Bruno: Yeah, if you are a foreign investor you need to be patient to make your first investment, but the return could be much quicker than it is in the US.

* This is an excerpt from an interview report. Download full report at Angels and Startups, Don’t Play in China Until You Read This.

Right now, there’s a lot of hot money in China. The differentiation you can make is the people you know on the ground. Being here, or working with people whom have been here for a while, is one of the keys of succeeding as an investor here. I have been able to — and my group as well — to find companies that are both a good investment from a team perspective, as well as from a valuation perspective.

To be credible, to be consistent, and to make sense, you need to be on the ground for a little bit. When you’re confident that you’re working with the right people on the ground, let’s say AngelVest, my angel group, or any other person that you feel is trustworthy, then once you have made the first investment it’s actually pretty quick to…

Photo: ~Brenda-Starr~

Rich: So, the patience comes not so much with the return, but with getting started, making sure you’ve got your feet on the ground and that you’re working with credible people.

Bruno: Yeah, and it’s much easier now than it used to be because you can now easily connect to investors in the US as well as China.

To be confident that you understand the market well enough you need to spend time on the ground. Otherwise you’ll need to rely on other people; however talented they may be, it’s always better if you see the company that you’re going to invest in.

The other thing is investing here in China is no different. Because the market has been educated about this offshore legal structuring, it is not that difficult to invest here in China.

What you have to focus on is actually the same as what you have to focus on elsewhere, which is the team, their talents, and their track record.

And you need to understand the regulatory environment because this is apparently a component that is not as strong as it is in the US, especially in the Internet arena.

* This is an excerpt from an interview report. Download full report at Angels and Startups, Don’t Play in China Until You Read This.

Bill Payne

You just read another story on how quickly certain angels invest and you’re secretly admiring their ability to make decisions on the spot. Now you’re thinking: Due diligence is SO yesterday – screw it and close more deals already!

Do what you want; you’re investing your own money, not ours. But first, check out our interview with Bill Payne, Angel of the Year in 2009. You might want to rethink your “strategy.”

What you’ll learn:

• How much time should be spent on due diligence
• Due diligence process
• Whether angels should speed up the due diligence process and why
• Whether angels and angel groups should hire due diligence service providers
• Payne’s due diligence red flags
• Whether intellectual property (IP) protection is important
• Due diligence on IP
• And more…

More About Bill Payne

Payne co-founded Solid State Dielectrics, a capacitor dielectric materials company, in 1971 and sold it to DuPont in 1982. Having made his first angel investment in 1980, he went on to become one of the most prominent angel investors in the U.S.

Payne’s received the Hans Severiens Award (the highest honor in angel investing in the U.S.) in 2009, and a similar designation as the Arch Angel of New Zealand in 2010.

As an angel educator, Payne was appointed Entrepreneur-in-Residence to the Kauffman Foundation and he’s served on the founding committee of the Angel Capital Association. To date, he’s taught over 80 workshops and seminars on angel investing in five countries.

At the time of writing, Payne’s invested in over 50 startup ventures.

* Edited interview

Time Spent on Due Diligence

VH: As you’ve already pointed out, in a 2007 study, “Returns for Angels in Groups,” angels who did less than 20 hours of due diligence per deal received portfolio returns of 1.1x, as compared with the 7.1x return received by those who spent more than 40 hours on due diligence. So, it does appear that there’s a positive correlation between portfolio returns and the time spent on due diligence.

However, we often hear that good angels make decisions quickly. Some super angels even go as far as to using an “index fund” approach to angel investing. They make a bunch of bets across a wide range of startups, hoping that a few would turn into Facebook or Groupon. Some did, and went on become some of the hottest companies of our time. Their portfolio is diversified, no doubt, but these super angels appear to spend significantly less time on due diligence.

Based on your experience, how much time should average angels spend on due diligence?

BP: 100 hours sounds about right.

Super angels spend significantly less time on everything. Remember, angels invest time and money in portfolio companies. How much time per company can super angels invest when they have 100 companies in their portfolios?

Super angels aren’t typical angels, who invest with their own money. Super angels are just prolific seed-stage investors, most of whom invest from a fund that consist not just their own money.

VH: Some inexperienced angels believe that if super angels are using the “index fund” approach then it must be a good strategy. They might model super angels at a much smaller scale, making small bets on a bunch of startups without doing much due diligence. What warnings or advice would you give to average angels who attempt the “index fund” approach?

BP: Average angels won’t try it because they know better.

New and naïve angels may, but frankly they won’t have enough money to make 100 investments at US $25,000 a pop.

If the wealthy want to invest in 100 untested and unstudied companies, what can I do? They could spend their money on a 10-year cruise around the world!

VH: Yuri Milner and SV Angel recently announced that they’ll invest in every single Y Combinator startup, some 40 startups in total. They’re investing in these startups sight unseen and basically outsourcing due diligence to Y Combinator. How do you feel about that?

BP: Well, how will Y Combinator handle the next 10 people who want to do that? It’s a one-time thing that physically can’t be repeated.

REMEMBER: Super angels are a Silicon Valley phenomenon. There are angel groups and entrepreneurs all over the country. Why focus so much time and effort on Silicon Valley? Let’s talk about trends outside Silicon Valley…in the real world.

Due Diligence Process

VH: You made half of your 50+ investments before joining your first angel group. What was your due diligence process like before joining a group?

BP: Solo angels don’t have the time or sufficient knowledge to do adequate due diligence on all deals, so they do deals less frequently or they do less due diligence. Now I only invest through angel groups.

VH: Can you briefly explain the due diligence process? For example, what does validating the business plan mean? What are involved? How long does it take?

BP: Due diligence is a process for comparing reality with a target company’s business plan.

Groups usually assign due diligence to a team of five or so. Some focus on background checks on the team and the entrepreneur, others validate the technology, size of the opportunity, financials, competitive landscape, and the “must-have” nature of the product.

By talking to customers, we determine if the product is something those potential buyers need or must-have.

All this takes about 100 hours of our collective time.

VH: Some criticize angel groups for turning into micro VC firms because of the relatively long due diligence process. How can angels speed up and streamline the process without skipping necessary steps?

BP: Frankly, angels in groups don’t care what others think about our doing it. Due diligence is clearly important. The 2007 studied you mentioned in the beginning clearly shows the value.

It’ll take a couple of months to validate any business plan. There’s no need to speed up the process. We’re part-time investors. Get over it!

And, we’re not VCs – we do our own due diligence. Are we really being criticized for doing more preparation before investing? Is this really a justifiable position for anyone to take?

The bottom line: We’re part-time investors. Due diligence is going to take a while. Be patient.

VH: Should solo angels and angel groups outsource due diligence to due diligence service providers?

BP: Let’s see…I’m personally investing US $25,000. How much can I afford to outsource? Clearly none of it!

It also can’t be justified for angel groups, who make an average investment of about US $300,000.

Due Diligence Red Flags

VH: What are the top 5 to 10 red flags you look for during the due diligence process?

BP:

• Entrepreneur
• Team
• Size of opportunity
• Competitive landscape
• Amount of capital required
• Customer validated product/technology
• IP ownership (who owns the Intellectual Property)

VH: Some investors believe IP protection is important while others believe otherwise. Which school of thought is correct? What does due diligence on IP involve?

BP: Angel-funded companies never have enough money to defend infringement. This is why the importance of intellectual property is questioned.

Nonetheless, investors seek a competitive advantage. We use our networks to attempt to ascertain the exclusivity and freedom to operate.

Where I find IP valuable is at exit.

* Special thanks to exit strategist Basil Peters for recommending Bill.

Image by: PhillipC

Talk with experienced angel investors, and you’ll realize that unless they have a trusted syndication partner across the border, proximity still matters.

True, tech advancement and the falling cost of communication might have enabled investors to invest farther from home, but the effect might not be as significant as we think.

After all, trust and face-to-face contacts are essential in angel investing.

Entrepreneurial angel Joshua Schachter, for example, doesn’t invest in companies that are out of his networks (Bay Area and New York). “I don’t like doing deals sight unseen,” Schachter avows.

Similarly, Canadian angel investor Boris Wertz, former COO of AbeBooks.com, which was sold to Amazon.com, told The Globe and Mail:

You need to be selective about it. Stick to an industry you really understand, and pick companies close to home – coaching over the phone is a tough one. You want to see them in person as often as possible.

In 2008, a team of academics from the University of Maryland drew a sample of 136 firms and examined proximity measures [PDF] based on the zip code of investors relative to the zip codes of the startups’ headquarters. They found that investors generally lived close to the companies they backed.

Sixty percent of angels lived within three hours of driving time from the firms in which they invested, and 18 percent were within the same zip code. The researchers also pointed out that pure angel-backed companies (i.e., those that haven’t raised money from venture capitalists) were most likely to be in the same zip code as the angels.

Yes, the sample size is small, but it does provide insights into investors’ preference in regards to proximity.

Why Angels Invest Close to Home

Angels invest for different reasons.

Some invest locally because they want to support local entrepreneurs as they’d been there themselves and want to “pay it forward” within their local community.

Others like Dharmesh Shah, an entrepreneurial angel and the founder of HubSpot, enjoys the welcoming advantages of helping out local entrepreneurs: “One of the side benefits of being an angel investor is that it builds credibility and good will within the local community,” Shan avouches.

For yet others, it’s due to the risky nature of angel investing. These investors invest close to home because it’s easier to monitor local investments and help resolve issues quickly at the first sign of trouble. They believe this helps improve company performance and reduce the risk of their investment.

Jamie Rhodes, chairman of Central Texas Angel Network (CTAN) in Austin, Texas, says: “We invest in Texas-based companies because investors like to drop in on their investments.”

Most investors don’t actually monitor their investment like a hawk or visit their portfolio companies every day, but the ability to do so without having to travel a long distance does offer them a sense of security.

Because they feel more secured, investors who invest close to home are more likely to “rely on trust in lieu of more formal control mechanisms,” according to Venture Capital: Investment Strategies, Structures, and Policies. Those who invest aboard tend to use more formal (and costly) control mechanisms to protect their investments.

Not to Say Angels Don’t Invest Abroad

Having said that, investors are willing to commute to find good deals. As mentioned in the beginning, experienced investors are more willing to invest aboard if they have a trusted syndication partner across the border.

They’re also more willing to back companies located in a distant area that they’re very familiar with or frequently travel to.

Even so, convenience still plays a big role.

As Forbes’ Maureen Farrell writes, “most angels and VC can only go so many places so often so proximity to investors or at least proximity to an easily traveled route helps.”

Don’t Do This Just Because It’s Close to Home

Of course, don’t invest in a company operating in an industry you’re unfamiliar with just because it’s close to home. Without knowledge of the industry, you can’t properly evaluate the real risks and potential of investing in that company. And you won’t be able to leverage your expertise if the company needs help.

But if you must invest in a sector that’s new to you, either due to a strong urge or whatever reasons that captivate you, then check out “Angel Investing: Effective Ways to Invest in the Unknown” to learn how to go about it.

Image by: L.Bö

* This is not legal advice. Consult with your lawyer.

Should angel investors care about Private Placement Memorandum (PPM)? Antoine Brand, a reader of Venture Hype, wondered.

Since it’s a question asked by many an entrepreneur, we decided to look at both sides of the table and examine the role PPM plays in an investment deal. We’ve used a fictitious company called Yo!Woo and its 2 angel investors, Annice (an accredited investor) and David (a non-accredited investor), to tell the story.

We first talked about Regulation D and defined what exactly a PPM is and whether it’s required in all investment deals. We then compared a PPM to a business plan as a fund-raising tool and looked into how Yo!Woo can get into trouble raising fund with a business plan. Please read previous articles to better understand the scenario below.

• Private Placement Memorandum: What Da Heck Is It?
• PPM vs. Business Plan: A Startup’s Fund-Raising Nightmare

How does David’s action affect Annice’s investment?

Picking up where we left off, Yo!Woo is unable to return David’s investment capital because it’s already spent a large chunk of the money toward achieving the milestone. David’s lawyer is happy to take Yo!Woo to court and take a bite out of its liquidated assets as a payment for legal fees.

For early-stage companies, this kind of hiccups is enough to have a major negative impact on employee morale. Yo!Woo is distracted. Management is stressed out and frustrated, and employees are scared of losing their jobs and ending up with worthless stock options. The entire atmosphere turns gloomy. Everyone’s focusing on the lawsuit rather than iterating products and acquiring customers. Annice’s investment is in jeopardy.

Yo!Woo will have to fight in court or return David’s investment – both require money that Yo!Woo doesn’t have.

What can Yo!Woo do?

It can -

• find a lawyer who’d take equity to represent the company in court;
• raise money to return David’s cash;
• raise money to fight in court; or
• declare bankruptcy and liquidate all available assets.

No matter which option the company chooses, they’re all extremely taxing on young companies like Yo!Woo. It’s all the more difficult to raise money from new investors in murky situations like this.

Most likely, Yo!Woo will go back to its other existing investor, Annice, who can either put more money in to bail the company out of its current situation and hope that it’ll pick things up quickly after the incident, or refuse to invest further and endure higher risk of Yo!Woo going bankrupt, thus losing her original investment.

A well-prepared PPM would have prevented this nightmare.

Had Yo!Woo used a PPM to document all the information that’s been communicated to investors, it would have avoided potential accusations or violations.

Had Annice made sure Yo!Woo was in compliance with the securities law before writing the check, she would have avoided the unpleasant investment experience caused by other investors.

As you can see, improper documentation exposes the company to severe penalties and possible criminal repercussions that not only irk the company but also other investors in the deal.

Preparing a PPM

The best way to go about preparing a PPM that’s in compliance with the securities law is of course to hire a qualified securities lawyer to guide the company through the process.

If cash is tight and Yo!Woo decides to purchase a PPM template and go the DIY route, it should, at the very least, have a qualified securities lawyer review the PPM draft to make sure it’s valid.

Image by: Stefan Baudy

* This is not legal advice. Consult with your lawyer.

Antoine Brand asks -

What is a private placement memorandum? Should Angel Investors be concerned if the company doesn’t have one?

Since many an entrepreneur has asked the same question, why don’t we look at both sides of the table and examine the role it plays in an investment deal?

Say, an up-and-coming company called Yo!Woo is undergoing rapid growth and expansion. It needs money, and it’s planning to sell securities (debt, equity, or combination of both) to 2 angels: Annice, an accredited investor, and David, a non-accredited investor.

Under the Securities Act of 1933, any company wishing to offer and sell securities must register the offering with the Securities and Exchange Commission (SEC) — unless it meets an exemption.

Regulation D (Reg D)

You see, the registration process is anything but fun. It’s costly, complex, and time-consuming.

Luckily for Yo!Woo, Regulation D contains 3 rules that exempt fund-raising companies from registering their securities with the SEC — provided that certain conditions are met. These rules are: Rules 504, 505, and 506.

Each rule has different requirements, such as investor status (accredited or non-accredited); the maximum amount a company can raise; the number of people it can raise money from; and the type of information that must be disclosed to each type of investors.

Rule 504 allows Yo!Woo to raise up to US$1 million while Rule 505 up to US$5 million. With Rule 506, Yo!Woo can raise an unlimited amount of capital. Visit their respective links to learn more.

If Yo!Woo meets the criteria of the Rule it pursues, it can offer and sell securities to Annice and David without having to register with the SEC.

Private Placement Memorandum: What Is It?

A Private Placement Memorandum (PPM, Offering, or Offering Memorandum) is a disclosure document that details the risks, terms, and other aspects of the investment opportunity. It helps prospective investors understand the potential downfalls, and it makes it clear that the transaction is speculative in nature and only those who can afford to lose the entire investment should consider the opportunity.

Yo!Woo must include factual and realistic information about the deal in the PPM, such as a summary of offering terms and subscription procedures; a description of the company; information about the management team; risk factors and conflicts of interests; and any other information that’s considered “material” by a potential investor.

Whether a PPM is required would depend on the state laws and the specific Rule (under Regulation D) a company pursues.

If the company sells securities to non-accredited investors, “then a formal private placement memorandum, similar to that filed in a nonexempt filing, has to be provided to the investors, and the seller of the securities needs to show that the investors are ‘sophisticated,’” shares Scott Shane, author of Fool’s Gold.

Private Placement Memorandum: Subscription Agreement and Investor Questionnaire

The PPM also includes a Subscription Agreement and an Investor Questionnaire. The investors, Annice and David, will need to return a signed copy of these documents and send a check to the company if they decide to invest in the company.

The Subscription Agreement is a “sales contract” for purchasing (or subscribing) the securities at agreed terms and conditions. The Agreement also confirms that the investor has received and reviewed all documentations; is aware of the risks involved; and is either an accredited or sophisticated investor.

Just as the PPM discloses Yo!Woo’s information to Annice and David, the Investor Questionnaire discloses to the company the investors’ investing sophistication, such as background, employment, and business or investment experience evidencing their capability in evaluating an investment opportunity.

Together, these documents assure Yo!Woo that Annice and David are aware of the risks and that their wealth standard or investing sophistication meets the federal and state requirements.

Next:

• Why raise money from accredited investors
• Definition of accredited investors
• PPM vs. business plan
  
• Why using a business plan to raise money could haunt entrepreneurs and co-investors
  

This is a guest post by Christopher Grey, a contributor to TheStreet.com and the co-founder and CFO of CapLinked.

Grey was a senior executive and partner in private equity, finance, and banking for 15 years. He was directly involved in the origination and management of billions of dollars of debt and equity investments.

Other members on CapLinked’s management team include Eric Jackson, former VP Marketing at PayPal, and Dave Schwartz, former CTO at National Payment Network.

Nearly three years after the worst economic downturn to hit America since the Great Depression began, politicians, economists, business leaders, and commentators are still debating how to get the economy moving again.

Unemployment is stuck at 17.5% if you look at the broad measure that includes discouraged workers and labor force dropouts.

Business spending is stagnant.

GDP growth, even though it is artificially inflated by government stimulus, is weak, as is consumer spending.

Main street banks and businesses are still hurting and afraid to take on any risk.

Even state and local governments are slashing jobs and cutting budgets.

The only groups doing well are the Federal government and Wall Street, which is no coincidence since they are one and the same entity.

Yes, that’s right.

It’s well known that the Federal government and the Federal Reserve bailed out Wall Street. What isn’t common knowledge is that the existence and daily operations of Wall Street, the Federal Reserve, and the Federal government are inextricably connected.

They have a deeply symbiotic relationship. Even as Wall Street howls in protest over financial reform and politicians campaign against Wall Street, they need each other to survive.

The Treasury and the Fed need Wall Street to keep the government bond market functioning properly. This is critical to funding everything that the government does.

Wall Street also creates the appearance of a transparent financial market for everything from stocks to commodities to corporate bonds. Of course the market is anything but transparent, but Wall Street and their facilitators and the Fed, Treasury, and the SEC have a vested interested in making people believe that it is.

Regular investors are limited in what due diligence they are even allowed to do on investment in public securities. If investors, especially foreign investors, lost confidence in our financial markets, our entire system would collapse. Like it or not, Wall Street, the Fed, and the US government are joined at the hip.

The unfortunate consequence of this is that you need to go outside of Wall Street to find real capitalism and entrepreneurship. Private companies cannot rely on government backing.

Small- and mid-sized private businesses have the real risk of failure. They and their angel investors are the real risk takers. In the market for private capital, there is no reward without risk.

The good news is that the rewards for taking risk in that market can be larger than anyone ever dreamed. This is especially true in technology. Even during this terrible economy of the past few years, investors in private technology companies such as Facebook, Zynga, Mint, Linkedin, Quora, Twitter, Groupon and many other businesses have reaped extraordinary returns—returns that Wall Street can’t match.

Angel investing beats investing in Wall Street because it provides a chance to make significant money and you can do as much due diligence as you want. Even better, you can personally get to know the people running it.

Obviously there is also the risk that you can lose money. Any investment in a private company whether small or large, no matter what industry, and no matter how much due diligence you do, is a risky bet. However, you will at least have more control over your own analysis rather than just accepting what is spoon fed by Wall Street and will benefit more on the upside if the business does well.

Admittedly, I’m biased in speaking about this topic. I’m a co-founder of a software business called CapLinked. CapLinked is a secure, collaborative network for private companies, investors, and advisors to interact with each other.

Companies can use CapLinked to raise capital, do investor relations, and share information with their board, advisors, and key employees.

Investors can use CapLinked to manage deal flow, close deals, manage their portfolio, and share information with their companies and their advisors.

Advisors can use CapLinked to manage their deals and share information with their investor and company clients.

I’m passionate about helping private companies, investors, and their advisors. Capitalism is what this country needs to get things moving in the right direction.

Wall Street is corrupted by its connections to and dependency on government.

Real capitalism is happening on Main Street.

CapLinked is a tool that can help Main Street businesses, their investors, and their advisors to succeed. That’s why I co-founded this business and why I’m writing about it. It’s currently free to anyone who wants to use it. Please take a moment to check it out if you think it’s something that might be valuable to you or someone you know.

Interested in submitting an article to Venture Hype? Just follow these guidelines to get your article featured.

Tom Williams of McGarry Bair

Back in April, we met a patent attorney through Greg George, who suggested we do a post on intellectual property (IP).

Law? IP? *yawn*

Before you doze off, wait! This patent attorney happened to be McGarry Bair’s (@McGarryBair) Tom Williams (@RealGTom), who’s fun, witty, and enthusiastic – not your typical lawyer.

In fact, McGarry Bair isn’t your typical IP law firm either. Read Part 1 of the interview, Tom Williams of McGarry Bair: Implications of IP for Angel Investors, for a more detailed introduction, and learn about the various forms of IP and how IP produces money-making opportunities.

In Part 2, IP Mistakes Startups Make That Could Jeopardize Your Angel Investment, Williams describes several common mistakes startups make, provides an overview on IP insurance, and points out why most startups don’t have such insurance.

Here, Williams explains how IP attorneys can help investors in the investment process and how patent attorneys are different from other IP attorneys.

Where Do IP Attorneys Come In

In Profiting From Promising Startups: Improving the Odds (Part 2), we mentioned that you can seek help from an experienced lawyer to assess or reduce product risks. This is where an IP attorney comes in.

An IP lawyer can help you evaluate a potential investment opportunity. Williams’ firm, McGarry Bair, for example, offers due diligence services to investors. It can help you

• review a company’s IP holdings;
• evaluate roadblocks to product commercialization or product lines expansion;
• evaluate potential flaws in a company’s IP;
• work with trained valuation professionals to valuate and price the IP;
• perform chain of title analyses; and
• prepare IP transfer licenses and/or assignments to help prepare closing documents.

IP Attorney / Patent Attorney

According to Williams, IP attorneys have a lot of sub-specialties. Some do trademark or copyright only, some are patent attorneys as well.

A ‘patent attorney’ actually has a special meaning. It’s someone who’s obtained an approved hard-science undergraduate degree, went to law school, passed a state bar, and passed the Patent Office bar examination.

So, patent attorneys can have a number of technical specialties as well as legal specialties. Some are better at mechanical inventions, some at electrical, computer, chemical, pharmaceutical, etc.

So if you’re looking for an IP attorney to help you or your newly-formed angel group evaluate opportunities, you need to first determine your needs. Will a trademark or copyright lawyer suffice, or is a well-rounded patent attorney more desirable?

No matter what your requirements are, Williams stresses that working with someone you like is just as important.

Just for Fun

VH: Any funny anecdotes you’d like to share?

TW: It might be an indicator of the type of work we do that a “funny anecdote” about patent law isn’t popping right into my head.

But you certainly can’t say that the Patent Office doesn’t have a sense of humor, what with the new method of swinging on a swing (US6368277) or the “peanut butter and jelly sandwich” patent (US6004596).

Not everything is the light bulb…

VH: Who was your favorite cartoon character as a kid? We know it’s not Scooby Doo.

TW: Has to be Calvin of “Calvin and Hobbes” by Bill Watterson.

Calvin’s father was a patent attorney in the comic strip, and Mr. Watterson’s father was a patent attorney and worked at the Patent Office.

I mean, come on, who else has created a patent attorney cartoon character?

Now, if Batman’s alter ego was only a patent attorney…

Tom Williams of McGarry Bair

In Part 1 of the interview, Implications of IP for Angel Investors, patent attorney Tom Williams (@RealGTom) of McGarry Bair (@McGarryBair) provided a summary of various forms of intellectual property (IP) and explained how IP produces money-making opportunities.

Here, he’ll talk about several common mistakes startups make, provide an overview on IP insurance, and point out why most startups don’t have such insurance.

Common IP Mistakes Companies Make

IP is one of the most important considerations when seasoned investors evaluate an investment opportunity. They want to make sure the potential investee 1) hasn’t infringed other companies’ IP and 2) has taken reasonable measures to defend its competitive edge by protecting its IP.

Looking at some of the most common IP mistakes startups make could provide insights into how they might jeopardize your investment.

Williams points out that startups often

• become married to their name before undergoing a trademark adoption or clearance process;
• don’t have a clear idea of how their concept differentiates them from the marketplace and, technologically, from prior products/services; and/or
• fail to resolve IP ownership issues early on in their development – and ending up not owning 100% of their IP.

If the startup outsources code development or other content to a third party, the startup should have agreements in place to address ownership. As Williams notes, “outsourcing can create ownership in that third party.” You want to make sure your investee, not the third party, owns the IP.

And if the startup’s patent attorney is hired based on low fees, it might imply that the IP counsel isn’t properly compensated “to spend enough time to adequately evaluate the IP and place appropriate protections in place,” he continues.

As an IP-conscious investor, you may want to clear the above with the potential investee before making your investment decision.

Worst Mistake

What’s the worst mistake of them all? William says it’s disclosing or discussing the product openly before seeking legal advice from a qualified IP attorney.

He explains:

In the United States, companies have a year from the first disclosure or offer for sale to file a patent application.

But in some countries, any disclosure before filing will forfeit their patent rights.

Sometimes, even a pitch to an investor, which discloses enough of an invention, can compromise US and foreign patent rights.

This means that once the founder/inventor has put its invention/technology in the public domain, such as pitching to you and other investors, there’s a chance that it’d invalidate the patent application.

It sucks to know that the product you totally dig might not receive IP protections in the future, all because the startup hasn’t filed a patent app before her pitch. At the minimum, the company should have filed a perfunctory provisional patent application, suggests Williams.

Reciting some of the unfortunate meetings his firm’s had with clients, Williams shares:

Some of the worst meetings I can remember are ones where an inventor has made a fatal disclosure of an invention before protecting it and we have to tell the inventor that his/her invention is free for the world to use.

Ouch.

Intellectual Property Insurance

IP insurance typically insures against lawsuits by a company’s competitors. It provides a vehicle to assist and/or fund the prosecution or defense of IP-related infringement lawsuits, shares Williams.

If you’re thinking about requesting potential investees to obtain IP insurance, check out what Williams has to say:

Insurance coverage can be expensive. Many startups simply don’t have the resources to put towards one or more policies.

Sometimes IP insurance companies require that a certain level of due diligence be performed — typically by IP counsel — which includes searches, and filing patent and trademark registration applications.

So even if startups have the funds to obtain IP insurance, they often get rejected because of the speculative nature of their new market or product, or the existence of a substantial competitor in the market.

That said, we’ve handled cases for clients that had insurance. They were able to obtain financial assistance under their policy to defend a lawsuit against a competitor, which they otherwise wouldn’t been able to defend.

Stay tuned for Part 3 of the interview, where Williams explains how IP attorneys can help in the investment process and tells the differences between IP attorneys and patent attorneys.

Product risk is one of the investment risks inherit in angel investing. You want to reduce risks by making sure the product 1) solves problems, 2) hasn’t infringed other companies’ intellectual property (IP), and 3) is protected by IP to keep competitors out of its turf.

Granted, betting on companies with patented ideas isn’t a sure-win. But you could easily lose your entire investment investing in one whose competitive edge isn’t protected by IP. Resourceful competitors can copy the unprotected invention without breaking a sweat, and chew up your startup investee like it’s a delicious snack.

Venture Hype interviewed Tom Williams (@RealGTom) of McGarry Bair (@McGarryBair) to explore the implications of IP for angel investors.

Tom Williams & McGarry Bair

Tom Williams is a patent attorney at McGarry Bair. Obsessed with law and tech, the enthusiastic lawyer frequently brainstorms new ways to make IP law painless and profitable (did you know that’s even possible?).

McGarry Bair is a new-gen IP law firm that leverages technology to get the job done. The firm’s lawyers talk IP, sports, music, tech toys, good eats, and etc. — you know, things that are “in.” And at 10 a.m. sharp every Wednesday, they hang out to socialize and indulge in milk and cookies.

The firm is fun, no doubt, but it means serious business when it comes to IP cases. McGarry Bair is hailed as “An Innovative Law Firm for Innovative Clients” by Forbes; “Go-To Law Firm® for the Top 500 Companies” by Fortune Magazine; “one of the top 20 most innovative law firms” by Michigan Lawyer’s Weekly; and “Top Trademark Law Firm” by Intellectual Property Today.

Without further ado…

IP in a Nutshell

The various forms of IP differ widely. The type of IP protection your investee needs would depend on the nature of the product and how it’ll be used.

Williams provides a quick summary:

Patents provide your investee the exclusive right to (a) make, use, sell, or offer for sale; or (b) import devices, systems, methods, and even plants and ornamental designs (inventions) in return for a public disclosure of the invention.

Trade secret is the opposite of a patent. Rather than publicly disclosing the technology in a patent, a trade secret protects information. The information is maintained in confidence and gives your investee a commercial advantage over the competition.

Trademarks are your investee’s brands. They protect nearly any symbol used in commerce, so a consumer can identify the goods or services sold under your investee’s symbol.

Trade dress is related to trademarks and protects the look and feel of a product’s design, styling, and appearance.

Copyright is a bundle of individual exclusive rights that prohibit others from reproducing, distributing, performing, displaying, or even making derivative works (works based on another work) of your investee’s original work.

The long and short of it is that the various forms of IP, when used most effectively, can optimize the protection of your investee’s creative output and reduce the risk of your investment.

IP Produces Money-Making Opportunities

“IP is an asset of a company like any other kind of asset,” states Williams. Your investee’s IP can be bought, sold, or rented/licensed for royalties.

But the startup’s IP can also protect its revenue streams, as it prevents others from encroaching into the company’s market.

Williams adds that the company can use IP

• offensively to stop its competition from infringing on its intellectual property;
• defensively to protect its own ideas and to stop others from entering into its space, and;
• in a “freedom to operate” sense, competitively to create enough barriers around a product, so a business can operate without having to worry about infringing others’ IP.

Stay tuned for Part 2 of the interview, where Williams describes some common mistakes startups make, provides an overview on IP insurance, and points out why most startups don’t have it.

* VH: Special thanks to Greg George of GTI Advisors for recommending Tom.

William R. Kerr

Startup businesses need more than just cash in their kitty to achieve success and business longevity, according to a Harvard Business School paper into entrepreneurial funding.

While it is important that seed businesses receive the necessary funding to get their operations up and running, sometimes the psychological support they receive is just as important as the financial leg up.

Only an archangel can make this happen!

Angels vs. VCs and Friends & Family

Where a venture capitalist may swill some cash around in their managed fund and occasionally flick some in the general direction of promising startups, angel investors give new businesses their proverbial set of wings – give yourselves a pat on your cherubic backs for that one!

Angels are oftentimes seen to provide the same type of support that friends and family might.

But just like the merciless honesty we expect to receive from friends and family, angel investors don’t back a venture they don’t believe in – and this point of distinction appears to make all of the difference.

Angel-Backed Companies Less Likely to Kick the Bucket

The Harvard report penned by William R. Kerr, Josh Lerner, and Antoinette Schoar tables evidence that angel-funded firms are less likely to kick the bucket than firms that rely on other forms of initial financing.

This is good news for you angels out there who have invested your hard-earned cash in a venture and look forward to continued pay days!

While venture capitalists might be intent to keep flogging the dead horse that still promises to win a race, angel investors are proven to seek out companies that are committed to the growth of more than just their bank accounts.

According to Kerr, Lerner and Schoar, the improvements that can be seen within businesses funded by sophisticated angel investors can be logged at between 30% and 50% – more than the improvements noted in businesses using other types of initial financing.

Kerr, Lerner and Schoar go on to say that these statistics can be attributed to:

• the use of networking that is initiated by most angel investors;
• the dedicated due diligence they put into researching each new venture before signing on the dotted line;
• the personal assessment undertaken to weigh up the chances of recovering their outgoings; and
• the way that angel firms survive and thrive by upping the ante on diversifying their portfolio and maintaining a personalised approach to their business backing.

It is okay to initiate a “Give me an A, N, G, E, L” cheer here punters!

More Than Money

The concept comes back to the nature vs. nurture school of thought.

Josh Lerner

Does a new baby require only milk to satisfy her growth and development needs?

Unlikely.

Just like an infant, startup businesses are usually seeking added value from an angel financier.

Adding value means helping out and being there when the
company needs you (e.g. providing helpful advice and critical connections), not stepping on the founder’s toes when your help isn’t needed.

The overall vibe of the Kerr, Lerner and Schoar report is that angel investors should embrace the fact that they are expected to give more to their investments than just the funds.

Take Away

You’re all acutely aware of the fact that the success of your investments is balanced greatly on the success of those you invest in, so take away some key points of thought from the Kerr, Lerner and Schoar paper.

• Due diligence, due diligence, due diligence – Look beyond the business plan and executive summary. Intensively evaluate every member on the startup team. Listen carefully as they present their ideas to you. Do they believe in themselves as much as they expect you to?
• Document, document, document – The Kerr, Lerner and Schoar report details information about how much effort Tech Coast Angels put into maintaining their database of companies not funded by them, but should be! Food for thought…
• Score it – Take a ballot on a new venture detailing your interest level in a pitch delivered by a startup, your overall confidence in the facts and figures that back them up, and your belief in their commitment to drop their egos and put in the hard yards to make success happen.