Some dealmakers believe that IPR is something that needs to be left to lawyers and does not come under the purview of the dealmakers themselves. Nothing could be further from the truth – you may get away without serious damage in some cases, however, especially in the case of a technology product company, the amount of potential damage that may occur due to ignoring a technical IPR evaluation can be prohibitively expensive.
There are various aspects to IPR that need to be understood in the context of an acquisition. It is best to create a check list and evaluate each of these aspects in a chronological order as you move along a potential transaction:
Pre-LOI (letter of interest):
Are you a potential victim of window dressing for sale? Sometimes when a company’s owners decide to get it ready for a sale, along with depressed salaries and lower variable pay, one of the most damaging things that people do is to reduce R&D spends. While in the immediate short run, it will deliver above average profits, the after-effects will show up in a couple of years when the product starts falling short of the market requirements and increasingly customers stop buying the product.
Are there any restrictions around non-compete provisions, joint development rights, licenses, first right of refusal, residual interest, change of control, etc., or unclear development / ownership chain on the IPR such that third parties may exercise some control on whether the IPR can be alienated? In such cases, there could be an impairment to the IPR and it needs to be carefully evaluated.
Lack of a dedicated R&D team, CTO and live roadmap may also be indicators of less than optimum IPR, however, this may need to be evaluated with a bit of caution since small companies and start-ups may not have the requisite structure and people may be wearing multiple hats.
It is also important to get an initial feel of the quality of the IP by having your own technology team run a high-level evaluation of the IPR before sharing the LOI as a critical go/no-go evaluation milestone or make the LOI and initial offer price subject to the successful completion of IPR diligence. This could be followed up by a more detailed diligence during the due-diligence (DD) stage post an LOI to the target company.
This is the stage at which the target company will be more willing to open up and provide the acquirer an opportunity to evaluate the IPR and product quality.
However, most people also don’t realize that this creates a Catch 22 situation. While the opportunity to evaluate the product and IPR is quite welcome, what if the transaction does not go through? You may have similar product roadmap or plans for product evolution in case you have a competing product. Similarly, in case you rule out an acquisition, you may want to carry out the development of a similar product. In such a case, what stops the target company (or an eventual acquirer) from filing a suit for copyright infringement at a later stage?
When looking at the IPR evaluation from the point of view of the target company, they may have valid fears that the potential acquirer may copy ideas in case a potential transaction falls through.
A middle ground in such a scenario might be to make it clear that the team conducting the technical diligence would not be the team directly working on the product, restrict the technical DD to high level product capabilities and roadmap alone. For product quality, code quality review etc., get a third-party technical expert to review the IPR and provide an overall quality report to the buyer with the quality report not including confidential information. It is also important to document a release agreement to prevent future litigation in case a transaction falls through.
It’s also important for the legal team to go through customer contracts and understand the treatment of IPR in the customer contracts. Does the target company provide IP rights to the customer for any customization done for the customer? Is there a preferential right given to customers or any restrictive covenants that the target company has agreed to? It’s important not to leave this aspect to the lawyers, especially if the lawyers are third party lawyers engaged for legal due diligence since they may not necessarily understand the requirements of the acquirer, the industry and products as well as your in-house counsel or even your business persons.
It is also important to understand the use of open-source software – this is an item that can potentially fall between the cracks due to the oft-seen silos in which the acquisition teams operate. While the technical due diligence team may not find any major issues with the use of open-source software and components in the creation of the product IPR, it is important to combine the minds of the legal, technical and the business teams to understand the implications of the open-source usage. Use as components or usage of items such as OS, databases etc., is common and entirely fine. However, any derivative works created on top of open-source code is a grey area. Legally, the use of open-source code is subject to “Copy-Left” licensing terms where the usual practice is to ensure that any derivative works using open-source code also legally remain open-source and the acquirer may not be able to charge for such code and moreover, may have to release the modified code to public domain too.
Further complications need to be kept in mind when evaluating asset purchase transactions (including carveouts) where an acquirer is not buying an entire company. The IPR is not just software and documentation, it is also the trained manpower that has the necessary background information and experience in the field. Not everything that comes out of experience can necessarily be documented. A lot of the innate knowledge that the workforce carries with it is also important. Hence, identification of critical talent, ensuring the critical talent comes along with the transaction (especially important during an asset purchase or carve-out transaction) and if that is not possible, then structured knowledge transfer of the IPR is essential. While the identification aspects should be addressed during the DD stage, the codification of the mechanisms of how the knowledge and people transfer needs to happen should be clarified in the SPA negotiation stage.
Sometimes complications may arise due to country specific regulations. For instance, while sale of licenses and services is fine, sale of IPR may not be allowed without regulatory approvals. We came across such an instance when evaluating a transaction with a South African company. The Central Bank required the sellers to seek approval for the sale of IPR and prove that the transaction price was comparable to other such transactions. This was advised by the local law firm. Its important to therefore appoint a good local law firm in the country where the transaction is being effected to understand the nuances and also understand how to structure a transaction in a compliant manner.
Sometimes acquirers may be tempted to undertake an asset purchase transaction, especially as a shortcut to avoid certain tax, inherited liability or other statutory issues. This is best avoided as several countries have the concept of “succession”. If a company acquires the substantial assets and contracts of a particular target, then its considered the legal successor to the target company and will be liable for all the liabilities of the target company.
SPA Negotiation Stage:
This is the stage where you need to create water-tight contractual terms to gain (i) unencumbered and complete ownership transfer of the IPR, (ii) gain protection for the IPR against third party claims, and (iii) ensure transfer of essential IPR components, people, knowhow, tools, background material, tools, etc., especially when its an asset purchase or a carve-out transaction. Most people are aware of the standard tools in the SPA such as indemnity obligations, representations, warranties and escrows to ensure that any IP claims can be settled giving recourse to the sellers.
To address complications arising out of an asset purchase or carve-out transaction, where you may be provided only a license or joint ownership of a particular version of an IPR and not the undivided absolute ownership of the IPR, it’s important to get a clear title to that version to ensure un-restricted right to use, license, amend, sell or dispose-off acquired IPR in any manner. While the IPR in such cases effectively has a “Joint” ownership, it may not be practical to express it in such manner in the SPA draft. This is especially the case when such joint ownership may entail sharing of succession risks and rewards and a third party might include you as a co-defendant for IP breach claims against the seller. In such case, an exclusive, unrestricted, royalty free, perpetual license without termination rights, for a particular version of the Software code may be obtained with the above rights to replicate the benefits of ownership without adopting the risks arising out of joint ownership.
While its true that it takes multiple iterations to design a piece of software and bring it to the current stage where it lies, it is also equally true that through the learnings realized during the process, similar software can be re-created by the seller (especially in case they are not continuing with the business) in a more efficient manner and probably in some cases with better architecture and functionalities out of the previous learnings. Hence, having a legally binding non-compete (product and customer level) for a reasonable period of time, adequately compensated thru the sale proceeds, while balancing the right to livelihood of the sellers, needs to be incorporated in the SPA.
Closing Stage Activities:
Along with the people, IP rights, knowledge and know-how transfer, it is also important to ensure completion of the practical aspects of the software handover. Therefore, ensuring the adequate repositories of the software, all previous and current versions, documentation, underlying licenses etc., all need to be properly codified and handed over with one or more technology specialists who were involved in the process ensuring the completeness of the handover.
While from an action point of view, technology base absorption and consolidation is chronologically amongst the last pieces of the puzzle, it is also something that needs to be planned right upfront – possibly even before the LOI issuance.
If a particular target brings in new technology, that complements your own technology, then cost implications for consolidation may not be high. However, if it is a parallel product, i.e. similar to your own product, then it entails a certain cost of consolidating customer installed base. This is critical to include in the business case and planning for technology consolidation is a key driver of cost synergies to make any M&A transaction successful.
In conclusion, while this article is not meant to be an exhaustive treatise on IPR implications in M&A transactions, it does offer a product company perspective. We would love to hear your learnings, best practices and words of wisdom.