Evaluation of the IP Representations within the NVCA Kind—Contemplating Obligatory Revisions
The National Venture Capital Association (NVCA) model stock purchase agreement form (Model Form) was recently updated in August 2020. After reviewing the updates to the intellectual property related sections of the Model Form, certain language and concepts regarding allocation of intellectual property risk could be revised to better reflect the NVCA goals of providing fair terms between the investor and the company and promoting consistency among financing terms. [i]
Any model forms project will cause reasonable and sophisticated practitioners to disagree as to whether certain proposed language is fair and would push companies and venture capitalists to reduce transaction costs by bringing the parties toward a middle ground that adequately protects and benefits both sides. So, there are inherent limitations in any attempt to craft language that can be used in all scenarios. The nature of a venture capital investment transaction is such that the intellectual property representations cannot be as complete as in a merger and acquisition transaction. Further, black ink on a document is valuable real estate in a venture stage stock purchase agreement, often with pressure from both parties to limit the length of the agreement.
However, even with all of the above understandings, these proposed revisions will for each modified representation, address at least one and often multiple of the following:
- limit a representation to something that a company can more reasonably make given their position as a young, emerging growth company;
- expand the scope of what a company should be reasonably responsible for given updates in technology and how companies interact with customers or engage in marketing;
- trade some valuable ink space currently used to address an often fixable (and thus less material) infringement risk for a more relevant infringement representation;
- use language that is more technically accurate and consistent with usage in the intellectual property litigation arena; and
- clean up a few minor drafting nits.
Ideally, this article should be read with a copy of the Model Form handy as some suggestions and comments below apply based upon specific word choices in the Model Form. All quoted language comes directly from the Model Form, with liberal quotations from the specific language of the applicable representation being discussed as a result of some arguments being dictated by, at times, the editing or exclusion of a small number of words. However, space constraints prevent quoting large portions of the Model Form and it is always helpful to read these suggested revisions within the context of the entire Section 2.8 of the Model Form. The term “Company” below has the same meaning as “Company” as used in the Model Form.
2. Encumbrances on Company Intellectual Property
The current draft of the Model Form in Section 2.8(c) applies to “Company Intellectual Property” which is defined in a manner that effectively includes both intellectual property that is owned by Company and intellectual property that is licensed by Company. So all of the representations in Section 2.8(c) must be analyzed as to whether it is reasonable for Company to make representations about intellectual property Company doesn’t own.
It is not reasonable for Company to represent that there are no options, licenses, agreements, claims, encumbrances or share ownership interests (“Encumbrances”) for the licensed intellectual property. Company is not in a realistic position to know about Encumbrances on licensed intellectual property, such as any other licenses that may have been granted in the same intellectual property or any liens that a third party may have granted in their intellectual property. Moreover, the existence of Encumbrances does not necessarily indicate anything negative about Company’s use of licensed intellectual property.
3. Licenses Entered into by Company
The Section 2.8(c) representation asks Company to make a representation that they have not entered into any licenses for intellectual property. That is unrealistic given the prevalence of software and technology within almost every business. Of course, Company may certainly disclose the existence of such licenses as an “exception,” but given that almost every entity conducting business of any type licenses at least some software, the representation would better reflect reality by asking Company to schedule out material third party licenses and represent that Company is not in breach of such third party licenses.
Recommended Revisions to Model Form: “2.8(c) Other than with respect to commercially available software products under standard end-user object code license agreements, there are no outstanding options, licenses, agreements, claims, encumbrances or shared ownership interests of any kind relating to the Company Intellectual Property that is owned in any manner by the company, nor is the Company bound by or a party to any options, licenses or agreements of any kind with respect to the patents, trademarks, service marks, trade names, copyrights, trade secrets, licenses, information, proprietary rights and processes of any other Person. [Section 2.8(c) of the Disclosure Schedule lists all material licenses obtained by Company in intellectual property]. Company is not in material breach of any licenses in intellectual property.”
4. Definition of Intellectual Property
The Model Form defines the term “Company Intellectual Property” to include most of the traditional categories of intellectual property with an option to include mask works. The definition does not include an option to include rights of publicity, which is probably just as—if not more—important than an option to include mask works, since mask works are only applicable to semiconductors. Rights of publicity considerations are relevant for content that includes any images, names or likenesses of anyone. In addition to the obvious category of companies in the social media space, many companies display personnel images on their website or products in addition to their marketing materials. There is not universal agreement as to whether rights of publicity are intellectual property rights, so the catch-all language in the definition of “Company Intellectual Property” referencing “similar or other intellectual property rights” does not provide certainty as to whether the representations for intellectual property would also cover rights of publicity. There is a similar uncertainty as to whether the language in Sections 2.8(a) and 2.8(b) of the Model Form that reference violation of “proprietary rights” and “intellectual property rights” by Company would cover any violations by Company of an individual’s right of publicity. It is therefore important to consider whether Company is in a space where violations of rights of publicity may occur.
Recommended Revisions to Model Form: “(c) “Company Intellectual Property” means all patents, patent applications, registered and unregistered trademarks, trademark applications, registered and unregistered service marks, service mark applications, tradenames, copyrights, trade secrets, domain names, [mask works,] information and proprietary rights and processes, rights of publicity, similar or other intellectual property rights, subject matter of any of the foregoing, tangible embodiments of any of the foregoing, licenses in, to and under any of the foregoing, and in any and all such cases [that are owned or used by] [as are necessary to] the Company in the conduct of the Company’s business as now conducted and as presently proposed to be conducted.”
5. Problems with Open Source
The purpose of the open source representation in Section 2.8(g) is to elicit disclosures of use of open source software used “…in connection with any of its products or services that are generally available or in development” that would require Company to undertake certain obligations that may diminish the value of proprietary Company Intellectual Property. The legal effects of using open source software is one of the most asked about diligence items for investors in technology companies or any company that has proprietary software; it is not surprising that there is an entire section of the Model Form devoted to this topic. Whether or not use of open source software is problematic for Company is very fact specific, so the related representation should be drafted in a manner that would encourage the Company to disclose any potentially problematic situations related to open source software so that investors can perform follow up diligence. The Model Form open source representation is too narrow in scope and seems to assume that Company may only be making harmful decisions about open source software in factual scenarios.
For example, the footnote states that many of the potentially “onerous” effects of using open source software only occur if there is a distribution of open source software within a product that was actually “released” to the public. While it is true that there must be a “distribution” of GPL licensed software[ii] in order for certain terms of the GPL 2.0 or GPL 3.0 license to apply, neither GPL 2.0 nor GPL 3.0 require that such distribution be made within a product. It is not uncommon for software developers to “contribute” modifications of open source software for use by other developers even if such modifications are not used within a product commercialized by such developer’s employer. So a distribution of open source software that is made as part of a contribution by Company employees to an open source project may have negative effects on the Company while not requiring any sort of breach of the Model Form open source representation.
The same footnote also states that the open source representation is intended to require disclosures for certain use of open source software related to any products that the “Company has released…” However, the actual language of the open source representation arguably only applies to any use of open source software in connection with any products that “…are generally available” [emphasis added] which would seem to not include any Company products that were formerly released and are no longer “generally” available. Once open source software is distributed to anyone by Company, whether or not such distribution is ongoing or occurred only in the past (even if just sporadically), the potentially negative effects to the Company of such distribution remain even though such past distributions arguably do not lead to any breach of the open source representation.
To address the potential holes and ambiguities of the existing Model Form open source representation, the suggested revisions take away the qualifier that the use of open source software was done in conjunction only with any currently available product or service and simply reference any actions that would cause any Company Intellectual Property (besides the Open Source Software itself in some situations) to be subject to certain obligations. Whether past actions unrelated to currently available products diminish the value of Company owned intellectual property will always be a very fact-based analysis and having an overly narrow open source representation would eliminate certain disclosures that should be subject to further analysis by investor’s counsel.
Recommended Revisions to Model Form: “(g) The Company has not embedded, used or distributed any open source, copyleft or community source code (including but not limited to any libraries or code, software, technologies or other materials that are licensed or distributed under any General Public License, Lesser General Public License or similar license arrangement or other distribution model described by the Open Source Initiative at www.opensource.org, collectively “Open Source Software”) in connection with any of its products or services that are generally available or in development in any manner that would materially restrict the ability of the Company to protect intellectual property owned in any manner by the Company proprietary interests in any such product or service or in any manner that requires, or purports to require (i) any Company IP Intellectual Property[iii] (other than the Open Source Software itself) be disclosed or distributed in source code form or be licensed for the purpose of making derivative works; (ii) any restriction on the consideration to be charged for the distribution of any Company IP Intellectual Property; (iii) the creation of any obligation for the Company with respect to Company IP Intellectual Property owned by the Company, or the grant to any third party of any rights or immunities under Company IP Intellectual Property owned by the Company; or (iv) any other limitation, restriction or condition on the right of the Company with respect to its use or distribution of any Company IP Intellectual Property (other than the Open Source Software itself).”
6. Software Licenses
Section 2.8(d) devotes a whole section to having Company represent that it “possesses” valid licenses for all software on computers and “software-enabled electronic devices” owned or leased by the company. Rather than devote a whole section to licenses of only one type of intellectual property (software) and even then, only software used on certain machines, investor’s counsel should consider substituting Section 2.8(d) with a more targeted and applicable representation regarding the type of intellectual property that is material to Company’s business.
While every company will use software, the risk that use of unlicensed copies of widely commercially available software such as Adobe Acrobat Reader or Microsoft Windows will cause irreparable harm to Company is relatively low outside of certain narrow and specific circumstances. Further, with the increased use of cloud computing services, it is likely that at least some of the material software used by Company will not be installed on Company owned or leased hardware but instead will be installed on hardware operated by the cloud service operator. Finally, the representation merely requires that Company have a “valid license” to “use” the software. The term “use” is considered imprecise in the context of software licensing since Company may need to do a broad range of activities with licensed software such as modifying, distributing and reproducing such software. The right to “use” software generally is not considered to cover modifying or distributing such software. If Company needed to distribute certain software as part of its business, the Model Form representation arguably does not address this concept.
While almost all investment targets use software, whether such software use justifies an entire subsection of Section 2.8 should be carefully considered given that other language may already partially cover the concepts. Since a drafting option under the Model Form for Section 2.8(a) and the definition of “Company Intellectual Property” creates a “sufficiency” representation that the Company has or can obtain all “necessary” rights in intellectual property for the conduct of the Company’s business, the additional language in Section 2.8(d) may not add much value if Company’s business is not materially affected by the status of their software licenses. Further, Company’s material inbound intellectual property licenses may not be in software but may be in patents (such as a biotech spinoff from a university), trademarks (such as a franchisee or merchandising partner), or non-software copyrights (such as an online publication). For any of these, substituting a more focused representation would be more valuable.
If a software use representation is still needed, it would be better to substitute the Model Form software representation with something not limited to certain hardware in order to definitely capture software that may be used in cloud services and that specifies that Company has adequately broad license rights in such software.
Recommended Revisions to Model Form: “(d) The Company has obtained and possesses valid licenses to use for all of the software programs that are used, modified or distributed by the Company in the conduct of its business and such licenses allow Company to exercise all rights exercised by the Company in such software programs when conducting its business present on the computers and other software-enabled electronic devices that it owns or leases or that it has otherwise provided to its employees for their use in connection with the Company’s business.”
Include the following explanatory footnote: This Section 2.8(d) is less critical if there is language in Section 2.8(a) that the company has obtained all rights in Company Intellectual Property necessary to conduct its business. If such language to cover the concept of Company having “sufficient” intellectual property already exists, consider substituting a different representation to cover an intellectual property risk that is not addressed in any manner by the existing Model Form language.
Section 2.8(b) and Section 2.8(a) both deal with Company infringement of intellectual property, but the language in these sections is inconsistent. The language in Section 2.8(b) should be made more consistent with the language in Section 2.8(a) that addresses whether Company has received any notices alleging that Company (or its conduct of the business) has violated various intellectual property rights. Using the same language in both Section 2.8(a) and 2.8(b) as recommended below would bring the language in Section 2.8(b) more in line with the more accurate view that infringement occurs as a result of actions taken with regard to intellectual property and not by the intellectual property itself. The key difference is that Section 2.8(a) references violations of intellectual property rights by Company or resulting from conduct of the business while Section 2.8(b) references violation of intellectual property rights by Company’s products or services.
Recommended Revisions to Model Form: “(b) [To the Company’s knowledge,] no product or service marketed or sold (or proposed to be marketed or sold) by the Company’s conduct of its business (or proposed conduct of its business) does not or will not violates or will violate any license or infringes or will infringe any intellectual property rights of any other party.”
The Model Form intellectual property representations could be edited to be more accurate or applicable in almost all venture capital transactions. Some of the above revisions should be applied regardless of the nature of the investment target, while others are best used depending upon the investment target. This exercise was a reminder that the intellectual property representations should be reviewed and possibly revised (even after taking into account those proposed revisions above that apply in all situations) only after taking into account the nature of the investment target. There is a common reluctance to engage in tinkering too much with the Model Form intellectual property representations in a venture deal, but if the goal of the representations is to both elicit necessary disclosures for diligence purposes and to help guide the investment target in the diligence process, then the intellectual property representations should be tailored to address certain specific topics that are not in the current Model Form.
[i] A considerably shorter article addressing some of these topics by the author appeared in the Fall 2020 edition of the ABA Venture Capital and Private Equity group newsletter “Preferred Returns.” Space constraints in such publication prevented a more detailed analysis and inclusion of suggested revisions that appear in this article.
[ii] The GPL 2.0 and GPL 3.0 licenses are among the most common open source licenses, and are believed by many to potentially create diligence issues given the nature of their terms.
[iii] This is a minor error but should be corrected. “Company IP” should be replaced with the defined term “Company Intellectual Property.”