Early Creators of IP as Founders or Equity Holders
Often, intellectual property is the most valuable assets a company has. For an extreme example, think of the music industry. At Michael Jackson’s death his portfolio of music masters was worth more than $1 Billion. In many cases, early founders will have worked together to create intellectual property that is the heart of the business. Since each co-creator has rights in the intellectual property, it is important that everyone involved transfer their rights in the intellectual property to the business. In return, these IP creators will want a share of ownership interest in the business. It is rare that a creator of IP will accept or a new venture will be able to purchase IP from its creator. Instead, these individuals often become early equity owners. This is true even if those individuals do not continue on with the business. Often the individuals working together on an early venture do not stay together through the difficult growth and development of the business. Look at the early Microsoft team. Only two of the large founding group remained in the company as something other than silent shareholders at the time it went public.
Difficulties with Issuing Equity for IP
The primary concerns when exchanging equity ownership for intellectual property rights are valuation of the intellectual property and other laws governing the transfer.
Valuing intellectual property is difficult. There are any number of methods that one can employ in arriving at a valuation. Unfortunately, there is no single readily accepted method. As such, exchanging equity for ownership rights can lead to unintended tax consequences for the IP holder. That is, the IRS may hold that the exchange of equity is taxable compensation to the recipient. There must be an exemption under section 721 for partnership-taxed entities and section 351 for corporate-taxed entities. See our business taxation material for more information on tax repercussions of equity for property.
- Note: This is a concern for any transfer of property to a business entity in exchange for an ownership interest.
The ability to transfer intellectual property is governed by a combination of state and federal law. Specifically, it involves state contract law and a combination of federal and state intellectual property laws. A contract is only enforceable to the extent of its terms. It can be tricky to adequately identify exactly what is included when transferring intellectual property. Federal patent laws have strict requirements on who can file a patent. Until a patent is awarded, transferring rights in the patent is difficult. Also, enforcing those rights may be challenged.