The Private Equity Analyst Guide to Venture Capital and Private Equity Attorneys
2002 EDITION
REPRINTED FOR GOODWIN PROCTER
The Private Equity Analyst | Guide to Venture Capital and Private Equity Attorneys
Strategies for Conducting Intellectual Property Due Diligence
B Y M ARY J. H ILDEBRAND
AND
J ACQUELINE K LOSEK , G OODWIN P ROCTER LLP
E
VEN IN A SLOW- GROWING ECONOMY,
a sound investment strategy can yield substantial rewards. But it is as important as ever to manage risk effectively. In the postSeptember 11, post-Enron era, investors take a lot more care in assessing risk. Financial information—even if it is certified as accurate by third parties—is inherently regarded as unreliable in many sectors. Thus, as private equity firms contemplate potential investments, the due diligence process has assumed greater significance.
any merger, acquisition or investment. Properly conducted, intellectual property due diligence provides a prospective investor with detailed information about the intellectual property of a potential portfolio company that may affect pricing or other key elements of the proposed transaction. In certain circumstances, the effort could lead to the termination of a proposed investment. As described below, the consequences of mismanaging or ignoring intellectual property due diligence can be severe. Without the proper investigation into a company’s assets, an investor may find, after the deal is already concluded, that the company does not own the sought-after intellectual property, or that it has been transferred to third-parities, or encumbered by third-party interests or litigation.
A thorough due diligence involves examining not only the financial information of a company, but also the company’s key assets. For the vast majority of enterprises, this means a review of the intellectual property assets of the target company—especially give that the economy is more and more technologically driven. Needless to say, a review of intellectual property is especially important when the target company operates in the technology sector. While current economic conditions remain challenging, the technology sector continues to be the key industry for capital investments. In the first quarter of 2002, for example, investments in the technology sector accounted for 71% of total investments by U.S. venture capital firms. Even traditional bricks-and-mortar enterprises own and rely upon intellectual property as an integral component of their businesses. Examples range from the ingredients and manufacturing process for Coca-cola, a closely guarded trade secret, to the many domestic and international trademarks owned by Colgate-Palmolive and other multi-national conglomerates. 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
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 has 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 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 rule, investigating a startup dot-com, in business for one year after raising and spending $50 million on an array of different business initiatives, would present a much different challenge from investigating 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 key components.
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The Private Equity Analyst | Guide to Venture Capital and Private Equity Attorneys
Key Components of Intellectual Property Due Diligence
1. Identify and locate intellectual property. An initial goal of intellectual property due diligence is to identify and locate the intellectual property assets of the target company. This list may be incredibly varied depending on the nature of the business, and can include patents, patentable subject matter, copyrights, trademarks, domain names, trade secrets, mask works, inventions, works of authorship, hardware and devices. Of course, some assets require closer evaluation and analysis than others due to various factors including complexity, competition and foreign registration of the assets. 2. Learn the nature and scope of the claimed rights in the intellectual property. The target company’s rights could range from outright ownership to a license to use intellectual property, with many gradations in between, including contingent rights in intellectual property to be developed in the future. 3. Evaluate the validity of the target company’s rights in the intellectual property. This means making a judgment about the relative strength of rights claimed by the target company. Special care should be taken to ensure that the target compay’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 intellectual property infringement claims. This exercise includes analysis of situations where either the target company’s intellectual property assets may infringe a third party’s rights, or the target company has a valid 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 company to third parties. This analysis includes the examination of licenses, distribution agreements, reseller arrangements and any other transaction by the target company that involves a transfer of rights in the intellectual property that may impact the value of those assets. As an example, if the target company 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
• Include intellectual property experts in the due diligence team. Prior to starting intellectual property due diligence, make sure the proper team is in place. The legal team that undertakes intellectual property due diligence must have a basic understanding of the primary product lines, business environment and future plans of the target company 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. • Ensure that the intellectual property due diligence plan reflects the importance of the deal. Once the proper team has been assembled, the next step is to develop a well-drafted intellectual property due diligence questionnaire designed to assist in identifying areas that merit further inquiry—areas of genuine concern that are relevant to the business and/or the specific transaction at issue. • Take nothing on faith. Our firm recently worked for a client who was attempting to acquire a company 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 company’s business method. Not only did we find that the method 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 company. The company 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 to the questionnaire, the deal, and the business, further investigative activities may include 1) conducting searches in appropriate databases in all relevant jurisdictions to identify patent rights including pending or provisional patent applications, registered patents, registered copyrights and registered trademarks; 2) examination, analysis and verification of the results of such searches; 3) verification of claimed but unregistered intellectual property rights; 4) review and analysis of relevant provisions of executed agreements that could include licenses, consulting and confidentiality agreements, assignments and other
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The Private Equity Analyst | Guide to Venture Capital and Private Equity Attorneys
documents; 5) interviews with key business and technology development staff at the company and, where the situation warrants, with previous employees and consultants; 6) examination and analysis of potentially infringing registrations and third-party intellectual property rights; and 7) other efforts appropriate to the situation. • Confirm, confirm, confirm. In another matter, a client was investing $50 million in a company holding numerous patents. As part of 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: If the computerized search appeared to be accurate but was not and no further manual search was performed. This highlights the extreme importance of verifying information that is presented through more than one source. • Understand the relationship between the documents and the business. While it is important to examine all agreements, registrations, filings and other documents to ensure that they are valid, the legal team must establish a relationship between such documentation and the relevant intellectual property. We recently represented a client interested in acquiring a division of a company that held a large collection of patents. Prior to the investment, the division 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 division’s business. • Foreign laws may impact the deal. In recent years, the number of cross-border mergers and acquisitions has increased dramatically. This fact, combined with the reality that many people 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, recall 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, avoid making assumptions about such foreign assets based upon an under-
standing of U.S. laws and procedures pertaining to intellectual property. • Resolving intellectual property due diligence issues. The investigative stage is not likely to be the end of the intellectual property due diligence process. Consider a recent transaction in which we were involved, where a client was acquiring an Internet company. One of the main reasons our client was interested in the company was the software it had developed. During the course of the intellectual property due diligence, we discovered 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, nor did the consultants 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 importance of obtaining complete and accurate information before investing in a company. 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 can actually make or break the deal.
About the authors: Ms. Hildebrand is the Chair of the Intellectual Property/Technology Practice Area of Goodwin Procter LLP. She can be reached for comment at mhildebrand@goodwinprocter.com. Ms. Klosek is an associate in the Intellectual Property/Technology Practice Area of Goodwin Procter LLP and the author of the recently published “Data Privacy in the Information Age” (Quorum Books, Westport, CT, 2000). She can be reached at jklosek@goodwinprocter.com.
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