While the current economic environment continues to be challenging, a sound investment strategy may yield substantial rewards. At the same time, however, it has become increasingly more important for private equity and venture capital firms to focus attention on managing the risks that may be associated with such investments. In the post- September 11, post-Sarbanes-Oxley era, there has been a dramatic shift in the way that individuals–as well as companies –assess risk. Previously, a certain quantity of risk was acceptable and was often even viewed as something that would likely like result in enhanced reward. After Enron, Worldcom and related debacles, investor confidence in financial information, including information certified as accurate by third parties, is inherently regarded as unreliable in many sectors. Thus, as general partners contemplate potential investments, the due diligence process has now assumed greater significance.
Conducting proper due diligence involves examining not only the financial information of a company but also assessing the company's key assets. For the vast majority of enterprises, this will necessitate a review of the intellectual property assets of the target company. The compelling need to conduct a thorough review of intellectual property assets (intellectual property due diligence) before engaging in investments is being influenced by a number of factors including the fact that the economy is technologically driven. While intellectual property due diligence will be essential in connecting with an investment in virtually every type of target company, it is especially significant where the target is involved in the technology sector since in this industry, most products and services will involve intellectual property assets. In today's environment, this is key given the amount of investment in enterprises in the technology field. While current economic conditions remain challenging, the technology sector continues to be the key industry for capital investments. In the first quarter of 2003, for example, investment in the technology sector[1] accounted for 63% of total investments[2], up slightly from 56% in the first quarter of 2002 according to VentureOne Data.
Still, although the importance of intellectual property due diligence in the technology sector cannot be denied, intellectual property due diligence should not be limited to transactions involving the technology sector. Even companies engaged in traditional bricks & mortar enterprises own and rely upon intellectual property assets as an integral component of their business. Examples range from the ingredients and manufacturing process for Coke, a closely guarded trade secret, to the many domestic and international trademarks owned by multinational conglomerates such as General Electric. The process of identifying all intellectual property assets, verifying ownership and ensuring that such assets are free of encumbrances for the intended business use is fundamental to any merger, acquisition or investment.
Properly conducted intellectual property due diligence should provide a prospective investor with detailed information about the intellectual property assets of a target that may affect pricing or other key elements of the proposed transaction or, in certain circumstances, even recommend termination of proposed investment. As described below, the consequences of mismanaging or ignoring intellectual property due diligence can be severe. Without the proper investigation into an entity's intellectual property assets, an investor may find, after the deal is already concluded, that it does not have ownership of the sought-after intellectual property assets or that the intellectual property assets have been transferred or encumbered by third-party interests or litigation.
The Goals of Intellectual Property Due Diligence:
Just as business transactions vary, the nature and scope of intellectual property due diligence in a given deal will have its own characteristics and requirements. Among other factors, intellectual property due diligence will be affected by the target company's policies and practices related to document retention and organization, registration procedures and the location of the intellectual property assets, as well as the length of time in business, the maturity of the management team and the target company's industry environment. As a general proposition, a start-up in business for one year after raising and spending $50 million on a series of transactions, employees and consultants for an array of different business initiatives would present a much different challenge from an intellectual property due diligence perspective than a well established firm with stable legal relationships, form documents and a records library. Reality usually lies between these two extremes and, despite the discrete issues present in each transaction, the goal of intellectual property due diligence is always the same: protecting the investors. In our experience, this is best accomplished by focusing on the following five areas.
1. Identify and locate intellectual property assets of the target. An initial goal of intellectual property due diligence is to identify and locate the intellectual property assets of the target. This list may be incredibly varied depending on the nature of the business, but could include patents and/or patentable subject matter, copyrights, trademarks, domain names, trade secrets, mask works, inventions, works of authorship, hardware and devices. Of course, some intellectual property assets require closer evaluation and analysis than others due to various factors including: complexity, competition and foreign registration of intellectual property assets.
2. Ascertain the nature and scope of the target's claimed rights in the intellectual property assets. The target's rights could range from outright ownership to a license in the intellectual property assets, with many gradiations in between including contingent rights in intellectual property to be developed in the future.
3. Evaluate the validity of the target's rights in the intellectual property assets. Essentially, this means making a judgment about the relative strength of rights claimed by the target. Special care should be taken to ensure that the target's actual rights comport with its representations to the potential investor and are sufficient to permit continued operation of the business without interruption.
4. Evaluate any potential intellectual property infringement claims. This exercise includes analysis of situations where (a) the target's intellectual property assets may infringe a third party's rights, and (b) the target has a valid (or even a colorable) claim of infringement against a third party. Either circumstance has the potential to seriously disrupt the operation of the business.
5. Analyze any grant of intellectual property rights made by the target. This analysis would include licenses, distribution agreements, reseller arrangements and any other transaction by the target that involves a transfer of rights in the intellectual property assets that may impact the value of those assets. As an example, if the target had granted an exclusive license to its primary invention for a period of five years, a business plan that contemplates issue of additional licenses for the same technology would not work.
Tips in Conducting Intellectual Property Due Diligence:
1. Include intellectual property experts in the due diligence team. Prior to commencing any intellectual property due diligence, effort should be directed to ensure that the proper team is in place. As a threshold matter, the legal team that undertakes to conduct intellectual property due diligence must have a basic understanding of the primary product lines, business environment and future plans of the target to ensure that the team remains focused primarily on the intellectual property assets that are relevant to the business. Since the intellectual property due diligence team will participate in the investor's evaluation of a proposed transaction, it is also essential that the team understand the relative importance of the proposed investment to the client. Early familiarity with these issues should enable the legal team to contribute to the entire process in a meaningful way.
2. Ensure that the intellectual property due diligence plan reflects the importance of the deal. Once the proper team has been assembled, a necessary step is to develop a well-drafted intellectual property due diligence request that will use questions that are designed to assist in identifying areas that merit further inquiry as evidenced by a positive response. By the same token, a negative response to certain questions permits the legal team to move on to areas of genuine concern that are relevant to the business and/or the specific transaction at issue.
3. Take nothing on faith. Our firm recently dealt with a matter in which a client was attempting to acquire a target whose main asset was a business method for processing insurance claims over the Internet. As part of our efforts, patent counsel did a search on the target's business method. Not only did we find that the target's invention might be infringing another patent, we also found that there was active litigation between an entity that was holding a patent on a similar method and another company using a method similar to the one used by the target. The target later admitted that they had discussed this issue with other attorneys. They did not, however, disclose it in response to the intellectual property due diligence request.
Depending on the nature of the responses, the deal and the business, further investigative activities may include (a) conducting searches in appropriate databases in all relevant jurisdictions to identify patent rights including pending and/or provisional patent applications, registered patents, registered copyrights and registered trademarks, (b) examination, analysis and verification of the results of such searches, (c) verification of claimed but unregistered intellectual property rights, (d) review and analysis of relevant provisions of executed agreements that could include licenses, consulting and confidentiality agreements, assignments and other documents, (e) interviews with key business and technology development staff at the target and, where the situation warrants, with previous employees and consultants, (f ) examination and analysis of potentially infringing registrations and third-party intellectual property rights, and (g) other efforts appropriate to the situation.
4. Confirm everything. In another matter, our client was making a $50 million investment into a target company holding numerous patents that were of interest to our client. As part of our intellectual property due diligence, patent attorneys conducted a computerized search of the relevant patents. This search revealed that the ownership interests were not what we expected them to be. As is our custom, this initial computerized search was followed with a manual search. The manual search of the actual documentation revealed that the ownership interests were indeed as they were expected to be and that the computerized search was erroneous. In this case, the inaccuracy in the computerized search was the result of a secretarial error in preparing the filing documents. Consider, however, the results if the opposite had occurred, that is to say, that the computerized search appeared to be accurate but was not and no further manual search was performed. This highlights the importance of verifying information that is presented through more than one source.
5. Understand the dynamic relationship between the documents and the core business. While it is extremely important to examine all agreements, registrations, filings and other documents to ensure that they are valid, the legal team must clearly establish a relationship between such documentation and the relevant intellectual property assets. We recently represented a client that was interesting in acquiring a division of a target that held a large collection of patents. Prior to the investment, the target provided us with voluminous documentation purportedly pertaining to its patents. However, an inspection of the documentation revealed that the information provided concerned patents that had nothing to do with the target's core business.
6. Foreign laws may impact the deal. In recent years, the number of cross-border mergers and acquisitions has increased dramatically[3]. This fact, combined with the reality that many individuals developing intellectual property assets for American companies are from outside of the United States, increases the likelihood that intellectual property due diligence will involve review and analysis of non-US intellectual property assets. When analyzing such assets, it must be recalled that few countries treat intellectual property in the exact same way and rights often depend on complex treaties and conventions executed by and among many different nations. Accordingly, it will be important to avoid making assumptions about such foreign assets based upon an understanding of US laws and procedures pertaining to intellectual property.
Specific Recommendations By Category of Intellectual Property Asset:
The nature and extent of the due diligence inquiry will depend on the type of intellectual property rights involved. Generally, intellectual property rights can be broken down into four main categories: patents, trademarks, copyrights and trade secrets. Each class of intellectual property rights will necessitate the use of different methods of review. This section presents recommendations for steps that should be taken when reviewing intellectual property assets in each of these classes of rights.
Patents:
- Review all issued, pending and abandoned patent applications and patents in the United States and in foreign countries. Such review should include not only those patents owned by the target but also those previously owned or licensed by the target.
- Examine all patent searches conducted by or on behalf of the target in relation to the inventions of the target.
- Confirm that all issued patents are being properly maintained and that the target is current with all maintenance fees.
- Review and evaluate all threatened or pending interferences.
- Evaluate the scope and nature of any transfer of rights by evaluating all relevant agreements including licensing and manufacturing agreements.
- Investigate the underlying technology of the target.
Trademarks:
- Examine all trademarks and service marks used by the target.
- Examined all trademarks and service marks registered by the target in the United States and abroad.
- Examine both the geographic area of use and the date of the first use of the mark in the given territory.
- Examine the prosecution files for any registrations of pending applications and examine all trademark searches performed in connection with such pending applications.
- Review all quality control manuals files or guidelines relating to goods or services sold under the marks.
- Review all trademark licenses, not only through trademark license agreements but also through all other types of agreements that include trademark licenses, including, for example, co-branding agreements and marketing and distribution agreements.
Copyrights:
- Review all copyrighted works that the target has created, commissioned or to which it has acquired rights.
- Evaluate all work-for-hire agreements and contracts relating to consulting services and development work.
- Review all documents concerning copyright registrations, including applications, correspondence, transfers and security interests.
- Review all licenses related to copyrighted works used by target.
- Review and evaluate the target's policy for identifying and protecting its copyrights in works it develops or has developed for it.
- Review and evaluate the efforts undertaken by the company to avoid claims of copyright infringement and obtain proper copyright clearances.
- Identify and evaluate all actual or pending claims of copyright infringement asserted against the target.
Trade Secrets:
- Obtain an inventory of all material trade secrets utilized by the target.
- Determine whether non-disclosure agreements have been executed with key employees, consultants and other individuals or entities having access to the target's confidential information.
- Determine whether non-compete agreements have been executed between the target and its key personnel.
- Review employment records of key personnel.
- Consider the impact of recent arrivals and/or departures of key personnel.
- Evaluate the adequacy of exit interviews.
- Evaluate security policies including physical, technical and administrative security procedures employed by the target.
- Review and evaluate all relevant agreements including know-how licenses and technical assistance agreements.
Resolving Intellectual Property Due Diligence Issues
It should be recognized that the investigative stage is not likely to be the end of the intellectual property due diligence process. This is clearly illustrated by a recent transaction in which we were involved. In this matter, a client was acquiring an Internet-based target. One of the main reasons for interest in this target was software believed to have been developed by the target. During the course of the intellectual property due diligence, however, it was revealed that the software was actually developed by the company's former consultants. Unfortunately, such consultants were not engaged under any type of written agreement that addressed the ownership of the intellectual property developed by the consultants for the target nor did they ever execute any agreements assigning their interests in the software to the company. As a result, it became necessary to track down the former consultants and obtain their agreement to an assignment of their interests in the software. This is only one example of the types of issues that will often have to be addressed post-audit.
Conclusions:
Recent events have underscored the obvious. It is absolutely essential to obtain complete and accurate information before making any investment. As we have seen, even information previously considered reliable, such as audited financial statements, may now require independent verification. With questions about business practices hanging over the heads of many companies and competition for limited investment funds at a very high level, it is even more important to conduct thorough and complete due diligence into all aspects of a company's operations including, notably, the intellectual property assets. At the very least, what is discovered during the intellectual property due diligence process can assist in the proper valuation of a given deal. Often, it goes much further than that. It can actually make or break the deal.
FOOTNOTES
1. The definition of "technology sector" in this context includes software, networking equipment, telecom, semiconductors, IT services, computers and peripherals.
2. See VentureOne data at www.ventureone.com.
3. Bernard S. Black, The First International Merger Wave (and the Fifth and Last U.S. Wave), 54 U. MIAMI L. REV. 799 (2000). LIBNJ/1105629.1