Intellectual Property (IP) due diligence can represent a critical part in an overall due diligence process in connection with a number of business deals including:
- private equity financing;
- refinancing; and
- in- or out-licensing.
Unfortunately, though, IP due diligence often receives superficial attention and, moreover, often not until after the terms of a transaction are established. This is particularly significant because in many cases a high proportion of an entity’s assets may be intangible.
So why is this? Certainly, one factor is that many entities lack a true understanding of the nature and value of their IP portfolio. On the other side of the fence many prospective acquirers or investors also lack understanding of the IP involved in a deal. Other reasons include a lack of appreciation of the type of information that can be generated from a sound IP due diligence exercise and a lack of awareness of the global competitive landscape within which an entity operates or proposes to operate. These factors may have a profound impact on future business success or failure.
IP assets, including patents, designs, trademarks, copyrights, confidential information, and other know-how, can be core to many deals, particularly those which are heavily technology focused. Additionally, the competitive landscape associated with many technical fields is complex and rapidly evolving. Therefore entities contemplating commercial transactions are well advised to obtain a full understanding of the value and risks associated with relevant IP before a transaction is closed. Adopting such a proactive approach in relation to IP risk management helps protect against present and future global market developments.
How much diligence is due?
A central question in any IP due diligence exercise is often posed as “how important is the IP to the transaction?” or “what are the drivers of the transaction which IP may enable?” However, a problem with such approaches is that the importance (or in some cases the non-importance!) of the IP may not be fully appreciated until after the due diligence study is undertaken. Perhaps, therefore, a suitable amount of IP due diligence can best be determined by balancing risk with cost. In such a scenario IP due diligence is as much about what is not done as it is about what is done.
Traditional IP due diligence
Traditional IP due diligence is often limited to the following enquiries:
- Identification and status of registrable IP
- Establishing ownership of the IP
- Identifying any encumbrances (such as agreements or licences)
While these are all important, they fall well short of generating the type of information necessary to reasonably assess future risk to a business venture. It is apparent that restriction to such enquiries fails to address the inherent strength of the IP, its alignment with future business strategy, and extraneous competitive factors that likely impact the value of the IP. Effectively, it’s IP due diligence with your head in the sand!
What can go wrong?
Some simple examples of where a limited IP due diligence study can fail to uncover critical issues are:
- a technology company gearing up for IPO and pinning its hopes on an exciting patented new product was rendered essentially valueless on the basis of public disclosure years earlier, which a limited due diligence study had failed to uncover
- a company with broad granted patent rights was acquired by a larger competitor. Limited due diligence did not include freedom to practice analysis in a key geography and failed to recognise that key new products falling within the broad patent claims actually infringed 3rd party patents. The value of the deal was significantly diminished
- a company identified South America as a potential future market for its product. Extensive development work was undertaken with a view to partnering with a local company to market and sell the product. However, prior to finalising the deal it was discovered that no patent protection was present in South America. In fact patents were never filed there and it was now too late. Limited IP due diligence had focused on analysing existing IP rights and did not take into account future company strategy.
Effective IP due diligence is a marriage of technical, legal and commercial enquiries. Focusing on deals that are technology enabled, a thorough understanding of the strength and weaknesses of an entities patent portfolio and associated know-how, positioned within the global competitive landscape should be acquired.
Effective IP due diligence
Advantageously, IP due diligence should be performed as early as possible in the deal making process, particularly where patents could play a key role.
Important enquiries may include:
Patent strength and value
Patent strength can be related to a number of factors including:
- scope of granted patent rights
- validity of granted patents
- potential scope of patents not yet granted
- ease of work-around of granted patent rights
- market size that a patent may protect
- geographic coverage
Such assessments depend on a careful analysis of claim scope in view of the products or services relevant to the market sector that the patent protects.
Patent value may include the additional factor of market value in terms of a royalty rate or acquisition price that the patent may command.
3rd party rights
There remains a misconception that a patent gives its owner the right to make or sell a product or perform a process. However, a patent does not afford the right to make or sell anything. It is an exclusionary right, excluding others from the claims of the patent. In this regard it is important to determine the freedom to practice a technology, based on the granted patents of others, in relevant geographical areas. Even inherently strong patents may have their value significantly diluted in the light of granted 3rd party patents.
The value of a patent may be severely impacted by competitive technologies. This is particularly true in rapidly developing fields. Such dilution may be in the form of existing and future competitive patents but also in the form of non-patented developments.
Therefore, effective IP due diligence should include a study of the competitive technology landscape so that the value of a particular technology can be compared to others. These competitive technologies may be different but may solve the same problem as that of the patent under question. Typically, an entity will not be fully aware of the global competitive developments in the field that it operates in. Further, while varying from field to field it is generally accepted that some 80% of technology is only ever published in patents and in no other form of communication. Therefore, patents represent a good proxy for the general state of developments in a field. Undertaking such a technology landscape study based on patent publications may seem like a daunting task, but modern patent and business analytics software has significantly shortened the time and reduced the cost of obtaining and organising such key information and providing relevant and valuable market insight.
A sound IP due diligence exercise provides not only an opportunity to understand the strengths and weaknesses in the IP associated with a deal but also around the overall business case. It may be possible to determine that a business venture will be significantly less profitable than first envisaged, or in the extreme, will not succeed. Alternatively, that a business venture has more potential value than first thought.
Additionally, sound IP due diligence not only reveals relevant issues, it also provides valuable global market intelligence by identifying who is developing or using similar technologies. This may lead to new partnerships, collaborations or other opportunities.
How much does IP due diligence cost?
Compared to the risk of losing a significant investment, IP due diligence is relatively inexpensive. However costs and timing are obviously key factors in any transaction process and a flexible approach that focuses on an entity’s needs should be undertaken. It is apparent that even where IP does not appear to be of key relevance to a transaction, some level of IP due diligence may reveal problems which impact on the final outcome. Watermark can work closely with clients, irrespective of their experience in IP, to provide due diligence output aligned to needs, while balancing risk with cost.