July 2019 Issue
The importance of intellectual property (IP) cannot be overstated. It is, arguably, a company’s most important asset, critical to fostering innovation and driving economies. According to the European Patent Office, for example, 42 percent of total economic activity in the European Union in 2017 – around €5.7 trillion annually – is generated by IP-intensive industries.
Unlocking IP value is a key element in any business sale, as it can differentiate a business from its competitors, provide an important revenue stream through licensing agreements, entice new customers, form a key part of an organisation’s marketing efforts and even act as collateral when securing loans.
Unsurprisingly, for certain sectors, IP is now a key factor behind M&A. IP is incentivising parties to pursue deals, perhaps to gain a foothold in a new market, expand global market share or to gain an advantage over competitors. “IP plays an important role, especially in technologically driven M&A transactions,” says Katrin Winkelmann, a partner at Eisenführ Speiser. “IP issues can be of enormous importance to the success of a transaction. IP is of particular relevance in assessing the unique selling propositions of the target and in assessing whether the target’s business model and products are free of third-party rights and whether any potential for possible IP disputes exists.”
But IP has not always played a central role in mergers. In past years, acquirers often decided to finalise the structure of a transaction before addressing IP issues. “Even then, IP was typically addressed solely as a risk allocation issue, with representations and warranties in the purchase agreement determining whether the buyer or the seller was absorbing the risk that an IP asset was, among other potential problems, susceptible to infringement or was itself infringing on third parties,” explains Tracy Bacigalupo, a partner at Morrison & Foerster LLP. “This is no longer the case. IP now constitutes much of the value of many companies today, and M&A activity is increasingly driven by IP issues.”
One of the biggest trends that has occurred in the last few years has been the growth in e-commerce acquisitions. “IP is the main component of value in e-commerce transactions because of the importance of protecting the identification and source of goods sold online,” says Ms Bacigalupo. “Recent examples include Farfetch’s announcement in late February 2019 that it had acquired Toplife from JD.com, a Chinese online retailer, for $50m. The deal effectively brings JD.com’s existing luxury platform, Toplife, into Farfetch’s Chinese operations. JD.com, one of FarTech’s largest shareholders, will use Farfetch’s online presence and technology and logistics platforms to connect foreign brands to Chinese customers.”
The same can be said for the fashion industry, where the value of a brand’s IP is often at the heart of what is being acquired. A recent example is DSW’s partnership with Authentic Brands Group (ABG) in late 2018, to acquire brand designer and developer Camuto Group for $375m. Of this purchase price, DSW paid $56m to acquire a 40 percent stake in the IP of Camuto Group’s proprietary brands, with ABG taking a 60 percent share.
If acquirers ignore or undervalue the potential of IP, they can weaken negotiation strategies, reduce the chances of securing future licensing agreements and damage their ability to obtain financing. To fully understand a target’s IP portfolio, acquirers must undertake due diligence.
The goal of due diligence is to assist the buyer in assessing the value of a prospective acquisition, to identify and mitigate potential risks. Through due diligence, the buyer is better able to assess the risk, and to build an accurate picture of the assets and liabilities.
Conversely, failing to undertake adequate due diligence can lead to an overvaluation of the target, expose the acquirer to unknown risks and liabilities, and create integration problems which could undermine synergies.
Given the financial and legal importance attached to IP, dedicated due diligence should not be ignored or dismissed. In transactions that feature hundreds or even thousands of patents, it is clear that a considerable amount of work must be done – and quickly – as part of an IP investigation. Buyers need to prepare for the rigours of due diligence, and have the ability to investigate the strength and enforceability of the IP in question.
Due diligence allows acquirers to understand exactly what they are buying. Once the relevant IP is identified, acquirers and their advisers can evaluate possible risks and how to address them before completing the transaction. Determining what IP is important or necessary to the target’s business involves assessing and categorising all IP owned, used and licensed in or out. Searching registration databases, such as the US Patent and Trademark Office (USPTO) and the US Copyright Office, can offer insights into the true ownership of registered trademarks and copyrights.
Messy, complicated IP ownership issues, for example, can be fatal to a transaction. Do existing licensing arrangements limit future exploitation of IP rights? Does the target depend on third-party licences, and will these survive the transaction? Is there any litigation risk, such as pending infringement and damages claims? Do any of the assets in question rely on open-source code or otherwise stem from open innovation? This may limit future commercial exploitation, so due diligence is critical.
The focus of IP due diligence will also depend on the objectives of the transaction. The difficulty lies in the fact that IP portfolio analysis is complex, requiring specialist knowledge to find potentially problematic points. “M&A transactions usually take place under extreme time pressure, so it is crucial to focus the analysis on the issues relevant to the transaction in question,” says Dr Winkelmann. “In order to undergo a meaningful and goal-oriented IP due diligence, one must first understand the target company and its business. Is it a technology company or a brand company? What are the core products and core market? What is to be acquired – the whole company or only a part of it? Extremely important for the identification of the relevant points to be examined are the economic goals of the planned acquisition. Is the deal about access to new products, technologies or markets? Or is it a pure share purchase, possibly with planned consolidation? Is the transaction intended to strengthen the investor’s IP portfolio? Answering these questions is an important prerequisite for targeted IP due diligence.”
Ideally, the target itself will have maintained a comprehensive record of its IP portfolio and chain of title. An up to date IP register is a clear indicator that the target values IP and is aware of its importance to the M&A process. The register should comprehensively document all forms of IP, including the application number and status of each trademark, patent, design and so on.
“As an intangible asset, the value of IP is often not readily apparent without full transparency from the seller, including as to the scope of its IP and its business operations generally,” notes Ms Bacigalupo. “Compared to other forms of property, IP has an expansive definition and many businesspeople do not necessarily realise the extent to which their internal resources or processes may be protected by IP law. Consequently, the buyer must often ‘push’ the seller to identify all of its IP, especially in the areas of non-registered IP, such as trade secrets. The buyer must also thoroughly investigate the disclosed IP for potential risks, so that it can best determine its value. Potential key considerations include validity, ownership, exclusivity and protection of IP.”
It is important that all critical points for the transaction are addressed during IP due diligence, to support the decision of whether to proceed or walk away. “In the worst case, a deal breaker is identified and the transaction must be aborted,” says Dr Winkelmann. “However, this is rarely the case in practice. Purchase price adjustments also generally only occur if risks cannot be covered elsewhere. Closing conditions are of great importance if the risks can be eliminated, and this has to be done by the target company before the transaction is completed. Also of high relevance are the covenants of conduct and action, in particular for the period between signing and closing. This may include, for example, the maintenance of important industrial property rights or the performance of certain procedural acts which still have to be performed by the target.”
Acquirers also need to undertake a detailed review of any potential disputes that may have a financial impact post-close, such as IP claims, which could affect the value of the acquisition.
During due diligence, the acquirer must assess the risk of the target company’s potential liability from future claims by competitors and other parties, including former employees, former consultants and current employees. A detailed review of settlement agreements and court opinions or orders relating to the target’s IP assets should be made.
Warranty and indemnity (W&I) insurance can address specific and general risks, effectively hedging them with monetary compensation. The policy is typically negotiated alongside the sale agreement and taken out at the time of signing, coming into force on completion of the sale. W&I insurance has seen a significant increase in popularity in recent years. It is used in a wide variety of deals and often facilitates completion.
In the cross-border M&A context, there are many post-merger challenges which can jeopardise value creation – including IP management. For multinational companies, their IP portfolio often contains international IP rights, which adds to the complexity of an IP audit.
Local nuances may also complicate IP due diligence. As an example, if a foreign investor wishes to acquire a German target company, it is prudent to consider the implications of German employee invention law, according to Dr Winkelmann. “These specific legal regulations lead to the considerable risk that the true owner of a patent is not the company entered in the register, but the inventor as a private individual, which could result in considerable risks for the buyer,” she says. “Since this is not apparent from the official patent register, detailed analyses are necessary if the buyer wants to avoid unpleasant surprises in the future. Another example is the situation when a German investor acquires a target company abroad and wants to integrate the local development department into his or her innovation process. In some countries, it is necessary for inventions to first be registered in the inventor’s home country, which might collide with the filing strategies of European companies.”
Post-close portfolio management
Following completion of a transaction, it is important that the acquired IP portfolio is aligned with the strategic objectives of the buyer. The insight and understanding of the IP portfolio gained in due diligence should be used to plan and develop these IP rights for future value. “Parties should examine which parts of the IP portfolio are to be used for which business models and products after the transaction and which parts are less relevant for the future and can be exploited elsewhere,” says Dr Winkelmann. “In addition, the opportunities for generating new IP rights resulting from the combined technologies and development activities of the acquirer and target should not be missed. Ultimately, however, the measures used and their implementation are always unique and strongly dependent on the strategic objectives of a particular transaction.”
Though acquirers should conduct an IP audit prior to completion, it is advisable to repeat the process post-close, which may highlight gaps in protection and help to map out the change of ownership for the acquired IP rights. If change of ownership is not recorded on the relevant registers, the buyer may not be able to enforce or exploit those rights against third parties. However, this can be a costly and time-consuming process. Different jurisdictions have their own requirements and fees, from completing simple documentation to more onerous processes that impose strict time limits and include higher fees.
For transactions to be successful, acquirers must have full sight of the assets they are acquiring. While assets such as real estate, equipment, inventories and financial instruments were previously the main focus of due diligence efforts, today it has become essential to prioritise IP assets, as they are often the lifeblood of an organisation.
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