Conducting focussed and timely due diligence is vital to a successful M&A deal. A KPMG study revealed that effective due diligence is one of three critical areas for generating long-term success from M&A deals, the other two being a well-executed integration plan and the correct valuation. Even though it is always an important pre-deal activity, those companies who focus their attention on due diligence have a positive expectation of a successful deal as compared to the average company.
Due diligence in M&A deals is more than just IP due diligence, but that is where we focus our attention, for obvious reasons. There are perhaps three main areas in an IP due diligence analysis: the identity, ownership, and status of the IP assets; the strength and value of the IP assets; and the risk of infringement of third party IP rights. Each of these areas should be assessed for the target company. They should also be assessed early on in the pre-deal timeline; we have too many stories of companies waiting until the last minute to make even basic checks as to the status and strength of a target company’s key IP. Waiting to the last minute may not only cause delays, it may also limit the opportunities available for negotiating a better deal if issues are found.
Ownership and status
It is important to assess what IP a target company has, who owns it, and what is its status. That IP might include patents, trade marks, designs, know-how and confidential information. Among other considerations, the following are clearly important:
- What patents and patent applications does the target company have throughout the world?
- What is the status of those patents and patent applications, have the maintenance fees been paid?
- Are there any validity issues with the granted patents, such as known prior art, issues with inventorship, etc?
- Is there a clear chain of title of those patents and patent applications to the target company?
- This may involve assignments from inventors, consultants, or suppliers who assisted with the development of the innovation, or from third party companies from whom the rights were purchased.
- Are there any material exemptions from the assignments which may cause issues, for example were any rights reserved in a particular territory?
- What trade mark registrations does the target company have throughout the world?
- Are there any unregistered trade marks?
- What design registrations does the target company have throughout the world?
- Are there any unregistered designs?
- Are there any trade secrets that are essential to the company’s business?
- If so, is there a policy in place for identifying trade secrets?
- What steps has the company taken to protect those trade secrets?
It is also important not to forget that the company may have IP for which it has not yet sought protection, either because it does not realise that the IP exists or because the R&D has not yet reached the stage where it is ready to be protected. An IP audit of the target company can be a valuable tool to enable the discovery of IP which is not immediately visible to you, or even the target company itself.
Value and strength
Related to the ownership and status of a target company’s IP, is the strength and value of that IP. Although these two aspects are clearly related, a valuable patent may not be particularly strong, and a strong patent may not be particularly valuable. Nevertheless, a valuable patent is clearly more valuable if it is also strong.
The value of IP is notoriously difficult to assess, and as such there are many methods available. The three most common are the cost approach, the income approach, and the market approach. The method, or methods, you use will depend on many factors, but in particular on whether the patent is currently in use, i.e. does it cover one or more of the company’s products, whether is it currently being licensed, and whether it is known to cover a competitor’s product.
Briefly, these methods can be summarised as follows:
- the cost approach involves determining what the replacement cost would be for the invention protected by the patent;
- the income approach presumes that the value of the IP is the current cash value of the future benefits of the IP. For example, for a patent, the future benefits would be increased sales, cost premiums, licensing fees, reduced cost of manufacturing, etc.
- the market approach essentially relies of the old adage that something is only worth what someone is willing to pay for it. This approach relies on there being an active market for IP in the sector, and knowledge of previous transactions for comparable IP. For most sectors this will not be the case.
Feeding into the analysis will be objective factors such as the remaining lifespan of the patent, whether it is part of a large family of patents covering many countries, the size of the market in the country the patent covers, etc. In addition, it may be possible to feed in more subjective factors such as how litigious the patent owner is, the public’s perception of patented products in the sector, whether the patent is within a patent pool, etc.
Whichever method of analysis is used it will have its drawbacks, especially because the lifetime of IP generally far exceeds the ability to predict what will happen in the market over that time. This means that, in general, it is far easier to value a portfolio of IP, rather than individual IP rights.
The strength of any individual IP right is dependent on many factors, but is generally easier to assess than the value since it is inherently more objective. In particular, where the relative strength of patents in an IP portfolio is being assessed, the task is far less daunting. Such a comparative analysis of strength can be useful in assessing whether an IP portfolio has strength in the right places. If the strong patents are not in use, and not valuable as a result, then that strength is more or less irrelevant, at least at that point in time.
In effect, the strength of an IP right is proportional to how enforceable that right is against a third party. The enforceability, or at least the perceived enforceability, will be dependent on which point in the process the IP right is. Taking a patent for example, the strength will increase as the patent application progresses through the patent prosecution process from first filing, through to search and examination, onto grant, post-grant reviews, and finally litigation in a national court. At each stage, the patent application, and subsequent patent will increase in strength.
A number of objective factors will feed in to the analysis of the IP strength, and these objective factors include:
- the length of prosecution of the patent
- a granted patent that required a hard fight to get through the examination process, where the patent examiner raised a number of well thought out objections, will likely be stronger than a granted patent which had a comparatively easy ride
- number of forward citations
- a granted patent which has been cited many times by patent examiners as being relevant prior art in the field is likely to be stronger than a patent which has not
- number of backward citations
- a granted patent which had a large number of prior art documents cited against it during the examination process, will likely be stronger than a granted patent which had fewer prior art documents cited against it
- number of claims
- a granted patent with more independent clams, and more dependent, fall-back, claims, is likely to be stronger
- length of specification
- although not a robust indicator of strength, a granted patent, or patent application, with a long specification likely had more time spent on it during the drafting process, with more information included, and may be stronger as a result
An appropriate infringement risk analysis, often called ‘freedom to operate’ or simply FTO, is an important tool in any deal, but also when launching any new product. Personally, I find the term ‘freedom to operate’ can be misleading, because it implies a binary situation where the company either has freedom to operate or it does not. I believe that it is much more appropriate to use the term infringement risk analysis, which seems much more likely to ensure a company balances those risks against the perceived commercial gain of launching the product.
Any successful infringement risk analysis will balance the costs involved with the size of the deal, or project. As a rule of thumb, setting aside one or two per cent of the total project budget is generally appropriate.
At the very least the infringement risk analysis of third party patents will start with a review of the company’s current products, and any upcoming products to determine the scope of the search for third party rights; the budget available will also feed in to the scope of the search.
The search will discover a number of patents and patent applications that are of potential relevance, and each then needs to be analysed to determine the potential risk. At this stage, it is often useful to allocate a risk level in dependence on the key factors which indicate patent strength. For example, a granted patent in a key jurisdiction with claims to patent monopoly that are relevant to a company’s product would likely be allocated the highest risk level, while a pending international patent application with broad and relevant claims, yet to enter a key jurisdiction, with a negative search report, would likely be allocated the lowest risk level.
As well as conducting an infringement risk analysis, which primarily relates to future risks, an analysis of ongoing, and known, risks should be conducted. There are many considerations when conducting such an analysis, including:
- Is the company infringing (or has the company infringed) the IP rights of any third party?
- Is a third party infringing (or has a third party infringed) the IP rights of the company?
- Is the company involved in any IP litigation or other disputes, or received any offers to license or letters before action from third parties?
- What technology, if any, does the company license from third parties, and how critical are those licences to the company’s business?
- Has the company granted any exclusive technology licences to third parties?
- What indemnities has the company provided to (or obtained from) third parties with respect to possible intellectual property disputes or problems?
In summary, when you are carrying out IP due diligence, the identification of a target company’s IP, and the subsequent analysis of the ownership and status, and value and strength is an important, but often difficult, task. In addition to the analysis of the target company’s IP, you should consider the infringement risks which may exist because this is crucial to ensure that the target company is able to market a new product, or continue to market existing products; remember, a small target company may have slipped under the radar of a third party with relevant IP.
IP due diligence is therefore critical to you achieving a successful deal, and if done well can feed in to the other critical areas for generating long-term success. A timely IP due diligence briefing by experienced patent attorneys can provide your deal team with important information on IP, and highlight any areas that need your particular attention.
Such a briefing can also be an important ongoing tool to help your deal succeed well into the future by informing the company of areas of weakness in an IP portfolio, or even to highlight future acquisition targets.
If you need assistance with IP due diligence, please do get in touch: our experienced team will be happy to help.
This article is for general information only. Its content is not a statement of the law on any subject and does not constitute advice. Please contact Reddie & Grose LLP for advice before taking any action in reliance on it.