Whilst the concept of conducting an investigation into the material aspects of a commercial transaction is not new, such due diligence investigations often focus on the tangible assets and ignore or at least give insufficient weight to the intangible assets. Yet, the most valuable part of a business is often the intangible assets, in particular intellectual property.
A high-profile example of due diligence failure was the 1998 purchase of the legendary Rolls Royce automobile company. Volkswagen and BMW were in a bidding war to purchase the company and, ultimately, Volkswagen posted the winning bid of nearly US$800 million, acquiring almost everything necessary to make a Rolls Royce automobile – the plant, machinery and designs.
Unfortunately Volkswagen overlooked arguably the most valuable part of the business – the right to the Rolls Royce trade mark. After the deal closed, Volkswagen could make a luxury car that looked like a Rolls Royce, but could not call it a Rolls Royce.
Another company (producing Rolls Royce airplane engines) owned the Rolls Royce mark and had licensed the mark to the Rolls Royce automobile company under a licence that terminated in the event that the automobile company was sold.
Soon after, BMW acquired the rights to use the Rolls Royce trade mark on automobiles for significantly less than Volkswagen had paid for the tangible assets.
The story highlights the need for a prospective purchaser or licensee to conduct adequate due diligence prior to completing a transaction for the transfer or license of intellectual property rights.
In this article, the term "vendor" will be used to refer to either a vendor in a sale of IP or a licensor in a licence. Likewise, "purchaser" will refer to either a purchaser or licensor. However, the nature of the due diligence enquiries required for each may differ depending on the circumstances of the transaction.
Purpose of Due Diligence
At the most fundamental level, the purpose of due diligence is to determine whether to go ahead with the transaction at all, and if so, on what terms. Due diligence should ensure that:
- the purchaser is fully informed before making a final commitment;
- the IP is priced appropriately given all available information; and
- risk is efficiently allocated between the purchaser and vendor.
Due Diligence Process
The due diligence process in most cases should start before any agreements have been entered. At the stage an opportunity arises, a purchaser should conduct at least very basic due diligence to determine whether to invest the time and effort in commencing negotiations in the first place.
This may involve some background research on the other party to the transaction, investigation of the markets involved and operators in those markets, and perhaps quick title searches on the specific IP in question.
In the course of complex negotiations, the parties may enter into a heads of agreement or memorandum of understanding that will encapsulate the fundamentals of the deal, subject to the completion of full due diligence enquiries. However, prior to commencing the negotiations leading to a heads of agreement, the prospective purchaser should also consider whether to request a period of exclusive negotiations, to ensure the time spent in negotiations is not ultimately wasted through a third party purchasing the IP during the course of negotiations. The vendor will likely try to avoid this because interest from a third party may result in a better price.
The process of in-depth due diligence will involve a visit to the offices of the vendor's patent attorney, and may also warrant a site visit to the premises of the vendor.
Upon completion of the full investigation, a due diligence report should be prepared to highlight any risks that could not be investigated, or that were investigated but remain a risk (including the level of risk and whether this makes it a deal breaker). This information can be used to feed into the transaction document, suitable warranties to cover off the outstanding areas of risk, or a revision of the price or retention of part of the price in an escrow account until the risk subsides.
Defining the Scope
The first step in the due diligence process is planning. What is the overall objective? What do you need to know? What are the key areas of risk? Are there aspects of the transaction that are less important than others?
The answers to these questions will depend to a great extent on the IP strategy of both the vendor and purchaser. It is essential to have a sound understanding of the IP strategy of each organisation to get the maximum benefit from the due diligence process.
Understanding the purchaser strategy is important. The purpose to which the acquired IP will be put will affect issues such as freedom to operate, the required breadth of any patent claims, and such like. For example, is the IP being acquired simply to shut down a competitive product or will it form the core IP for a diversification growth strategy? If the trade secret elements of the IP are most valued by the purchaser, then careful consideration of the secrecy protocols used by the vendor will be paramount. The competencies of the purchaser are also important, for example in determining the length and detail of any technology transfer process required to ensure the acquired IP can be effectively put to use. For example, are the purchaser's scientists already well versed in the technology area or is it a new field, such that they require a good deal of time with the vendor's technical team to fully understand how the technology works?
Understanding the vendor IP strategy is important to gain better insight into the specific risks involved in the transaction, given the purchaser's intended use for the IP. For example, if the vendor uses a ring fencing strategy in its patent protection, a key risk may be ensuring all relevant patents relating to the product and all improvements to it are included in the transaction. If the vendor is a university, it may have a fairly relaxed attitude towards publishing potentially patentable information, which will make interviewing department heads more important to determine the existence and scope of publications relating to patents of interest.
Sometimes a period of preliminary due diligence is used to refine the scope of the full due diligence enquiries. A limited investigation will be conducted to identify key areas of risk involved in the transaction. As mentioned above, an understanding of the business and IP strategies of the vendor and purchaser will assist in this process.
In-Depth Due Diligence
Patents and Designs
The objective with patent and design due diligence is to ensure:
- the patent claims cover the product/process of interest and the purchaser's intended use, or in the case of designs, the registered design actually covers the product shape presently marketed
- the patent claims/registered design are valid and enforceable
- the purchaser will have freedom to operate following the transaction
- the vendor's chain of title is complete all the way from the inventors/author
- the existence and extent of encumbrances, such as licences, covenants not to sue, mortgages, charges and such like, is known
- annuity payments have been made and there are no unexpected surprises in terms of payments due shortly after the transaction settles
- there are no known infringements of the patents/registered designs
- there are no known challenges or possible challenges to the patents/registered designs
The purpose of trade secret due diligence is to determine the existence of valuable trade secrets, determine how well those secrets have been kept and identify any potential leaks of the secret. This will involve evaluating security policies employed by the vendor, such as document shredding, document storage and access logs, site visit records and protocols, physical security measures on premises, and reviewing records of breaches of these security measures, encryption and password protection of electronic data. Confidentiality and non-compete agreements will be reviewed. Key staff may be interviewed and the whereabouts and activities of any recent ex-employees noted.
In addition to the usual chain of title and encumbrances issues, trade mark due diligence should focus on:
- the adequacy of any registrations in terms of whether they protect the marks actually used and the full range of goods/services
- the degree of control exercised over any licensee's use of the marks, as poor control can lead to invalidity of the registration
- whether the ways in which the mark has been used may have caused it to become generic and therefore invalid
- whether any registrations may become susceptible to removal for non-use or invalidated for any other reason.
Determining whether there are any infringements or possible challenges to the registrations for example, by a third party that first used a similar mark prior to the vendor, may also be important.
In relation to copyright, the purchaser should:
- identify all key copyright works and obtain in relation to each work of interest, the author's name, citizenship, and address, and the date of creation and date and place of first publication for the work, and ensure originals are securely stored
- review employment agreements and consultant/contractor agreements to determine ownership provisions
- evaluate the vendor's policy for identifying and protecting copyright works
- evaluate the vendor's design processes to identify attitudes towards copyright and infringements
- establish existence of old drafts of copyright works, which may be required for any copyright infringement proceedings
- identify all assertions of copyright infringement by or against the vendor
- review all copyright assignments, licences, and other transfers
- identify all relevant customs notices pertaining to the copyright works.
In the event any IP is the subject of commercial agreements, such as a licence agreement, care should be taken to determine whether the agreements can be transferred (with or without consent) to the new IP owner, and the most appropriate mechanism for achieving this transfer (usually a novation).
It is also a good idea to require in the transaction document a warranty that there are no outstanding breaches of the licence agreement by either party.
In cases where some of the IP to be purchased has been developed in foreign countries, it is highly recommended that local attorneys in the foreign jurisdiction be made responsible for due diligence on the foreign IP.
There are a number of areas where New Zealand law in relation to IP (and importantly ownership of IP and remuneration of inventors) differs significantly from the laws in foreign jurisdictions. For example, both Japan and Germany have special requirements and rules in relation to employee inventions.
For example, Japan's Supreme Court recently ordered Hitachi to pay a former employee ¥163 million (US$1.4 million) for his inventions, which were patented in Japan and elsewhere. Hitachi originally paid the employee ¥2.31 million in 1976 for assigning his rights in a patent for technology used in optical discs, CDs and DVDs. Japan's Patent Law entitles inventors to claim more money if they can demonstrate that the remuneration was "unreasonable".
Be aware that in some countries, including New Zealand, any assignment by one party of its share in patents owned by two or more parties can only proceed with the consent of all the co-owners.
Adjusting the Transaction Document
Once the due diligence report is complete, there may be a list of issues that need to be resolved, assuming none of the issues are deal breakers. Some issues must be addressed prior to settlement, some after settlement and other issues will affect the value assigned to the IP. These issues should be dealt with in the transaction document.
In addition, the purchaser could consider inserting representations or warranties into the transaction document to address any areas where risks remain.
Where the vendor is not willing to provide a warranty, the parties could consider holding a portion of the settlement funds in an escrow account for a predetermined period. These funds can be paid to the purchaser if the risk materialises, or to the vendor at the expiry of the escrow period.
The value of the due diligence process depends significantly on the time spent planning the process and identifying the objectives of the transaction and the intended strategy for the IP once acquired.
Without spending this initial preparation time, the results obtained by blindly looking at the IP in question may be relatively useless.
One of the main areas that is neglected in due diligence relating to IP is determining the scope of the protection relative to the product to which it relates, and in particular whether the protection actually covers the aspect of the product from which the purchaser expects to derive competitive advantage. The due diligence may reveal that in fact the IP effectively protects one aspect of the product which is not essential to the product generating income, in which case the value of the IP to the transaction is less.
The outcome of the due diligence process should be confirmation of certain factual assumptions underpinning the purchaser's assessment of value, and therefore the price offered for the IP.
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.