[This article is part 6 of an 8-part series covering the key elements involved in the sale of IP-based and professional services businesses. The next article in the series will be “The Purchase Agreement.”]

Introduction

Once a Knowledge-Based Enterprise (“KBE”) seller and a prospective buyer have agreed on the key elements of a transaction, the buyer will want to conduct a thorough review of the KBE. This will help to ensure the buyer is getting a good value for the purchase price and to identify any potential risks or liabilities.  This process is referred to as “Due Diligence.”

The details and scope of due diligence will vary depending on the size and nature of each transaction.  However, there are several areas of the KBE and its operations that most buyers will want to investigate in a typical transaction.  To avoid derailing the transaction, KBE sellers must be prepared to supply a range of materials and information to the buyer during the due diligence review.

Although a KBE seller may be tempted to avoid disclosing negative information that could threaten the closing or result in less favorable deal terms, it is generally advisable to err on the side of disclosure.  Otherwise, if an undisclosed risk or liability is later discovered by the buyer, the seller risks losing the deal or worse, the buyer could file a lawsuit alleging fraud or misrepresentation by the seller.

The purpose of this article is to provide an overview of the due diligence process in transferring intangible property and to describe the key elements, as well as discuss areas of special concern for KBEs.

What is Due Diligence?

Due diligence is the comprehensive appraisal of a business that is undertaken by a prospective buyer of a KBE. This is done to establish the KBE’s assets and liabilities as well as to evaluate commercial potential and determine whether or not the buyer should consummate the transaction.  In addition, information and materials disclosed during the due diligence process will often result in a modified purchase price or other deal terms. 

When is Due Diligence Conducted?

The due diligence period often begins informally during negotiations.  However, formal due diligence typically begins when the parties agree to key deal terms and execute a term sheet or “letter of intent” (“LOI”).  In smaller transactions, the negotiations of the parties may lead directly to a purchase agreement.  In all instances, the due diligence period should not usually end until the transaction closes. 

Who is Responsible for Due Diligence?

The formal diligence process typically begins with the buyer – or more likely, the buyer’s legal counsel – submitting a written diligence request or checklist to the KBE seller.  The KBE seller will then review the list and begin gathering the requested materials and information.

Much of the information requested will pertain to the KBE’s financial records and business operations, and thus will be handled by the KBE seller’s accounting and business personnel, including both internal employees as well as external resources such as banks, accountants, and other consultants.

Requested materials related to corporate documents, litigation, contracts and other legal matters will be handled by the KBE seller’s legal counsel. Since the review might reveal certain liabilities or other issues, it is important that the KBE seller work closely with legal counsel in all aspects of the diligence process.  Experienced legal counsel can assist in managing problems that are identified, making appropriate disclosures as needed, and working with buyer’s legal counsel to help ensure they are satisfied with the information provided.

How is Due Diligence Conducted?

The breadth and scope of due diligence will vary from transaction to transaction.  In most situations, KBE sellers should be prepared to provide a wide range of information and documents related to the following: 

1.     Corporate documents such as formation documents, bylaws and meeting minutes;

2.     Shareholder information such as capital tables, option grants, and shareholder agreements;

3.     Government permits and licenses relating to the KBE’s operations; 

4.     Financial records including detailed balance sheets, profit/loss statements, and asset records; 

5.     Assets including a list of all equipment, inventory, and other business property of the KBE;  

6.     Tax records for federal, state and local filings over the most recent several years; 

7.     Debts, liabilities and other obligations of the KBE including loans and lines of credit, and any liens, security interests or other restrictions on the company or its assets; 

8.     Insurance coverage for all aspects of the KBE; 

9.     Customer and supplier information, details of the business relationship, any contracts, and any orders in progress; 

10.  Other key contracts of the KBE such as software licenses, independent contractor agreements, vehicle and equipment leases, etc.;

11.  Real estate and leases including real estate owned as well as office and warehouse leases;

12.  Intellectual property assets and licenses (see below for more detail on IP due diligence);

13.  Employees, employee benefits and employment agreements;

14.  Disputes and litigation including past, pending and anticipated issues;

15.  IT, Cybersecurity and data privacy information is an area of increasing importance for all companies but is typically at the core of a KBE’s business.

Special Issue for KBE Transactions: IP Due Diligence

Today, the most important group of assets of a target company is often its intellectual property (“IP”) which includes patents, trademarks, trade dress, copyrights, trade secrets, domain names, and other proprietary information and materials.  As such, IP due diligence has become a vital component of a due diligence investigation.

Failure to include all IP assets in a due diligence investigation can have a significant impact on the true value of the acquisition. For an acquiring company, IP due diligence is crucial.  Otherwise, the acquiring company cannot correctly value the target and might significantly overpay for the assets it acquires.  Even worse, the acquiring company could be purchasing an IP infringement lawsuit.

Perhaps the greatest cautionary tale supporting the use of IP due diligence is a 1998 purchase by Volkswagen, AG.  Volkswagen bid and paid $795 million for Rolls-Royce Motor Cars Ltd., but soon discovered that the “Rolls-Royce” trademarks were not part of the deal.  Rolls-Royce PLC had gone into receivership in the 1970s and, although Rolls-Royce Motor Cars, Ltd was sold at that time, the “Rolls-Royce” trademark was retained by Rolls-Royce PLC.  At the end of the day, Volkswagen had spent $795 million for a luxury car company, but could not use the Rolls-Royce brand.

IP due diligence should also be conducted by the target company in preparation for the negotiation of the terms of the deal.  For the target company, IP due diligence allows it to better ascertain the value of its IP assets, and therefore overall worth.  It also permits the target company to clean house and ensure that all registrations, licenses and assignments are current, properly executed, and recorded.  

Develop an IP Asset Inventory

Before the parties can properly value the IP Assets of the target company, they must compile a full and accurate inventory of all IP assets, an “IP Asset Inventory”.

Much information regarding pending and registered patents, trademarks, copyrights and domains can be gleaned from publicly available sources such as the U.S. Patent and Trademark Office (USPTO), the U.S. Copyright Office, WHOIS databases, as well as foreign registries and databases.  In addition to registration and ownership information, these sources often contain details regarding the IP assets such as prosecution history, chain of title, etc.

Additionally, the acquiring company must also evaluate the target company’s non–public IP assets, lest it base decisions on only a partial view of the entire IP Asset Inventory.  Of course, prior to releasing such information, the target company should require the parties to enter into a non-disclosure agreement (NDA) to protect its proprietary IP assets.

The non-public portion of the IP Asset Inventory may include:

·      Non-published patent applications and related materials such as patentability or prior art searches;

·      Unfiled or unregistered trademarks and related materials such as clearance searches;

·      Trade secrets and confidential business information; 

·      Licenses and assignments relating to the IP assets; and

·      Letters and other communications relating to litigation, claims of infringement, title disputes, or other adverse action related to the IP assets.

Conducting the IP Due Diligence Investigation

After obtaining the information described above, the acquiring company can more fully evaluate the risks and benefits associated with the proposed transaction.  Although each situation is unique, an IP Asset Inventory evaluation should involve the following steps:

Step 1:  Review the IP Asset Inventory to determine the target company’s rights with respect to each of those IP assets (e.g., owner, co-owner, license, etc.). 

Step 2: Review any active litigation, settlements, coexistence/consent agreements, assignments, and any other agreements affecting the target company’s rights in the IP assets.

Step 3: An evaluation of whether the IP is enforceable, and that registrations are current.

Step 4:  Assess the value of the IP.  Analyze the value of the IP as it relates to current production and future expansion of the business.

Conclusion

Failure to adequately administer the due diligence process, make appropriate disclosures, and address issues that arise could result in a reduced sale price, the termination of the deal, or post-closing litigation.

As such, although many of the business and financial aspects of due diligence will be handled by the KBE seller’s internal and external financial and business personnel, the due diligence process should be managed and coordinated by the KBE seller’s legal counsel for the transaction. 

About the Author:

Jim Chester is a 20+ year business and technology attorney, professor, and entrepreneur.  He is a recognized authority in buying and selling technology businesses, global technology transactions, and providing strategic legal counsel for innovators and industry disruptors.  For more on Jim, visit here. He may be reached at jim.chester@klemchuk.com.

To view the previous articles in this 8-part series:

1 - Transferring Intangible Assets: Playbook for Buying & Selling Knowledge-Based Enterprises

2 - Transferring Intangible Assets: Playbook for Selling a Knowledge-Based Business - Overview of the Process

3 - Transferring Intangible Assets: Playbook for Selling a Knowledge-Based Business - Preparing for the Sale

4 - Transferring Intangible Assets: Playbook for Selling the Knowledge-Based Enterprise - Finding Buyers

5 - Transferring Intangible Assets: Playbook for Selling the Knowledge-Based Enterprise- Negotiating the Deal

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