IP issues for private equity & venture capital

June 2020 | SPOTLIGHT | PRIVATE EQUITY

Financier Worldwide Magazine

June 2020 Issue

Intellectual property (IP) and other intangible assets now account for over 80 percent of company value in the S&P 500, by some estimates. Established and emerging companies use patents, trademarks, trade secrets and other forms of IP to protect a range of technologies, spanning blockbuster drugs and high-tech devices to household brands and secret formulas. IP can thus be a powerful tool to establish and maintain market position. For investors and managers, fully understanding and evaluating an investment company’s IP can be crucial to realising the value of an investment.

Issues to consider before investing

Before entering a transaction, investors should survey the relevant market and identify IP assets that may be important for achieving investment goals. For example, patent protection may take centre stage when investing in a competitive market (or one with low barriers to entry), involving products that are susceptible to reverse engineering. Trade secret protection may contribute more value in industries where the innovations can be successfully maintained in confidence, without discovery by consumers and competitors. Increasingly, consumer data and access to data streams may drive transactions. Strong trademarks and associated brand goodwill are also frequently listed as important assets on corporate balance sheets. Often, evaluating a combination of these IP assets, and others, is required.

With key assets identified, ownership of these assets should be confirmed. As with real-property assets, certain governmental administrative bodies maintain records of IP ownership for assets, including patents, trademarks and copyrights, and underlying law often provides an incentive for IP owners to properly record their ownership interests. However, often public records do not tell the full story, and additional steps may be needed to confirm ownership of important assets.

For example, the employment history of key personnel should be considered, particularly where senior members of an investment company may have previously worked on similar technology at competing firms. Employment timelines should be aligned with the company’s IP assets, to ensure, for example, that inventors named on the company’s patents were employed by the company when the patented invention was conceived. Additionally, patents filed by employees shortly after leaving a competitor to join the investment company should be considered to ensure that protected technology was not transferred. As the recent trade secret litigation between Waymo and Uber demonstrates, alleged misappropriation of IP can carry a hefty price tag and reduce the expected value of an investment.

Understanding licensed IP assets

Additional consideration may be required when a target of potential investment relies on licensed IP assets for its business. For example, licence agreements may impose field-of-use and other restrictions on the licensee’s use of the IP, which may conflict with or constrain an investor’s goals for the investment. Additionally, licensees may not have so-called ‘standing’ to enforce rights under licence, meaning that the company may not be able to bring litigation against third parties to protect its market, potentially leaving an investment company at the mercy of the IP owner.

Depending on the nature of an investment, change-of-control and other provisions related to transfer of corporate ownership should also be considered to ensure alignment with investment objectives. Failure to do so can be costly, as demonstrated by the now infamous case of Volkswagen’s failed share-purchase bid for Rolls-Royce, where a trademark licensor’s change-of-control veto power proved extremely costly. Volkswagen bought the Rolls-Royce Motor Cars Group without securing the rights to the Rolls-Royce trademark, and when the trademark rights were ultimately awarded to a competing bidder (BMW), Volkswagen was unable to fully realise the expected returns on its £430m investment.

The importance of understanding IP licence restrictions is also underscored when an investment company relies on open source software (OSS) in its business. OSS is now ubiquitous in the software industry and is frequently employed effectively by sophisticated firms. However, OSS can create risks when it is incorporated into proprietary software products without a full understanding of the licence requirements governing the use of the OSS. This risk may be of particular concern when investing in emerging companies, which may have relied on OSS to reduce development costs and time to market without a proper consideration of licence restrictions associated with the OSS. For example, OSS distributed under ‘copyleft’ licences, such as the GNU General Public License (GPL) licence, may require independently developed software incorporating the copyleft licensed OSS to be licensed under open source terms and made available to the public.

Evaluating owned IP

Once ownership of the IP assets is confirmed, additional diligence can be performed to better understand the value of company owned IP assets. If patents are an important aspect of the investment, the validity of the investment company’s patents can be considered. Prior disclosure by third parties or the patent owner can operate to preclude or negate patent rights. Accordingly, a review of earlier patents and publications to assess the innovative contributions of the investment company’s patents can be performed. Likewise, the investment company’s own prior disclosures, sales and offers to sell its technology should be reviewed and compared to the respective patent filing date. Additional considerations that can contribute to patent value include the breadth of patent claims and ease with which such claims can be designed around, as well as possible infringers and their ability to shoulder the burden of potential enforcement.

Additional IP assets, including trade secrets and trademarks can also be evaluated. For investment companies that rely on trade secret protection, the company’s procedures for maintaining secrecy should be investigated. The company’s employment contracts, employee training procedures, non-disclosure agreement practices, and physical and electronic security measures should be considered. For trademarks, consider whether the investment company’s mark has been registered, and if so, whether the registration aligns with the company’s use of its mark.

Government regulation

Investors should be cognisant that the IP landscape is continuously changing, driven in new directions by market forces and developments in underlying legal frameworks. For example, the increasing collection and monetisation of user data has drawn recent scrutiny and led certain governmental bodies to act. Prudent investors should evaluate compliance with legislation, such as the General Data Protection Regulation (GDPR) and the Health Insurance Portability and Accountability Act (HIPAA), and consider investment companies’ data security practices to assess potential liability for data breaches. Compliance with reporting obligations for any past breaches that may have occurred should also be considered.

Ultimately, while many investors may consider diligence to be a less glamorous side of deal making, proper diligence can be a powerful tool for ensuring investments achieve their goals. This can be particularly true in IP-heavy industries, where understanding important IP assets can avoid unwanted surprises and ensure investments are priced appropriately to account for understood risks.

David K. Bailey is an associate and Paul Ragusa is a partner at Baker Botts LLP. Mr Bailey can be contacted on +1 (212) 408 2542 or by email: david.bailey@bakerbotts.com. Mr Ragusa can be contacted on +1 (212) 408 2588 or by email: paul.ragusa@bakerbotts.com.

David K. Bailey and Paul Ragusa

Baker Botts LLP