One Size Does Not Fit All: Tailoring IP Due Diligence to the Transaction
Investing in, acquiring, or partnering with companies in the San Francisco Bay Area requires a due diligence investigation, where intellectual property (IP) will likely play a major role. The adequate level of review largely depends on the individual situation, the investor or buyer’s strategic objectives, and the type of transaction.
Levels of IP Due Diligence
The depth and intensity of IP due diligence can vary widely and may require reviewing patents, trade secrets, trademarks, copyrights, semiconductor layouts, methods of doing business, special know-how, and product formulations. Further, if the target company owns IP in foreign countries, local counsel may need to review the additional and different types of IP. In addition to other areas of due diligence (e.g., litigation, including IP litigation), an IP review generally falls into four categories.
Level 1: Ownership & Right to Use
In almost all transactions, IP due diligence entails identifying and cataloging all IP owned or used by the target. If the target licenses relevant IP from or to others, the licenses should be reviewed. Potential limitations to the target’s right to use should also be identified, including if the IP is pledged or subjected to liens or other encumbrances, such as a loan or other transactional collateral. Licenses (or trademark co-existence agreements) that grant exclusive rights to certain entities also may be limited to territories or fields of use that may conflict with the buyer’s current or intended IP use after closing.
Level 2: Relevant IP Scope
Determining whether the subject matter of relevant IP actually and sufficiently covers the target’s current products and services may require additional analysis. Often the target company owns patents or trademarks for IP assets that it no longer uses, particularly if the products, services, or branding have developed and improved over time. In some instances, the IP may cover features of current products or services, but not the unique aspects giving them their competitive advantage. Likewise, patents or trademarks covering products in their current form may not hold up if the buyer wants to expand the brand into different markets or the shift the products into a different field of use.
Level 3: Validity & Enforceability
Sometimes, the reviewer needs to verify the patent’s validity by determining if it is novel, non-obvious, and if all formal requirements of a patent application are met. Patent enforceability in the U.S. may depend on different aspects, such as a patent owner’s equitable conduct in the prosecution history. Identifying inequitable conduct (e.g., intentionally not referencing problematic prior patents) is difficult and has become less important since the America Invests Acts allowed remedying such conduct.
Level 4: Infringement of Third-Party IP (Freedom-to-Operate)
Potentially, the most expansive analysis entails whether the buyer can conduct the acquired business in its anticipated form without infringing third-party IP rights (freedom-to-operate). This product clearance or right to use opinion identifies potential “blocking” patents, which may derail the buyer’s entire business strategy. As a side product, a freedom-to-operate study often identifies areas, where new patents can still be filed or where products can be further developed. Another side product includes elements of Level 3 review regarding invalidity. The freedom-to-operate study reveals if the Patent Office examiner, as often happens, missed some earlier invention that would invalidate a patent for lack of novelty or for obviousness.
Transaction Types & Levels of IP Due Diligence
Before deciding the appropriate levels of IP due diligence for investments and acquisitions, one needs to understand the deal structure and objectives of the IP due diligence.
Venture Capital Investments
Seed and angel investors may require little or no IP due diligence, partly because investments are often obtained before invention development and filing applications. Early in the product development cycle, some investors will require freedom-to-operate studies (Level 4). If the study shows that the product cannot be used without infringing existing third-party IP and leading to costly litigation, the investors might recommend product modification or not invest at all.
If the company already owns IP, investors often ask about the solidity of the company’s IP, which can require at least Level 1 and possibly some Level 2 review. Typically, one finds that company founders, employees, or consultants still own some IP, never having properly assigned it to the company. The diligence report then recommends executing IP assignments prior to closing. To protect their investment, some investors go further and require evidence showing that all filed patents do in fact cover the technology that provides the target company its competitive advantage (Level 2).
Asset Deals and Acquisitions of Business Units and Divisions
Cataloguing the relevant IP (Level 1) is crucial in an asset deal, where the buyer buys only the assets listed or identified in the asset purchase agreement. Here, recommending formal steps to perfect the IP transfer after closing is particularly important. For trade secrets, these steps also may require documenting clean contractual terms, backed by solid and specific representations, warranties, and indemnifications.
Even more crucial is when the buyer does not buy all company assets, but only those of certain business units or divisions within that company (carve-out transaction). If an IP asset goes unlisted or not sufficiently identified, it will generally not transfer to the purchaser. Interesting situations also arise when the seller uses some IP — often basis technologies — throughout its company and in many different divisions. For those “shared” IP assets, the acquirer must remember to negotiate non-exclusive, fully-paid paid-up licenses as part of the deal, thereby necessitating that due diligence requests include IP assets sold AND assets currently used.
In any acquisition, a Level 2 and 3 analysis proves useful in determining the acquired business’ value, as well as potential liabilities and expansion possibilities. For an established company, a Level 4 analysis is less important since it has sold the same product or service for some time without being sued.
Stock Purchase or Merger
In an acquisition by stock purchase or merger, it may be less critical than in an asset deal to accurately and completely list the target IP (Level 1), since the acquirer in a stock deal automatically receives all company-owned IP, whether it is listed or not. However, analyzing whether the company owns or licenses the IP is just as important, and for purposes of corresponding representations and warranties, schedules listing the IP are still useful. When a third party, including the seller’s group companies, owns technologies, it can be difficult or impossible to convince these individuals to assign or license any missing IP after the main transaction has closed.
By contrast, if a merger’s objective is to combine and synergize the two companies or develop new business opportunities, the IP due diligence should analyze any third-party IP that could hinder expansion into a new field (Level 4). This may entail tailoring the scope and depth of freedom-to-operate studies over a wide range of budgets depending on the deal’s importance — often a worthwhile investment, especially when the products yield a high margin or are produced in high volumes.
Going The Extra Mile
Determining when to go beyond the traditional scope of due diligence (Levels 1-4) often requires an in-depth analysis of the size of the target’s patent portfolio, its position relative to competitors, and new or untapped licensing opportunities. By understanding the client’s business objectives, the IP assets involved, and the transaction type, one can determine the right approach — whether a traditional due diligence or an even more strategic approach — for the most successful outcome.