Intellectual property (IP) rights are often taken for granted - until you come to sell your business or take in new investment. At this point, the buyers or investors will ask "what IP do you have, and can you prove that you own it?"

I have seen this happen a number of times while I was running Eircom's M&A activity. Our legal due diligence team would find issues with IP in a prospective investment or acquisition. This would often be expensive and time consuming to remedy, or might even derail the whole transaction.

The most common fault was to omit an IP ownership clause in the contracts of employment of developers (particularly in software companies). This is easy to do in the frenzy of developing new products, getting them to market and keeping the cash flow going. The remedy is to have the employment contract re-signed with the IP clauses included. This may not always be possible and can be costly. Better to do it from day one!

Sometimes a software company would develop a good bespoke application for a particular customer and then realise that this application could be used widely by other similar customers - in other words, it could be "productised". This is potentially very good news for a business, as it can generate "scalability", which adds significant value. The issue here is that the original customer will (if properly advised) have retained ownership of the IP it paid for. The software company must either obtain permission to use the IP (which may be refused if the new customers are competitors of the original customer), or rewrite the code from scratch. 

If your company creates bespoke software (or other products), the message is - try to retain ownership of IP created if you can, and have this as a term of your contract.

Intellectual property is a wide subject, with many other potential pitfalls for businesses. It includes patents, trade marks, trading names, domain names, copyright and designs. My advice is to get specialist advice at an early stage, as IP issues are easy to prevent but may be very expensive or impossible to remedy later.

This is the name given to a section of the employment contract for entrepreneurs raising finance, and it often causes them some angst when first seen.

In brief, Good Leaver, Bad Leaver provisions impose a penalty on business promoters who leave the business of their own volition within a specified time.

The provisions are there because investors are backing a particular management team and are keen to ensure that the team stays in place and builds value until a profitable exit can be made. Since slave labour was abolished about 200 years ago, companies wishing to retain key people have to rely on a carrot and stick approach rather than legal sanction.

The stick in this case is usually a provision requiring a Bad Leaver to transfer his or her shareholding to the other shareholders (or the company itself) at less than market value. Part of the rationale for this is that a key manager leaving will reduce the value of the company. The main reason, however, is to act as a disincentive for the individual to consider leaving in the first place.

A further consideration for investors is that, particularly in early stage companies, they often invest at a valuation that gives the promoters significant sweat equity. In effect, some of the cash invested increases the value of the promoters' equity. Investors do this to ensure the management team has a worthwhile share in the upside, but the quid-pro-quo is that the team stay the course and produce the goods.

What can promoters do to reduce the burden of bad leaver provisions? 

In some cases, entrepreneurs may be able to point to other factors that ensure they will stay with the business - for instance, significant personal guarantees of company borrowings. It may also be possible to negotiate a sliding scale of discount that reduces as the business grows, as new management is added and as the promised additional value is consolidated.

My advice to promoters? Understand what is happening and why, and get good advice at the right time.

A good many years ago, I ran a finance company with a specialist insurance agency. There was sufficient volume of business to consider forming a captive insurance company. This would increase margins by reducing the number of intermediaries between customer and underwriter, and give us direct access to the wholesale insurance market.

The captive operation required an insurance licence, and the key requirement for obtaining the licence was a financial model proving the concept to the regulator. I'm going to talk about this model, because it used some unusual techniques and the insurance industry itself (the Lloyds market) had some fascinating aspects which emerged during my research.

Dealing with probability and uncertainty
The first difference between insurance and normal businesses is that margins can't be assumed. Usually, cost of sales can be estimated fairly accurately. In the insurance business, claims are the cost of sales, and claims are inherently uncertain. This unpredictability is the reason we need insurance in the first place.

To deal with the uncertainty, I assumed a portfolio of assets at risk, estimated the average loss rate and assumed a normal distribution of claims above and below the average. I then used a random number generator to select a loss profile for each iteration of the model. This is a simulation technique that I have seldom found a need for since.

There were some weaknesses in the loss estimating process because of the surprising lack of statistical data - more on this later. However, the average loss rate could be inferred from the premium rates, which were long established, and the regulator seemed happy with the assumed standard deviation.

So far so good - the claim costs were calculated for each iteration and the premium income came direct from the assumed portfolio of assets at risk.

Insurance - the value proposition
It's useful at this point to step back and assess the insurance industry as one would for any new business.

First, what need is being addressed? Clearly, people would like to eliminate any possibility of a really serious or catastrophic loss, even one of very low probability. Peace of mind is something people will pay for. 

Second, what value proposition is being delivered? The insurance market is a risk pooling mechanism that gives individuals access to the average loss rate for the whole risk pool. People can choose to pay something related to the average loss every year, rather than risk losing their entire asset in any particular year.

This pooling mechanism is costly to set up and manage, and good profits are essential to its continued existence in the private sector. Therefore, premiums will always exceed losses, and this fact raises other issues.

When to insure?
This can be a question large businesses need to address, and answering it gives further insights into the insurance industry.

There are some conditions that need to be present for insurance to make financial sense for the customer:

• The potential loss should be serious - threatening the existence or profitability of the business
  
  
• The probability of the event should be low

For example, I am aware of a large company with around 1,000 premises used in their business. If any of these were destroyed by fire, there would only be a minor disruption to the business and the cost of rebuilding would be relatively insignificant. Therefore, these premises were self insured, as the fire premiums would normally exceed the losses, year-on-year. 

However, this company had three premises that were critical to around 30% of their total revenues. Losing this revenue would have been very serious, so this risk was insured.

Reinsurance
Back to the model.

We have our revenues and our uncertain cost of sales - profits in some years but unsustainable losses in others. To ensure its long term viability, the captive insurance company has to plug into the pooling mechanism of the insurance market and spread the risks it assumes. This is what the regulator was checking into and is what the model had to demonstrate.

Risk sharing was achieved through suite of reinsurance treaties which I will describe below. This is the wholesale insurance market - insurance companies insuring each other. It is a whole new world of specialist policies, concepts and language that the ordinary business person never has reason to see.

Quota Share reinsurance - the reinsurer takes a percentage of each and every claim - up to a specified maximum for any individual claim - and receives the same percentage of the premium, less a generous discount for cost of business acquisition and administration. This is the working level of reinsurance and is simple to model.

Risk XL (excess of loss) reinsurance, in three bands. The reinsurer pays every individual loss between upper and lower limits (after earlier reinsurance has paid out). The reinsurance premium is a minimum percentage of total premium income, increased if needed so that the reinsurance premium is at least the average burning cost (claims) over a stated period of years, plus a margin for costs and profit.

There were separate specialist Risk XL underwriters for the different risk levels. The First XL reinsurer expected losses every year and had the lowest averaging period. The higher level XL specialists had longer averaging periods and expected few or very few claims.

As I started my research, I expected to find plenty of statistical evidence for the premium ratings. However, I found none. The underwriters simply used loss experience gained over many years, and a cost-plus-margin approach to pricing.

Modelling Risk XL required many years of claims history and I achieved this by using the Escalator Table, which I describe later.

Quota Share and Risk XL were the main reinsurance treaties. There were several others to cover various eventualities.

Catastrophe reinsurance covered claims where a single event, like a fire or a plane crash, wiped out a number of insured assets at the same time. The premium principle was the same as for Risk XL. Stop Loss reinsurance covered a situation where total claims exceeded total premium income by a small margin, and covered losses from this point up to say 150% of total premium income. The reinsurance premium was again a percentage of total premium income.

A proper set of reinsurance treaties should prevent the insurance company running out of cash no matter what losses emerge. 

Again, I expected to find detailed statistical workings being used by underwriters to prove their reinsurance strategies. Instead, I was offered a single rule-of-thumb, which was clearly the result of centuries of experience in the Lloyd's insurance market, dating back to the days of marine policies written in Lloyd's coffee house. The rule was: "never allow any single retained loss to exceed 4% of your total premium income". Remarkably simple. When I tested it with my model, it proved reliable. If I allowed a situation to exist where one loss could exceed 4% of premium income, then sooner or later, with enough iterations, the company became insolvent. Otherwise, it never did.

The Escalator Table
To run the model over many iterations (years), I used what I will term an Escalator Table, since a down escalator gives a visual analogy of how it works.

When my model was complete - with administration costs, profit and loss account, balance sheet, cash flow, reinsurance calculations, etc. - I set up a table with columns for all the main figures, including cash balances and reinsurance claims. 

The top row of the table picked up these figures every time the model was recalculated. Every recalculation produced a new claims scenario and a new profit or loss and cash flow. The top row of the table was the top step of the escalator.

I then copied the whole table and pasted it down one row. A new recalculation produced a new top row. Repeating this gave a further year's experience, with each earlier year moving further down the escalator.

I used a 50-year escalator. When the initial year reached the bottom, it disappeared when overwritten. I created a simple macro to repeat the process 50 times and make a completely new 50-year simulation. In the technology of the day, the simulations would take several minutes to work through.

The reinsurance premiums were calculated using the escalator table figures for the claims history. The cash and profit figures for the balance sheet picked up their opening figures from the previous year in the table.

It was fascinating to watch the years roll out when the simulation was running. Large losses would appear, the reinsurance costs would go up and the profits would be affected. Then the reinsurance claims would drop out of the average calculation and things would improve again. When properly set up, the cash balances would stay healthy.

The model was ultimately audited by one of the large accounting firms, the application went in and the insurance licence was obtained. 

I am sometimes asked this question by people starting a business or bringing in partners. "My company has standard articles of association - is this enough?"

I've been involved in businesses and have advised others, both with and without a shareholders' agreement. Some have worked fine, but issues have arisen with others.

The problems can arise when certain things happen:

• An individual's circumstances can change and their attitude to the business alters accordingly. This can affect their view on salary, dividends, investment, growth strategies, risk taking, sale of the business, etc.
  
  
• A transaction or event emerges that was not envisaged at the start, or was not properly considered - a founder wants to leave, an offer is made for the business, a founder wants to sell his/her shares, etc.

Sorting out these issues is much more difficult when they are happening and emotions are running high. It's better to work through the issues at the start, when everything is theoretical.

This can be the main benefit of a shareholders' agreement. The agreement deals with a series of future scenarios, and the signatories discuss these thoroughly and work out their views with the help of experienced advisers.

Another advantage is that the shareholders' agreement is private, while articles of association are a public document, filed in the Companies Office.

Entrepreneurs may encounter a shareholders' agreement for the first time when negotiating investment from an experienced angel investor or venture capital fund. Investors have cash at risk and are detached from day-to-day management, so need additional protection.

Typical matters covered in a shareholders' agreement are a list of important actions that require a particular majority decision, plus share dealing terms - offer round, tag along and drag along. I may cover these in future posts.

So, do I believe a shareholders' agreement is a good idea? The answer is yes, but make sure you do the thinking properly at the start.

This blog will focus on business and financial issues. I welcome comments and interactions on anything discussed or on related matters.

I'm going to moderate comments to eliminate anything objectionable or off-topic. If I do this, I will flag it with reasons.