One Size Does Not Fit All: Tailoring IP Due Diligence to the Transaction

OVERVIEW

Investing in, acquiring, or partnering with companies requires a due diligence investigation in which intellectual property (IP) will play a role. An IP diligence review basically determines if a company has good title to its IP, and whether third-party IP might be asserted against the company’s products or services. The level of review varies by the strategic objectives and the type of transaction. Oftentimes, a limited budget requires identification of the most important issues to review. This article, from a primarily US perspective, describes four levels of due diligence review, and the level of review warranted by different types of transactions. For efficiency, key questions upfront can focus the review.

TOP TAKEAWAYS

1. IP diligence should be tailored to the type of transaction. 
2. Focus review with appropriate questions and conversations with the founders and developers upfront.
3. Early involvement of in-house counsel to set guidelines is key.

FOUR LEVELS OF IP DUE DILIGENCE

IP diligence checklists are universally used, but do not help in determining where to focus the review. The four levels of IP Due Diligence, from basic to complex, are:

Level 1: Ownership. Does the target own or have licenses to the IP? This involves identifying and cataloguing the IP assets. Public assignment records can be checked, such as the patent assignment records and trademark assignment records of the United States Patent and Trademark Office (USPTO). Copyrights are often not registered, since that is not required for ownership, and trade secrets obviously aren’t publicly recorded. Overseas, local counsel can advise on other categories of IP and ownership rules. 

Licenses should be reviewed for limitations of the target’s right to use the IP. For example, the IP could be pledged as collateral for loans or other transactions. Licenses (or trademark co-existence agreements) may grant exclusive rights to certain entities, or may be limited to territories or fields of use that may conflict with the intended use of the IP by the buyer.

Figure 1

Level 2: Scope. Does the IP actually cover the business of the target (the “used” portion shown above)? Also, does it sufficiently cover current products and services, including the features that set them apart from the competition? A target company may own patents or trademarks for IP assets that it does not use anymore, especially if products, services or branding have developed and improved over time.  In some instances, the IP might cover some features of the current products or services, but not the unique aspects which give them their competitive advantage.  In other instances, the patents or trademarks might cover current but not future uses of the products. Determining the scope of US patents, for example, may involve determining the meaning of claim terms by reviewing the patent file history on the Patent Office’s public file site for Patent Application Information Retrieval (PAIR). 

As shown in the chart below, IP often covers past products because IP issuance lags product development. The IP may not cover some competitive advantage features and future products. If particular IP only covers obsolete products, further review can be skipped.
 

Figure 2

Level 3: Validity. Are IP applications likely to result in a registration or can existing registrations be invalidated? Validity reviews require in-depth review and add significant expense. They make sense if IP is a major driver of a deal. The reviewer will typically do a key word search, such as on the USPTO’s patent database site, or the WIPO (World International Patent Organization) search site. The reviewer may also check to see if any patents are being challenged for validity at the US Patent Trial and Appeal Board (PTAB).

Level 4: Freedom-to-Operate (FTO) Study: Will the purchaser be sued for infringing third-party IP? This product “clearance” or “right to use” review is the most complex and costly. It identifies potential blocking patents, which may derail the buyer’s business strategy.  This is usually more important when acquiring small companies that fly under the radar of third-party IP owners. A reviewer may start with a conversation with founders or key developers to identify known problems and key competitors. The search for third-party IP will then focus on identified key products or features, with a key word search of identified competitor patents.

TRANSACTION TYPES AND LEVELS OF IP DUE DILIGENCE

Before deciding the appropriate levels of IP due diligence for investments and acquisitions, the deal team needs to understand the deal structure and objectives of the IP due diligence.  

Venture Capital Investments
Seed and angel investors may require no or very little IP due diligence, partly because their investment is needed to even develop the invention or file patent applications.  If the product has not been developed yet, some investors will require freedom-to-operate studies (Level 4).  If the study shows that the product outlined in the business plan cannot be used without infringing existing third-party IP and ultimately costly litigation, the investors might recommend a modification of the product or decide not to invest.  

If some IP has already been developed, investors may ask how solid the company’s IP is, which means at least Level 1 review, and possibly portions of Level 2.  A typical finding is that some of the IP was not assigned to the company by the founders, employees or consultants, and assignments need execution before closing.  Some investors, typically in later stages, go further and require evidence that any filed patents actually cover the technology that provides the target company its competitive advantage (Level 2) to protect their investment.  

Asset Deals and Acquisitions of Business Units or Divisions
Cataloguing the relevant IP (Level 1) is crucial in an asset deal, in which the buyer buys only the assets listed or identified in the asset purchase agreement.  Here, recommending formal steps to perfect the IP transfer after closing is particularly important.  For trade secrets, these steps may require including certain precise contractual terms, backed by solid and specific representations, warranties and indemnifications.  

This is even more essential where the buyer does not buy all the assets of a company, but only those of a certain business unit or division within that company (“carve-out transaction”).  If an IP asset is not listed or sufficiently identified, it will generally not transfer to the purchaser.  Often the seller uses shared IP (basis technologies) throughout its company in many different divisions, not just the unit being sold. Thus, the buyer must review IP assets sold AND assets currently used, and remember to negotiate non-exclusive, fully paid up licenses for un-transferred IP being used by the acquired unit.

In any acquisition, a Level 2 and Level 3 analysis is useful to determine the value of the acquired business as well as potential liabilities and possibilities for expansion. 

Stock Purchase or Merger
In a stock purchase or merger, identifying the target IP (Level 1) may be slightly less important, as the stock deal does not require an actual assignment of the IP.  However, analyzing whether the company owns or has the right to use (license) the IP is just as important.  If some technologies are owned by third parties, even group companies of the seller, it can be difficult or impossible to convince these individuals to assign or license any missing IP after the main transaction has closed.  

If the objectives of a merger are synergies or developing new business opportunities, the IP due diligence should include the analysis of third-party IP that could hinder the expansion in a new field (Level 4).  Even though freedom-to-operate studies may be costly, they can be well worth the investment, especially for products with a high margin or high sales. 
 
Transaction Types and Level of Due Diligence (DD) Table:

Table 1

Key questions to ask the buyer or investor.
The following are questions that in-house counsel may ask their business client (the buyer or investor) and the other side (the target) before even commencing any IP diligence. The answers to these questions will allow in-house counsel to direct IP counsel to tailor the IP Due Diligence, especially when in a time crunch or on a budget:

1. What type of transaction is it? For venture capital investments, Level 1 (Ownership) is often revealing, and Level 4 (FTO) is recommended if the start-up’s product is early in the development cycle. For asset deals, Level 1 has to be very detailed, and Levels 2 (Scope) and 3 (Validity) are important. For stock deals or mergers, Levels 2 and 3 are equally relevant. In addition, Level 4 (FTO) is important when mergers are driven by the intention to expand into a new field.

2. What are the buyer’s (investor’s) strategic objectives or future plans? If some products will be dropped, diligence of the related IP can be minimized. If other products may expand into new markets, Level 4 might be crucial.

Key questions to ask the target:

1. Does the company own IP in foreign countries? Involve foreign diligence counsel early for significant markets (in particular for unique IP with no US equivalent or different rules, e.g., moral rights, utility model patents, different rules on patents on medical procedures & software).

2. Are there any products, services or IP the company has offered for many years? If so, any lawsuits or other problems are likely to have already surfaced, and less diligence is needed.

3. Does the company own IP on products it does not use anymore? If so, diligence on IP that only covers those assets may be skipped, or evaluated for sale or license.

4. Does the target own any IP that competitors might be interested in? This could suggest evaluating validity and scope to see if the IP is a good defensive weapon, or evaluating a license or sale valuation.

5. How was the product developed (what was the source)? This will provide a roadmap of areas needing investigation for risks. An early conversation with the founders or technology developers can reveal competitors, FTO reviews already done, key people recently hired from a competitor, consultants used, etc.

CONCLUSION

IP diligence should not be the same for every transaction, but should be tailored to the type of transaction. By asking the appropriate questions upfront, including a conversation with the founders or key developers, the review can be focused and tailored to fit within an appropriate budget. This requires early involvement by in-house counsel to set guidelines for the review and avoid runaway costs.

Authors: Siegmar Pohl and Paul Haughey of Kilpatrick Townsend & Stockton LLP

ADDITIONAL RESOURCES 

“Cybersecurity Due Diligence in M&A Transactions”, by Raymond O. Aghaian and Matthew Holohan, Law Weekly Colorado, May 2017

“Patent Freedom to Operate for Technology Follower Companies”, by Paul C. Haughey and Fei Shen, Kilpatrick Townsend & Stockton LLP, June 12, 2020

“When to Obtain Opinions of Counsel to Avoid Willful Infringement: Guidance for In-House Counsel”, by Paul C. Haughey and Edward J. Mayle, Kilpatrick Townsend & Stockton LLP, May 13, 2020

“Willful Blindness: Guidance for In-House Patent Review Policies”, by Paul C. Haughey, Kilpatrick Townsend & Stockton LLP, March 13, 2020

“Protecting Your Trade Secrets: Best Practices for Securing Information With New and Departing Employees”, ACC QuickCounsel by Joel D. Bush II and John M. Moye, Kilpatrick Townsend & Stockton LLP, August 11, 2015

“Trade Secrets: Legal Framework and Best Practices for Enforcement (United States)”, ACC Guide by Joel Bush, Partner, Allen Garrett, Partner, and Ben Richardson, Associate, Kilpatrick Townsend & Stockton LLP, December 2020