Intellectual Property in Insolvency Proceedings

The unique nature of startups, particularly the nature of the assets they rely on, creates complex legal and economic challenges when they face insolvency. In a world where many startups close within two years of their founding, entrepreneurs in this field must pay special attention to the various legal aspects arising from these challenges.

Unlike traditional industrial companies, the core assets of startups often include knowledge, human capital, technology, and intellectual property. These are intangible assets which, unlike tangible assets such as real estate or machinery, are not always clearly registered and sometimes depend solely on the founding team or company employees. These assets, of course, carry significant weight when the company faces insolvency proceedings, whether in liquidation or in the formulation of a rehabilitation process aimed at economic recovery.

What specific difficulties do startups face when entering insolvency?

The insolvency of a startup differs from the collapse of an industrial company. While an industrial company can sell tangible assets, most of a startup’s value lies in intangible assets: copyrights, patents, trade secrets, source code, business reputation, and the team’s know-how. As such, a startup facing insolvency will encounter several specific challenges:

1. Immature Technological Assets – Technological developments are sometimes incomplete or have not yet reached a stage where they can generate actual profits, so the asset is essentially a “potential for producing a technological product.” This potential is, in fact, the basis for investment in these companies.
2. Dependence on the Development Team – Another challenge is the high dependence of intellectual property on the founders or developers. When employees leave due to the company’s insolvency, the organizational knowledge “leaves” the company with them. This situation endangers the integrity of the technological asset and can lead to a total loss of value. If the startup has not developed mechanisms for knowledge retention and clear legal ownership of developments, this dependence will make effective insolvency management difficult.
3. Time Gap Between Investment and Value Creation – In startups, there is a clear time gap between financial investment from capital raising and owner loans and the creation of economic value for the technological product or IP. As explained by the Haifa District Court: “When dealing with requests for the opening of proceedings against a startup company that has encountered financial difficulties, it is necessary to examine whether this is a temporary difficulty, whether investors continue to support the company and wish to maintain its existence or have abandoned it, whether the company is working to raise additional investments, whether the company’s creditors or some of them agree to wait and allow the company to continue development, and so on” (Insolvency Case (Haifa) 56123-03-21).
4. Transfer of Management to an External Trustee – The transfer of control from high-tech-specialized corporate officers to a court-appointed trustee, who may lack experience in the field, can result in the mishandling of intellectual property assets.
5. Impact on Licensing Agreements – Agreements, including licenses for the use of intellectual property assets, may be altered, canceled, or continued, depending on their terms and applicable law. When the rights holder goes bankrupt, they may lose access to essential technology unless the rights are protected by law or contract. Sometimes the law allows continued use, but this is not always enforceable. Well-drafted agreements can include protective mechanisms, such as the right to continued use, restrictions on transfer, and specific clauses for dealing with insolvency situations.
6. Timelines – Companies facing insolvency proceedings must contend with challenging schedules, especially those with significant intellectual property. As the court explained in a case where the main asset of a company facing liquidation was a pharmaceutical patent: “Urgency in proceedings centered on intellectual property is critical, as knowledge that holds value today may easily lose its value tomorrow: such is the nature of knowledge in these fields.” (Liquidation Case (Jerusalem District) 67317-03-19).

The Israeli Legal Approach to Valuing Intellectual Property

Israeli law recognizes intellectual property as an asset for all intents and purposes, but there is no uniform statutory or case law framework for its valuation in insolvency. The Insolvency and Economic Rehabilitation Law, 2018, does not include a dedicated chapter for intellectual property, and case law addresses the issue mainly in the context of asset sales and company rehabilitation.

Courts may rely on external expert valuations – such as those provided by valuation experts, accountants, and sometimes patent attorneys – to assess the value of intellectual property. However, the challenge remains: the value of such assets derives mainly from their future potential, not their current market value. For example, in a transaction for the sale of software code under development, it is difficult to assess how much a potential buyer will pay without knowing whether they have a team capable of operating and developing the code, or what the target market is.

In certain cases, courts have expressed willingness to consider various valuation methods, such as the discounted cash flow (DCF) method, the market comparison method, or hybrid approaches. Although these methods have not necessarily been applied in cases where the asset being valued is intellectual property, they can certainly be relevant in such cases, which require flexibility and adaptation to specific circumstances. At the same time, it is important to note that the lack of legal uniformity may also lead to uncertainty among investors, trustees, and creditors.

The Centrality of Intellectual Property in Rehabilitation Proceedings

A financial crisis does not negate the value of intellectual property. On the contrary, intellectual property can become a lifeline for saving the business. In rehabilitation proceedings, preserving intellectual property is often the key to saving the company. The company’s technological assets, even if not yet profitable, are what attract new investors and justify its continued existence. Therefore, when planning an economic recovery process for a startup, emphasis should be placed on retaining the development team and treating it as part of the asset, maintaining the intellectual property, and properly registering rights.

In Israel, there is a growing tendency to adopt a flexible approach, including mechanisms such as sale as a “going concern” or bringing in a strategic investor during a stay of proceedings. This allows bridging the gap between the current value of the assets and their future potential and can reduce harm to creditors by maximizing their recovery rate.

The Insolvency and Economic Rehabilitation Law, enacted in 2018, grants extensive powers to the trustee appointed when a company’s insolvency proceedings are initiated. Unlike specific provisions in other legal systems (for example, Chapter 11 of the U.S. Bankruptcy Code), the Israeli Insolvency Law does not include explicit reference to intellectual property assets. However, the law grants relatively broad powers to trustees for the purpose of managing and rehabilitating the company. In our view, in appropriate cases, it is advisable to consider appointing trustees who are experts in intellectual property to ensure that the goal of maximizing creditor returns is indeed preserved through proper management of the company’s intellectual, technological, and human capital. For example:

• Licensing Intellectual Property Assets: Analyzing and enforcing existing and potential licensing agreements can ensure ongoing income.
• Sale of Assets: Selling intellectual property assets that are not core to the business can generate immediate cash flow.
• Strategic Partnerships: Using intellectual property assets in joint ventures allows for leveraging without losing control.

Each of these strategies requires careful legal, tax, and business consideration.

In Conclusion: Forethought is Key

The impressive growth of the Israeli high-tech industry, as well as the challenges it is expected to face in the coming years, requires appropriate preparation for scenarios of business failure. Proper management of intellectual property assets, orderly registration of rights, advance contractual planning, including protections for the use of rights and precise drafting of royalty rights, and clear definition of employment relationships with developers and creators can all turn a crisis into an opportunity.

Early consultation with legal advisors and intellectual property valuation experts, along with awareness of the possible proceedings under insolvency law, enables strategic planning. The goal is not only to protect existing assets but also to manage risks, maximize the chances of recovery, and ensure that the legacy of Israeli innovation continues to flourish.

***

Adv. Ran Feldman is a partner in the Dispute Resolution and Insolvency departments. Adv. Ran Vogel is a Partner in the IP Group.