Investing in EU software/AI start-ups: what you should be on the lookout for from an IP perspective

In this fourth industrial revolution, as we enter the age of artificial intelligence, software and AI-based technologies are at the centre of innovation. Digital technologies are relatively easily reproducible and scalable. They also present lower implementation, infrastructure and operational costs, compared to other capital-intensive sectors, such as pharmaceuticals, real state or extractive industries.

Although private equity and venture capital investments in the enterprise software sector have suffered a decline since 2021, investing in software start-ups can be extremely lucrative and yield substantial returns for those who acquire an equity interest, particularly at early stages.

The promise of hitting a unicorn that would generate significant revenue continues to attract many investors who see in software a good opportunity to diversify their portfolios.

But investing in this type of companies, where the main asset is intangible in nature and technically complex, can be very challenging. Setting aside the issue of the valuation of software solutions, from a purely legal perspective there are several issues to be considered, particularly, when it comes to intellectual property.

Software is, after all, a creation of the human mind and, as such, is protectable by exclusive IP rights. Control over those rights is what makes the technology valuable. Therefore, when analysing whether or not to invest in a company and, particularly, when conducting due diligence, it is important to closely evaluate certain IP aspects to guarantee a successful operation.

 

How is software legally protected?

At international level, software is protected under copyright law, although some jurisdictions also allow its patentability. However, at EU-level, patents cannot be granted over software as such, leaving aside the possibility to patent so-called "computer-implemented inventions", which would be a topic for another day.

In the EU, copyright automatically protects a computer program from the moment it is expressed, i.e., from the moment the source code is written. This means that there is no need to proceed to fulfil any other formalities for the creator to assert their rights over the software in question.

Although this lack of registration makes copyright a more attractive means of protection from a cost perspective, it also raises issues related to proof of ownership, which may lead to uncertainty and even possible liability.

In order to mitigate this problem, the industry resorts to different means that leave trace of ownership of the initial software and its subsequent versions. Many start-ups decide to register their computer programs with public registries such as the Benelux Office for Intellectual Property, the French Agency for the Protection of Programmes or some private ones, such as Safe Creative. Others may opt to place the source code in escrow with a notary public or another escrow agent, whereas others may embed copyright notices or other markers in the source code to evidence their title.

It is important to keep in mind that copyright protection only extends to the source code and object code, as well as to the technical documentation pertaining to the software, but not the underlying ideas, principles or functionalities. To address these gaps, it is important for the investor to enquire on the strategy followed in order to safeguard non-copyrightable valuable assets, such as algorithms, which can be protected as trade secrets.

 

How does a start-up ensure that it holds all the rights to its software?

Software and AI development usually requires the involvement of several people, both employees of the company and external contractors and freelances. Therefore, although being provided with evidence of registration is a good indication that the copyright belongs to the target company, it has to be backed up with a complete chain of title, showing that all rights actually sit with the company. Otherwise, the investor might be left to see the possibilities to commercialize the software thwarted, not to mention the risks of exposure to litigation and potential damages.

When it comes to employees, the EU Software Directive determines that all economic rights over a computer program created by employees in the execution of their duties or following the instructions given by their employer, belong to the latter, unless otherwise provided by contract. This presumption does not necessarily extend in every jurisdiction to other protectable elements, including visual appearance, logos or even algorithms. Notably France and Luxembourg do not provide for automatic assignment of copyright to the employer outside the case of pure software.

Conversely, in most EU jurisdictions, software solutions or other works commissioned to a third party not bound by an employment contract are not automatically assigned to the entity hiring its services. In these cases, only a carefully drafted assignment agreement could allow the precious IP rights to flow from the contractor to the start-up.

Consequently, when evaluating the opportunity of the investment, it is paramount to review the contracting policy with employees and third-party contractors. These agreements should include broad IP assignment clauses affecting all types of IP rights, including trade secrets, and untethered from time or territorial constraints. Moreover, it would be relevant that the assignment clause also includes obligations on the employees to sign periodical confirmatory assignment documents to guarantee that new creations are also covered. The assignment clauses should be coupled with confidentiality and, in the case of employees, also non-compete obligations to prevent them from divulging sensitive information to competitors or to start their own ventures.

 

How does the structure of the software affect its commercial exploitability?

Another main issue to consider when analysing the marketability of the software solution of the target is the structure of the software. Many solutions created by a start-up may make use of already existing components or software libraries as building blocks for their proprietary computer program. The future commercialisation of the program highly depends on the licenses under which such components are being employed.

In some cases, the components will be proprietary software themselves, that is to say, software licensed under full copyright terms and generally subject to subscription payments. The main issue here is to analyse the validity of the licenses and any restrictions they may have in terms of duration, scope of use and territory, in order to determine whether there are any possible infringement risks or obstacles to the commercialisation of the target's software.

Many companies also integrate open-source software (OSS) components in their solutions. OSS can indeed offer significant cost savings and accelerate development timelines, but contrary to popular belief, it cannot be used just any old way: OSS comes with specific obligations that, if not properly managed, can create risks to the start-up’s intellectual property and overall business strategy.

OSS is subject to the specific terms of its license, which notably determines the user's ability to use, modify, and distribute, including under what terms the software integrating such component is to be made available to the public. Some OSS components are licensed under the so-called "restrictive licenses", such as the General Public License (GPL), that allow freedom of use but have a viral effect compelling any software developed using such component to be licensed under the same terms, which could make it virtually impossible to commercially exploit the computer program.

Other OSS licenses, such as Apache 2.0 or MIT, are permissive and not only allow for commercial exploitation but allow the software based therein to be distributed under any other license terms, provided that the corresponding copyright notices are included.

Additionally, investors should assess the start-ups’ awareness and handling of the potential security vulnerabilities associated with OSS. While open-source communities often provide regular updates and patches, start-ups need a robust process for monitoring, updating, and securing their software to protect against cyberthreats. Moreover, investors may want to assess whether the concerned start-ups have a clear strategy for addressing any potential legal and IP issues related to OSS, including the management of contributions to open-source projects, which could inadvertently expose proprietary innovations to public disclosure. A comprehensive approach to OSS management will not only mitigate risks but also demonstrate the start-ups' maturity and preparedness for scaling its operations.

 

How is the start-up making available its AI/software solution in the market?

Where the main activity of the start-ups is selling technology they developed, be it downloadable software or software-as-a-service (SaaS), it is crucial to understand the nature and structure of the licenses they grant to third parties, including the so-called End-User Licence Agreements (EULA),

These licenses can significantly impact a start-up's revenue streams, control over its intellectual property, and market positioning.

Investors should carefully assess the scope of the licenses issued, including the rights granted (e.g., use, distribution, modification), their duration, and any territorial restrictions. Broad or perpetual licenses may limit a start-up's ability to capitalize on its IP in the future, particularly if the licensing terms are exclusive or involve key technologies. Furthermore, the inclusion of sublicensing rights can lead to complications in tracking and controlling how the licensed IP is used, potentially diluting its value and the start-up's market leverage. Licenses containing automatic regular updates of the software without any financial compensation if case of major updates may also bear a significant weight on the business of the company overtime.

The commercial implications of licensing agreements are also critical. Start-ups often use licensing as a strategic tool to enter new markets, form partnerships, or generate recurring revenue through royalties. However, poorly negotiated licensing agreements can result in unfavourable terms, such as under-pricing,  legal ambiguities, or conditions that restrict the start-up's ability to innovate or expand internationally.

Investors should be on the look-out for licenses that are aligned with the start-up's long-term business strategy, providing adequate protection for its IP while allowing for scalability and revenue optimization.

Additionally, clear terms including robust enforcement mechanisms (e.g., in case of breach of contract or termination) as well as unequivocal dispute resolution provisions are essential to safeguard a company's interests and ensure that it remains in a strong position to enforce its rights should conflicts arise.

 

Main takeaways

Acquiring equity in AI/software startups could potentially have a high return on investment thanks to the rapid scalability and marketability of digital solutions. However, when evaluating your investment, consider whether:

1. the software has been registered in any public or private registry or put in escrow as a means to prove ownership;
2. any person, be it employees or external contractors, participating in the development process has assigned all their IP rights to the start-up as broadly as possible;
3. the components of the software not created in-house are correctly licensed and whether the conditions of such licenses allow for sound marketability, particularly, if OSS is involved; and
4. the licensing policy to the users of the software is aligned with a long-term business strategy, providing adequate protection for its IP while allowing for scalability and revenue optimization.

*This article was previously published in the LPEA Insight Out