India: IP Audit Is Central To M&A

Last Updated: 6 January 2016
Article by Lucy Rana and Rishu Srivastava
Most Read Contributor in India, September 2018

An IP audit is an essential criterion that should be fulfilled in all M&A as it helps in gaining insight on the information pertaining to creation, maintenance, validity, strength, use and challenges, if any, to Intellectual Property Rights.

Over the years, development of IP has caused an upward swing in the economic and financial development of the nation, and an upsurge in research, development and technological capacity of both developed and developing countries. The intangible capital is rightfully touted as the most powerful asset of the company. Intellectual Property Rights (IPR) protection and enforcement lays the foundation of a company's dominance in the market, and is a source of continuing profitability for it.

While mergers and acquisitions (M&A) remain an aspect of corporate strategy dealing with buying, selling, dividing and combining entities that would help the enterprise grow, the IP is undoubtedly a significant consideration affecting takeovers in high end industries. Patents, trademarks, domain names, trade secrets, copyrights and other IP assets owned by an organization often make it a lucrative target for acquisition. Thus, before acquiring any firm, a complete "SWOT" analysis should be conducted to determine its inherent and profound technologies, resources, licensing opportunities, infringement and opposition possibilities and threats from competitors.

Why an IP audit is necessary?

It is estimated that if Coca-Cola happens to lose all its tangible and physical assets, the brand name "Coca-Cola" and other IP assets would be valuable enough to enable positive cash flow within one year. It is crucial for financial executives, advisers and accountants to comprehend and understand that transfer of intellectual property is an essential aspect of all major transactions and should be audited.

Like its financial counterpart, the due diligence investigation and IP audit helps in amassing necessary information required to understand the business and market of the firm. A good audit would not only ascertain validity and reliability of information but would also help identify the real worth of IP assets. Fundamentally, an IP audit is an essential criterion that should be fulfilled in all M&A as it helps in gaining insight on the information pertaining to creation, maintenance, validity, strength, use and challenges, if any, to IP rights.

What is to be considered in an IP audit?

It is imperative to undertake a comprehensive review of the company's IP assets, relevant agreements and compliance procedures before any M&A. The classic case of Volkswagen-BMW-Rolls Royce signifies the importance of conducting an IP audit when a company contemplates acquiring or merging with another firm. In a bidding deal in 1998, Volkswagen paid millions of dollars to purchase the ownership of Rolls Royce and Bentley automobile assets, only to realize that it owned everything necessary to make Rolls Royce except the rights to use the Rolls Royce trademark. BMW on the other hand, succeeded in procuring the use of the Rolls Royce trademark. Thus technically, while Volkswagen owned the machinery, the brand was owned by BMW. However both the companies later reached an agreement that allowed Volkswagen to use the said trademark till 2002.

Some of the important questions that should be considered in an IP audit are:

  • The intangible assets owned or protected by the firm and their legal status;
  • The value of the IPR owned by the firm and the risk associated with it;
  • How the company manages its IP portfolio, including policies related to internet and security, and who all are responsible for its management;
  • Whether the company has disclosed its know-how, trade secrets or other IP to someone;
  • The measures taken by the company for creating, maintaining and protecting its IP assets;
  • Accessing licensing, sub-licensing, cross-licensing issues affecting the IP rights;
  • The financial, commercial and legal risks linked to a target company's IP portfolio;
  • Whether the company is infringing on someone's IP portfolio or if its assets are infringed upon by a third party;
  • Detailed account of circumstances surrounding infringement, if any;
  • Measures taken by the company to prevent IP infringement, and its policies for the same;
  • Employee contracts including Non Disclosure Agreement;
  • Detailed account of past, present and potential litigations, including the litigation suits filed by and against the company.

IP assets owned by the organization and their valuation

The company's rich IP portfolio is an indispensable asset. A trademark, for instance, if properly registered and protected, can provide tremendous worth to the company. It is estimated that the value of the "Apple" brand is almost half of its market capitalization.

Therefore if a company is valued, as in M&A, its intangible assets must also be valued. The acquisition on the other hand may either be driven by a motive to acquire a company's technology or IP, or both. The success story of the acquisition of Thums Up by Coca Cola and the capitalization of the "Thums Up" brand name by the latter in its market share against Pepsi bears testimony to the value of intangible properties. Acquisition of the Crocin brand by SmithKline Beecham and purchase of the Uncle Chipps brand by Ruffles Lays, are other examples of a company's interest in buying a brand name rather than its physical assets. Brand building is a long and arduous process that involves significant investments and risks, thus the acquisition of a reputed brand would help a company gain significant market share. The typical IP assets that a company owns and should be audited are delineated below:

Patents:

The patent auditing should encompass determination of the patent owned by the firm as well as the application for patent filed in native and foreign countries. It is very important to determine the compliance with laws of another country in case an application for patent is filed abroad. The auditor should also note that mere filing does not guarantee the grant of patent and a company may file a large number of patents only to attract acquisition.

Appropriate search should be conducted to verify if the patent has actually been registered in the name of the target company.

The FTO analysis and patent mapping should be done to determine patentability of the invention, and in case of granted patent, the same would help in ascertaining if the subject matter of the patent is infringing other inventions or if there is any likelihood of opposition. This will also help in determining whether the granted patent would enable the acquirer to keep the rivals and competitors out of the market.

It is also pertinent to ascertain if the company has been paying regular annuities or royalty in case of any licensing.

Copyrights:

Copyrights are important in media, entertainment and the software industry. Though registration of copyright is not mandatory, it is prima facie proof of ownership in case of any dispute. Thus it should be ascertained what all copyright is owned by the company or whether permission from the author/ creator of the copyrighted work has been secured in case the company does not own the rights for the same. It is also important to determine the work that can be protected by copyright.

Trademarks and Trade Secrets:

Auditing should be conducted to determine the trademarks actually owned and registered by the firm, and to determine what all trademarks can be protected under the ambit of the Trademarks Act.

It would be wise to determine the strength of the trademark and the distinctness it has acquired over a period of time. It should also be determined whether the trademark has been protected in all of the desired classes.

It should also be ascertained if marks have been applied in other countries and renewal fees are paid on time.

The auditor should also determine if the trademark used by the firm is licensed by a third party or the company itself has licensed others to use its Trademark. The terms and conditions delineated in all license agreements should be properly evaluated and audited.

Auditing should also be conducted to determine if the company has taken adequate measures to protect its trade secrets, including technical know-how, advertising plans, customer details, financial statements and bank details.

Domain Names:

With the advent, globalization and rapid commercialization of the internet, domain names have become significant business identifiers. Auditing should thus be conducted to determine if the trademarks owned by the firm are registered, and domain names are renewed regularly. It should also be ascertained whether the domain name is being misused or squatted by others.

Industrial Designs:

This includes auditing of all design registered and capable of being registered with the Patent Office. It should also be ascertained whether registered design is renewed or is worth renewing for another five years.

Agreements:

In addition to the above mentioned IP rights, auditing of all the agreements, including the Employee agreement, Non Disclosure Agreement, Licensing and Assignment, Contracts and Joint Venture should be conducted. This would help in ascertaining if all the requirements have been complied with or not, the ownership of rights in case of collaborative research and in case if an employee has developed something during his tenure in the firm but is now a part of different organization. Licenses given to third parties should also be checked to ensure that IPR has not been assigned to them due to improper wording of license agreement. The auditing of license agreement also helps in determining any geographical or time limit.

Auditing steps involved in M&A

  1. Ensure that the company owns an IPR, and in case if any of the IPR is licensed to it, then such a license should be transferable.
  2. The status of all the pending applications for IPR protection should be determined to ensure the chances of its grant or registration. The conflicting applications filed by the third parties should also be determined
  3. Legal counsel should be sought to determine if the IPR owned by the firm is infringing someone else's rights or if any other entity is claiming interest in IP rights owned by the firm.
  4. Ascertain whether any governmental approval is necessary in exploitation of the IPR.
  5. The security agreements, licenses and contracts should be thoroughly evaluated.

Conclusion:

IPR has played a crucial role in making smaller companies climb up the value chain as extensive research conducted by them to develop the latest technology enables them to compete with larger, more successful and established companies. The intangible assets have become drivers behind significant mergers and acquisitions in an essentially knowledge and information based economy and their role is expected to become all the more important going forward. The IP audit is thus, a valuable tool for both potential targets and buyers as it helps in formulating efficient business strategies and evaluating assets owned by the firm. The underlying essence of business ethics, "if you don't measure it, you can't manage it" aptly highlights and sums-up the relevance of an IP audit.

Previously published by LegalEra

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.

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