IP DUE DILIGENCE: HOW DEEP SHOULD WE DIVE?

This is the third 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 four.

When you’re starting any type of due diligence process, it’s important to know the depth of investigation that will be needed to support your business objectives. Scoping this out at the beginning can help you establish working parameters and guidelines, and help your company save time and money.

IP due diligence is routinely conducted in the context of transactions with tech companies (e.g., IP licenses, mergers and acquisitions and when companies are seeking funding, etc.). The depth of the investigation that will be needed will generally can depend on the following factors:

• Amount of investment or compensation provided in the transaction 
• The perceived importance of the tech company’s patents in the transaction. 
• The goals of the company conducting the review (typically an investor, acquirer, licensee, etc.)
• The type and purpose of the transaction
• The nature and commercial importance of the business and/or assets being acquired

In this post, we’ll explore typical objectives for a few different scenarios and what’s involved at different levels of investigation to address these objectives.

3 LEVELS OF DUE DILIGENCE 

The primary goals of an IP due diligence review vary according to context.

For example, an early-stage investor in a fledgling tech startup may be content to know that a patent application has been filed and nothing more. Meanwhile, a later-stage investor in a more mature tech startup may want reassurance that the patent(s) or pending patent applications have merit.

We’ll summarize the appropriate depth of investigations for various contexts in three “levels” — but in reality, every deal is different, and there’s no specific recipe for any type of deal. 

You can think of these three “levels” as a potential starting point for setting objectives at the outset of a due diligence review.  These levels are also incremental, so a higher-level investigation will also include everything from the previous levels. 

Let’s take a closer look at what each level involves.

ZEROTH LEVEL: BASIC DUE DILIGENCE 

We call this the “zeroth level” because it’s the bare minimum of due diligence that should be done in any transaction where patent rights matter. It is a basic level of review that typically consists of checking for “red flags.”

Think of it like you’re buying a used car: You’ll want to check CarFax (or other public records) to make sure, at the very least, that you’re not buying a stolen car.

In the same way, an investor in a transaction where there are IP rights involved will want to verify ownership rights of the patents.

A zeroth-level due diligence is usually appropriate for early-stage investments, such as during a typical Series A or B investment round, where there are no specific high-value IP assets that are critical to the deal. 

This often entails reviewing the company’s IP agreements, interviewing the company’s executives regarding business history and standard practices, and checking assignment records, among other things.  Such information may be gathered from:

• Public databases
• Copies of relevant patents and pending applications
• Patents and publications of the company
• Investors’ background knowledge of the company

From an IP perspective, the main goal is to ensure that the target company owns all the relevant IP and that there are no credible third-party claims to the company’s IP. To accomplish this goal, the legal team will: 

• Screen preliminary information to check whether the company has been honest and accurate about what IP they own
• Ensure the company has taken necessary steps to document ownership, and that no other party has a valid claim to ownership.
• Check expiration dates and renewal fee records of patents issued
• Review any pending patent applications to verify status and ensure they are in good standing.
• Confirm that patent applications have not been abandoned or lapsed

Most of these can be accomplished by reviewing the USPTO’s records, which are accessible online (through the USPTO’s Public PAIR system) for published applications and issued patents. However, for any unpublished applications, the legal team will have to rely on records provided by the company.

KICKING THE TIRES: STRATEGIC DUE DILIGENCE 

A strategic due diligence will involve some amount of substantive review during the process and supplements a basic level due diligence with a deeper screening process. We call this “kicking the tires.”

Let’s go back to our used car analogy: This is like test driving the car and making sure the tires have tread and the engine runs.

This level of due diligence is usually appropriate for later stages of investment where a foundation of IP exists to support a commercialization strategy or business plan, or in the context of a lower-cost, non-exclusive license. 

The main goal is to understand the company’s IP strategy and ensure that it aligns with the commercial goals of the deal that’s being negotiated. Additional objectives may also include:

• Ensuring that company’s patent properties describe the company’s foundational technology
• Determining the number of patent applications filed and jurisdiction of filing
• Reviewing patents and pending patent applications for competent drafting
• Reviewing any pending applications to determine likelihood of allowance
• Determining the extent to which the patent claims preclude others from competing with any key commercial products
• Assessing whether a company’s patent strategy is aligned with its business goals

To accomplish these objectives, the legal team will:

• Learn about the company’s products and services relevant to the transaction
• Review the contents of the patent applications and issued patents (at least the most important ones) for quality of drafting
• Analyze claims of issued patents for overall breadth and relevance to company’s products/services
• Analyze prosecution history of pending applications for likelihood of successful outcome and scope of claims relative to products/services
• Review foreign patent properties to identify any inconsistent outcomes in different jurisdictions

DEEP DIVE: EXHAUSTIVE DUE DILIGENCE 

“Deep dive” due diligence is an exhaustive review of the patent portfolio to ensure that it will support specific business objectives. This is like taking the used car to your mechanic, who spends an entire day running tests and searching for flaws.

A deep dive is usually appropriate for a merger, acquisition or other large capital investment where the commercial terms of the deal are tied to a level of exclusivity (provided by the IP assets) for some product or market. 

An exhaustive due diligence entails a detailed review of the target company’s IP to flag any issues beyond basic and strategic depths of review for further consideration. This in-depth and thorough review ensures that the company’s IP actually provides some degree of enforceable legal protection to justify the deal.

The main goal of a deep dive due diligence is to ensure that the IP assets are valid and enforceable and will support the commercial terms of the deal. A deep dive investigation focuses on identifying the claims of the patents that are part of the transaction as well as any issues pertaining to the validity and enforceability of those claims. 

When conducting this level of investigation, the legal team will: 

• Validate the information that was provided by the tech company during negotiations as a basis of the deal
• Check for history of litigation or undisclosed information regarding the patents and patent applications
• Assess scope of the claims of the relevant patents and patent applications
• Assess validity and enforceability of the patents
• Conduct an invalidity analysis to test the strength of patents crucial to the business deal
• Review scope of patent claims in line with business objectives

To accomplish these goals, the legal team will:

• Prepare claim charts to ensure that the claims of issued patents align with products / services of the company
• Search for “unknown” prior art that might invalidate the patents
• Analyze the patents’ claim scope and interview technical experts to determine whether there are viable “design-arounds” that competitors could use to avoid the patents
• Analyze substantive arguments in file history and citation history to identify vulnerabilities in an enforcement context

CONDUCT THE RIGHT LEVEL OF DUE DILIGENCE

An experienced patent attorney can help direct due diligence efforts that are in line with your company’s business objectives. 

It’s worth investing in the right legal team to ensure that you scope the review properly, and execute each step with precision and skill.