Academic journal article Journal of Corporation Law

Recoupling Founders with Their IP - Improving Innovation by Rationalizing IRC Section 351: Licensing vs. Assignment of Founders' IP in VC-Backed Startups

Academic journal article Journal of Corporation Law

Recoupling Founders with Their IP - Improving Innovation by Rationalizing IRC Section 351: Licensing vs. Assignment of Founders' IP in VC-Backed Startups

Article excerpt

ABSTRACT                                     493 I. INTRODUCTION                              494 II. TRANSFERRING IP RIGHTS                   496 III. PATENT LAW                              497 IV. BANKRUPTCY LAW                           499 V. TAX TREATMENT                             502 VI. FOUNDERS ATTACHMENT TO INVENTIONS        505 VII. GETTING FUNDED WITHOUT IP ASSIGNMENT    508       A. Skype                               509       B. Google                              509       C. Square                              510       D. Blockchain and SAFTs                510 VIII. PROPOSED REFORM                        511 IX. CONCLUSION                               512 


Conventional wisdom and common practice require that founders assign to the startup company all intellectual property rights that they individually own and that the company uses at a very early stage. (1) Without such assignment, the argument goes, the founders will not be able to secure venture capital funding. (2) Delaying transfer of founder IP to the startup company may have negative tax implications and other ramifications that could be expensive. (3) Thus, U.S. startup founders typically assign their IP rights to the startup company upon the company's formation in exchange for founder stocks. (4)

Anecdotally, however, this is not a complete description of the spectrum of tech-based startup IP allocation. Most notably, the Skype-eBay case was a success story of founders who retained personal property rights to their intellectual property. (5) The Skype story, however, is an example of a foreign startup company. This fact raises the question of whether different business culture, customs, and legal rules explain the different practices. Are U.S. entrepreneurs discouraged from retaining IP rights, and does it negatively affect innovation and social welfare? This Article explores the U.S. practice of early founder assignment of IP in the context of venture capital (VC) backed startup companies, the motivations for this practice, and its potential inefficiencies and suboptimal effects on innovation.

This Article argues that the U.S. tax rules, in particular Section 351, (6) potentially distort founders' decisions by motivating them to assign their IP rights to the startup company at an early stage. Seeking to avoid negative tax consequences, ex-ante, founders are incentivized to transfer the technology to the company rather than to keep the ownership of the IP separated from the business entity. The Article further argues that under certain situations, the premature assignment of IP may result in inefficient use of innovation and reduction of the total social welfare.

However, if, contrary to current common practice, the IP is kept separately from the startup company, and the company receives only a license to use the technology, then the use of the founders' IP may be more efficient. For example, should the company end up in bankruptcy, the founders can continue to develop and exploit the technology with no delay since the IP is not the property of the bankrupt company. on the other hand, if the technology is transferred to the company instead of being merely licensed to the company, a lengthy liquidation process can hijack the technology. until the bankruptcy procedures are resolved, the technology may not be put to use.

This Article further argues that the anticipated forfeiture of the IP from its original author discourages entrepreneurships. The decoupling of the idea from the inventor discourages innovation in two distinct ways. First, this Article argues that inventors are likely more capable and better motivated to advance their own invention than anybody else. (7) Second, the risk of a forced separation from the invention decreases the expected benefit from inventing ex-ante, thus demotivating the entrepreneurs.

The disturbing decline in new U.S. startup companies, (8) described as a "national emergency," (9) makes the case for lifting hurdles to entrepreneurship and amending legal rules that distort entrepreneurial choices and increase the cost of innovation. …

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