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INVESTING–Steps Involved in a Legal Review Before Investing



Protecting the Value of the Biotech Start-Up

Biotech start-ups require a large amount of capital to bring their products to market.

Venture capital funds or big pharmaceutical companies acting as corporate partners typically provide this capital. Because of the size and nature of the investments, these investors carefully review not only the business and technology, but also the legal compliance, of biotech companies before they make any investment.

The legal issues that arise during this review may reduce the value of the start-up or, in some cases, cause the loss of the potential investor. Lawyers, venture capitalists and corporate development officers refer to this process as due diligence. This article describes some of the steps necessary to prepare for this legal review.

Lawyers agree that the most important aspect of the due diligence process for the biotech start-up is the value of its technology. This value depends, in part, on the company’s strength of ownership and its intellectual property protection of the technology.

– Contracts Help Provide

Ownership Protection

A start-up protects its ownership rights in its technology by entering into the appropriate contracts with its employees, consultants, or other third parties that may be involved in the development of the technology, such as universities or research institutions.

If there are any issues regarding the ownership of technology, the company’s counsel and scientific personnel must investigate the technology’s research and development to determine the extent of third party rights in the technology.

If the founder or an employee has developed the technology, the start-up must determine whether a previous employer may have rights in the technology. This involves the review of agreements with the former employer.

If there is any doubt as to the technology’s ownership, the start-up must license in the technology from the previous employer or a potential investor may refuse to invest due to the risk that a third party owns the technology.

Unlike many information technology concerns, life sciences start-ups will be successful only if their technology is legally protected from competition by large pharmaceutical companies, known in the industry as big pharma.

Because big pharma has the capital to successfully compete against start-ups that lack intellectual property protection, the value of a biotech start-up is greatly reduced, or in some cases rendered worthless, if its technology lacks this protection.

– Various Sources

Of IP Protection

Intellectual property protection is obtained through the use of patents, trademarks and copyrights. In life sciences, many new products are eligible for patent protection.

The application process for a patent is complex and requires a commitment from the company’s scientific personnel to be successful. The application process begins with an infringement analysis of competitive products and prior art searches to determine whether the patent is likely to be approved by the U.S. Patent and Trademark Office.

An application containing an extensive description of the technology and the specific claims for protection is then filed with the Patent and Trademark Office. There is a review process that usually takes years before the Patent and Trademark Office issues the patent. This same basic process is used for trademarks, service marks and copyrights, though the review process is different.

To further strengthen the start-up’s intellectual property protection, it also must enter into contracts with employees, consultants and technology partners that contain terms that clearly provide that the company has all rights in the technology and its related patents, trademarks and copyrights. These agreements must be drafted in a way that assures that any work completed during the development of the technology is the start-up’s property.

– Carefully Structuring

License Agreements

If a biotech start-up has licensed in technology, the license agreements must be structured so that the start-up has clear access to use this technology in its products. Important terms include the duration and scope of the license, the nature of royalty payments and the fields or areas that license allows for product development.

Buy-out provisions and termination clauses based on minimum sales or other milestones also must be structured so that the biotech start-up is able to meet these requirements and retain the license rights.

The formation of the biotech start-up must be carefully structured so that the company complies with all legal formalities. The start-up also must comply with all continuing legal requirements, such as annual meetings of shareholders and meetings of directors for corporations.

– Compliance Is

Important For All

Compliance with these legal requirements is important whether the legal entity chosen for the business is a corporation, limited liability company, or some other vehicle.

A corporation is usually chosen as the legal vehicle for a variety of reasons. Before an investment is received from a venture capital fund or corporate partner, “business angels” usually provide the seed round of financing unless founders are in the position to do this.

The division of ownership following this round must remain mostly with the founders and scientists who are active in the business and critical to its success. This allows the venture or big pharma money to take a significant percentage ownership in the start-up and still leave enough equity to provide incentives to the management and scientific team.

Most larger investors also prefer a small number of sophisticated seed round investors. This lowers the risk of a dispute with a minority shareholder.

The start-up also may define the relationship of the shareholders to one another and to the company through shareholders’ agreements. The terms of these agreements often include, among other terms, a right of first refusal for the company and shareholders who are not selling their stock if any shareholder wishes to sell stock to third parties.

The biotech start-up must retain counsel that will structure the company and its relationships with employees, consultants and technology and commercial partners so that the due diligence process does not result in legal issues that reduce the value of the start-up. This requires that management, technology personnel, and counsel work together closely in forming the company and in establishing relationships with third parties.

Lesko is the head of the business and technology group in the San Diego office of Foley & Lardner.

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