Scoping an IP Due Diligence

Anyone involved in merger and acquisition (M&A) transactions will be familiar with due diligence investigations. Before buying a business, it makes sense for the vendor to investigate the target business to identify potential ‘skeletons in the closet’ that might affect value. In the context of a capital raising that requires a prospectus to be issued, the exercise of due diligence may afford a defence to liability if it turns out that the prospectus is defective.

For larger M&A transactions, the due diligence process is typically formalised by the use of a ‘data room’ (either physical or virtual) containing documents relevant to the business. Access to the data room is usually strictly controlled, and there will generally be a question and answer process by which bidders have the opportunity to ask questions of the target’s management.

Balancing risk and cost

Thoroughly assessing the IP of a business can be a costly exercise, and a key issue which arises time and again for those undertaking due diligence investigations is how best to scope the investigations in a manner that appropriately balances risk and cost.

‘Materiality thresholds’ will generally govern what is to be reported to the bidder’s management (or what is to be included in a prospectus) and they are the starting point for scoping any due diligence.

From an IP perspective, scoping a due diligence exercise can be particularly tricky. A typical IP due diligence will involve searches to ascertain what IP is owned by the target business. However, ownership searches alone do not provide any meaningful information in relation to the quality or validity of the relevant IP. For example, searches may show that a business has filed multiple patent applications. However, without further investigation it is not possible to draw any conclusion as to whether those applications are likely to result in granted patents, or whether the applications have any real value whatsoever.

Similarly, a typical IP due diligence – which involves compiling schedules of IP owned by the target business – will not reveal potential ‘freedom to operate’ risks, such as a key brand that is owned by another entity.

Five key areas of enquiry

We suggest that the best way to scope an IP due diligence is to focus on what is of most value and potential value to the target business. For example, we suggest asking management the following questions:

  1. What are the key product or service lines of the target business? Which product lines generate the most revenue for the business, or are most profitable? Do those product lines embody any IP (e.g. brand names, patents, designs), and if so, what is the breadth/strength of that protection? Patent and design expiration dates relevant to key product lines may provide an indication of when the business can expect to face additional competition.
  2. What are the key markets in which the business operates? Which countries generate the most sales for the business? IP searches should be focussed on those countries.
  3. Is capacity for expansion part of the perceived value of the business? For example, are there countries into which the business does not presently sell, but into which it might expand? Which brands and product lines would be sold in those countries? If expansion plans contribute to the perceived value in the business, it would be worthwhile checking that there are no issues with using key brands in those countries.
  4. Are there particular manufacturing technologies or product features that are valuable to the business and which the business considers proprietary? Are those technologies protected by patents, or can they be protected as confidential information?
  5. How is IP managed within the target business? The quality of a business’s IP management systems may provide an insight into the likelihood of identifying hidden IP issues. How is IP managed in the business? Who within the business is responsible for identifying new IP and instructing attorneys? What systems/processes are in place for making decisions in relation to new filings and renewals? How much does the business spend annually on IP protection and enforcement?   Armed with the answers to these questions, it is possible to scope an IP due diligence that is focussed on what is material to the target business. A properly scoped and targeted IP due diligence is likely to provide information and insights that are useful to management, and will assist management to make quality decisions in relation to the proposed transaction.

First published in Watermark Journal Vol 30 No 1