Surviving Intellectual-Property Due Diligence

Thursday, February 1, 2007 - 00:00

Intellectual property (IP), once seen as a dull but necessary legal expense, has steadily advanced into the big leagues of business strategy. From profit-shy research institutions to secretive hedge funds, nearly every sector of the U.S. economy has embraced IP as a means of securing market position or generating revenue. Patent filings more than doubled between 1990 and 2005, for example, and USA for Innovation estimates that U.S. intellectual property today is worth between $5 trillion and $5.5 trillion - equivalent to about 45 percent of U.S. gross domestic product (GDP) and greater than the GDP of any other nation in the world.

The price of opportunity, of course, is vulnerability; one player's advantage often accrues at the expense of its rivals. Businesses sometimes learn this the hard way. Their sources of capital or prospective acquirers, however, cannot afford to pay for that lesson. As IP has assumed greater strategic prominence in the boardroom, so has IP due diligence in funding and M&A activity. Gone are the days when representations and warranties alone could allay IP concerns. Today's transactional due diligence often involves a deep dive into a prospect's patent portfolio, defensive precautions, secrecy practices and open-source policies. From the perspective of the scrutinized company, compliance is not only burdensome; if not done carefully, it can compromise the very IP rights at issue.

Anticipating The Questions

Part of managing diligence compliance is knowing what to expect. Cheaters ace the test by getting the questions in advance. In IP diligence, that's not cheating - just common sense. Funders and acquirers usually focus on three primary areas:

Offensive Strategy . Even tall piles of patents may not satisfy the savvy suitor. Does the portfolio serve a well thought-out business strategy? Or is it the product of enthusiastic scientists leading gullible managers and lawyers? Every patent, to justify its ongoing expense, must satisfy a business objective: walling out competitors, generating licensing revenue, facilitating strategic partnerships, or laying in reserve as trading goods should patent-flush competitors threaten. To build and maintain an effective portfolio, it's essential to have an ongoing mechanism for evaluating every patent and application against these objectives. If you anticipate IP diligence and don't have a patent committee, institute one; if you have a committee, re-evaluate its composition and effectiveness. IP diligence will quickly distinguish between effective oversight and rubber stamping. The committee must - must! - include active participation by marketing as well as scientific constituencies. Otherwise, the patent portfolio will reflect what the techies think is cool rather than what customers want to buy or obstacles that will trip up competitors. Marketing consultant Ralph E. Grabowski is widely known for his observation that successful technology businesses consistently invest more in marketing a product than in engineering it. That mindset should inform patent-procurement efforts as well.

No patents? That's all right, too, so long as there's a business justification. Suppose your company sells financial advice based on a proprietary analysis of market data. Patent that analysis and competitors may simply read your patent, then use its teaching secretly; if their use of the analysis leaves no "fingerprints" on the results, infringement will be undetectable, and you'll wish you had kept the system as a trade secret. Such circumstances justify avoiding patents altogether. So do poor prospects for monetizing or trading IP rights or the inability, due to the prior efforts of others, to obtain broad enough patents to make the exercise worthwhile. Be sure you've thought through the issues and can communicate your rationale.

Defensive Precautions . It's easy to focus exclusively on building your own IP portfolio and leave concerns over third-party rights for maana. Corporate counsel may be tempted to adopt a reactive posture, waiting for competitors to assert their patents or hoping for an industry-wide failure of nerve. Some foolishly believe in playing ostrich, fearing that an aggressive competitor will parlay knowledge of its patents into a damage-trebling claim of willful infringement. That's almost always the wrong approach. Willfulness is difficult to prove, and the benefits of early awareness far outweigh the risks. An efficient, ongoing program of patent searching and review facilitates design-around efforts that avoid infringement altogether. It also enriches understanding of the state of the art, leading to more informed research and patenting efforts.

In transactional IP diligence, the initial risk-analysis questions focus on actual disputes or third-party threats and how these were handled. The more difficult questions come later, and look to the future - i.e., your company's ability to anticipate IP problems and react to them.

Attention to Detail . Patent lawyers' hair turns gray and their malpractice insurers grow fat because it's easy to forfeit important rights. Eligibility bar dates, fee deadlines, marking requirements, mistaken assumptions of "small entity" status, the lurking rights of prior employers or universities - so many traps into which IP opportunities may stumble. Combine these with the ease of incorporating so-called "open-source" software into product offerings without awareness of license requirements and you have a minefield of potential hazards, any of which can strike funders or acquirers with genuine fear or as an excuse to renegotiate valuation. Review everything before inquiring minds pose the inevitable questions. Obtain IP status reports, as well as a complete list of deadlines and outstanding action items; review employment agreements and the past affiliations of key inventors; verify license compliance and ensure the open-source policy is not only in place, but that no unaccounted-for code appears in products shipped to customers. Beware the sins of youth: many newly minted engineering graduates have been weaned on open-source tools and use them with reflexive abandon, much to the consternation of their middle-aged bosses.

And Giving The Answers

Having the right answers isn't enough, unfortunately, because actually giving them can invite trouble. Patent applications, while fair game for scrutiny, remain secret until published; in some circumstances that won't occur unless and until a patent issues. If a deal goes sour and the disappointed suitor knows the contents and filing particulars of a patent application, mischief may follow. At the very least, therefore, obtaining a nondisclosure agreement (NDA) in advance of diligence disclosures is essential. But NDAs don't obviate precautions; withholding the serial numbers of unpublished applications can preclude later meddling during prosecution.

Discussing patent strategy, trade secrets or as-yet-unfiled invention disclosures invites greater risk. A patent applicant at least possesses a filing date. The victim of trade-secret misappropriation has only its word and whatever admissible evidence it can muster against the wrongdoer. The wise discloser in IP diligence, therefore, will file "provisional" patent applications covering not only inventions still in the disclosure stage, but also on trade secrets it never intends to patent. Provisional applications can be abandoned after the deal closes or craters, and will disappear without a trace. On the other hand, if eventual patent protection is desired, the provisional will serve as a priority document so long as it contains enough description to support later patent claims. The greater the quality and quantity of information in a provisional, and the more limited the disclosures in IP diligence, the more security the provisional will provide.

Particular risk attends disclosure of legal opinion letters, such as those relating to the patentability of an invention or third-party IP rights. These documents enjoy the benefit of the attorney-client privilege, which can be waived if the opinion is divulged in the course of due diligence. Dealmakers sometimes resort to "common interest" agreements to preserve the privilege notwithstanding disclosure of an opinion, but rarely is disclosure truly necessary. An investor or acquirer can typically obtain what it needs without seeing the opinion itself. Suppose, for example, that your patent lawyers have performed a prior-art search and issued a privileged report. Your company is free to furnish the references mentioned in the report, since these are public documents, and the suitor's patent counsel can readily perform its own analysis. More work for the suitor, to be sure, but if the privilege is waived in the course of a successful deal, both sides have lost something valuable.

Finally, it's important to observe confidentiality obligations. A key license to important technology, for example, can represent a valuable asset. But check the terms before bragging. Licensors frequently limit the degree to which an agreement can be disclosed even to the licensee's prospective deal partners. For instance, it may be acceptable to disclose the existence of the license or even its general nature, but specific terms may be secret. Indeed, even without specific disclosure restrictions, licenses almost always contain provisions to safeguard confidential information provided by each party to the other.

The objective, in complying with IP due-diligence requests, is to give the right answers in the right way. Understanding the business and legal concerns motivating the requests will provide a roadmap to effective responses. But resist the temptation to speed once the route seems clear; the perils of careless disclosure may hide until long after the journey ends.

Steven J. Frank is a Partner in the Intellectual Property Transactions and Strategies Group of Goodwin Procter LLP, and the author of Intellectual Property for Managers and Investors (Cambridge Univ. Press).

Please email the author at sfrank@goodwinprocter.com with questions about this article.