In the modern world, where technology and progress are key factors for success, a company’s strength is measured not only by its tangible assets but also, and especially, by its intellectual property. Patents, which constitute a central part of this intellectual property, can be the decisive factor in determining a company’s value and in assessing the economic feasibility of its acquisition. In fact, mergers and acquisitions often heavily rely on the value of the patents owned by the company, and intellectual property is sometimes the critical factor that influences the final decision to proceed with the deal.
Patent due diligence, an essential process that allows companies to obtain an accurate picture of the legal and commercial status of their patents or those of the company they intend to acquire, is crucial. This process can be conducted either by external firms or by the company itself and serves as a critical tool for identifying economic potential, mitigating unnecessary risks, and ensuring well-informed and sound decision-making. A thorough examination of intellectual property assets can not only enhance the potential profitability of a deal but also prevent future legal disputes and protect the company’s interests.
For example, in the well-known case of Albin Trank, Elbit Systems sold its shares in a company that developed a computerized artificial kidney to Diatronics, declaring that the development did not infringe any existing patent. After the transaction was completed, it was revealed that the development did indeed infringe an American patent, leading to a lawsuit from Diatronics and a breach of agreement by Elbit. This case underscores the significant importance of patent due diligence, which can prevent such situations and maintain the credibility of the parties involved in a transaction.
In this article, we will examine the patent due diligence process, which serves as a central tool for assessing the risks and opportunities associated with intellectual property assets. Due diligence is required in various situations, such as mergers and acquisitions, investments, collaborations, and technology transfers, and its purpose is to ensure that business decisions are made based on comprehensive, accurate, and reliable information. A deep analysis of patent due diligence processes enables the early identification of legal and technological gaps, the evaluation of patent values, and the examination of the legal feasibility of enforcing or defending them.
What is Patent Due Diligence?
Patent due diligence is a critical process aimed at comprehensively examining a company’s intellectual property assets, with a particular focus on patents. This thorough examination is conducted by skilled intellectual property professionals to assess the status of the company’s IP portfolio before entering into significant transactions such as company acquisitions, investments, or license sales.
The due diligence process typically takes place after the parties have agreed on the principal terms of a deal but before the transaction is finalized. Due diligence can be conducted from an “offensive” approach when there is an intent to acquire a company, invest in it, or purchase a product or license from it, or from a “defensive” approach when the company itself intends to be sold, sell a license, merge, or go public. In any case, the primary goal of this examination is to identify existing risks and evaluate the value of the company’s intellectual property assets.
As part of patent due diligence, existing patents and patent applications, trademarks, registered designs, copyrights, trade secrets, and any combination thereof are examined. The more significant the intellectual property is to the intended transaction, the more comprehensive and in-depth the examination will be. This process allows the potential buyer to obtain a clear and detailed picture of the state of the intellectual property, which can help avoid unpleasant surprises after the deal is closed.
One of the key tools in this process is the creation of an “IP map” of the company, a document that records all intellectual property components, their current owners, the agreements and supporting documents, and their legal status. The IP map helps identify gaps and deficiencies in the company’s assets, providing time for correction before the deal is closed. Additionally, the document can serve as a basis for negotiations with investors, addressing critical points that may arise during the negotiation process.
The importance of patent due diligence stems from the fact that many companies rely on their intellectual property as a primary source of value and market strength. Therefore, early identification of potential issues and understanding the legal and commercial risks associated with intellectual property can significantly enhance the chances of a successful transaction.
The Risks Involved in Failing to Conduct Patent Due Diligence
Failing to conduct patent due diligence can expose both the buyer and the seller to significant risks, with potential issues only becoming apparent at a later stage, leading to serious consequences for the transaction. Even when negotiations between the parties have advanced and the economic terms have been agreed upon, the discovery of defects at a late stage may result in reopening negotiations, this time from a weaker position. In other cases, the transaction may be delayed until the defects are corrected, a process that can take months or even years, often causing the buyer to lose interest in the deal.
If due diligence reveals shared ownership of the intellectual property or other issues, this may necessitate additional and complex negotiations with another party, potentially increasing the cost of the transaction or even leading to its cancellation. Such cases are not uncommon and underscore the critical importance of thorough and early due diligence.
An example illustrating the risk of failing to conduct due diligence is the case of Digeo. The company purchased a patent during the bankruptcy sale of another company without verifying its legal validity. After filing a lawsuit for patent infringement, Digeo discovered that the patent was invalid due to false statements made by the inventors. As a result, the company had to withdraw the lawsuit and bear the legal and financial consequences of purchasing a worthless patent.
On the other hand, Therakos, a subsidiary of Johnson & Johnson, managed to avoid a similar risk through comprehensive due diligence. During negotiations to acquire a patent, the company’s patent attorneys discovered that the patent had been amended in a way that limited its use, potentially leading to legal problems in the event of an infringement lawsuit. Thanks to this early discovery, the company halted the negotiations and successfully avoided the risk.
Another example of the risks of not conducting due diligence can be seen in the case of Amgen. The company purchased patents without being aware of an immunity agreement signed between the previous owners of the patents and the defendants, allowing them to manufacture and sell a generic version of the drug protected by the patents. Ultimately, the court denied Amgen’s request for a preliminary injunction, leading to a significant legal and financial loss.
These cases demonstrate the critical importance of conducting patent due diligence for both buyers and sellers. A comprehensive and professional review can minimize risks, identify potential defects in advance, and ensure the smooth and efficient completion of the transaction.
How to Conduct Due Diligence – The Three-Step Method
Intellectual property due diligence is a complex and costly procedure, and it is not always necessary to conduct it before every business transaction. However, when a company is facing a significant commercial deal, it is highly advisable to perform due diligence on the intellectual property related to the transaction, particularly using the three-step method. This method divides the due diligence process into three main stages: prioritization, investigation, and analysis of results. This approach allows company managers and attorneys to view the entire scope systematically and focus on maximizing the economic value of the intellectual property, rather than examining each asset individually. This method positions them to achieve the maximum economic and business objectives of the transaction.
The first step, prioritization, enables the company to focus resources and efforts on the most business-critical assets. In this stage, the company identifies which intellectual property assets are most essential to the transaction and ranks them according to their risk and economic potential.
The second step, investigation, involves a thorough examination of the assets identified in the previous stage. At this stage, the company conducts legal and technical checks to ensure the validity, ownership, and value of the assets. Additionally, it assesses whether there are any legal issues or defects that could impact the validity of the intellectual property and its future use.
The third step, analysis of results, is a critical stage where the company summarizes the findings from the investigation, analyzes their implications, and develops recommendations for the next steps. In this stage, the company must evaluate the risks and opportunities revealed and adjust the business strategy based on the findings.
By employing the three-step method, the company can approach due diligence in an organized and focused manner, allowing it to make informed decisions and maximize the business value of the emerging transaction.
Example of Applying the Three-Step Method
To illustrate the three-step method for patent due diligence, consider the following scenario:
Company “Advanced Technology Ltd.” plans to sell a key patent that provides it with a significant advantage in advanced technologies. The patent relates to an innovative process in the manufacturing of electronic components. The company wishes to sell the patent to “Technology Acquisition Seekers Ltd.,” which aims to integrate the technology into its manufacturing processes.
Step One: Prioritizing Objectives
Before starting the intellectual property due diligence, the attorney should understand the company’s management priorities. Understanding these priorities will help determine the role and importance of the intellectual property in the intended transaction and tailor the due diligence accordingly. The more central the intellectual property is to the transaction, the more thorough and comprehensive the due diligence should be.
In the case of “Advanced Technology Ltd.,” which seeks to sell a central patent, the attorney will carry out the first step of the due diligence by asking key questions such as: Is the patent a central or secondary element of the transaction? Which companies are interested in the offered technology and what are their business goals? Is the licensing process in this field standard or unique? What is the nature of the intended transaction (sale, licensing, merger, etc.) and what are the primary objectives of each party in the deal?
If the due diligence is “defensive,” meaning the goal is to protect the company from selling or licensing its technology, slightly different questions will be asked. For example: Are the company’s products, software, or services covered by its intellectual property? Is the central patent used by the company registered in its name? What about related patents and are they also registered? Are all the company’s services or products legally and properly transferable?
In general, this step involves determining the importance of the intellectual property in the context of the intended transaction and defining the scope of the due diligence based on the weight the intellectual property holds in the deal.
Step Two: Substantive Investigation
Suppose “Advanced Technology Ltd.” plans to sell its key patent in the field of electronic component manufacturing to “Technology Acquisition Seekers Ltd.” The patent is considered a critical component of this transaction, so a comprehensive investigation is required to verify its validity and scope of protection.
In this step, the attorney representing “Technology Acquisition Seekers Ltd.” will conduct a thorough investigation of the patent. The investigation will include the following checks:
Ownership: We will examine the previous transfers of intellectual property rights from the inventors to “Advanced Technology Ltd.” It is essential to ensure that the transfers were executed properly and that no third parties could claim ownership of the patent or any part of it. For example, if it turns out that one of the inventors did not sign a rights transfer agreement, this could affect the validity of the patent transfer to the acquiring company.
“Freedom to Operate“: We will check whether “Technology Acquisition Seekers Ltd.” will be able to use the patent or integrate it into its manufacturing processes without infringing on third-party rights. For example, if there is another patent that could impose restrictions on the use of the sold patent, we need to assess the legal implications.
Scope and Validity: We will evaluate the scope of protection provided by the patent and its legal strength. For example, if the patent does not meet formal requirements, such as a lack of a sufficiently detailed description of the technology, its legal validity may be weakened. In such a case, we will need to consider whether re-registration or amendments to the registration process are required.
Additionally, during the investigation, the acquiring company’s attorney will request that “Advanced Technology Ltd.” provide all relevant information and documents related to its patent portfolio. This request aims to ensure that the acquiring company receives a complete and accurate picture of the patent’s status and potential risks associated with it. The required documents include, among others:
1. Patent Files: Copies and schedules of all patents and patent applications filed, including their expiration and renewal dates in all registered countries.
2. Ownership and Usage Rights: All agreements related to ownership and usage rights of the company’s intellectual property, including licenses, assignments, and additional rights granted to third parties.
3. Patent Searches: Copies of patent searches conducted by or on behalf of the company to identify competing technologies and relevant prior publications.
4. Examination Reports: The latest examination reports of patent applications still pending registration, to understand the registration status and concerns raised by patent examiners.
5. Confidentiality and Rights Assignment Agreements: Confidentiality agreements and intellectual property rights assignment agreements with third parties, including employees, consultants, and business partners.
6. Dispute History: Documents related to disputes or legal claims involving the company’s patents or third parties, including court rulings, settlement agreements, and pending lawsuits.
7. Inventor History: Invention disclosure memoranda, inventors’ publications, and confirmations that the inventors transferred intellectual property rights to the company.
8. Research and Development Agreements: Agreements related to research and development collaborations that could affect patent ownership or usage rights.
The provided information will be used to assess the validity of the patent, the legitimacy of rights transfer, and the potential impacts of existing or future disputes. Collecting complete information is crucial to ensure that the acquirer is aware of all potential risks before committing to the transaction.
Step Three: Analysis of Results
In this step, the due diligence team of “Technology Acquisition Seekers Ltd.” analyzes the results obtained during the substantive investigation to assess the risks and benefits associated with acquiring the patent. This analysis encompasses all aspects raised in the previous stages and is conducted with reference to the initial purpose of the transaction.
Legal and Business Analysis:
1. Verification of Ownership Rights: We will verify the ownership of the patent and its registration status in all relevant countries. The validity of previous transfers will be checked, and any potential legal risks from third parties that could challenge ownership will be examined.
2. Assessment of Patent Strength and Enforceability: We will review the patent claims and determine whether they provide sufficient protection for the technology being sold. The feasibility of enforcing the patent in the countries where it is registered will be evaluated, especially considering the markets where “Technology Acquisition Seekers Ltd.” plans to operate.
3. Examination of Relevant Licenses and Agreements: We will review all existing agreements and licenses related to the patent to ensure there are no terms or commitments that could restrict its use. We will determine if any adjustments to the transaction terms are needed based on these findings.
Recommendations and Next Steps:
1. Pre-Closing Actions: For example, if additional patent registration tasks are needed in certain countries, these actions may need to be completed before finalizing the deal.
2. Request for Additional Information: If there are gaps in documentation or critical details, it may be necessary to request additional documentation from the selling company before proceeding.
3. Adjustments to Transaction Terms: Economic adjustments to the transaction terms may be necessary if the patent protection is not as extensive as initially anticipated by the parties.
4. Post-Closing Actions: For instance, it may be necessary to file requests for patent amendments or updates to the patent registration in accordance with the terms set out in the transaction.
5. Risk Considerations: The question of whether to accept certain risks, such as those related to patent enforcement in specific countries, or whether to make corrections to reduce risk before purchase, needs to be addressed.
In summary, at this stage, after evaluating all the collected information, a clear and comprehensive picture of the patent and intellectual property status of “Advanced Technology Ltd.” will emerge. This analysis will enable “Technology Acquisition Seekers Ltd.” to make an informed decision on whether to proceed with the transaction, modify its terms, or reassess the economic value of the acquisition.
By using the three-step method, the acquiring company will gain a complete and accurate understanding of the patent and will be able to make informed decisions about its acquisition, while the selling company can maximize the value of the patent and complete a successful transaction.
Due Diligence vs. Liability
In the field of patents, it is possible to cover risks through liability clauses or indemnification provisions in the agreement between the parties. The question arises as to why invest in an expensive due diligence process when liability clauses and indemnification provisions can cover these risks. While these clauses are effective, they are often limited in time and scope and do not cover all aspects of intellectual property. Additionally, the operational terms of liability and indemnification clauses are complex and sometimes include requirements such as prior notice to the indemnitor before filing a claim. Moreover, in many cases, these clauses are activated only when the indemnitor had “reasonable knowledge” of the issue causing the loss, which complicates the proof of the claim.
Even when all conditions for activating liability are met, there is no guarantee that liability will fully compensate the affected party. There are situations where financial compensation is insufficient or cannot reflect the full extent of the damage incurred. Furthermore, even if the financial compensation is appropriate, the indemnitor may not always have sufficient assets to fully compensate the affected party.
Thus, it follows that comprehensive due diligence is not only a tool for identifying defects and risks in advance but also a mechanism that provides greater assurance against risks that may only become apparent after the deal is closed. This allows a company to avoid relying solely on liability and indemnification clauses, which may not always offer a complete solution.
(For further details, see the book: Yonatan Drori, “Patent Law,” Perlstein-Ginosar Publishing, pages 1443-1459 (2023)).
