Sealing The Deal: Best Practices For IP Due Diligence In M&A Transactions

Following the best practices for IP due diligence in M&A transactions is crucial to the merger process. Acquiring IP-based companies can be a complex task, with several factors influencing the seamless transfer of ownership rights.

Dealmakers often make the mistake of assuming that purchasing the company automatically means a transfer of its IP assets. However, you’ll take the necessary steps to secure the representations and warranties

This documentation affirms that the seller owns the assets and is entitled to use them as needed. Examining these papers for authenticity is essential, which is why you must retain the services of a trained legal team. Make sure that the lawyers have the necessary expertise in IP law.

Companies with a robust IP portfolio are much in demand for acquisitions since giant corporations prefer to purchase new technology. That’s because investing in in-house R&D typically involves a high expense and does not always assure results.

Experts estimate that the Intellectual Property (IP) market size was $8.2B in 2022. It will likely grow at a CAGR of 13.2% from 2023 through 2031, reaching the $25.02B mark.

These figures become all the more relevant since the business landscape is increasingly becoming more knowledge-based. Almost every vertical relies on upcoming technologies to stay lean, agile, and scale quickly, resulting in more IP-driven mergers.

Why Best Practices for IP Due Diligence in M&A Transactions is Critical

Best practices for IP due diligence become essential since information about intangible assets isn’t always available on public platforms. Sellers don’t always broadcast complete details to protect their trade secrets and trademarks from competitors.

When negotiating an M&A deal, acquirers must conduct meticulous due diligence to learn everything they can about the IP. These intangible assets include patents, copyrights, trademarks, and trade secrets.

Data and Personally Identifiable Information (PII) the company may have compiled for operational purposes can also be a part of its IP. Transferring ownership to the acquirer may involve compliance with regulations, which buyers should prepare for.

Read ahead for an overview of the significant steps you should take when navigating the purchase of an IP-based startup. That’s how you can be sure of addressing any issues that could arise related to not just the ownership. But also the development of the IP, its representations, and warranties.

Understanding How IP Representations and Warranties Work

When acquirers purchase an IP-based company, they need to be sure that the assets they’re buying are free of encumbrances. And that all representations and warranties are accurate and verifiable. These representations are essentially similar to the definitive acquisition agreement.

Here are some examples of the best practices for IP due diligence:

• The seller has registered the company’s Intellectual Property (IP) and any other intangible assets it uses for business operations. The registration is solely in the company’s name.
• The company has not granted nor is under any obligation to grant any licenses or assignments of the IP. Nor are the licenses and assignments, express or implied.
• The company has not disclosed nor is under any obligation to disclose to any person secret information or confidential materials.
• The company has not received any notice from third parties about infringement of their IP rights.
• All payments and fees for the grants and renewals of the company’s registered IP are paid up to date.
• The company is not facing any infringement issues on the IP assets it owns.
• The company’s business activities don’t infringe on any third-party intellectual property rights.
• Any intangible assets like know-how and technology that the company owns, uses, or deploys is secure from third parties. The seller has maintained written records of the assets and kept them confidential and secret as practically possible.
• The company may have entered into agreements for assigning, granting, or licensing the use of its IP. However, it has taken the necessary steps to protect its rights over the IP to own and use the assets mentioned in the agreement.

Using IP Assets Licensed From Third Parties

• If the company has and is using IP assets from third parties, it has acquired the necessary licenses.
• The licenses are valid, and no termination notice has been received.
• All the parties involved in the exchange of the IP have complied with the licenses.
• There are no ongoing disputes or disagreements between the parties concerning the IP.
• There are no circumstances because of which the agreement needs to be terminated or modified in any way.

Employees and Consultants Using the IP

• Any secret materials are only shared with the company’s employees and consultants under strict, enforceable confidentiality contracts.
• The company may have hired employees or consultants and assigned any rights concerning its products or software. If they develop any IP inside or outside their employment tenure in the company, the contracts for ownership transfer should be clearly enforceable.
• There are no outstanding compensation and fees payable to employees or consultants for the IP they developed for the company.
  

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Objectives Behind Representatives and Warranties

Following the best practices for IP due diligence in M&A transactions benefits dealmakers on both sides of the negotiation table. This is why retaining the services of expert counsel is advisable. Here are some of the aspects you’ll cover.

• You’ll want the seller to provide complete assurance that the intangible assets are free of any disputes or litigation.
• If buyers find the representations and warranties untrue, they can terminate the agreement and cancel the M&A deal.
• Buyers can claim compensation for the damages resulting from any misrepresentation if they face litigation or penalties for infringement.
• The objective behind the due diligence is for acquirers to feel confident that the seller is the sole and exclusive owner of the IP.
• You’ll also want to be sure that the IP is not subject to any limitations. Or any encumbrances that can restrict your ability to use the IP yourself or permit third parties to deploy it. If the limitations take away from the IP’s value in any way, you can choose to cancel the M&A deal.
• Most importantly, the targeted company should not infringe, violate, or misuse any third parties’ IP rights.

Essentially, the objective of the best practices for IP due diligence in M&A transactions is identifying potential risks. These risks may arise from third parties raising claims on the IP after the deal is closed and signed.

Assurances for Sellers

Sellers can also add protective terms in the indemnification provisions of the acquisition agreement. These provisions can include:

• Deductibles and thresholds
• The right to defend against claims brought by third parties
• Conditions that any infringement claims will be limited to the purchase price placed in escrow.
• Materiality qualifiers and knowledge qualifiers
• Confirmation that whatever representations they offer are only for the possible infringement of the patents they issue. And not all other IP rights.
• Clarifications that sellers are not aware of any third parties diluting their IP

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Essential Documentation for Transferring Intellectual Property Rights

The seller must provide all the relevant documentation for scrutiny as part of the best practices for IP due diligence. Typically, they place all these documents and any other confidential information in a virtual data room.

Setting up this room early before the negotiations will help avoid delays since the process is complex and time-consuming. Here’s some of the paperwork you’ll want to scrutinize.

• Patents and patent applications. Check for the patent numbers, jurisdictions where they are applicable, filing, and registration details. Also, check the date when the patent was issued.
• Trademarks and service marks the seller owns, including domain names
• Core trade secrets and proprietary works and know-how
• Software and databases, including PII
• Contracts and agreements with employees and consultants, including confidentiality and Invention Assignment Agreements
• Any technology licenses the seller may have acquired from third parties
• Any technology licenses the seller may have given to third parties
• Ongoing litigation, arbitration, and claims for infringement of the IP
• Liens or encumbrances on the IP
• Social and digital media assets such as LinkedIn, Facebook, Twitter, and Instagram, among others
• Contracts providing indemnification to third parties for IP issues
• Open source software the seller may have used to in or to create new products and services
• Any source code or object code in escrow

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Why Clarifying Ownership is a Critical Issue

Confirming that the seller owns the intellectual property is a critical part of the best practices for due IP diligence. Infringement, liens, and litigation risks aside, acquirers should also focus on the actual development of the intangible assets (IA).

Technology and IP-based companies use their IA to run operations, which are vital for their current and future growth. However, many startups often overlook the importance of Invention Assignment Agreements in their early stages.

According to this agreement, employees and consultants sign over their ownership rights on the assets in exchange for fair and due compensation. Without this document, ownership or the right to use could belong to the individuals responsible for creating the IP.

This possibility can raise several problems, especially if the individual is not working for the company. Or has joined a competing company. As the acquirer, you’ll want to ensure that the complete usage and ownership will belong to the buyer.

Yet another issue to resolve is the possibility of the seller developing the IP in partnership with third parties. Then again, creating the IP may have involved using university, government, or military funds and/or resources. These issues can also be hurdles in the transfer of the assets.

The seller may have to honor shared ownership rights that limit the transfer of the assets. Acquirers may also have to compensate the collaborators to gain control of the IP. For this reason, your legal team will scrutinize the relevant documents and make sure that employees have ceded their rights.

Making the Distinction Between Ownership and Usage Rights

When it comes to Intellectual Property, dealmakers need to be sure of both–ownership and right to usage rights. Several reasons can prevent IP owners from monetizing or selling their company and its intangible assets. Here are some issues to examine as part of the best practices for IP due diligence.

• Third parties may have made claims that the patents are not valid.
• Third parties may claim that the seller’s patents infringe on their patents and other IP rights.
• Banks, investors, and other lending agencies may have a lien on the IP for loans and funding.
• Unclear Invention Assignment Agreements with contractors and employees where they cede their rights on the IP they’ve created.
• If the seller has not ideated the IP, they must acquire consent and approvals from third parties who developed the IP. Only after legal transfers can they sell the company and its assets.
• The seller may have failed to register the patent or IP with the requisite government agency.
• The seller may have provided broad and non-specific licenses to the IP to third parties. These entities may not be competing with the IP owners.
• ROFR (Right of First Refusal), exclusivity, or identical rights assigned to third parties.

Let’s Do a Quick Recap

In today’s economic ecosystem, IP plays a critical role in ensuring any company’s long-term scalability and profitability. Technology has quickly become one of the core assets for any organization in any business vertical.

This is why clarifying ownership and the right to usage have become the most crucial aspects of the best practices for IP due diligence. Dealmakers want complete assurance that the IP rights don’t have any previous liens, litigation, or encumbrances.

This is where IP representations and warranties come into play. The seller must provide detailed data and other information about the IP and company for scrutiny before getting an offer. Reps and warranties also contain clauses that specify the remedies and compensations buyers are entitled to.

That is, in case any ownership issues arise after the M&A deal is finalized and signed. Before entering into any IP-driven M&A transaction, follow the best practices for due diligence for a smooth transfer.

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