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In this article, Anmol Rathore, pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata discusses how to conduct an Intellectual Property due diligence check.

Introduction

What is Intellectual Property (IP)?

Intellectual property (IP) refers to creations of the human mind including inventions, literary and artistic works, industrial model and trademarks used in trade and commerce. In other words, IP is the protection of creations of mind which have both commercial and moral value attached to it. IP primarily encompasses patents, copyrights and trademarks. Intellectual property rights (IPR) entitles the creators, or owners, of these intellectual properties to benefit from these intangible creations of the human intellect.

What is IP due diligence?

With cut-throat competition in every industry, business enterprises in order to expand their business, to raise capital and to provide financial gain have understood the importance of intellectual property (IP) assets. Therefore, companies regularly conduct IP audits to understand the full value of these intangibles assets and make the most of their potential benefits. IP due diligence is the evaluation of an IP portfolio of any business, “checking valid intellectual property rights subsisting therein and scope of their protection, analyzing the risks involved with respect thereto and in turn, assessing their potential value”.

In other words, IP due diligence is an exercise which provides comprehensive knowledge of the value and risks of a company’s intangible assets.  Any business transaction involving IP, the due diligence is designed to examine and analyze the strength, scope and future potential that could be derived from the intangible assets- patents, copyrights or trademarks.

IP due diligence is conducted in following scenarios:

  • If there is a Merger & Acquisition
  • If an investor wants to invest in any startup company
  • If a company wants to raise money by mortgaging its IP assets

Why is IP due diligence important?

  • IP due diligence helps a business reorganize its operations with the aim of enhancing the marketability of its products or services
  • IP due diligence helps to maximise the value of these intangible assets which can boost the company’s balance sheet
  • Ignoring IP due diligence could over-value or devalue the assets that have to be acquired
  • IP due diligence helps to reveal risks and allows the acquirer to tackle the issues pre-close

With the increasing number of acquisitions more small and medium-sized enterprises (SMEs) looking to raise capital, pursuing a deal without conducting IP due diligence is unlikely. As a seller, you are ‘stress testing’ your IP. In doing so you detect the risks connected to IP assets, fix what is possible, and if it cannot be fixed, create a suitable narrative justifying the price. As a buyer, you are informing yourself about the risks of acquiring the IP, and therefore adjust the valuation of acquiring the IP assets. Without conducting IP due diligence, a business enterprise cannot understand the risk, and therefore the price. Therefore, due diligence is more of an information gathering exercise. You are informing yourself about risk and therefore price because the price is a function of risk. Without the proper information, any business cannot develop the right strategies to mitigate the risks or correct the price (selling) when the risks cannot be mitigated.

How to Conduct IP due diligence?

The task of conducting an IP due diligence requires professional skills and should be conducted thoroughly. Ideally, IP due diligence should be conducted at the onset of the negotiations as it helps to identify any legal issues which may affect the value of the IP.  When more time is allowed to complete due diligence investigation, this not only helps to determine a more reasoned value of the IP, but corrective action can proactively be taken if any legal concerns are identified.

Though every business transaction is different from each other and will have a different set of requirements for conducting an IP due diligence. Some of the general requirements that should be involved in an IP due diligence are:

Identify IP assets

In all businesses, patents, domain names, trademarks and brand names are the intangible assets and these are the intangible subject matter that needs to be identified.

Verify Ownership and existence of IP

Ownership is often one of the first issues investigated while conducting an IP due-diligence. A series of questions are asked about each IP asset to establish the target company’s rights in it and whether those rights are free of any strains and can be easily transferred. If the ownership of the IP asset is disputed, the seller cannot transfer the title and rights of the asset to others. If the seller does not own the intangible asset, the evaluation will be done to check whether proper steps were taken to obtain the rights from the actual owner.

Check for applicable territory and terms

It is important to check the validity of each IP asset i.e., their term and territory. Most IP rights are limited to a certain territory only.  So it is important to ascertain the territories in which the IP rights are protected. If the company operates in several countries and has not got the IP rights covered in all those territories, it might cause problems in the future.

IP assets like patents and copyrights are valid for a limited time period. On the other hand, copyrights can be protected perpetually. Local IP laws of each territory should be scrutinized to check the validity term of different IP assets.

Check for any Third-party claims

Along with the ownership check, it is sensible to check any third-party claims or interests with respect to the seller’s IP asset. Sometimes rights can accrue in favour of a third party unknowingly also. So, scrutiny of all license and franchise agreements, joint venture agreements, memorandum of understandings should be done to identify if any exclusive rights have been granted in relation to relevant IP. The records of IP office can be perused with regard to the relevant IP asset to find any discrepancy.

Evaluate potential IP infringements

Further, while conducting IP due diligence it is important to check whether a third party is infringing a company’s IP right or it is the company that might infringe a third party’s right. In both cases, if the relevant IP rights are subject to any encumbrance, a dispute is likely to arise with the consequence of disrupting the business operations. A freedom to operate (FTO) search should be conducted to check whether the investor could make, use or sell the IP assets without infringing any third party rights. This provides a more comprehensive insight into patent rights of others and identifies any potential roadblocks. If any potential legal roadblocks are identified, steps can be taken to circumvent the issues that might arise later in the future.

Steps to be followed to conduct an IP due diligence

Following steps should be taken while conducting an IP due diligence in order to comply with the above requirements:

  1. Set a proper IP due diligence team and discuss fully with IP professionals your expectations from the transaction
  2. Prepare and send an IP due diligence checklist
  3. Identify and separate the IP assets of the target relevant for the transaction– at the outset, segregate IP rights or protectable intangible assets relevant for the transaction from those which are not so; the IP due diligence should highlight the importance of connecting such additional IP rights with the main IP rights for the transaction; this will ensure that the focus of due diligence for the transaction is clearly set.
  4. Commission a thorough search of the ownership of the IP, gather information on other IP rights which may affect the use or sale of these rights in the future. Analyze if there is any litigation or infringement involved.
  5. Further, it is the duty of the due diligence team to verify facts and confirm information received from the target, if and when any discrepancy is found, going back to the target with the further set of issues and questions must not be avoided at any cost.
  6. Analyze protected and protectable IP rights – Status check, validity check, ownership check, claim check and conflict check should be conducted, in the manners specified above.
  7. Provide a final diligence report on risks involved along with the strategies to mitigate the risks and liabilities involved.
  8. Document, execute and record the IP agreements

Conclusion

No matter what the composition of the IP portfolio or no matter what the type of transaction conducting due diligence enables to identify as well as mitigate the risks involved or managed so that expectations and objectives can be met. A well-timed and properly conducted due diligence investigation can benefit both the parties involved and may lead to long-term relationships and business collaborations.

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