The role of intellectual hygiene in maximising shareholder value
January 2019 | SPECIAL REPORT: INTELLECTUAL PROPERTY
Financier Worldwide Magazine
January 2019 Issue
Virtually any company worth an investor’s interest will have demonstrated some level of financial hygiene, even if it is currently struggling. The concepts are familiar enough: strong ongoing business planning, profitable operating and pricing models, effective business intelligence capabilities, rigorous cost control and credit management, sound cash management, judicious use of debt funding and so on. Anyone looking to buy a company will typically place the financials at the top of their priorities and of course those financials feed directly into the price negotiations. But what sellers often miss is that the buyer can be even more interested in the company’s intellectual hygiene. If the buyer’s due diligence begins to reveal poor intellectual hygiene, the price will decrease along with the amount of any agreed purchase price placed into warranty reserve and the extent of indemnities demanded. The impact on the value realised by the seller can be significant.
Intellectual hygiene is essentially about how a company identifies, manages and locks in the value of the intellectual property it creates or has previously acquired. In this context, it is also important for a company to be able to distinguish which of its intellectual property is relevant and which is irrelevant. For example, a manufacturer may have built up what looks like an impressive patent portfolio with all the attendant maintenance costs. But if, on closer inspection, few of those patents are actually expressed in its product range, or if many have already been superseded by a competitor’s inventions, they may have very little relevance to a valuation.
While patents are often seen as the pinnacle of intellectual property, they are generally significant, along with design rights, only to product manufacturers. The core of most companies’ IP is comprised of copyrights, know-how and brand rights, such as registered trademarks, domain names and unregistered trade names.
Intellectual hygiene can be readily understood where it relates to registration, whether of a patent, trademark or URL. The questions are simple enough. Does the company have registrations at all? Does it have registrations in the jurisdictions where it actually operates, or into which a buyer might be looking to expand the business? Has it paid its renewal fees? Was it entitled to apply for the registrations, and is anyone challenging or currently infringing those registrations? Even so, it is surprising how many companies do not maintain a log of their registrations and renewal dates linked to a file collating all relevant information about each registration. If a buyer has to set the seller to work putting that log together during a pressurised due diligence process, the risk of omission of key information is significantly increased.
It is with regard to unregistered intellectual property, particularly copyright and know-how, that good hygiene most proves its value. The starting point is to be clear about the difference between the two.
Software provides a useful example. Copyright protects the physical expression of an idea. Anything written down, on paper or digitally, is automatically protected by copyright if it is original. Software is therefore a copyright work. Know-how, on the other hand, is not, strictly speaking, intellectual property in the legal sense, although it is considered as such from a commercial point of view. Know-how is, simply put, the distillation of a company’s collective experience and expertise in how to operate, create its products and, in this example, write its software. The coding manual which is maintained about how the software operates and the methodologies applied to writing the software is itself a copyright work but it contains know-how.
Why is that significant? Because anyone studying the coding manual will acquire the know-how. If they were to then write up what they had learnt in their own words, this creates a new copyright work which contains the same know-how but does not infringe the original manual. Know-how can, therefore, only be protected, in a practical sense, by limiting access to materials and training which disclose it on a ‘need to know’ basis and, in a legal sense, by the appropriate use of restrictive covenants. Know-how is more a type of confidential information, and even a trade secret if it is significant enough to the company, and good intellectual hygiene requires it to be managed as such.
A crucial consideration, after identifying what is copyright and what is know-how, is to be aware of who is creating it. In the UK, and most jurisdictions, the company owns any copyright produced by an employee in the course of his or her employment. This requires, however, that the employee’s job role be to produce that kind of copyright, or that he or she accepted the particular task by way of special assignment. If, for example, a sales executive also had a talent for coding and came up with a solution to a problem with the company’s core software product, even if he or she shared it with the development team, the company would not automatically be entitled to claim the solution as its own.
Things get trickier when the author of the copyright is not actually an employee. If he or she is a consultant or independent contractor, under UK law the individual will own the copyright even if they had been specifically engaged to develop it, unless they agreed in writing to assign the copyright to the company. This particular rule varies across jurisdictions so may, for example, not hold in the US where a ‘work for hire’ is generally owned by the customer. This can create an issue when it comes to assigning the copyright in a short-timed deal situation, particularly if a request by the company to assign comes some time after the copyright has been created. The consideration for such assignment can also become a clear aspect for a potential stand-off between the company and the author of the copyright.
Getting the right contracts in place at the outset, with both employees and contractors, is first-level hygiene and ensures a company secures outright ownership of its core copyrights, such as software, and has mechanisms in place to protect its know-how. In doing so, one thing a company must avoid is adopting a one-size-fits-all approach. Restrictive covenants are notoriously difficult to enforce if badly drafted and are subject to a reasonableness test. This means they have to be appropriate to the particular circumstances and it is often tougher to pass that test with restrictions in employment contracts than in consultancy agreements. While seeking to enforce such restrictions after the damage has already been done clearly will not be the preferred option, it can offer a level of comfort to a buyer and should act as a contractual deterrent in the first instance.
There is also second-level hygiene which a buyer’s due diligence often exposes as poorly managed. It is very common for a company to work collaboratively with its customers and its own suppliers. This can be in the context of delivering a proprietary software solution which is then customised to the customer’s requirements with the input of partner suppliers. It can even be under a formal collaboration agreement in pursuit of a mutually beneficial outcome. In all cases, the parties are independent contractors with each other and by default own any copyright work they each produce. Each party to a collaboration agreement will need, in particular, to consider what freedom it wants to licence any intellectual property it owns or develops under the agreement to third parties. It may, for that reason, be advisable to treat wholly new IP in a different manner than, say, incremental improvements to, or bespoke work-arounds deriving from, existing intellectual property.
There can be challenging consequences for a company if it does not think through and then agree written terms as to the ownership and exploitation rights of any intellectual property generated during the collaboration, whether software copyright or even patents. In the example of a software company, it has been known for a customer to end up owning key developments in the supplier’s software kernel because the supplier carelessly signed a time and materials support contract for customisation work which typically gives ownership of all deliverables to the customer. When a potential buyer realises that a significant element of the company’s latest release is actually owned by one of the company’s customers, it makes for a painful and costly conversation.
Good intellectual hygiene is therefore essential to a company carrying out its normal day-to-day and strategic operations. It will shape and improve how the company organises its activities, who it engages to work with it and on what terms, and how it collaborates with customers and suppliers. While a seller can try to give a company a thorough scrub up immediately before seeking a buyer, or during due diligence, that is not always enough to secure the best price. It will always be better to show a potential buyer from the outset that the company has a firm handle on some of its core assets and to present a well-ordered, professional set of documentation during the transaction process, the value of which should not be underestimated.
Mark O’Halloran and Hayley Bevis are partners at Coffin Mew LLP. Mr O’Halloran can be contacted on +44 (0)23 9236 4959 or by email: firstname.lastname@example.org. Ms Bevis can be contacted on +44 (0)23 9236 4321 or by email: email@example.com.
© Financier Worldwide
Mark O’Halloran and Hayley Bevis
Coffin Mew LLP