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Guiding your intellectual property through escrow arrangements.

In the end, the escrow agreement helps to motivate the developer to quickly resolve any disputes with end-users, while providing a tool for the end-user to limit risk if a resolution is not reached.

Intellectual property (IP) encompasses software rights and licensing, copyrights, patents, trademarks, and trade secrets. It is intangible and is perceived as having commercial value and receives the legal protection of a property right. Intellectual property is also an asset, which means that it can be bought, sold, licensed, exchanged, or given away as any other form of property. The intellectual property owner also has the right to prevent the unauthorized use or sale of the property. Today, for intellectual property in particular, technology offers both promise and risk in the digital age; it offers more quantity, more quality, and greater access, while at the same time harvesting undue risk. It offers the risk of making your business vulnerable--an individual or organization can pilfer your business information if left unprotected.

Each company's primary objective should be to protect its intellectual property, while maintaining competitive dominance or aspiring to become a leading figure in the marketplace. In addition, businesses can no longer focus solely on regional competitors--they must broaden their scope of vision to include the global marketplace. Technology has made it possible for small- to medium-sized businesses to be viewed as equivalent players (in the eyes of a customer) to multinational corporations in similar industries.

With the rapid adoption of technology, particularly the Internet, and its widespread use in today's digital economy, many organizations struggle to gain competitive advantage; intellectual property is viewed as a means to help an organization protect its market position within an industry. There is a wealth of executive-level interest in intellectual property protection and data protection due to an increasing focus on intellectual property as a competitive differentiator. Achieving sustainable competitive advantage involves evaluating how critical intellectual property is to your organization's success.

* How easy would it be for a competitor to duplicate your business model, systems and processes, technology, and ideas, if they were not protected?

* How can you minimize the risk of possible infringement on your business?

As organizations have become more reliant upon superior technologies and software systems to deliver competitive advantage and service to clients, there is an increasing pressure to ensure that organizations are protecting these significant technology and software system investments to prevent potential customer loss. This is achieved through intellectual property protection solutions. The protection of intellectual property requires an investment of both time and money. Like any other business investment, careful planning greatly increases your chance of success. For contract managers, the first step in this process is to assess these significant investments, and periodically evaluate whether or not they are mission-critical to your organization. It is advised that this periodic review should become part of a contract manager's due diligence process in order to minimize potential risk.

How Critical Is Your Software to Your Business?

Let's consider the ramifications for computer software end-users. Many of the software technology companies that experienced explosive growth during the mid-80s and early 90s have faced bankruptcy, mergers, or acquisitions. Traditionally, more than 60 percent of all newly created high-technology companies have disappeared within five years of their creation. During the recent fluidity of the technology market this percentage has dramatically increased. An increasing number of layoffs and a high employee turnover rate have been equally problematic. Another concern lies within the evolving world of programming. Newer programming methodologies (i.e., multi-layered application designs) make access to key data more critical than ever. A successful organization insures its assets only after evaluating the assets' worth against certain criteria and risks. A major gap exists in the manner in which software end-users protect their software investments (within their own procurement organizations). Often colleagues with in a licensing group will have widely varying practices in this area and inconsistently utilize escrow arrangements with some agents by overusing the service or not using it at all. In any event, there is rarely a consistent, uniform approach in the employment and execution of escrow arrangements. Companies that license critical programs should evaluate licensing policies and develop a set of documented best practices. Such consideration will weigh the potential cost to the end-user if the software were not supported as required by the license agreement. To make this evaluation, the end-user will need to consider several aspects of the software and its relationship to the end-user's operations.

Determining Your Risk

In order to assess the "risk factors" in conjunction with your intellectual property, it is important to ask yourself these questions:

(1) Is your software unique in nature? In many cases, software involves complex, custom code that cannot be reproduced quickly. At a minimum, several months would be involved to select a new vendor to provide a replacement product and many more months to design and write a replacement product. Market ready or off-the-shelf replacements for products that are escrowed are simply not available.

(2) How much do you depend on the software? Many products are critical to an organization's operations, and any down time associated with the product would be devastating. Today, many licensed products are embedded in a company's own products-- because these are often tied to mission-critical operations, they are often escrowed. What contracts would be affected if this technology fails? What would be the legal impact should your software fail?

(3) How much have you invested in the product? Most licensing experts have established a pre-determined dollar value, where if exceeded, an escrow is automatically required. It is important to remember that a technology investment goes well beyond licensing. Similar to other assets, you will need to consider the costs associated to that event. For example, if a customer relationship management (CRM) tool is implemented to be used as a large part of your sales force automation process, and that tool is supporting a large sales force; it is critical that you think beyond the initial cost of implementation or consultation to include training, programming, deployment, etc.-if there is a significant investment involved, then it stands to reason that it should be escrowed.

(4) How committed are the developers to the product? It is obvious to many end-users that smaller organizations run a high risk of going bankrupt or suffering a cessation of business. Moreover, one should realize that deliberate sabotage is also a risk to consider; employees and subcontractors have access to key components of licensed technology. Another risk includes large developers. Even though they run little risk of going bankrupt or discontinuing operations, it is important to remember that even large corporations can discontinue a product, divest of a division, or stop support of a product to encourage movement to a newer, more improved product.

To Escrow or Not to Escrow

In order to decide whether or not to protect your organization's intellectual property investment in software through an escrow arrangement, your organization should develop a standard checklist of factors to consider. It is advised that you put weighted values and costs associated with those values to determine the costs of the initial escrow versus the potential risk and losses to your organization in the event you were unable to further utilize that software investment. There are many factors-depending on their effect upon your organization-that contract managers should include and weigh on your checklist. You will need to consider the value of your operational dependencies, replacement costs, and time to replace this software investment if necessary.

* Will this software be intricate to the roles of your organizational users and how will their inability to perform those roles affect your organization?

* Will this software application have an impact upon service level agreements that your organization has with its customers?

* Does it enable the production-critical materials or services, or is it tied to productivity?

The cost to your organization should include an assessment of both tangible and intangible costs such as revenues or compensation for non-productive employees, lost business opportunity, damaged reputation, or the net present value of customer defection. To fully understand the effects of these tangible and intangible costs, you will need to get business and IT owners for these applications involved in the cost and risk assessment to determine the total impact.

After careful consideration of the earlier risk factors with key business and IT owners for the software that is being purchased, contract managers will be able to make both a qualified and quantified decision to determine whether there is a business need for intellectual property protection.

Additional issues that may be unique to your organization should also be weighed when determining the need for an escrow agreement. Many organizations will form a cross-functional internal team comprised of risk management, IT, legal, and business personnel to identify the level of risk with which their company is comfortable. Your organization will then able to establish objective criteria that determine when escrow arrangements are required for licensed technology.

One additional item that the decision-makers should consider is whether or not your organization can realistically support the key technology using the contents of the escrow deposit. While many critics of escrow agreements will incorrectly assume the technology cannot be supported, it remains the norm that most organizations can maintain the technology if the escrow deposit is properly created. To determine if the software escrow deposit is complete, this will require qualified technical personnel to assess the contents. If necessary, it may also require compiling of the software code and evaluating the executable code in a test environment to ensure that your organization has what it will need to support itself on the software.

A more common, although not immediately obvious, benefit of a software escrow is that it adds value as a point of leverage against non-compliant developers, and thus provides some benefit to the end-user even if the deposit is never released. If a developer is failing to honor its license obligations, the end-user, may threaten to seek release of the escrow, forcing the developer to provide the support to which they have previously agreed. Most organizations hope that they will never need to request a release of their software escrow, but as a contract manager, you are responsible to ensure that your organization's investment is fully protected in the event that such an action becomes necessary.

By employing these criteria, the decision-makers may then come to a uniform and objective decision about when to escrow critical software. The key concept in this area is to understand that without any objective criteria, the escrow decision is left to subjective and personal judgment that results in inconsistent application of the service, which can put your organization's software investment at risk.

Finally, the timing of the escrow request is best placed prior to signing the license agreement or the payment of the initialization fees. Most developers are more likely to agree to the escrow and key negotiation points in the escrow agreement, while general discussion on the license agreement is still in production.

Selecting an Escrow Agent

After using your checklist to assess whether your costs of an escrow outweighs the risk of potential loss to your organization, you must then select an escrow agent, or neutral third party, to help negotiate terms and conditions between yourself and the developer. The selection of a reliable and experienced escrow agent is just as critical in deciding whether or not to escrow the software in the first place. Professional escrow companies are considered the best option when selecting the right escrow agent for your business need. More experienced agents often contribute the services and advice that make the difference between effective escrow arrangements and just a service that provides little more than a false sense of security. The same due diligence involved during the evaluation of an insurance company should also be exercised when picking an escrow company. An escrow without an agent that meets the qualifications to efficiently and effectively design and execute an escrow contract that protects your orga nization's interests can put your organization at risk.

Contract Essentials

After selecting an agent, the next most important step toward an effective escrow arrangement is drafting the contract. Contract managers should pay particular attention to this process, through which the foundation for the terms and conditions of the arrangement is outlined. It is the agreement that clearly defines the obligations to deposit and update a usable deposit, the terms under which it may be released, and what recourse each side has in this process. If drafted in clear terms, the contract helps to avoid many of the pitfalls that result in ineffective or costly arrangements. A well-crafted agreement precludes ambiguities and cumbersome requirements that destroy the escrow and often throw the involved parties into litigation. You will find that the escrow agent will offer a standard form of agreement that provides a good starting point for crafting a customized contract. This standard agreement should be reviewed by an attorney on a regular basis to ensure that it is both effective and balanced. A go od escrow agent will also offer suggested conditions to help modify the terms to meet specific needs.

The Escrow Deposit

Another critical area in an escrow arrangement is the definition, preparation, and maintenance of the escrow deposit. Following the execution of the escrow agreement, the deposit materials must be delivered to the escrow agent. However, it is often during this stage that a failure normally occurs in the end-user's organizational responsibilities that serve to harm the escrow arrangement. Up until this point in the creation of an escrow, the legal staff oversees much of the process and focuses almost exclusively upon the contract. Yet most legal staff has a minimal understanding about the technical components of a technology product, and defers the decision to the developer about which materials to deposit in the escrow. Technical staff from both the end-user's and developer's organization is strongly encouraged to be involved in this process in order to create a usable deposit and become familiar with the use of each element in the deposit. Not only will this cooperative effort involve staff with technical sk ill sets, but it will also demonstrate to the developer that the end-user is serious about the quality of the deposit.

While it is difficult to provide direction on what materials should be included in each escrow deposit, certain common components are generally acknowledged to be required for a successful deposit. These include:

* Source code for each version (including all tiers of the architecture);

* User and installation documentation;

* Compilation and execution procedures;

* Third-party software identity (unless end-user rights preclude inclusion), including and a list provided of where such resources may be obtained;

* Necessary hardware and compilers; and

* Passwords and encryption keys.

It is possible that certain elements of the list are not applicable to a particular escrow arrangement, but such omissions should be justified by the developer or deposit creation team and provided to the end-user. Certain items on this list will often help, if the escrow deposit is ever deployed. They also will greatly increase the success rate of a timely and effective employment of the materials. The developer should also provide up-to-date contact information of key programmers who could be hired as consultants if the developer were to cease operation.

Although relatively new, this practice of hiring key programmers as consultants is quickly growing in favor and has resulted in easing the otherwise painful deployment of the escrow deposit for many end-users who lack sufficient internal technical abilities to deploy the materials.

Verification Testing

Once the escrow deposit is made, the end-user should give consideration to testing the escrow deposit to verify its accuracy and usability. While many consider technical verification services to be essential to the effectiveness of escrow arrangements, less than 5 percent of all escrow deposits are ever tested. Such failure to consider this step may leave some doubt in the completeness of the escrow deposit, leaving any shortcomings to be discovered in a time of crisis. Not all escrow deposits need to be verified (since all do not contain software), just as all software does not require an escrow. Your organization should use the same checklist and costs versus risks criteria that it has developed to determine the need to test an escrow deposit. If the need for a software escrow account "scores" high enough, an escrow is established. If the score exceeds a second mark, then it is also significant enough to be tested. The goal of any test is to determine that the escrow deposit, if deployed, would work as requ ired and in the time required by your organization. Based upon the experience of most professional escrow agents, audits on their accounts indicate that as much as 20 percent of all escrow deposits are effectively useless because of technical shortcomings or the omission of critical components--facts that can only he uncovered by testing. High numbers of troubled escrow deposits call for a consideration of verification testing.

Summary

The refinement of escrow services over the past 20 years has allowed organizations to create effective escrows. As with any service, there is a never-ending effort with industry leaders to analyze the legal and operational side of these services to ensure that all parties involved in the agreement are provided with the level of security they counted upon when entering into the agreement.

It is important to note that alternative courses to escrow agreements do exist. Litigation, access to source code, and the use of substitute products all offer a level of protection to organizations that are looking to limit risk when licensing technology. However, an escrow normally does not conflict with many of these alternative risk reduction plans. In fact, an escrow arrangement often empowers and complements these options. Critics of escrow agreements may suggest that the services are flawed in some respect, but these criticisms almost always focus upon the execution of the plan instead of some inherent shortcoming of the plan itself. For example, critics discount escrow because there is no way to keep the materials up-to-date. However, many services, including updating the escrow deposit, are offered by professional escrow agents as a way of improving the chances that the escrow will protect the organization in need.

Like a payoff of any insurance policy, an escrow release may not be the first choice for either the developer or the software purchaser. It is not meant to be the only solution. However, there are cases where it is the best solution available and helps to limit the disastrous impact that an organization may otherwise suffer.

After all, when your house is aflame, the firemen may be the first to have your attention, but an insurance claims agent will not be far behind. In the end, the escrow agreement helps to motivate the developer to quickly resolve any disputes with end-users, while providing a tool for the end-user to limit risk if a resolution is not reached. While all parties hope such problems never arise, experience demands we prepare for the possibility.
Operational          Replacement Costs X  Time to Replace =
Dependencies +

* Number of Users    * License Fee        * Are substitute products
                                            readily available?


* Customer Impact    * Retraining         * If software is customized
                                            or embedded in
                                            other applications
                                            how long will it
* Lost Productivity  * Customization        take to recode?

* Lost Revenue       * Reprogramming

                     * Hardware           * How long will it
                                            take to negotiate a
                                            new license with
                                            a new vendor?

Operational          Rick Factor
Dependencies +

* Number of Users    After considering
                     your risks of lost
                     productivity or revenue,
                     or your exposure
* Customer Impact    to increased costs,
                     can you determine what
                     level of software
                     escrow protection is
* Lost Productivity  needed and how serious
                     you should consider
* Lost Revenue       your escrow agreement?


To help assess your business needs for an escrow arrangement, and' to determine your company's level of risk, please download a detailed checklist at www.dsiescrow.com/checklist.

RELATED ARTICLE: Selecting the Right Escrow Agent

When considering escrow agents, be prepared to question whether on not the organization has the right experience.

* Do they operate their own intellectual property media vault?

* Do they carry levels of errors and omissions insurance?

* Do they have in-house legal advisors, who can aid in making solid decisions?

* Do they have a strong background in administering deposit verification testing?

* Do they have consistent and verifiable standards in place?

* Are they a stable, longstanding organization? How many clients have they worked with worldwide?

* Do they offer advanced services to maintain accounts, including electronic delivery of escrow updates?

* Have they successfully administered a significant number of releases?

* How many cases of litigation has the company been involved in during the release process?

About the Author

RICHARD SHEFFIELD is vice president of operations for. DSI Technology Escrow Services, Inc.. an Iron Mountain company DSI is a global intellectual property protection firm, serving more than 45,000 clients in 80 countries since 1982.' Sheffield has worked in the technology/ legal field since 1990. He is a frequent speaker at conferences throughout world on intellectual property and technology security issues and has" 'authored numerous papers on business solutions for IP issues. Send comments on' this article to cm@ncmahq.org

Disclaimer

This article is for informational purposes only and is in no way intended to provide legal advice, direction, or counselling to any person; company, or institution. The reader is strongly advised to consult with appropriate legal counsel for advice pertaining to these and other intellectual property issues.
COPYRIGHT 2003 National Contract Management Association
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Copyright 2003 Gale, Cengage Learning. All rights reserved.

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Author:Sheffield, Richard
Publication:Contract Management
Date:Jul 1, 2003
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