IP Due Diligence in Corporate M&A

2010/07/05,By Jia Xiaohai,[Comprehensive Reports]

  Intellectual property (IP) has become an important factor enterprises must consider in mergers and acquisitions (M&A).
  In recent years, more and more mergers and acquisitions target technologies, IP, and technical personnel responsible for research and development (R&D). In the meantime, IP rights may usually be viewed as valuable assets for the target companies holding knowledge-based innovation, high-tech, or specific manufacturing processes.
  Due diligence valuation is generally involved in the M&A process for the legal and financial status of the targets. In the past, IP was classified as within the scope of legal due diligence with the contents usually limited to the ownership of trademarks, patents, copyrights and a review of relevant contract terms. However, IP is different from inmovables and other tangible assets. IP is an intangible asset and there are no clear criteria in the assessment of its value due to its intangibility. Some IP issues are relatively complex, and some particular technologies or softwares may become obsolete with the development of modern science and technology, which, in turn, has brought many uncertainties and difficulties to the valuation of IP assets. Therefore, when acquiring a target with major IP assets, especially when the stakes are high, it is particularly important to lift IP matters from the other legal relationships and treat them as an independent legal relationship in the valuation. The larger the proportion of IP in the target’s core assets, the greater the elements of variables and uncertainties in the target’s operations and development. This in turn also determines whether the acquiring party is able to eventually achieve its key strategic objectives through acquisition. IP due diligence valuation not only depends on lawyers, but sometimes includes the cooperative efforts of patent agents, technical professionals and experts from trade associations in order to ensure a smooth and efficient acquisition while minimizing risks and costs.

  I. Due diligence valuation procedure
  1. In the early stage of an M&A, the buying company and the target may make initial contacts about the purchase intentions, general situation of the target and the acquisition process. This includes discussions about how and when to conduct a due diligence valuation. Some IP matters, such as trade secrets, are unique and confidential. If they are disclosed to a third party, it is likely that they will lose their economic value. Therefore, it is necessary that a confidentiality agreement be signed between the targeted and the buying company seeking a due diligence valuation.
  2. Given the many unpredictable variables in the M&A process, it is not uncommon for an acquiring party to abort its acquisition plan after conducting a due diligence valuation. The target should work out a disclosure schedule of trade secrets with lawyers, patent agents and other professionals, even if a confidentiality agreement has been entered into with the acquiring party, in order to discuss gradual disclosure step by step and in stages in the order of importance. If the party which may be acquired discloses all of its IP rights at the very outset, particularly all of its trade secrets, that party may suffer irreparable losses in the event that the acquisition plan is aborted.
  3. The acquiring party should, at the same time, urge the target to make sufficient communications in advance with the technical staff who master core technologies in order to make them understand the acquisition and purposes of the due diligence valuation. This is necessary because during the course of a due diligence valuation, lawyers from the acquiring party will communicate with these people through talks and inquiries and ask them to answer related questions. If this staff does to know in advance the details of the acquisition, they might be uncooperative or wait to resign after the original enterprise is acquired, which may lead to risks of a loss of technologies and brain drain for the acquiring party.
  4. After solving the above problems, the acquiring party and the acquired party should agree to the basic legal framework and fiscal strategy in the acquisition, sign a letter of intent, and begin with due diligence investigations.
  5. As mentioned earlier, a complex IP due diligence investigation needs participation between lawyers, cooperation with patent agents, trademark agents and technical professionals. Therefore, selection and organization of a professional team is the prerequisite for a smooth due diligence investigation; besides, a good professional team can ensure an efficient, comprehensive and professional due diligence investigation.
  6. After the team is formed, an information request sheet should be sent to the target in order to obtain relevant information in writing. Generally, an IP due diligence investigation requires the following major information in writing from the target:
  * Basic corporate information, including business scope, operation mode, and main products;
  * An IP inventory, including exclusive and jointly owned, or licensed rights over patents, designs, utility models, trademarks, copyrighted software, semiconductor circuitry designs, etc., and legal documents showing such rights or license and contracts, etc.;
  * An inventory of pending applications;
  * Contracts for licensing agreements, joint technology development, agency agreements, and transfer and assignment, etc.;
  * Information statements on past and present IP litigation, arbitration, judgments entered and administrative penalties;
  * Bylaws governing internal service inventions;
  * Bylaws governing the protection of trade secrets;
  * IP-related resolutions of shareholders meetings, board of directors, and minutes of important meetings;
  * Lists of corporate IP managerial personnel, and bylaws of IP management;
  * Lists of engaged law firms and IP firms retained as counsels, and any powers of attorney granted therefore.
  7. Upon receipt of the above informational documents in writing, lawyers of the acquiring party will examine them in order to understand the target’s operation conditions, business mode, main products and marketing, etc., and make an overall determination of the role of these IP rights in the target’s operations and their contributions to the enterprise’s profits. In the meanwhile, in order to ensure accuracy, completeness and timeliness, the information may be checked and verified in advance through the internet, news media, industry listings, the Patent Office, the Trademark Office and other relevant public information. Through such a preliminary investigation, possible problems and risks may be detected in advance, and doubtful points which are not set out in the written materials can be summarized. This is necessary in order to have a definitely clear view during future site investigations at the premises of the target and enhance work efficiency.
  8. Lawyers and other professionals, after examinations of the written materials, can arrange for a site investigation at the operation and manufacturing premises of the target. The purpose of the site investigation is to verify information recorded in the written materials, and also to check the current status of all IP rights, methods of maintenance and practical usage and other aspects. Meanwhile, information which is not incorporated in the written materials may be gathered and added through question and answer sessions with the corporate managerial and R&D personnel.
  9. After the site investigation, the materials collected should be analyzed, summarized, and reported in writing to the acquiring party. The written report should state clearly the current IP status of the target company, existing problems, potential risks, etc., and may also provide some professional advice and solutions so that the acquiring party may have an overall assessment and judgment as to whether to proceed with the acquisition and how to adjust business strategies after the acquisition.
  With regards to the timing of a due diligence investigation, it is usually set to occur after the signing of the letter of intent and before a formal signing of the acquisition agreement. As it relates to this particular intangible asset of IP, usually the first investigation phase will then be conducted, and both parties may discuss whether to proceed with the acquisition. If they decide to proceed, then a second detailed phase and in-depth due diligence investigation may be conducted prior to the formal signing of the purchase agreement. In practice, if there is not ample time to conduct the second phase investigation before the signing of formal purchase agreement, terms permitting price adjustments may be added to the purchase agreement. This will allow the acquiring party to conduct the second phase investigation after the formal signing of the purchase agreement and make appropriate adjustments to the acquisition prices with reference to results of the second phase investigation.
  As noted above, it is very favorable for the acquired party to have two or more phases of due diligence investigations. The acquired party may gradually and selectively disclose, if there is a need, its IP status in order to avoid risks arising from premature IP disclosure. However, the phased approach is not that favorable to the acquiring party since it is time consuming and may increase uncertainties. Therefore, successful completion of the due diligence investigation requires full coordination and communication in advance by both parties so as to fully protect their interests.
  II. Purpose of IP due diligence Valuation
  1. IP due diligence has the same purpose as other due diligence, which is to identify problems and potential risks through collecting the relevant information about the target. The purpose is to identify the following key issues of IP rights:
  * Ownership and particulars of rights;
  * Defects on ownership and other legal problems;
  * Competitiveness in the industry;
  * Contributions to the corporate earning ability;
  * Possible uncertainties arising from business development;
  * References to the acquisition price;
  * References to acquisition conditions and relevant contracts for the purchase.
  2. Scope of investigations
  With the economic globalization and the rapid development of information technologies, IP rights modern enterprises possess have not been limited to the traditional trademarks, patents, copyrights. The following is a list of IP related contents in the operations and production activities of an enterprise for reference:
  * Trademarks
  * Trade names
  * Corporate names
  * Inventions
  * Utility models
  * Designs
  * Copyrights
  * Semiconductor integrated circuit’s layout-designs
  * Trade secrets
  * Protection of Appellations of Origin
  * Domain names related to the enterprise and goods
  * New varieties of plants
  * Business fame
  * Important figures who master core technologies
  * IP rights as part of the enterprise’s capital contribution
  Some items may not involve a legal relationship, such as technical personnel who master core technologies, but they are also an important factor indispensable to the appraisal of the overall value of an enterprise. In particular, in an era when competition between enterprises equals competition between talents, R&D personnel and technical personnel who master a core technology are particularly important valuable assets to the enterprise. If the R&D personnel who master the technologies jump ship after the acquisition is completed, for the acquiring party it is like buying a computer and having all of the software and upgrade capabilities uninstalled. Without the R&D personnel, an enterprise with IP as its core competitiveness may, just like the computer, become obsolete.
  3. Investigation emphases
  ① Determination of rights
  An examination of ownership, particularly of patents, trademarks, not only includes confirmation of the registration status and ownership recorded in the rights certificates (for instance whether there is joint ownership, lien, licensed right of third parties, etc). It also includes the duration of the terms, possible risks of invalidation/cancellation, any third-party infringements, scope of protection, etc. and the relevant information in connection with a number of inventions and trademarks to be filed for registration. Particularly noteworthy are the jointly developed patents with third parties and service acts made by staff members; contract clauses leading to disputes when rights are exercised, and restrictive terms on the exercise of the rights. If the target’s right is under license from another, the examination must be particularly focused on the terms relating to scope of rights and conditions of royalties payment under the license contract. In addition, the acquiring party should watch out for any disabling situation when the right owner is dissolved or transfers its rights to third parties.
  ② Contingent debts
  IP may bring some contingent liabilities to the rights holder. For example, when a patent infringes upon the legitimate rights of a third party, there may be preservation measures adopted by administrative authorities or courts or claims for damages raised by the plaintiff. In some countries, patent and trademark infringement will lead to severe penalties, so if the acquired party's products have been exported, investigations should be made into the legal environment of the export countries in order to analyze the possibility of infringements upon the legitimate rights of a third party or the potential for any other claims for compensation. In addition, as regards to the patent royalties in patent implementation under special circumstances, such as service inventions, joint conventions and entrusted conventions provided in Articles 6 and 8 of the new Patent Law, the acquiring party must be familiar with the relevant terms of the contract in order to prevent the acquiring party from having to pay huge royalties in the future.
  ③ Contract risks
  In IP-related contracts entered into between the acquired party and third parties, including licensing contracts, joint development contracts, and entrusted development contracts, a careful examination should be made as to whether there are terms unfavorable to the acquired party. The must be analyzed to determine what effects the acquisition may have on the contracts, and terms on inheriting rights and obligations in the contracts. Some contracts contain provisions which state that the contract shall be immediately rescinded or modified in the event of any changes in rights holders. If such a circumstance arises, the acquiring party should consider whether advance communication with the other party to the contract is necessary to gain written consent from the party.
  ④ Risks of leaking trade secrets in the event of final M&A failure
  In corporate M&A, oftentimes the acquiring party identifies many problems that cannot be solved and decides to abandon the acquisition after a series of due diligence investigations. In this case, the internal technical secrets of the acquired party may have been obtained by the acquiring party and the obtainment is legitimate. If the acquiring party is a competitor in the industry, the acquired party should study and work out the timing to disclose IP and IP-related technical secrets; certainly the acquired party cannot ignore signing a confidentiality agreement with the acquiring party.
  ⑤ IP due diligence has its limitations. IP rights, especially patents, such as inventions, may lose their novelty and creativity due to development of new technologies and be ruled invalid by the court even if they are valid during the investigation. Therefore, the acquiring party, in deciding on an acquisition, should selectively sort out patents of great vitality as acquisition targets. Lawyers advising the acquiring party on the due diligence should also notify the acquiring party in advance of the limitations of IP due diligence.
  III. Conclusion
  In M&A, IP due diligence involves the above-mentioned investigations related to laws, and also includes analysis and appraisal of the IP value in an enterprise from the perspectives of business, technology, finance and taxation. IP is an intangible asset, which distinguishes it from other tangible assets, and we need to conduct investigations different from those applied to tangible assets during the M&A process. For tangible assets, the acquiring party can, in a relatively straightforward manner, make a judgment about the value of the enterprise through data in the financial statements. However, as for the IP value in the enterprise, a professional team needs to be engaged to conduct meticulous investigations and research and the investigation results can be used as bargaining power for the acquiring party and also as important references and bases to lower risks and reduce costs in the acquisition.

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