Originally published in Managing Intellectual Property, June 2006

In today's fast-paced, technology-driven world, the strength of a company's intellectual property can determine the value of a corporate transaction. In corporate transactions involving IP, the business goals related to pursuing the transaction are often on one side of the table, the IP goal of deriving maximum value on the other. How do you unite those two sets of goals so that they mutually, and possibly synergistically, coexist? More importantly, how do you capitalize on the results of IP due diligence so that the overall business objectives are realized, even enhanced, by the risk- and value-based discoveries made during the due diligence investigation?

By applying a three-stage approach to IP due diligence, the answers to these questions can be realized. The three-stage approach helps converge the business and IP goals to form a united front that brings tangible value and an instructive body of knowledge to the transaction and related negotiations. The decision-making of the deal becomes more informed, and the risk-taking by the involved parties more calculated. Before we explore the three-stage approach, it is helpful first to identify who, what, where, when, and how IP due diligence is generally handled in today's technology-driven industries.

IP Due Diligence
IP due diligence is a legal exercise wherein skilled IP counsel defines, examines and analyzes an IP portfolio of a target company, either offensively (to purchase or in-license) or defensively (to sell or outlicense). Regardless of whether you are the target company or the buyer in a business transaction involving IP, the due diligence should be designed to reveal the value of the involved intangible assets – patents, trade marks, copyrights and trade secrets – by examining the strength, scope and enforceability of the IP, the ownership rights surrounding the IP, and the future potential to be derived from the IP. The breadth and depth of these inquires should be directly proportional to the importance of the IP and its corresponding impact on the value of the transaction.

Ideally, IP due diligence should be conducted at the onset of the negotiations surrounding the transaction. With the performance of strategically timed due diligence, not only can a more reasoned value of the IP be determined, but corrective action can proactively be taken, if and when any legal concerns are identified that may affect the value of the IP.

In most instances, however, when IP counsel is initially engaged for due-diligence purposes, the terms of the transaction have already been set to account for the perceived value of the involved IP. Then, just before the deal is finalized, the IP attorneys are sent in to conduct a reconnaissance mission to confirm the pre-determined value, typically under severe time constraints, and to discover whether any deal breakers are rooted in the IP. For example, IP counsel is usually provided with a list of patents and trade marks, and then asked to determine, in the next two weeks, whether there are any IP issues that cannot be resolved or that would significantly reduce the pre-determined value of the IP.

No matter when IP due diligence becomes implicated, the driving force behind its role in any deal is the transaction itself, whether the deal is a straight purchase of IP or a merger or investment. Depending on the type and value of the transaction, IP counsel usually develops comprehensive checklists to organize and assess the IP of a target company within a particular industry. Those checklists are invaluable for conducting an efficient and thorough due-diligence investigation. But in addition to relying on such checklists, IP counsel needs to move beyond issue-spotting to arrive at risk assessments and, importantly, strategic solutions to any existing or potential problems. These tangible conclusions will allow the financial team to more realistically calculate the value of the involved IP assets for integration into the transaction.

The Three-stage Approach
The three-stage approach divides the many goals of IP due diligence into three components for focused analysis: (1) prioritization of the objectives; (2) the substantive investigation; and (3) analysis of the results. Examining these components helps educate in-house corporate counsel and managers on the bigpicture perspective needed for going beyond the issue-spotting of the IP due-diligence checklist, to derive maximum value from the IP underlying any technology-driven corporate transaction while concurrently satisfying the business goals of the deal. Whether IP lies at the heart of the relevant transaction or is just an added benefit that could be capitalized on, this approach separates the IP due diligence into manageable and strategically focused inquires that identify potential sources of liability and risk, and provide an understanding of the intrinsic value of the IP underlying the transaction.

As illustrated by the cyclic diagram below, this approach allows for the substantive discoveries of the investigation to be incorporated with the business priorities to provide an appropriately reasoned value of the IP to the transaction.

To facilitate an interactive discussion and convey the core concepts of this three-stage approach, a hypothetical corporate scenario is explored. The scenario highlights the tenets of each stage of a typical due-diligence investigation in relation to a patent due diligence and discusses select viewpoints of a target company and two potential buyers.

Corporate Scenario
In this scenario, target company, Acme, desires to sell off part of its IP portfolio that includes a key US patent touted as covering an industry-impacting process. Based on Acme's own assessment, the assets of the overall transaction, including the IP portfolio surrounding this key patent, are valued at around $300 million. Acme is entertaining two interested buyers: Buyer 1 and Buyer 2. Although this corporate scenario is intended to exemplify a patent due diligence, the strategic plan for carrying out the analyses involved in a typical due diligence is not limited to analyzing a patent portfolio alone, but applies equally to broader IP portfolios.

Buyer 1 is an established, international company with diverse commercial products in multiple industries, which seeks to incorporate Acme's key patented process into one of its established manufacturing processes. In contrast, Buyer 2 is a domestic start-up company that recently obtained funding to support its business plan, which largely consists of implementing Acme's full IP portfolio in a stand-alone manufacturing business. Both buyers are diligently investigating the IP, but with distinct business objectives that create different priorities, resulting in the identification and resolution of different legal issues within the substantive investigation. Given these differing perspectives and objectives, each investigation will likely have different budget parameters as well.

Prioritization
Before any typical due-diligence steps are undertaken, corporate priorities, such as the preliminary working parameters and guidelines of the IP due diligence, must be identified. That is done by asking questions about the nature of the business and industry and the purpose of the relevant transaction. The answers will identify the role and importance of the IP and dictate the basic legal issues that must be considered regarding the IP. With those business-focused IP objectives defining the boundaries of the due diligence, the second stage of analysis is effectively outlined with a road map. Those objectives determine the degree of investigative diligence – that is, the depth of the legal and factual inquiries necessary for the particular circumstances surrounding the transaction.

Each business is unique, as are the ways each protects and values its intangible assets, such as IP. No two companies, moreover, have the same business objectives and reasons for engaging in an otherwise seemingly similar business transaction. As such, target companies and potential buyers need to understand at least the nature of the target company, its competitors and the nature of the industry in which the relevant IP is being evaluated and valued. Questions taking those considerations into account and seeking to extract the relevant factual information may include:

  1. Is the intellectual property driving the contemplated deal or is it secondary?

  2. Who are the companies interested in or using this technology?

  3. Is the relevant industry litigious? Or are licence programs routine?

  4. Does the target company have a sophisticated or elementary IP protection policy?

  5. What type of transaction is being contemplated by the parties?

  6. What are the most important objectives of the transaction to the parties?

  7. How do the intangible assets fit into each party's business objectives?

The answers to this sampling of questions help reveal the significance of the role IP plays in the transaction at issue to the parties and helps ensure that the due diligence is timely in occurrence, focused on the particularities of the deal, and sufficient in scope.

An Example of Defensive Due Diligence
From our corporate scenario, prior to offering its technology for sale or license, Acme conducted defensive due diligence in the form of a self-investigation and valued its IP portfolio including the key US patent at around $300 million. To arrive at that assessment, the business personnel indicated to IP counsel that the company was not able to use the family of patents surrounding the key patent to their fullest extent because of limited funding for implementation and marketing. Given those factors, Acme's objective was to realign its resources to focus on its primary technology area. As such, the business personnel desire to extract the value inherent in the family of IP surrounding the key patent from a licensing perspective or, depending on the interests of the buyer, sell off the relevant section of the portfolio to provide additional funding for the target company's primary endeavours. Based on these facts, the IP is driving the transaction for Acme.

With a defensive due-diligence investigation seeking to place a value on the IP involved in the transaction, IP counsel not only seeks to maximize the value of the present IP portfolio, but also tries to capture the value seen in its future potential. Based upon those circumstances, Acme's IP counsel would probably seek answers to a few basic questions about the IP:

  1. Which of Acme's technologies are involved in this sector of the business?

  2. Are those products, processes or services covered by Acme's IP?

  3. Is the key patent valid and enforceable? Are the surrounding patents?

  4. Does Acme's use, manufacture, sale or offer to sell those products or services infringe a US patent or family of US patents owned by another?

  5. Does Acme have clear title to the key patent and its family of cases?

  6. Is that title freely transferable?

Conducting this type of defensive due diligence will assist in moving the IP due diligence associated with the transaction forward by predicting what will be asked by any interested buyer. As a result of timely conducting this type of defensive due diligence, Acme obtains not only a status check of its IP portfolio but also an identification of the portfolio's strengths and weaknesses. This advance knowledge allows proactive steps to be taken by Acme, if desired, in preparation of any offering of its IP, and, in any future due-diligence investigation at least allows the surprises to be minimized and the strengths and weaknesses inherent in any deal to be advantageously managed. Moreover, it adds some degree of appeal to an interested buyer or licensor when a target company's IP assets are in order. Although the prioritization of the business objectives begins the due diligence, its focus and boundaries are constantly evolving at this early stage. Accordingly, by envisioning this three-staged approach as a funnel, directed at distilling down the main issues for consideration, changes in circumstances, such as a change in the type of transaction from a merger to a licensing agreement, can be handled efficiently to redirect or refocus the investigation.

The Investigation
The major component of all IP due diligence is the actual fact-based investigation. During this stage, periodically revisiting the prioritized business objectives and legal issues identified in the first stage maintains the appropriate focus throughout the investigation. The typical investigation begins with the following two questions (from either the target company's or the buyer's perspective):

What are the products or services involved with this transaction?

Does the existing IP cover those products or services?

To answer those questions, the various products or services must be inventoried and then the IP must be examined to see whether it encompasses those assets. By keeping the investigation focused at this stage on the relationship between the products of interest and the relevant IP, the investigation should remain on a path that parallels the goals and objectives of the transaction. After cataloguing the IP, the investigation turns to focus on one or a combination of the following legal analyses:

  1. freedom-to-operate considerations;

  2. scope-of-protection;

  3. validity and enforceability concerns; and

  4. ownership issues.

The applicable components of a comprehensive due-diligence investigation are generated by the traditional IP due-diligence checklists often relied on to organize the audit of information from the perspective of the target company or the buyer. The substance of each of those components is briefly discussed below.

Freedom to Operate
A freedom-to-operate analysis evaluates whether or not the buyer will be able to make, use and/or sell the target company's products or services, if acquired, without infringing the IP rights of a third party. This analysis identifies potential legal roadblocks, such as valid patent claims of others that may be infringed and thus stand in the way of using the target company's IP. If any potential blocking patents are identified, a more detailed analysis will likely be needed.

Scope, Validity and Enforceability
The scope, validity and enforceability analyses assess the scope of protection and strength of coverage of the target company's current and/or commercial assets. For example, determining the scope and validity of a patent begins with construing the claims and starts with the claims themselves (Phillips v AWH Corp, 415 F3d 1303, 1312 (Fed Cir 2005) (en banc), cert denied, 126 S Ct 1332 (February 21 2006)). Validity assessments usually include evaluation of the novelty and non-obviousness of a patent's claims, compliance with formal requirements such as the written-description, enablement, and best-mode requirements, as well as judicially created doctrines such as obviousness-type double patenting. Enforceability, particularly in the US, centres on inequitable conduct and the compliance by the inventors, assignee and prosecuting counsel with the duty of disclosure under Rule 56 (see for example 37 CFR § 1.56). Concerns about the validity of key patents, the narrow scope of important claims, or about possible inequitable conduct, may result in a reduced valuation of the IP in the transaction. These issues may or may not be deal breakers, depending on their significance to the overall transaction objectives and their ability to be managed or addressed.

Ownership
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 company's rights in it and whether those rights are free of any encumbrances and can be clearly transferred. Initial questions may include:

  1. Who are the inventors?

  2. Did those inventors properly assign the IP rights to the target?

  3. What are the target's rights to transfer and assign?

  4. Are there governmental rights from funding?

  5. Have there been any third-party challenges to those rights?

The answers to these initial questions should help identify those areas of ownership rights requiring further investigation.

Due Diligence from the Offensive Perspective
Returning to our corporate scenario, this time from the viewpoint of Buyer 1, we outline a possible investigation perspective taking into consideration Buyer 1's priorities. As mentioned, Buyer 1 primarily seeks to ensure that it can incorporate soley Acme's key patented technology into its existing manufacturing process. With such a narrow focus, Buyer 1 wants to be able to answer at least the following questions after the investigation:

  1. Is the desired technology covered by any patents?

  2. Are those patent rights valid and enforceable?

  3. Is the ownership of the relevant patents transferable?

  4. Is there any litigation pending or any risk for future litigation associated with the use of the desired technology that can be identified and possibly quantified now?

To answer those questions, Buyer 1 would likely consider analyzing freedom to operate, scope, validity and enforceability and ownership components of the investigation. Each distinct analysis would be narrowly focused and goal driven to eliminate time and money spent on issues or questions that do not assist in answering the basic, focused questions of the business transaction for Buyer 1. For example, the invalidity of any non-critical patents in the portfolio would probably present little concern to moving forward. Additionally, presuming Buyer 1's existing manufacturing process does not infringe any third party patent claims, the freedom-to-operate analysis can be focused on the newly added process alone.

Buyer 2, however, approaches the potential deal with Acme from a different perspective than that of Buyer 1. Buyer 2 seeks to obtain Acme's full IP portfolio directed to this technology and turn it into Buyer 2's primary business. Thus, it needs the answers to the same questions as Buyer 1, but with respect to the entire patent portfolio. For example, Buyer 2's scope, validity and enforceability analysis will probably be of greater importance than for Buyer 1, as Buyer 2's business will be fully covered by this portfolio. To that end, the invalidity of any patent in the portfolio may be a deal stopper, as Buyer 2's business plan could not be implemented with full patent coverage. The freedom-to-operate analysis for Buyer 2, moreover, needs to cover not only the key process step, but should confirm the freedom to practise the entire process from start to finish to be used by Buyer 2. The patent term associated with the key patent and the other patents in the portfolio will also be critical to securing Buyer 2's presence in the marketplace for a worthwhile period.

As mentioned in the above-discussed prioritization stage, the relevant factors for consideration in any due-diligence investigation are constantly evolving as more and more facts are uncovered. This is especially true in the investigation stage where voluminous information is often collected, examined, and analyzed. By using this three-staged approach as a funnel to distil out the relevant issues, the evolution of the IP not only can be taken into consideration, but further can be used to efficiently direct the due diligence. In other words, the broad questions asked in the prioritization stage function as filters that can be reassessed as information flows into the investigation.

The Results
The third and final stage of our IP due diligence approach involves synthesizing the results: the risks and benefits uncovered during the investigation need to be balanced in view of the objectives of the due diligence to the transaction. The boundaries of the investigation should be revisited to confirm that they continue to reflect the priorities initially identified. In addition, there may be limitations on what information was disclosed by the target company and what information the buyer could review given time constraints that need to be integrated into the overall evaluation. Accounting for all of these factors is commonly done to arrive at the final recommendation for the client. The resultant advice and the value of the IP may be represented in the transaction as a monetary figure and/or may help produce a strategic position in the marketplace associated with the IP.

Accumulating and analyzing the risks, benefits, and boundaries or limitations of the IP due-diligence exercise will be in part captured on the checklists used throughout the investigative stage of the diligence. From these checklists, the transformation of the intangible assets into quantifiable terms occurs with the assistance of accountants and other professionals. But the benefits of conducting due diligence do not end there.

IP due diligence provides something else: it confers a body of knowledge on the investigating party. In the simplest terms, after completing a timely conducted and thorough due-diligence investigation, a party now knows what it is selling or buying. That information can have far-reaching effects. This body of knowledge can be parlayed into reshaping transactions, reinvigorating stalled negotiations, reconciling valuations and articulating issues for resolution. As such, IP due diligence supplies a vehicle to facilitate valuing IP and to collect knowledge; both are indispensable in educated decision-making and calculated risk-taking.

Meeting Expectations and Objectives
No matter what the composition of the IP portfolio (patents, trade marks, copyrights, trade secrets or a combination thereof), no matter what the type of transaction (merger, acquisition, licence or joint venture) and no matter what the corporate arena is (domestic or international markets), the three-staged approach is based on combined business and IP perspectives, which enable the involved risks to be identified and mitigated or managed so that expectations and objectives can be met.

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.