Giving IP its due

As intellectual property increasingly is seen as an essential part of a company's business, due diligence on a potential acquisition target's IP is now often another box to be checked on the pre-acquisition ?to-do? list.

The nature of IP-related liabilities, and consequently the nature of IP due diligence, is quite unique from that of other types of risks covered in a typical M&A due diligence endeavor. The challenge of performing due diligence on the IP issues in a potential investment is that a massive amount of information is available – the liability often resides in the risk of overlooking the pins in the proverbial haystack.

For private equity general partners and other types of acquires who want to ensure that they will not tread upon someone else's IP rights, there is a vast and growing body of information to sift through. There are also many new potential competitors to keep on surveillance, namely anyone with an interest in patenting something to which access could be essential given the nature of the business. The emergence of so-called ?patent trolls,? whose key objective is to look for and obtain patents, then sue the typically unwitting ?infringers? of those patents, has added further complexity to IP due diligence.

?As soon as something becomes commercially successful, you are going to have people that will try to work around your IP or may knowingly infringe upon your IP,? says Penny Attridge, director of intellectual property development at Quester, a UK-based venture capital firm. ?Or, they may come up with a completely different invention that substitutes or bypasses your IP.?

Given the vast and rapidly changing nature of IP, conducting this aspect of due diligence can be a costly and time-consuming process, and there is no real one-size-fits-all approach. However, there are a few pointers to keep in mind when approaching this issue that can help make handling an IP inquisition somewhat less burdensome.

Know thy market
It has become fairly common knowledge that liabilities can lurk within a target company's IP base, but the particular types of exposure – and best ways of addressing such risks – can vary widely depending on the market in which one is active.

For instance, Darby Technology Ventures (DTV), the Latin America-focused venture capital fund of Washington-headquartered emerging markets investor Darby Overseas Investments, often encounters the issue of IP protection when making acquisitions in jurisdictions where IP rights are less enforceable than, say, in the US or Western Europe.

In addition to re-domiciling acquired companies in the US, Darby also requires the companies in which it invests ?to have initiated the patent process not just in their home countries, but also in the US,? says Jonathan Whittle, a principal at DTV. ?If they are going to do business elsewhere, they will also need to adopt an international patent strategy. From an emerging markets perspective, we want to see that these companies' IP assets are adequately protected – not just locally, but internationally as well.?

Meanwhile, in the very early-stage sector, scientists are often strapped for cash and have limited resources available for protecting or defending their IP rights, says Attridge. Here, the problems most likely to arise are typically related to the verification of ownership and inventorship, says Attridge. ?As soon as something becomes successful, the [IP rights] become open to challenge. Therefore, you need to know where the IP rights are and what the issues are. If there has been a dispute about inventorship or ownership, IP due diligence will hopefully uncover this.?

?In all technology sectors, the investor environment and the acquisition environment has continued to become more sophisticated on issues relating to IP, particularly in an active patent litigation climate,? says Cestjon McFarland, a partner and IP attorney at the Seattle office of law firm Preston Gates & Ellis.

Referring in particular to cases where companies have spun out of universities, Attridge says: ?Intellectual property issues that come to light can have a devastating effect on the valuation of companies. If something comes to light, it seriously damages the relationship if it is felt that the licensor [of the IP] did know that there were issues and that they were not revealed to the licensee. It may so damage the relationship that the licensee may terminate the license due to breach of contract.?

Just as IP liabilities can compromise the value of a business, having well protected IP rights can boost a company's worth. Because the road to obtaining a patent can be a long one, it is rare for an early stage investor to be able to invest in a company that already holds a patent. ?You can get a good read on what the reasonable prospects are for being able to secure a patent, but the process of obtaining a patent can take several years,? says Whittle. ?If a company has already secured a patent, and that patent is for a technology in an industry that is growing rapidly and is dependent on that technology, then the company is probably going to get a significant boost to valuation because it has real leverage on the market.?

Cost considerations
IP due diligence tends to be an effort where you get what you pay for. ?The cost of IP due diligence depends on the size of the company, how long it's been in business, how many contracts are in place, and other considerations,? says Mark Wittow, another Seattle-based partner in Preston Gates' IP group. ?The acquiring company needs to look at how the [target's] IP was developed or acquired and how the company is distributing or otherwise using that IP, as well as examining patents, trademarks, copyrights and trade secret protection.?

One area of concern in any acquisition is that the asset in question might infringe someone else's IP. Conducting a ?freedom to operate? analysis can be a very expensive process, as well as highly time-intensive. While some companies – particularly those in the hardware and biotechnology arenas – may undertake patent searches fairly religiously, in other industries, it might not be a common practice, as McFarland notes. ?They simply wait until they receive notice of infringement before they take steps to address the issue.?

Small companies in particular often do not have the funds to engage in freedom to operate analyses. ?Acquirers have to take that into consideration when thinking about whether to make the purchase,? says McFarland. On the other hand, he adds, being exposed to patent suits can be hugely expensive as well – particularly for companies that are smaller in scale.

Two areas where it is particularly common for problems to arise are employee agreements and independent contractor agreements. ?You can have a huge problem arise from a one or two sentence clause in an agreement,? McFarland says. ?For a company to properly own a patent developed by its employees, it often needs to have appropriate language in its employment agreements that addresses state law concerns about employer over-reaching to inventions developed outside the scope of employment. If independent third parties develop the IP for you, you worry also about how your agreements with outside contractors address the ownership of that IP.?

While it is unlikely that an IP due diligence effort will provide an absolutely accurate assessment of potential exposure to IPrelated liabilities, it does offer at least a modicum of comfort that may be important not only for an entity considering making an acquisition but also for other parties that may become involved in the company further down the road, be it as coinvestors, debt providers, or buyers.

?It's really a question of knowing what you're getting,? says Quester's Attridge. ?No IP due diligence is rock solid and invincible, but it helps you to know what the strengths and weaknesses are of the IP in question so you can make a sound decision.?

Adds McFarland: ?A lot of times, M&A attorneys will assess legal acquisition costs based on how much an acquirer plans to pay for the target company. IP is different – even the smallest acquisitions can have significant IP problems that take time and money to work out.? Therefore, the legal fees associated with IP due diligence work on a small, problem-laden acquisition could be similar to those for a less troubled, medium-size investment.

?IP due diligence is not only about spotting the problems, but also how to fix them if they are not insurmountable,? stresses McFarland. ?It helps in developing a strategy for repairing or revising what is causing the problem.?