This is the second in a four-part blog series that examines the IP due diligence process for tech startups and provides insight on due diligence as part of a company’s patent strategy. Read part one here.
The strength of a tech company’s IP portfolio can have a big impact on the company’s overall value and eventual success. That’s why the IP due diligence process is a critical and often necessary part of any merger, acquisition, licensing or funding deal with a tech company.
Knowing what to expect in the due diligence process can help you and your legal team prepare for some the hurdles on the road to success. In this post, we’ll examine the different stages of the due diligence process.
What Happens During Due Diligence?
Though every due diligence investigation is unique, generally the process has three stages, from the perspective of the investor or other outside entity conducting the due diligence review:
- Prioritization of objectives
- Analysis of the findings
These three stages are always a bit fluid: Throughout the due diligence process, it may be necessary to revisit a previous stage. For example, you may want to reprioritize your objectives during the investigation. Or during the analysis of results, you may learn that further investigation is needed to address new concerns.
At various points in the due diligence process, the tech company should be prepared to meet with representatives of the outside company and assist with the process as needed. Sometimes meetings are needed at the beginning of the process, to help inform priorities or to address higher priority objectives. Meetings may also be conducted later in the process, for example, to address questions or issues that were discovered during the investigation, to fill in missing information, etc.
Now let’s take a closer look at the three parts of the due diligence process to understand how they work.
Part 1: Prioritization of Objectives
Defining goals at the outset will allow you and your legal team to do a thorough job during the due diligence process. Time is often limited during the due diligence investigation and prioritizing these goals will allow the process to be conducted more efficiently, and ensure that the most important aspects of the review are completed in a timely manner.
Here are some examples of objectives for a due diligence review of a patent portfolio:
- Confirm status of patent properties
- Confirm ownership of patent properties
- Evaluate the geographic scope of patent rights
- Evaluate the scope of patent rights
- Evaluate the validity of patent rights
- Evaluate the enforcement value of patent rights
- Evaluate existing licenses to third parties
- Evaluate alignment between the company’s business strategy and patent strategy.
- Identify opportunities to improve or leverage the patent portfolio after the transaction.
- Identify third-party patent rights that could interfere with the company’s freedom to operate.
These are just some of the objectives that an outside company might have in conducting a due diligence review of a tech company's patent portfolio, for example, ahead of a funding event or another type of transaction.
The objectives should be prioritized based on the type of transaction and a number of other business factors. (For example, if the company is still developing its first product, then the scope and enforceability of the company's existing patents is less important.)
Part 2: The Investigation
The actual fact-based investigation is usually the most time-consuming part of IP due diligence — but it’s also the most important.
The information acquired during this process will help identify potential issues and problems lurking in the company's patent portfolio. The main purpose of the investigation is to flag issues to be addressed in the next part of the due diligence process.
To begin the investigation, the outside company will typically ask the tech company (i.e., the company whose patent portfolio is being reviewed) to inventory and catalog all information related to the patent portfolio, including:
- Databases of all patent properties, including a list of outstanding deadlines and action items (the docket)
- Copies of all applications filed and patent office correspondence
- Copies of invention disclosure records, employment agreements, NDAs, license agreements
- Any litigation records or notices from third parties
So if you're a tech company heading into a transaction, you should have all this information available and well-organized ahead of time.
The documentation collected by the tech company will typically be uploaded to a virtual "data room" (a secure cloud-based file system), so that it can be accessed by the outside company that is conducting the due diligence review.
After collecting the information about the patent portfolio, the investigation will typically turn to one or more of the following legal analyses:
Ownership is often one of the most important issues explored in an IP due diligence investigation, as it establishes the target company’s rights in the patent portfolio and queries whether those rights are free of third-party claims.
Questions that may be asked about ownership rights include:
- Who are the inventors?
- Were the IP rights properly assigned by the inventors?
- Has the company properly documented ownership of the patent properties?
- What are the company’s rights to transfer and assign?
- Have there been any third-party challenges to those rights?
- Are there any estranged inventors who might claim ownership?
2. Scope of protection, validity and enforceability concerns
Scope of protection, validity and enforceability analyses determine the breadth and strength of coverage of the target company’s patent assets.
Determining the scope of protection of a patent begins by evaluating the claims of the patent itself. Some questions that may be asked include:
- How narrow or broad are the claims in any issued patents?
- Do these claims cover the company’s products?
- In what countries or regions have the patent properties been filed?
- Have patent applications been successful in all countries or regions?
Validity assessments look into whether the claims in a patent property are “valid.” At the most basic level, the status of each patent property should be reviewed to ensure that it's still pending or in force. A more in-depth analysis will examine whether the claims of a patent satisfy the statutory requirements for patentability, such as eligibility, novelty, non-obviousness and utility.
Questions that may be asked about the validity of your company’s patents include:
- Are the patent properties vulnerable to challenges? For example, could any of the patents be invalidated based on new prior art or recent changes in the law?
- Have all maintenance fees and annuities been paid?
- Have any applications gone abandoned?
- Have any critical deadlines passed?
Enforceability analysis centers on whether the claims in a patent can be “enforced” in a litigation context. For example, this analysis may examine whether the patent portfolio could be used “offensively” to actively pursue infringers.
Enforceability analysis may also look at whether patents are vulnerable to challenges associated with the inventors’ duty to disclose relevant prior art to the patent office.
Here are some concerns that may be looked at when determining the enforceability of your company’s patent portfolio:
- Do the patents cover technology that has real-world commercial value?
- Is it possible to detect infringement of the patent by third parties?
- Did the inventors satisfy their duty to disclose relevant prior art?
- Has the company granted any rights to third parties?
3. Freedom to operate
A freedom-to-operate (FTO) analysis evaluates whether any third parties have patent rights that would cover the company’s technology.
An FTO analysis will also consider the legal status of third-party rights as well as the territorial scope and duration. In the vast majority of cases, a typical due diligence review will not include a freedom to operate analysis unless there are specific concerns raised early in the process.
Part 3: Analysis of Results
The third stage of the IP due diligence process involves analyzing any problematic issues uncovered during the investigation (Part 2, summarized above). This allows the outside entity who’s conducting the due diligence review (i.e., the prospective investor, acquirer or licensee) to analyze the risks and benefits uncovered during the due diligence investigation.
Generally, each problematic issue should be assigned an action item based on the business objectives and priorities set out in Part 1.
At a high level, there are five types of action items that may be designated to address problematic issues:
- Actions to be taken by the patent owner before the transaction: Classic examples include recording assignments or paying outstanding fees.
- Additional information to be provided by the patent owner before the transaction can move forward: For example, providing documentation of ownership, obtaining permission to assign agreements, etc.
- Adjustments to deal terms or legal provisions of the transaction: In some cases, due diligence may reveal that the patent portfolio provides less protection than was initial advertised, and the economic terms of the deal may be revised accordingly
- Actions to be taken by the patent owner after the transaction: For example, reviving applications, taking corrective actions, transferring files to a new firm, etc.
- Ignore: Some issues are worth noting in the context of a transaction, but not necessarily worth the time and effort of taking action to address
A company’s approach to IP due diligence must be based on both business and IP perspectives. Thinking about the due diligence process in three fluid stages will help you identify, mitigate and manage risks associated with a transaction.
Make the most of due diligence
Engaging IP counsel at the outset of a potential transaction is a smart step toward ensuring you have the proper edge at the negotiating table.
Experienced IP counsel will be able to advise on proper strategy throughout the due diligence investigation . They can identify issues and give practical advice during this crucial process, helping you achieve a successful deal and to generate long-term success for your company — while highlighting any areas that may need your particular attention.