Disposable Corporations

At least one corporation has now been formed to avoid product liability exposure in a graceful manner. It is a domestic startup company with a single product (a small patented bracket) with a large potential market. Given the very large potential sales and the exposure to product liability litigation by (careless) users, the use of a disposable corporation seems reasonable.

[All income, which is exclusively patent royalties, derived from such a corporation (and also the purchase of such a corporation, in the form of prepayments of future royalties) are patent royalty payments and thus should be subject to capital gains treatment. The corporation continually goes into debt as royalty payments are 110% of net income. A buyer would also pay up these arrears in back royalty payments. The actual sale price would be $1.00. Disposable corporations would also be good for situations which now stifle an industry due to serious product liability exposure; for example, the domestic production of small aircraft. In the event of litigation, since the assets of the corporation are limited and most non-critical, routine work is contracted out to third parties, the potential recovery from a judgment would be nominal.]

The patent holder is the owner of the corporation and holds 100% of the stock. The patent license between him (as patent holder) and him (as head of the company) stipulates that the patent royalties to be paid are 110% of net profits. This means that the company continually goes into debt and that all payments are royalty payments (subject to capital gains treatment). Should the company be sold, the back royalties need to be paid plus some multiple of future royalties (say 12 times earnings) — this becomes the effective purchase price although the actual purchase price would be $1.00. Thus even the sale of the company should give rise to capital gains for the proceeds. A buyer would also buy the patent and this preserves the defensive character of the arrangement.

The company should be a subchapter S corporation. If possible, the production (and assembly/shipping) should be done by third party contractors. Supposing however that litigation is brought against the company. It is not a thin company and has some assets and an insurance policy. The company's indebtedness however can be the object of a lien filed at the state or county level which would give the patent holder priority over any (product liability) plaintiff. Nonetheless, if the production contracts are properly constructed, a new company can be formed and the new company then proceeds to conduct business as usual. The name, the marketing lists and other key items are licensed to the company by the patent holder restrictively (i.e., made easy to transfer to a new company). Another option which provides much more certainty is to simply put the old company into bankruptcy.

The company should operate without incurring debts (prepaying all contractors if and when possible). If funding is to be sought from investors, participation in the patent royalty can/should extend to these participants (this however requires careful drafting of the investment documents). In essence what is being sold is not stock but participation in the royalty flow. This allows the company to be disposed of quickly (the one stockholder is also the sole member of the board). The royalty flow from the new company thus maintains continuity of royalty payments. The use of a disposable corporation is useful for certain types of startup situations and for these, it should effectively avoid spurious (product liability) litigation when the principal product or process has US patent protection.

A standard royalty agreement (between the inventor and the disposable corporation) to implement and to create a disposable corporation is given below. Also given are the two documents to be used to define the functionality and operations of the disposable corporation (the Notice) and the associated investor agreement (the Non-Stock Transfer Agreement). Although the Notice is terse, it can be and, in some cases, should be expanded to cover the scope of information found in a regular SEC Reg A filing.