with these issues were allowed to choose whatever open source code they wanted, based on technical specifications, comfort level or familiarity, without any regard to the licenses involved, you could create an extraordinary mess virtually overnight.
When diligencing these issues, it is very simple to get down to bedrock. You really only need two things:
A list of every single piece of third party code in the product.
Assurances from the team that they know the license requirements for each piece of third party code and comply with them.
Any team that cannot pull together such a list, given a reasonable amount of time, is one you should stay very far away from.
Q: Intellectual Property (IP) can come in many forms. Most people are familiar with patents, and some are aware of trade secrets. What are some of the advantages and disadvantages of each?
This is such a misunderstood subject, that it is worth spending a moment on it. The “big four” - patent, copyright, trademark and trade secret - operate in very different ways because they have entirely different public policy concepts behind them. It is valuable to consider the implications of those differences. Keep in mind that I am talking generally about the US federal statutes. Each state has its own rules, generally very similar and parallel, but not always.
The entire point of patents is to encourage the detailed disclosure of novel useful inventions so that they may be used for the good of all humanity. The carrot the government uses to encourage that useful disclosure is the granting of a temporary monopoly on the right to use the concept, usually 20 years. After the temporary monopoly period has expired, anyone can use the patent like a recipe to build copycat technology. Patent law is about getting useful ideas out into the public domain.
Copyright law, on the other hand, is about encouraging creative endeavors by making sure that the authors and creators of things like books, films, software programs, poems, paintings, recordings, sculptures and photographs are able to get paid for their work. Unlike patent coverage, which requires a detailed filing for obvious reasons, copyright protection attaches immediately and automatically as soon as the work is created. Additional protections can be obtained by taking the extra step of registering it with the copyright office, but it is not necessary. If you create something, you have a copyright, and it allows you to prevent others from copying your work unless they agree to terms you set, such as the requirement to pay for your song or for a copy of your software. (Side note: new SaaS models are making this a little trickier - SaaS software is often not licensed but rather access and use is permitted under a services contract.)
If Patent law is about encouraging disclosure of useful things, and copyright law is about making sure poets and painters can make a living, what is trademark law about? Trademark law is a consumer protection statute. It is designed to prevent competitors from offering something of potentially inferior quality that looks confusingly similar to your known and trusted favorite. Federal trademark law says that if you register your logo and the design of your packaging, and it is unique enough to get a trademark, you can prevent anybody from putting a product out there that looks confusingly similar to consumers. That’s all. It does not protect the product, but rather just the way it looks in the marketplace.
And what about trade secret law? What is the policy goal behind that? Basically, trade secret law is fundamentally industrial policy focused on national competitiveness. Trade secret law is in a lot of ways the most useful and most straightforward of the four forms of IP. The concept is simple: if you have a secret, such as an algorithm, a recipe or a formula, and you derive economic value from its being unknown to your competition, and you take care to keep it a secret, you can prevent anyone who misappropriated it from using it. It is straightforward because it is such a simple concept: if an American company takes money from shareholders and works hard to develop proprietary know-how, and keeps that know-how to itself, no other company from the U.S. or anywhere in the world is allowed to steal that secret and use it to compete in the US market.
In terms of advantages and disadvantages, patents and trademarks require filings, work, and expense to obtain, but offer robust protections in return. Copyright and trade secret do not require any filings and offer the opportunity to monitor and self-police the copying of your work.
OK, so with that said, what are the risks and diligence implications here?
With patents, you want to make sure the patent strategy makes sense: will the the company likely be granted the patents they seek, and will they be of some actual business value (infringement will be discoverable and it will be worth chasing competitors who infringe)? If so, then it is probably worth spending some company money pursuing them. But if the patents are weak, unlikely, hard to monitor, or expensive to enforce, the company may not want to spend as much money or effort chasing the patents.
With copyright, there is not too much that needs to be done except to make sure the company is not plagiarizing the works of others (see open source discussion above), and consider whether the company should register its copyrights. Registering copyrights, in particular valuable works, would give the company access to the U.S. Federal courts and the possibility of treble damages for infringement. (For example, it is possible to obtain a registered copyright for your source code, even with provisions for redacting the bulk of it to keep it a secret).
With trademarks, you want to make sure the company has done a defensive check to make sure their marks are not stepping on any toes before they build up a lot of brand equity in them in the eyes of customers. And, you want to make sure they take the time to at least seek domestic, if not limited international, protection for the key marks, along with packaging and product collateral.
With trade secrets, you want to make sure the company has tight confidentiality agreements with employees and partners, discloses as little as possible of the sensitive materials, and maintains physical access controls in their facilities where necessary.
Q: In what types of companies are patents critical for building long term value?
Patents are a messy area. At a conceptual level, they have no intrinsic face value - they are merely a right to keep others out of a space. In effect, they are nothing more than a right to sue to maintain your fence around an area. It is up to you to make being in that area valuable. If being in the area is valuable, then the right to keep someone out of the area will be valuable.
Where this becomes important is in three basic scenarios:
You discover an absolutely key enabler to a breakthrough new technology that allows you to serve a very valuable market in a way no one else can. That is a huge advantage and will result in the patent being valuable.
You make and own a key discovery that is directly in the obvious and logical product roadmap path of a big company and you can block and frustrate the heck out of them by not allowing them the obvious progression in their development. (Or force them to buy you, to the delight of your investors.)
You end up being the first to seek and receive a patent for something that becomes very commonly used by the time the patent issues.
However, none of these scenarios is a slam-dunk money-maker. In the first scenario, you still need to go build a company to service the market. You have an IP advantage that can be used to keep others from copying you, which may give you an edge on your route to building a valuable company, but it will be up to you to enforce that advantage, and it might be very expensive.
In the second scenario, the only way you make money is to threaten that you will sue the big company if they try to move into the area covering your patent. Effectively, you are going out and trying to set up a toll booth. Any money you make off of this patent will be indirect - you are hoping they will be forced to buy or license the patent.
In the third scenario, you are basically a patent troll. Your business model for getting money from the patent boils down to chasing everyone in the market who adopted the patented technology and forcing them to pay license fees.
Q: So why do investors focus so much on patents?
Trading Card Theory: Patents can have real defensive value as trading cards. If you build up a decent portfolio in a competitive space, and someone comes after you asserting one of their patents, it can be a life-saver to have a few of your own to counter-assert.
Lottery Ticket Theory: Occasionally patents can be exceptionally valuable, for example in the drug discovery space. If you get a patent on a critical element of a drug targeting a multi-billion dollar market, that can be worth a lot of money. Since they are a relatively affordable lottery ticket to acquire (and I do mean relatively - they are by no means cheap), it is considered standard practice to pursue them to one degree or another in certain industries.
Exit Value Theory: Even though a small start-up might not have the bandwidth or resources to aggressively enforce a patent portfolio, a big strategic buyer might, and such a buyer might be convinced to buy a particular start up or pay a lot more for it if the alternative is to have a potentially bothersome patent portfolio fall into the hands of a competitor.
Q: So what are the Diligence implications in all this?
You have to:
Understand which patent theory is relevant to the company.
Make sure the effort and expense being expended is proportional to the outcome being sought.
Prevent a company from going to either extreme.
The company should neither be over-confident about the value of their patent portfolio, nor totally dismissive of the potential value of a few key patents, even if only held as defensive insurance or something to juice the value of an exit many years down the road.
Want to learn more about performing due diligence quickly and effectively? Download this free eBook today Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies or purchase our books at Amazon.com.