Escrow Services – Insurance for Intellectual Property Transactions

Posted on Posted in COO

Software, Web Services, Data Services and Fabless Semiconductor ventures are all examples of attractive opportunities for entrepreneurs. They all have low capital requirements for launching because the primary asset is IP or Intellectual Property. True, there is often someone’s personal savings, angel funds or perhaps even VC money needed to launch a company, but for startup companies producing IP it’s largely the human capital of dedicated and smart entrepreneurs that is the largest input factor.

Once your product is ready for market, the challenge of selling even the best IP can often be more difficult than creating it in the first place, particularly if your target customer is a medium to large enterprise. The sales cycle for enterprise B2B software or to get a fabless semiconductor design embedded in a larger SOC or System On a Chip, can be at least six months and often more than one year. Even after your product passes all the technical due diligence, it turns out that one of the main reasons a sale falls through is that it’s difficult for a startup company to convince the decision maker of a large enterprise that your company is viable enough to warrant a strategic relationship.

Put yourself in the shoes of the large enterprise decision maker and consider a report published by the US Bureau of Labor Statistics’ Monthly Labor Review in May of 2005 which concluded that over 60% of all Information companies fail within their first four years. Will he or she be serving the best interests of the enterprise’s shareholders and board by taking on the risk of doing business with your company? If the decision maker’s job is ultimately on the line, then even if your company’s product is outstanding, they would be statistically right to pass on your deal more than 60% of the time. So, is there something you can do mitigate the risk of doing business with your firm? The answer is yes.

Before your IP is used as part of an online service handling millions of transactions a day or embedded on a chip and shipped all over the world as part of some electronic device, your client, the large multinational bank or giant electronics firm, needs to know that support will be available a couple years down the line when a bug is found or an upgrade is needed. The sad truth is that even you can’t know if your company will still be around, so you need provide some form of insurance that your client’s business won’t be impacted if your company does fail. That’s where an escrow agreement comes in.

An escrow agreement between two or more parties establishes the rights to access or take possession of IP in the event of a set of predetermined conditions (usually the bankruptcy of or failure to fulfill some obligation by the owner of the IP). The agreement specifies a neutral third party who will hold a copy of the IP on behalf of the parties to the escrow agreement and establishes procedures for taking possession of IP by a beneficiary in the event a condition is triggered.

With an escrow agreement in place, a large enterprise can be assured that if your startup company fails, is purchased by a competitor or otherwise is unable to meet its obligations, they will have the right to continue to use your IP and, if necessary, have access to the actual formulas and know-how so that they can assume responsibility for long term maintenance and support of the IP for as long as it is embedded in their products or services.

Escrow agreements usually require that a copy of documentation and or electronic data be placed on a disk or other media and stored at an escrow service. When software, designs and/or data is updated, a new copy of the IP is sent to the third-party escrow service at some predetermined interval so that the beneficiary is assured that it will have the most recent version of IP in the event that it needs to exercise its escrow rights.

The cost of escrow can be borne by either or both parties as agreed in the terms of the sale or partnership. Escrow services typically require a setup fee, update fees and some sort of fee in the event that a beneficiary claim is triggered. For an extra fee, some escrow companies can also provide independent validation of software or data based on criteria provided by one or the other of the escrow parties.

Here is an example of how an escrow agreement might work:
Your company is a startup that collects data and sells restricted access to that data via the web as a business to business service. Your intellectual property is the data, your methods of gathering the data and you infrastructure for providing the data as a web service. Your target customers are large banks that need to look up a record from your company’s database in order to provide services to their customers.

You’ve been in negotiations with a very large client for a number of months and the client’s CIO is concerned that your company’s infrastructure may not be robust enough to sustain millions of transactions each day. The CIO is also worried that you won’t have the financial wherewithal to scale your company as their needs grow and may ultimately declare bankruptcy and “go dark” on them.

In order to close the deal you offer to put an entire copy of your database, software and description of your data collection methodology in escrow. You agree to update the database monthly and the latest version of your software at least quarterly. You do not allow the client to see your software or your methodology documentation, but you do agree to allow the client to have the escrow company test the data after each update. You allow your client, at their expense, to specify up to 1,000 random queries for the escrow company to run against the data. The escrow company will verify that the data in their possession contains the results required to satisfy your client’s queries.

In the event that your company fails or is acquired by a competitor of your client who might cut off access to the data, your escrow agreement provides for your client to instruct the escrow company to release the data, software and methodology to the client so that they might maintain their operations and have their own developers establish and continue operation of the data service.

Your escrow agreement might have language specifying a single lump sum payment or ongoing licensing fee in the event of an escrow action. It might also include restrictions on resale or sublicensing of the IP to third parties after your company fails or is sold.

The CIO of your prospective client is fully reassured by the escrow agreement. In fact, he is so impressed with your company’s confidence in its long term prospects that he signs a longer term partnership agreement than you had hoped for and even agrees to absorb the cost of the escrow service, so that your startup can devote all of its resources to growing the company.

In Conclusion
So if your startup venture’s age comes into question when pursuing an enterprise customer, think of ways that you can insure your company’s performance even if you can’t insure your finances. It’s still up to you to run your company well, but an escrow agreement should allow you to overcome viability as an objection to a long term contract.

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