Technology and intellectual property (IP) have become vital components to virtually every business in all industries as they often drive the value and efficiencies of a business and enable companies to monetize their products and services. In order to capitalize on this trend, private equity (PE) investors are making significant investments in companies focused on developing and commercializing IP. In 2017, a record number of PE deals were IP and technology focused, ranging from consumer-facing companies with valuations driven by trademark portfolios and brand awareness, to cloud platform and biotech companies with significant patent portfolios and research and development efforts. According to analysts of PE deal-trends, this wave of IP-centric PE transactions has continued and will continue to grow during 2018.
When engaging in IP-driven PE transactions, it is critical that both investors and target companies focus not only on how IP impacts the overall value of the deal and the operation of the target company going-forward, but also on how the investment and the PE firm’s exit strategy may impact the IP in the future. In order to do that, both sides must engage at the outset to understand the IP-related assets and technology valuable to the business, the IP rights involved that protect those assets, and any risk associated with the use and monetization of the IP-related assets. The result of this analysis will drive the parties’ negotiation of the terms of the investment, including representations and warranties, indemnities, limitations on liability and structure of the financial investment, such as any financial terms tied to benchmarks, ROI and other performance indicators.
Analyzing the IP Assets for Risks and Opportunities
Comprehensive due diligence of IP-related assets in a PE transaction is needed to ensure that both the PE group and the target company have the information needed to make smarter, more informed deal decisions during each stage of the transaction. Described below are areas of common focus in a PE transaction that relates to IP and discusses how both sides typically address these issues in the transaction documents.
1. IP Ownership. The most obvious (but commonly glossed over) analysis is confirming that the target company owns the IP that is key to the business that it purports to own. This generally means ensuring that the PE firm has an understanding of the development history of the IP assets and has reviewed documentation to confirm that developers of the IP have signed agreements that irrevocably assign rights in the IP to the target company. It is not uncommon to find in early stage companies, particularly those without sophisticated IP counsel involved at early stages of the company’s existence, that there are gaps in the chain of title or issues as to the ownership of the IP assets. Investors will also want to confirm that the proprietary assets are not subject to security interests that may conflict with financing opportunities used by the PE group.
In the transaction documents, the target company should make representations and warranties that it exclusively owns all of the proprietary IP free and clear of any lien or encumbrance. In addition, it is common to see representations that the target company has obtained valid and enforceable agreements with all current and former developers contributing to key IP (employees, independent contractors, etc.) assigning all rights in the IP to the target company. These representations are typically without qualification as to knowledge, time period or materiality.
2. Freedom to Operate. A significant focus of any IP analysis is on the extent to which the target company has the freedom to operate within the space in which it conducts business without risk of infringement or competitive overlap. Investors often look to patents as a first line of defense. Obtaining patents that cover key technology may provide the target company with some competitive advantage as the target company can exclude third parties from practicing under the same claims of the issued patent. Patent portfolios should be carefully reviewed by IP counsel to ensure the claims actually cover the technology and products of value to the target company.
In addition, target companies should consider obtaining, and PE investors should request, a freedom to operate analysis with respect to the key technology and products of the business. A freedom to operate analysis is conducted with the help of IP counsel to determine whether any third-party patents and other third-party intellectual property prevent or limit how the target company operates and provides some assurance that the target company can monetize the IP used in the business with little risk of a third-party claim of infringement. While these types of analyses are helpful, they are usually narrow in scope (limited in time to issued patents at the time of the transaction, which would not take into account unpublished patent applications) and can be costly and time intensive for an early stage company to obtain.
Depending on the outcome of that analysis or if a freedom to operate analysis is not available or is impractical to obtain, the parties will use representations and warranties, caps on liability and, in special cases of identified risk, specific indemnities to address the risks of infringement and potential future claims. The investor’s main objective is to maintain the strength of its investment and limit the downside to the extent third-party IP claims diminish the target company’s value and the investor’s exit opportunities.
Investors should strive for a non-infringement representation and warranty without any qualification as to knowledge or materiality and each party will try to quantify the risk through caps on liability. Investors should require that the IP representations are fundamental and are not subject to a cap on liability as well as a lengthy survival period of the representations and warranties. Target companies push for IP as a non-fundamental representation limited to the caps and baskets. As a compromise, particularly if the IP representation remains unqualified, the parties typically end-up somewhere in the middle of that spectrum with a set of quasi-fundamental IP representations and warranties that are subject to a cap that is higher than the regular cap in the agreement and with an increased survival period (usually 18 months – three years).
3. Customer Agreements. PE investors need to understand how the target company has monetized the IP. Typically, this means cataloging what out-bound licenses or other agreements the company has entered into with customers and other third parties and then reviewing those agreements for specific provisions that may hinder the company’s future ability to operate or significantly expand the target company’s liability profile as to third parties. For example, are there exclusivity provisions or non-competes that limit how the target company may operate in the future? Do the agreements prohibit sale of the IP-assets or change of control of the target company? Do customer agreements contain provisions where the target company gives broad indemnities with uncapped liability? Each agreement should be set forth on a disclosure schedule so there is no misunderstanding between the parties concerning the universe of the agreements and limitations that may cover the proprietary IP, and representations and warranties should be made that the applicable parties comply with such agreements. If issues are uncovered in those agreements that are unacceptable to the PE investor, we often see the parties collaborating to terminate or renegotiate the problematic agreements as a condition of closing to the extent the agreements limit an investors financing or ability to exit the investment with an IP asset intact.
4. Third Party IP. Target companies will need to provide documentation and representations and warranties in the transaction documents to demonstrate they have sufficient rights or licenses for any third party IP necessary to conduct business, including technology incorporated into any products offered by the target company or used to run backend business operations. Investors should be careful to review the terms of these contracts to ensure that termination rights are not triggered as a result of the investment and conduct the same type of diligence and review described above with respect to customer agreements.
5. Data Security. An increasing concern with early stage technology companies is data security. At a minimum, investors should review:
- the administrative, technical and physical safeguards in place for compliance with industry standards;
- privacy policies to ensure adequate notices are provided and consents are obtained from customers from whom data is collected; and,
- the scope and impact of any previous or ongoing data breach.
In addition, the PE investor should review the cyberliability insurance policies to ensure adequate coverage. Representations and warranties should be included in the transaction documents to expressly address the target company’s data security efforts.
The above list of issues is not exhaustive and only skims the surface of the complexities involved in addressing IP issues in PE transactions. Attorneys who specialize in IP and technology issues in PE transactions can be a valuable asset to both the target company and the PE group, and should be engaged in the early stages of the transaction to assist in identifying risks associated with the IP assets of the target company. As noted above, the impact of these issues can have real consequences for the transaction, including adjustments to the scope of the investment, the requirement for performance benchmarks for underperforming or under-developed IP assets, and the use of other tools and performance incentives for the target company that help the PE firm guarantee a return on their investment.
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