Many modern businesses consist primarily of technology in the form of intellectual property. Although they may own physical assets and employ staff (though they are more likely to be engaged as contractors) the real value in the business sits almost wholly in the intellectual property developed.
There are many advantages that come with this type of business. For example, it is very quickly scalable once demand for the product takes off and it is also possible for such a business to operate with very low overheads in terms of office and staffing costs. A business like this is also unlikely to have large sunk capital costs once the initial product has been developed. As a result, it is also unlikely to incur significant debt to creditors as its low overheads result in low debt overall.
However, often the main expense for a business like this will be developing and scaling the product and (much more importantly) marketing and promoting the product to users. A developer of a new product will often be so blinded by the amazing potential they see in their product that they will forget they need to actively promote it and this is often where we see IP based companies fall over.
One thing any entrepreneur knows is that they will make a lot of mistakes, especially in their first attempt to grow and operate the business. Smart entrepreneurs know and accept that they will make mistakes. As painful as it may be to admit, your first shot at the business is more likely than not to fail.
Ideally, such a learning process will not result in the valuable IP being lost. A liquidation or receivership will often lead to the IP being sold off to the lowest bidder, or being deemed of no value whatsoever as anybody who is not involved in the product from the beginning will see no potential. The developer and owner however will often be able to see where the mistakes were made and how, on a second go at the business, the product may well succeed. However, those lessons cannot be learned from if the IP has disappeared into the ether through receivers or liquidators with no appreciation of the potential.
One way to prevent this situation is to have the trading and IP owning entities quite separate, so that the failure of the trading entity will not drag the IP owning entity into the collapse. This needs to be done very carefully, both in terms of the initial structuring and also in how the two companies are operated.
The beauty of this arrangement is that, if done properly, a failure of the trading entity will allow the IP owning entity to terminate the licence or reseller arrangement, effectively cutting the trading entity loose. The IP owning entity will then be free to licence to another entity, including one set up with an almost identical structure to the failed trading company. The trading company is likely to have very few assets and so a liquidation will be essentially meaningless.
There are a number of options in terms of who the shareholders of the two entities should be, but the most important aspect of the structuring is to have in place a clear licence or reseller arrangement between the two entities. It is important to comply with tax and transfer pricing rules to ensure that the two entities are at arms-length.
However, it will be important for the directors of that company to ensure that they are not breaching any duties as a director, as that may lead to personal liability for those directors. If those directors are the founders (as is likely), this will lead to a cross-contamination of the liquidation to the IP owning entity.
Operation of the Trading Entity
Even if the initial structuring is done perfectly and in line with all advice from your lawyer or accountant, a failure to operate the companies correctly can still lead to the IP owning entity being held partially or wholly responsible for the debts of the trading entity. Various cases in New Zealand over the last 10 years have eroded the "corporate veil" which shields one company from being responsible for the debts of another.
This has often been the case where a parent has paid rent or other expenses on behalf of the subsidiary, even to the stage where the landlord was confused as to who the tenant actually was. Although the parent company tried to argue that the companies were separate entities, the court held that the parent entity had effectively presented itself as being responsible for the debts of the subsidiary and therefore was responsible. It is very important for the IP owning entity to be as passive as possible.
One Shot to Get it Right
Although it is possible to restructure an existing business as set out above, it is certainly a lot more difficult, especially from a practical point of view, if existing suppliers and other creditors start to ask questions at the same time. Any transfer of IP to a separate company will also need to be done on an arms-length basis and for a proper valuation of the IP – which can be an expensive and time consuming process. It is far simpler if all of this takes place at the beginning before there is any real tangible value in the IP.
The best strategy is to establish the IP owning company, ensure that all IP is captured in that company, and only once the product is ready for launch to consumers should the trading entity be set up with the reseller agreements and/or licence agreements in place.
There is never any guarantee of such a structure working to protect the IP but it will certainly take a very determined creditor a lot of time and money to take this structure down. This will be a lot easier for the creditor if the separate operation of the two entities has been confused in some way.
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© McVeagh Fleming 2019
This article is published for general information purposes only. Legal content in this article is necessarily of a general nature and should not be relied upon as legal advice. If you require specific legal advice in respect of any legal issue, you should always engage a lawyer to provide that advice.