Avoid IP Pitfalls When Dissolving and Winding Up Your Business

by Glenn E.J. Murphy

Both Forbes and the New York Times report that about twenty percent of new businesses formed in 2021 will fail within their first year of existence, about thirty percent within two years, about fifty percent within five years, and about seventy percent will fail by their tenth year.  But even those that fail will create or acquire valuable assets, including some forms of intellectual property, whose value may survive the existence of the enterprise.  For businesses that thrive and grow, they may too cease operations, whether due to a merger or other reorganization, a sale of the business or its assets, or a bankruptcy or other judicial proceeding.  Whether you are a founder, shareholder, officer, director, executive, or other responsible employee, or a legal adviser to any of them, you will encounter the dissolution and winding up of a business, probably sooner than you expected.  In the inevitable event that a business closes its doors, many problems involving intellectual property may be avoided by the exercise of due diligence at the inception and during the life of the business.

“Intellectual property” broadly encompasses a class of intangible assets whose use requires the consent of the owner.  Typically associated with patents, trademarks, copyrights, and trade secrets, intellectual property includes any confidential information that could be the subject of any of these specific rights, or that has value independent of such rights, including confidential commercial information, software, databases, and other proprietary collections of information created or accumulated during the life of the business.  For purposes of dissolution winding up, these intangible assets are treated the same as the physical assets of the enterprise.

Whether the business in question is a corporation, LLC, or partnership, its obligations upon dissolution are similar.  In addition to filing articles of dissolution or other documents notifying the relevant authority (usually the Secretary of State of the state in which the enterprise is organized) of the dissolution, the business must wind up and cease its business operations, satisfy outstanding liabilities and obligations, liquidate its assets, and distribute any surplus to its shareholders, members, partners, or other stakeholders in proportion to their shares or capital accounts.

Many problems of intellectual property at dissolution arise because the business has not clearly allocated or properly documented title to these assets.  The resulting defects in title may impair or even substantially destroy the value of the affected assets.  How defects of title affect a dissolution depends in some part upon the context.  In a voluntary dissolution as part of a corporate restructuring, where a related company succeeds in interest to the assets, the harm of any defects in title may be minimized or overlooked (but maybe not forever).  On the other hand, if the assets must be liquidated in an arms-length sale to a disinterested buyer, clouds on title may make liquidation difficult or impossible.  At a minimum, they can substantially diminish the value realized for the assets in liquidation.

In addition to title problems, other issues may arise, including questions over who owns intellectual property and in what share, and who may continue to use them after dissolution.  Even when a business dissolves amicably, disagreements can arise. Therefore, founders of an enterprise must consider these issues in advance and develop a plan at formation to minimize these typical and avoidable disputes.  The business must also implement and periodically review the plan, to ensure it continues to serve the goals of the enterprise, and that the business is diligently executing it.

Diligent planning begins with a thorough understanding of the kinds of intangible assets a business is expected to create, acquire, or accumulate.  For a business engaged in scientific or technical activity, the discovery of new inventions and the development of technical or commercial trade secrets are easily imaginable.  But even businesses not engaged in technical pursuits will create or accumulate confidential information that has intrinsic value.  A good example of such “soft IP” is the centerpiece of the 2011 bankruptcy liquidation of Borders bookstores, its customer list, acquired by Barnes & Noble for almost $14 million at auction.  A thorough inventory of potential intellectual property assets is essential to determine what measures will be required to create and perfect the enterprise’s interest in them.

Ideally, the articles of incorporation, operating agreement, partnership agreement, or other formation documents of the enterprise address ownership of intellectual property and its disposition and use upon dissolution.  Of course, to facilitate transactions and maximize the value of the assets to the business, it is preferable to have all intellectual property relevant to its operations owned by the business entity.  But even if that is not the case, whatever ownership allocation is decided upon should be documented clearly in the formation documents.

A frequent problem is the failure to secure the rights to inventions and other creations made by employees within the scope of their employment.  It is surprising how often businesses do not acquire important rights from an employee, either by design or unintentionally.  Ownership of inventive rights is governed by state laws, which uniformly hold that inventions belong to their inventors, unless agreed otherwise.  In the absence of an assignment from the employee, the employer acquires no rights or only very limited rights from the employee, who remains the owner.

The absence of a contract obligating the employee to assign their intellectual property rights as a condition of employment puts the employer at great disadvantage, because without that obligation, they have no leverage to compel the employee to assign.  At best, they can offer additional consideration for the assignment, if the employee (or ex-employee) will take it.  Otherwise, they may find themselves co-owning those rights with the employee.  Therefore, if employees will engage in inventive activity within the scope of their employment, and the business wants to own the rights to those innovations, the business must have and diligently follow procedures with supporting documentation to obtain title from the employees.  At a minimum, employees should be required as a condition of employment to execute an agreement to assign their intellectual property rights to their employer, and to do such things and execute such papers later on as needed to vest full legal title to those rights in the employer.

Concern over securing employees’ rights extends to the employees of other businesses as well.  In a common scenario, Company A and Company B form a joint venture in which they allocate certain rights arising from the work to each party.  Under the agreement, A is to receive rights to a particular invention made by x, y, and z.  x and y are employees of A; z is an employee of B.  Unknown to A, Company B does not have its employees under an obligation to assign.  Company B solicits an assignment from z.  z, consulting their lawyer before executing the assignment, refuses and asks for more money.  A dispute breaks out over z’s refusal; z quits.   Worse yet, z starts a new business using the patented technology in competition with A and B.  What recourse do A and B have?  Unfortunately, not much.  Without any obligation to enforce, Company B cannot compel inventor z to assign.  Of course, Company A may have an action against B for breach of the joint venture agreement, but that gives A no leverage to prevent the damage that z can cause.

This situation points to the dangers of naked co-ownership of intellectual property rights, which is to be avoided at all stages of the enterprise.  Patent rights offer a clear example.  The joint inventors also jointly own their patent, unless and until they each assign their rights to someone else.  And absent any agreement otherwise between them, each holds an undivided joint interest in the patent.  None owes any obligation to the other; they are not each other’s fiduciaries.  Each may use, license, sell, mortgage, and generally do anything they wish with their interest without the other owners’ permission.  In the situation above, z holds a naked (that is, unconditional) undivided joint interest with Company A.  Not only can z form a new company using the patent, z can grant access to the patent to any number of A’s competitors.  Worse yet, because under Federal jurisdictional law, all owners of a patent must be joined in a suit for infringement, A cannot sue any infringers without z as a co-plaintiff.

The key fact not known to A when entering the agreement with B was the absence of B having their employees under an obligation to assign.  When one is dealing with a large, publicly-traded corporation, there may be little risk in assuming your business partner has their employees bound to assign.  On the other hand, many closely-held but substantial companies may not, and certainly it is a concern when dealing with smaller businesses and startups.  You must ask this question in any situation where your company may acquire intellectual property rights from another business, and enter into no agreement until you can confirm that the other business has its employees under an obligation to assign.

Naked co-ownership of intellectual property rights between founders or other stakeholders, whether at the inception of the enterprise or following dissolution, is also to be avoided.  The value of intellectual property rights derives from the right to exclude, which in the case of patents, cannot be enforced without the unanimous consent and joinder of all owners of a patent.  Too often one sees operating agreements or other founding documents or contracts in which “all intellectual property rights will be jointly owned by the Parties” or some similarly worded allocation.  Unless the parties are in complete agreement on the use and enforcement of the rights, such unrestricted joint ownership can substantially diminish the value of the these assets.  Dealing with the issues of ownership, use, exploitation, and enforcement of jointly-owned intellectual property rights is an admittedly complex and potentially contentious problem, ripe for avoidance, but it is essential that the rights of the individual owners in some way be restricted by the group.  At a minimum, each co-owner should not be able to sell, license, or otherwise transact its interest without the consent of the others. All owners should also be obligated to cooperate in the enforcement of the rights against unauthorized users.  In this way the value of the assets as a whole can be preserved while the company is operating and after its dissolution.

It sometimes happens intangible intellectual property rights are not liquidated in dissolution.  This may be by design, where the stakeholders have worked out a plan ahead of time.  But liquidation of assets sometimes is overlooked, and the enterprise officially dissolves  before the assets are moved out of the now-defunct enterprise.  The status of rights owned by defunct entities is governed by state laws pertaining to corporations and other business entities.  In Pennsylvania, title to the unliquidated assets of a defunct corporation or LLC is divided among the shareholders or stakeholders of the enterprise pro rata.  Of course, each owner takes their interest unconditionally, with all the drawbacks of naked co-ownership just described.  In Delaware, unliquidated assets of defunct corporations remain the legal property of the corporation and may be transacted even after the three-year winding up period expires by a trustee or receiver in Chancery Court.  The better course in any case is to avoid reliance on these default allocations by establishing and following a clear plan for disposition of these assets upon dissolution, whether at the inception or at a later time, and in any event before the dissolution of the enterprise is at hand.

As with most endeavors, the old adage of an ounce of prevention applies.  A clear plan for dealing with the ownership and disposition of intellectual property rights, from inception through operation to dissolution and post-dissolution, and a diligent execution of that plan, will put your enterprise in a better position when the inevitable arrives.

Please enter your e-mail address to receive a link to the webinar video.

This site is protected by reCAPTCHA and the Google Privacy Policy and Terms of Service apply.

Please enter your e-mail address to receive a link to the webinar video.

This site is protected by reCAPTCHA and the Google Privacy Policy and Terms of Service apply.