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In recent years, intellectual property has become an increasingly important asset for many companies. As these companies engage in merger and acquisition transactions, there has been a growing need to handle the intellectual property aspects of these transactions carefully. Many intellectual property lawyers tend to focus on specific practice areas within intellectual property law, such as patents or trademarks. However, to handle effectively the intellectual property issues in an M&A transaction, the intellectual property lawyer should be a generalist � understanding many different aspects of intellectual property law. In most transactions, the intellectual property issues will not be segregated as being patent or trademark issues. Instead, M&A practice is more an exercise in issue spotting in all areas of intellectual property law. In the context of M&A transactions, due diligence refers to an investigative process through which one or more parties to the transaction attempt to understand better the business of the target company or other party or parties to the transaction, both from business and legal standpoints. Because the consummation of a transaction may depend upon the results of due diligence, and the terms governing any consummated transaction will often be based on the results of due diligence, it is a critical tool in any M&A transaction. From a business perspective, the goal of performing due diligence is to determine whether a transaction makes business sense. This determination is most often based upon whatever criteria each party believes make the transaction beneficial to its interests. If a purchasing party, for example, believes that the company that it is acquiring will provide some added value, or provide synergies to its business, due diligence is used to verify the accuracy of these beliefs. Similarly, if the purchaser has based its valuation of the target company on certain financial assumptions, it will use the due diligence process to check the veracity of those assumptions and to ensure that the financial terms of the transaction are appropriate. Due diligence may also be used to ensure that a transaction is structured properly from a business standpoint, e.g., as a particular type of merger or as an asset transaction. From a legal standpoint, the primary purpose of due diligence is to identify and evaluate the assets and liabilities of a target company to the extent necessary for a particular transaction. In the context of an M&A transaction, a major objective of the due diligence process is to identify the target company’s liabilities and potential liabilities in order to assess whether such liabilities affect the overall value of the company. Although intellectual property due diligence is a subset of the overall due diligence process that takes place in a transaction, it is an important part of the exercise. If the acquisition value is based in material part on the target company’s intellectual property assets, the due diligence investigation will be designed to ensure that these assets exist, and are owned or controlled by the seller, or operate to the seller’s benefit, in a manner consistent with the buyer’s understanding and expectations in going forward with the deal at the agreed-upon price. How much due diligence? As a theoretical matter, the role of the intellectual property lawyer in a transaction is to identify all intellectual property issues that may affect the target company. As a practical matter, the intellectual property lawyer performing due diligence should use a commonsense approach to identify issues material to the target company or the purchaser, or issues that may affect the value of the target company, either financially or by virtue of its intrinsic value to the purchaser. The level of materiality will depend on the size of the transaction or the importance of the intellectual property that may be affected by an issue. The appropriate level of due diligence will typically vary between stock and asset transactions, between businesses that are mature and those that are start-ups, and between technology and nontechnology companies. In asset transactions, in which the buyer directly acquires each asset of the target company, more detailed due diligence is often warranted. All material intellectual property assets used by the target company should be identified and the ownership of those assets by the selling entity confirmed. In stock transactions, due diligence should be performed to ensure that acquisition of the target company’s stock will in fact transfer and provide to the buyer all material intellectual property assets. The level of due diligence is also often more stringent in transactions involving the purchase of small companies and start-ups, since such companies tend to have less regard for following legal formalities concerning the protection of their intellectual property. Such companies may also derive a greater portion of their value from intellectual property. In contrast, the level of due diligence is often less in transactions involving a publicly traded target company, since such companies will have had an obligation to disclose material issues in government securities filings. Similarly, for a large company that licenses most of its software from commercial vendors, the origin of the software code is normally of little importance. For a small company that is in the business of developing and licensing its software to third parties, the origin of each line of code may be critical. Of course, these examples represent the extremes, and there will be many shades of gray in between. When performing intellectual property due diligence, one must always consider the relative importance of intellectual property to the overall transaction. In other words, it is important to keep perspective and not lose sight of the forest from the trees. If there is reason to believe that issues are material to the business, the lawyer performing due diligence should make the other lawyers on the transaction aware of them. Otherwise, upon discovering a problem, that lawyer should inquire of other lawyers or businesspeople on the transaction as to whether the intellectual property at issue is particularly material to the company. When issues that affect valuation are uncovered, business executives can determine what effect, if any, these issues will have on the purchaser’s desire to acquire the target company or whether these issues may be used to negotiate specific contractual protections or other terms. When legal issues are uncovered during due diligence, the M&A lawyers on the transaction will determine how best to address these issues. In many cases, representations, warranties and indemnities are added to the transaction documents to cover specific legal issues identified during due diligence. It is important to remember that the people receiving information on IP due diligence issues expect that only the most important issues are filtered out for their consideration and likely do not have a specific understanding of intellectual property. Therefore, the lawyer performing due diligence should choose the issues and wording carefully. Less important issues should be considered by the transaction team during the course of reviewing the due diligence memorandum, which sets forth issues large and small. The due diligence process The intellectual property due diligence process consists of obtaining and reviewing materials relating to the intellectual property assets and liabilities of the target company. These materials can be obtained in various ways, including from the target company or its seller as part of an offering memorandum or other information packet distributed to facilitate the transaction, from public sources, from written due diligence requests provided by the purchaser to the target company or seller for general categories or specific pieces of information or from discussions between the parties and counsel for the parties. At the beginning of some transactions, the seller prepares an offering memorandum describing the business for sale. This memorandum may provide an idea of the type of company involved, the importance of intellectual property to the company, its strategies for protecting intellectual property and the position of the company relative to its key competitors. During the due diligence process, the buyer will often submit a due diligence request to the seller setting forth a list of information and documents that the buyer would like to review in connection with the transaction. This request may be quite lengthy and detailed, covering all aspects of the target company, including tax, corporate, environmental, compensation and benefits, and antitrust, as well as intellectual property. Any due diligence request list should be tailored appropriately to include requests for information specific to the transaction or target company. In transactions involving small technology companies, for example, the buyer will often request copies of most or all of the target company’s employment and independent contractor agreements, and the seller may well be able to provide such agreements without much difficulty. On the other hand, if a target company has one or only a few key technologies, the purchaser may want to review the file histories of pending patent applications on these technologies or opinions of counsel as to whether these technologies infringe the intellectual property rights of others. After reviewing documents provided in response to an initial due diligence request, supplemental due diligence requests may be sent to the seller to request additional required documents or to address issues uncovered during the initial stages of due diligence. In many cases, at this stage, the seller will make its counsel, sometimes accompanied by one or more relevant businesspeople, available to the buyer’s counsel to answer specific questions about the particular subject-matter of interest to the buyer. With regard to intellectual property, these discussions are often the most expeditious way to obtain a full understanding of the manner in which the target company protects its intellectual property rights and to gain a better understanding of the liabilities and potential liabilities, if any, that are known to the company. These discussions are particularly useful in identifying and exploring possible or alleged infringement issues known to the company but that are not disclosed or discussed sufficiently in the data-room documents. When intellectual property issues loom large in a transaction, the person conducting intellectual property due diligence may wish to request such discussions very early in the process, as a means of expediting an understanding of the nature, substance and complexity of any serious issues. It goes without saying that one must report the results of due diligence to the other members of the team handling the transaction. Important issues that are uncovered during the transaction should immediately be brought to the attention of those managing the transaction. In extreme cases, these issues may result in abandonment of the transaction, restructuring of the transaction or renegotiation of key business terms. For example, if a highly material infringement issue is uncovered, the transaction may be put on hold while the businesspeople work out an appropriate indemnification or adjustment to the purchase price. In many transactions, counsel may be asked to prepare a due diligence memorandum that summarizes the status and results of due diligence. In general, a due diligence memorandum should include an executive summary at the beginning of the memorandum, which will highlight key issues that have been identified and open issues that require additional analysis, and a detailed discussion concerning the scope of the due diligence performed, the materials reviewed and the issues identified. When drafting a due diligence memorandum, counsel should keep in mind that the target audience is usually not intellectual property lawyers. As a result, one should avoid the use of IP jargon and unnecessarily legalistic discussion. In sum, intellectual property issues are becoming increasingly important in M&A transactions. In theory, the intellectual property lawyer handling a transaction should identify all intellectual property issues that may affect the target company or the purchaser if the transaction is consummated. However, the expense and time required to uncover every possible issue during due diligence are prohibitive, and the number of issues that would emerge would obscure the actual importance of any single issue. Therefore, common sense must be used during due diligence to identify issues only material or highly relevant issues. The same commonsense approach must be used in all aspects of the transaction and should be adopted in dealing with the ancillary documents executed at closing, such as license agreements and assignments. David M. Klein ([email protected]) is a partner at New York’s Shearman & Sterling and leads the firm’s technology transactions and outsourcing practices. He is the author of Intellectual Property in Mergers & Acquisitions (Thomson/ West 2003).

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