HOW TECH INVESTORS SHOULD APPROACH IP DUE DILIGENCE

This is the final post 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, part two and part three.

If you’re an investor who has experience investing in tech companies, you’re probably well aware of the need for IP due diligence. And if you’ve done a number of deals, you’re also aware of the wide range of issues that can crop up as a result of the due diligence process.

In this post, we’ll survey some of those issues and take a look at how we’ve seen savvy tech investors deal with them.  

When you’re investing in a tech startup, a properly conducted IP due diligence review should provide you with detailed information about the IP assets of the target company. This allows you as an investor to: 

• Be prepared when negotiating key elements of the proposed transaction 
• Protect against surprises after the deal is concluded
• Obtain additional insight on how the target company handles their business

WHY DUE DILIGENCE IS IMPORTANT 

Without the proper investigation into an entity’s IP assets, an investor may find, after the deal is already concluded, that the company doesn’t actually own the IP assets or that the IP assets have been transferred or encumbered by third-party interests or litigation. 

Ideally, IP due diligence should be initiated at the outset of negotiations, with the bulk of the work taking place when the deal terms have been set (for example, after a letter of intent or term sheet has been signed). However, no matter when IP due diligence becomes necessary, the driving force behind the work is the transaction itself. 

Here’s how investors should approach IP due diligence for a business transaction where important IP assets are involved.

UNDERSTAND HOW DUE DILIGENCE FITS WITH YOUR BUSINESS STRATEGY

IP due diligence is a critical part of any transaction, particularly for an investment in an IP-centric tech company. 

A strategically timed due diligence review can determine a more reasoned value of the IP involved and allow for proactive corrective action if and when the investigation identifies legal concerns that may affect the value of the IP.

Here’s how you can leverage IP due diligence as an investor:

• Assess value: Due diligence can help you assess the value of the target and determine and/or mitigate risks associated with the deal.
• Leverage in negotiations: The information from due diligence can be used as leverage in negotiations. For example, reassessing the valuation of the company’s patents upon discovering problems with them during due diligence.
•  “CYA”: Some investors will need to document the fact that they have done a reasonable review of IP assets, or else they might be liable to their own backers.
• Basis for making recommendations: Investors also often act as advisers or even board members of the tech startups that they invest in, and the due diligence review can offer an independent source of information to inform the investor’s advice or direction.

PREPARE FOR DUE DILIGENCE

First, interview the tech company executives about their patent strategy during negotiations and have them send a summary of their portfolio. Hearing their responses to a few high-level questions up front can give you a good feel for whether the company has taken a thoughtful approach in their patent strategy.

Here are some questions that you can ask the tech company about their patent strategy:

• Is your technology covered by any of the company’s issued patents or pending applications?
• Is your technology covered by any third-party patents?
• Are there any estranged founders or inventors who might claim ownership of your IP?
• Have you had a law firm help with your IP strategy and patent filings?
• Do you have a written founders’ agreement, and have you used written IP agreements with all employees and contractors?

Next, you should interview patent law firms that can conduct the IP due diligence, ideally choosing one that’s highly experienced with intellectual-property matters. The firm you hire should have at least one professional who understands the technology in question; they don’t need to be an expert, but they should at least have the technical background to understand the substance of the patents.

ADDRESS PROBLEMATIC ISSUES IDENTIFIED DURING DUE DILIGENCE

Most tech investors will have their outside law firm conduct the due diligence process.

In the end, as an investor, you’re likely most interested in knowing what significant insights were identified during the due diligence process review, and what you and your legal team should do to address them.

It can be useful to think about taking all the issues uncovered by the IP due diligence review and putting them into four buckets:

• Fatal problems: deal breakers
• Unfixable problems: deal changers
• Fixable problems: action items
• Inconsequential problems: red herrings

Let’s take a look at the issues that generally fall into each one of these categories — and what you can do about them.

FATAL PROBLEMS IN IP OWNERSHIP OR PROTECTION

While rare, fatal issues can happen. These are the “deal breakers” — things that will typically make the investor completely walk away from the deal. 

Examples of these “deal breakers” may include:

• Fraudulent or dishonest statements by the tech company in dealing with the investor
• Bad faith/character/ethical issues in patent portfolio history
• Legitimate third-party claims to ownership of the company’s IP
• Disastrous mismanagement of IP portfolio 

If these “deal breakers” arise, ask yourself the following questions to make the best decision regarding the transaction:

• Were the ethical/bad faith/character issues isolated to someone who has left the company? 
• Will this be an ongoing problem, or is it an isolated/past issue?
• Can you trust the team going forward? 

The reason these issues can be fatal for the deal has nothing to do with the IP itself; they’re fatal because they destroy the investor’s trust in the company that they’re investing in.

Often, when a savvy investor encounters a breach of trust, they terminate the transaction and don’t look back. Although there may be an opportunity for the tech startup to rehabilitate the transaction, a loss of trust often can’t be repaired. That’s one reason a startup should bring any issues to light early on in due diligence! 

UNFIXABLE, SUBSTANTIVE PROBLEMS

These are issues that cannot be corrected (or they’re not economically feasible to correct) but that you (the investor) can live with. They’re substantive in the sense that they affect the perceived value of the deal/company. Examples include the following:

• Viability of the IP (such as poorly drafted applications, sales/disclosures before critical date, killer prior art)
• Lack of IP (for example, the tech company has simply not filed patent applications to adequately protect their inventions, and the relevant filing deadlines have passed)

Here are some questions that can help with your decision-making process: 

• How do these issues affect business strategy/viability?
• Is the tech company willing and able to take a better approach in the future?

If these problems are raised during a due diligence review, here are some possible ways of addressing them:

• Adjust the deal terms or legal provisions of the transaction
• Revise the economic terms of the deal if due diligence reveals that the patent portfolio provides less protection than initially advertised
• Recommend internal training, new internal processes or new personnel (internal or external) to ensure better management going forward

Savvy investors can use these types of “unfixable” problems to demonstrate the non-monetary value that the investor (and the investor’s human network) will add through strategic advice and guidance. 

Many tech startup operators get into a habit of doing things on their own, which can lead to major mistakes when dealing with highly complex issues related to intellectual property. The due diligence process can provide a wake-up call for the operators, and can help them see where they need to seek outside assistance. 

FIXABLE, SUBSTANTIVE PROBLEMS

These are issues that can be corrected and are significant enough to warrant correction. Some of these problems include:

• Competence of team
• Problems in IP ownership or protection:
  • Non-ideal claim scope
  • Lack of written assignments from current employees
  • Patentable inventions that aren’t protected by patent applications yet

Here are some questions to consider that can help you in handling such problems: 

• Can you improve the team (e.g., by hiring new internal specialists)?
• Is the startup team willing to listen, learn and adjust?
• Is the startup team willing to work with another law firm or bring in someone to help?
• Will future IP lack viability, or is this an isolated issue?
• How much will it cost to fix the problems in IP ownership or protection (e.g., continuations, reissues, CofC, CIP, amendments, etc.)?

There are a few ways to handle these issues if they arise:

• The tech startup takes action before the transaction closes, such as:
  • Recording assignments
  • Paying outstanding fees
  • Asking inventors to execute formal documents (assignments, declarations, etc.)
• The tech startup provides additional information before the transaction moves forward, including:
  • Providing documentation of ownership
  • Obtaining permission to assign agreements, etc.
• The tech startup takes actions after the transaction, such as:
  • Reviving applications and taking corrective actions (e.g., drafting new claims for pending applications)
  • Filing new patent applications or transferring files to a new firm, etc.

If these are the only issues that arise during the due diligence process, most people will not want to delay the transaction, so we often see the vast majority of these issues being addressed after the deal closes.

INCONSEQUENTIAL PROBLEMS

These are garden-variety mistakes that you either knew about, or they’re so typical that you’re not surprised to see them, and they don’t affect the deal. 

These issues are common, as startups are usually operating with constrained resources, and most investors don’t expect a startup to be “perfect.” Most investors will usually deal with these problems in the following ways:

• Ignore them: Some issues are worth noting in the context of a transaction, but not necessarily worth the time and effort it would take to address.
• Use them as leverage in negotiations: After all, no one likes surprises.

As an investor, it’s important that the team you hire to conduct due diligence truly understands which issues fall in this category. A smart IP counsel can save you a lot of time by properly “triaging” the important issues for you to focus on. Flagging all issues upon discovery is important, but your legal team should know which issues deserve your attention and which don’t.

WORK WITH AN EXPERIENCED IP ATTORNEY FOR YOUR DUE DILIGENCE

For investors, information discovered during the IP due diligence process can assist in the proper valuation of a deal and offer leverage in negotiations.

An experienced due diligence team that understands the primary product lines, business environment and future plans of the enterprise can ensure that your team remains focused on the IP issues that are most relevant to your transaction.

The team at Henry Patent Law Firm has the experience, knowledge and technical expertise to help with your due diligence. Get in touch — we’d love to hear from you!