Letter of Intent
Assuming your discussions with the Target company are progressing well, it's time to prepare a letter of intent (LOI). This document sets out the core business parameters for the deal: who is buying what, the purchase price, any phased payment process for the purchase price, expectations surrounding employees, and other key deal points.
How long should the LOI be? I've worked with short ones (i.e. two pages long), and lengthy ones (i.e. north of 15 pages). The length will of course be a function of the complexity of the deal. The more moving parts to the transaction, the longer the LOI. Also, some parties find it useful to highlight in the LOI a number of the key provisions that they will expect in the definitive purchase agreement. This can greatly reduce negotiation time later on. On the other hand, it can also bring the deal to a grinding halt, so in each case you have to think through the strategic and tactical ramifications of a short versus lengthy LOI. To do this well, legal counsel needs to understand the objectives of the parties, the negotiating dynamics, and other important factors.
Should the LOI be binding? That depends. In some cases the parties want a document that is truly binding, save and except for the satisfaction of one or more conditions. In this case, you are really not talking about an LOI, but rather something like a memorandum of understanding that is binding in and of itself, whether or not it is superseded by a lengthier document.
The typical LOI, however, is not binding as to the terms of the deal, but merely reflects the thinking about price and other key factors, all of which are not carved in granite until a definitive purchase agreement is signed. Nevertheless, the deal points in an LOI do represent an important psychological commitment to most business people, and in my experience, relatively few LOIs do not result in concluded deals. Thus, notwithstanding its non-binding nature, you must take the LOI very seriously. It is a small high-tech M&A community. Any person that walks away from signed LOIs with regularity will soon be cut out of the all-important deal flow.
Even when the general points of an LOI are non-binding, certain aspects of it are made legally effective, such as the requirement that parties keep each other's information confidential. A Target often extends this to include that the prospective purchaser not be able to hire or solicit any of the Target's employees for a period of time if the deal does not proceed.
Another typical binding provision is the so-called "no shop" clause. This requires that the Target negotiate only with the other party to the LOI for a period of time, typically in the 30 to 90 day range. This exclusivity gives the preferred acquiror comfort that, although the success of its own deal is not assured, the Target will not be scooped by someone else for a period of time.
Due Diligence
So the LOI is signed and the (usually purchaser's) lawyer has begun to prepare the definitive purchase agreement. This is the time when you will undertake vigorous "due diligence" on the Target, the process by which you review intensely the operations, financial condition, intellectual property and other important aspects of the Target.
In many respects, the diligence you undertake on a high-tech company is similar to the process you would follow with any type of business. A key difference, though, relates to intellectual property, often the crown jewels of a high-tech company. What follows are specific diligence tips for various high-tech assets.
Patents. Patents are the trump cards of the intellectual property world, inasmuch as they can afford effective exclusivity, and in certain cases monopoly profits. Importantly, independent creation is not a defence to a patent claim, so patents are indeed the strongest form of intellectual property protection. And while patents were once restricted to the mechanical devices in high-tech products (i.e. the head reading component in a disk drive), today, especially in the United States (the key market for any technology company), patents are being granted for software features and even methods of doing business over the Internet.
Accordingly, conducting comprehensive diligence on a technology company's patent portfolio is important. Are the patents in good standing? Has the Target filed corresponding patents in key foreign markets? And what is the overall scope of protection of the patent portfolio? Is it broad or narrow? In effect, what is the economic value of the patent portfolio?
If the Target does not have registered patents, a patentability search may be appropriate, both for defensive and offensive reasons. The former refers to the risk that the Target's products or R&D infringes a third party's patents, even if other patent owners have not yet asserted demands. The latter refers to the potential economic value to be reaped by the purchaser of the Target if the Target's technology is patentable.
Copyright. If the Target's key products are software-oriented, the diligence process will want to review the copyrights in such programs. There are voluntary copyright registration systems in Canada and the U.S., and searches should be conducted in both. The copyright in most software, however, is not registered, and even if it is, a thorough "author-based title search" should be undertaken anyway.
Copyright in software and related documentation arises when people (i.e. software programmers, technical writers, etc.) create the program or write the documentation. Thus, you will want to be sure that anyone who contributed to the copyright materials, whether they are employees or contractors (or employees of contractors), has, either by operation of law (in the case of copyright-but not moral rights-employees who create works in the course of their employment) or typically by contract, transferred their copyright, and waived their moral rights, in the relevant work.
Trade Secrets. Software and other technology assets can also contain trade secrets. There is no registry system for trade secrets. Therefore, it is a case of reviewing the Target's information handling practices to ensure they have taken the steps necessary to preserve the secrecy that judges look for to satisfy a trade secret claim. These include: physical security of the premises (i.e. locked doors and filing cabinets); computer/network security; and contractual protection through confidentiality provisions in employment, customer and other agreements with third parties that are given access to the trade secret.
Trade Marks/Domain Names. Trade marks can be protected at common law (under the doctrine of passing off), or, preferably, under the relevant country's national trade mark registration regime. Therefore, as with patents and copyrights, searches of the national registry (in at least Canada and the U.S., but possibly other key markets as well), will be in order, again for both defensive and offensive reasons. Of course, judgment has to be exercised here as with all aspects of the diligence review; if the Target's products will be re-branded with your own marks, then the whole question of trade mark diligence is downgraded in importance.
Do not forget about the relatively new mark-related asset, the Target's domain name, either in the .com, .ca or other space. As these registrations become critical for the Target's Internet presence, they are acquiring ever increasing value. Indeed, if the Target is an Internet portal or similar service provider, the domain name may be a key asset. Generally, however, a registered trade mark for a particular good or service can override a domain name registration in a similar line of business. Thus, if the Target only has domain names, you have to review carefully who owns the corresponding off-line trade mark registrations.
Web Site. If the Target is a dot-com or an Internet participant whose primary business is operating a Web site, then you will want to look closely, as part of diligence, at the license or other rights that the Target has for all the material, software and content on its Web site. Also very important will be the Web promotion, licensing and related agreements that the Target has in place buttressing its business. These types of material contracts can be the heart and soul, both operationally and economically, of the Target if they are in the Internet space.
Software Products. Besides the core intellectual property issues discussed above, other questions regarding software (and often other technology-based assets) have to be pursued during diligence. What third party software is used to create, or indeed are embedded in, the Target's products? It is rare for any software product to be built from scratch nowadays. As a result, understanding what belongs to the Target, and what is merely licensed by the Target (with technical and financial implications) becomes important.
Also relevant will be exploring thoroughly the quality of the technology, in terms of known problems, customer concerns, support processes, and possibly key development plans (i.e. are you buying a stable but leading-edge product, or a soon to be obsolete program that will need an entire rewrite within days of your purchase?). Obviously the findings related to these matters will drive the discussions surrounding purchase price, or may cause you to reconsider the deal altogether.
A further area in need of diligence-related analysis relates to the exploitation of the software product. Have any customers been given access to source code, the highly sensitive crown jewels of the program, or have OEMS, VARS and other acronyms been given distribution rights, particularly of an exclusive nature for any geographic or vertical market? Again, the exercise is a variation on Plato's adage, "the truth shall save you money, time and (hopefully) grief."
Process. From even this brief discussion, it is readily apparent that proper diligence takes time. Therefore, start as soon as possible. And be methodical. Compile notes and observations in a structured, organized manner; this investment will pay solid dividends when you have to integrate the Target after the acquisition.
So, you have completed the diligence review, and you still want to buy the Target. Next month, a discussion of the agreement used for this purpose.
George S. Takach is a partner in the Toronto office of McCarthy Tétrault, where he is Head of the High-Tech Law Group. This column is intended to convey brief, timely but only general information and does not constitute legal advice; readers are encouraged to speak with legal counsel to understand how the general issues noted above apply to their particular circumstances.