Importance of IP due diligence

December 2017  |  FEATURE  |  MERGERS & ACQUISITIONS

Financier Worldwide Magazine

December 2017 Issue

Protecting intellectual property (IP) assets should form an integral part of any company’s operations. To that end, companies must undertake robust IP due diligence in the event of an acquisition – whether carried out by a prospective purchaser in relation to the IP assets of the target business or by a company on its own IP assets in preparation for a transaction.

“Although due diligence may not be seen as the most important factor in a deal success, it is obviously an essential part of deal execution,” says Dan Tiemann, US Group Leader, Deal Advisory and Strategy at KPMG. “Without it, acquirers may be ill-prepared for what they have in store when they try to integrate their target. Effective due diligence helps to reveal risks and allows the acquirer to understand and tackle those issues pre-close.”

For a vendor, a structured approach to IP due diligence will maximise the value of its IP assets. For a purchaser, a failure to carry out IP due diligence could result in paying for assets that are worth less than originally thought. Properly conducted, IP due diligence will provide a prospective investor or merger partner with detailed information about the IP assets of a target that may affect pricing or other key elements of the proposed transaction or, in certain circumstances, even recommend terminating the business relationship altogether.

As more companies turn to M&A to drive growth, the importance of due diligence has increased. It is almost inconceivable that a company would approve any form of transaction without making a thorough inspection of the assets and engaging professionals to assess the risks. Pursuing a deal without conducting a thorough IP assessment of the target company should be unthinkable. IP assets, much like physical assets, must be documented and analysed prior to completion.

However, even when carried out attentively, IP due diligence is rarely straightforward. It presents acquirers with pitfalls and challenges which must be overcome if they hope to arrive at a proper valuation for a prospective target. Further, companies must think of IP due diligence as part of the wider risk management process. “As a buyer you are informing yourself about the risks of acquiring the IP, examining how to fix any risks and, where they cannot be fixed, to adjust the price to reflect the risk,” says Sean Jauss, a partner at Mewburn Ellis LLP. “As a seller you are ‘stress testing’ your IP. In doing so you understand the risks, fix what is possible, and if it cannot be fixed, create a suitable narrative justifying the price. In either case, you cannot understand the risk, and therefore the price, if you do not have suitable information. That information is gained through conducting due diligence. Due diligence should be considered an information gathering exercise. You are informing yourself about risk and therefore price, because price is a function of risk. Without that information you cannot develop appropriate risk mitigation strategies or correct the price to reflect risk which cannot be mitigated.”

Value of IP

For many organisations, IP assets, including patents, trademarks and copyrights, are their backbone. They can be leveraged in a number of ways to drive value. Primarily, however, they can be sold, licensed, mortgaged and grown. The value of a company’s IP can be derived from the way in which the company manages its assets. By aligning an existing IP portfolio with a clear, well-defined business strategy, companies can generate significant value from their IP assets.

Establishing ownership of IP is essential. Failure to do so can cause transactions to collapse and disputes to arise. Companies should ensure that their chain of title is clearly defined and documented. Ownership is often one of the first issues explored in an IP due diligence investigation, since it can be a deal breaker. Typically, a series of questions are asked about each piece of IP to establish the target’s rights and whether those rights are free of any encumbrances and can be fully transferred.

An up to date – and regularly maintained – IP register containing information on the status of IP will be beneficial. In the event of a transaction, an IP register will help the acquiring party conduct due diligence and can also help smooth the ownership transition. Further, it can add value to a company by making its IP assets clear and well-defined – an attractive proposition for would-be acquirers.

Businesses are now believed to double the amount of data they capture and store every 1.2 years – for many organisations, managing data related to their IP assets can be a challenge. Embracing data solutions will prepare them for an IP audit.

“It is becoming more popular to undertake landscape analysis of IP,” says Dr Jauss. “Big Data analysis can help to map out complex IP portfolios in a graphically easy to understand way. However, undertaking the analysis can be complicated and requires technical specialists. It is very important to ask the right questions; otherwise you run the risk of the old computer axiom: ‘garbage in, garbage out’.”

Companies must also make sure that their IP is protected in the right markets at all times. Prosecuting IP infringement is an integral part of this process.

Flaws in a seller’s IP management could have financial and reputational implications. The value of a transaction could be reduced if there are issues relating to ownership. Deals could be delayed or cancelled if, for example, a third party is discovered to co-own the seller’s IP. “The possibility that the seller is not entitled to its IP is by far the most common risk,” says Dr Jauss. “In particular, the use of outside contractors in the development of IP can cause entitlement problems, especially where there are no written contracts. Other common risks are poorly drafted or misunderstood licences, IP of questionable validity and IP disputes.”

Third-party rights and the freedom to operate must be factored into due diligence. Acquirers need to anticipate and mitigate litigation risk, with particular attention paid to third parties. It is important to determine not only whether the target has IP protection for its business assets, but also whether it has freedom to operate against any third-party IP. If the seller is infringing, or has infringed, the IP rights of any third-party – or vice versa – a buyer will want to know before closing the deal. Consequently, the target should be able to identify and summarise its position with respect to any relevant third-party IP.

Any technology which the target licences from third parties must also be identified. For example, proprietary or customised software or databases owned by or licensed to the target should be assessed.

Acquirers must also be aware of the target’s legal status and whether the seller is involved in, or has been involved in, any IP-related disputes. Given the cost and uncertainty caused by legal disputes, acquirers must be aware of any potential liabilities associated with the target. This is particularly pertinent during M&A, as litigants could become more aggressive when a merger is pending.

IP analysis

Due diligence is a multifaceted process. The first stage, for both a buyer and a seller, is to investigate the IP. A buyer will tend to do this once the transaction is underway. A seller can, however, conduct its own audit at any time. In fact, there are many advantages to regular self-audits. It is important for companies to ensure that their IP portfolio is ‘due diligence ready’. Quarterly reviews of IP assets and the company’s IP strategy, for example, would be ideal.

Due diligence is a fact-based investigation which should propose two important questions for the target as well as the buyer: what are the products or services involved with this transaction and does the existing IP cover those products or services?

Acquirers must ensure that they are informed by the seller of any adverse issues related to their IP. This can be done via a due diligence questionnaire, for example, with appropriate questions relating to IP ownership and disputes, among others. Every IP due diligence inquiry is unique, however. Ultimately, the process should prioritise four key objectives: assuring that the buyer is receiving value for its investment; identifying factors which could impede the development of the target post-acquisition; providing the acquirer with the means to renegotiate the terms of the transaction if less value is found than was initially expected; and familiarising the buyer with the assets it will be acquiring.

Risk and reward

Due diligence is an integral part of any transaction. For acquiring companies, information about the strength of a target’s IP assets informs the valuation and influences negotiations. It helps to assess any risks associated with the seller’s IP portfolio and may determine whether the acquisition is worthwhile. For sellers, due diligence can improve the marketability of their company, and allow them to identify weaknesses in their IP portfolio which might hinder or compromise a sale.

IP specialists should be retained to verify the ownership of IP, detect restrictions on its use and ascertain the validity and strength of IP rights and evaluate potential infringements. “IP is a complicated area of law. The issues can likewise be complicated. You should engage appropriate technical specialists to undertake IP due diligence,” says Dr Jauss.

Done badly, due diligence can lead to overvaluation of the target, exposure to unknown risks and liabilities and integration problems which could undermine synergies driving the deal. Given the financial and legal importance attached to IP, dedicated due diligence on this aspect cannot be ignored or lightly dismissed. In transactions that feature hundreds or even thousands of patents, it is clear that a considerable amount of work must be done – and quickly – in an IP investigation. Buyers need to prepare for the rigours of due diligence, and have the ability to investigate the strength and enforceability of the IP in question.

When IP issues surface during due diligence, some may be catastrophic, but other, smaller issues may be resolved post-close or as a closing condition. Amending and updating licences, and filing and adapting IP applications, for example, can be simple workarounds when issues arise.

Properly protected and administered, IP can drive a business forward and generate significant revenue. As such, companies must ensure that their IP portfolio is well protected, correctly catalogued and ready for due diligence if an exit strategy is on the cards.

© Financier Worldwide

BY

Richard Summerfield