Firewalling your intellectual property from creditors

Business owners can mitigate risk by separating the ownership of IP from day-to-day trading

When a New Zealand company or individual becomes insolvent, their assets are typically seized or sold to pay off creditors. For software developers, this can mean losing ownership of their source code. Other valuable intellectual property could also be lost, including domain names, trade marks, documentation, customer lists and client data.

If you have spent a lot of time, money and effort developing your software and brand, losing ownership of that “irreplaceable” intellectual property could be much worse than losing replaceable tangible assets.

Fortunately, software owners can mitigate this risk by separating the ownership of IP from day-to-day trading risks, so that one legal entity is responsible for commercial trading with the software, while a separate legal entity owns the IP. The aim is to ensure that if the trading entity becomes insolvent, the IP is protected by virtue of it being owned by a separate legal entity, and therefore out of reach of a claim against the trading entity.

Separating assets and parts of a business into two or more entities is relatively common; for example, business owners and professionals commonly put their houses and personal assets into a trust and franchisors commonly use separate trading and licensing entities. However, New Zealand software developers sometimes overlook this concept as a way to protect their software and related IP.

To understand how a separate-ownership model can work for a software firm, it is useful to briefly consider that most software owners do not actually “sell” software, but licence it. That is, the developer (via a licence) grants each customer the non-exclusive right to use the software. This use is subject to terms and conditions contained in the licence. The software remains owned by the original owner.

Example of separate-ownership model

An example of a separate-ownership model (using two limited liability companies) is as follows:

Two companies are formed – HoldingCo Ltd and TradingCo Ltd. HoldingCo Ltd owns the IP (eg the software, domain names). HoldingCo licenses the IP to TradingCo on terms that allow TradingCo to sub-license the software to end users, and use the trade marks and other IP (referred to as the “head licence”).

TradingCo markets and licences the software to customers. HoldingCo, on the other hand, has no dealings with customers.

There are some important points to add to this example. Only TradingCo should actually trade (for example, deal with customers, market the software and so forth). HoldingCo should have no external dealings (or as few as possible). This will minimise the exposure of HoldingCo (which owns the IP) to legal liability.

If TradingCo becomes insolvent, its liability will be limited to its own assets – not any of the IP owned by HoldingCo. However, if TradingCo itself owned HoldingCo, then TradingCo would effectively own the IP, which would defeat the purpose of the separation.

Similarly, if HoldingCo, or its shareholder, guaranteed TradingCo, the IP would be exposed to TradingCo’s risks.

The licence between HoldingCo and TradingCo should be properly documented and terminate if certain events occur, as discussed below.

Because it is common for software and related IP to be continually developed and extended, all new IP should also be protected. This can be achieved by appropriate terms in the licence that automatically transfer (and licenses-back) any new IP from TradingCo to HoldingCo.

There may also be other important issues depending on specific circumstances.

If the trading entity gets into trouble

In the example, a collapse of TradingCo would not put the assets of HoldingCo at risk.

However, if HoldingCo’s licence of its IP to TradingCo (the head licence) was not structured and documented appropriately, a third party could potentially gain control of the head licence. Even worse, if the head licence created a world-wide, royalty-free license to use the IP, the effect could be comparable to losing ownership of the IP altogether.

Accordingly, the head licence should be set to automatically terminate if TradingCo becomes insolvent or other adverse events occur. The head licence could also allow the licensor (HoldingCo) to terminate the licence at will.

If necessary, a new company (NewCo Ltd) could be set up and HoldingCo could grant a new head licence to NewCo, allowing trading (via NewCo) to resume relatively seamlessly.

Is the risk real?

Before implementing a separate-ownership model, it is fair to ask: how real is the risk that a software owner could lose their IP? After all, shouldn’t a good licence agreement and insurance protect the licensor from claims?

Appropriate licences and insurance can remove (or mitigate) many risks for licensors and are certainly key risk management tools. However, it is the insolvency of a company (or bankruptcy of an individual) that can result in loss of IP assets. Such events can be triggered by slow-paying debtors, excessive borrowing, or any number of other mishaps or misfortunes.

Separate ownership can also make it safer for a developer (via the trading entity) to bring in new investors, or enter into joint ventures and other arrangements with third parties, while ensuring that their existing IP is not put at risk.

Is it worth it?

There are good reasons in many cases to implement a separate-ownership model, and many businesses have done so.

The model can provide effective protection for valuable IP while requiring only minor practical changes (if any) to a firm’s day-to-day operations.

Some effort is required in setting up the appropriate structure and creating the necessary documentation, and there can be factors requiring special attention, such as:

• Existing licensing and IP ownership arrangements;

• Existing lending security agreements; and

• Shareholder issues.

However, resolving these issues in order to implement a separate-ownership model is usually a one-off task, with occasional reviews and administration recommended. It can also be a good opportunity to tidy up any outstanding company and shareholder matters (eg adopting or updating a shareholders’ agreement and a constitution).

In any case, we recommend assessing all relevant issues, and the pros and cons of your particular circumstances, before taking any steps.

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