IP Due Diligence: What Does It Mean to You?

The evaluation of the assets and liabilities of a business is referred to as a due diligence review. Most commonly, these evaluations determine the value of a business for purposes of investment or the establishment of a relationship with the business. Because the value of intellectual property has increased substantially recently and patent protection in many countries has expanded to cover software and business methods, businesses without IP assets and existing or potential IP-related liabilities are rare. With the consistent increase in damages for IP infringement and the possibility of business-crippling injunctions, it is likely that any business will be subject to, or will itself conduct, an IP due diligence.

Due diligence reviews identify problems early on when they are easier to cure. Thus, reviewing the process and its results is helpful in understanding and addressing issues affecting the value of your business, and will allow you to meet due diligence reviews calmly and effectively when they arise.

When Should a Due Diligence Be Conducted?

Most situations in which due diligence reviews are advisable fall into one of the following categories: 1) investing in or purchasing a business; 2) establishing a relationship with a business (eg, mergers, joint ventures and licensing); 3) stock offerings (eg, initial public offerings); and 4) adversarial proceedings (eg, litigation).

In addition, an internal IP due diligence review should be undertaken whenever circumstances arise that may involve a due diligence review of your business by another party. For example, a buyer may ask that a seller warrant that it is: 1) the sole owner of each of a list of identified IP assets; 2) not aware of any infringement of its IP rights; or 3) not aware of third-party IP rights that are infringed by the seller's business activities. Investigating these issues through an internal due diligence allows the seller to address difficulties or potential difficulties at a time and in a manner of its choosing (ie, before they are uncovered in the buyer's due diligence) and to qualify the warranty language accordingly. Although disclosing such unfavorable information may have a negative impact on the deal, this impact pales in comparison with the consequences of such a problem surfacing unexpectedly during negotiations or after a deal has been completed.

As a great deal of confidential information is likely to be communicated, it is imperative that a nondisclosure agreement be executed before any non-internal review commences. Even with a nondisclosure agreement in place, the transfer of sensitive material may carry risks that are most effectively dealt with by requiring the receiving party to employ outside counsel. Most nondisclosure agreements strictly limit the use that can be made of the disclosed material. Usually excepted from the scope of these agreements is information independently developed by the receiving party. These provisions are well intended, but are often insufficient to prevent a conflict from arising when the receiving party, after declining a deal, introduces an “independently developed” product incorporating the information. Such accusations may be minimized or avoided if the most sensitive information is provided only to a party's outside counsel with strict limitations as to the scope of information that may be provided to the client.

The Scope of IP Due Diligence

The scope of the due diligence will also vary widely depending on the circumstances and the goals of the due diligence as well as the makeup of the party being examined. In general, the due diligence will involve: 1) the identification of all IP assets; 2) an evaluation of the value of these assets; and 3) an evaluation of the IP rights of third parties and their potential impact on current or future business activities.

Identification of IP Assets

The IP assets of a business will usually consist of patents, trademarks, copyrights and trade secrets. Ensuring proper identification of these IP assets will involve several tasks that are relatively simple, but which can have a significant impact on the final result. For example, requesting a list of issued patents and pending patent applications is easy enough, but it is not advisable to accept such a list as definitive. The documents establishing ownership of the assets must be examined in detail. If outside consultants or design firms are involved, agreements setting out ownership of the material developed must be closely read. If IP development has been completely internal, a review of the scope and date of Employee Agreements is essential. Often this review will raise issues that can be corrected quite easily by the examined party, but that would be difficult or impossible to cure after a deal has been completed. For example, the examined party is in a much better position to locate the documents necessary to establish the chain of title to IP assets acquired from third parties or to track down inventors and induce them to sign necessary documents, etc.

Finally, if IP has been developed in foreign countries it is important to consult local attorneys to determine whether the creators of the IP (eg, inventors, software developers, etc.) retain rights to their creations regardless of agreements assigning those rights away.

Evaluation of IP Assets

The first step in evaluating IP assets is to determine their relative importance so that efforts may be focused accordingly. For example, if a business is being acquired so that the acquirer may market one product under the acquirer's name, the due diligence may rest almost entirely on the evaluation of a core group of assets (eg, patents and trade secrets covering the particular product). If, on the other hand, the examined business will continue to function as a unit, a more thorough review of the entire IP portfolio will need to be completed.

Once the assets have been ranked, each asset is examined to determine its value. The examined party's patents, for example, should first be reviewed to determine the scope of their coverage in relation to that party's products. This review involves applying the claims to both current and future products to determine if the claims actually cover those products and, if so, how broadly. Language that strictly adheres to details of the product's construction and/or operation should be reviewed to determine if competitors will be able to effectively design around the patents (ie, make use of the advantages of inventions embodied in the product without infringing the claims of the patents). Regardless of the possibility of design around, it is important to review the patents to identify pending applications that relate back to the earlier patents. Such applications allow claim language to be submitted that is tailored to new product configurations or products of competitors.

In addition, the geographic scope of coverage of each IP asset must be reviewed to ensure that this scope corresponds with the market. Patents and trademarks have effect only within the country that issued them. International treaties make worldwide coverage possible for patents and trademarks, but filings must be made in the various countries to obtain this coverage. Also, there are time limits for foreign patent filings that must be strictly adhered to or coverage will be denied. Copyrights are less restricted by national borders, but there are many important distinctions in protection mechanisms and enforcement from country to country. Thus, when valuing assets with significant overseas markets, local legal expertise should be sought.

Licensed IP must be evaluated in terms of its scope and relation to the products as described above and, in addition, the license agreement itself must be carefully reviewed to ensure that the licensed asset(s) will be available for use as desired. These agreements often include significant field of use and geographic limitations and may strictly limit the transfer of the licensed rights or the modification of the licensed asset. Even where such limitations seem to directly challenge an intended use, there may be a solution (eg, the deal may be restructured as a stock purchase that allows the acquiring party to make use of the IP without an assignment). Whether such a solution is available or not, it is necessary to identify the issue early on before committing to a deal.

Finally, it is important to make a determination as to the possibility that any of the IP assets are invalid. The examined party should be asked to discuss in detail any challenges to the validity of any of its assets including providing the material forming the basis for any challenge as well as information on the resolution of the matter. In addition, the examined party should be asked to provide the results of any internal studies of IP asset validity (eg, searches for prior art relevant to patents, etc.). The relevant patent files should then be cross-checked to ensure that this material has been submitted to the patent office. For key assets, an independent search and determination with respect to validity is strongly recommended.

Evaluation of Third-Party IP

Third-party IP rights must also be reviewed to determine whether the examined party's business activities are infringing any of these rights. For example, it is a common misconception that obtaining a patent confers the right to make the described product. In fact, patents grant only the right to prevent others from making, using or selling the invention and several parties may have valid patents covering various aspects of a single product.

The examining party must be asked to discuss in detail any assertions of IP infringement and its responses. For example, if patent infringement has been asserted, the precise wording of the assertion and its timing can have a significant impact on the course of future legal proceedings. Whether the party sought an outside legal opinion evaluating such an assertion may also affect the amount of damages a court may grant for infringement. Thus, a party should be asked to discuss generally the nature and timing of these opinions. If more information is desired, the party may be asked to turn over the opinions for review. However, such a disclosure may waive the attorney-client privilege with respect to these opinions. In any case, it is often wiser to seek independent legal opinions than it is to rely on the conclusions of attorneys who do not represent your interests.

The evaluation of the assets and liabilities of a business is referred to as a due diligence review. Most commonly, these evaluations determine the value of a business for purposes of investment or the establishment of a relationship with the business. Because the value of intellectual property has increased substantially recently and patent protection in many countries has expanded to cover software and business methods, businesses without IP assets and existing or potential IP-related liabilities are rare. With the consistent increase in damages for IP infringement and the possibility of business-crippling injunctions, it is likely that any business will be subject to, or will itself conduct, an IP due diligence.

Due diligence reviews identify problems early on when they are easier to cure. Thus, reviewing the process and its results is helpful in understanding and addressing issues affecting the value of your business, and will allow you to meet due diligence reviews calmly and effectively when they arise.

When Should a Due Diligence Be Conducted?

Most situations in which due diligence reviews are advisable fall into one of the following categories: 1) investing in or purchasing a business; 2) establishing a relationship with a business (eg, mergers, joint ventures and licensing); 3) stock offerings (eg, initial public offerings); and 4) adversarial proceedings (eg, litigation).

In addition, an internal IP due diligence review should be undertaken whenever circumstances arise that may involve a due diligence review of your business by another party. For example, a buyer may ask that a seller warrant that it is: 1) the sole owner of each of a list of identified IP assets; 2) not aware of any infringement of its IP rights; or 3) not aware of third-party IP rights that are infringed by the seller's business activities. Investigating these issues through an internal due diligence allows the seller to address difficulties or potential difficulties at a time and in a manner of its choosing (ie, before they are uncovered in the buyer's due diligence) and to qualify the warranty language accordingly. Although disclosing such unfavorable information may have a negative impact on the deal, this impact pales in comparison with the consequences of such a problem surfacing unexpectedly during negotiations or after a deal has been completed.

As a great deal of confidential information is likely to be communicated, it is imperative that a nondisclosure agreement be executed before any non-internal review commences. Even with a nondisclosure agreement in place, the transfer of sensitive material may carry risks that are most effectively dealt with by requiring the receiving party to employ outside counsel. Most nondisclosure agreements strictly limit the use that can be made of the disclosed material. Usually excepted from the scope of these agreements is information independently developed by the receiving party. These provisions are well intended, but are often insufficient to prevent a conflict from arising when the receiving party, after declining a deal, introduces an “independently developed” product incorporating the information. Such accusations may be minimized or avoided if the most sensitive information is provided only to a party's outside counsel with strict limitations as to the scope of information that may be provided to the client.

The Scope of IP Due Diligence

The scope of the due diligence will also vary widely depending on the circumstances and the goals of the due diligence as well as the makeup of the party being examined. In general, the due diligence will involve: 1) the identification of all IP assets; 2) an evaluation of the value of these assets; and 3) an evaluation of the IP rights of third parties and their potential impact on current or future business activities.

Identification of IP Assets

The IP assets of a business will usually consist of patents, trademarks, copyrights and trade secrets. Ensuring proper identification of these IP assets will involve several tasks that are relatively simple, but which can have a significant impact on the final result. For example, requesting a list of issued patents and pending patent applications is easy enough, but it is not advisable to accept such a list as definitive. The documents establishing ownership of the assets must be examined in detail. If outside consultants or design firms are involved, agreements setting out ownership of the material developed must be closely read. If IP development has been completely internal, a review of the scope and date of Employee Agreements is essential. Often this review will raise issues that can be corrected quite easily by the examined party, but that would be difficult or impossible to cure after a deal has been completed. For example, the examined party is in a much better position to locate the documents necessary to establish the chain of title to IP assets acquired from third parties or to track down inventors and induce them to sign necessary documents, etc.

Finally, if IP has been developed in foreign countries it is important to consult local attorneys to determine whether the creators of the IP (eg, inventors, software developers, etc.) retain rights to their creations regardless of agreements assigning those rights away.

Evaluation of IP Assets

The first step in evaluating IP assets is to determine their relative importance so that efforts may be focused accordingly. For example, if a business is being acquired so that the acquirer may market one product under the acquirer's name, the due diligence may rest almost entirely on the evaluation of a core group of assets (eg, patents and trade secrets covering the particular product). If, on the other hand, the examined business will continue to function as a unit, a more thorough review of the entire IP portfolio will need to be completed.

Once the assets have been ranked, each asset is examined to determine its value. The examined party's patents, for example, should first be reviewed to determine the scope of their coverage in relation to that party's products. This review involves applying the claims to both current and future products to determine if the claims actually cover those products and, if so, how broadly. Language that strictly adheres to details of the product's construction and/or operation should be reviewed to determine if competitors will be able to effectively design around the patents (ie, make use of the advantages of inventions embodied in the product without infringing the claims of the patents). Regardless of the possibility of design around, it is important to review the patents to identify pending applications that relate back to the earlier patents. Such applications allow claim language to be submitted that is tailored to new product configurations or products of competitors.

In addition, the geographic scope of coverage of each IP asset must be reviewed to ensure that this scope corresponds with the market. Patents and trademarks have effect only within the country that issued them. International treaties make worldwide coverage possible for patents and trademarks, but filings must be made in the various countries to obtain this coverage. Also, there are time limits for foreign patent filings that must be strictly adhered to or coverage will be denied. Copyrights are less restricted by national borders, but there are many important distinctions in protection mechanisms and enforcement from country to country. Thus, when valuing assets with significant overseas markets, local legal expertise should be sought.

Licensed IP must be evaluated in terms of its scope and relation to the products as described above and, in addition, the license agreement itself must be carefully reviewed to ensure that the licensed asset(s) will be available for use as desired. These agreements often include significant field of use and geographic limitations and may strictly limit the transfer of the licensed rights or the modification of the licensed asset. Even where such limitations seem to directly challenge an intended use, there may be a solution (eg, the deal may be restructured as a stock purchase that allows the acquiring party to make use of the IP without an assignment). Whether such a solution is available or not, it is necessary to identify the issue early on before committing to a deal.

Finally, it is important to make a determination as to the possibility that any of the IP assets are invalid. The examined party should be asked to discuss in detail any challenges to the validity of any of its assets including providing the material forming the basis for any challenge as well as information on the resolution of the matter. In addition, the examined party should be asked to provide the results of any internal studies of IP asset validity (eg, searches for prior art relevant to patents, etc.). The relevant patent files should then be cross-checked to ensure that this material has been submitted to the patent office. For key assets, an independent search and determination with respect to validity is strongly recommended.

Evaluation of Third-Party IP

Third-party IP rights must also be reviewed to determine whether the examined party's business activities are infringing any of these rights. For example, it is a common misconception that obtaining a patent confers the right to make the described product. In fact, patents grant only the right to prevent others from making, using or selling the invention and several parties may have valid patents covering various aspects of a single product.

The examining party must be asked to discuss in detail any assertions of IP infringement and its responses. For example, if patent infringement has been asserted, the precise wording of the assertion and its timing can have a significant impact on the course of future legal proceedings. Whether the party sought an outside legal opinion evaluating such an assertion may also affect the amount of damages a court may grant for infringement. Thus, a party should be asked to discuss generally the nature and timing of these opinions. If more information is desired, the party may be asked to turn over the opinions for review. However, such a disclosure may waive the attorney-client privilege with respect to these opinions. In any case, it is often wiser to seek independent legal opinions than it is to rely on the conclusions of attorneys who do not represent your interests.