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Case Study - Find the Skeleton in the Closet!

Published: 1/10/2007 11:43:58 AM
A Due Diligence Case Study

Find the skeleton in the closet

I recently evaluated a start-up that makes sensor systems for law enforcement and military applications.  Due to my strong interest once the company was presented to the angel group I belong to (the Band of Angels), I ran point on performing as much due diligence as possible.

Conveniently for me, the company was quite organized in its documentation, to the point of having many of the supporting documents in PDF form available online for viewing.  I concluded that good organization and transparency were both good signs.  So I spent the hours piecing together the company's history, which had involved a previous merger and significant intellectual property (IP) that was important to the company's valuation and potential future defensibility.

As I focused more intently on the IP, I had to work hard to follow and confirm the chain of title, since there had originally been three co-inventors on the core patent and title had changed hands among them and between them and other parties on several occasions.  This involved spending a lot of time on the USPTO.gov site, the government patent and trademark office site for searching patent and trademark claims, matching company-supplied documentation with government confirmation documents.

After probably 10-15 hours of work, and despite a written opinion from a well-respected law firm that had given the IP a clear chain of title, I concluded that the company really had rights to only 2/3rds of the patent and that one of the original inventors had not sold or granted his interest to the company.  Presenting this conclusion to the CEO, he admitted that it was indeed the case, and that the other patents the company had filed or received were essentially designed to "box in" this hold-out inventor, so that if he sold his interest to a competitor, the competitor would not be able to use the interest to harm the company.  Furthermore, the CEO intended to negotiate with the hold-out from a position of strength after the financing round closed, in order to obtain the final 33% right to the patent.

I accepted his explanation, as did my colleagues who also subsequently invested. 

The moral of this story is that there are almost always skeletons in the closet of start-up companies.  It's your job as an angel investor to find them so that you know exactly what you're buying.


Don Jones

www.VentureDeal.com

 

Don Jones
CEO, VentureDeal

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