Investment in technology companies globally is very active, prompting many journalists to describe current conditions as "Bubble 2.0".

The stats show that the market in the US has some remarkable valuations for tech companies, but these valuations are largely directed at the Big 5, being Facebook, Zynga, Groupon, Twitter and LinkedIn, whose valuations total well in excess of $71 billion. This compares to 1999 when it took 24 web companies to total a valuation of $71 billion. There is definitely heat at the top end of the US tech market. Goldman Sachs bought into Facebook on a valuation of $50 billion (some 100 times earnings), while 3-year-old Groupon knocked back $6 billion from Google in order to seek to list later this year for $15 to $25 billion. LinkedIn just went to a $9 billion valuation on its IPO.

We have seen significant upturn in tech M&A deals in Australia. US coupon powerhouse WhaleShark Media acquiring relatively unknown Melbourne company retailmenot for $90 million, US venture fund Accel Partners picking up a minority stake in collaboration software company Atlassian for $65 milllion and a consortium of investors aquiring a 40% stake in Scoopon/CatchoftheDay at a valuation of $200 million. There are many others.

The purpose of this article is to provide a high level overview of some of the key issues arising in connection with an M&A deal that has a strong IP/IT focus.

As with any transaction, it is important from the outset to undertake detailed due diligence investigations on the target's corporate profile, its assets and its major contractual undertakings. In particular, when dealing with a target with a key IP/IT portfolio, it is necessary to review the IP/IT assets and all agreements the target has entered into relating to those assets.

The following sections touch on some due diligence points and structural issues that prospective buyers/advisers need to be mindful of when dealing with IP/IT matters.

Ownership of IP

Confirmation should be obtained from a target that it either owns, or has valid enforceable rights to use, all IP and IT that is used in its business. The process of confirming ownership of IP can be done in a number of ways but most practically by:

  1. Searching relevant registers – governmental or otherwise (such as trade mark or patent registers or registers for ownership of domain names);
  2. Reviewing all documents relating to the ownership of IP and any third party agreements pursuant to which IP rights are granted to the target; and
  3. Interviewing relevant stakeholders.

From a transactional structuring perspective, it is also helpful to obtain detailed warranties around the ownership and use of IP/IT rights. What also follows from this is that it is necessary to ensure that the IP/IT owned and used by the target is all that is required to operate its business.

Depending on the nature of a particular transaction, if the core IP/IT is owned outside of the target group (and ownership of IP/IT (rather than rights to use) are a fundamental requirement), transitional arrangements may need to be put in place to ensure that IP/IT is transferred into the target group.

IP Infringement

Broadly speaking, there are two core areas of concern to a buyer when acquiring an IP/IT portfolio, these are:

  1. Infringement by the target company of a third party's intellectual property rights. IP infringement litigation is very costly (particularly patent infringement litigation) and can take years to resolve. Consequentially, it is essential to understand what the key infringement risks are up front any make all necessary enquiries to determine whether the target will be restricted from operating without fear of infringement suits.
  2. Infringement of the target company's intellectual property by third parties. Knowing whether the target company is aware of third-party infringement is useful in determining the value of the target company's intellectual property assets. Such infringement suits (or prospective suits) should be reviewed and considered in the due diligence process.

Contractual rights

A thorough due diligence includes a review a material agreements to which the target is a party and significant from an IP/IT perspective are licensing arrangements. It is also worth noting that licences can appear in a range of agreements that are not necessarily identified as such – for instance under research and development contracts, joint venture arrangements, consulting distribution and software development agreements.

For agreements where the target receives a license to use a third party's IP/IT, the buyer should confirm that the scope of the license is broad enough to cover all current and anticipated future uses of the licensed IP/IT (including the right to make modifications, if applicable) and contains ownership provisions allocating ownership of any permitted modifications.

For agreements where the target company grants a license to a third party to use the target company's IP/IT, the buyer should confirm that the scope of the license is narrowly enough to ensure that only those rights needed by the licensee are granted, the target's ownership of its IP and/or IT is clearly stated, and the licensee is obligated to maintain the confidentiality of the target company's intellectual property and technology.

Other key points to look out for in licence arrangements include: the parties, definitions and description of the IP/IT involved, exclusivity and non-compete obligations, field of use, relevant royalties, term, warranties and indemnities, governing law and jurisdiction and any specific provisions that could impact on the proposed transaction (such as change of control and assignment provisions).

Source Code

Possession of the source code (which is, in its simplest form, intellectual property in the form of copyright) is usually critical to the target's ability to operate its business platform or to evolve its products and services. Care needs to be taken to ensure that, if the target does not have possession of the source code, appropriate arrangements are in place to ensure the third-party provider is obligated to provide support to the target (and if required, its customers). The buyer should also confirm whether any source code for the target's products has been provided to any third party, whether to an escrow agent or directly to a third-party licensee.

Open Source Software

The manner in which open source software is used by a target, and the open source license governing its use, can have a significant impact on the target's IT arrangements. It is therefore critical to obtain a complete and accurate listing of all open source software used by the target and copies of all applicable licenses, and a description of how such open source software is used. Depending on the nature of those open source arrangements and the underlying product, the buyer may decide that it has other preferred open source software products it wishes to integrate with the target business.

Employee Issues

Generally speaking, in the absence of an agreement to the contrary, ownership of IP initially vests in the inventor. Therefore, the buyer should confirm that all of the target's employees and contractors have executed written agreements assigning ownership of all IP/IT developed by them during the provisions of services to the target. In certain limited circumstances, a license from the employee or contractor to the target company may be sufficient, though those cases should be carefully reviewed prior to a determination of sufficiency.

Non competes

Once a deal has been struck it is prudent to ensure that, to protect the value of the buyer's investment, appropriate non-complete obligations are entered into by relevant stakeholders. Fundamental to this is ensuring the restraint is enforceable on policy grounds (in other words, if someone is paid for the restraint, it is more likely to be upheld). For the target, the key is to ensure that if there is potential to "trip" the non-compete, appropriate "carve outs" from the non compete obligations are build into the transaction documents.

Conclusion

In conclusion, there is no doubt that the US is seeing some heady valuations and all eyes are focussed on the IPO market later this year as a number of the big tech companies are targeting a listing. However, Australia has seen strong investment activity across the range of tech businesses and multiples, while high, are not necessarily excessive, given the historical revenue growth of these companies. Certainly the social commerce sector seems crowded at the moment and it may be ripe for a consolidation, but the impact is not widespread enough to warrant comparisons to the bubble conditions of 1999/2000 – but of course who knows what tomorrow might bring.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.