Intellectual Property – Due Diligence Made Easy

(IPRinfo 2/2012)

Richard Gearhart
Partner, Gearhart Law

Olli Pekonen
Director of IPR, Beneq Oy

How do you help your client get $20 million? Or, how do you save your client $20 million? Simple, just do your intellectual property (IP) due diligence (DD) right!

IP’s role as a company asset is on the rise. Moreover, true value of IP assets is not only in the ideas they protect, but also the value they create for investors, purchasers and licensees.

If your client is buying or selling a business, you, as their attorney, are responsible for ensuring that any intellectual property1 is properly represented in the case of the seller, and properly understood and reviewed in the case of the buyer. Improper due diligence around IP matters can have significant consequences for the buyer or the seller. This article addresses the sale of assets, but the considerations also apply for license deals and other types of acquisitions or investment transactions.

Considerations when representing the seller
If you are representing the seller, your first task is to advise the seller to define the universe of IP that will be part of the transaction. In some cases, it may be all of the seller’s assets; in other cases it will only be a part of the asset portfolio. You should have a careful discussion with your client to understand exactly which IP assets your client will convey. This should be done at an early stage, as you are formulating your agreement, so the definition of the IP estate can be factored into the definitions and schedules used in the agreement. If the transaction involves patents, or your client has retained IP counsel, they should be involved at an early stage in the formulation of these definitions.

If you are representing the seller, you should carefully consider when you will first allow the buyer to review your client’s IP. Often the review of IP involves the release of sensitive, confidential information. If the buyer is a direct competitor, you should do your best to guard against the possibility that the IP is not reviewed until as late as possible and the basic terms have been agreed to by both parties. Often, a disclosure plan is needed for this end. In scientific terms, this is the ”appropriability” problem inherent in usage of IP. One good method is to make a disclosure strategy where the IP information is revealed piecemeal: e.g. first have a ”radar screen” image of the entire portfolio of filings (possibly divided into the most major technology sectors) and then collect the links of the public database entries (e.g. Espacenet) to those ”radar screen pictures”. This picture contains the filings divided into company’s internal classification system (say, general machine parts, machine parts of X, application A, application B). In the first step, for yet unpublished disclosures the company can disclose the number of filings but not the content itself. By this way the buyer/investor gets a very nice idea of the focus areas of the company, but does not become aware of the actual contents of the applications, blocking rampant carbon copying of the unpublished ideas (for the published ones, the ”harm” is mostly done already). The additional benefit of the ”radar screen” is that if the company can internally classify its ideas/filings in a proven way, it is far more aware of the nature, balance, and contents of its IP portfolio than a company that files patents (or other registrable IP) just because filing IP is a business trend on the rise. Of course, well administered and organized IP portfolio is prone to increase the valuation of the IP asset.

In all, you should feel confident that the buyer is reasonably committed to the transaction before granting access to your client’s unpublished IP. This would, at a minimum, be after a confidentiality agreement and term sheet are executed. It is better to wait until at least one round of draft agreements is exchanged. If your client has IP counsel, then delaying this is also a cost advantage to the seller.

If the confidential information is especially sensitive, special confidentiality agreements can be drafted limiting review of the confidential information on a strict need-to-know basis.

It is not unusual, for example, for the IP to be placed in an electronic data room where access can be controlled. Computerized data rooms allow controlled access for different members of the due diligence team. A thing to remember is, however, that all the data can, at the end of the day, be copied from the dataroom with some effort, e.g. taking screenshots of the information therein.

As the seller’s representative, in the legal sense you should obviously advise your client to take steps to ensure that the IP is in the best possible shape before presenting it to the buyer. Any issues that can be resolved should be resolved; for example, all assignments for patents should be in place, and unresolved issues with inventors should be resolved. If the transaction involves conveying a website, then it should be confirmed that the client is, in fact, the owner of the website. Any unpaid renewals for trademarks should be up to date. Summary reports of the IP should be prepared. Any trade secrets should be investigated to make sure that they have not been inadvertently lost. Finally, any know-how should be identified and documented.

A strategy needed to address difficult issues
If there are any difficult issues in the IP estate, develop a strategy to address them, and present the issues in the best possible light. IP issues only occasionally sink deals, but problems can create a renegotiation or later adjustment of the transaction’s value and eventual remuneration, depending on the criticality of the IP.

In all likelihood, you will receive an IP checklist from the buyer to start the IP due diligence. Get ahead of the issue and provide your client with your own, similar IP checklist earlier in the process. This will help you smoke out and resolve any IP issues before the due diligence starts with the buyer, and accelerate the transaction.

As a final word related to IP selling, a lot of know-how and skill will reside in the minds of the inventors, no matter how well it is documented (so called ”tacit” or ”silent” information). What the buyer of the IP asset usually wants to see is some continuity in the employment of the inventors. As workers are at the liberty of choosing their employer, the only way to mitigate the risk of loss of talented inventors is to provide good human resource and compensation schemes for the talented inventors, and show leadership and continuity through the weeks and months the company or its IP assets are being sold.

Considerations when representing the buyer
If you are representing the buyer, your job is to evaluate the IP and ensure that it represents good value.

As a first step, do a freedom to operate (FTO) search for the key technologies, business names, trade names and copyrighted materials. This cannot be emphasized enough, even if the business is established. One of the authors recently consulted with a businessman who purchased a retail business that had successfully operated in the area for years without a website. His lawyer had not done a FTO search on the businesses name. After he purchased the business, he put up a website, and almost immediately received a cease and desist letter from a store with the same name in Maryland. The Maryland store owner had a federal trademark registration on the name long before the second store opened. The Maryland store owner only became aware of the name because the previous owner of the New Jersey store had not advertised on the Internet. The New Jersey owner was forced to change the name of his store, and lost much of the goodwill he had purchased when he bought the business.

Avoiding the IP of third parties is usually more important to the ultimate success of the transaction than quality of IP assets for sale, as important as the IP of the seller may be. Also, conducting the FTO search first will often identify other third-party IP that can be used when evaluating the strength of the seller’s IP. For example, an FTO patent search may reveal patents that are relevant to the seller’s IP for purposes of patentability.

You can always ask the sellers if they have done their FTO homework, and if so, if they are willing to share part or all of their findings. They may refuse to disclose this to maintain the attorney-client privilege, but the sellers may be willing to disclose underlying prior art or relevant trademarks without divulging opinions. It’s worth a try, and usually the sellers get extra points for providing this type of disclosure.

If you’re representing the seller, and you have an issue with the IP asset, disclosure with an explanation is always better than waiting for the buyer to find out independently. One of the authors recently represented a buyer during an IP due diligence and found out independently that the key patents in an acquisition were the subject of a validity arbitration-the seller never told the buyer’s business team that the patents were at risk. The buyer terminated the transaction the next day. Honesty is really the best practice in DD. After all, very often the goal of a DD is the merger of two organizations, and the operations of the joined companies will experience a major hiccup if trust cannot be established between the parties on all levels of the two organizations.

Identifying the strength of the seller’s IP is beyond the scope of this short article, and needs to be completed by competent practitioners. However, the buyer’s business counsel can assist by providing a strong set of representations and warranties in the agreement drafts, which will hopefully smoke out at least some IP issues. Consult with the IP counsel for particular clauses that can address particular issues the IP counsel would like addressed.

Finally it is important to investigate origin and ownership of the IP assets. Ownership of trademarks and copyrights needs to be determined. For patents, inventorship needs to be confirmed.

In a recent US case,2 an IBM employee violated her employment agreement by filing patents on inventions she made during her employment and could not prevail in a third-party claim. The court concluded that the patents were the property of IBM as a consequence of her employment contract, and, therefore, the employee lacked standing to sue the defendant. In addition, the court found that the plaintiff also lacked standing because she had made improper assignments of the same patent to different entities at different times. A careful review of the assignments would have revealed the defects. Of course, assignment of the invention is country specific. E.g. in Finland the transfer of rights related to the invention follows the Employment Invention Act. In Germany, a similar law is in place. In all, careful understandings of the source of the IP and following the chain of title are important tasks to protect the interests of your client.

Strategic and operational practicalities
A lot of insight to the value of the IP asset in a company can be gained from observing ”the way” the company manages and uses its assets. If you are representing the buyer (or are the buyer), try to find out how the following things are managed in real life terms. And if you are representing the seller, prepare yourself to answers questions related to the following areas:

* IP management process: If the IP management process is not defined and/or described in the operations manuals or guides of the company, there is a very good chance that things are done in a haphazard, reactive way. For a large portfolio it is almost certain that, for example, office actions or annuities are past their due date. How are decisions on IP done? How does the company determine what is of value to it, and what is of less value? IP is not about firefighting, it is a vital component of long term business strategy.

* At the other end of the spectrum, if the IP management process is completely outsourced, there is a good chance that the company lacks ”IP culture”, and the best ideas are not even discovered yet or they are already accidentally published etc. One key element in IP strategy is to find a balance between in-house and outsourced work. How are decisions done in this matter? How do IP related work products flow from inside to outside and vice versa? Fostering long-term relationships to outside counsels is also vital as it takes a long time to get up to speed in complex IP matters.

* If the (key) inventors are no longer with the company, there is a good chance that at least some technology areas have, for some reason, become less attractive than the management would like to believe, or would like the others to believe. In such a case, the risk of legal issues between the company and the inventors is also heightened. Of course, there can be understandable reasons for the absence of the inventors and innovators, but finding causes of this might give the buyer good leads to some deeper underlying problems in the business being bought. It also depends on the maturity / life cycle of the company being acquired – a lot of judgment is needed when assessing the impact of loss of inventors to the IP’s value.

* The relationship of the IP portfolio vis-à-vis the business should be checked. If there is no or weak match (the portfolio is not really related to the things the company does), the buyer probably should beware. Can you find the causes for the filing of the patents that appear to be of little value? Or can you find the causes of the company entering new business areas with no IP backing? Is the company following its strategy?

* If the inventions do not lump up to some amount of discrete ”piles”, there is a good chance that the filings/patents do not create sensible protection. Perhaps company under acquisition has been ”filing happy”, shooting applications here and there, with no real strategic intent. A solid portfolio has several unique landmark filings followed by ”quantification” of the invention, manifested by many smaller scale filings in a sensible order. Again, finding the ”train of thought” on why the filings were done sheds important light in this matter. And if you cannot find this train of thought, why is this?

* Does the company have any procedure or rule when determining what to file and what to keep as a trade secret? Registering IP is publishing, and esp. for patents, competence is also destroyed when patent applications are published. Can the company reap rewards during the time-limited monopoly of the patent, and can it show that an infringement has really taken place? How will the contemplated transaction change this? Especially this bullet requires deep understanding of the business realities related to both the buyer and seller.

A vital piece of a puzzle
In all, successful DD is one piece of a puzzle where organizations and/or capital of at least two companies are merged. The sad truth is that many investments and mergers fail to reach their original planned goals.

Why this is so is a complex matter involving business, organization, capital and operations synergies. But surely ”getting the IP straight” from both legal and business strategy viewpoint is a very important aspect in this process, too!

Richard Gearhart is the partner and founder of Gearhart Law, LLC, located in Summit. He concentrates in all aspects of the patent field, including global litigation and patent prosecution.

Olli Pekonen is the Director of IPR in Beneq Oy (Vantaa, Finland), a supplier of production and research equipment for advanced thin film coatings. Beneq’s extensive IP portfolio contains e.g. well over 100 patent filings. Olli concentrates in various aspects of IP generation, prosecution, value generation and value capture.


For purposes of this article, ”intellectual property” (or IP) means those assets of the business comprised of patents, trademarks, copyrights, know-how and trade secrets.

”Patents” are government documents (e.g. from the U.S. Patent and Trademark Office in the U.S.) granting the exclusive rights to use the inventions or technology in the country in which the patent is issued.

”Trademarks” are government certifications granting the owner the exclusive rights to use a name or logo in connection with particular classes of products in the country or state in which the trademark is issued.

”Copyrights” protect original works of expression, and may be registered or unregistered. It is not necessary for copyrights to be registered in order for them to be transferred.

”Know-how” is particular practical knowledge that is useful in an industrial process. A ”trade secret” is any business secret that gives a competitive advantage.