CONSULTING AS A WAY TO BOOTSTRAP

Ah, the joys of bootstrapping! When every penny counts and love money is getting scarce, it is not uncommon for startups and small companies to engage in consulting services during their first months (or even years) of activity to bring some external source of revenues to the business and help fund core development work or to keep the “sharks” at bay and postpone a round of dilutive funding. Although this may sound like a good plan from a business standpoint, at least as long as it doesn’t become a distraction to the team, it is nevertheless not without risks either. Fast forward many years when the company is ready to be acquired and someone is looking under the hood during due diligence; some of these early gigs may come back to haunt the business owners and can directly impact the transaction or diminish the value of the company as a result. Why? Well, because no one will be willing to pay full retail value for IP assets whose ownership has been granted to external companies or which have already been licensed to various potential customers.

If one could consult in a field that is unrelated to their business, things would be a lot simpler. A core part of the problem however lies in the fact that potential consultants will naturally look for consulting jobs with some overlap into what brought them to their startup in the first place and, similarly,  clients are interested by their relevant technical skills, not how fast they can assemble a 500 piece puzzle. This means that the entrepreneur/consultants will need to  be extremely careful in entering into an agreement with a third party in that capacity: they can inadvertently jeopardize the future of their own business by signing away valuable IP or licensing rights to another company in an ill-judged work-for-hire relationship. The consequences of this range from losing a potential licensee, in and of itself devastating in fields with small numbers of large firms (i.e., Big Five accounting firms), to not being able to sell licenses (the core of software enterprises) or provide competing services at all, and leave the client, not the consultant, in full control of the developed IP.

Fortunately, there are certain ways to limit the control by other companies over the embryonic IP of startups. The most obvious is to stay away from consulting. But you certainly didn’t read all the way through here only to hear this truism. One more practical guidance is to structure the consulting relationship (and contract) with the client in a way that preserves full ownership of the commissioned IP.
It is important to do this up-front: it would be unpleasant and a waste of time to negotiate all other aspects of a lucrative contract only to have it founder on this rock. In many cases, clients may not even care too much about ownership and simply want a good product to integrate into their operations without having to worry about selling it: a piece of software that measures worker productivity for an HR department of a printer manufacturer, for instance, won't likely be of much long-term interest to a company beyond its day-to-day functionality. In that instance and in ones like it, granting an internal use license and pocketing the ownership rights might be entirely feasible. However, even in a case as rosy as the one above, there are risks. If that printer manufacturer is one of three or four in the industry, you may have just cost your company a substantial chunk of its potential clientele. Once again, however, there are ways to avoid jeopardizing your business. For instance, a version- or time-limited license keeps the client coming back to buy new versions technology. This is especially helpful if being up-to-date is a key component of your contribution, such as for anti-virus software.
Since retaining full ownership for the consultant is not always (actually it rarely is) possible, the next best thing is to make sure the consultant is left with some rights to the created IP that are “equivalent to ownership” -to use lawyers parlance- and which allow the consultant to commercial exploit the commissioned IP, and ideally sub-license and even assign those rights. Unfortunately for innovators, asking the guy who paid for the work to grant you back rights equivalent to ownership is equally difficult rationalize. Cash is king and a person who sees the relationship as a “work for hire” will not welcome the idea of paying for the consultant to develop their business. People who do this are called investors… You may be able to receive some level of a license back to your work, but it is unlikely to contain broad commercial rights.

Therefore, it is very important for the business that does some consulting on the side to really segregate the work that is funded internally from that which is funded externally, generally along the lines of what is core and what is not. Then, the contract needs to be really clear about what this “Preexisting IP” is and also leave room for parallel creation of IP outside of the consulting agreement. This is generally referred to as “Independent Development”. The former ensures that the client does not own the ideas that brought them to your company in the first place, and the latter makes sure that the client does not own unrelated IP developed concurrently to the commissioned work. Another step to take is to try to get a license-back agreement, which would allow you to produce or use a product internally, but not the ability to license it to other entities and are usually non-transferable, making commercial exploitation of an IP more difficult. This may have some value if your business model is “in the cloud” for instance, where there is no distribution downstream.

Providing representations and warranties on the IP being created is another area of risk for consultants. Representations are essentially affirmations that the consultant has infringed no IP up to the date of contract and warranties provide promises that they will continue to not infringe the IP of others indefinitely. These can be dangerous for consultants, especially as it pertains to patents, because those can be unknowingly infringed quite easily. If an IP owner sues your company (or your client) a few years down the road, the company becomes that much more difficult to sell. So it is best to avoid these if possible, but if a client requests representations and warranties, the consultant should try to have the language of the contract cover trade secrets and copyrights, and avoid patents for the reason mentioned above. Should a client persist in demanding representations and warranties covering non-infringement of patents, make sure at least that the language includes only those patents that you knew of at the effective date  (preferably without any duty to investigate)  to ensure that your company isn't threatened in the long run. Ideally you want any possible liability to have lapsed by the time prince charming shows up at the door and to be capped at the full amount received under the contract. Investors and acquirers love those capped liabilities.
In short, CWD or “consulting while developing” is a little bit like having a little thing on the side…; while it may feel satisfying to some in the short term, if you’re not careful, you might be carrying some liability for much longer than you’d like. And it eventually catches up with you. Just ask Arnold! J