Why patents are effective in raising funds for startups - Points for investors to look at intellectual property

For startups, financing is one of the most important issues that determines the growth of the company. It goes without saying that the appeal of a product and the ability of a team to execute are important in order to attract the attention of investors, but in recent years intellectual property (IP), including patents, has been attracting attention as a factor that greatly influences the success or failure of fundraising.

A patent is not just a "certificate of technology." For investors, patents are a moat that prevents competitors from enteringand evidence of a business's sustainable competitive advantage. In fact, the number of cases in which the status of intellectual property is investigated in detail during due diligence (DD) of VC funds is increasing year by year, and we are living in an era where the presence or absence of an intellectual property strategy is directly linked to valuation.

In this article, we will comprehensively explain why patents are important for startup funding, what investors look at in terms of IP during due diligence, typical failures that lower investors' evaluations, and IP strategies depending on the funding round. If you are an entrepreneur or start-up manager who is preparing to raise funds, please read this article to the end.

Why patents are important for fundraising

When raising funds for startups, the existence of patents influences investors' decision-making in many ways. Here we detail three reasons why patents are important for financing.

Proof of competitive advantage

One of the risks that investors are most concerned about when investing in startups is the emergence of competitors. Even if a product or service is innovative, the first-mover advantage will not last long if competitors can easily imitate it. The most powerful answer to this concern is proof of technological superiority through patents.

Obtaining a patent is evidence that the technology has passed the examination for novelty (the technology does not yet exist in the world) and inventive step (the technology cannot be easily thought of from conventional technology). This is objectively certified by the Japan Patent Office, a third-party organization, and provides investors with highly reliable evidence supporting their company's technological capabilities.

In particular, holding patents on your core technology means you can legally prevent competitors from entering the market with the same approach. Investors see the potential for higher returns in startups that have this "defensive strength." This is because the barrier to entry created by patents can be expected to maintain and expand market share.

Prevention of imitation by large companies

One of the biggest threats to startups is imitation by larger companies. When large companies with deep financial resources, large development teams, and established sales channels enter the same space, it is extremely difficult for startups to compete head-on. However, with the legal weapon of patents, it is possible to reverse this "David vs. Goliath" situation.

Patent rights have equal legal effect regardless of the size of the invention or the size of the applicant's company. In other words, even if a startup with 10 employees owns a patent, it can be enforced against a large company with a market capitalization of several trillion yen. If a large company infringes a patent and imitates a startup's technology, it can legally defend itself by seeking an injunction or seeking damages.

Investors place great importance on this point. Particularly for startups entering a growing market that large companies are likely to be interested in, the question always asked is, "What would you do if a large company seriously entered the market?" Being able to answer this question by saying, ``We have patented our core technology and can legally prevent competitors from entering the company'' will be a big plus when making investment decisions.

Corporate value at exit

The ultimate purpose of investors investing in startups is to exit through IPO (initial public offering) or M&A (mergers and acquisitions). The existence of a patent portfolio has an extremely large impact on corporate value at the time of exit.

In the IPO scene, intellectual property, including patents, is evaluated as a company's "intangible assets." During the listing examination, the status of intellectual property is checked from the perspective of business sustainability and competitiveness, so having a strong patent portfolio will also have a positive effect on preparations for listing. In addition, technological superiority based on patents will lead to investor trust when forming stock prices after listing.

In M&A situations, the value of patents is even more direct. For the acquiring company, the target company's patent portfolio is an "asset" that can be acquired immediately through acquisition. Considering the time and cost of developing equivalent technology in-house, a premium is typically added to the acquisition price of a startup that holds patents. In fact, in technology field M&A, a significant portion of the acquisition price is often calculated based on the value of intellectual property, including patents.

Four points for investors to view IP in DD

During due diligence (DD) in the funding process, investors investigate intellectual property from multiple angles. Here, we will explain four points that investors particularly value. By understanding these in advance and preparing appropriately, you can pass the DD smoothly and earn high evaluations from investors.

Business alignment

The first thing investors check is whether the patents that have been applied for and obtained are consistent with the actual business. Even if you own a large number of patents, if they are unrelated to your core business, they will not be valued by investors. In fact, there is even a risk that your application will be viewed negatively as ``filing an application without a strategic focus.''

What investors are looking for is a state in which business strategy and intellectual property strategy are integrated. Specifically, it is important that the technology that differentiates the product is covered by patents, that there is a patent application plan in line with the direction of future business expansion, and that a portfolio is constructed with an eye to future market development.

For example, if a startup is developing a medical diagnostic system that utilizes AI, a patent strategy that comprehensively covers each element of the product, including not only the AI algorithm itself, but also data preprocessing methods, user interfaces, and diagnostic results display methods, will be highly evaluated.

FTO investigation (Freedom to Operate)

An FTO (Freedom to Operate) investigation is an investigation to confirm whether a company's business activities infringe on the patent rights of other companies. For investors, the risk that their investee companies infringe on the patents of other companies is an extremely serious issue. If patent infringement is discovered, an injunction may make it difficult to continue business or result in huge damages.

Investors check in DD whether a startup has conducted an FTO investigation and, as a result, has secured freedom of business activities. If an FTO investigation has not been conducted, investors may conclude that the potential risk of patent infringement is not understood, which may lead to them not investing or tightening conditions (lowering valuation, adding special clauses, etc.).

Ideally, it is important to complete an FTO survey before raising funds to clarify the existence of risks and countermeasures. Even if a risk is discovered, you can eliminate investors' concerns by preparing workarounds such as changing the design or obtaining a license. ``Understanding and appropriately managing risks'' is more important to investors than ``zero risk.''

Appropriateness of claims

One of the most important factors that determines the value of a patent is the quality of the claims. Intellectual property experts who work with investors in DD examine the claims of patents that have been granted or are pending, and confirm whether the scope of rights adequately protects the business.

If the claims are too narrow, the defense of the patent is significantly reduced because competitors can circumvent the scope of the patent and practice similar technology. Conversely, if the claims are too broad, there is a risk that they will be invalidated in relation to prior art. Investors evaluate claims that are neither too broad nor too narrow, and that accurately cover the core of the business.

The balance between independent claims (main claims) and dependent claims (sub-claims) is also important. Portfolios that have independent claims that cover a broad range while dependent claims that gradually limit specific embodiments are highly resistant to invalidation trials and are highly valued by investors. Strategically structuring claims in collaboration with a patent attorney is the key to an intellectual property strategy with an eye on funding.

Global Strategy

For startups with global expansion in mind, investors also check in detail their intellectual property protection strategies overseas. Patent rights are based on territoriality, so patents obtained in Japan are valid only within Japan. If you plan to expand into overseas markets but only file domestic applications, investors will judge you harshly as a flaw in your IP strategy.

The ideal global IP strategy is to file applications in each country in stages based on business development priorities. An approach that first secures a filing date using a PCT application (an international application based on the Patent Cooperation Treaty) and then transfers to each country within 30 months according to the business plan is superior in terms of both cost efficiency and strategic flexibility.

Investors check the filing status and filing plans in major target markets (such as the United States, Europe, and China), and also evaluate whether a strategy has been established that takes into account the differences in patent systems in each country (first-to-invent versus first-to-file, differences in examination standards, etc.). Building an international IP portfolio is an important indicator of the potential for growth into a global company.

The following is an overview of the IP checklist that investors check during DD. Before you start raising funds, be sure to prepare each item.

Failure examples that lower investors' evaluations

In order to successfully raise funds, it is essential to understand the "don'ts" regarding intellectual property. Here we introduce three typical failures that can significantly lower investors' evaluations. All of these are frequently seen in real startups, and can be avoided by being aware of them in advance.

Pre-filing information disclosure

One of the most fatal mistakes startups make is disclosing their invention before filing a patent application. Under Japanese patent law, if the content of an invention becomes publicly known (publicly known state) before the application is filed, it is generally not possible to obtain a patent (loss of novelty). This includes presenting at conferences, publishing papers, presenting at trade shows, posting on websites, and even presenting at pitch events.

In Japan, there is a relief measure called the "lack of novelty exception," but this system has procedural restrictions and there are many countries where it does not apply to overseas applications. Particularly in the United States, there is a one-year grace period, but in Europe and China, as a general rule, applications are not accepted after publication. Therefore, when looking to acquire global rights, disclosing information before filing will have fatal consequences.

If this problem is discovered during an investor's DD, it will be determined that ``intellectual property management is not being carried out appropriately,'' leading to the postponement of investment or a significant deterioration of conditions. In particular, filing a patent application after explaining the details of the technology at a pitch event is a common failure pattern in startup funding.

Ambiguity in rights attribution

Ambiguity over patent ownership (who owns the patent) is a significant risk factor for investors. There are many cases in which startups start their business based on technology developed by the founding members while employed at university or at a previous company, or outsource development to outside engineers or freelancers. In these cases, the relationship between the inventor and the patentee tends to be unclear, which often causes problems in DD.

Under Japanese patent law, the right to obtain a patent belongs, in principle, to the inventor. Regarding inventions made by a company's employees in the course of their duties (employee inventions), it is possible to stipulate in advance that the rights will be transferred to the company in the employment regulations, etc., but if this provision is not in place, there is a risk that problems will arise regarding the attribution of rights. Additionally, if co-founders are involved in the invention, the handling of shared patents becomes an issue.

In the worst case, the issue of ownership of rights may lead to litigation with retired founding members or outsourcing companies, which poses a risk to the survival of the business. Investors place great importance on this risk, so raising funds without clear ownership of rights will be at a significant disadvantage.

Cheap or bad application

For cost-conscious startups, it is a natural decision to reduce the cost of filing patent applications. However, sacrificing the quality of your application to cut costs can be costly in the long run. In particular, there are many cases where essentially useless patents are created by filing applications on one's own without specialized knowledge or by hiring low-quality agents who sell at low prices.

Typical examples of low-quality applications include problems such as the scope of claims being unnecessarily narrow (the specific structure of the product is described as is, which can be avoided with a slight design change), the description of the specification being insufficient and the interpretation of the scope of rights being limited, and the prior technical search being insufficient, which is likely to result in rejection.

If these problems are discovered when an intellectual property expert examines a claim in an investor's DD, it will be determined that the patent has been obtained but has no substantial defense. This may even be less impressive than having no patents. This is because it becomes clear that ``despite investing in intellectual property, no results are being produced.'' Even with a limited budget, it is important to work with an experienced patent attorney without compromising on the quality of your application.

Intellectual property strategy by funding round

It is important to develop a startup's IP strategy in stages, depending on the funding round. We organize investors' expectations for each round and IP measures accordingly.

Seed ~ Early

At the seed to early stage, the direction of the business is often not yet determined, and building a large-scale intellectual property portfolio is not realistic. At this stage, investors focus on the company's strategic thinking about intellectual property and the minimum level of protection for core technology.