Tech Startup Scramble: Security Interest versus License Agreement

We live in the age of the tech startup. Entrepreneurs with exciting ideas and nothing but a nickel in their pockets have created the next big thing and reshaped the very society we live in.

Far more frequently, the startups go belly-up, leaving investors and lenders to divvy up what’s left. In many cases, lenders leave themselves unnecessarily exposed due to a lack of due diligence.

A Battle for Priority

Priva Technologies, Inc. received a secured loan from lender one, Pro Marketing Sales, Inc., while the company was in its early stages in order to develop a microchip encryption technology called Secured Key Storage Integrated Circuit (SKSIC).

The security agreement drafted by Pro Marketing Sales, Inc. included a first-position lien on all  Priva’s assets, including intellectual property. The collateral description also included all assets to be acquired by Priva.

Investing in Encumbered Intellectual Property During Bankruptcy

Fast-forward three years. Priva is filing for chapter 11 bankruptcy in Michigan. A key part of Priva’s reorganization plan was to develop its assets and use them to pay for its debts.

Enter lender number two, Cyber Solutions International, LLC., who entered into a Design Service and Intellectual Property License Agreement with Priva in exchange for two payments of $200,000.

Priva used this money to develop SKSCI (the technology which Pro Marketing Sales’ initial loan had financed) into a second-generation product called Tamper Reactive Secure Storage (TRSS). The license agreement granted Cyber Solutions International exclusive license to and other rights in TRSS.

Pro Marketing Objects to License Agreement

Obviously Pro Marketing objected to Priva’s licensing agreement when Priva presented it to the bankruptcy court. Their argument was pretty straightforward: the license agreement was subordinate to Pro Marketing’s lien under the security agreement. The court

The court approved the license agreement but acknowledged that it could not stop Pro Marketing from foreclosing on Priva’s intellectual property. Priva continued its development of TRSS in bankruptcy as part of its reorganization plan.

It didn’t work out. Cash shortages forced Priva to convert its case to a chapter 7 liquidation. Pro Marketing foreclosed on all of Priva’s intellectual property. Priva, in turn, terminated its agreement with Cyber Solutions. Cyber Solutions filed suit and against Pro Marketing, seeking a declaration that its license agreement was enforceable and that TRSS was not in the scope of Prop Marketing’s lien because it was a second-generation product.

The Case Boiled Down to Two Phrases

One from Pro Marketing’s security agreement, which granted a first-position lien in “‘all rights, priorities and privileges relating to’ copyrights, trademarks, patents and trade secrets, ‘as well as mask works fixed in semi-conductor chip products.’”

The other from Cyber Solutions’ license agreement, which assigned to Cyber Solutions “all right, title and interest in and to any and all updates, modifications, or improvements” to any Priva technology funded by Cyber Solutions.

In the end, the court sided with Pro Marketing. For one, their security agreement prohibited Priva from transferring any interest in the collateral without the prior written consent of Pro Marketing. Consent had not been obtained. Further, because the license agreement itself acknowledged the existence of liens on Priva’s pre-TRSS technology.

The Lesson?

You can lead a horse to water but you can’t make it drink. Priva was in bankruptcy. All information regarding its capital structure and secured debt was publically available. Cyber Solutions had all the information it needed to make an adequate assessment of the risk of licensing Priva’s intellectual property. It just didn’t make the right call.

Cyber Solutions could have continued with the license agreement and tried to contract around the pre-existing liens by approaching the lienholder and making a deal. Instead, they ended up with a complete loss of their investment.

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