Intellectual Property Assets in Mergers and Acquisitions

INTELLECTUAL PROPERTY ASSETS IN MERGERS AND ACQUISITIONS Editors Lanning Bryer Ladas & Parry New York, New York

Melvin Simensky Visiting Scholar in Intellectual Property Law New York Law School

JOHN WILEY & SONS, INC.

INTELLECTUAL PROPERTY ASSETS IN MERGERS AND ACQUISITIONS

Dedication To Stuart, who has the best business instincts but also the largest heart; to Nicole and Joseph, who are always fun and wise; and to Van, who is the true academic of the family. —Lanning G. Bryer For my beautiful wife for being there for me. —Melvin Simensky

Wiley Intellectual Property Series Early-Stage Technologies: Valuation and Pricing by Richard Razgaitis Edison in the Boardroom: How Leading Companies Realize Value from Their Intellectual Assets by Julie L. Davis and Suzanne S. Harrison From Ideas to Assets: Investing Wisely in Intellectual Property by Bruce Berman Intellectual Property Assets in Mergers and Acquisitions by Lanning Bryer and Melvin Simensky Intellectual Property in the Global Marketplace, Volume 1: Valuation, Protection, Exploitation, and Electronic Commerce, Second Edition by Melvin Simensky, Lanning Bryer, and Neil J. Wilkof Intellectual Property in the Global Marketplace, Volume 2: Country-by-Country Profiles, Second Edition by Melvin Simensky, Lanning Bryer, and Neil J. Wilkof Intellectual Property Infringement Damages: A Litigation Support Handbook, Second Edition by Russell L. Parr Intellectual Property: Licensing and Joint Venture Profit Strategies, Second Edition by Gordon V. Smith and Russell L. Parr Licensing Intellectual Property: Legal, Business, and Market Dynamics by John W. Schlicher Patent Strategy: The Manager’s Guide to Profiting from Patent Portfolios by Anthony L. Miele Profiting from Intellectual Capital: Extracting Value from Innovation by Patrick H. Sullivan Technology Licensing: Corporate Strategies for Maximizing Value by Russell L. Parr and Patrick H. Sullivan Technology Management: Developing and Impelementing Effective Technology Licensing Programs by Robert C. Megantz Trademark Valuation by Gordon V. Smith Valuation of Intellectual Property and Intangible Assets, Third Edition by Gordon V. Smith, Russell L. Parr Value-Driven Intellectual Capital: How to Convert Intangible Corporate Assets Into Market Value by Patrick H. Sullivan Technology Management: Developing and Implementing Effective Technology Licensing Programs by Robert C. Megantz

INTELLECTUAL PROPERTY ASSETS IN MERGERS AND ACQUISITIONS Editors Lanning Bryer Ladas & Parry New York, New York

Melvin Simensky Visiting Scholar in Intellectual Property Law New York Law School

JOHN WILEY & SONS, INC.

Copyright © 2002 by Lanning G. Bryer and Melvin Simensky. All rights reserved. Published by John Wiley & Sons, Inc. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012, (212) 850-6011, fax (212) 850-6008, E-Mail: PERMREQ @ WILEY.COM. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in professional services. If professional advice or other expert assistance is required, the services of a competent professional person should be sought. This title is also available in print as ISBN 0-471-41437-9. Some content that appears in the print version of this book may not be available in this electronic edition. For more information about Wiley products, visit our web site at www.Wiley.com

ABOUT THE EDITORS LANNING G. BRYER

Lanning G. Bryer is a Partner in the New York office of Ladas & Parry and is Director of the firm’s Mergers, Acquisitions, and Licensing Group. Mr. Bryer is an active committee member of several intellectual property organizations, including the Trademark Licensing Committee of Licensing Executive Society (United States and Canada) and the Editorial Board of The Trademark Reporter. He recently served on the International Editorial Board of The International Trademark Association (formerly the U.S. Trademark Association) and currently serves as co-chairman of The International Annual Review. Mr. Bryer has written and lectured extensively on foreign trademark practice and commercial transactions involving the acquisition, financing, and licensing of intellectual property. Mr. Bryer is coauthor and coeditor of a treatise titled Worldwide Trademark Transfers and the twovolume John Wiley & Sons treatise titled Intellectual Property in the Global Marketplace. He is a graduate of Johns Hopkins University and Hofstra University School of Law. MELVIN SIMENSKY

Melvin Simensky is Visiting Scholar in Intellectual Property Law at New York Law School. Prior to this engagement, he was a partner at several law firms where he both counseled and litigated trademark, copyright, advertising, and entertainment law matters. Mr. Simensky specializes in the intellectual property aspects of commercial transactions involving both mergers and acquisitions and financings. Mr. Simensky was previously adjunct professor of law at New York University School of Law, where he taught a graduate school seminar on the intellectual property aspects of the entertainment business. He is formerly a columnist on entertainment and intellectual property law issues for the New York Law Journal. Mr. Simensky has been on the Board of Editors of The Trademark Reporter and Copyright World and has been an expert witness on U.S. intellectual property law in numerous domestic and foreign court proceedings. Mr. Simensky is coauthor of both a five-volume treatise titled Entertainment Law as well as a casebook of the same name. Mr. Simensky has published many articles and has lectured at numerous conferences on intellectual property and entertainment law. He is a graduate of Yale University and New York University School of Law.

v

ABOUT THE CONTRIBUTORS Benedict Bird and Anna Carboni are partners and Deborah Lincoln is a consultant in the international law firm of Linklaters & Alliance. They are all based in its Intellectual Property and Technology Department in London. They have been assisted in writing this chapter by Steven Altham and Brian Sher, both associates in the EU/Competition Department of Linklaters & Alliance, and by their continental colleagues, Patrick Rignell based in Paris and Markus Deck and Jiri Philippi based in Cologne. Sheldon Burshtein is a partner of Blake, Cassels & Graydon LLP, and practices in the Intellectual Property Group in the Toronto, Canada, office. He is a member of the Bar of Ontario and is registered as a professional engineer in Ontario. He is also a patent agent and a trademark agent, and he has an engineering degree as well as civil law and common law degrees from McGill. He is certified as a Specialist in Intellectual Property (Patent, Trade-mark and Copyright) Law by the Law Society of Upper Canada. Andrew W. Carter is a managing director of InteCap, Inc., the largest consulting firm in the country that focuses on the economic, strategic, and valuation issues surrounding intellectual property. He assists clients with their intellectual property licensing programs and is frequently a damages expert witness in patent infringement lawsuits. He is a licensed CPA and holds an MBA in Business Policy and a BS in Chemical Engineering. Marie-Eve Cote is a lawyer with Leger Robic Richard, Lawyers, and Robic, Patent & Trademark Agents, Business Law. Her practice is mainly focused in commercial and corporate law, which includes the negotiating and drafting of commercial agreements, namely mergers and acquisitions, reorganizations, and shareholder and partnership agreements. She is also developing an expertise in due diligence. She also practices in the commercial fields of intellectual property, particularly the negotiation and drafting of license agreements, distribution agreements, transfer of technology, and related agreements. Christian Danis is a lawyer with Leger Robic Richard, Lawyers, and Robic, Patent & Trademark Agents, Commercial and Corporate Law. His practice focuses mainly on the negotiating and drafting of commercial agreements, including mergers and acquisitions, reorganizations, and shareholder agreements, as well as the commercial aspects of intellectual property, with an emphasis on licensing, transfers of technology, and research and development agreements. Patrick A. Gaughan is president of Economatrix Research Associates, Inc., an economic and financial consulting firm, located on Wall Street, that analyzes damages and conducts valuations for litigation purposes. He is a professor of economics and finance at Fairleigh Dickinson University and has authored numerous publications, including Mergers, Acquisitions and Corporate Restructurings. Louis-Pierre Gravelle, is a patent agent and lawyer with Leger Robic Richard, Lawyers, and Robic, Patent & Trademark Agents, Intellectual Property Law. His practice focuses on patent law, specifically on drafting and prosecuting patent applications, particularly in the telecommunications field. He

vi

ABOUT THE CONTRIBUTORS vii also handles infringement, validity, and patentability opinion and is involved in technology transfer, particularly in due diligence matters. He is a member of the Quebec Bar Association as well as of the Intellectual Property Institute of Canada. Tira Greene is an international lawyer specializing in intellectual property law as well as legislative reform and the drafting of intellectual property law for developing countries. She currently works as an independent consultant and also undertakes projects on behalf of the World Intellectual Property Organization. Glenn Gundersen is a partner at Dechert in Philadelphia, where he has practiced since graduating from the University of Virginia School of Law in 1980. He is the author of the book Trademark Searching: A Practical and Strategic Guide to the Clearance of New Marks, the second edition of which was published by the International Trademark Association in 2000. He is a frequent speaker on trademark, copyright, and other intellectual property issues for the major organizations in the IP field, including the American Bar Association, International Trademark Association, American Intellectual Property Law Association, and Practicing Law Institute, and has written numerous articles for the National Law Journal and other publications. William M. Heberer is an attorney with Hall Dickler Kent Goldstein & Wood LLP in New York. He practices in the areas of intellectual property, advertising, marketing, and entertainment law. Thomas G. Jackson is a partner in the law firm of Phillips Nizer Benjamin Krim & Ballon LLP. He is a member of the Clayton Act, Section 7, Intellectual Property and Internet Committees of the Section of Antitrust Law of the American Bar Association, a past member of the Antitrust and Trade Regulations Committee of the Association of the Bar of the City of New York and past chair of the Technology in the Courts subcommittee of the Federal Courts Committee of the Federal Bar Council. Panagiota (Betty) Koutsogiannis is a lawyer with Leger Robic Richard, Lawyers, and Robic, Patent & Trademark Agents, Business Law. Her practice focuses on commercial aspects of intellectual property and technology transfers, license agreements, research and development agreements, and joint ventures. She also practices in other fields of commercial and corporate law, such as mergers and acquisitions, and has developed a particular expertise in due diligence and audits in the higher tech sectors. She is a member of various organizations such as the Licensing Executives Society (USA and Canada), Inc., and the Information, Telecommunications and Intellectual Property Section (Quebec Division) of the Executive Committee of the Canadian Bar Association. Robert B. Lamb is a clinical full professor at New York University’s Stern School of Business. He previously taught at Wharton and Columbia. He has published a number of books on corporate strategy, mergers and acquisitions, and public finance. He has also published four chapters in Intellectual Property in the Global Marketplace, dealing with Financial Valuations of Intellectual Property in Financial Transactions. Professor Lamb is a consultant to major financial institutions, corporations and to the US Government. He has often been quoted in the Wall Street Journal, and other business media. Michael Lasinski is a managing director at InteCap, Inc., a professional services firm focused on IP management issues. His focus is on IP valuation and related issues in licensing, sale, merger, acquisition, and tax-related transactions. Prior to joining InteCap, Inc., he was with Coopers & Lybrand (now PricewaterhouseCoopers) and Ford Motor Company. He holds both an MBA and BSEE from the University of Michigan, is a licensed CPA in the state of Illinois, and is co-chairman of the Valuation and Taxation Committee of the Licensing Executives Society.

viii ABOUT THE CONTRIBUTORS Scott J. Lebson is an associate in the New York Office of the international law firm of Ladas & Parry, where he specializes in commercial transactions involving the acquisition, financing, and licensing of intellectual property. David A. Loewenstein concentrates his practice on patent litigation. He has litigated cases in several technologies including: computer software patents, electromechanical devices, laser-based optical flow cytometers, nuclear magnetic resonance (NMR) instruments, pharmaceuticals, medical devices, monoclonal antibodies, electro-chromic mirrors, heart pacemakers, contact lenses, satellite spin stabilization, vehicle electronic engine controls, and nuclear power plant design. He also has significant experience with trademark and antitrust litigation, and intellectual property licensing and trademark cancellation proceedings. Theodore C. Max is a litigation partner at Phillips Nizer Benjamin Krim & Ballon LLP specializing in intellectual property law. He combines his skill and experience as a trial attorney with his knowledge of copyright, trademark. and entertainment law in servicing Phillips Nizer’s many diverse clients in the fashion apparel and accessories, music, entertainment, publishing, film, and multi-media industries. He is the author of several articles and has contributed to several books regarding intellectual property law. He is currently Editor-in-Chief of The Trademark Reporter, the official journal of the International Trademark Association. He obtained an undergraduate degree from Hobart College and a Juris Doctor from New York University Law School. Susan Barbieri Montgomery is a partner in the Boston office of Foley, Hoag & Eliot LLP. Her practice is focused on strategies for intellectual property asset development and protection, and international business transactions. She is a frequent author and lecturer on intellectual property and business transactions. She is co-editor of the treatise Worldwide Trademark Transfer Law & Practice, Clark Boardman Callaghan (1992), and an adjunct professor at Suffolk University Law School. She is currently serving on the Council for the ABA IP Law Section and is a past member of the Board of International Trademark Association and Volunteer Lawyers for the Arts. Francois Painchaud is a partner in Leger Robic Richard, Lawyers, and Robic, Patent & Trademark Agents, Business Law. His practice focuses on information technology and technology transfers in all high technology fields and includes the preparation and negotiation of transfers, license agreements, research and development agreements, and joint ventures. He also practices in other fields of commercial and corporate law such as mergers and acquisitions. He is the Montreal Local Committee Chairman and an upcoming trustee of the Licensing Executives Society (USA and Canada), Inc. (LES). He serves on the Board of Directors of various technology-driven private and public companies and is a professor (sessional lecturer) on the law faculty of McGill University on the law of trade secrets and technology transfers. Leonard Schneidman, a senior tax partner in the Boston law firm of Foley, Hoag & Eliot LLP, is a graduate of the Harvard Law School (1965) and the NYU Tax Program (1966). He has written and lectured extensively on various tax topics and is listed in the Best Lawyers in America and Euromoney Guide to Leading U.S. Tax Lawyers. Gordon V. Smith is president of AUS Consultants, Moorestown, New Jersey. He is an adjunct professor at Franklin Pierce Law Center and the founding director of the Intellectual Property Management Institute. He has authored and co-authored several well-known books on intellectual property valuation and licensing. Michael J. Ward is the company secretary of Counsel Limited, a licensed company manager based in Anguilla, British West Indies (www.counsellimited.com) that specializes in active management of client corporations. He has a reputation for designing and implementing novel and effective group structuring solutions in a fast moving and rapidly evolving legislative and regulatory environment.

CONTENTS

PREFACE

xxvii

ACKNOWLEDGMENTS

xxx

CHAPTER 1 MERGERS AND ACQUISITIONS: AN OVERVIEW

1.1

PATRICK A. GAUGHAN, PH.D. COLLEGE OF BUSINESS, FAIRLEIGH DICKINSON UNIVERSITY ECONOMATRIX RESEARCH ASSOCIATES, INC. Introduction Fifth Merger Wave Exported to Europe Fifth Merger Wave Compared to Prior Merger Periods

1.1 1.1 1.3

Types of Mergers, Acquisitions, and Corporate Restructurings Why Do Firms Merge? Growth Synergy Consolidating and Roll-Up Mergers of the Fifth Merger Wave Diversification Related versus Unrelated Diversifications Leveraged Transactions

1.4 1.5 1.5 1.5 1.6 1.6 1.6 1.6

Role of Intellectual Property in Mergers and Acquisitions

1.7

How do Mergers Turn Out and What Can Go Wrong? What Can Go Wrong with Intellectual Property Motivated Acquisitions? Trends in Deal Prices for the Fifth Merger Wave Winners and Losers in Mergers and Acquisitions Effects of Sell Offs

1.7 1.8 1.8 1.8 1.10

Conclusion

1.11

Endnotes

1.11

ix

x

CONTENTS

CHAPTER 2 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS IN MERGERS AND ACQUISITIONS

2.1

ROBERT BOYDEN LAMB NEW YORK UNIVERSITY STERN GRADUATE SCHOOL OF BUSINESS Introduction

2.1

A Firm’s IP Has Become a Major Factor in Valuing M&A Deals

2.3

3M Corporation’s Shift from Internal R&D for IP to A Mixture with External Acquisitions for New IP

2.4

The Winner’s Curse in M&A Auctions and Its Effect on New IP Creation, Transfer, and Sharing

2.5

Investment Bankers Use Four Basic Methods of Valuing Mergers and Acquisition Transactions Comparable Company Analysis Comparable Transactions Analysis Discounted Future Steps to a Valuation Option Valuation

2.6 2.6 2.8 2.9 2.9 2.12

Damodaran’s Option Valuation Procedure for a Patent Value of Underlying Asset Variance in the Value of the Asset Exercise Price of Option Expiration of the Option The Dividend Yield An Important Caveat on Investment Bankers Selection of Valuation Method

2.13 2.13 2.13 2.13 2.13 2.13 2.16

Alternative IP Valuation Methods

2.16

Today’s Compression of the Product Life Cycle and Modern Valuation Problems

2.17

Mergers and Acquisitions and the Consolidation of Market Power in Various Industries in the World

2.19

Free IP Giveaways Impact M&A Growth and Price

2.22

Bundling of Free IP Add-ons Impact M&A Prices

2.23

Impact of Rapid Technological Advance on M&A Valuations

2.24

Merger Failure Is the Norm

2.25

Failed Merger Negotiations Risk IP Losses

2.27

Impact of New Internet IPO Market on M&A Prices

2.27

Typical M&A Valuation Problems of High-Technology Firms

2.28

M&A Valuation of IP Combines Investment Banking with Strategy Consulting

2.31

CONTENTS xi

Example of a Merger Valuation of IP in an Actual Transaction

2.33

Valuation: To Believe or Not to Believe

2.34

Models of Intellectual Property Firms: Incestuous Family, Network Alliances, Winner Take All, a Wheel of Fortune

2.37

Divestitures versus Acquisitions Signal the Driving Role of IP in Today’s Businesses Wheel of Fortune

2.38 2.39

AICPA Accounting Rule Changes Impact Merger and Acquisition Transactions and Valuations

2.39

Before the Long-Term Change in Pooling Accounting Rules

2.40

Ranges of Intellectual Property Financial Valuation

2.42

Valuation of Established Intellectual Properties

2.42

Valuations of a Competitor’s Intellectual Properties

2.44

Investment Bankers’ Merger and Acquisition Valuation Problems

2.44

Endnotes

2.45

CHAPTER 3 INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY ACCOMPANYING MERGERS AND ACQUISITIONS

3.1

GORDON V. SMITH AUS CONSULTANTS Introduction

3.1

The Asset Portfolio Monetary Assets Tangible Assets Intangible Assets

3.1 3.1 3.2 3.3

Business Enterprise Value in Mergers and Acquisitions Acquisition Premiums Acquiring Intangibles

3.3 3.3 3.4

Intangible Assets and Intellectual Property Rights Relationships Assembled Workforce Customer Relationships Distributor Relationships Undefined Intangibles Goodwill Going Concern Value Intellectual Property Proprietary Technology Patents

3.4 3.4 3.5 3.5 3.5 3.6 3.6 3.6 3.7 3.7 3.8 3.9

xii CONTENTS

Copyrights Trademarks Internet Domain Names Computer Software Mask Works Right of Publicity Intellectual Capital

3.10 3.11 3.13 3.13 3.15 3.15 3.15

Comment

3.16

Endnotes

3.18

CHAPTER 4 VALUATION OF INTELLECTUAL PROPERTY ASSETS IN MERGERS AND ACQUISI4.1 TIONS

MICHAEL J. LASINSKI INTECAP, INC. Introduction

4.1

Reasons for Valuing Intellectual Property in Mergers and Acquisitions 4.2 Strategic Reasons to Value Intellectual Property Management 4.2 Transactional Reasons to Value Intellectual Property 4.2 Company Acquisition Planning and Due Diligence 4.2 Licensing Intellectual Property 4.3 Acquiring or Selling Intellectual Property (in the Absence of a Business Combination) 4.4 Establishing Equity Contributions 4.4 Corporate Spin-Offs 4.4 Tax Reasons to Value Intellectual Property 4.4 Intercompany Transfer Pricing 4.4 Intellectual Property Management Subsidiary 4.5 Charitable Donations of Patents and Related Technology 4.5 Purchase Price Allocation 4.6 In-Process R&D 4.6 Financial Reasons to Value Intellectual Property 4.6 Obtaining Financing/Raising Capital/IP Asset-Backed Securitizations 4.6 Reorganization/Bankruptcy/Loan Workouts 4.7 Legal Reasons to Value Intellectual Property 4.7 Valuation Approaches and Their Application The Premise of Value: Fair Market Value The Sources of Potential Value Valuation Approaches: Market, Cost, and Income Market Approach Cost Approach Income Approach (Discounted Cash Flow Analysis) Amount of the Income Stream Duration of the Income Stream Accounting for the Risk of the Income Stream

4.7 4.8 4.8 4.9 4.9 4.9 4.10 4.11 4.13 4.13

CONTENTS xiii

Pricing Considerations in Licensing The Range of Negotiations: The Floor and the Ceiling The Licensor’s Theoretical Floor The Licensee’s Theoretical Ceiling Industry Royalty Rates Other Pricing Factors

4.16 4.16 4.16 4.17 4.17 4.18

Conclusion

4.18

Endnotes

4.19

CHAPTER 5 ACCOUNTING FOR INTELLECTUAL PROPERTY DURING MERGERS AND ACQUISITIONS

5.1

ANDREW W. CARTER INTECAP, INC. Introduction

5.1

Accounting for Intellectual Properties in Mergers and Acquisitions Asset Recognition Objective of Accounting System Financial Reporting of Business Combinations-General The Pooling Method The Purchase Method Which Method to Use

5.1 5.1 5.2 5.2 5.2 5.3 5.3

Financial Reporting for Acquired Intangible Assets Amortization Tax Treatment Impairment of Intangibles

5.3 5.5 5.5 5.6

Proposed Financial Accounting Standards Board Changes and Recent Developments 5.6 Proposed Elimination of the Pooling Method 5.6 Goodwill and Amortization 5.7 In-Process Research and Development Charges Definition of In-Process Research and Development Charges Historical Treatment of Research and Development Potential Changes Increased SEC Scrutiny of In-Process Research and Development Write-Offs

5.8 5.8 5.8 5.8 5.9

Bibliography

5.10

Endnotes

5.11

xiv CONTENTS CHAPTER 6 INTELLECTUAL PROPERTY ASPECTS OF ACQUISITIONS

6.1

GLENN A. GUNDERSEN DECHERT Introduction

6.1

Acquisition Agreement Contents of the Acquisition Agreement

6.1 6.2

Other Documents Transfer Documents Obtaining Assignments of Licenses Ancillary Agreements and Obligations

6.3 6.3 6.4 6.4

Drafting the Description of Assets Identifying the Intellectual Property Being Transferred as Part of a Stock Sale Identifying the Intellectual Property To Be Transferred in an Asset Sale Determining the Disposition of Jointly Used Intellectual Property

6.5 6.5 6.5 6.7

The Substance of Intellectual Property Representations and Warranties

6.7

How Intellectual Property Law Affects Representations and Warranties Patents Trademarks Copyrights Trade Secrets Rights of Publicity Industrial Design Rights Internet-Related Assets

6.8 6.8 6.9 6.10 6.11 6.11 6.11 6.11

Negotiating Representations and Warranties

6.12

Indemnification

6.16

Endnote

6.17

CHAPTER 7 U.S. ANTITRUST AND INTELLECTUAL PROPERTY IN MERGERS AND ACQUISITIONS

7.1

THOMAS G. JACKSON PHILLIPS NIZER BENJAMIN KRIM & BALLON, LLP Introduction

7.1

Enforcement Agency Policies Horizontal Merger Guidelines Non-Horizontal Merger Guidelines Antitrust Guidelines for the Licensing of Intellectual Property Antitrust Guidelines for Collaborations Among Competitors

7.2 7.2 7.2 7.3 7.3

Intellectual Property Issues in Merger Cases Horizontal Mergers and Joint Ventures

7.3 7.3

CONTENTS xv

Vertical Mergers Mergers Involving Horizontal and Vertical Restraints Exclusive Licensing

7.5 7.6 7.7

Conclusion

7.7

Endnotes

7.7

CHAPTER 8 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE IN BUSINESS TRANSACTIONS

8.1

SHELDON BURSHTEIN BLAKE, CASSELS & GRAYDON, LLP Introduction Need for Intellectual Property and Information Technology Due Diligence What Due Diligence Is Identification of the Nature of Primary and Related Transactions Share Purchase Asset Purchase Purchase from Receiver or Trustee Financing Due Diligence by Parties Other than the Purchaser Due Diligence by Seller Due Diligence by Borrower Due Diligence by Issuer Scope and Cost of Work for Intellectual Property and Technology Due Diligence Time Cost Nature of the Transaction Ancillary Agreements Nature of the Business Value of Intellectual Property and Information Technology Structure of the Business Domestic Issues of Multinational Transaction Multiple Location Business International Businesses Plans for the Business The Marketplace Assistance Secrecy Agreements Representations, Warranties, and Opinions Transitional Issues

8.1 8.1 8.3 8.3 8.4 8.4 8.4 8.5 8.6 8.6 8.7 8.7 8.8 8.8 8.8 8.9 8.9 8.10 8.11 8.11 8.13 8.13 8.13 8.14 8.14 8.15 8.15 8.15 8.16

Intellectual Property Rights Overview of Intellectual Property Patents Types of Searches

8.16 8.16 8.18 8.19

xvi CONTENTS

Limitations of Searches Follow-up Designs Types of Searches Limitations of Searches Follow-up Trademarks Types of Searches Limitations of Searches Trade Dress Domain Names Follow-Up Tradenames Copyright Types of Searches Limitations of Searches Moral Rights Neighboring Rights Database Rights Follow-up Semiconductor Chip Rights Plant Rights Personality Rights Proprietary Information Foreign Rights Secured Intellectual Properties On-Site Technology Investigations Products, Advertising, and Packaging Intellectual Property Maintenance Costs

8.21 8.22 8.23 8.23 8.24 8.25 8.25 8.26 8.27 8.28 8.28 8.29 8.30 8.31 8.32 8.32 8.32 8.33 8.33 8.33 8.33 8.34 8.35 8.35 8.36 8.37 8.39 8.39 8.40

Contract Review Agreement Review Secrecy Agreements License Agreements Assignments Franchise Agreements Distribution and Supply Agreements Co-packing and Toll Manufacturing Agreements Joint Venture and Strategic Alliance Agreements Research and Development Agreements Government Agreements Sponsorship and Co-promotion Agreements Advertising Agreements Employee and Contractor Agreements Settlement Agreements Information Technology Agreements

8.40 8.40 8.42 8.42 8.43 8.43 8.43 8.44 8.44 8.44 8.45 8.45 8.45 8.45 8.47 8.47

Information Technology Issues Hardware Software

8.47 8.47 8.48

CONTENTS xvii

Data Internet Issues Electronic Commerce Computer and Information Technology Industry

8.49 8.49 8.50 8.51

Liabilities Infringement Risks Litigation

8.52 8.52 8.53

Industry-Specific Issues Franchise Industry Merchandising Industry Pharmaceutical Industry Biotechnology Industry Publishing Industry Entertainment Industry Sports Industry

8.54 8.54 8.55 8.55 8.55 8.55 8.56 8.56

Regulatory Issues Technology Transfer Restrictions Access to Information Privacy and Personal Information Issues Competition and Antitrust Issues Franchising Industry Pharmaceutical Industry

8.57 8.57 8.58 8.58 8.58 8.59 8.59

The Results of Due Diligence Interpretation Representations and Warranties Definitions Title Validity and Enforceability Noninfringement Opinions

8.60 8.60 8.60 8.61 8.62 8.62 8.62 8.62

Conclusion

8.64

Endnotes

8.64

CHAPTER 9 INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST ISSUES IN MERGERS AND ACQUISITIONS

9.1

MELVIN SIMENSKY VISITING SCHOLAR IN INTELLECTUAL PROPERTY LAW, NEW YORK LAW SCHOOL WILLIAM M. HEBERER HALL DICKLER KENT GOLDSTEIN & WOOD, LLP Introduction

9.1

Understanding the Transaction Form of Transaction Parties to the Transaction

9.3 9.3 9.4

xviii CONTENTS

Due Diligence Defining the Intellectual Property Audit Components of an Intellectual Property Audit Identify the Target’s Intellectual Property Assets Confirm Ownership Rights Assess the Strength and Enforceability of Target’s Rights Review Relevant Licenses and Agreements Analyze Potential Liabilities Checklists for Specific Assets Copyrights Patents Trademarks Trade Secrets Domain Names and Websites

9.4 9.5 9.5 9.5 9.6 9.6 9.6 9.7 9.8 9.8 9.9 9.9 9.11 9.11

Representations and Warranties

9.12

Recording of Transfers Assignments Security Interests Uniform Commercial Code: Article Nine Intellectual Property and Federal Preemption Proposals for Reform

9.12 9.12 9.13 9.13 9.14 9.20

Endnotes

9.21

CHAPTER 10 PATENT OPINIONS

10.1

DAVID A. LOEWENSTEIN BROWN RAYSMAN MILLSTEIN FELDER & STEINER LLP Introduction

10.1

Legal Framework Infringement Claim Construction Literal Infringement The Doctrine of Equivalents Contributory and Induced Infringement Validity

10.2 10.2 10.2 10.3 10.3 10.4 10.4

General Considerations Concerning Opinions Patents Give the Right to Exclude Applicable Legal Principles Identify the Foundation and Scope of the Opinion Identify the Device or Process at Issue Identify the Possibility of Pending Patent Applications Identify the Intended Recipient Assessing an Opinion’s Competence

10.5 10.5 10.6 10.7 10.7 10.7 10.7 10.8

CONTENTS xix

Clearance or Right to Use Opinions Reasons Not to Get Opinions Opinions Used Against the Recipient Is Ignorance Bliss? Opinions on Applications Patentability Opinions Opinions on Technical Merit

10.9 10.10 10.10 10.10 10.11 10.11 10.12

Disqualification and Waiver Rule 3.7: The Lawyer-Witness Rule Are the Authors “Necessary Witnesses”? Scope of the Waiver/Disqualification

10.12 10.12 10.13 10.13

Endnotes

10.16

CHAPTER 11 INTERNATIONAL MERGERS AND ACQUISITIONS: THE CANADIAN PERSPECTIVE

11.1

FRANCOIS PAINCHAUD, LOUIS-PIERRE GRAVELLE, PANAGIOTA KOUTSOGIANNIS, CHRISTIAN DANIS, AND MARIE-EVE COTE LEGER ROBIC RICHARD Introduction

11.1

Duality of the Canadian Legal Regime

11.1

Overview of the Transaction: Objective, Scope, and Costs Mergers, Competition Law, and Intellectual Property The Competition Bureau and Intellectual Property Enforcement Guidelines

11.2 11.3 11.4

Intellectual Property in Due Diligence Audits Patents Co-ownership of Patents Assignment of Patents Research at the Patent Office Trademarks Introduction Rights through Use Registration Application for Registration Term of Protection Limits on Trademark Enforcement Review of Marking in Association with Trademarks Assignment of Trademarks Research at the Trade-marks Office Copyright Rights Term of Protection Registration

11.6 11.7 11.8 11.10 11.11 11.12 11.12 11.12 11.12 11.12 11.13 11.13 11.13 11.14 11.14 11.15 11.15 11.15 11.16

xx

CONTENTS

Ownership Limits Due Diligence Assignment of Copyright Insolvency Moral Rights Research at the Copyright Office Marking in Association with Copyright Trade Secrets Definition of Trade Secrets Enforcement of Trade Secret Rights Assignment of Trade Secrets Nature of the Right Industrial Designs, Integrated Circuit Topographies, and Plant Breeders’ Rights Other State-Granted Licenses Assets in Personnel Impact of Employee-Employer Relationships

11.16 11.17 11.17 11.17 11.17 11.18 11.18 11.18 11.18 11.18 11.20 11.20 11.21 11.21 11.22 11.22 11.22

Licenses, Assignments, and Other Agreements Relating to Intellectual Property Licenses Assignments in an International Context

11.24 11.24 11.26

Security Interests in Intellectual Property Legislative Context Validity and Perfection of Security Interests Security Interest Searches and the Intellectual Property Registers Enforcement

11.26 11.26 11.27 11.27 11.29

Tax Considerations Eligible Capital Expenditures Depreciation of Intellectual Property Costs and Undepreciated Capital Cost (UCC) Undepreciated Capital Cost Scientific Research and Development Advantages under the Income Tax Act Deductions-Section 37 ITA Investment Tax Credit—Section 127 ITA Withholding Tax When Purchasing Intellectual Property Assets Non-Arm’s Length Transfers Tax-Free Transfers of Property to a Corporation Divisive Reorganizations Doing the Bump during Corporate Reorganizations Liability for Unpaid Tax

11.29 11.29 11.30 11.30 11.31 11.31 11.32 11.32 11.32 11.33 11.33 11.34 11.35 11.35

Endnotes

11.36

CONTENTS xxi CHAPTER 12 INTERNATIONAL MERGERS AND ACQUISITIONS: THE EUROPEAN PERSPECTIVE

12.1

BENEDICT BIRD, ANNA CARBONI, AND DEBORAH LINCOLN LINKLATERS & ALLIANCE Introduction

12.1

Structure of the Transaction Private Acquisition of Shares Private Acquisition of Assets Private Acquisition of Part of a Business Public Offer Merger Demerger Joint Venture Scheme of Arrangement

12.1 12.2 12.2 12.2 12.2 12.2 12.2 12.3 12.3

Due Diligence Purpose and Method of Due Diligence Confidentiality and Privilege Registrable Rights Patents Supplementary Protection Certificates Trademarks Designs Utility Models Plant Breeders’ Rights Identifying Registered Rights of the Target Investigating Registered Rights of the Target Unregistered Rights Trademarks Copyright Moral Rights Database Rights Designs Semiconductor Topography Rights Confidential Information Identifying Unregistered Rights of the Target Investigating Unregistered Rights of the Target Trademarks Copyright Designs Database Rights Semiconductor Topography Rights Confidential Information Identifying Contractual Rights Investigating Contractual Rights Dealing with Issues Arising from Due Diligence

12.3 12.3 12.4 12.5 12.5 12.5 12.6 12.6 12.8 12.8 12.8 12.8 12.10 12.10 12.10 12.10 12.10 12.11 12.12 12.12 12.13 12.13 12.13 12.14 12.14 12.14 12.14 12.14 12.15 12.15 12.16

xxii CONTENTS

Warranties and Indemnities Purpose of Warranties and Indemnities Factors to Take into Account Which IPRs Are Likely to Be Relevant? Should the Warranties Be Limited to “Knowledge, Information, and Belief”? Do the Warranties Cover IPRs That Are Licensed to, as Well as Owned by, the Seller? Which Group Company Is Giving the Warranty? Updating of Warranties Disclosure Letters

12.16 12.16 12.17 12.18

Transferring the Intellectual Property Rights Intellectual Property Rights Owned by the Target or a Company in Its Group Assignment or License? Formalities for Assigning Registered IPRs Formalities for Assigning Unregistered IPRs Intellectual Property Licenses Stamp Duty and Other Taxes

12.19 12.20 12.20 12.21 12.21 12.22 12.23

The French Perspective Merger Demerger Confidentiality and Privilege Confidential Information Purpose of Warranties and Indemnities Transferring the Intellectual Property Rights The Universal Transmission Principle Formalities Required Transferring Intellectual Property Owned or Licensed by the Target or a Company in Its Group Formalities for Assigning Registered IPRs Formalities for Assigning Unregistered IP Rights Intellectual Property Licenses Stamp Duty and VAT

12.23 12.23 12.24 12.24 12.24 12.24 12.24 12.24 12.25

The German Perspective Structure of the Transaction. Due Diligence Intellectual Property (Commercial Protection Law and Copyright Laws) Patents Supplementary Protection Certificates (Ergänzende Schutzzertifikate) Utility Models (Gebrauchsmuster) Semiconductor Topography Rights (Halbleiterschutzrechte) Plant Breeders’ Rights (Sortenschutzrechte) Trademarks (Marken) Registered Design Rights (Geschmacksmuster) Copyright (Urheberrecht)

12.26 12.26 12.27 12.27 12.28 12.29 12.29 12.29 12.30 12.31 12.31 12.31

12.18 12.18 12.18 12.18 12.18

12.25 12.25 12.25 12.25 12.26

CONTENTS xxiii

Secret and Nonsecret Know-How (Geheimes und Nicht-Geheimes Know-How) Warranties and Indemnities Transfer

12.31 12.32 12.32

Competition Law Relevance to Corporate Transactions The EC Competition Rules Assessing Market Power Article 81 Agreements Having as Their Object or Effect the Prevention, Restriction, or Distortion of Competition Appreciability Exemption Modernization of EC Competition Rules Licenses of IPRs Patent and Know-How Licenses Licenses of IPRs Other Than Patents and Know-How Research and Development Agreements Guidelines on Horizontal Cooperation Agreements The Sale Agreement Article 82 The ECMR

12.35 12.36 12.36 12.37 12.37 12.38 12.39 12.39 12.40 12.41 12.41 12.44

Appendix 1

12.45

Endnotes

12.47

CHAPTER 13 INTELLECTUAL PROPERTY TRANSFERS—HOLDING COMPANIES

12.33 12.33 12.33 12.33 12.34

13.1

SUSAN BARBIERI MONTGOMERY AND LEONARD SCHNEIDMAN FOLEY HOAG & ELIOT, LLP Introduction

13.1

Formation of the Holding Company Contribution of Intellectual Property Rights Domestic Transfer of Intellectual Property Rights Offshore Transfers of Intellectual Property Rights Business Purpose

13.2 13.2 13.2 13.3 13.3

Use of a Domestic Holding Company Delaware Investment Holding Companies Attacks on Delaware Investment Holding Companies

13.4 13.4 13.5

Use of a Foreign Holding Company Offshore Intellectual Property Rights Licensed to a Related United States Licensee Deductibility of License Royalties Royalty Rate The “Superroyalty” Provision

13.7 13.7 13.7 13.7 13.8

xxiv CONTENTS

Withholding for U.S. Tax Internal Revenue Service Enforcement

13.8 13.8

The Effect of Tax Treaties Withholding Rates Cascading Royalties Limitations on Treaty Benefits Anti-Conduit Regulations Foreign Holding Company Licensing to Its Foreign Affiliates

13.8 13.8 13.9 13.9 13.10 13.10

Endnotes

13.10

CHAPTER 14 OFFSHORE CORPORATIONS

14.1

TIRA GREENE CONSULTANT ANGUILLA MICHAEL J. WARD COUNSEL LIMITED ANGUILLA Introduction

14.1

Offshore Jurisdictions

14.1

Holding Company or Active Business?

14.2

When to Go-Before the Intellectual Property Exists

14.2

When to Go-Early in the Development Cycle

14.3

Transaction Types

14.4

Which Vehicle to Use

14.6

Conclusion

14.8

Endnotes

14.8

CHAPTER 15 ACQUISITION AND LICENSING OF FAMOUS NAME TRADEMARKS AND RIGHTS OF PUBLICITY IN THE UNITED STATES

15.1

THEODORE C. MAX PHILLIPS NIZER BENJAMIN KRIM & BALLON, LLP Introduction

15.1

Fair Use Defense: “A Rose By Any Other Name . . . ”

15.4

Right of Publicity: What’s in a Persona The Name Must Be Identifiable and Known to Be Protected A Person’s Persona Also May Be Identified by a Photograph or Likeness Voice and Sound Are Now Protectable under the Right of Publicity

15.5 15.5 15.5 15.6

CONTENTS xxv

State and Common Laws Govern the Right to Publicity in the United States Postmortem Rights of Publicity Seventeen States Recognize Common Law Rights of Publicity Alabama California Connecticut Florida Georgia Hawaii Illinois Kentucky Louisiana Minnesota New Jersey Ohio Oklahoma Pennsylvania Tennessee Texas Utah Wisconsin

15.6 15.6 15.7 15.7 15.7 15.7 15.7 15.7 15.7 15.8 15.8 15.8 15.8 15.8 15.9 15.9 15.9 15.9 15.9 15.9 15.10

Federal Protection of the Right of Publicity under the Lanham Act § 43(a): Implied Endorsement

15.10

Defenses to Right of Publicity Claims First Amendment Parody Statutes of Limitation

15.10 15.10 15.10 15.10

Transactions Involving Famous Name Trademarks and the Right of Publicity: Assignment and Licenses

15.11

Endnotes

15.16

CHAPTER 16 TRANSFER OF INTELLECTUAL PROPERTY UPON MERGER OR ACQUISITION

16.1

LANNING G. BRYER AND SCOTT J. LEBSON LADAS & PARRY Introduction

16.1

Means of Acquiring Intangible Assets Mergers Purchase Agreement Supplemental Closing Documentation Sale of Assets Stock Purchase

16.3 16.3 16.3 16.4 16.4 16.4

Tax Considerations

16.5

xxvi CONTENTS

Antitrust Patents Copyrights Trademarks Grant-backs Competition Law in the European Community

16.5 16.7 16.7 16.7 16.7 16.8

Worldwide Recordal of Intellectual Property Rights Separate Documents for Each Jurisdiction Are Required Costs

16.9 16.10 16.11

Transfer of Trademarks Assignment Intent-to-Use Trademarks The Paris Convention Goodwill under the Community Trademark System Goodwill under the Madrid Agreement and Protocol Recordal of Trademark Assignments in the United States Benelux The Community Trademark Madrid Agreement and Madrid Protocol Other Multilateral Treaties

16.11 16.11 16.12 16.12 16.12 16.12 16.13 16.13 16.14 16.14 16.15

Worldwide Patent Assignment Recordal

16.15

Transfer of Patents in the United States

16.15

Transfer of Trade Secrets in the United States

16.16

Worldwide Copyright Assignment Recordal

16.16

Transfer of Copyrights in the United States

16.16

Transfer of Domain Names

16.18

Conclusion

16.19

Endnotes

16.19

INDEX

I.1

PREFACE Understanding how intellectual property rights are involved with mergers and acquisitions—the topic of this book—is essential given how merger and acquisition (M&A) activity in the intellectual property field has come to dominate, both in volume and in value, merger transactions generally. This situation was true in the 1990s, and it is true now. The driving force behind a majority of present mergers and those completed during the past decade has been the acquirer’s desire to obtain the target’s intellectual property assets. In the past 15 years, as the number of M&A transactions has exploded, a significant majority of these deals occurred because of the acquirer’s perceived need for the target’s intellectual property assets. These intangibles have included assets such as groundbreaking technologies, unique patents, mask works, Internet domain names, and significant media portfolios in the form of copyrighted movies, television programming, books, and music. The mergers of America Online (AOL) with Time Warner, Exxon with Mobil, American Home Products with Warner Lambert, and Travelers Group with Citicorp were all heavily influenced by the acquirer’s desire for the target’s intellectual properties. All of these mergers have taken place since April 6, 1998. Of these four transactions, AOL’s acquisition of Time Warner represents one of the largest M&A deals in history. AOL bid $180 billion to acquire Time Warner’s intellectual property assets, consisting of a TV cable system and its huge library of copyrighted films, TV series, and magazines. Intellectual property assets are particularly valuable because they enable firms to create and hold monopoly power on unique products and services. Key intellectual property rights can provide owners with significant business advantages by allowing, for example, the creation of “specialized” goods that are capable of generating high profit margins. This situation contrasts with competitors that can produce only “standardized” products selling at much lower margins. Today’s role of intellectual property in mergers and acquisitions favorably compares to the role such property plays in advanced economies. For example, in the United States in 1929, the ratio of intangible business assets to tangible business capital was 30 percent to 70 percent. By 1990, such ratio was nearly reversed, from 63 percent to 37 percent. Today, more than 70 percent of U.S. growth comes from intangible asset exploitation versus less than 30 percent from tangible property. An interesting feature of M&A activity is that it occurs both in boom and bust times. The boom side of the equation is amply demonstrated by the fact that recent M&A activity has accounted for a significant percentage of the world’s economy. Such a phenomenon is reflected in the ratio of recent M&A activity to the world’s largest economy: that xxvii

xxviii PREFACE

of the United States. Thus, global M&A activity in the year 2000 was valued at nearly $4 trillion, or a robust 40 percent of the estimated $10 trillion American economy in 2001. M&A transactions also occur in less economically vibrant times. Much of this activity takes place when a company, to obtain the economic benefits of consolidation in a particular industry, goes out and starts buying its competitors. In the health care industry, for instance, hospitals continue to merge to acquire the economic clout necessary to force insurers to increase their coverage payments to the hospitals. For example, in Cleveland, Ohio, two hospital organizations control more than 80 percent of the market. Due to their combined economic power, these two organizations have been able to negotiate rate increases with their insurers of more than 15 percent for some hospital services. The dominating presence of intellectual property in mergers and acquisitions coincides with the emergence of several new intellectual property-oriented M&A considerations. First, most merger and acquisition activity was once dominated primarily by the United States. This circumstance, particularly during the 1990s, changed with the sweeping globalization of intellectual property-oriented mergers. For example, in 1999 the U.S. merger volume rose to a record $1.7 trillion while Europe’s merger volume more than doubled from the prior year to $1.23 trillion. Indeed, the largest hostile takeover ever, and for intellectual property assets at that, did not occur in the United States but rather in Europe with British Vodafone’s acquisition of Hannesmann of Germany for $183 billion. Second, because of the difference between tangible assets (such as inventory and factories) in contrast to intangible intellectual property assets, methods ordinarily used to value mergers involving tangible assets do not work well when applied to acquisitions of intellectual property. Despite the fact that M&A’s involving intellectual property has dominated the merger scene for several years, merger participants are still failing to apply appropriate M&A valuation procedures. Third, it is unquestionable that Europe has newly arrived as a major player in the global M&A scene. Such a recent arrival also appears to have ushered in the new phenomenon of taking European Union (EU) competition law seriously. Such law deals with regulating the impact of mergers on their respective principles. Analogous American law is found in this country’s antitrust principles. In today’s global economy, it is critical for most companies to be capable of conducting business internationally. In other words, such companies must become knowledgeable about other nations’ competition laws or their equivalent. As this book is being readied for publication, the EU’s European Commission, which enforces EU competition law, has just rejected a proposed merger between General Electric Company and Honeywell International. Some have described this action as a “milestone.” Not only did such rejection involve the determination by European regulators of a transaction between two American companies, but more significantly, such rejection followed upon the merger’s prior approval by U.S. antitrust regulators. The preceding issues and considerations are substantially discussed in several of this book’s chapters. Patrick Gaughan sets the table in defining and explaining what makes an M&A deal unique. Robert Lamb’s contribution in his chapter on “The New Role of Intellectual Property in Mergers and Acquisitions” discusses the changing European role in world M&A activity while also considering various methodologies to value such

PREFACE xxix

business activity. Gordon Smith, in his chapter on “Intangible Assets and Intellectual Property Accompanying Mergers and Acquisitions,” and Michael J. Lasinski, in his chapter on “Valuation of Intellectual Property Assets in Mergers and Acquisitions,” provide an in-depth treatment of the valuation of intellectual property in the mergers and acquisitions context. United States antitrust principles form the subject matter of Thomas Jackson’s chapter while Benedict Bird, Anna Carboni, and Deborah Lincoln discuss the competition rules of the European Commission. Accounting issues are identified and discussed by Andrew Carter in Chapter 5, while significant M&A legal issues are covered by Glenn Gundersen in Chapter 6 and due diligence issues by Sheldon Burshtein in Chapter 8. David Lowenstein covers the critical topic of rendering legal opinions in Chapter 10. In Chapter 11, Francois Painchaud and his colleagues, Louis-Pierre Gravelle, Panagiota Koutsogiannis, Christian Danis, and Marie-Eve Cote provide the Canadian perspective on M&A transactions. The complex and unique issues of holding companies and offshore transactions are treated, respectively, by Susan Barbieri Montgomery and Leonard Schneidman in Chapter 13 and Tira Greene and Michael Ward in Chapter 14. Finally, in Chapter 15, Ted Max provides insight on the protection and transfer of famous name trademarks and rights of publicity in mergers and acquisitions. We are pleased to note that this book, like our other Wiley publications, treats its subject matter from both a legal and a business perspective, and these perspectives are interdisciplinary in nature. While we have obtained contributions from both prominent domestic and foreign legal practitioners, we have also presented the work of businesstrained professionals, including a professor of economics, a professor of management and finance, and several experts on the valuation of intellectual property assets and accountants. We hope our readers find that this book provides useful information relating to the significant business and legal issues when mergers and acquisitions take place to acquire another entity’s intellectual property assets. Lanning G. Bryer Melvin Simensky October 2001 New York, New York

ACKNOWLEDGMENTS The editors of this book owe significant debts of gratitude to many people without whose time and effort this work would not have been possible. First, we wish to thank our spouses and children who patiently endured the lost evenings and weekends during the birth, development, and publication of this work. We are indebted to our law partners and colleagues for their understanding and forbearance and for believing in the value of this project. The editors would be seriously remiss if they did not, at every opportunity, extend their deep appreciation to the many contributors who submitted chapters, and sections of chapters, to make this work what it is. The editors wish to express their sincerest appreciation to Scott J. Lebson, an associate in the New York office of Ladas & Parry and coauthor of Chapter 16, for his tireless efforts in the research, drafting, corresponding, and organization of this book. Without his skill, energy, and dedication, this work would not have been possible. The editors wish to thank their former professional and trade editor at John Wiley & Sons, Inc., Martha Cooley, who had the vision to approach us to write this book and the persistence and courage to convince us to do it. Finally, we thank the splendid professional and trade editor of John Wiley & Sons, Inc., Susan McDermott, for assuming command of this project and her encouragement and assistance in making this book a reality.

xxx

CHAPTER

1

MERGERS AND ACQUISITIONS: AN OVERVIEW1 Patrick A. Gaughan, Ph.D. College of Business, Fairleigh Dickinson University Economatrix Research Associates, Inc.

INTRODUCTION

The 1990s featured the most intense period of mergers and acquisitions in U.S. economic history. This period is now recognized as the fifth merger wave in U.S. history. Merger waves are periods of unusually intense merger and acquisition activity.2 There have been five such periods since the start of the twentieth century, with the previous one occurring in the 1980s. This wave featured many record-breaking mergers. When it ended in the late 1980s, many thought that there would be an extended period of time before another one began. However, after a short hiatus, an even stronger merger wave took hold, far eclipsing that of the 1980s. The merger wave of the 1990s was path breaking due to the dollar value of the transactions and the unusually high number of deals (see Exhibits 1.1a and 1.1b). While the fourth wave of the 1980s was known for both its megamergers and its colorful hostile deals, the fifth wave has featured far larger deals, as well as a good supply of hostile transactions. Fifth Merger Wave Exported to Europe. While the fourth merger wave of the 1980s was

largely confined to the United States, large-scale mergers and acquisitions finally made their way to Europe in the mid-1990s.3 In recent years, cross-border deals within Europe have grabbed the headlines. Even hostile takeovers, long thought to be an exclusively American phenomena, started becoming more common in Europe. This is underscored by the fact that the biggest deal of all time was the Vodafone– Mannesmann $183 billion hostile takeover. In addition to deals within Europe, transAtlantic deals, with European buyers of U.S. companies and vice versa, started to become commonplace. With the development of the European Union and the erosion of nationalistic barriers as the continent moved to a unified market structure with a common currency, companies began to see their market as all of Europe and more. It became clear that a European consolidation was in order. Although there are many indications that there will be realizable benefits from such a consolidation, only time will reveal the magnitude of these benefits. 1.1

1.2

MERGERS AND ACQUISITIONS: AN OVERVIEW

10,000

8,000

6,000

4,000

2,000

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

0

Exhibit 1.1a Merger and Acquisition Transaction, 1980–2000

Source: Mergerstat Review, various years

200

$ Billions

150

100

50

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

0

Exhibit 1.1b Dollar Value of U.S. Acquisitions of Foreign Companies, 1980–2000

Source: Mergerstat Review, various years

The main volume of non-U.S. mergers and acquisitions is taking place in Europe, with Asia well behind (see Exhibits 1.2a and 1.2b). However, the fact that corporate restructuring is taking place in nations such as Japan and Korea is reflective of their pressing need to revamp their conservative and poorly performing corporate structures

INTRODUCTION 1.3 350 300

$ Billions

250 200 150 100 50

Exhibit 1.2a

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

0

Dollar Value of Foreign Acquisitions of U.S. Companies, 1980–2000

Source: Mergerstat Review, various years

200

$ Billions

150

100

50

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

0

Exhibit 1.2b Dollar Value of U.S. Acquisitions of Foreign Companies, 1980–2000

Source: Mergerstat Review, various years

in light of their prolonged recessions. Due to the continued weak economies in Asia, many companies in Japan and Korea are not looking at acquisitions, but at sell-offs and other forms of restructuring. While this chapter primarily focuses on the U.S. merger market, most of the principles that are discussed also apply to non-U.S. mergers. Fifth Merger Wave Compared to Prior Merger Periods. The fifth merger wave began in approximately 1993 as the economy began to recover from the 1990-1991 recession. As the economy expanded, firms sought to meet the growing demand in the economy

1.4

MERGERS AND ACQUISITIONS: AN OVERVIEW

by acquiring or merging with other companies. One of the things that is unusual about the fifth merger wave is that it somewhat closely followed the fourth merger wave, which began in approximately 1984 and ended in 1989. That fourth merger wave was a period characterized by megamergers and many highly leveraged transactions. These highly leveraged transactions often relied upon the financing provided by the junk bond market that grew dramatically in the 1980s, only to collapse at the end of the decade. The three prior merger waves were at the start of the century, during the boom in the 1920s, and at the end of the 1960s. Each was different from the others. The first merger wave, which occurred between 1897 and 1904, featured a transformation of the American economy from one of many small companies to larger, sometimes monopolistic firms dominating an industry. This period of consolidating acquisitions was ironic in light of the fact that the Sherman Antitrust Act was passed in 1880—less than a decade from the start of the nation’s first merger wave. However, there are several reasons for the lack of antitrust enforcement, including the difficulty the courts had in interpreting the broad provisions of the law and the fact that the Justice Department lacked the resources, if not the mindset, to stand in the way of this first great merger wave. This changed with the passage of the Clayton Act in 1914 and the establishment of the Federal Trade Commission in the same year which, along with the Justice Department, enforces antitrust laws. The second merger wave began in 1916 and continued until the economic downturn in 1929. This wave featured many of the same types of horizontal transactions as the first wave, but also had a good percentage of vertical transactions. It has been said that the first wave was a mergers toward monopoly period while the second wave was a mergers toward oligopoly period. Like the first wave, it also ended when the market and the economy turned down. This pattern was mirrored again in the third merger, which took place between 1965 and 1969. This wave featured conglomerate acquisitions, which are acquisitions outside of the bidder’s own industry. Such deals were partly caused by the fact that bidding companies wanted to expand but were halted by the intense antitrust enforcement that prevailed in the 1950s and 1960s. The only alternative left to expansion-minded companies was to look outside their industry and buy companies that would not be considered in any way a strategic fit by today’s standards. Many of these companies paid a price for these nonstrategic deals when they sold off those diversifications in the 1970s and 1980s. As noted previously, one characteristic of merger waves is that they tend to occur during economic expansions, and they tend to end when the market and the economy slow down. This makes sense in that expansions bring about increasing economic demand, causing companies to look to grow. When the economy slows, companies are not thinking about expansion as much, and mergers play a lesser role in corporate planning. In addition, when the market turns down, deals that could have been financed by stock may become more expensive. TYPES OF MERGERS, ACQUISITIONS, AND CORPORATE RESTRUCTURINGS

Mergers and acquisitions are usually, but not always, part of an expansion strategy. They can be horizontal deals, in which competitors are combined. The 1998 $77.2 billion merger between Exxon and Mobil is an example of a successful horizontal deal.

TYPES OF MERGERS, ACQUISITIONS, AND CORPORATE RESTRUCTURINGS 1.5

They can also be vertical transactions, in which suppliers merge with buyers or distributors. The 1993 $6.6 billion merger between Merck, a pharmaceutical manufacturer, and Medco, a pharmaceutical distributor, is an example of a vertical deal. Companies may also acquire firms that are in totally different industries. These types of deals are called conglomerate mergers. Daimler Benz’s acquisitions in sectors such as the aerospace industry help convert the premium automobile manufacturer into a conglomerate and Europe’s largest industrial company. The legacy of such deals is not impressive, but some companies, such as General Electric, have shown some success (at least up to the sizable acquisition of Honeywell). When companies look to downsize, as opposed to expand, they have several alternatives available to accomplish this. They may simply sell a division through a divestiture. They may also consider a spin-off, such as when AT&T spun off different components of the overall company. When a company does this, shareholders in the original company usually become shareholders in different and separate corporate entities. Another alternative to downsizing is an equity carve-out, which is an issuance of stock in the division that is to be separated from the overall company. A less radical alternative is to issue a tracking stock that will follow the performance of the division in question. When the market is pressuring for a sell off, however, a tracking stock may not be sufficient to meet the demands of the market. Why Do Firms Merge? Growth. One of the most common motives for mergers is growth. There are two broad

ways a firm can grow. The first is through internal growth. This can be slow and ineffective if a firm is seeking to take advantage of a window of opportunity in which it has a short-term advantage over competitors. The faster alternative is to merge and acquire the necessary resources to achieve competitive goals. Even though bidding firms will pay a premium to acquire resources through mergers, this total cost is not necessarily more expensive than internal growth, in which the firm has to incur all of the costs that the normal trial and error process may impose. While there are exceptions, in the vast majority of cases growth through mergers and acquisitions is significantly faster than through internal means. Synergy. Another commonly cited motive for mergers is the pursuit of synergistic ben-

efits. This is the new financial math that shows that 2 + 2 = 5. That is, as the equation shows, the combination of two firms will yield a more valuable entity than the value of the sum of the two firms if they were to stay independent: Value (A + B) > Value (A) + Value (B) Although many merger partners cite synergy as the motive for their transaction, synergistic gains are often hard to realize. There are two types of synergy: that which is derived from cost economies and that which comes from revenue enhancement. Cost economies are the easier of the two to achieve because they often involve eliminating duplicate cost factors such as redundant personnel and overhead. When such synergies are realized, the merged company generally has lower per-unit costs. Many of the consolidating mergers of the fifth merger wave are partially based upon the pursuit of such

1.6

MERGERS AND ACQUISITIONS: AN OVERVIEW

synergistic economies. Because this is an important part of the fifth merger wave, it is discussed separately in the section that follows this one. Revenue enhancing synergy is more difficult to predict and to achieve. An example would be where each firm believes that it can sell its products and services to the other firm’s customer base. Another example would be a situation where one company’s capability, such as research prowess, is combined with another company’s capability, such as marketing skills, to significantly increase the combined revenues. Consolidating and Roll-Up Mergers of the Fifth Merger Wave. One interesting characteristic of the fifth merger wave is the trend toward consolidating, or roll-up, mergers. In certain industries, such as the printing and the funeral home industry, leading firms, sometimes called consolidators, acquired competitors across the nation in an effort to build dominant companies. Other industries, such as banking and telecommunications, spurred on by significant changes in the regulatory environment, also saw many such consolidations. Many of these acquisitions were based on the hypothetical pursuit of economies of scale and other such efficiencies. It is clear now, however, that if anything, roll-up companies got less efficient as they pursued deal after deal, not pausing to integrate the companies they had already acquired. In retrospect, it is clear that the roll-up strategy was highly questionable. Diversification. Other motives for mergers and acquisitions include diversification, whereby companies seek to lower their risk and exposure to certain volatile industry segments by adding other sectors to their corporate umbrella. The track record of diversifying mergers is generally poor with a few notable exceptions. A few firms, such as General Electric, seem to be able to grow and enhance shareholder wealth while diversifying. However, this is the exception rather than the norm. Diversification may be successful, but it seems to need more skills and infrastructure than some firms have. Related versus Unrelated Diversifications. Not all kinds of diversifications turn out

poorly. While research studies show that unrelated diversifications tend to yield poor results, related diversifications, mergers, and acquisitions into a field that is close to the acquiring firm’s main line of business tend to have a more impressive track record.4 Other studies have shown that increased corporate focus tends to be associated with higher share values.5 This result has intuitive appeal. The lesson from such research tells us that staying with what a company knows best may yield positive results, but straying into businesses that it does not know is an uphill battle that only a select few companies can manage successfully. Leveraged Transactions. The fourth merger wave featured the introduction of the leveraged buyout (LBO). This is a transaction that is financed using a significant amount of debt and often involves taking a public company private. Many of those deals relied upon financing from the junk bond market, which grew dramatically during the fourth wave. Junk bonds, bonds with a Standard and Poors rating of BB or lower, had been around for decades. However, the late 1970s featured the introduction of the original issue junk bonds—bonds that were lower rated right from the date of issuance. A combination of factors, including the willingness of market-makers such as Drexel Burnham

HOW DO MERGERS TURN OUT AND WHAT CAN GO WRONG? 1.7

Lambert to provide liquidity to this market, enabled the junk bond market to grow dramatically in the fourth wave. Unfortunately, many of the highly leveraged deals collapsed when the economy turned down at the end of the decade. Leveraged transactions continued to be conducted in the fifth merger wave. After a short hiatus, LBOs started to become more common in the 1990s, but there were a number of differences between these deals and those of the fourth merger wave. The transactions tended to be smaller and were a fraction of the size of some of the megaLBOs, such as the RJR Nabisco $24.6 billion LBO. ROLE OF INTELLECTUAL PROPERTY IN MERGERS AND ACQUISITIONS

Part of the fuel for the fifth merger wave was provided by the technology sector, where the attraction of merger targets was often their valuable intellectual property. The rapidly evolving high tech sector caused industry participants to rapidly seek out assets, often in the form of intellectual property, so as to keep up with the rapid pace of technological development in their industry. This helps explain why some of the more prolific acquirers of this wave were Cisco and, to a lessor extent, Lucent Technologies. Clearly Cisco accomplished this task better than Lucent. With the collapse of the market values of these companies, the currency they often used to finance acquisitions, their stock, became devalued. This, along with other troubles, led to a significant slowdown in acquisitions in this sector. HOW DO MERGERS TURN OUT AND WHAT CAN GO WRONG?

As previously noted, certain types of mergers, such as diversifications, tend to yield poor results. Unfortunately, many other acquisitions and mergers yield mediocre results, and some are outright failures. Prominent examples include the Snapple acquisition in which Quaker Oats overpaid and synergies were impossible to find. Others include the recent failed Kroll-O’Gara merger or the various failed deals in the automobile industry, such as the BMW-Rover acquisition or the Daimler Benz acquisition of Fokker and merger with Chrysler. While hindsight is omniscient, it is hard to see how Quaker Oats could justify the high premium it paid in a market that was saturated and showed limited growth potential. The adverse result in the Snapple deal is illustrative of one of the pitfalls of mergers—overpaying. The higher the price that a bidder pays, as a multiple of earnings, the higher growth in earnings that is needed to justify the price. Sometimes bidding contests can cause acquisition prices to rise well above that which can be justified by any reasonable expectation of growth. This is why successful bidders in takeover battles sometimes get inflicted with what is called the winner’s curse. Other recent examples include the failed Rite Aid acquisition program. Rite Aid’s 1996 $1.4 billion acquisition of the incompatible Thrifty Pay Less chain was one of the factors cited for the firing of the company’s chief executive. When a potentially compatible acquisition of Revco was halted by the Federal Trade Commission, the company went to a less favorable choice. Rite Aid also did not anticipate the integration problems it would have following the acquisition. This underscores another pitfall of mergers and acquisitions—post-merger integration. In spite of abundant premerger planning, it is sometimes difficult to predict all of the post-merger integration problems that will occur.

1.8

MERGERS AND ACQUISITIONS: AN OVERVIEW

What Can Go Wrong with Intellectual Property Motivated Acquisitions? Deals based upon the acquisition of intellectual property can present their own unique set of challenges. Hard physical assets are often easier to evaluate. For example, a company seeking to acquire the real estate assets of a target company can have those assets appraised individually and come up with an objective valuation. Due to the intangible nature of many intellectual property assets, they are often harder to value. This is particularly true in the rapidly evolving high-technology sector where it is often hard to anticipate both the demand for new products and technologies and the responses by competitors who may be pursuing a similar strategy. The possibility of acquiring intellectual property that may be worth much less or much more than what was originally estimated is greater than the variation that one might expect with more tangible assets. Unfortunately, the rapidly changing nature of some sectors may mean that internal development may be too slow a process and acquisitions may be the only viable route. In such cases, this may simply be a risk that companies have to assume to stay competitive. Trends in Deal Prices for the Fifth Merger Wave. As deal volume rose to record breaking

levels, deal prices also reached new heights (see Exhibit 1.3a). Several factors explain this. For one, the growth of the economy created a situation in which aggressive bidders seeking fast growth bid up the prices of target companies. In addition, the persistent decline in long-term interest rates helped lower discount rates that are used for valuation (see Exhibit 1.3b). Lower discount rates increase the present value of future cash flows and result in higher values of target companies. Between high demand for companies and lower discount rates, values reached unprecedented levels in the late 1990s and in 2000. When the economy slowed in 2001, the pace of deals also slowed with it—consistent with historical experience. This pause notwithstanding, mergers and acquisitions remain a permanent part of many companies’ corporate strategy. Winners and Losers in Mergers and Acquisitions. Various constituents are affected dif-

ferently by mergers and acquisitions. One natural group to focus on are the sharehold-

500 400 300 200 100

Exhibit 1.3a Number of Leveraged Buyouts, 1980–1999

Source: Thomson Financial Securities Data

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

0

HOW DO MERGERS TURN OUT AND WHAT CAN GO WRONG? 1.9 $200

Billions

$150

$100

$50

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

$0

Exhibit 1.3b Dollar Value of Leveraged Buyouts, 1980–1999

Source: Thomson Financial Securities Data

ers of the different companies involved in the deal. The shareholder wealth effects differ based upon whether the deal is friendly or hostile. These effects are summarized as follows:6 1.

2.

3.

4.

Target shareholders earn positive returns from merger agreements. Several studies have shown that for friendly, negotiated bids, target common shareholders earn statistically significant positive abnormal returns.7 These returns are a function of the premiums that target shareholders receive. Target shareholders may earn even higher significant positive returns from tender offers. Target common shareholders of hostile bids which are tender offers also receive statistically significant positive returns.8 The hostile bidding process may create a competitive environment which may increase the acquiring firm’s bid and cause target shareholder returns to be even higher than what would have occurred in a friendly transaction. Target bondholders and preferred stockholders gain from takeovers. Both target-preferred stockholders and bondholders gain from being acquired.9 Given that bidders tend to be larger than targets, the addition of the bidder as another source of protection should lower the risk of preferred stocks and bonds, making them more valuable. Thus, like the target common shareholder effects, this is an intuitive conclusion. Acquiring firm shareholders tend to earn zero or negative returns from mergers. Acquiring firm stockholders tend not to do well when their companies engage in acquisitions.10 These effects are either statistically insignificant or somewhat negative. Presumably, this reflects that markets are skeptical that the bidder can enjoy synergistic gains, which more than offset the fact that it is paying a premium for the target. The fact that the bidder’s stock response is small compared to that of the target is due to the fact that bidders tend to be larger than targets.11

1.10 MERGERS AND ACQUISITIONS: AN OVERVIEW

5.

Acquiring firm shareholders tend to gain little or no returns from tender offers. Acquiring firm shareholders also tend not to do well when their firm takes over a target through a hostile bid. There is some evidence that there may be a response that ranges from either mildly positive to zero.

Effects of Sell Offs. Sell offs are the opposite of mergers. They are a form of downsiz-

ing and are often a result of a determination that a prior acquisition did not work out satisfactorily. These sell offs can come in various forms, such as through a straight divestiture where a company simply sells off a division to a buyer. Other possibilities include a spin-off, which is when a new company is formed and shareholders in the original company become shareholders in both the original firm (which is smaller as a result of the spin-off) and the newly formed company. Another alternative is to do an equity carve-out involving a public offering of stock in a newly formed company, which is the division being separated from the parent company. Exhibit 1.4 shows that the shareholder wealth effects of sell offs are positive. It can be seen from Exhibit 1.4 that numerous research studies, covering an extended period of time, show that the decision of a parent company to sell off a division has a positive effect on the parent company. It seems to imply that the market believes that the division had a negative effect on the overall company, and separating the division from the parent company should increase shareholder value. This is due to the fact that resources would not have to be diverted to the division, as well as the fact that the parent company would receive payment in exchange for its interest in the division.

Days

Average Abnormal Returns (%)

Period Sampled

Sample Size

Alexander, Benson, and Kampmeyer (1984)

–1 through 0

0.17

1964–73

53

Hite and Owers (1984)

–1 through 0

1.50

1963–79

56

Hite, Owers & Rogers (1987)

–50 through –5

0.69

1963–81

55

Jain (1985)

–5 through –1

0.70

1976–78

1, 107

Klein (1983)

–2 through 0

1.12

1970–79

202

Linn and Rozeff (1984)

–1 through 0

1.45

1977–82

77

Loh, Bezjak & Toms (1995);

–1 through 0

1.50

1982–87

59

Rosenfeld (1984)

–1 through 0

2.33

1963–81

62

Study

Exhibit 1.4 Average Stock Price Effects of Voluntary Sell-Offs12

Source: Patrick A. Gaughan, Mergers, Acquisitions, and Corporate Restructurings, 2nd ed. (New York: John Wiley & Sons, 1999), 413.

ENDNOTES 1.11 CONCLUSION

The merger and acquisition business continued to grow in the year 2000. The economic growth of the 1980s and 1990s has fueled two major merger waves in the United States. The most recent merger wave, the fifth in U.S. history, spread to Europe as the continent was enjoying economic growth. This growth, combined with the economic impact of the European Union and deregulation, helped the fifth merger wave in the United States spread to Europe. It is unknown how these fifth-wave deals will turn out. It is hoped that deal makers learned from the mistakes of prior merger periods and crafted deals that will not be as susceptible to the flaws of past transactions. However, one can be sure that the fifth wave will have brought its share of failures. ENDNOTES 1 Many of the topics that are briefly introduced in this chapter are discussed at length in Patrick A. Gaughan, Mergers, Acquisitions, and Corporate Restructurings, 2nd ed. (New York: John Wiley & Sons, 1999). 2 Patrick A. Gaughan, Mergers, Acquisitions, and Corporate Restructurings, 2nd ed. (New York: John Wiley & Sons, 1999), 21–60. 3 Patrick A. Gaughan, “Mergers and Acquisitions in the 1990s: A Record Breaking Decade,” Journal of Corporate Accounting & Finance 11, no. 2 (January/February 2000): 3–5. 4 P.G. Berger and E. Ofek, “Diversification’s Effect on Firm Value,” Journal of Financial Economics 37, no. 1 (January 1995): 3965. 5 R. Comment and G. Jarrell, “Corporate Focus and Stock Returns,” Journal of Financial Economics 37, no. 1 (January 1995): 67–87. 6 This section is taken from Patrick A. Gaughan, Mergers, Acquisitions, and Corporate Restructurings, 2nd ed. (New York: John Wiley & Sons 1999), 522–525. 7 Debra K. Dennis and John J. McConnell, “Corporate Mergers and Security Returns,” Journal of Financial Economics 16 (2), (June 1986): 143–187. Paul Asquith, “Merger Bids, Uncertainty and Stockholder Returns,” Journal of Financial Economics 11 April 1983: 51–83; Paul Asquith and E. Han Kim, “The Impact of Merger Bids on Participating Firm’s Security Holders,” Journal of Finance, 37, (1982), 121–139; Peter Dodd, “Merger Proposals, Management Discretion and Shareholder Wealth,” Journal of Financial Economics 8 (1980): 105–138. 8 Michael Bradley, Anand Desai, and E. Han Kim, “The Rationale Behind Interfirm Tender Offers,” Journal of Financial Economics 11 (1–4), (April 1983): 183–206. 9 Debra K. Dennis and John J. McConnell, “Corporate Mergers and Security Returns,” Journal of Financial Economics 16 (2) (June 1986): 143–187. 10 Paul H. Malatesta, “The Wealth Effect of Merger Activity and the Objective Functions of Merging Firms,” Journal of Financial Economics 11 (1–4), (April 1983): 155–182; Nikhil P. Varaiya, “An Empirical Investigation of the Bidding Firm’s Gains from Corporate Takeovers,” Research in Finance 6 (1986): 149–178. 11 Michael Jensen and Richard Ruback, “The Market for Corporate Control: The Scientific Evidence,” Journal of Financial Economics 11 (1–4) (April 1983): 5–50. 12 Gailen Hite, James Owers, and Ronald Rogers, “The Market for Interfirm Asset Sales: Particial Sell offs and Total Liquidations,” Journal of Financial Economics 18, no. 2 (June 1987); Prem C. Jain, “Sell-Off Announcements and Shareholder Wealth,” Journal of Finance 40, no. 1 (March 1985); Scott C. Linn and Michael S. Rozeff, “The Corporate Sell Off,” Midland Corporate Finance Journal 2, no. 2 (Summer 1984); Charmen Loh, Jennifer Russell Bezjak, and Harrison Toms, “Voluntary Corporate Divestitures as Antitakeover Mechanism,” The Financial Review 30, no. 1 (February 1995).

CHAPTER

2

THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS IN MERGERS AND ACQUISITIONS Professor Robert Boyden Lamb1 New York University Stern Graduate School of Business

INTRODUCTION

America Online (AOL) announced its merger with Time Warner in a transaction originally valued at $180 billion, the largest in history (their combined value was $360 billion), in January, 2000. Within days the value of the merger had fallen to near $120 billion as the stock market adjusted the soaring AOL valuation as a pure Internet firm down to a hybrid blend with Time Warner’s old media and cable business. Three months later the merger’s value had risen. Yet, by December 2000, most pure-play Internet stocks’ prices had plunged, causing many to collapse, and even some of the strongest firms lost 75 percent of their market value. They continued to decline further in the first quarter of 2001. Despite this sharp decline, the surviving Internet giants’ (such as AOL, eBay, and Cisco Systems) stock prices remained higher than many traditional bricks and mortar firms. In fact, the proliferation of bricks and clicks combination firms, plus thousands of joint ventures and strategic alliances between traditional brick-and-mortar companies and high-tech Internet firms forced experts at investment banks, consultants, and academics to rethink old methods of securities analyses and mergers and acquisitions (M&A) valuation procedures. Today there is a spectrum of new business models, numerous technology dynamics, new international markets, and changing global legal and political forces that can impact M&A valuation. These can confound even experienced securities analysts and M&A experts. To date, only a minority of analysts, economists, and investment bankers admit publicly that their old tools of securities valuation, ratio analysis, or traditional discounted cash flow models may not work as well anymore. Yet, the number of underlying valuation questions and dilemmas is crucial, for most U.S. mergers in 1999–2000 involved high-tech firms, firms with complex intellectual property (IP) or intangible assets, or Internet valuation issues. Moreover, similar M&A valuation complexities are now spreading abroad. 2.1

2.2

THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

Global mergers and acquisitions continue despite the huge stock market decline, and in many industries the digital revolution and use of the global Internet are becoming vital mechanisms for new business-to-business communications, reverse auction suppliers’ bidding, comparative pricing transparency, actual transactions commitments, and final delivery terms. By 2000, more than 100 industry-wide Internet exchanges had been announced. GM, Ford, Daimler-Chrysler, Toyota, and other manufacturers launched Covisent (the largest such exchange) to try to capture the $240 billion per year in auto manufacturers’ purchases, plus a percentage of the additional $500 billion in auto suppliers’ purchases and a share of the billions in many auto-related services transactions.2 While only a few of these industry-wide online exchanges were actually operational by the first quarter of 2001, many corporations were using the Internet increasingly for procurement of their supplies. GE purchased $20 billion in orders over the Internet in one year. Many of the old economy industries realize they must try to embrace today’s digital revolution, including the Internet, in one way or another in order to drastically cut excess costs; speed their systems and processes; and link suppliers, producers, and buyers. Other important factors beside the high-tech digital revolution and the Internet are driving recent M&A valuations and causing merger waves to sweep across the global business landscape. Many foreign governments have deregulated key industries, resulting in the introduction of new laws impacting the volume of M&A transactions, valuations, and auction prices paid and affecting who controls key assets and intellectual properties that governments owned or funded. As a direct result, frantic mergers of giant oil companies, utilities, defense, drug, financial services, communications, aerospace, rail, shipping, auto, and media firms have caused massive global industry consolidations. The United States took the lead both in deregulating many industries and in spearheading consolidation. In fact, The New York Times stated that “A major legacy of the Clinton administration will be that it encouraged one of the greatest periods of industrial concentration in American history, affecting old and new sectors ranging from oil and pharmaceuticals, to telecommunications, broadcasting and the Internet. Call it the Age of Oligopoly. Corporate mergers have grown so frequent and so large, said Robert Pitofsky, the chairman of the Federal Trade Commission, that ‘there’s not a week that goes by that we’re not called upon to review a big merger that has significant implications for the marketplace.’”3 This global merger wave also fostered greater international competition of foreign businesses inside many countries’ economies. In fact, today’s merger wave is global, racing faster abroad than in the United States. From 1992 to 2000, every year rewrote the record for merger volume. United States merger volume totaled $6.5 trillion in the 1990s. In 1999, world merger volume jumped 36 percent to $3.4 trillion. United States merger volume rose to a record $1.75 trillion, while Europe’s merger volume more than doubled to $1.23 trillion. More than half this volume increase occurred in 1998 and 1999.4 Global mergers in 2000 alone grew to almost $4 trillion. There are many causes of this latest global wave of mergers and acquisitions. As a result of the stock market boom of the last decade, acquisition-hungry companies had an inflated stock value, which could be used as merger currency. Due to the increasing interdependence of global markets, the M&A revolution not only affected the United States, but also the

A FIRM’S IP HAS BECOME A MAJOR FACTOR IN VALUING M&A DEALS 2.3

growing markets of Europe and Asia. For example, the drive to achieve global wireless and Internet connections is what led Britain’s Vodafone to acquire Airtouch of the United States for $62 billion, then Mannesmann of Germany for $183 billion, in the largest hostile takeover ever. That merger’s success depended directly on Vodafone’s separate side deal with Vivendi, a French conglomerate possessing wireless technology along its original water utility routes and major stakes in media. In fact, these and other giants and alliances in Europe, the United States, and Asia are fighting simultaneously for the fastest broadband access to the Internet and access to digital media and information. A FIRM’S IP HAS BECOME A MAJOR FACTOR IN VALUING M&A DEALS

For 15 years, the prime cause of the majority of mergers has been many firms’ urgent desire to acquire valuable technological assets that were being developed by the fastest growing companies. In many cases, these assets are ground-breaking technologies, unique know-how, trade secrets, patents, trademarks, copyrights, databases of information, rare customer lists, unique corporate reputations, and new business models, which collectively are known as intangible assets and intellectual properties. Battles for these rare assets have often driven what some called merger mania. The Internet has sped up the race for these rare assets, but it has also been forcing radical changes in many nations’ old laws and accounting rules on IP rights and intangible assets. The attraction of these intangible assets and intellectual properties is financially driven by the value added to the firms who possess them and their ability to create superior products and services, which generate the highest profit margins. These assets are often unique and difficult to imitate. Firms that possess them can sometimes achieve a longterm sustainable competitive advantage over competitors who can produce only commoditized products or services at razor-thin margins. In many cases the acquisitions are preceded by intense auction bidding where several companies fight to acquire the target firms that possess these rare intangible assets and intellectual properties. For example, on November 4, 1999, Warner Lambert announced its $67 billion merger with American Home Products. That same day, Pfizer, Inc., proposed a $72 billion acquisition of Warner Lambert in a hostile bid to prevent its merger with American Home Products. Ultimately the bidding war, which was won by Pfizer, reached $93 billion. Pfizer stated why it had rushed in and bid so high: The company was desperate for Warner Lambert’s teams of scientists and their know-how, their labs, and their portfolio of patents to help propel the creation of many breakthrough drugs. Twin revolutions in genetics and computerized testing of millions of medical compounds are fast overturning the way drug companies do business. A frantic race (which requires armies of scientists) is on among firms to sort through all the gene discoveries and pinpoint a few new blockbuster drugs.5 These multi-billion dollar merger fights among drug firms are literally wars for talent and battles for the best pipelines of proven patents. The vital importance of these drug patents has grown in the recent past as many of the major pharmaceutical companies are losing the exclusive rights to their products. In response, many drug giants merged, bought out, or allied with biotech firms or joint ventured with cosmetic, health food, or competitor drug firms. To add to the maelstrom, new regulations under the Hatch Waxman Act are unclear about possible extensions for many

2.4

THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

future-generation drugs. In the fight for drug rights, companies not only see the current drug, but also the franchise. Although a 20-year drug patent often has a useful life of only 10 years, the next-generation drugs based on this first one can be protected under patent extensions of up to 7 years. This franchising of a drug’s future generations could extend a company’s hold on the drug almost indefinitely. Likewise, with giant drug firm mergers, joint ventures, or alliances the companies have recently succeeded in combining two firms’ blockbuster drugs (each with expiring patents) into a so-called blended drug to attack two sides of the same illness together, and thus extend patent life. Across many high-technology industries, not just biotech, this same merger war for cutting-edge knowledge assets is occurring both to capture top innovators and scientists and to buy a collection of legal rights. Often these merger fights are really battles to obtain and retain rare or unique know-how, product patents, and process patents, or to patent new business models, new forms of matter, and new forms of life. These are also contests to control copyrights, trademarks, trade secrets, or other legal monopolies of intangible assets that provide firms with their most secure means to ensure a sustainable competitive advantage. 3M CORPORATION’S SHIFT FROM INTERNAL R&D FOR IP TO A MIXTURE WITH EXTERNAL ACQUISITIONS FOR NEW IP

This use of M&A to acquire the IP of other firms is not restricted to high-tech firms, but has spread rapidly to many traditional companies. Even firms that had grown for decades by their internal culture of constant innovation and new product development found they simply could not keep pace with the explosion of new IP creation among countless startup companies across the United States and the globe. It has become more cost efficient for companies to acquire technology rather than attempt to recreate the IP internally. For example, during the past 100 years the 3M Corporation became legendary as one of the most innovative companies in the world, filing for more new patents each year than most firms would in their entire lifetimes. The entire corporate culture of 3M was also famous for allowing employees to use 15 percent of their work time to create new IP that developed literally 60,000 new products. However, by 1998, 3M concluded that it could not continue to meet its firm’s target requirement of creating 30% of its profits from products less than four years old. Nor could 3M guarantee to continue to achieve its 10 percent financial rate of growth, simply by its own internal research and development (R&D) and by sharing its central bank of thousands of patents, to develop new products. The company could hope to achieve only a 7 percent rate of return from its internal growth engine, well below its long established 10 percent minimum. Therefore, 3M changed its legendary corporate strategy to require each of its many business division heads to constantly recommend potential acquisitions of companies whose cutting edge IP and creative R&D teams could jump-start 3M’s overall total rate of corporate financial growth well beyond what it could achieve internally.6 So far this acquisition strategy (aimed at buying companies for their R&D and IP creation machines) is succeeding. Securities analysts credit this new blend of 3M’s acquisitions of IP from acquired companies and its internally generated IP each year with enabling the corporation to regain its financial pace of growth. 3M’s highest performing corporate divisions are in key new target acquisition fields like health care, Internet equip-

THE WINNER’S CURSE IN M&A AUCTIONS 2.5

ment, and fiber-optic cable businesses. 3M now is forecasting internally and externally that its future growth must be “driven by three engines:” bolt-on acquisitions to existing businesses; brand-new cutting-edge IP bought in mergers; and the continuing IP being created by 3M’s traditional businesses.7 In short, IP growth continues to be the central core of 3M. It is now generally acknowledged that IP can only be generated from the combination of internal R&D plus many acquired companies’ IP resources. 3M is not alone among traditional companies in reaching the wrenching realization that their past highly successful engine of growth is simply no longer sufficient to guarantee survival nor to achieve past yardsticks of corporate growth. Most top managers now realize they must reach out via mergers, acquisitions, joint ventures, strategic alliance partnerships, or licensing for new IP just to survive or remain competitive. As a result, thousands of traditional companies, partially deregulated government firms (such as Deutche Post Office’ acquisition of DHL), and countless high-tech and startup companies are all joining in today’s huge wave of global mergers and acquisitions. THE WINNER’S CURSE IN M&A AUCTIONS AND ITS EFFECT ON NEW IP CREATION, TRANSFER, AND SHARING

The bidding wars in many M&A battles are so intense that frequently what is known in M&A financial theory as The Winner’s Curse occurs. In short, whichever buyer wins an M&A auction has usually paid too much for the target firm and will probably not be able to achieve even its minimum hurdle rate of return on its investment. The combined entity will not achieve the necessary synergies to be more profitable than the individual companies prior to the merger. According to experts, taking various metrics into consideration, over the last 50 years up to 80 percent of all mergers and acquisitions have failed to achieve their required rates of return.8 While there are many causes of merger failures, the most common cause of failure is the payment of excess premiums over the stock market price of the target company. Although the winner’s curse phenomenon occurs in many M&A situations, it is most frequently a problem in auctions for new economy companies whose key resources are their intangible assets and intellectual properties. This is a result of the difficulty in accurately valuing these assets. Companies whose unique strengths and financial growth potential are their knowledge assets, social capital, IP, and intangible assets are often overvalued. This was particularly apparent during the technological bull market of the 1990s. When investment bankers value a firm whose key assets are its intellectual properties and intangible assets in a merger, they often have difficulty using financial accounting measures of performance, such as return on sales, return on assets, or return on equity. These are often based on the firm’s past performance, and they don’t accurately measure the future potential value of the merger or acquisition. Many assumptions are required to justify any future valuation. Even investment bankers who estimate financial returns from strong firms with huge R&D expenses, creating hundreds of new patents, trademarks, copyrights, know-how, and new technology, must work cautiously with the company’s management to forecast realistically expected future free cash flows. These bankers must use assumptions determined through the due diligence process. Although often financial assumptions may appear reasonable, they may not be based on any fundamental analysis. Such assumptions have proved false, leading to incorrect projections of future revenues, profits, or cash flows from these intangible

2.6

THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

assets. Many of the most famous failed mergers and acquisitions were based on estimates and key assumptions that were wrong or unrealistic. A classic example of these M&A valuation problems was Quaker Oats’ $1.7 billion purchase of Snapple, which later was sold for only $300 million. Snapple was a fledgling beverage firm with unique patents, trademarks, trade secrets, company reputation, and very fast growth-rate, which Quaker Oats thought would be similar to the success of Gatorade. Snapple had all the IP and intangible assets, but its primary distribution channels were small convenience stores that could charge expensive prices but were much harder to supply than supermarkets, which sold Gatorade. These small stores could not support the huge volume of sales that Quaker Oats and its bankers forecast for Snapple. Price competition from other beverages in supermarkets inevitably forced the profit margins for Snapple down from what convenience stores could charge. Snapple’s valuable and unique new brewing technique was reverse engineered, or copied, by many other beverage companies. Also, the market niche it had pioneered became so overcrowded with competitors selling copies of Snapple that the original Snapple’s forecasted growth rate, on which investment banks’ valuation forecasts had been based, could not be sustained. Quaker Oats sold Snapple, after additional large yearly investments, for a bargain price of only $300 million to a small beverage company that served convenience stores. It was highly profitable immediately. While the Snapple acquisition by Quaker Oats remains a classic blunder, its valuation mistakes remain quite common. A far worse case was Mattel, the leading toy producer that bought The Learning Company, a youth-focused interactive media firm, for $3.4 billion, and less than two years later sold it for a zero dollar payment. The old toy firm was completely out of its depth in the new interactive media world. The CEO Jill Barad was fired, but with a multi-million dollar exit payment. Mattel is hugely burdened by this total loss. Another factor that some experts argue is significant in driving the Winner’s Curse in systematic M&A auction overbidding is “agency costs,” or self-interested motives of CEOs and investment bankers to enlarge their own personal bonus or firm’s fee by completing the larger transaction at whatever cost it takes. In fact, some observers have suggested that these “agency costs” (including CEO pay scales pegged to size of firm, incentive bonus payments, and investment banking firm’s fee structures based on the larger size of the merger transaction) is an important reason for what has been called the recent “merger mania.” To complete the merger, the CEO of the acquiring firm, caught up in the heat of the M&A auction process, may seriously consider any conceivable synergies of this deal that will justify a higher final valuation offer. INVESTMENT BANKERS USE FOUR BASIC METHODS OF VALUING MERGERS AND ACQUISITION TRANSACTIONS

There are four types of technical valuations that are most commonly used by investment bankers. The following pages outline these methods and some of their pluses and minuses. Comparable Company Analysis. Comparable company analysis requires the investment

banker or internal corporate finance team to carefully identify as many comparable companies to the target firm as possible (normally between 2 and 20). Then they mea-

INVESTMENT BANKERS USE FOUR METHODS 2.7

sure each of these comparable firms in terms of their stock market value, P/E ratio, Enterprise Value/EBITDA, or (more common with new economy companies that don’t have positive cash flows) Enterprise Value/Revenue. In theory, the comparable analysis provides the buying firm with a range of fair equity market prices as a guide to determine an offering price for the target. 1.

2.

The first problem is that the equity stock market, which in past decades was relatively stable, is so volatile today that the price of many comparable companies can easily move up or down by more than 40 or 50 percent during the 6 to 22 months that a merger deal is being completed. In fact, the spike or plunge in value of the stock price (volatility) of several of the companies that investment bankers deemed comparable can range from 10 or 15 percent in one week or even one day. This means that M&A professionals are forced to create bands of high-to-low stock market price ranges for each separate company included in the comparable company index or average they use in their price comparisons for the client buyer in their so-called Pricing Book. Although price volatility can be problematic, the use of a large enough universe of comparable companies should diversify most of the outliers. For example, in Spring, 2000, AT&T planned to spin-off its wireless business as a separate tracking stock to take advantage of recent huge wireless firms’ valuations (reaching $62–$350 billion) including the following: Airtouch of the United States, Vodafone of the United Kingdom, Mannesman of Germany, and DoCoMo of Japan. After April, 2000, the sudden plunge of most Internet and high-tech stock prices by 50 to 80 percent negatively impacted the price for AT&T’s wireless company despite its potential for future Internet access. AT&T only raised $10.5 billion and was lucky to find buyers even in the lowest range for its large wireless firm’s spin-off sale in that very bad market. AT&T’s wireless firm had the same assets that it had six months earlier, but its potential for market cap had suddenly shrunk. Because comparable company analysis is based on market valuation, the equity value can vanish with the falling market, as in this case. The second key problem is that frequently there are no truly comparable companies to the target firm. This is especially true if the firm’s key assets are its intellectual properties and intangible assets. The greatest asset new high-tech, biotech, Internet, or knowledge-based companies (those that have the potential for the fastest growth) have is their uniqueness. The real potential economic and financial power of these firms, if they succeed, is founded upon the originality of their concept, new materials, new technology, or innovative business model. Today’s startup firms’ future value is founded on their breakthrough scientific genome tests, discoveries of light waves, and other path-breaking science, or their new image trademark products, trade secrets, know-how in process improvements, or their new entire business model. A firm’s originality is often its critical competitive strength, but is also a difficult financial stumbling block in its valuation if based on comparables.

Comparable Transactions Analysis. The second classic method used by investment bankers to value mergers and acquisitions is to carefully identify a cluster of compara-

2.8

THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

ble merger transactions done during the current period. Investment bankers attempt to select recent mergers in which the structure of the deal, nature of the companies, size, total sales, total profits, total scope of operations, line of business, type of customers, and growth rate are similar to those of the firm in the pending deal. Although it is impossible to find past deals that are exactly the same, the more closely matched the comparable factors, the more accurate the analysis will be. Once again, the global volatility of stock markets has made it far more difficult to identify with reasonable certainty what is truly comparable. For example, AT&T paid twice as much for Media One, a TV cable company, in 1999 as it paid in 1998 for Telecommunications, Inc. (TCI), which was a significantly larger cable company. This is a critical example because when AT&T bought TCI, cable companies were out of favor and expensive to install. After Microsoft invested in Comcast and AT&T’s bid for TCI was accepted, suddenly it was widely realized that cable TV lines were a major broadband into 73 percent of U.S. homes, and their cables passed by 90 percent of all U.S. homes. They could be used for local telephone connections and Internet connectivity on a major scale because cable lines were already installed across the United States, and each had a monopoly in its region. In short, the tangible TV cable lines were now seen to have enormous potential for delivering intangible asset value by distributing a vast range of intellectual properties. These include all kinds of specific information on health, transportation, business or scientific data, video, music, voice telephone calls, sports, education, testing services, electronic games, financial transactions, security services, gambling, and pornography. One result of AT&T’s $110 billion spent on acquisitions of cable systems was AOL’s fear that it would be prevented by the cable monopolies from gaining access to broadband already connected to the Internet. Thus, AOL rushed to bid over $180 billion originally for Time Warner, which owned both the second largest TV cable system in the United States and a vast range of the most valuable intellectual properties in huge libraries of copyrighted movies, TV series, magazines, books, and music. AOL’s initial bid was 70 percent above current market price. Time Warner did not negotiate a collar, or valuation price floor, on AOL’s stock price change, and AOL’s price for Time Warner by the date the deal closed was $108 billion.9 Even if TV cable firms had been similar, all these merger transactions were done at huge variances in relative price because of high- or low-valuation perceptions of the market and of the range of intangible assets and intellectual properties that complement, or add functional uses to, that basic cable line. It was often the commercial potential of complementary products and services that dramatically expanded the perceived financial acquisition value of Internet firms, high-tech firms, biotech firms, or virtual firms completed in a six-month to one-year period. As a result of this, January 1999 to May 2001 witnessed 50 to 250 percent price differences in acquisition prices paid for relatively similar firms. In each case, investment bankers and firms’ Chief Financial Officers (CFOs) could point to supposed comparable transactions to justify the wildly inflated or deflated acquisition prices they decided to pay for other companies. While there is nothing unique in today’s acquisition price swings, the height of the spike, whether up or down in value, is new. Discounted Future Cash Flows. The third, and most intrinsic, method of merger valua-

tions is the discounted cash flow model (DCF). The DCF analyzes the forecasted free

INVESTMENT BANKERS USE FOUR METHODS 2.9

cash flows to be achieved by the new firm formed from the combination of the two merged entities. It is largely the widespread recognition of the inherent valuation problems in using comparable company analysis and comparable transactions analysis mentioned above that has resulted in the continual reliance on discounted cash flow analysis of M&A transactions. This valuation method, like the others, is subject to various problems, inadequacies, and misuse. This is due in part to DCF analysis’ reliance on a range of “assumptions” about future growth in sales, profit, market share, stock price, technology innovation, brand-name value, inflation, old laws, and enforcement of regulations. Financial analysts at M&A departments of investment banks and consulting firms and finance professors in most business schools prefer this valuation method for more traditional companies because it is considered to be more widely applicable in all sorts of industries and all stages of growth. The DCF also provides a valuation of a firm’s intrinsic value based on performance, rather than the market’s perception of the firm’s value. While this is normally true, DCFs have proven inaccurate in valuing knowledge companies whose primary future financial value is based on intangible assets, know-how, innovative technology, or new business systems. The basic difficulties result from discounted cash flow analysis’ dependence upon the interrelation among numerous assumptions about when knowledge assets will generate sales, cash flows, profits, or future streams of income, or in which future years particular amounts of revenues, profits, or future stock price levels will be achieved. Such assumptions are often just as inadequate as if based on unrealistic extrapolation of growth rates from noncomparable companies or noncomparable transactions. Steps to a Valuation. After understanding that there are three main valuation methods, it is important to remember that the investment banker does not use only one. Bankers use a combination of the three techniques to arrive at a valuation that they—as well as the company—believe is fair. The bankers will have an understanding of where the market values the company under the current market conditions, as well as what the intrinsic value of the company is, considering its future forecasted cash flows and using both types of comparable analysis and a discounted cash flow analysis. Although admittedly not a perfect science, the use of all three methodologies is widely considered the most accurate measure of a company’s value. Without citing a specific transaction, the following steps provide a basis for corporate valuation of a target company in an M&A transaction in practical terms:

Comparable Company Analysis 1.

2.

Find a peer group to use in the analysis. The larger the universe of companies, the more accurate the analysis. A large, diversified sample within the comparable universe provides more statistically accurate data, as outliers carry less weight. Research analysts within most major investment banks can provide the comparable universes for most industries. Whenever possible, companies with similar characteristics, such as industry, size, scope, and geographic location, should be used. When you don’t find a company publicly traded in that sector, you may have to look at a company with a similar operating structure. Determine which metrics will be used to compare all of the companies. It is important, especially with new economy/technology companies, to determine

2.10 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

3.

what the comparison will be based on. Many technology companies, whose assets include high percentages of IP, do not have positive earnings or even EBIT.10 Without these traditional comparative line items, bankers have gone to alternatives such as revenues or hits to a website for the dotcom companies. A fairly simplistic spreadsheet will provide the analyst with a low, base, and high range of price valuation for the company once these steps have been completed.

Comparable Transaction Analysis 1.

2.

3.

Find similar transactions that have occurred in the recent past. It is important to use recent transactions because the underlying market condition is the determining factor in valuation. Using transactions that occurred during different market trends will skew the metrics and provide an unsupportable company value. Once again, a larger sample will provide more accurate data for the analysis. In addition, investment bankers also do sensitivity analyses by taking snapshots of the market at three different economic levels. Determine what metrics will be used in the comparison. It is important, especially with new economy/technology companies, to determine what the comparison will be based on. Many technology companies (whose assets include high percentages of IP) don’t have positive earnings or even EBIT.10 A fairly simplistic spreadsheet will provide the analyst with a low, base, and high range of price valuation for the company once these steps have been completed.

Discounted Cash Flow The DCF analysis is the most involved and most time consuming of the three, and it often requires a number of assumptions about changes in a firm’s growth rate and number of years of growth. 1.

2.

Working with management, bankers determine the future cash flows of the company. Is this firm in a period of stable growth or high growth, or is its growth declining? Is this firm now in a high-growth period, but expected in five years to decline to only a stable growth rate? Bankers first take management’s forecasts for growth rates during this process. An extensive due diligence process is undertaken once the bankers have an idea about management’s projections, during which revised projections are developed. It is of utmost importance that the investment bank and any outside experts feel comfortable with the forecasts, considering the name and reputation of the bank will be placed on the fairness opinion. Determine the growth rates for the stable period for which a terminal value is to be computed. This terminal value represents the present value of the free cash flows the firm may generate beginning with the last year of its stable growth period and lasting the remainder of its life. The terminal value is usu-

INVESTMENT BANKERS USE FOUR METHODS 2.11

3.

4.

ally calculated as a growing perpetuity of a single cash flow projected with the growth rates of the stable period. Alternatively, one can compute the terminal value of a comparable financial ratio with the stable period growth rates based on the projected values. Because the terminal value represents the vast majority of the company’s value, it is important to find an appropriate multiple of the firm value or a perpetuity rate. Determine an appropriate discount rate to present value the cash flows of the high-growth period, stable period, and the terminal value. Use the Weighted Average Cost of Capital (WACC) as the most accurate approximation of what the next dollar of capital will cost the company to raise. The WACC is generally a weighted average of the firm’s cost of equity and after-tax cost of debt. When the company has preferred stock, WACC is computed as a weighted average of cost of equity, after-tax cost of debt, and cost of preferred stock. Discount the cash flows to present day or a defined point in time using the WACC.11

These steps will provide the firm’s value in present dollars. It is necessary to subtract the total debt of the company and add back any cash on the balance sheet to find the equity value. (The amount of cash added back depends on how you define the free cash flows.) The investment banker divides the equity value by the number of outstanding shares to find a per-share value. (In some cases they divide by the number of diluted shares outstanding.) In general, comparable transactions analysis leads to a higher company value than comparable company analysis because the prices you use in comparable transactions include both the premiums and the fair market values. From 1980 to 2000, the average control price premium paid for a firm in a merger was 40 percent above the market price for that firm two months before the merger announcement. DCF analysis is based more on the expected future cash flow, assumptions about potential growth rates of the firm, and future financial performance of the business being valued than on the firm’s stock market prices or transaction prices of other mergers. As a result, DCF analysis of a merger often produces the highest financial valuation of a company in a merger of these three methods of valuation. When a firm has high capital expenditures, its cash flow could be negative. It is important to have a positive Net Present Value (NPV). Even though one’s firm might show a loss in its accounting statements, when one converts the accounting earnings into free cash flows by adding back non-cash charges like amortization, the firm may have a positive cash flow. It is important to be clear on exactly what inputs each valuation model requires. (Be aware that certain factors are not required as inputs.) Option Valuation. The three traditional M&A valuation methods (comparable companies, comparable transactions, and discounted cash flows) do not work well when analyzing bankrupt firms, financially-troubled companies, startup firms, or innovative companies whose major assets are currently unprofitable technologies, patents, copyrights, trademarks, or trade secrets. This is because such firms often lack profits, net

2.12 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

income, or even sales revenue and ongoing positive cash flows that traditional valuation models usually require as inputs. Therefore, a fourth method known as Option Valuation, or Real Option Valuation, has begun to be used in M&A valuation for these types of currently unprofitable firms that could generate significant financial value in the future. For example, Real Option Valuation can be applied to companies whose assets are comprised of nothing more than patents for as yet unutilized products. Based on the option-pricing model, this method, which is applied to value both biotech companies that hold a number of patents and each individual patent, is described in detail in Aswath Damodaran’s book Damodaran on Valuation. A potential acquirer can determine the possible value of the products protected under the patents and the value of the biotech firm by using this general technique. Martha Amram and Nalin Kulatilaka refine the general Real Option Valuation model more specifically in the chapter “Developing a Drug” in their book Real Options.12 They show that biotech firms are examples of a “sequence of learning options” that frame or affect the next drug business option choices by reducing risky outcomes, because these companies learn to select better success paths. David Kellogg, John Charnes, and Riza Demirer go into even more depth on the importance of tracking a drug firm’s learning options from each phase in FDA clinical trials in their paper, “Valuation of a Biotechnology Firm: An application of real-options methodologies.”13 These clinical trial stages of success, or learning options, are vital to giving the acquiring firm critical information necessary for deciding which specific biotech firms to buy and at what price. Learning options that biotech and pharmaceutical firms consider go beyond the ones noted in both the Amram-Kulatilaka book and in the Kellogg, Charnes, and Demirer paper. They include not only the choice to invest or abandon the project at different drug trial phases, but also options to seek joint-venture partners or to apply for “orphan drug status” to the U.S. government for vital funding of new drugs that were originally deemed not commercially viable. First, the basic Real Options Valuation method for a patent and for valuing a biotech firm in an acquisition will be outlined. This is followed by a review of actual drug companies’ “sequence of learning options” and an analysis of the stages of choices in firm growth as a series of option decisions: which drugs to research, which to develop, which to keep funding, and whether to buy a firm, joint venture, or strategically ally with biotech companies. This range of real option valuations is stressed, because many giant pharmaceutical firms must spend more than $500 million on each successful new drug to make up for all those that failed to pass the required tests. Now their old blockbusters are losing their patents, so they are forced to make a decision based on different options: whether to invest, acquire, merge, make strategic alliances, buy equity stakes in biotech firms, or pay licensing fees. DAMODARAN’S OPTION VALUATION PROCEDURE FOR A PATENT14

It is assumed that each product will be developed only if the net present value of the free cash flows generated by the sales of this product is greater than zero. In this way, the patent acts in a similar manner to a call option on a stock—the option will be exercised only if the cash flows are positive. With that in mind, the inputs for the valuation

DAMODARAN’S OPTION VALUATION PROCEDURE FOR A PATENT 2.13

of the patent as an option on the future product will consist of the “underlying asset or product, the variance in value, the time to expiration on the patent option, the exercise price of the patent option or the cost to develop the product, the risk-free rate, and the patent equivalent of the dividend yield or yearly payoffs from the patent, once developed, until its patent life expires.” Value of Underlying Asset. This value is derived, once the product is introduced, from

the determination of cash flows for the life of the patent. Because patents are for products that don’t exist, this determination can be difficult at times. This fact, however, is exactly what gives the option value. If the cash flows are certain, there is no need to use an option valuation. Variance in the Value of the Asset. Considerable uncertainty [variance] is likely to be

associated with the cash-flow estimates and the present value, which measures the value of the asset now—partly because the potential market size for the product is unknown and partly because technological shifts can change the cost structure and profitability of the product. One of two methods can be applied to determine this variance. First, one can use a comparison of similar existing product’s cash flows. Second, one can perform a sensitivity analysis using various scenarios to determine a range of probable cash flows on the product to be developed. The value of a product patent will gain value in an environment where high-technology, competition, and markets all change rapidly, just like a traditional option on a stock gains value with stock price volatility. This is in contrast to the value in a stable industry. Exercise Price of Option. The cost of developing the product can be seen as the exer-

cise price. If the present value of the cash flows is higher than the exercise price, the product will be developed. Expiration of the Option. The expiration is the legally permitted life of the patent.

(While in some cases, such as pharmaceuticals, it may be possible to extend the expiration date on the life of the original drug patent, assume the standard patent life expiration date for this case example.) The Dividend Yield. The yield for a patent is equivalent to the yearly payoffs from the

product—once it has been developed from the patent—until its patent expiration date. Because patents have a limited life, there is a real cost associated with waiting to complete development of the new product. Because the number of years of its potentially useful life with patent law protected monopoly profits years is reduced, Damodaran assumes that excess profits from the patented product disappear when the patent expiration date approaches because new competitors, who are selling nearly identical products, emerge. He also assumes that if the cash flows from the product are evenly distributed over time, and the life of the patent is n years, then the annual cost of delay of the product launch is 1/n. Once its development is complete, care must be taken to accurately estimate both the number of years and the expected yearly payoffs for this product until its patent expiration. Damodaran analyzes it this way:

2.14 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS Assume that a firm has the patent rights for the next 20 years to a product that requires an initial investment of $1.5 billion to develop and that it has a present value (PV), right now, of cash inflows of only $1 billion. The technology is rapidly evolving, however, and there is a possibility that this will become a valuable project in the future. Assume that a simulation of the project under a variety of technological and competitive scenarios yields a variance in the PV of inflows of 0.03. The current risk-less 20-year bond rate is 10%. The inputs to the option-pricing model are as follows: Value of the underlying asset = PV of inflows (current) = $1, 000 million. Exercise price = PV of cost of developing product = $1, 500 million. Time to expiration = Life of patent = 20 years Variance in value of underlying asset = Variance in PV of inflows = .03 Risk-less rate = 10% Based upon these inputs, the Black-Scholes model provides the following value for the call: d1 = 1.1548

N(d1) = 0.8759

d2 = 0.3802

N(d2) = 0.6481

Cash value = $1,000 million exp(–0.05)(20)(0.8759) – $1,500 million exp(–0.10)(20)(0.6481) = $190.66 million.15

What Damodaran concludes is that the product, although presently unprofitable, has value if seen as an option over the lifetime of the patent. This value can be added as an asset to the acquiring company. The valuation of a company whose primary assets are its patents starts by adding together the values of each of its individual patents. However, Tom Copeland and Vladimir Antikarof, in their book, Real Options: A Practitioner’s Guide, say that we must keep technological or product market uncertainties separate in option valuations of a patent, and track how they interact on value. For example, a drug firm’s stages of “learning options” may gradually reveal that certain breakthrough patents of a biotech firm (for the tetracycline family of drugs, for instance) could really be the foundation blocks for whole new clusters of follow-on pharmaceutical patents. Key strategic mergers or acquisitions of firms possessing such potential breakthrough intellectual properties may cause a chain reaction of financial growth. Therefore, scientists and bankers analyze whether this firm’s patent is for one drug or for a key family of drugs. Often, an acquiring firm making its strategic investment cannot know with any certainty if its Option Valuation of a patent or potential breakthrough new business model is worthless, worthwhile, or truly invaluable. This Option Valuation estimation uncertainty leads some M&A experts to recommend the use of an earn out method of payment structure for the purchase of both a patent and a firm whose key assets are their patents. In short, the Real Options model is being transformed from a simple mathematical calculation of expected value to concrete provisions within the merger or acquisition deal structure. This means that the final price for a patent or for the firm with that patent will be determined only once the drug or technology comes to market or achieves specific milestones. For example, the seller of a pharmaceutical patent can initially receive a modest payment for selling the rights to the patent, but can retain some

DAMODARAN’S OPTION VALUATION PROCEDURE FOR A PATENT 2.15

form of carried interest, or equity ownership, in the patent if it really produces results. Thus, if the drug passes phase I, the seller will receive $1 to $3 million; at the end of phase II, he will receive $5 to $7 million; if it passes phase III, he will receive $10 to $20 million, and so on. This will ensure both that the buyer does not overpay and that the seller does not miss out on a huge future financial opportunity. This earn out acquisition plan may be used for M&A Real Option Valuation of firms that have several patents in different stages of the FDA drug approval process—as in the case of pharmaceutical firms in their purchase of various biotech companies, for example. Of course, many argue that it is much better to have cash now rather than later, but again, how can you define the real potential cash value of a drug at such an early stage? If the two parties align their interests, through such acquisition deal “earn out” Real Options structured into contract agreements, they may have higher chances of success, because both parties have to contribute to the lengthy process, and both share in the risk and the rewards. This particular deal structure of an earn out for Real Option Valuations in biotech firm acquisitions is an extremely clear example of the commercial importance of “learning options” at each milestone (phase I, phase II, phase III) stage of FDA drug testing approval. In the absence of such an earn out Real Option structure for most acquisitions of early stage IP firms, the buyer or seller will more than likely incorrectly measure the firm’s potential financial value, because its collection of patents is often very hard to estimate with any reasonable degree of accuracy.16 An example of this type of uncertain option valuation situation existed with Napster, the hugely popular peer-to-peer free file-sharing company that had 60 million users in 2000. Bertelsmann, the world’s third largest media corporation, in November 2000, made a $50 million loan to Napster to enable the company to develop a new profitable business model based on all subscribers paying a $5 to $10 monthly fee for downloading music from many file sharers. Market research studies of Napster users had shown that customers might well be willing to pay up to $15 per month for that music file sharing service. Bertelsmann’s $50 million investment in Napster was buying an option, or purchasing the future financial possibility that the company would survive its current legal problems. The chief executive of Bertelsmann, Thomas Middelhoff, stated publicly that he intended to use a Napster-like file-sharing, or peer-to-peer business model, for all of Bertelsmann’s media and information products and services in music, books, magazines, television programs, movie videos, and data with many new Internet distribution channels. Because there is no way to determine whether Napster will even exist in the future, or whether other companies and new technology will capture the market, any valuation of Napster is highly speculative. However, only some version of the Real Option Valuation model could perhaps provide a reasonable way to analyze Napster’s file-sharing business model’s potential financial payoffs and figure them to be derived from specific business opportunities in Bertelsmann’s segments of each media industry. Securities analysts viewed Bertelsmann’s $50 million investment in Napster purely as a speculative option. To have any value, Bertelsmann would need to convince major music firms to join this experiment. By April 2001, Napster’s legal case looked very bleak, as the U.S. federal judge issued her injunction.17 Nevertheless, two new Napster alternatives sponsored by the five giant record labels were announced to be ready for launch by early fall of 2001. Bertelsmann, AOL-Time Warner’s Warner Music, EMI, and Real Networks formed a joint venture called Music

2.16 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

Net that would market their digital music to online companies. Likewise, Sony Music Entertainment and Vivendi Universal’s Universal Music group said they would roll out Duet, a music licensing operation online. Yahoo has signed up both of these online music joint ventures. Finally, many Internet experts still believe that the peer-to-peer model is potentially immensely powerful, and someday teams of corporations and networks of individuals will use it. An Important Caveat on Investment Bankers Selection of Valuation Method. Financial experts agree that one of the most important tasks of investment bankers is the careful determination of what the most appropriate valuation methodology is for each particular company. Most professionals realize that if they use the wrong methodology, false assumptions, and incorrect inputs, it will result in baseless valuations for M&A transactions. Nevertheless, standard but inappropriate valuation methods are commonly used in M&A deals, and they have been blamed for the resulting failure of a number of attempted mergers. Although a top manager may suggest a ballpark number he or she would like the firm to sell for, true professionals should not start in advance with an estimated financial value of what the final price could be and then select a valuation method most likely to lead to that number.

ALTERNATIVE IP VALUATION METHODS

The previous section was a simplified explanation of the four basic valuation processes. There are many variations and iterations that can be applied. Most investment bankers and consultants in M&A will agree that the DCF and comparable analyses are the most widely used methods to determine the value of a target company’s IP, with Real Option Valuation being used for special situations. But according to a September 25, 2000, research report by Dresdner Klienwort Benson, other measures can be used, such as: Proxy Valuation: A large number of companies do not value their own internal IPR (IP Rights) separately and simply assign a value as a percentage of market capitalization as a proxy for individual project valuations. However, this assumes that the IPR have no value above their book value and that the value of the property changes with share price movement. Calculated Intangible Value (CIV): In one method developed by NCI Research, the industry’s average return on tangible assets is multiplied by the company’s tangible assets (can be historical, but can also be based on forecast data). This number is subtracted from the company’s profit before tax giving the excess return. This return is multiplied by the tax rate and then subtracted from the excess return giving the post tax premium. The net present value of this premium can then be calculated giving the CIV of the IPR IP Rights. Return on Investment (ROI): The ROI for each individual project can also be calculated. This looks at the average return being generated each year on a particular project or set of IPR (IP Rights). To do this, the analyst needs to be able to break out the original cost and investments in the project and either forecast the return or already have revenues that can be separated out. This requires a significant amount of information that may not be readily available and ignores the time value of money invested in the project. This technique can be extended and combined with a DCF to give the cash flow ROI (CFROI). This allows companies to value the present value of the net cash return at the investor’s dis-

TODAY’S COMPRESSION OF THE PRODUCT LIFE CYCLE 2.17 count rate. In other words, it attempts to restate the investment in current returns. To be able to calculate the CFROI four key inputs are needed: life of asset, the amount of total assets, periodic cash flows and release on non-depreciating assets. Payback Period: Other performance measures examine the payback period for the investment in the IP Rights, i.e. how long it takes for the IPR to cover the costs for all its R&D” of a prototype model, batch production and first profitable sales in a commercial rollout. TODAY’S COMPRESSION OF THE PRODUCT LIFE CYCLE AND MODERN VALUATION PROBLEMS

Many experts are now deeply engaged in studying these current financial valuation problems from different perspectives. Aswath Damodaran has concluded The value of a firm is based upon its capacity to generate cash flows and the uncertainty associated with these cash flows. Generally speaking, more profitable firms have been valued more highly than less profitable ones. There seems to be, at least from the outside, one more key difference between technology firms and other firms in the market. Technology firms do not make significant investment in land, buildings or other fixed assets, and seem to derive the bulk of their value from intangible assets. The simplest way to illustrate this divide [between high tech firms and traditional bricks and mortar firms] is by looking at the ratio of market value to book value at both technology and non-technology firms. Like the price earnings and the price to sales ratios, the price to book value ratio at technology firms is much higher than it is for other firms. [Exhibit 2.1] compares the price-to-book value ratio for technology sectors to that of nontechnology sectors.18 (It shows a 700% difference between them.)

18.00 16.00 14.00 12.00 10.00 8.00 6.00 4.00 2.00

Exhibit 2.1 Price-to-Book-Value Ratios by Sector

Internet

Specialty Retailers

Chemicals

Auto & Truck

Semiconductors

Computer Software & Svcs

Computer & Peripherals

0.00

2.18 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

Damodaran criticizes those who argue for new financial methods or new metrics to evaluate new technology firms and new business models. “This search for new paradigms is misguided. The problem with technology firms, in general, and new technology firms, in particular, is not that they lose money, have no history or have substantial intangible assets. It is that they make their initial public offerings far earlier in their life cycles than firms have in the past, and often have to be valued before they have an established market for their product. In fact, in some cases, the firms being valued have an interesting idea that could be commercial but has not been tested yet. The problem, however, is not a conceptual problem but one of estimation. The value of a firm is still the present value of the expected cash flows from its assets, but those cash flows are likely to be much more difficult to estimate.”19 There is often a wide range in the financial valuations of the same IP or intangible assets. For example, a particular IP’s financial value often would be quite different if it were owned by a firm that had no sales or production facility yet, but only a patent, trademark, or copyright with potential for future income, than if it were owned by a functioning company with a track record of sales, profit, and cash flow. In fact, there was a wide spectrum of different valuations that investment bankers, venture capital firms, mezzanine capital firms, and providers of seed capital or angel investment would attribute to the very same intellectual properties. That valuation spectrum stretches over six different valuations: 1. 2. 3. 4.

5. 6.

The totally untested patent stage held by one independent inventor The fully tested prototype product A fully developed production process for the one product A fully developed production-distribution-marketing process for various products stemming from the original patent, which is held by a fledgling company that has sales, but is not yet returning a profit A company with a proven track record of one to five years of profit earnings and actual cash flows A well-known product with brand recognition

Each of these six valuations of the same new technology is based both on the stage of its actual commercialized development into a real and successful business and the greater degree of certainty of the future cash flows that technology IP can reasonably be expected to deliver. It is vitally important to realize that today mergers and acquisitions can take place— and increasingly do take place—at every single one of these different stages of that IP’s development. Literally thousands of single inventors’ innovations and countless fledgling start-up firms with no fully tested product yet, no FDA approved drug, no profits, or few sales have been bought in acquisitions in this decade for many millions or (in a few cases) billions of dollars. In short, because of a new realization of the potentially huge financial value of a variety of intellectual properties in the global business environment—especially in high-technology, biotechnology, or the Internet—aggressive corporations are often moving in earlier and earlier to buy up any highly promising IP firm. Because of today’s urgent needs for speed to market and setting new technology industry standards in what are known as winner-take-all markets, corporations believe

M&A AND THE CONSOLIDATION OF MARKET POWER 2.19

they cannot wait for a fledgling IP startup firm to reach its full business potential before entering a bidding war to buy it. For example, in early 2000, Cisco Systems (near its high) purchased Cerent, a private start up company that had, as yet, no profits, and less than $300 million in sales, for $6.9 billion. It was an example of the huge acquisition value that a unique, essential IP owned by one small firm can have at a particular moment in time to another unique, but giant firm that controlled the backbone of the Internet. Corporations like Cisco, Intel, Microsoft, and the giant pharmaceutical firms all increasingly want early IP ownership options, or major early investments for, key IP access rights. Thus, a very wide range of staged investment and acquisition deals is structured by investment bankers to make sure the maximum number of new highpotential intellectual properties is available for corporate clients to use as and when they are needed, or they pay to lock up IP ownership options to prevent competitors’ access to them. MERGERS AND ACQUISITIONS AND THE CONSOLIDATION OF MARKET POWER IN VARIOUS INDUSTRIES IN THE WORLD

At the other end of the spectrum from these small, unique start-up firms, bought up early because of their future potential, are giant corporations and their multiple acquisitions of already famous brands. These are really consolidations of market power. In 1998, the big three auto firms controlled 70 percent of the United States industry. The big three beverage firms controlled 90.3 percent of the industry, and the big three tobacco firms controlled 88.4 percent of the industry. Trademarked brand-name recognition was probably the most powerful anchor for the continued dominance of these giants in each of these industries. Each of these giant firms uses its well-known and high-priced stock, its surplus free cash flow from high-profit margins, or its superior debt capacity to do mergers and acquisitions to capture other top brand-names to add to its stables.20 For example, Ford bought Jaguar and Volvo, Daimler-Benz bought Chrysler and control of Mitsubishi, and Volkswagen bought Nissan. Each of these companies did this to extend their global brand-name auto product lines. Similarly, Coke bought Minute Maid, PepsiCo bought Tropicana, and both Coke and PepsiCo are buying famous bottled waters to extend their brand-name control in beverages. Waves of M&A transactions have eliminated many competitors from various markets. For example, the big eight accounting firms bought each other out to become the Big Five. In pharmaceuticals, the largest 20 became the giant seven via mergers. Due to mergers, there are now six media giants in the world. The 30 largest U.S. military contractors became the giant four in recent mergers. These many industry-wide merger waves, although launched for cost-cutting efficiencies, became oligopolies that enabled the surviving giants to act more as profit magnets in creating a circle of tightly interconnected networks of overlapping or closely complementary businesses. For example, in mid-2000, a General Motors’ subsidiary, Hughes Corporation Direct TV, was the largest satellite firm in the United States. It had 10 million customers and a tracking stock market value that was higher than GM’s entire automotive business.21 The Board of GM and securities analysts expected that Direct TV could be sold for over $20 billion. However, by May 2001 (after the sharp tech stock decline) GM and Hughes Direct TV announced they were in negotiations with Rupert Murdock’s News

2.20 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

Corporation, which has over 100 million viewers globally, at a merger price of under $9 billion. This merger would create by far the largest global TV satellite empire, and be a serious competitor to all cable and media giants. No other serious bidders were reported for Hughes Direct TV except News Corp.22 This was in large part because Murdock was the only potential major buyer who could fully leverage all his own intellectual properties: Fox TV, 20th Century Fox film, global media, news and data streams over Direct TV, and join his global 100 million viewers to 10 million Hughes customers to achieve large economies of scale in satellite equipment purchases. Like AOL-Time Warner, this News Corp.-Direct TV merger is important because it is a working example of global market power derived from combining dominant ownership of distribution channels with powerful IP media libraries, streams of new content, and networks of key alliances. Microsoft’s CEO, Steve Balmer, was reported in the Wall Street Journal to have implicitly warned the CEO of Hughes Direct TV not to sell his firm to any corporation but News Corp.23 Microsoft instantly pledged to invest at least $3 billion in a Direct TV-News Corp. entity in order to have a major role in all its commercial opportunities, from home banking, investing, shopping, travel services, to set-top boxes for phone and Internet services.24 Microsoft was signaling to the market that this News Corp.-Direct TV merger was a unique marriage of dominant giants that made significant opportunities for value creation and value capture by its network of corporate allies possible. What made News Corp.’s merger offer so powerful, despite its relatively low market price, was that no other buyer could exploit so many different financial and operational synergies by controlling Direct TV. For example, in 2000 News Corp.’s British subsidiary, B-Sky-B, already had 5 million satellite TV customers who do home banking, order pizzas, and make other purchases via two-way satellite communications technology, which was more advanced than U.S. satellite TV companies, and News Corp. stated it would be made available quickly across the United States.25 News Corp. could reduce fees that Direct TV paid to certain companies by selling its own films, major sports events, and global TV shows on Pay-Per-View Direct TV. Securities analysts in media, telecommunications, and retail and the Internet experts stated that if News Corp. succeeded in this deal to control Hughes Direct TV, it could quickly and significantly drop prices in competition with cable TV companies and steal cable customers and other satellite firms’ customers via a lower cost of customer acquisition than many other firms. Although Murdock’s forecast that the combined firm would double Direct TV’s customers to 20 million in a short span of time may be overly optimistic, this is another clear example of global industry consolidation.26 These M&A industry consolidation patterns are deliberate, strategically planned initiatives. They are not an accident, but are targeted by corporations in order to achieve specific market share dominance goals; rank number one, two, or three in an industry; or hit what is called critical mass—the minimum size currently thought necessary to be a viable player in a key industry sector. As a result, many mergers and acquisitions that are targeted to buy firms with specific IP or intangible assets are not really single one-off deals but are often part of an ongoing strategic acquisition program to build that critical mass in a chosen business field. This is the most crucial fact in understanding the clustered patterns of acquisitions by specific corporate buyers. It also helps explain the bidding valuations they offer, or will ultimately pay, for specific firms whose IP or intangible assets fill their firm’s crit-

M&A AND THE CONSOLIDATION OF MARKET POWER 2.21

ical gap or provide links with 5 to 10 other current products or services sold by their firm. Before he became chairman of Cisco Systems, John Chambers laid out a large grid showing a number of vital new technology mergers, acquisitions, or intellectual properties that were all directly in Cisco’s path to future success in dominating the backbone of the Internet for Cisco’s Board of Directors.27 Chambers stated that Cisco must either buy those specific firms or provide seed capital to startup firms currently pioneering in each of the key technologies on that large grid and help advise or direct their paths of growth until they were ready for Cisco to acquire them. Cisco Systems did carry out that major acquisition program and seed those many technology startups before buying them, often at huge prices. As a result, at one point in 2000 it became the most valuable company in the world ($550 billion) before its stock fell by 80 percent in 2001. While Cisco’s 10-year acquisition program was more unique, and much more expensive, than that of most other firms, it was also similar to many companies. Hundreds of famous brand-name firms acquired by Kraft, Nabisco, General Foods, CocaCola, PepsiCo, and Heinz were bought to continually strengthen their existing mass of foods, snacks, or beverages that could be sold through each firm’s existing distribution system to its existing major corporate client retailers. Proctor & Gamble, Colgate Palmolive, and Gillette did the same in buying many famous brand-name personal product firms to enlarge their lines and reap economies of scale and economies of scope in cross-selling many closely related products directly through their preestablished marketing, merchandising, and distribution channels. These corporations’ acquisition bid price for each new famous brand-name firm automatically presupposed their corporation would quickly achieve major cost synergies, especially in huge reductions in the acquired firm’s existing cost structure, by using the acquiring firm’s existing managerial staff, systems, style, structures, skills, and current bureaucratic infrastructure. For decades a number of these giants succeeded in buying countless name-brand firms and achieving the targeted cost reductions and revenue enhancements. Over time, the giants’ mergers became a cookie-cutter formula. These ever-growing organizations, whose mergers copied the over-priced valuations paid by competitors, led the corporate parents to become less productive and more wasteful. Their acquisition machines became static stocks in the market while they continued to gain market share. These acquiring corporations took it for granted that their giant firms’ huge resources and existing tailor-made customer base and their broad and deep current systems and business practices, would more efficiently exploit the brand-name equity value of the target firm. In theory, this strategy was reasonable. However, in fact, often the excessive acquisition price paid, the incompatibility of the giant firm’s distribution channels to those used by the target firm, or the giant’s organizational layers of bureaucracy led to underperformance by the acquired brand-name firm. An analysis of the major brandname acquirers demonstrates that while their market share dominance grew, their profitability and efficiency ratios gradually tended to erode.28 Newell Rubbermaid provides an example of nearly 30 years of virtually nonstop acquisitions (often in related product categories clustered around kitchen utensils, window dressings, and writing instruments) to be sold to Wal-Mart, Kmart, or Home Depot mass discounters, which Newell had targeted for its entire business career. This way,

2.22 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

Newell captured more shelf space for new name-brand product offerings for its corporate growth and became and remained the category managers for Wal-Mart and other giant discounters. The company’s standard mode of acquisition was to acquire famous brand-name firms at inexpensive prices when they were doing poorly and were badly managed. The company would immediately install new management, tighten financial systems, cut nonselling items, and push the newly acquired products through the same mass-discount clients. By not paying excess price premiums for these brand-name firm acquisitions and turning them around quickly, Newell was able to rank 24th in the entire S&P 500 for 10 years. This string of acquisition successes stopped when Newell finally bought Rubbermaid (a famous brand-name firm as large as Newell, but terribly managed) at an inflated price premium and spent three years turning it around. Once again, even the most successful firms doing multiple acquisitions of famous brandname firms at low or no premium prices for years will stumble and erode their value if they buy large, badly managed companies at premium prices that require long, intense merger integration work.29 FREE IP GIVEAWAYS IMPACT M&A GROWTH AND PRICE

A vitally important business strategy is that many companies give away a key initial IP, new technology, or a key trade secret in order to capture a wide range of customers early so they will buy that company’s future add-ons and later product developments. This initial product or service giveaway strategy has become standard practice in a number of industries: from free packs of cigarettes, free computer software, free mobile telephones, free new food products, free music CDs, free new financial services, and a year’s free rent for commercial real estate to no payments for a year on furniture. Many corporations’ global growth strategy is to lock in as many potential customers to their basic system, product, or technology as rapidly as possible, so that their company’s IP becomes the basic industry-wide standard from which all others must work. However, this giveaway strategy is expensive and risky. Dangerous financial consequences are inherent in adopting this free giveaway strategy, although it achieves the fastest possible global dissemination of a company’s key initial IP for both the first mover firm that pursues it and the competitors who imitate it. Free open source code computer operating systems have become one of the most interesting global competitive movements against Microsoft’s dominance of the computer operating system market. Open source code has been adopted by almost all major computer manufacturers (including IBM, Compaq, and so on) launching ongoing new product lines based on Linux, the free open source computer operating system whose continued development has been fueled by an army of volunteers and computer hackers along with serious firms who compete with Microsoft. Microsoft largely ignored Linux and its inroads into the market until May 2001, when it began a national campaign to vigorously warn firms using open source code operating systems and their open source code software derivatives that this could seriously threaten the patent protection and copyright protection of their own products, which could now be claimed to be open to public domain misappropriation. While Microsoft’s argument in favor of its own proprietary software systems is inevitably self-serving, it has pointed to a potentially serious business strategy issue that a number of firms may need to address. IBM

IMPACT OF RAPID TECHNOLOGICAL ADVANCE ON M&A VALUATIONS 2.23

immediately stated that its lawyers had carefully researched its adoption of open source code operating systems, but other firms may face risks. Free computers, free telephones, and free Internet service are only a few of the many major industry examples that are forcing the speed of change in corporate strategy worldwide and forcing investment bankers and corporate financial analysts to rethink their valuation models of many M&A transactions. For example, European analysts believe it was partly the rapid global growth in free Internet service providers and firms offering free phones or free computers to customers who contracted to watch ads that helped pressure AOL to sign its deal with Time Warner to add new media and information content to its basic $19.95 a month Internet subscribers, to prevent them from defecting. AOL’s soaring stock price was highly vulnerable to a sudden plunge from another key threat: cable TV regional monopolies like AT&T’s TCI and Media One or Time Warner. AOL lacked its own TV cable or other Internet distribution and might be held hostage by cable, phone, satellite, or wireless firms via extortionate price increases. Merging AOL with Time Warner not only solved these two key strategic threats of free Internet and cable hold-up, but also let AOL raise its monthly fee by over 10 percent to $21.95, added one million new subscribers in six months, locked in many long-term bundled advertising contracts across all its media and Internet services, and squeezed ad revenue from its many media and Internet equipment suppliers who had never advertised before.30 Offers of free Internet service and free phones continue, but AOL-TW’s bundling is more powerful. BUNDLING OF FREE IP ADD-ONS IMPACT M&A PRICES

Microsoft competitors view its many giveaways of new IP in its bundle of Internet offerings as the latest gambit in that company’s long-term market-dominance strategy of bundling giveaways to lock in each new generation of customers to its expanding range of software and closely interrelated products or services. Investment bankers have been forced to analyze the key threat of free bundled services and products in their valuations of mergers and acquisitions of stand alone companies that lack the deep pockets of financial giants. Microsoft’s new “.Net” giveaways and cheap bundles of software for Internet devices, Internet business services, TV cable set-top boxes, wireless phone software, or financial systems software are widely considered by investment bankers to impose a financial cap on the M&A price of other companies possessing new intellectual properties that compete in Microsoft’s ever-increasing space. The U.S. Justice Departments’ monopoly judgment against Microsoft did not prevent it from making billions of dollars of niche acquisitions in all kinds of Internet and cutting-edge businesses for new IP giveaways or bundles in each next-generation MS product. M&A experts cannot avoid factoring this free-bundling threat into their valuations of many firms. IMPACT OF RAPID TECHNOLOGICAL ADVANCE ON M&A VALUATIONS

This problem by no means rests exclusively with Microsoft Corporation. George Fisher, former CEO of Kodak and Motorola, warns, “Companies have to project out: ‘How will I be competitive in a world [in which] technology will be virtually free?’”31 The speed at which each new technology leapfrogs its predecessors, making them

2.24 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

obsolete, is the most crucial problem facing many corporations. More than 97 percent of the firms that originally entered these technology markets ultimately went out of business. What are the best competitive strategies and best M&A options for different companies to adopt when confronted with competitors willing to use industrial espionage? Especially in high-tech industries, this geometric rise in the power of new generations of technologies is matched by an almost equally dramatic decline in the price they can charge for many of their recent technologies. In 1997 Intel had 90 percent of the world microprocessor market. In 2001 Intel and AMD became locked in a brutal price war and high stakes technology innovation giveaway battle as they both continually launched newer, more powerful microprocessor and network devices at ever-lower competitive prices. What is perhaps not widely realized is that this current Intel versus AMD technology and price war was made possible by AMD’s becoming a “Virtual Gorilla” in the words of AMD’s CEO, Jerry Sanders.32 For four years, AMD made crucial strategic alliances with Intel’s enemies, Motorola and Fujitsu, to share technology and plants. Also, AMD made crucial acquisitions of firms to help it leapfrog Intel in crucial capabilities. Finally AMD was literally given a new $1 billion fabrication plant by the Government of Saxony in former East Germany to provide their highly educated workforce with cutting-edge technology jobs in the new AMD factory. One key result of this Intel versus AMD price and technology war of leap frog is that the profit margins of both firms will shrink significantly, and the market value of both firms may shrink as well, which could make it much more difficult and expensive for them to do the mergers and acquisitions they will need to do to keep up in this brutal battle. Another important fact is that the new molecular-level chemical research is creating breakthrough innovative circuits on the tiniest of scales. Their developers claim these tiny molecular circuits could take the place of large current microprocessors made of silicone, copper, gallium arcinide, or indinium, and in 2000 they publicized that they would have fully workable prototype models in less than four years. Once complete and ready for commercial production, these potent new molecular circuits could be made in small, inexpensive labs at a fraction of the cost of the current multibillion dollar fabrication plants that make microprocessors today. This could make many current plants obsolete. Rapid technological advance inevitably leads to a problem called stranded investment, in which new technology makes old investments obsolete. Literally hundreds of billions of dollars of stranded investments have been incurred over the last two decades in telecommunications, computers, electronic video devices, power plants, energy distribution systems, and biotechnology industries. Much of this may be a total write-off. Most companies must first spend huge amounts of money to develop intellectual properties; then more on plants and facilities to build, ship, market, and provide service and support for all the products based upon those intellectual properties—only to have those products made virtually worthless by the on-rush of technological advances. Investment bankers and corporate financial analysts today know they cannot afford to be oblivious to the brutal reality of rapid technological leapfrogging by innovation, which John Maynard Keynes called “gales of creative destruction.” To cope with this widespread problem, investment bankers doing mergers and acquisitions today have developed more sophisticated financial valuation modeling techniques in order to more accurately measure the useful life of each asset bought in a merger. These computerized

MERGER FAILURE IS THE NORM 2.25

simulations of multifactor valuations provide a step in the right direction, but are frequently proved wrong because key assumptions built into their models turn out to be rigid, static, or insufficiently realistic when confronted by actual corporations’ conditions in specific M&As. This M&A valuation problem is not easy because, as Business Week concluded, “High tech has its own inverted logic ever since the invention of the transistor at AT&T Bell Laboratories in 1948: Power goes up and prices come down in lock step. In the past few years, though cheap technology has crossed an invisible threshold to assume a central role in economies around the world.”33 This constant technology change is probably one of the most critical facts confronting investment bankers and corporate financial planners doing mergers and acquisitions, primarily of knowledge-based companies possessing various intellectual properties and intangible assets. Because of the digital revolution, speed of new telecommunications, and world economic power of the Internet we now have truly interdependent global markets and competitors. As a result, the inherent value of a corporation’s intellectual properties has vastly expanded to be exploited in almost every country. However, in valuing a merger or acquisition of that corporation, the investment banker must consider the huge scale of global piracy of all intellectual properties and the very high and prohibitive cost of protecting them.34 It is not sufficient or professionally realistic today to simply value the potential financial free cash flows that might be derived from the intangible assets, intellectual properties, and business model of the firm. Too many of these potential financial synergies forecast to be derived from hundreds of mergers fail to be achieved because of many hard realities of actually integrating two companies or theft, copying, or reverse engineering of technologies or IP assets by many aggressive competitors. MERGER FAILURE IS THE NORM

For over 50 years, there has been between a 70 and 80 percent rate of failure of mergers and acquisitions to pay back the money invested in them. Often they don’t achieve even the minimal hurdle rate of return that the investment bankers and corporate financial analysts forecast in advance. These high rates of merger failures have been measured using a range of different criteria by investment bankers, consulting firms, and professors. Overwhelmingly negative results remained consistent for that entire 50year period. For example, in 1999 KPMG International analyzed 700 of the most expensive deals from 1996 to 1998 and found that 83 percent failed to boost shareholder wealth—in fact, 53 percent reduced shareholder wealth.35 In 1999 Arthur Anderson Consulting analyzed all large mergers completed between 1994 and 1997 and found that 70 percent did not achieve the benefits they sought to accomplish.36 In 1999, Mark Sirower studied 100 large deals from 1994 to 1997 and found that two-thirds of the deals met with negative market reactions, and most remained underperformers a year later.37 In 1999 Right Management Consultants studied 179 mergers and found that less than one-third of the mergers had successfully combined cultures. In 1999, the Hay Group analyzed 65 mergers and found that 75 percent failed to place employees in the right roles in the first six months after merging. In 1998 Daimler-Benz studied cross-border business combinations and found

2.26 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

that 70 percent of all cross-borders mergers fail to thrive. In 1998, J.P. Morgan analyzed 116 acquisitions of more than $1 billion by European companies since 1985 and found that 44 percent added no value after three years.38 In 1998 A.T. Kearney studied 115 mergers from 1993 to 1996 and found that 58 percent did not add value. In 1996 Coopers & Lybrand studied 125 companies during their post-merger period and found that 66 percent were financially unsuccessful.39 In 1987 Michael Porter analyzed 3,788 acquisitions by 33 leading U.S. companies from 1950 to 1986 and found that acquired companies were divested at a rate that ranged from over 50 to 74 percent.40 In 1987 Mc Kinsey & Co studied 116 acquisitions and found that 77 percent did not cover the costs incurred in the deal.41 The former head of Lehman Brothers, Warren Hellman, stated, “So many mergers fail to deliver what they promise that there should be a presumption of failure. The burden of proof should be on showing that anything really good is likely to come out of one.”42 The latest tidal wave of merger activity is doing exactly what past tidal waves have done—hide the cold, hard reality that most mergers fail to achieve any real financial returns. The most commonly cited cause of M&A failure is the excessive control price premium paid by acquiring companies, which their future management efforts cannot earn back. Key reasons for paying excessive premiums center on their necessity to complete acquisitions, the synergies that the two combined companies can achieve together, the acquiring CEO’s ego, and the winner’s curse in M&A auction bidding that inflates the bidding price beyond its reasonable payback limit.43 A second cause of merger failure is that in 80 percent of all cases the managers failed to make post-merger integration plans for successful integration of the two former companies into one.44 Integration failure is often a direct result of management’s inability to execute the synergies assumed during the valuation process. Although often blamed for a lack of foresight after mergers fail, bankers argue that they base their synergistic forecasts on management’s projections. A third cause of merger failures is the lack of understanding of the acquired firm’s IP and intangible assets or their practical uses, growth potential, or inherent limits. Inflated pricing of the acquired firm’s IP and intangible assets is common. In-depth M&A planning is often difficult, because valuable IP and knowledge assets are hard for acquiring firms to grow, enhance, or retain. Despite the fact that each acquisition had originally passed many types of tests and financial forecasts, between 50 and 74 percent of corporate acquisitions often had to later be divested.45 Although a number of investment bankers blamed a firm’s poor merger integration or radically changed market circumstances, most professionals agreed that one of the key reasons for such high failure rates and divestitures was that overzealous bidders, or their investment bankers, had allowed an inflation of financial projections that it could never sustain for the merger. However, more in-depth and longer-term analyses of failed mergers showed that even when M&A price premiums were low, most corporations failed to fully exploit many of the intellectual properties or intangible assets in their acquired businesses because they often failed to test the future opportunities they held. They frequently divested these firms at bargain prices to specialists who profited. One such classic industry case involved the 1999–2000 bargain basement divestitures of many specialty chemical subsidiaries of petroleum or

IMPACT OF NEW INTERNET IPO MARKET ON M&A PRICES 2.27

large chemical companies who had acquired them and gone nowhere. In less than 18 months these specialty chemical companies were soaring in value, now owned by their prior managers who exploited the unique chemical technologies, know-how, and other intellectual properties that were unseen or not funded by their prior corporate parents’ chiefs. FAILED MERGER NEGOTIATIONS RISK IP LOSSES

Many announced mergers fail to be completed for a wide variety of reasons. It is important to remember that a large amount of vitally important secret proprietary information about each company is shared during the intense merger negotiation periods, as the two firms perform their due diligence investigations of the other firm prior to final merger. The vital information learned about the proposed merger partner company includes the way that firm researches, designs, and develops new products. That firm’s specific production processes, how it manages its procurement, designs its organizational systems, the production methods for its goods and services, how it controls quality, how it organizes its distribution, and how it manages its sales and foreign operations are often examined in detail by its potential merger partner. All of this constitutes the potential merger partner’s intangible assets or IP. Both firms originally signed explicit written confidentiality agreements to be shown or told all this secret proprietary information about the other firm; however, if that merger fails to be completed, all the secret information divulged in those merger negotiations is now in the heads of the entire team of that other firm’s negotiators. As a result, the very firm that would have been your partner now has a much stronger ability to compete against you once the merger has failed to be completed. This is because it understands more about your firm’s crucial IP and what the real range and depth of your intangible assets are. IMPACT OF NEW INTERNET IPO MARKET ON M&A PRICES

Another key factor in recent merger failures, even by giant corporations, was the high IPO price inflation. There was a huge value inflation in the past decade, which was a direct result of the decade-long bull market on Wall Street. In 1987, the idea of valuing a company at two times its yearly revenues was considered unrealistically high. By 2000, Wall Street firms were rating companies as a “strong buy” because their trading was at only 21 times the estimated revenue.46 What is most important to understand is that this inflation spread from many new Internet companies’ IPO stock prices, to overvaluation of the entire NASDAQ stock market, to the inflation in the pricing of most M&A transactions. Investment bankers often showed each client corporation lists of new Internet IPO valuations of recent high-priced merger transactions, and those of comparable companies, to justify recommending increasingly-inflated estimates for proposed M&A deals. As a result, the separate markets for IPOs and M&A deals had high inflation rates that were continually mutually reinforcing each other. While circular patterns of value inflation often occurred in the past, they never happened on such an enormous international scale, nor so fast, as today. Although each

2.28 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

market’s proponents attributed this equity value growth to a “virtuous circle,” critics derided it as simply a “vicious cycle” of excessive equity pricing. As soon as many Internet companies went public at highly inflated prices, they rushed to do mergers and acquisitions using their inflated stock as currency. The central point, however, was not just that their high IPO price made them willing to overpay in M&A deals, but that their need for growth and speed was so intense that companies looking to enter the market had to keep making larger deals in order to remain relevant. One part of this was simply an Internet land grab for growth in firm size. “The gorilla wins in every market,” stated Paul Deninger, CEO of Broadview International, summarizing accepted wisdom. Different competing technologies are all reaching critical mass. Each has its own IP roots, trunk, branches, and leaves of new products and services.47 However, the much more important driving force was the position of firms at critical juncture points, where key future business innovation must pass. This combination of the nonstop pace of deals, the explosion in deal size, and the compulsion to achieve breakthrough technological innovations was the hallmark of M&A momentum. TYPICAL M&A VALUATION PROBLEMS OF HIGH-TECHNOLOGY FIRMS

Because a majority of companies that completed M&A transactions in the last five years were high-technology firms, it is important to realize that the accounting measure of operating earnings for high-technology firms is skewed by the treatment of R&D expenses as operating expenses. According to valuation expert Aswath Damodaran, this understates operating earnings of the technology firms whose primary assets are intellectual properties and intangible assets. It also understates how much technology firms are reinvesting into assets, the free cash flow produced by many high-technology firms because of operating expenses, and the total capital invested in these high-technology firms due to lack of capitalization of R&D expenses.48 Investment bankers, who are aware of the accounting problem faced by hightechnology firms, make adjustments to the financials of merging firms in order to reverse the accounting treatment of R&D. A key question raised is whether R&D expenses for high-tech firms are really an operating expense or a capital expense. As Damodaran notes, accounting standards require us to consider R&D as an operating expense, even though it is designed to generate future growth and it is more logical to treat it as a capital expenditure. Investment banking valuation experts therefore engage in a series of assumptions that adjust the financials of a high-tech firm in order to capitalize its R&D. While there are significant justifications for criticizing many of our archaic accounting conventions, the result of investment bankers’ method of capitalizing the high-tech firms’ R&D is to add over a billion dollars a year as an upward adjustment to the operating income of a firm like Compaq Computer. When this same upward adjustment of the operating income is made to many of the high-tech firms engaged in merger transactions, it makes their performance look significantly more positive than they reportedly were and tends to justify paying a higher acquisition premium to acquire such firms. It enables the high-tech acquiring firm to view its own adjusted operating income in a much more positive light so that it can justify increasing its bid for a target company.49 Either way, this issue is fraught with valuation adjustments that

TYPICAL M&A VALUATION PROBLEMS OF HIGH-TECHNOLOGY FIRMS 2.29

in the name of clarity serve collectively to justify higher bids in M&A deals, which ultimately the combined companies usually are unable to pay off. These widespread practices of financial revaluation and incorrect valuation often impact the failure rate of mergers. Rampant M&A transactions occur among high-tech firms because technology innovations can create brand new products, improve existing product performance, or lower their costs. Many firms seek process innovations by M&A high-tech deals because they cut waste, skip intermediary stages, shrink time requirements, use new substitute materials, streamline production, innovate designs, and build worker team empowerment. The most successful firms, such as Microsoft, Oracle, GE, and Vodaphone-Mannesman, continually combine strategic M&A for technological product innovations, process innovations, and service innovations to create a virtuous circle. Each innovation sparks other innovations in a chain reaction not only at their firm, but also with their suppliers, customers, and allies. For 100 years, 3M Corporation continually improved upon these two parallel R&D innovation tracks in new products and new processes, and now they have become world leaders in what they call “the process of micro-replication.” It is clear that 3M’s new chief executive, who came from being one of the three CEO finalists at GE, is inculcating the highly successful GE process of extending the virtuous circle of innovation beyond 3M itself to interrelate closely with innovations by its suppliers and customers. While successful mergers by firms to acquire ever-newer technologies have often been led by a stellar company which became the standard, the glaring fact is that the majority of high-tech firms acquired went bankrupt. Whether bought by non-high-tech firms or by significantly different technology firms, most have destroyed huge amounts of shareholder value. This is partly because so many firms are pouring investments into a wide range of competing high-technology firms that it is physically impossible for more than a few to become the generally accepted standard technologies of their specific sector. The “winner-take-all” pattern of single technological dominance in a sector has been repeated frequently. This has often led to a herd instinct among many firms who invested simultaneously in multiple competing technologies so they would not be excluded from the single winning standard that ultimately prevailed. These multiple follow-the-leader patterns result in excessive funding of many competing technologies that for the most part become stranded investments, when only one definitive technology becomes the standard that most complementary product firms decide they must adopt in order to ensure their own company’s survival and success. In this century there has been a dramatic transformation in what economists call the production functions of companies—the major assets that create value and growth.50 Intangibles are fast becoming substitutes for physical assets. John Kendrick, a wellknown economist who has studied the main drivers of economic growth, reports that there has been a general increase in intangible assets contributing to U.S. economic growth since the early 1900s. In 1929, the ratio of intangible business capital to tangible business capital was 30 percent to 70 percent. In 1990, that ratio was 63 percent to 37 percent.51 Today, more than 70 percent of U.S. growth is contributed by intangible assets, versus less than 30 percent that is contributed by tangible assets. For the sake of clarity, we will distinguish between intangible assets and IP, but in reality they frequently go together. While IP is generally legally considered to include patents, trademarks,

2.30 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

copyrights, trade secrets, know-how, new business processes, new technology, and customer lists; intangible assets are said to be corporate reputation, worker loyalty, and organizational designs and systems. NYU Stern Business School professor Baruch Lev has gathered intangible capital together, including both IP and intangible assets. He groups them into four categories: “First are assets that are associated with product innovation, such as those that come from a company’s R&D efforts? Second, assets that are associated with a company’s brand, which let a company sell its products or services at a higher price than its competitors. Third are structural assets — not flashy innovations or new inventions but better, smarter, different ways of doing business that can set a company apart from its competitors. And forth are monopolies: companies that enjoy a franchise, or have substantial sunk costs that a competitor would have to match, or have a barrier to entry that it can use to its advantage.”52 Professor Lev provides a very useful example of the value of intangible assets. AMR Corp owns American Airlines and most of the SABRE computer reservation system. Whereas American is one of the largest airlines in the world, with roughly 700 jets in its fleet, nearly 100,000 employees, and exclusive and valuable landing rights in the world’s most heavily trafficked airports. On the other hand you have SABRE a computer reservation system. How can a computer reservation system be as valuable as all the remainder of American Airlines’ assets? The reason is that when dealing with tangible assets, your ability to leverage them—to get additional business out of them—is limited. You can’t use the same airplane on five different routes at the same time. You can’t put the same crew on five different routes at the same time. And the same goes for the financial investment that you’ve made in the airplane. But there’s no limit to the number of people who can use AMR Corp.’s SABRE system at once: it works as well with 1, 5 or 10 million people. The only limit to your ability to leverage a knowledge asset is the size of the market. Economists call physical assets ‘rival assets’ meaning that users act as rivals for the specific use of an asset. With an airplane, you’ve got to decide which route it’s going to take. But knowledge assets aren’t rivals. Choosing isn’t necessary. You can apply them in more than one place at the same time. With many knowledge assets, the more areas you apply them the greater your return. This is because, with many knowledge assets, you get what economists call ‘increasing returns to scale.’ These ‘increasing returns to scale’ on a firm’s IP fixed cost network like the Saber system, works as well with 1, 5, 10 million customers, which is crucial to the financial power of IP and intangible assets. The larger the network of users is, the greater the benefit everyone gets from using it (to everyone using it, and the greater value it has as a whole). Knowledge assets are very expensive to acquire, to develop and extremely difficult to manage. For example, it is important to consider the extremely high prices that high-tech companies are paying to acquire smaller companies, as they look for knowledge assets that they can leverage. November 1, 1999, Cisco announced that it had acquired Cerent Corp. for $6.9 billion, yet, for the first six months of 1999, Cerent’s sales totaled roughly $10 million. That’s what it can cost to acquire a knowledge asset. The cost to develop a new pharmaceutical is $500 million. Finally, America Online spent nearly $1.5 billion on customer acquisition when it was creating its franchise. That’s what it can cost to create a high barrier to entry. There’s another downside of knowledge assets: Property rights are fuzzy. When it comes to a

M&A VALUATION OF IP

2.31

tangible asset, such as an airplane, American Airlines doesn’t have to worry much about ownership. No one is going to steal an airplane. But American Airlines definitely has to worry about someone stealing Saber System’s [computerized software yield management models for maximizing total profit from every passenger seat and every square foot of cargo space.] The proliferation of thousands upon thousands of very costly patent-infringement lawsuits attests to the difficulty of defining and keeping property rights when you’re dealing with knowledge assets of companies. And while the benefits that come with knowledge assets can be enormous, they are much more uncertain than the benefits of tangible assets. When you invest in tangible assets such as an office building you almost always can get some return. But when you’re building knowledge assets you could quite possibly wind up with nothing.53 M&A VALUATION OF IP COMBINES INVESTMENT BANKING WITH STRATEGY CONSULTING

By 1975, investment bankers and strategy consultants involved in mergers and acquisitions were developing new methodologies to value intellectual properties. Whereas traditional financial valuation models, including Damodaran’s, assumed that the financial value of a patent ended with its expiration date, because competitors rushed in to compete away any excess profits, strategy consultants tracked the lowered, but continued, superior profit margin earned by certain original patented products after expiration because of their brand-name recognition and loyal customers. Two intellectual properties, the patent and brand-name, could be combined to extend the original patent value. Strategy consultants have learned to integrate the original patent-protected monopoly earnings and the later residual earnings from loyal customers after patent expiration with their analysis of patterns of continual cost reductions from economies of scale and experience curve effects to model the range of comparative profit margins achievable by different direct competitors in each market during each year. (However, some strategy consultants and investment bankers doing M&A valuations at that time did not realize that if brand-name was built into the growth rate of the firm’s Cash Flow estimation, they might well be double counting it.) By the 1980s, investment bankers and corporate strategy analysts became more aware of the wide variance in total earnings projections, or rates of return, caused by different rigid valuation models because they could only be as good as the basic assumptions on which they were calculated. Thus, if one or two key assumptions in the original model were incorrect, the financial valuation of a patented product’s future earnings and future growth rate would be way off the mark. For example, new competitors using more advanced technology would not be on the same experience curve of cost reductions as the largest producer or original patent holder, but might suddenly achieve dramatically cheaper production than did the market share leader or original patent holder. Each year as certain new technology leapfrogged old, the useful life and forecasted financial value from many past patents were suddenly cut short. As a result, a wide variance of technology forecasts and other critical factors forced the creation of multiple scenarios with differing assumptions behind each separate valuation model. By 1990, simple multiple-scenario financial forecasting of best case, average, and worst case in M&A valuations became normal for investment bankers and corporate

2.32 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

financial analysts. Many key problems still remained with these supposedly more sophisticated financial valuation models, however. This was because many of the most powerful growth companies are driven today by the knowledge assets inside their key employees, their know-how, commitment to quality, systems of teamwork, human incentives, social architecture (as GE calls it) or social capital. The knowledge assets of today’s firms, such as eBay, are often structured using new virtual business models, which dramatically leveraged the value and growth rate of firms’ total intangible assets (including their corporate reputation) by outsourcing most of their basic functions. No typical financial valuation model was capable of accurately estimating the inherent value of these knowledge assets inside the employees of these growth companies, such as Nokia, the key to their innovativeness, or the social capital of their methods of teamwork that added significant productivity enhancements each year to their specialized businesses, such as Southwest Airlines. A crucial fact that was not realized in standard financial valuation was that these knowledge assets and the social capital embedded in new methods of teamwork appear as less costs in year cash flow projections, but somehow these intangible assets are capable of generating huge growth in a firm’s income. Although traditional financial valuation experts sought to focus solely on discounted cash flows of the business, they kept running against a wall; many, if not most, of the core assets in today’s M&A deals were not on the balance sheet or the income statement, or accurately measured in past or current cash flows, but existed only in projections, estimations, or forecasts of future cash flows. These forecasts, estimations, and projections were simultaneously contingent on a range of future events, new technology breakthroughs, new business model patents, or collateral developments in several new industries and the timing of regional or foreign national adoption. A new valuation process required a number of innovative types of business development assumptions. The problem of the new valuation process is two-sided because it requires crucial changes in accounting and finance. Accounting faces the most glaring transformation because it has resisted the changes in our 500-year-old financial accounting rules, terms, practices, and procedures for decades. Most importantly, it needs a new focus on what is truly important for accountants to measure, because these knowledge assets— not book value, fixed assets, depreciations, amortization, and so on—were the key drivers of the financial value of firms. Until the recent work of Baruch Lev and his accounting institute, there was no clear understanding of the nature and depth of the problem that the accounting profession faced in regaining its relevance.54 Even today, few accountants make the first steps to try to understand knowledge assets and intangible resources and why these are powerful creators of financial value in firms but very easily evaporate in M&A transactions. The other side of the valuation problem lies in the often rigid, limited, or traditional valuation practices and metrics that investment banks believe their corporate M&A clients expect to see or are capable of understanding. It is not unusual for new MBA and Ph.D. graduates who have been trained in the latest financial analysis tools to enter the M&A department at an investment bank and find their analysis of M&A deals is often strictly limited to “crunching numbers” for iterations of discounted cash flow analysis, comparable companies, or comparable transactions analysis. Most of their indepth work in business schools into the more sophisticated financial analysis of real

EXAMPLE OF A MERGER VALUATION OF IP IN AN ACTUAL TRANSACTION 2.33

options—for valuing patents on biotech genomic breakthrough drugs, new business models, new technologies, or copyrights on innovative software—is rarely put to use in the M&A department’s continual rush to complete each new deal. At certain strategy consulting firms (McKinsey, Booze Allen, Ernst & Young, Cap Gemini), cutting-edge valuation boutiques (Intellectual Capital), and Valuation Services at AUS Consulting, more interest is shown in exploring innovative valuations of social capital and knowledge assets and combinations of intangible resources in the multiplication of firm value. However, a need for far more significant development work on innovative valuation methods still exists, especially for understanding the dynamics of rapidly evolving new business models and the growth of the multiplier effects of intangible assets in firms. EXAMPLE OF A MERGER VALUATION OF IP IN AN ACTUAL TRANSACTION

A major U.S. investment bank was appointed by a major European health care corporation to assist the company in the sale of one of its divisions, which is a leading European medical device company. The division is an autonomous unit that is not very integrated with the rest of the corporate medical device company, thus causing a conglomerate discount on the corporation’s overall stock price. The main objective of the divestiture is to unlock the IP value of the core business. Another goal of the company may be to capture some of the synergies that the next owner may gain in this acquisition.55 In this European firm, the R&D investments and potential for IP breakthroughs are the key drivers of its financial valuation’s rapid growth. A wide range of possible values exist for this firm, however. The investment bank valued the company to be only between 275 to 320 million euros on a standalone basis. In an auction transaction to European corporate bidders, the company’s potential value rose to between 320 and 375 million euros. Yet, the highest financial valuation possible, the investment bank said, would result only if that very same European company were sold at a global auction to one of the three most powerful U.S. medical devices firms willing to pay a price over 500 million euros. However, the corporate board felt pressed to forego this highest financial value achievable for fear of jeopardizing its corporate reputation by selling to a U.S. firm that would seek to close key EU plants. The European company is a leading cardiovascular device manufacturer with R&D, brand franchise, manufacturing plants, sales force, and market position as its main assets. The company is known for its technology, breadth of product range, and reliability. Although a small player compared to its peers, the company has consistently passed its competitors in achieving key milestones in the industry. This success is due, among other things, to its clinical research program and excellent relationships with physicians in the major markets around the world. Furthermore, this is the only company in the industry that has never faced a recall, which is important to value assessment in this industry because of the outstanding litigation issues. The company’s weaknesses are derived from its past poor performance. As is typical, at least in Europe, because this company division belonged to a wealthy corporation, it had poor procedures for requiring its profitability independent of the corporation’s. During the last two years, the corporate parent had also been spending heavily on this company’s sales network, which prevented the company from showing good financial results. The company expects to boost the firm’s total sales by leveraging

2.34 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

the productivity of the sales representatives hired. It normally takes two years in this particular sector of the medical devices market before a new salesperson is considered totally trained and fully productive. VALUATION: TO BELIEVE OR NOT TO BELIEVE

Investment bankers’ valuation of the intellectual capital of this company for its acquisition, as in many startups, is based not as much on the scientists or their technology as on the experience and industry credibility of the management. Will the management be able to maintain the timing and high quality product introductions it has demonstrated in the past? Clearly, when looking at the past results to extrapolate in the future, no investment banker could find any source of value from the company’s bottom line figures for the last five years. Instead, they had to look for another source of value. To do so, they first performed an in-depth evaluation of the cardiovascular medical devices industry landscape. They next assessed the company management’s business plan against its competitors in both its top line sales and cost structure. From this information, the investment bankers derived a detailed three-year forecast of the company’s future performance, plus a seven-year projection. In a detailed valuation such as this one, it is required to consider the market size and market growth rate for each of the countries in which that company operates. The base reference point for the investment bankers was the current sales by each firm in each national market for cardiovascular devices. The next step was to study the strategic advantage of each competitor, their current market share and growth forecast in terms of units to be sold and potential prices to be charged in each region for the years of the projection. For competitive advantages in a high growth sector, it is relevant to measure the firepower of the company’s R&D in terms of its capacity to generate a continuous flow of products ahead of the general trends and before its competitors. It was also necessary, however, to estimate the current pipeline of the company’s new cardiovascular devices that would likely result from all past efforts, and the time spent to fully implement and produce the projected range of anticipated products. In the valuation, relationships with the many heart disease specialists were crucial in the speed with which the company could obtain the license to introduce a product in the regulated areas: the United States, European Union, and Japan. The company had been consistently able to implement the new findings from its R&D research into the old products by leveraging the tool’s original investment for as long as three years for its line of products. At that point, a new platform was built from scratch to enable the company’s base to grow successfully the next few years. Growth was planned to be leveraged by outsourcing noncore production. But what growth rate was most likely? Because of growing competitive intensity in cardiovascular medical devices, each company’s base cost structure in this sector would be its most vital competitive tool. This was because the products became so quickly commoditized that the capacity to squeeze every cost, compress each stage of production, and shrink needed materials to achieve higher productivity became critical for survival.

VALUATION: TO BELIEVE OR NOT TO BELIEVE 2.35

Finally, the investment bank’s valuation analysis included a systematic assessment of potential technologies that could eventually substitute or complement/bundle a product from one industry to another. In this case, the cardiovascular drugs represented a weak threat to the medical device industry because of the side effects in their treatment of the same heart problems. On the other hand, some complementary medical device products existed that could impact the company’s overall revenue line. After their preliminary valuation analysis and due diligence, the investment bankers determined that, on the one hand, this company’s management had been conservative in its assessment of the growth of market, new products, and complementary products and the price and projection of its profit. On the other hand, the company had been aggressive in its estimation of its U.S. penetration, sales for the year 2000, cost structure and containment, projected market share growth, and the weak competitors’ reaction. Before the investment bankers could begin to project the quarter-by-quarter product introductions, they had to visit the factory and R&D facilities and get to know their respective managers to be sure that the managers would be capable of reaching their projected target milestones and deadline timetables. After visiting the company’s facilities, the investment bank, valuing the firm for its merger or acquisition auction, decided to introduce more realistic assumptions about all the aggressive issues. Overall, however, the investment bank gave credit to the company’s R&D capability of rolling out a series of new products. This would provide most of the company’s financial value. The acquisition bidders, who receive the investment bank’s Information Memorandum, prepared for the company’s valuation in its acquisition auction, typically do not have access to all the detailed information the bank gathered to back up numbers, especially if the key value driver is intangible. As a result, the bidding firms and their bankers must carefully estimate what they believe the target firm’s IP and intangible assets are truly worth to their corporations (including all real or imagined synergies) and decide what price to offer. The value of the firm’s intellectual capital is most significantly impacted by proof of its legal right to the patents for various cardiovascular devices. The legal legitimacy of the patents and the number of national jurisdictions in which the patents are legally upheld and can be judicially protected, is the single most important and relevant factor that could erode the value of the company. The number and quality of cross-licensing agreements and the relevance of pending lawsuits against competitors are used in this industry as strategic weapons to increase a firm’s bargaining power in similar situations. In the medical device industry, product prices of companies erode quickly because of the high degree of intense competition. Sources of growth in value, therefore, can often result from the range of new, rapidly launched, closely related products that this company is able to introduce to the market in a relatively short and definite time. If the product is deemed unique, rare, or in hot demand, another potential source of growth can come from the company’s ability to raise its prices. To a large degree, both of these key potential means of enhancing the company’s value are derived directly from its capacity of key innovations from the R&D department. The race to develop new medical devices is so rapid in this industry, however, that companies that can’t innovate fast enough by themselves are forced to introduce small variations of the market leader’s products. This immediately triggers the legal machinery

2.36 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

that all the companies have in place. Because no company can innovate everything by itself, all the companies eventually copy something from the others. As a result, all the companies have actual or potential legal issues, as well as cross-licensing agreements in a number of cases, against each other. Although some court decisions are finally reached in these patent battle zones, most of the time, the pending legal actions are used to force bargaining compensations from the patent-infringing parties because of the sluggish nature of the judicial system and complexity of the cases. For example, in the case of an acquisition, where the target had a cross-licensing agreement in place with one of the acquirer’s competitors, it was necessary to negotiate compensation in order to enable the competitor to use the technology it had cross-licensed. In such merger crises, all the pending legal issues with many companies would be laid out for settlement. Otherwise, the merger or acquisition would be illegal or would fail to close. Each competitor bidding to capture the company’s valuable IP has knowledge about the product’s introductory track record and its own perception of the credibility of the investment bank backing the projected financial numbers of the company’s product for three to seven years. The value of the intellectual capital, therefore, partly reflected in all these factors, not just in the sales or profit forecast relative to various competitors’ forecasts. Yet, other factors affected the valuation of the European company. These factors included the company’s WACC, taxes and tax credits, and range of synergies that the bidders, currently competitors of this company, would expect to derive from combining its resources with their own. In the end, however, the investment bankers invited the giant U.S. firms into the first round of bidding with the European firms in an attempt to raise the auction bids significantly but not truly maximize the final acquisition price. This forced the European firms to bid higher than they would have if no U.S. firms had been invited. In the final round of bidding, however, the parent corporation of the division being auctioned feared that the giant U.S. bidders would try to close the European plants and operating facilities if they won. That situation, the parent feared, could very seriously damage this corporation’s solid, long-standing reputation in various European countries. The parent company did not want to risk this reputation, so did not include the U.S. firms in the final round of bidding and chose to accept a lower selling price than it could have received for the subsidiary. Had this been a U.S. corporation selling its subsidiary, it probably would not have restricted itself to prevent the highest bidders from the final round, nor would it have decided to accept a less than maximum sale price. The European firm decided not to take another step that a United States firm would probably have taken to retain a carried interest in the medical device subsidiary. This carried interest could take the form of payments if the firm hit future earning targets or could require a percentage payment of a later sale price if this subsidiary was flipped or sold to a different buyer within the next three years. Noticeably, the European M&A negotiations are far more likely to be influenced by the stake holder interests of workers, job security, local communities the firm impacts, or local governments than would M&A auctions originated in the United States for an equivalent business. Although this type of practice is contrary to what many U.S. financial professionals believe management’s fiduciary duty to its shareholders is, it is common in Europe.

MODELS OF INTELLECTUAL PROPERTY FIRMS 2.37 MODELS OF INTELLECTUAL PROPERTY FIRMS: INCESTUOUS FAMILY, NETWORK ALLIANCES, WINNER TAKE ALL, A WHEEL OF FORTUNE

There is an important relationship between the explosive growth of many intellectual properties and the proliferation of new businesses by entrepreneurs working with their financial backers and mergers and acquisition dealmakers. This clustering of innovators with their financiers is a common pattern in the economic history of the fastest growing industrial regions of many countries. My father’s research (1928–1952) traced this crucial pattern of family and social networks of simultaneous technological and capital accumulation in various nations. The clearly linked development of various specific intellectual properties in new technologies for the growth paths of new business models required the critical mass of science, technical, and financial expertise in one place in one period. For example, key high-tech centers grew over the last 30 years in Silicone Valley, California, Route 128 around Boston, the Internet center in Northern Virginia, Triangle Park, North Carolina, and Silicone Alley in New York City. These tightly knit creative regions’ explosive growth stemmed not from new IP but from innovators all learning from each other during the continual interaction in family networks of new businesses in those regions. This phenomenon is sometimes termed the “agglomeration effect” and has been studied for decades by business historians, anthropologists, sociologists, and technology experts. In the case of Silicone Valley in California, the way that the creative technology IP innovators joined with new venture capital groups and startup investment banks of San Francisco like Hambrect & Quist has become a legendary case study. This incestuous extended family relationship between inventors, who create new intellectual properties, and their entrepreneurial financial backers and mergers and acquisition advisors acted as the lightning rod that sparked networks of innovations. What outsiders often did not realize, but insiders knew all too well, was that the first successful inventors and their entrepreneurs became the key advisors, mentors, board members, and vital angel investors in most second generation clusters of new innovative companies. In short, a chain reaction of new intellectual properties development and spinoff expansions came from these creative new business experiments of scientists and their financial backers, often feeding off of one another’s breakthrough ideas. In fact, by adding layer upon layer of new technologies and financing structures, those teams kept the IP chain reactions moving forward. It is important to recognize the extended family IP links and intergenerational pass-along roles that these scientific–business partnerships played in developing new industries such as transistors, microprocessors, personal computers, cellular and wireless phones, the Internet, and key biotechnology industries. Two key examples will help illustrate this network effect between the scientific innovators and the financial architects of the new industries. In case after case of business innovations, the old riddle comes up: Which came first, the chicken or the egg? When America Online pioneered highly user-friendly Internet connectivity from its primitive startup in Northern Virginia, it launched a new cottage industry of Internet firms based there. Within three years, Fortune Magazine provided a map of new online companies in the region and the “incestuous relations” among the founders and financial backers of all these pioneers. The same phenomenon took place with the key scientists

2.38 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

and financial backers who founded Digital Equipment Corporation, Wang and its offspring near Boston, and Texas Instruments and its offspring in Austin, Texas. In the North Midwest region, National Semiconductor, Control Data, Cray Research, and others joined. Likewise, the IP development via a clearly linked heritage from Xerox Park, Apple, Microsoft, Oracle, Silicone Graphics, Netscape, Cisco Systems, and Amazon.com from Northern California to Seattle, Washington, has by now, become legendary. Countless biotechnology companies have also clustered geographically. In an extraordinarily large number of cases, the first successful entrepreneurs not only helped fund the next generation with angel investing, but also helped arrange for their own firms’ original venture capital firms to do several rounds of private financing or mezzanine capital. These same successful biotech pioneers then took those new firms to their own investment bankers to either do initial public offerings or arrange for pre-IPO acquisitions of the private companies. Business historians, economic historians, growth economists, and business strategists have explored several classic models of dynamic explosive business growth periods linked to various scientific and technological pioneering developments and their networks of financial backers. By providing live, real-time, and continual global linkages, today’s Internet is exploding the number of these creative relationships between clusters of businesses based upon innovative intellectual properties and their inventors, entrepreneurs, and financiers. Japan’s “Softbank” has been the godfather of new ventures clusters’ rounds of financing and its M&A transactions in the United States, Asia, and Europe. DIVESTITURES VERSUS ACQUISITIONS SIGNAL THE DRIVING ROLE OF IP IN TODAY’S BUSINESSES

Divestitures, according to a McKinsey and Company study, comprised 40 to 50 percent of all M&A corporate financial transactions for two decades.56 A central part of the global merger waves of the past 40 years has been the divestitures of unrelated businesses. Since the 1960s, financial experts have pointed at thousands of divested firms as examples of conglomerate corporations selling off their numerous unrelated businesses. However, when lists of all the companies divested are compared to the core business of all those companies acquired, it is clear that the majority of those sold off tend to lack unique intellectual properties, intangible assets, and knowledge assets. In short, the core businesses of a majority of firms acquired were purchased because they possessed these unique, rare, or higher value-producing assets. Many corporations have sold off divisions and companies whose lack of high-value intellectual properties made them appear as not only having lower long-term potential ROI for the corporation, but also financially draining the other high-potential IP businesses the firm retained. The familiar pattern of firms making an acquisition and then divesting those noncore businesses has repeatedly demonstrated the shedding of the bland commodity-type businesses that lack unique brand equity value, strong patent portfolios, and valuable trade secrets, or which have only outmoded technology. Wheel of Fortune. In contrast to these wholesale divestitures, the patterns of mergers and acquisitions of IP firms repeatedly shows that they are often bought not only in

AICPA ACCOUNTING RULE CHANGES 2.39

focused clusters, but also as the central core assets of corporations, from which other key business functions are linked specifically to exploit that core. In its cover story, “Wheel of Fortune,” Economist Magazine stated, “Intellectual Properties form the hub of a giant global Wheel of Fortune of the New Business Model in today’s Entertainment Industry.” From that central IP hub extend ever-increasing numbers of new spokes of the entertainment distribution channels and subsector technological innovations wheel, which multiply the value of IP content into a universe of new media. A very similar M&A pattern of purchasing biotech and new breakthrough medical device firms as IP core assets can be seen in the rapid growth of giant pharmaceutical and healthcare firms. Among communications companies, the acquisition of firms doing most advanced transmission development with different colored light waves, optics, and new materials form the IP core of technology pioneers. AICPA ACCOUNTING RULE CHANGES IMPACT MERGER AND ACQUISITION TRANSACTIONS AND VALUATIONS

Despite the importance in M&A of buying firms with the most valuable intellectual properties because they can produce the most sustainable profits over time, tax law was another critical driver of many deals. Hundreds of billions of dollars of U.S. M&A deals from 1998 to 2001 were quickly completed to take full advantage of the pooling of interest accounting method for mergers and acquisitions before it was phased out. This rush was due to the fact that pooling of interest accounting for M&A deals enabled firms to avoid dragging down their yearly earnings by recording goodwill (the excess dollar value of their buyout price above the book value of the target company) in their public accounting statements for up to 40 years, which the traditional purchase accounting method for mergers and acquisitions set by the AICPA would have required. Although the Accounting Standards Board has adopted new rules that will end pooling of interest accounting, the AICPA was ultimately persuaded, after intense lobbying by investment banks and many corporations, to create new and very flexible accounting rules to permit firms to continue mergers and acquisitions without huge goodwill amortization writeoff costs each year. Although the final details of the new rules have yet to be worked out, firms will have the flexibility to determine when their goodwill is impaired and to amortize it at that time if the need is clear and obvious. This essentially means that firms can keep goodwill on their books, but need to amortize it only when the assets related to that goodwill are impaired. Intangible assets—such as patents that have a fixed useful life until their ultimate expiration date—would be amortized over the remaining years of each patent’s life. Traditional goodwill such as brandnames and strong firm reputation would not have to be amortized or written down in a yearly charge against the firm’s earnings. The new accounting rules, although substantial, should have no effect on the actual valuations of firms. Because the changes are only in accounting on paper, they will have no effect on a company’s cash flows. It is not certain, however, as to how the market will react to the new rules. In past M&A deals, the value paid above the book value of the firm has been split into three separate accounts: In-Process R&D, Identified Intangible Assets, and Goodwill. The percentage breakdown among the three accounts was, as one M&A banker

2.40 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

said, “like putting your finger in the wind.” The arbitrary allocation of these expenses has led to no uniform standard across the market or within industries. Because InProcess R&D and Identified Intangible Assets can be immediately written off, most companies try to allocate as much as possible to these accounts rather than submit to the resulting drag on earning of goodwill amortization. With the new standards, there will be tiny amortization of goodwill and, as a result, tiny effect on earnings. Firms with large amounts of goodwill, then, will at times realize substantial increases in earnings. This is when the dilemma arises: If reported earnings increase, shouldn’t the value of the company also increase? The professionals answer no. The problem is that the increase in earnings will have an immediate effect on a company’s P/E ratio. Because many industries such as health care trade directly on metrics such as P/E, it has not been determined if the market will immediately adjust for the changes. Although most people realize that no fundamental change will be made to the company’s value, some analysts still think there could be a price effect in the market. Merrill Lynch analyst Phua Young wrote about Tyco shares, which had earnings of $2.70 before the proposed change and $3.00 after: “In our view, the shares of Tyco International were inexpensive before the proposal. However, the FASB would make the shares even more attractive.” This sentiment assumes the market perception is more relevant than reality. Another analyst, UBS Warburg’s chief strategist Edward Kerchner, wrote in a report outlining companies that would most benefit from the rule change: “In theory there is no economic impact. But, certainly on the margins, this has to make some stocks look more attractive.” At this point, the probable reaction of the market has not been determined. BEFORE THE LONG-TERM CHANGE IN POOLING ACCOUNTING RULES

One key factor spurring the growth in the total merger volume and dollar value in the 1990s was the use of the pooling of interest method of accounting for mergers. This was because the pooling of interests permitted merging companies to simply combine the two companies’ total assets without being required to amortize, or writeoff, the goodwill or excess of the high merger deal price premium above the target firm’s accounting book value. The pooling of interest method gave acquiring firms a perceived benefit of no goodwill. In the majority of cases involving high-tech firms, the key resource was the IP and intangible assets they had created, innovated, broadly developed, or uniquely marketed. In fact, most joint ventures, strategic alliances, and mergers and acquisitions now hinge on obtaining access to the intellectual properties and intangible assets owned by other companies. Correctly valuing those intellectual properties is now a vital task of investment bankers. This was not usually the case. For decades, the acquiring company in most merger and acquisition transactions lumped together all the intellectual properties of the acquired company in one amorphous, undifferentiated combination, which was listed in the financial documents as goodwill according to United States accounting rules. Less than 20 years ago, many companies thought of most of their IP as a costly writeoff expense. At the same time, investment bankers valuing a merger often valued their client firms’ patents, trademarks, copyrights, ancillary rights, and potential for exploiting all other media rights as a pittance. Their IP valuation numbers were virtualy picked out of the air.

RANGES OF INTELLECTUAL PROPERTY FINANCIAL VALUATION 2.41

Today, most advanced investment bankers and strategy consultants involved in mergers and acquisitions treat IP very differently because they realize that these intangible assets and intellectual properties are often a fast-growth firm’s most unique, vital, and valuable assets. IP and intangible assets are valuable because they often allow firms to create rare or difficult-to-duplicate products or services. Key intellectual properties often provide sustainable competitive advantage such as high margins lasting over a decade or more to companies that own them. Firms that lack unique IP often sell only commodity products at razor-thin margins and compete in continual price wars. While most experts who analyze these values call them IP or intangible assets, others now call them knowledge assets or intellectual capital. The range of terms for these valuable intangibles proliferate as experts explore deeper into new business models demonstrating new potential for generating economic power and future wealth that traditional business assets do not. Although most valuation experts often use various financial theories of discounted future cash flows, some will now use the Black Scholes options theory, real options theory, or new valuation tools, as well, for measuring knowledge assets, knowledge earning, or intellectual capital that are not based on traditional accounting measurements. Merger analysts have developed an elaborate series of new valuation models for assessing each of the different intellectual properties of target firms for acquisitions, joint venture partners, or strategic alliances separately. Before the transaction, investment bankers use valuation models to perform a strategic audit of a firm’s various intellectual properties and intangible assets. Bankers and analysts are now able to better measure the dollar value of each patent, trademark, or copyright in each separate existing or potential market distribution channel. For example, Intellectual Capital in California and the Marketing Corporation of America in Connecticut work with hundreds of corporations and investment banks to create equity-valuation model grids, in which firms and bankers are provided the ability to compartmentalize, into a matrix of up to 200+ cells, elaborate cross-referenced valuations of each IP’s potential future worth, and discounted present value in dozens of distribution channels. Moreover, detailed market survey research and multiple-scenario financial models back these equity-valuation grids. Equity-valuation grids and other new financial and strategic tools help give investment banks the ability to analyze the combined value of several patents, trademarks, or copyrights owned by a target company. When three potential corporate acquirers examine a target company with the intent of capturing its various intellectual properties, investment banks and strategy consultants can provide a thoroughly documented range of valuations representing three or more potential scenarios. In short, investment bankers and analysts can provide pricing or auction bidding models that forecast future years’ net income streams and future cash flow projections for the different values for each corporate acquirer. RANGES OF INTELLECTUAL PROPERTY FINANCIAL VALUATION

A wide range often exists in the financial valuation of the same intellectual properties or collection of intangible assets. This is largely because many IP-centric companies have no sales or production facility but only a patent, trademark, or copyright with

2.42 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

potential for future income when compared to when those intellectual properties are owned by a functioning company with a record of sales, profit, and cash flow. In fact, a wide spectrum of quite different valuations exists, which investment bankers, venture capital firms, mezzanine capital firms, and providers of seed capital would attribute to the same intellectual properties. That valuation spectrum encompasses the following: • • • •

Totally untested patent stage held by one independent inventor Fully tested prototype product Fully developed production process for the one product Fully developed production-distribution-marketing process for various products stemming from the original patent held by a fledgling company, which has sales but is not yet returning a profit • Company with one to five years of profit earnings and actual cash flows • Well-known product with brand recognition Not all companies followed this traditional valuation spectrum step-by-step from fledgling start-up to major company. In 2000, many financial experts concluded that technology stocks accounted for a larger percent of the market capitalization of all stocks than ever, mirroring the increasing importance of technology in the economy. Aswath Damodaran went so far as to admit in his book, The Dark Side of Valuation, that as more and more technology firms became listed on financial markets, often at very early stages of their life cycles, traditional valuation methods and metrics often seemed ill suited to them. Damodaran also noted that although more profitable firms tend to be more highly valued than less profitable ones, this proposition had seemed to be turned on its head concerning new technology and Internet firms from 1997 to 2000. Although the Internet firms’ valuation bubble was said to have burst by 2001, the valuations of new technology companies, is significantly higher than traditional valuation experts would expect, even after the sharp stock market decline. VALUATION OF ESTABLISHED INTELLECTUAL PROPERTIES

The first and simplest financial analysis is of well-established intellectual properties. For example, many investment bankers and market analysts have done hundreds of brand-name equity studies in which properties or products were evaluated so their acquisition price for a potential buyer or their sale price to a potential seller could be established. Alternatively, many financial analysts do brand-name equity valuations for the corporate owner to realistically assess its inventory of patents, trademarks, or copyrights. This can be done for strategic management purposes; to help decide which products to keep, build upon, or sell off; or to decide which separate businesses a company should fund first, or how much of each of several businesses internal IP should be funded as part of a capital budgeting decision. Alternatively, these IP audits reveal which of a corporation’s businesses is lacking critical current IP and requires acquisitions of outside firms for its IP to fill vital gaps. The corporation is conducting these firm-wide IP inventory assessments with increasing frequency—often yearly, semiannually, or even quarterly—to keep current on what its real options are for current market valuations.

VALUATION OF ESTABLISHED INTELLECTUAL PROPERTIES 2.43

Investment banks and financial analysts often do valuations of licensing rights for each of the intellectual properties held by one firm if the properties are being offered to other firms as part of a company acquisition. A corporation’s potential to grow its future rate of return on its own resources and its ability to leverage its future growth rate off the combined IP portfolios of its cross-licensing partners, strategic allies, joint venture, or network partners are assessed in investment banks’ valuations of the existing network of cross-licensing contractual agreements and operational joint venture arrangements. Gene D’Ovideo, president of Intellectual Capital, has done two thousand of these brand-name equity valuations, plus licensing and cross-licensing valuations for investment banks managing corporations’ mergers, acquisitions, divestitures, or IP selfassessments. Like the vast majority of investment bankers, who do not yet usually use “Real Option Valuation,” D’Ovideo uses two standard methods of valuation in most cases for a patent, trademark, or copyright: first, a discounted cash flow analysis, and second, the valuation of the combined stream of yearly net income projections and future terminal value. The first method of valuing a particular trademark assesses how much incremental cash flow will be earned by a particular branded product compared to its generic counterpart; then their Net Present Values can be compared. If the brand-name is already well known and the product has generated known amounts of cash flow for a period of years, it is common to extrapolate—for three, five, or ten years into the future—the amount of cash flow likely to be earned with stable, rising, or falling sales. This brandname’s estimated cash flow figures are compared to those likely to be generated by a generic brand of the same product sold at a cheaper price during those same years. The two cash flow projections—for the brand-name versus the generic product to a set term of years—are then discounted back to their Net Present Values with one or more financial discount rates. The discount rates used represent a combination of an estimate of the time value of money or rate of inflation over that term of years, plus the relative risk of the overall market for the product or the uncertainty about sales forecasts. By subtracting the Net Present Value of the generic product from that of the brand-name product, the analyst can compute the brand-name’s value. In cash flow forecasts and options valuations, brand-name equity studies, and measurements of licensing rights to other firms, investment bankers are fairly certain of the financial figures of the company’s historic cash flows specifically derived from this product, year-by-year. In developing the cash flow valuations (or estimations of a yearly net income stream of a company with an established brand-name), an investment banker may benefit from calculating the rates of return on sales, return on investment, or return on assets with the historical financial figures supplied by the company for the brand-name product’s growth in sales, gross margin, and net profits. From these figures of historical financial growth, the financial analyst can estimate the product’s relative contribution to the firm’s overall net income over the past five years. It is not difficult for corporations to lay out reasonably defensible estimates of the net income forecasts attributable to this brand-name product by using this data with comparative financial ratio analysis, and making certain assumptions about the likely overall market changes during the next five years.

2.44 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS

A similar situation existed when, during a merger, the investment banker was asked to do a financial valuation of an established patent that is incorporated into a successful product. It is not difficult to do both a present value cash flow valuation and a future net income and terminal value calculation of the patent’s value, assuming that 10 years are left to run of the original 20-year patent life. The calculation is done by taking the year-by-year cash flows and profit margins of the last five years and extrapolating a reasonable forecast of future cash flows and profit margins for each year remaining of the patent life (while making varying assumptions about changes in supply, demand, demographics, alterations in the overall market, and the level of interest rates). The investment banker usually again provides the company with a sensitivity analysis that provides three or more scenarios and shows which factors might cause the variance in three financial forecasts for the value of the patent, collection of patents, or product streams possibly generated by the patent. VALUATIONS OF A COMPETITOR’S INTELLECTUAL PROPERTIES

When the investment banker is called on to value a patent, trademark, or copyright owned by a competitor because it is a target company for a hostile acquisition, accurate information about that company’s specific cash flows, profits, or the portion of its entire net income derived from just one of its many products is more difficult to obtain. This task requires far more estimation and in-depth research study by strategic, financial, and market analysts. Even industrial espionage has been used in trying to obtain reasonably accurate figures on the target company’s intellectual properties and separate businesses, lines, product cash flows, profit, and contribution to net income. Only from such data, estimates, or clandestine sources can bankers develop forecasts of future cash flow and net income contributions to evaluate the probable benefit and price of an acquisition. INVESTMENT BANKERS MERGER AND ACQUISITION VALUATION PROBLEMS

The chief executive of a company commonly comes to an investment bank with a specific price for which he is willing to sell his company. He may also tell the bankers the exact terms and conditions under which the company can be acquired by or merged with another firm. This often sets the acquisition floor price and fixes the key deal terms that get done. This practice is logical, prudent on the surface and deemed justifiable by the CEO and board of the selling company. Nevertheless, this valuation practice has important consequences that are rarely considered carefully by the bankers or the firms who employ them. The CEOs view this preemptive declaration of their valuation price and deal terms as their right and proof of their fulfillment of fiduciary duty to maximize shareholder value. They see this as not much different from a seller of a house setting the highest conceivable price hoping that someone will pay it. The investment bankers usually go along with this suggested price, acting as agents for the client company to maximize deal terms and earn the highest possible fee for their firms. The bankers may agree that this is in the company shareholders’ best interests and conclude that the price offered by bidders will be negotiated to its current market price if the selling firm’s declared price is ultimately not reasonable. A competitive auction for the company will force the final actual transaction price to be what a willing buyer would pay. A valua-

ENDNOTES 2.45

tion problem inherent in many mergers and acquisitions is that investment bankers sometimes, in effect, rubberstamp the price that the selling company’s CEO arbitrarily dictates as fair and reasonable. At times, investment banks do little independent, exhaustive, or thorough financial analyses for objective valuation of a number of merger or acquisition transactions. They may simply sign their firm’s name and reputation to lend legitimacy to the price paid in the deal and the fairness of the valuation process. This is not to say that this type of valuation is an evil, illegal, or immoral act, however. Instead, this is simply noting a number of the key facts that are apparent in the valuation practices of firms. In many M&A deals—especially friendly transactions—there is only one real bidder; little or no competitive price bidding exists in the majority of cases—only the original asking price. As a result, investment bankers, who were trained in corporate finance valuation techniques in business school and investment banking training programs, employ these tools in a number of cases only to the extent that they tend to legitimize the original price that the selling company’s CEO suggested as acceptable. ENDNOTES 1

This chapter was written with the research assistance of John M. Huerta and Daniel Cervantes, both MBA graduates of New York University’s Leonard N. Stern School of Business. 2 The Wall Street Journal (Nov. 20, 1999), B1. See also The New York Times (Nov. 20, 1999), C1. 3 The New York Times (June 11, 2000), A2. 4 Thomas Grubb and Robert Lamb, JP Morgan Securities, Transaction Values Computed by Securities Data Corporation, Capitalize on Merger Chaos (2000), 10. 5 “Pfizer Gets Its Deal to Buy Warner-Lambert,” The New York Times (Feb. 8, 2000), C1 & C5. See also “Pfizer Covets Warner’s Labs, Research Staff,” Wall Street Journal, Nov. 19, 1999; “Pfizer & Warner Lambert Merger for Labs & Scientists,” The New York Times (Feb. 9, 2000), C1. 6 Merrill Lynch Research Report on 3M Corporation, Oct. 24, 2000. See also Salomon Smith Barney Research Report on 3M, March 2000. 7 Ibid. 8 Capitalize on Merger Chaos, ibid., 155–159. 9 “Showtime for AOL,” Business Week (Jan. 15, 2001), 57–64. 10 Aswath Damodaran, Damodran on Valuation (New York: John Wiley & Sons, 1994), 360. 11 Damodaran on Valuation, ibid., 363. 12 Martha Anram and Nalin Kultilaka, “Developing a Drug,” Real Options (Boston: Harvard Business School Press, 1999). 13 David Kellogg, John Charnes, and Riza Demirer, “Valuation of a Biotechnology Firm: An Application of Real-Options Methodologies,” conference paper. 14 Damodaran on Valuation, ibid., 360–363 summarized. 15 Ibid., 364. 16 Ibid., 340–341, “A Few Caveats on Applying Option-Pricing Models.” See also Tom Copeland and Vladamir, Real Options: A Practitioner’s Guide (Texere, 2001). 17 Jack Eqing, “A New Net Powerhouse,” Business Week, Nov. 13, 2000. See also “Napster US Federal Court Injunction in Barnes&Noble.Com Joint Venture Case,” New York University Stern School of Business. 18 Aswath Damodaran, The Dark Side of Valuation, Financial Times/Prentice Hall (Upper Saddle River, NJ, 2001), 11. 19 Ibid.

2.46 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS 20 For consolidation of market power, also see Thomas Grubb and Robert Lamb, Appendix C, Capitalize on Merger Chaos (2000), 143. 21 The Wall Street Journal (May 2, 2001), A1 & A8 22 Ibid. 23 Ibid. and The New York Times (May 7, 2001), C1 & C14. 24 The Wall Street Journal (May 2, 2001), A8. 25 Ibid., A1 & A8, and The New York Times (May 7, 2001), C1 & C14. 26 Ibid. and see Thomas Grubb & Robert Lamb, Capitalize on Merger Chaos (2000), 143, Appendix C. 27 Grubb and Lamb, 19, 41, 88, 90. 28 Ibid., 38, example: Procter & Gamble’s acquisition of Noxell Cosmetics. 29 Prudential Securities Analysts Report on Newel Rubbermaid, Jan. 23, 2001. 30 “Show Time for AOL Time Warner,” Business Week (Jan. 15, 2001) and The Wall Street Journal (May 2, 2001). 31 Neil Gross and Peter Coy with Otis Port. “The Technology Paradox: How Companies Can Survivie as Prices Dive,” Business Week (May 6, 1995), 77. 32 “How to Compete with an 800 Pound Gorilla,” speech by Jerry Sanders, CEO of Advanced Micro Devices. Reprinted in a Robertsons Stephens’ Co. report, July 29, 1998. 33 Neil Gross and Peter Coy, 77. 34 Robert Lamb and Randy Rosen, “Global Piracy and Intellectual Property,” The New Role of Intellectual Property in Commercial Transactions, M.Simensky and Lanning Bryer, eds. (New York: John Wiley & Sons, 1997). Reprinted in M. Simensky, Lanning Bryer, and Neil Wilcoff, eds., Intellectual Property in the Global Marketplace (New York: John Wiley & Sons, 1999). 35 Nikhil Deogun, “Merger Wave Spurs More Sock Wipeouts,” The Wall Street Journal (Nov. 29, 1999), C1. 36 Neil Gross and Peter Coy with Otis Port. “The Technology Paradox: How Companies Can Survive as Prices Dive,” Business Week (May 6, 1995), 77. See also Bhushan Bahree, “Oil Mergers Don’t Live Up to the Hype,” The Wall Street Journal (July 23, 1999), A10. See also Saikat Chauduri and Behnam Tabrizi, “Capturing the Real Value in High Tech Acquisitions,” Harvard Business Review (Aug.–Sept. 1999), 124. 37 Mark Sirowar, “What Acquiring Minds Need to Know,” The Wall Street Journal (Feb. 22, 1999), A18. 38 Jeffery Liday, “Most Mergers Fail to Add Value, Consultants Find,” The Wall Street Journal (Oct. 12, 1998), B9. 39 Ibid. See also Alexandra Reed Lajoux and J. Fred Weston, “Do Deals Deliver on Post Merger Performance?” Mergers & Acquisitions (Sept./Oct. 1998), 34–37. See also Capitalize on Merger Chaos, 155–158. 40 Ibid. 41 Michael Porter, “From Competitive Advantage to Corporate Strategy,” Harvard Business Review (May–June, 1987), 45. 42 Jeffery Liday, “Most Mergers Fail to Add Value, Consultants Find,” The Wall Street Journal (Oct. 12, 1998), B9. See also Mark Sirowar, A18, and “The Synergy Trap,” The Free Press (1999). 43 Ibid. 44 Anne Fisher, “How to Make a Merger Work,” Fortune (Jan. 24, 1994), 66. 45 Michael Porter, “From Competitive Advantage to Corporate Strategy,” Harvard Business Review (May–June, 1987), 45. 46 Paul Deninger, CEO of Broadview International, interview.

ENDNOTES 2.47 47

C.K. Prahalad and Gary Hamel, “The Core Competence of the Corporation,” Harvard Business Review (May–June 1990). 48 Aswath Damodaran, The Dark Side of Valuation, 11. 49 Ibid. 50 John Kendrick, interview. 51 Ibid. 52 See Baruch Lev, Intangibles, (Brookings Institution, 2001), 5–7, 22–27 and 46, 47, note 61. Professor Lev’s original quotations are from an interview. 53 Ibid. 54 Ibid. 55 It is important that the European firms in this M&A bidding situation did not consider this type of “carried interest” or “flip fee,” which investment bankers in the United States would have focused on in any similar situation in which the seller feels constrained to demand top auction price at this moment from the buyer. 56 Tom Copland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies, 3rd ed. (New York: John Wiley & Sons, 2000).

CHAPTER

3

INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY ACCOMPANYING MERGERS AND ACQUISITIONS Gordon V. Smith AUS Consultants

INTRODUCTION

When a business enterprise is acquired, whether by purchase of assets or by purchase of stock, a portfolio of assets is included in the transaction. This is also true when a subsidiary or product line is acquired. This chapter examines the nature of one portion of that portfolio—intangible assets. THE ASSET PORTFOLIO

It is useful to first place these assets in the context of the entire portfolio. The creation of a business enterprise can be visualized as the act of turning cash and a concept into other types of assets that, in turn, will attract more cash. It is hoped that the value of these assets will, in time, be greater than the cash invested. As a business grows, new cash is required. Its source may be the original owner, outside investors in the company’s stock, earnings of the business itself, or lenders, but whatever the source, the same process is involved—converting cash into assets. The assets formed in this process fall into three classifications. Every business enterprise, from a pushcart vendor of hot dogs on the street to the largest multinational corporation, comprises three basic elements: monetary assets, tangible assets, and intangible assets. The composition of an acquired enterprise can be depicted as shown in Exhibit 3.1. Monetary Assets. Monetary assets, or net working capital, are defined as current assets

less current liabilities. Current assets include: • • • • •

Cash Short-term investments such as marketable securities Accounts receivable less reserves Inventories, including raw materials, work in process, and finished goods Prepayments

3.1

3.2

INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY

Working Capital

+

Business Enterprise

=

Fixed Assets

+

Intangible Assets

+

Intellectual Property

Exhibit 3.1 Composition of a Business Enterprise

Current liabilities include: • Accounts payable • Current portion of long-term debt • Income taxes and other accrued items In most cases there is an excess of current assets over current liabilities, so net working capital is a positive amount. The value of these assets is usually reflected in the amounts shown on the balance sheet. Tangible Assets. Tangible assets are usually shown on an accounting balance sheet as “Plant, Property, and Equipment.” Typically included in this asset category are the following classifications of property:

• Land • Land improvements such as paving, fencing, landscaping, yard lighting, sewerage and fire protection • Buildings, including building construction and services • Improvements to leased property, which may comprise structural improvements, building services, power wiring, and piping • Machinery and equipment, including machinery, power wiring, plant piping, laboratory equipment, and tools

BUSINESS ENTERPRISE VALUE IN MERGERS AND ACQUISITIONS 3.3

• • • • •

Special tooling, such as dies, jigs, fixtures, and molds Drawings Office furniture and equipment Licensed vehicles Construction in progress

The value of these assets must be independently estimated. Book values from the balance sheet are at best an imprecise surrogate for fair market value. Intangible Assets. Intangible assets and intellectual property usually do not appear on

a company’s balance sheet, but they are present in any case. Accounting theory defines intangibles as assets that do not have physical substance, that grant rights and privileges to a business owner, and that are inseparable from the enterprise. We define intangible assets as all the elements of a business enterprise that remain after monetary and tangible assets are identified. After working capital and fixed assets, they are the elements that make the business work and contribute to the earning power of the enterprise. Their existence is dependent on the presence of complementary assets and on the expectation of earnings. They usually appear last in the development of a business and very often disappear first in its demise. BUSINESS ENTERPRISE VALUE IN MERGERS AND ACQUISITIONS

One could infer from the previous discussion that the valuation of a business enterprise in a transaction is accomplished by adding the values of the underlying assets in the business portfolio. This is rarely done, however, and the purchase price in an acquisition is usually the result of valuing the entire portfolio based on its present or anticipated earning power. As an example, recently, when the share price of Yahoo! was $236.94, the value of that enterprise was $47.2 billion (199 million shares times $236.94 per share). That is, buyers and sellers in the marketplace, by coming to an agreement that a fair price for a share of common stock was $236.94, also concluded that the Yahoo! enterprise was worth $47.2 billion. They did this without any calculation of the individual values of the monetary, tangible, and intangible assets of Yahoo! If we were, however, to value the monetary, tangible, and intangible assets of Yahoo!, the sum of those values would have to be $47.2 billion, because, absent unusual circumstances, the value of the whole is equal to the sum of the values of its parts. Acquisition Premiums. An additional complexity can be added to this equation in the

case of a merger or acquisition. To continue the example, most of the present stockholders of Yahoo! are content with their investment and are not motivated to sell their shares. If another entity wished to purchase a majority of Yahoo! shares and gain control of the company, the offer to purchase would likely be in an amount higher than that at which the shares are currently trading. Acquiring companies may do this for a number of reasons.1 These may include the need to motivate all (or at least a majority) of shareholders to sell their holdings, to obtain control of the target’s assets, to exploit potential synergies, or to thwart competition for the transaction. The end result may be a value indication for the acquired company that exceeds that formerly in evidence in

3.4

INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY

the marketplace. This increased business enterprise value may be ascribable to specific underlying assets, or may be an increase in the value of goodwill represented by a residual. Whatever the allocation of value to underlying assets, the sum of the parts is still equal to the whole. Acquiring Intangibles. One reason for this discussion is that when mergers and acquisitions take place, the parties to the transaction (especially the buyer) become very sensitive to the nature and quality of the underlying assets of the subject enterprise. For that reason, they must be aware of the nature of intangible assets and intellectual property: how these assets contribute to the earning power of the target enterprise and how these assets will affect the operations and earnings of the combined enterprise. This has become critical, because the value of intangible assets and intellectual property often represents most of the enterprise value. An acquirer of the Yahoo! business, as an example, would be extremely sensitive to the fact that of the $47.2 billion total value (or more, if a premium were to be paid), $46.7 billion, or nearly 99 percent of that total value, is intangible assets and intellectual property!

INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY

Intangible assets are categorized as: • • • •

Rights Relationships Undefined intangibles Intellectual property

Rights. Every business enterprise acquires rights through establishing contractual agreements with other businesses, individuals, or governmental bodies. A large enterprise may have a bundle of rights comprising thousands of elements. These rights usually exist according to the terms of a written contract that defines the parties to the agreement; the nature of the rights, goods, or services transferred; the transfer consideration; and the duration of the agreement. Of most interest are the 12 types of contracts that are important because they enable a business to obtain goods or services at an advantageous price:

1. 2. 3. 4. 5. 6.

Leases of premises that are at rates or terms better than would be available in the current market. Such an advantageous lease is called a leasehold interest. Advantageous distribution agreements for the sale, warehousing, and movement of products Employment contracts that act to retain key personnel Financing arrangements that result in capital being available at more favorable terms or at lower rates than otherwise Insurance coverage at better-than-market rates Contracts for the supply of raw materials or purchased products at advantageous terms

INTANGIBLE ASSETS 3.5

7. 8. 9. 10. 11. 12.

Contracts for services such as equipment maintenance, data processing, or utility services Licenses or governmental certifications that are in short supply or are costly to obtain Rights to receive goods or services in limited supply, such as radio or television network affiliations or film distribution rights Covenants by a former owner or employee not to compete Contractual rights of a franchisee to an exclusive territory or product line License contract for the use of intellectual property that provides reduced costs or a profit opportunity

Some contractual rights are important because they afford the business the opportunity to provide goods or services to others at a profit: • Mortgage servicing rights to collect, process, and manage escrow and insurance matters on a portfolio of mortgages for a fee • Loan agreements purchased as part of a business enterprise on which there will be a future return of principal and interest • Agreements to provide food service, health care, data processing, advertising, or consulting services • Agreements to provide goods under contract for future delivery • Student enrollments or subscriptions that are prepaid • Licenses granted to another for the use of intellectual property in return for royalties • Franchises that protect a territory or product line and produce fee income

Relationships. Every business establishes relationships with outside agencies, other companies, and other individuals. These are often noncontractual but can be extremely important to the enterprise. They include assembled workforce, customer relationships, and distributor relationships. Assembled Workforce. One of the most obvious relationships of an enterprise is with its

employees. It can be very costly to locate, hire, and train a workforce, as evidenced by the expenditures made to retain employees and reduce turnover. The more specialized the workforce, the greater the cost of its assemblage and the larger its importance to the enterprise. Customer Relationships. Every business has customers, but not every business has customer relationships. For example, a newsstand in a large city probably has a number of customers who habitually purchase a daily newspaper. The newsstand proprietor does not know the identity of his customers or where they work, maintains no customer account records, and could not contact them to discover their interest in other publications. If the proprietor moved the newsstand to another location these customers would probably not seek him out, but rather would patronize another stand. This is not a customer relationship in the sense used here.

3.6

INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY

The most important customer relationships are those which have a high level of inertia (relative difficulty for the customer to migrate to another source of goods and services). Another important factor is that meaningful information is known about the customer, which enables a strategic exploitation of the relationship. Strong customer relationships are those that would persist through a change in ownership, change in personnel, or even a relocation. Distributor Relationships. A business that depends on others to distribute and/or sell its

products may have established relationships of considerable importance. Many companies have representatives that sell cosmetics, cookware, and cleaning products in the residential market, for example. These companies have no retail stores, so the relationship with their representatives is extremely important. Other businesses may sell complex products in a highly technical market through manufacturers’ representatives. Locating, hiring, training, and maintaining such representation can be a very costly process. Once accomplished, however, the relationship is an asset of importance to the enterprise. Undefined Intangibles. In spite of the fact that in recent years appraisers have analyzed, identified, and valued many intangible assets, there often remains a residual. That residual is commonly referred to as goodwill and/or going concern value. These concepts are distinct; the following discussion will separate them. Goodwill. Business people, attorneys, accountants, and judges have all had a try at

defining the concept of goodwill. Some of the more common explanations are: • Patronage. Many equate goodwill with patronage, or the proclivity of customers to return to a business and recommend it to others. This results from superior service, personal relationships, advertising programs, and business policies that meet with favor in the marketplace. • Excess Earnings. Another common aspect of a goodwill definition is the presence of excess earnings. That is, a business that possesses significant goodwill is likely to have earnings that are greater than those required to provide a fair rate of return on the other assets of the business. • Residual. Goodwill represents the residual between the value of the enterprise as a whole and the value of the other identifiable assets. This is a permutation of the excess earnings concept because the value of the enterprise will only exceed the value of the identifiable assets (and create room for the residual) if there are excess earnings. We cannot rely entirely on one definition to the exclusion of the others. Can there be goodwill in a business that is losing money (no excess earnings)? Of course. A temporary escalation of expenses, a casualty loss, the opening of a new plant, or the development of a new product line can temporarily eliminate earnings, but goodwill can remain. Can there be excess earnings and no goodwill? Certainly. Suppose a business has a single customer who is locked in for several years under a lucrative contract. There might well be excess earnings, but they are attributable to the contract, not to goodwill.

INTANGIBLE ASSETS 3.7

The accounting profession has long grappled with the question of how to reflect goodwill and other intangible assets in financial statements. In the previous example concerning Yahoo!, we noted that the value of the intangible assets of that enterprise was $46.7 billion, or nearly 99 percent of the market value of the entire business. We came to that conclusion by reference to the price of Yahoo! common stock as set in the marketplace by investors. By observing the financial statements of Yahoo!, however, one would only see the $500 million of monetary and tangible assets in the business. Yahoo! has spent billions of dollars developing customer relationships, partner alliances, and its brand. Obviously, investors feel that those expenditures have created intangible assets of value. However, accounting rules preclude reflecting the value of those self-developed intangible assets on the balance sheet. If, however, Yahoo! were to acquire another business that was a mirror image of itself, it would allocate its total purchase price to all of the assets acquired, tangible as well as intangible, and Yahoo’s! balance sheet after the transaction would reflect the value of those acquired intangibles, but not its self-developed intangibles. These issues are developed more fully in other chapters of this book. Going Concern Value. Going concern value has been defined as “the additional element

of value which attaches to property by reason of its existence as part of a going concern.” 2 To illustrate this concept, suppose one were to assemble all of the tangible and intangible assets for a business that was not yet in operation. These would include the following: • • • • • • • • • •

Employees (standing around) Machinery (in crates) Furniture and office machines (on the loading dock) Computer and peripherals (boxed) Cash (in bags) Computer software (on disks and tape) Office supplies (scattered about) Vendors (waiting to be seen) Customers (waiting in the lobby) Advertisements and radio/television commercials (ready to be placed)

Much is needed before this aggregation of assets is an organized business ready to sell its product. Nearby is an identical business that has legalized itself; established relationships with financial, banking, legal, and accounting firms; contracted with suppliers; designed a product; obtained an inventory; developed a business plan; readied its advertising program; written operating procedures; and is poised and ready to go. However, it has yet to make a sale, so it has no goodwill. The difference between the value of these two enterprises is “going concern value” or, as we prefer to describe it, the elements of a going concern. Intellectual Property. The final element of the intangible asset category is intellectual

property. This classification of property includes patents, proprietary technology, copyrights, trademarks, computer software, mask works, and the right of publicity. Intellectual

3.8

INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY

property is unique in that it is protected by law from its unauthorized exploitation by others. Proprietary Technology. The term proprietary technology refers to trade secrets and

know-how. Proprietary technology is very often more valuable to an enterprise than its patents. Karl F. Jorda3 describes this: “Patents are but the tips of icebergs in a sea of trade secrets. Over 90% of all new technology is covered by trade secrets and over 80% of all license and technology transfer agreements cover proprietary know-how, i.e. trade secrets, or constitute hybrid agreements relating to patents and trade secrets.” Jorda also opines that the decision as to which type of protection to seek is not simply a “patent or padlock” question, but one in which the inventor must decide “. . . what to patent and what to keep a trade secret and whether it is best to patent as well as padlock, i.e. integrate patents and trade secrets for optimal protection of innovation.” The owner of proprietary technology is relieved of the necessity of administering registrations (perhaps internationally), including legal costs and filing fees. A trade secret does not have to be reduced to some tangible form in order to be protected. In fact, some trade secrets are such that they cannot be so captured. An increasingly common reason not to patent is that the subject technology or information may be changing so rapidly that obsolescence may occur before a patent is granted. There are situations, as well, in which a company does not wish to reveal even the direction of its research program. All of this is, however, counterbalanced by the risk of having valuable information subject to being inadvertently divulged or independently developed by another. Trade Secrets have been defined in several ways: . . . information, including a formula, pattern, compilation, program, device, method, technique, or process that: (i) derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable by proper means by, other persons who can obtain economic value from its disclosure or use, and (ii) is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.4 . . . any formula, pattern, patentable device or compilation of information which is used in one’s business and which gives an opportunity to obtain an advantage over competitors who do not know or use it. It may be a formula for a chemical compound, a process of manufacturing, treating or preserving materials, a pattern for a machine or other device, or a list of customers . . . or it may . . . relate to the sale of goods or to other operations in the business such as a code for determining discounts, rebates, or other concessions in a price list or catalog; of bookkeeping; or other office management5 . . . any information not generally known in the trade. It may be an unpatented invention, a formula, pattern, machine, process, customer list…or even news.6

State laws govern one’s rights in trade secrets. Proprietary technology can take many forms, such as an extremely technical process or a formula. Collections of data are one form of trade secret. In order to be of material value, compilations of data should be organized, accessible, and (with the exception of historically significant information) should pertain to or be useful in current and future operations. Some examples of proprietary technology include the following:

INTANGIBLE ASSETS 3.9

• Management or technical experience and judgment that is embedded in the decision logic of computer software • Technical trial-and-error experience that is captured in drawings, operation manuals, tooling, fixtures, machine settings, or process designs • Formulas, recipes, specifications for ingredients, methods of combination, mixing times, and temperatures • Accounting procedures, personnel practices, marketing strategies, and sales techniques • Formations and plays of a sports team or its training regimen • Knowledge of materials or processes that do not work (negative knowledge can be valuable) • Artistic techniques for mixing or applying pigment, preparing a musical instrument, or exposing and processing film • Research and development information such as laboratory logs, experiment designs, and results • Results of product or material tests • Results of market surveys or consumer testing • Job files (such as for consulting engagements) and construction projects Information is not classified as a trade secret simply because it is not generally known outside of a business organization. It must be used in the business and provide its owner with some competitive advantage and be treated as secret. It is therefore necessary that procedures be in place to protect trade secret security. That is, documents should be safeguarded, access restricted, and confidentiality agreements in place with employees who must have knowledge for their work. The most valuable proprietary technology possesses some essential characteristics: • It produces an economic advantage. • It raises barriers to competition. • It creates a strong market position.

Patents. A patent is the legal process whereby technology is turned into controllable

property with defined rights associated with its ownership. A patent is the grant of a property right by the U.S. government to the inventor (or his or her heirs and assigns) by action of the United States Patent and Trademark Office (USPTO). The right conferred by the patent grant is the right to exclude others from making, using, or selling the invention. Burge describes a patent as a “negative right.” He explains: “While the right of ownership in most personal property is a positive right, the right of ownership in a patent is a negative right. It is the negative right to exclude others from making, using, or selling the patented invention . . . Indeed, in making, using, or selling his own invention, the inventor may find that he infringes the patent rights of others.”7 The following description refers to a utility patent that has a term of 20 years from the date of filing the application. Section 101 of the Code states, “Whoever invents or

3.10 INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY

discovers any new and useful process, machine, manufacture, or composition of matter, or any new and useful improvement thereof, may obtain a patent therefor . . .” The word “process” typically refers to industrial or technical processes. “Manufacture” refers to articles which are manufactured, and “composition of matter” relates to mixtures of ingredients or to new chemical compositions. Patents are also issued for plants. “Whoever invents or discovers and asexually reproduces any distinct and new variety of plant, including cultivated spores, mutants, hybrids, and newly found seedlings, other than a tuber propagated plant or a plant found in an uncultivated state, may obtain a patent therefor . . .” 8 Plant patents also have a protection term of 20 years. Design patents are issued for a term of 14 years and are described as follows: “Whoever invents any new, original and ornamental design for an article of manufacture may obtain a patent herefor . . .”9 Design patents protect only the appearance of an object, not its structure or utilitarian features. The U.S. Supreme Court found that living matter that owes its unique existence to human intervention is patentable subject matter in a 1980 decision.10 After some delay the USPTO has granted several patents on transgenic animals. When a patent application has been received by the USPTO, the applicant may identify products containing the invention with the words, “Patent Pending,” or “Patent Applied For.” This action does not provide any protection against infringement, either intentional or unintentional, because until the patent issues its validity is not known. It may, however, discourage copying since if and when a patent is issued, protection will ensue from the date of issuance and the copying will change from an annoyance to legal infringement. To obtain foreign patent protection, an inventor must apply for a patent in each country. The laws under which a patent may be granted differ considerably, as might be expected. Maintenance fees may be required, licensing may be compulsory to anyone who applies, and a patent may become void if manufacturing in the country does not occur. United States patent laws make no discrimination relative to the nationality of the inventor or applicant, so a foreign inventor can obtain patent protection for an invention by the same procedures as described previously. Copyrights. A copyright protects the expression of an idea, not the idea itself, just as a patent does not protect an idea, rather its embodiment in a product or process. Copyright protection commences from the time when that expression is fixed in some tangible form, even prior to its publication, not the time at which an application is accepted by the federal government. In fact, full copyright protection is present whether the work is registered with the Copyright Office of the Library of Congress or not. A copyright owner may reprint, sell, or otherwise distribute the copyrighted work; prepare works that are derived from it; and assign, sell, or license it. An increasingly important issue concerns the ownership of copyrightable works when they are created by someone for use by another. Such works might include, for example, computer software, written materials, or photographs, which are created by independent contractors or consultants. It is important to establish the ownership of such works. This issue has been the subject of litigation in recent years. Unless there

INTANGIBLE ASSETS 3.11

are specific arrangements between the parties, the copyright is the property of the creator. The fact that the creator was paid for the work does not automatically vest ownership with the buyer. Copyrights are protected for a period of the life of the author plus 70 years for works created after January 1, 1978. Copyright protection on “works for hire” extends for 95 years from date of publication or 120 years from the date of creation, whichever expires first. In December 1990, the Copyright Act was amended to include protection for “architectural works:” . . . the design of a building as embodied in any tangible medium of expression, including a building, architectural plans, or drawings. The work includes the overall form as well as the arrangement and composition of spaces in the design, but does not include individual standard features.11

In October 1992, the Copyright Office published final regulations for the registration of architectural works, which included some definitions and registration instructions. As with other registrable works, the issue of ownership can be very important because the design and ownership of a building are most often separated. While this has not always been so, it is now clear that computer programs are copyrightable. This is true whether the program is in the form of source code and intelligible to humans or in object code understandable only to a computer. Copyright is available for operating system or applications programs and extends to a program’s structure and organization as well as its coding. Computer databases are considered “literary works,” just as are dictionaries and catalogs. Further defined as a “compilation,” computer databases are protected primarily to the extent of what the author of the work created or contributed to the finished product. This may only be in the arrangement or order of presentation of data, but some degree of creativity must be evident. There has been a considerable amount of litigation over the degree of protectibility that the Copyright Act provides to computer screen images. The images are, of course, caused by software coding, and the problem was made more difficult by the fact that the same-appearing screen could be the result of different coding within a program. The question has been which element of the process is copyrightable, or are both? This seems to have been resolved in the courts and screen images are protected as “audiovisual works.” Trademarks. Trademarks can be extremely valuable business assets. Large amounts of

money are spent to create and nurture them, and when they are threatened large amounts of money are spent to defend and protect them. Trademarks are both longlived and ephemeral, powerful and delicate. A trademark as defined in the Trademark Act of 1946 “includes any word, name, symbol, or device, or any combination thereof adopted and used by a manufacturer or merchant to identify his goods and distinguish them from those manufactured by others.” Exclusive rights to trademarks are obtained by continued use, and when that use includes trade regulated by the federal government, the trademark may be registered by the Patent and Trademark Office.

3.12 INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY

Registration remains in force for 20 years and may be renewed for additional 20year periods as long as the trademark is in use in commerce. An affidavit must be filed between the fifth and sixth years following the registration date stating that the mark is still in use, how it is being used, and include a sample. If this is not done, registration will be cancelled automatically. Continued improper use of a trademark can result in its being found to be generic, and its protection will be lost. Many trademarks have followed this unhappy (for their owners) path, including “escalator,” “nylon,” “linoleum,” and “trampoline.” Technically, trademarks are used to identify goods, while service marks identify services. They are identical except for this; in common usage, both are referred to as trademarks or marks. The most common trademarks are some form of company name, usually in distinctive type style, or a logo. Trademarks can also apply to shapes (such as the distinctive shape of the Coca-Cola bottle), designs (such as the Ralston Purina “Checkerboard Square”), a building style (such as the “Golden Arches” of McDonald’s Corporation), a slogan, a color combination, or even a number, such as “4711” toiletries. The trade dress of a product describes its total image and includes its size, shape, color, or texture. Trade dress has typically referred to packaging, though more recently it has been used to describe the appearance of the product itself. A tradename is the name of a business, association, or other organization used to identify it. It may or may not be the same as the trademark used to identify the company’s products, such as IBM, which represents both. It cannot be registered at the federal level unless it is also a trademark. Ownership would be governed by common or state law. A tradename is typically not an asset of material value because the buying public recognizes goods and services by their trademark and, in many cases, can be entirely unaware of the actual name of the producing company. Some people use the term “brand” interchangeably with trademark. A brand shares some characteristics with a trademark, but the two are not entirely synonymous: Many think of a brand as being synonymous with a trademark. From the literature, it seems to us that a brand is more of a marketing concept, or a way that marketing professionals have developed to describe an asset that differs from the strictly legal concept of a trademark. Martin12 describes brands by contrasting them with “commodities”—soap vs. IVORY, pianos vs. STEINWAY, and breakfast food vs. KELLOGG’S Cornflakes. We think that a useful way to conceptualize a brand is as an aggregation of assets which includes, but is not limited to, a trademark. A brand also comprises a particular product, or more than one product, perhaps a formula and/or a recipe, trade dress, a marketing strategy, an advertising program, and/or promotional activities.

For the purposes of the tasks that accompany an acquisition or merger, one can assume that the trademark carries with it a full complement of all the ingredients necessary to also be recognized as a brand. One must understand that the distinction between a brand and a trademark can be important when one considers the economic life of each. Visualize how the economic life of a brand (comprised as it is of many elements) could be quite different from that of a trademark. Within the brand, there may be a constant turnover of its constituent parts as advertising programs and marketing strategies come and go. The economic life of a trademark can even be independent of a particular product if it is sufficiently strong and versatile and if the transition is carefully managed.

INTANGIBLE ASSETS 3.13

Federal registration of a trademark is not necessary to obtain protection. One can simply begin using the mark on goods or services and can, if other confusingly similar marks subsequently appear, enjoin their owner from using them. Federal registration does, however, provide some advantages. The owner of a federally registered mark can enjoin all subsequent users anywhere in the United States and can be awarded treble damages, infringer’s profits, and sometimes attorney fees in successful infringement litigation. The Trademark Law Treaty Implementation Act of 1998 brought some aspects of U.S. trademark law into conformity with international law. The primary change was the right to file a trademark application with the intention to use, with a period (three years) during which a lack of direct use will not invalidate the mark. Trademark registrations remain in force indefinitely, as long as the proper renewals are made, fees paid, and the trademarked goods or services remain in commerce identified by the mark as registered. With regard to foreign trademark rights, the Paris Convention affords benefits to trademark owners seeking non-United States protection. Member countries provide to foreigners the same trademark protection available to their own citizens. Under the Madrid Protocol, the World Intellectual Property Organization accepts a single international trademark application that provides protection in several jurisdictions. Since the United States is not a party to the Madrid Protocol, only U.S. companies with subsidiaries in relevant countries can use this option. In 1996 the European Community inaugurated the Community Trade Mark (CTM) system, which permits a single registration system for the 15 countries of the EC. The CTM registration system is administered by the Community Trade Mark Office. The system differs from the U.S. system, for example, by allowing registration of a mark prior to use and in allowing the owner five years to use the mark in commerce. Internet Domain Names. This subject is introduced here because even though Internet

domain names are not trademarks in the legal sense, they share important property characteristics with trademarks. This sharing has led to some very difficult international disputes and equally complex efforts to resolve them. From the standpoint of this book, however, there is no question that the Internet has enabled the creation of intellectual properties of great value. Some domain names have been taken as company names by their owners (amazon.com, for example). A website that receives thousands of hits per day becomes a prime location for advertising, like a billboard on a well-traveled highway. A website can be the core of a worldwide distribution system for products and services or can, in some cases, be an entity’s only place of business. Computer Software. Computer software is included here because it is subject to patent, copyright, or trade secret protection. Trademark protection is also becoming very important in the computer software industry. Revenue Procedure defines computer software to include:

. . . all programs or routines used to cause a computer to perform a desired task or set of tasks, and the documentation required to describe and maintain those programs. Computer programs of all classes, for example, operating systems, executive systems, monitors, compilers and translators, assembly routines, and utility programs as well as application

3.14 INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY programs are included. Computer software does not include procedures which are external to the computer operations, such as instructions to transcription operators and external control procedures.13

The Copyright Act defines a computer program as: “a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result.”14 Consider computer software to include the project description and research, source code, object code, program documentation, user instructions, and operating manuals. This form of intellectual property can be extremely important to a business enterprise, and it is categorized as either product or operational software. Product Software is developed for resale as a product. It can be individual, standalone programs or more complex modular systems that interface with one another, such as a general ledger system. The software may be sold with or without consultant support and related services. Operational Software is used by a company in its own internal operations. It may have been purchased, be used under license, developed by an outside firm under contract, or developed internally. The types of operational software include system software and applications software. System Software, sometimes called “the operating system,” is required by the computer hardware to operate. Usually obtained from the hardware vendor as part of the computer system, it is rarely developed—though it may be modified—by the user. Applications Software is used for the specific functions of the business. This might include: • Basic accounting functions such as general ledger; payroll; accounts payable and receivable; material, supply, and inventory control; and fixed asset accounting. These systems are often purchased and may be extensively modified. • Company-specific accounting systems for areas such as sales and commissions, product costing, purchasing, and customer billing. These would usually be developed in-house. • Management systems for functions such as personnel functions, property taxes, database systems for management information, property lease systems, word processing, or financial models. • Production systems for functions such as manufacturing scheduling, CADCAM (computer-aided design—computer-aided manufacturing), design models, engineering calculations, numerically controlled machines, and robotic operations. Recalling the previous discussion of proprietary technology, note that when computer software is designed in-house, and when it becomes more company-specific in its design and function, it is likely to embody more proprietary features. That is, it is likely that more time was spent by users in development to design the system and test the results. When the users of the system are heavily involved in the design, there will be more of their knowledge embodied in the system.

INTANGIBLE ASSETS 3.15 Mask Works. Standing somewhat in between computer hardware and software are

semiconductor chip products that embody circuitry and logic. The essence of a chip is the mask work, defined as: A series of related images, however fixed or encoded: (A) having or representing the predetermined, three dimensional pattern of metallic, insulating, or semiconductor material resent or removed from the layers of a semiconductor chip product; and (B) in which series the relation of the images to one another is that each image has the pattern of the surface of one form of the semiconductor chip product.15

Mask works are eligible for protection under the Copyright Act if certain conditions are met. Generally, these conditions require that the owner be a U.S. citizen or domiciled here or in a country that also protects mask works, or that the mask work is first commercially exploited in the United States. Protection lasts for 10 years from the date of registration. A copyrighted mask work must be marked “mask work” and have the symbol M. Right of Publicity. The right of publicity emerged from the long-existing protection granted primarily by state statutory or common law concerning the right of privacy. It addresses the right of a person to control and benefit from commercial exploitation of his or her identity. Since this is an age of celebrities, the commercial exploitation of that celebrity can be an extremely valuable right. In general, the right of publicity extends to a person’s name and likeness, as well as to voice or even identifiable robots. The right can even extend to those to whom a name or likeness has been licensed. Many states have adopted right-of-publicity laws. These and federal trademark statutes have afforded celebrities new means to protect their images and their markets. It is rather unlikely that the right of publicity would emerge as an important element in a corporate acquisition or merger. Rather than being an asset of the business, it is more likely that this concept might emerge in terms of litigation underway in which the corporation is a defendant. Many of the more notable cases involving the right of publicity resulted from the overzealous use of sounds and styles in advertisements for which proper permission had not been obtained from the creating personality. Intellectual Capital. A new term, Intellectual Capital, has entered the business lexicon.

This has been an outgrowth of the attention that has been given to intangible assets and intellectual property as managers of businesses seek to maximize their creation and contributions to the enterprise. Intellectual capital has been variously defined as “…what walks out the door at the end of the business day…” and “knowledge that can be converted to value.”16 Intellectual capital is not a new category of business assets, but rather a different way of classifying assets in order to focus on their management. Intellectual capital is a combination of Human Capital, Intellectual Assets, and Intellectual Property.17 An examination of the elements of these categories reveals that they comprise the intangible assets and intellectual property already discussed, with perhaps an additional, more detailed breakdown of human capital (what is termed the assembled workforce). Exhibit 3.2 depicts a more detailed business enterprise having many of the intangible assets and intellectual property previously discussed.

3.16 INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY Business

=

Working Capital

+

Fixed Capital

+

Intangible Assets & Enterprise Intellectual Property

- Inventory

- Offices

- Patents

- Cash

- Warehouses

- Trademarks

- Accounts Receivable - Manufacturing - Mineral Reserves

- Research Labs

- Copyrights - Technological Know-how - Designs - Formulae - Trade Secrets

Intellectual Property

- Distribution Networks - Supply Contracts - Licenses - Customer Lists

Intangible Assets

- Manufacturing Practices - Trained Work Force - Research Capabilities

Exhibit 3.2 Business Enterprise Assets

COMMENT

There is no question that in the world of international business bricks and mortar are giving way to intangible assets and intellectual property. Therefore, one must expect that these assets will loom large in the thinking of buyers, sellers, lenders, and investors when merger and acquisition transactions take place. Looking at the value of Bristol-Myers Squibb during April 2000, one sees that more than 90 percent of the value of this pharmaceutical company belongs to intangible assets and intellectual property. The market value of equity of Bristol-Myers Squibb was $125 billion in April. Long-term debt totaled another $3 billion. As such, the value of invested capital (debt plus equity) totaled $128 billion. The balance sheet of this business enterprise showed that net working capital equaled $3.7 billion; fixed assets totaled $4.6 billion; and other long-term assets were reported to be valued at another $3.2 billion. The remaining $116.5 billion of value is comprised of the intangible assets and intellectual property discussed in this chapter. The pie chart in Exhibit 3.3 shows the significant value of the intangibles possessed by Bristol-Myers Squibb.

COMMENT 3.17

Bristol-Myers Squibb Allocation of Value Net Working Capital

Fixed Assets Other LT Assets

Intellectual Property & Intangible Assets Exhibit 3.3 Bristol-Myers Squibb Intangibles Values

The significant value of intangibles is not limited to pharmaceutical companies or even other types of high-tech companies. The same relationship shown for BristolMyers Squibb is true for food companies, apparel companies, and manufacturers of household products. A similar analysis for Heinz, Nike, Philip Morris, and Procter & Gamble shows that more than 85 percent of their invested capital values are intangible. In each case, the character of the valuable intangibles may be different. For BristolMyers Squibb patented technology is a significant portion of the intellectual property. For Heinz, Procter & Gamble, Nike, and Philip Morris trademarks dominate. Regardless of the type, intangible assets and intellectual property dominate. Buyers are looking to acquire assets that they may not have the ability or resources to create themselves. They are looking to acquire intangible assets and intellectual property with speed; acquiring an entire enterprise may be the appropriate vehicle for that strategy. Buyers are also looking to fill gaps in their own technological expertise. At the same time, due diligence cannot be forgotten. Buyers must carefully investigate the existence and quality of the intangible assets they seek to acquire. The business press has highlighted the dire consequences of a headlong rush into an acquisition without sufficient attention to this due diligence. Sellers, however, need to receive fair value for their intellectual assets. That judgement may rest on a careful evaluation of how those assets will provide benefits and synergies with a potential acquirer.

3.18 INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY

Lenders are increasingly willing to accept intangible assets and intellectual property rights as collateral for debt. Intangible assets and intellectual property are more inextricably linked to a business enterprise than are most monetary and tangible assets. This means that much of the importance in value of intangible assets and intellectual property depends on a viable business enterprise. The liquidation value traditionally depended upon by lenders can be dramatically different for these types of assets. Lastly, investors who may stand to profit or lose money in corporate mergers and acquisitions are concerned with a proper evaluation of intangible assets and intellectual property. As this is written, a significant market correction is going on in the technology sectors. Investors are obviously re-evaluating the intangible assets and intellectual property rights that support the stock prices of these companies. ENDNOTES 1 For further discussion of this subject, see Gordon V. Smith and Russell L. Parr, Intellectual Property: Licensing and Joint Venture Profit Strategies (New York: John Wiley & Sons, 1998), Supp. 1999, Chapter 2A. 2 VGS Corp v. Commissioner, 68 TC 563,569 (1977). 3 David Rines, Professor of Intellectual Property Law and Industrial Innovation, Franklin Pierce Law Center, Concord, New Hampshire, in Germeshausen Center Newsletter (Spring 1999). 4 Uniform Trade Secrets Act, 1(4) (Drafted by the National Conference of Commissioners on Uniform State Laws as amended, 1985). 5 Restatement of Torts §757 Cmt.b. (1939). 6 E.I. Dupont de Nemours & Co. v. United States, 288 F.2d 904 (Ct. Cl. 1969). 7 David A. Burge, Patent and Trademark Tactics and Practice (New York: John Wiley & Sons, 1984), 27. 8 35 U.S.C. §161. 9 25 U.S.C. §171. 10 Diamond v. Chakraberty 447 U.S. 303, 206 USPQ 195. (1980). 11 17 U.S.C. section 102(a)(8). 12 David N. Martin, “Romancing the Brand: The Power of Advertising and How to Use It,” American Management Association (New York, 1999). 13 Revenue Procedure 69–21 (1969-2 CB 303). 14 The Copyright Act, 17 U.S.C. Section 101. 15 17 U.S.C. Section 901, Semiconductor Chip Protection Act of 1984. 16 Russell L. Parr and Patrick H. Sullivan, Technology Licensing-Corporate Strategies for Maximizing Value (New York: John Wiley & Sons, 1996), Chapter 14. 17 See note 16, 255.

CHAPTER

4

VALUATION OF INTELLECTUAL PROPERTY ASSETS IN MERGERS AND ACQUISITIONS Michael J. Lasinski InteCap, Inc.

INTRODUCTION

Business development and licensing executives have, on numerous occasions, entered into agreements that give away their intellectual property (IP) assets. Alternatively, they often walk away from transactions that would have resulted in significant value for their companies. This happens because the underlying value of the subject IP assets in the transaction is often unknown. For those involved in IP-intensive transactions who are willing to spend a little time and effort understanding the IP, analyzing the markets in which the IP will be commercialized, and crunching the numbers, the economic rewards can be significant. This chapter is intended to provide business development and licensing executives, as well as other senior management, with the theoretical foundations of IP valuation. It also provides guidance on the practical application of an IP valuation and highlights some of the analytical tools and data sources that may be used in the valuation process. With those objectives in mind, the chapter has been organized into the following sections: • Reasons for valuing intellectual property in M&A transactions • Valuation approaches and their application (including useful data sources) • Other pricing considerations This chapter is to be used for discussion purposes only and is not intended to be allinclusive on the topic of intellectual property valuation. The concepts and considerations presented do not represent those that InteCap, Inc. would necessarily apply in any particular case. The data to be relied upon, the theories employed, and the weight given to various factors will vary depending on the specific facts and circumstances of each valuation situation.

4.1

4.2

VALUATION OF INTELLECTUAL PROPERTY ASSETS

REASONS FOR VALUING INTELLECTUAL PROPERTY IN MERGERS AND ACQUISITIONS

Skeptics often argue that because of its intangible nature, IP cannot and should not be valued. This is because assigning a number to IP assets in the abstract is of little or no use. However, when considering the best methods of extracting value from a company’s intangible assets, negotiating mergers and acquisitions, or other transactions, a valuation can be critical. In fact, it is even more critical to perform a valuation for IP assets than for tangible assets. This is because the variety of ways a company can exploit its IP is often far greater than its tangible assets. Intangible assets can be bought and sold (like tangible assets); however, they can also be shared (for example, licensed), used in financing, used for legal purposes (for example, infringement litigation), used for tax planning (for example, donated), and for other purposes. To understand the importance of valuing IP in mergers and acquisitions, it is necessary to understand how IP is used and valued in the normal course of business. Reasons to value IP include the following: strategic, transactional, tax, financial, and legal. Strategic Reasons to Value Intellectual Property Management. For the most part, senior

business executives spend very little time thinking about IP matters. However, they do care a great deal about extracting maximum value from corporate assets, protecting current markets, and executing corporate strategy (for example, achieving revenue growth and financial targets). A thorough valuation analysis can provide senior management with information related to the importance of IP in achieving these corporate goals. In a recent survey of corporate Licensing Executive Society members, 12 percent of the 198 respondents indicated that they were using valuations to report IP performance to senior management. Unfortunately, it is often impossible due to time, resources, and other constraints to perform a full valuation analysis of a corporation’s entire IP portfolio. That is why companies such as Dow Chemical Company have developed processes to systematically and efficiently value corporate IP assets. Processes such as Dow’s help the company identify and highlight the value and risks presented by the IP. For example, the valuation process can highlight the value of expected price premiums or market share premiums that a company can expect by including a patented technology in its products. Alternatively, it may highlight the value of licensing a technology outside of the corporation’s scope of products. In many cases, the questions asked during the valuation process are often as enlightening as the final value. Transactional Reasons to Value Intellectual Property. A proper valuation helps ensure

prudent decisions in M&A transactions. However, valuations are also used in a variety of other transactions, such as licensing-out, licensing-in, IP acquisitions or sales, spinouts and joint ventures, and combinations of the transactions listed here. The following sections discuss the role of IP valuation in each of these contexts. In today’s society, an acquisition target’s IP (as well as that of its competitors) is a critical element of any transaction.

Company Acquisition Planning and Due Diligence.

REASONS FOR VALUING INTELLECTUAL PROPERTY 4.3

This is especially true within the pharmaceutical and e-commerce markets, where IP can result in significant price premiums and can provide a barrier to entry. However, because of current financial reporting and tax accounting standards, companies are not always required to explicitly value the IP acquired. This, combined with the fact that many current valuation methods used in business acquisitions do not account for the way in which IP assets differ from tangible assets, can result in inappropriate purchase prices or nonoptimal deal structures for either the seller or the buyer. As this book goes to print, the Financial Accounting Standards Board has issued FASB 141 and FASB 142 which supercede APB 16. These standards affect the way the value of intangibles and IP is reported (accounted for) in certain types of business transactions (combinations). See Chapter 5 for a more detailed discussion of these accounting changes. The acquiring company should be aware of both the reliance a potential acquisition candidate places on its IP and the strength and composition of its IP portfolio. In addition, the acquiring company may want to determine the value of the post-merger IP. For example, if the acquisition candidate relies heavily on trade secrets held by employees, the acquiring company must analyze confidentiality and noncompetition agreements, as well as its ability to retain the acquiree’s key employees. Finally, a company may need to analyze the strength, breadth, and life of key patents that protect top revenuegenerating products (for example, top 10 products based on revenues). This should be done for both the acquiree’s and the competitors’ IP. Remember, just because a company hasn’t been sued by its competitors for patent infringement doesn’t mean it won’t be in the future. This is especially true when the acquirer has deep pockets. Licensing Intellectual Property. The economic objective of a license agreement is to

establish a royalty amount that permits both the licensee and the licensor to earn a higher return than would be achieved by pursuing some alternative to licensing. Blind reliance on industry standard royalty rates or rules of thumb may result in forgone licensing income (by charging too low of a royalty) or ignoring profitable opportunities because they appear to fall short of required economic objectives. An independent valuation of the property can be helpful to both parties in setting royalties that are economically justified. A proper valuation helps to isolate and quantify key variables affecting the underlying economics of the transaction. Such variables may include product pricing and profitability, potential market penetration, required capital expenditures, inflation, required rates of return, functional life, technological life, and economic life. After quantifying the economic risk factors associated with the licensing transaction, both parties can negotiate license terms to shift risks from one party to the other. Also, basic financial modeling (for example, discounted cash flow analysis) aids in the evaluation of alternative payment structures, such as running royalties versus fixed payments. In addition to the above benefits, a valuation can be useful in monitoring actual license payments versus expected payments. A license that produces royalty income significantly less than that expected can be highlighted during annual license reviews and investigated for underpayment or other problems.1

4.4

VALUATION OF INTELLECTUAL PROPERTY ASSETS

Acquiring or Selling Intellectual Property (in the Absence of a Business Combination). The

valuation of intellectual property is important in the context of a sale for many of the same reasons previously discussed. However, there may be valuation considerations in a lump-sum compensation received from a technology sale that differ from the running income stream commonly generated by a license. For example, in a lump-sum transfer it is important to consider the after-tax cash flows and time value of money effects. It is also important to account for the tax treatment surrounding the acquired asset (for example, the amortization benefit available to the new owner). Further, although the useful life of a technology may be of less importance during a running royalty negotiation, it may be very important in the context of a lump-sum transfer. If one were to choose an improper period over which to value the technology, the negotiated price could be orders of magnitude different than the actual value. Establishing Equity Contributions. In joint ventures or company formations, it is relatively common for one partner to provide technology and IP assets while the other partner provides tangible assets and capital. Valuation of contributed intellectual property is important to determine the value of equity shares to be issued to each party. This not only is important for both tax and financial purposes but also may become critical in situations requiring buyout of equity shares. Corporate Spin-Offs. As companies face mounting pressure to focus on their core busi-

ness, many are spinning off noncore operations. Such spin-offs may involve the divestiture of entire divisions of the existing company. Alternatively, the company may choose to spin off embryonic technology into a startup company. In both cases, valuation of the intellectual property can substantially impact the structure of the transaction and the consideration that is exchanged. Tax Reasons to Value Intellectual Property. Although there are a number of proactive

reasons for valuing IP, many IP valuations are performed in order to comply with federal and state tax regulations. The following sections discuss IP tax strategies and how valuation plays a role in such strategies. Please remember certain tax strategies may not be appropriate for all companies; therefore, tax counsel should be sought prior to implementing any of the strategies discussed. Intercompany Transfer Pricing. Under the Internal Revenue Code (I.R.C.) Section 482, pricing for intercompany transfers of intangible assets may be adjusted by the IRS to reflect arm’s-length income levels. While Section 482 has been around for quite a while, the Tax Reform Act of 1986 added new teeth to the provision. The Code requires that payments for a licensed or transferred intangible asset be commensurate with the income attributable to the intangible. This is commonly known as the Super Royalty provision. Even though the Super Royalty provision was implemented in 1986, the final Section 482 regulations were not issued until July 8, 1994. These regulations discuss various methods to use in the valuation of intangibles and require the taxpayer to select the best method on an individual transaction basis. The best method is the method that “. . . under the facts and circumstances, provides the most reliable measure of an arm’slength result.” Factors that may be considered in determining the best method include:

REASONS FOR VALUING INTELLECTUAL PROPERTY 4.5

comparability, completeness and accuracy of data, reliability of assumptions, sensitivity of results to deficiencies in data and assumptions, and confirmation of results by the use of another method. In addition, the current regulations compel taxpayers to substantiate intercompany royalty rates with contemporaneous documentation. Taxpayers may risk substantial penalties by waiting until the time of an audit to justify intercompany royalty rates. A proper valuation can play an important role in satisfying the documentation requirements under Section 482.2 Intellectual Property Management Subsidiary. Some states, such as Delaware and Michigan, do not tax intangible asset royalty income when appropriate corporate structures are established. Because of this, one strategy that may allow a company to decrease its state income tax is the formation of a holding company. Intangible assets such as patents or trademarks are transferred to the holding company, which subsequently licenses them back to the operating companies. The license fees paid to the holding company by the operating companies decrease the operating companies’ taxable income and reduce their state tax liabilities. Conversely, the royalty income earned by the holding company is exempt from state taxes. An independent valuation is important to establish for state tax authorities the fair market value of the assets transferred and intercompany royalty rates that are consistent with the arm’s-length standard. In assessing the validity of the transaction, a key factor that states may consider is the presence or absence of legitimate business activities by the holding company. In other words, the transaction is less likely to be disallowed if the IP holding company actively participates in the management of the company’s IP. This requirement is actually a blessing in disguise, as it encourages the establishment of an IP holding company that seeks to proactively manage the company’s IP. Proactive measures such as creating a Board of Directors for the IP subsidiary and creating a business plan for managing the IP serve the dual purpose of reducing tax risk and improving the company’s management of its IP.3 Charitable Donations of Patents and Related Technology. In a number of recent news articles, DuPont indicated that it donated $64 million in IP assets to three universities in 1998.4 While these articles seemed to indicate that this was a new way for companies to give, it was not. Section 170 of the Internal Revenue Code allows companies to realize a tax deduction for the value of property donated to a qualified organization. Revenue ruling 58–260 appears to classify a patent as property that may be donated: “The fair market value of an undivided interest in a patent, which is contributed by the owner of the patent to an organization described in section 170(C) [charitable organizations] of the Internal Revenue Code of 1954, constitutes an allowable deduction….” Regulations require that the fair market value of the patent be determined through an independent appraisal. In addition to the tax deduction that results from the donation, a number of advantages result from the donation. First, a donation allows the company to make a contribution that benefits society. Second, donating the IP allows the company to avoid the cost of maintaining the patent(s). Finally, charitable donations assist companies in strengthening their ties with nonprofit research organizations such as universities.5

4.6

VALUATION OF INTELLECTUAL PROPERTY ASSETS

Purchase Price Allocation. Prior to the enactment of Section 197 of the Revenue

Reconciliation Act of 1993, significant tax incentives existed for acquiring companies to allocate the purchase price to certain amortizable intangible assets as opposed to goodwill. Under Section 197, the cost of most intangible assets, including goodwill and going concern value, is amortizable over a 15-year period. Therefore, the need to allocate the purchase price between various types of intangible assets for tax purposes may have been reduced.6 As mentioned previously, FASB 141 and FASB 142 are newly issued. These standards supercede APB 16 and affect the need to value certain identifiable intangible assets (including IP) in certain, if not all, types of business combinations. See Chapter 5 for a more detailed discussion of accounting trends and financial/IP reporting requirements in business combinations. In-Process R&D. In the context of normal business, the great majority of research and development costs are recorded as expenses in the period in which these costs are incurred. Therefore, research and development expenses typically appear on the income statement rather than the balance sheet. In certain business combinations, accounting standards have required capitalization of what is known as In-Process R&D. Because the In-Process R&D must be capitalized in certain business transactions (e.g, those accounted for under the purchase method), it must be valued. See Chapter 5 for a more complete discussion of this topic. Financial Reasons to Value Intellectual Property. As intangible assets grow in importance, traditional accounting principles fail to capture an increasingly large portion of the value of many companies. As a result, IP valuations are becoming more common in the world of corporate finance, as the following sections highlight. Obtaining Financing/Raising Capital/IP Asset-Backed Securitizations. One of today’s hot topics in IP management is using IP assets to obtain financing through raising capital, securing debt, or issuing asset-backed securities. Although using IP to raise capital or secure debt is not new, the use of royalty income to issue bonds is. The most prominent example of using an IP royalty stream for securitization of bonds is the now-famous Bowie Bonds. These are bonds that were issued using the royalty stream that David Bowie was receiving as security. This transaction was unique for a number of reasons. First, it gave David Bowie access to his future cash flows today. Second, it gave investors a unique vehicle in which to invest their money. Since the success of the Bowie Bonds, a number of financial institutions have become interested in the securitization of other IP-related cash flow streams. These institutions have raised or are in the process of raising funds for future securitizations. The paramount question facing most of these institutions is how to value cash flow streams from intangible assets.7 Reorganization/Bankruptcy/Loan Workouts. In cases of corporate reorganization or bank-

ruptcy, creditors and bankruptcy courts require an accurate representation of corporate asset values. In this context, intangible asset valuations can be used for purposes of

VALUATION APPROACHES AND THEIR APPLICATION 4.7

determining liquidation values or estimating the value of the remaining business interests. In loan workout situations, lenders may obtain a security interest in intellectual property as collateral for underlying debt instruments. A proper valuation can assist lenders in identifying marketable intellectual property and maximizing its value in liqui-dation. An example helps to highlight this point. In 1992, Orca, a disk drive manufacturer, filed for bankruptcy. The company had claims against it for more than $2.5 million, and assets valued at $1.3 million. The company (in bankruptcy) and legal counsel decided to auction off the company’s patent portfolio, for which it had paid approximately $500,000. Although the company had hopes of realizing as much as $600,000 for the portfolio, the bidding started at only $225,000. When the auction was completed, Samsung Electronics Co. had purchased the portfolio for approximately $3.65 million, or $1.15 million more than the total claims against the company!8 Legal Reasons to Value Intellectual Property. In addition to strategic, transactional, tax, and financial reasons, there are often legal reasons for valuing intellectual property. The Federal and Tax court system has recognized the value of intellectual property rights by granting substantial awards for compensatory damages in infringement and tax-related suits. Arguably, the most famous IP damages case was Polaroid versus Eastman Kodak, in which Polaroid was awarded more than $873 million. These types of awards and the volume of patent litigation highlight the significant value put on IP in today’s business world. Calculation of intellectual property damages (most often lost profits and reasonable royalty) is similar in many respects to valuation in other contexts outside of litigation. This is because damages attempt to compensate the harmed party for the economic benefit that it would have enjoyed had its IP not been infringed. Quantifying damages requires attention to variables such as sales volumes, prices, market share, profitability, and royalty rates for products that embody or utilize certain IP assets. Because of the high costs of litigation (average patent lawsuits through trial now exceed more than $1 million in legal fees and other costs), progressive companies have begun to perform valuations prior to the initiation of litigation. To determine the expected economic benefit of litigation, these valuations consider the potential damage awards that may be granted, the economic value of an injunction, and the costs of litigation. These valuations are then used to determine whether to pursue an infringer in litigation and to support settlement discussions.

VALUATION APPROACHES AND THEIR APPLICATION

Just as many reasons exist for valuing IP, numerous methods exist to value IP. IRS Revenue Ruling 59–60 acknowledged this diversity, stating that, “no formula can be devised that will be generally applicable to the multitude of different valuation issues . . . a sound valuation will be based upon all relevant facts, but the elements of common sense, informed judgment, and reasonableness must enter into the process of weighing those facts and determining their aggregate significance.”9

4.8

VALUATION OF INTELLECTUAL PROPERTY ASSETS

Although one formula cannot be derived to apply to all situations, a few fundamental principles exist that apply to most IP valuations. The first is the premise of value, the second is the source (or sources) of value, and the third is the valuation approach. In many ways, the valuation of intellectual property is similar to other valuations; however, the nature of intellectual property sometimes requires unique application of these valuation principles. The Premise of Value: Fair Market Value. Before value can be estimated, the premise, or

theoretical basis, of value must be considered. Often, this premise is defined as fair market value. Fair market value is “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.”10 The Sources of Potential Value. Those attempting to value intellectual property can lose

sight of the forest for the trees. In attempting to calculate how much someone would pay for the IP, analysts often neglect the issue of why someone would pay for it. Regardless of which quantitative valuation approach (market, cost, or income as is discussed in the next section) is used, it is important to focus on the issue of exactly how the IP may create value for its owner. There are numerous ways in which IP can create value. The following categories provide an overview of some of these sources of value: • Exclusivity Value. Exclusivity value derives from the legal right to exclude others from manufacturing, using, or selling products that incorporate the subject IP. This exclusive position may allow a company to charge a premium price, increase unit market share, or reduce manufacturing costs. Exclusivity may also provide more subjective benefits such as enhanced customer satisfaction. Finally, exclusivity may provide value by simply stopping a competitor from practicing a technology that the owner is unable to practice himself because of other IP that is blocking the owner’s ability to practice in the same field. • Defensive Value or Freedom to Operate. Legally, a patent provides the owner with the right to exclude. It does not provide the owner with the right to practice. This is because others may have IP that blocks this right as previously discussed. However, in business, a significant IP arsenal, or even one key patent, can create a détente situation in which competitors are wary of asserting their own patents for fear that the defendant may countersue. • Transfer Value. Another potential source of value is transfer value. A company may wish to buy or sell certain IP assets for any number of reasons. While these reasons are too numerous to discuss here, please note that patent licensing revenues have increased more than 700 percent from $15 billion in 1990 to $100 billion in 1998.11 This indicates not only that transfer value can be signifi-

VALUATION APPROACHES: MARKET, COST, AND INCOME 4.9

cant, but also that a number of companies are participating in the technology transfer arena. • Option Value. Patented inventions are sometimes made before their time. At the time they are made, marketing the invention may be infeasible due to technological, manufacturing, or market limitations. It may also not be desirable because of current investments in alternative technology. While such inventions may seem to have little value initially, they can possess a substantial option value. In other words, the current technology and protection may provide an avenue for future projects and products that may be very profitable. Real-option pricing theory can be used to evaluate these situations.12

VALUATION APPROACHES: MARKET, COST, AND INCOME

Once the premise of value and the source(s) of potential value have been determined, the appropriate valuation approach or approaches must be selected. The cost, market, and income approaches are well documented in the literature and are currently used by valuation professionals for both intangible and tangible assets. Market Approach. The Market Approach determines the fair market value of an asset based upon the price at which parties with comparable assets have previously transacted under similar conditions. In other words, the price paid in a similar transaction for similar assets should be similar to the price for the assets in the current transaction. The degree of reliance on comparable transactions depends on an assessment of whether the past comparable transactions are sufficiently similar to provide an indication of fair market value for the assets in question. Some of the factors that may be considered in assessing comparability include the nature of the assets transferred (e.g., patents versus trade secrets); similarity of products, industry, market size and characteristics; profitability; barriers to market entry; and so forth. By their very nature, IP and IP-related transactions tend to be unique; therefore, it can be difficult to find closely comparable transactions. However, inexact comparables may serve as a guide or indication of value, and adjustments can sometimes be made to account for the differences in transactions. In some cases, the Market Approach is useful for determining inputs to use in other valuation approaches, particularly the Income Approach. For example, if you are trying to estimate the lump-sum value of a portfolio of patents, it can be very difficult to find a transaction in which a similar portfolio of patents was sold. However, it may be possible to identify license agreements for similar patents that specify running royalty rates. These market-based rates could be used as an input into a valuation model created using the Income Approach, as discussed later. Cost Approach. The Cost Approach values assets based on the cost that would be incurred in the development of assets similar to those being valued. This valuation method is based on the premise that no party involved in an arm’s length transaction would be willing to pay more for a license than the cost to develop an alternative. Of

4.10 VALUATION OF INTELLECTUAL PROPERTY ASSETS

course, such an analysis is based on the assumption that an alternative could be developed. Although this assumption is almost always valid in other valuation contexts such as machinery or real estate, it may not be in the case of intellectual property. For example, it may be difficult to envision an alternative to a basic or pioneering patent. On the other hand, some patents may be minor improvements, in which case the development of an alternative would be relatively straightforward. Assuming that the development of an alternative appears possible, the next task is to develop an estimate of the cost of the alternative. Depending on the circumstances, one may choose to base the cost to develop the technology on historical development costs or current projected costs to develop an asset of similar value. In the case of technology, some of these costs may include materials used in development and testing, engineering, prototype production, factory overhead, consulting fees, and so forth. It is also important to consider the amount of time required to develop the alternative and the opportunity costs (such as lost sales and profits) of this delay. It may also be necessary to incur incremental marketing or promotional expenses in order to secure a comparable market position for the replacement product. The Cost Approach may be very useful in certain situations such as the valuation of embryonic technology where the market applications have not yet been defined and other approaches are difficult to use. However, in other circumstances, the Cost Approach may have certain limitations that suggest the use of another approach. These limitations include a lack of consideration for elements of future income streams, market conditions, useful life, and the risks associated with receiving future economic benefits. Income Approach (Discounted Cash Flow Analysis). While the Cost Approach determines an asset’s value by calculating the avoided cost of developing an equivalent alternative, the Income Approach focuses on quantifying the expected future income that the buyer may generate using the assets. The Income Approach values assets based on the present value of the future income streams expected from the asset under consideration. In finance terms, it is a discounted cash flow (DCF) model. This approach is often used in the context of one of a few theoretical constructs. Two constructs will be discussed in more detail:

1.

2.

Relief from Royalty. Under this construct, it is assumed that ownership of the subject intellectual property relieves the owner of the burden of paying a royalty to license it. The Income Approach is used to quantify this relief from royalty. Postulated Loss of Income. This construct is based on the assumption that the loss of the subject intellectual property would reduce the owner’s income. This loss could result, for example, from decreased market share, reduced prices, or increased costs. The Income Approach is used to quantify this loss of income.

It should be noted that these valuation constructs or approaches are not mutually exclusive, nor should one be used without consideration of the other. In fact, a recent appellate tax court opinion found that the use of the Relief From Royalty Approach under the facts of the Nestle Holdings, Inc. v. Commissioner of Internal Revenue

VALUATION APPROACHES: MARKET, COST, AND INCOME 4.11

Service necessarily undervalued certain trademarks. The appellate court found that the IRS’ valuation expert erred in the use of the Relief From Royalty Approach because it did not capture all of the economic benefits an owner generally derives from using a trademark. Because the Income Approach requires the user to quantify the expected future benefit from the asset, it is sometimes considered the most rigorous of the three methods. As a result, the Income Approach is useful not only for the value estimate that is ultimately developed, but also for the exercise itself. One of the primary benefits of the DCF model is its ability to measure alternative opportunities and transactions on an equivalent basis (i.e., net present value of cash flows). Another benefit of a DCF analysis is its ability to isolate and test the sensitivity of certain key variables. For example, a DCF model would help to answer the question: What market penetration rate must be achieved in order to yield a reasonable return on this acquisition? In addition, Monte Carlo analyses can be performed that can test the sensitivity of multiple variables at once and, therefore, identify expected best and worst cases, as well as a likely range of outcomes. There are three primary parameters that should be quantified in order to use the Income Approach: 1. 2. 3.

The amount of future income from the asset The timing and duration of the income stream The risk associated with the realization of the income stream

Amount of the Income Stream. Determination of the income stream is generally a twostep process. First, the user must determine the sales and profitability of products that incorporate the intellectual property. Second, the user must determine what portion of this income is attributable to the subject intellectual property because of a number of other factors that create value, such as the distribution channel or manufacturing knowhow. The following sections describe alternative approaches for achieving these two steps. Step 1: Determination of the Sales Base and Profitability. The size of the sales base is determined by a number of factors, including the overall market size, segmentation and share considerations, growth rate, product pricing, and other considerations. Once the sales base has been determined, profits can sometimes be forecasted by deducting relevant expenses such as additional development costs, manufacturing costs, operating expenses (e.g., advertising and promotion), the cost of required capital investments, taxes, and others. While many intellectual properties may produce an incremental stream of sales and profits, occasionally the intellectual property enhances profits only through manufacturing (or other) cost savings that accrue to the user of the property. In such cases, the cost savings may be an appropriate pool from which to apportion value to the IP. Step 2: Apportioning the Profit. The following discussion presents a number of alterna-

tive methods for attempting to determine what portion of the total profit is attributable to the subject IP.

4.12 VALUATION OF INTELLECTUAL PROPERTY ASSETS

• The Excess Earnings Method is based on the premise that a property’s value can be measured by the incremental earnings achieved by products that embody unique intangibles (e.g., intellectual property protection) relative to the profitability of similar benchmarks. Examples of benchmarks, as used here, may include profit margins on similar products without intellectual property protection, or more general measures of industry profit levels. The excess earnings may result, for example, from the proprietary product commanding a price premium, delivering certain manufacturing cost savings, or achieving larger sales quantities. Part or all of these excess earnings (depending on the circumstances) represent the portion of total profits attributable to the intellectual property, exclusive of other factors. • The Residual Income (Rate of Return) Method is another way to isolate the value of intellectual property. It is similar to the Excess Earnings Approach in that both attempt to quantify the incremental benefit of the subject IP. The difference is that the Excess Earnings Approach analyzes incremental profit, while the Residual Income Method examines incremental return on assets. Under the Residual Income Method, the user begins by identifying the tangible assets required to produce and distribute the products that incorporate the subject IP. The required return on these tangible assets is then computed by applying appropriate costs of capital to the tangible assets. This required return is then subtracted from the actual rate of return earned by selling the subject products. The residual return or income stream may be considered representative of the income attributable to the intellectual property. While theoretically attractive, this approach is often difficult to implement in situations where multiple, interrelated intangibles are employed in a business. • The Rules of Thumb are sometimes used to apportion the profit attributable to the subject intellectual property. These rules of thumb attempt to divide the anticipated profits in a manner that is commensurate with the nature of the intellectual property and the functions performed and risks assumed by each party to the transaction. The need to divide the profit pool has been recognized and endorsed by licensing practitioners, intellectual property infringement case law, Tax Court case law, and Internal Revenue Service regulations. An often discussed rule of thumb in licensing transactions is the 25% Rule, in which the licensor receives 25% of the profit generated by the licensed invention. A common question, however, is the definition of profit and whether it represents the total profit generated by the product embodying the licensed invention or the incremental profit generated by the specific IP.13 Comparables-Based Royalty Rates. The three previous methods (Excess Earnings,

Residual Rate of Return, and Rules of Thumb) represent alternatives for apportioning profit once the total profitability of the subject products has been determined. While each of these approaches is theoretically appealing, the two-step process of estimating profits and apportioning value to the IP is sometimes a difficult or impossible task in practice. A potential alternative in some cases may be to compute the income stream attributable to the IP using royalty rates specified in comparable agreements.

VALUATION APPROACHES: MARKET, COST, AND INCOME 4.13

Under this comparables-based royalty rates method, the royalty rate is determined using comparable agreements as discussed in the Market Approach section. Then the royalty rate is applied to the appropriate sales base. This method can be appealing for two reasons. First, it eliminates the need to forecast future profits. Second, because the royalty is determined using market comparables, the royalty rate may represent a de facto, market-based apportionment of profits. Duration of the Income Stream. In tandem with the estimation of the annual amount of

the income stream, it is necessary to forecast the duration of the income stream. There are three components to the duration of the income stream: 1. 2. 3.

The timing of market introduction for products incorporating the subject IP The adoption rate and life cycle of the products The length of the useful life of the IP

Timing of Market Introduction. The timing of market introduction may depend on a

number of factors, including perfection of design, development of manufacturing capacity, and the launch of advertising and promotional efforts. Interviews with personnel in various functions may be useful for estimating the timing of the market introduction. It may also be useful to analyze previous product introductions to identify potential obstacles and confirm the reasonableness of launch estimates. Adoption Rate and Life Cycle. In order to estimate the annual cash flows attributable to

products incorporating the subject IP, the analyst must consider the adoption rate and life cycle of the products. Different markets vary widely in their eagerness to adopt new technology. These differences should be reflected in the cash flow estimates. Length of the Useful Life. The useful life of intellectual property can be influenced by

a number of factors. The following points describe several alternative definitions for the life of IP. • Statutory or legal life is determined by the duration of legal protection, such as the life of a patent. • Functional or technological life represents the period before which technology is succeeded by superior developments, thereby becoming technically obsolete. • Market life refers to the length of time for which the market demands products incorporating the subject IP. For example, the consumer market, not technical obsolescence or patent expiration, ended the useful life of Sony’s Betamax technologies. • Economic life represents the period during which the property is producing an adequate return on invested assets. Accounting for the Risk of the Income Stream. The income stream attributable to intel-

lectual property is risky, as just about any future cash flow stream would be. In employing the income method, it is critical to account for this risk. Uncertainty, or risk, can impact the analysis in two ways. First, uncertainty might need to be reflected in the

4.14 VALUATION OF INTELLECTUAL PROPERTY ASSETS

estimated cash flows attributable to the intellectual property. That is, the cash flow estimates likely should reflect the expected outcome, not simply the most optimistic outcome. Second, once the analyst has developed estimates of the cash flows attributable to the IP, she must discount these cash flows at a rate that reflects the risk of the cash flows. The following sections describe methodologies for accounting for these risks. Computing the Expected Income Stream. A common pitfall when using the Income Approach is to create a model that computes the cash flows under the best-case scenario and then apply a discount rate to the flows. Such an analysis may inadequately account for the risk inherent in the cash flows. Consider the example of a company valuing a patented drug that it has recently developed. Using the Income Approach under the Relief from Royalty construct, the analyst may first forecast the estimated sales of the drug given successful completion of clinical trials and subsequent FDA approval. To this sales estimate, he or she applies a royalty rate based on comparable agreements in order to estimate the cash flows attributable to the patented invention. The analyst then discounts these cash flows to compute the present value of the IP. Unfortunately, the analyst has neglected a critical step—adjusting the cash flows for the risks that the drug faces during development and prior to commercialization. In this case, the drug may not be approved by the FDA; therefore, it may never generate any income. Risks such as this can seriously reduce the expected value. Decision trees may be a good tool for evaluating intellectual property with an uncertain future such as the previous drug example. The decision tree in Exhibit 4.1 illustrates a portion of the tree that might be created in response to the scenario outlined in the previous paragraph. Each branch of the tree, ending at the far right with a hollow left-pointing arrow, represents one potential outcome. Each outcome has an associated value, which reflects the forecasted cash flows, assuming that the particular outcome occurs. Note that the cash flows are zero if FDA approval is not received. Each node of the tree reflects an uncertainty or risk, and the probability that the outcome will take one branch as opposed to the other branch is assigned.

Patent Issues

$5,875

0.70 FDA Approval Received 0.40 Patent App. Denied

Expected Value of a License

0.30 FDA Approval Denied 0.60

Exhibit 4.1 Sample Decision Tree

$0

$1,909

VALUATION APPROACHES: MARKET, COST, AND INCOME 4.15

In order to compute the expected value, the value for each outcome is rolled back through the tree from right to left. Mathematically, the value for each outcome is multiplied by the cumulative probability of its occurrence. The cumulative probability of a given outcome is computed by multiplying together each probability on that particular branch. The expected value is essentially the weighted average outcome, in which the weights reflect the probability that a given outcome will occur. Please note that, depending on the data available and circumstances surrounding the valuation, the size (number of decision nodes) of the decision tree may be vastly different. Therefore, a valuation expert may have a decision tree with just one node (e.g., expected cash flows) or hundreds of nodes. In analyses where there are decision trees with many nodes, the analyst may wish to consider employing a real options approach to IP valuation. This decision to use real options will obviously be based on the information available as well as the circumstances of the valuation.14 Discounting Cash Flows to Their Present Value. Once the expected annual cash flows

have been forecasted, the cash flows must be discounted to their present value. The discounting process serves two purposes. First, it adjusts the cash flows to account for the time value of money, a principle that states that a dollar received today is more valuable than a dollar received at some point in the future. Second, the discounting process reduces the value of the cash flows to account for the risk that they may not occur. If the time value of money were the only discounting concern, cash flows would be discounted at a risk-free rate. Interest rates, or yields, on U.S. government securities are considered a reasonable proxy for the risk-free rate. The maturity of the securities used should correspond to the length of time prior to receipt of the cash flows (e.g., cash flows expected to be received in 10 years would be discounted using yields on longterm government bonds). Unfortunately, the discount rate must also reflect the inherent risk of the cash flows. That is, the rate should include a risk-free rate plus a premium to account for risk. Unfortunately, there is no textbook answer for how to compute this risk premium or how to directly calculate a rate that accounts for both the time value of money and the risk of the cash flows. The following list outlines a few alternative approaches for computing the latter. • Weighted Average Cost of Capital (WACC). A company’s weighted average cost of capital is defined in almost any finance textbook. In short, however, the WACC reflects the blended amount of return investors require for providing capital (in the form of debt or equity) to a company. Investors in firms that entail greater risk demand higher returns as compensation for undertaking the increased risk. The advantages of WACC are that (1) it can be estimated using stock market data and the company financial statements, and (2) WACC is widely accepted and generally understood in the financial community. Unfortunately, WACC has its disadvantages. First, it may not reflect all of the risk associated with IP assets. It is based on a number of assumptions that may prove unrealistic. Its computation is complicated and subject to discretion. Finally, a relatively large body of empirical research questions its validity.

4.16 VALUATION OF INTELLECTUAL PROPERTY ASSETS

• Hurdle Rates. Many companies have one or more hurdle rates, or rates of return, that new projects must be able to earn in order to receive funding. Depending on how they are determined, these rates may be useful in IP valuations, particularly when performing quick and dirty analyses. It should be noted that, like WACC, many hurdle rates are applied across projects at a company. However, each project must be discounted at a rate that captures the risk of the specific project. If the project’s risk level is significantly different from the firm overall risk level, use of the corporate hurdle rate is inappropriate. • Venture Capital Required Rates of Return. Venture capitalists (VCs) invest money in high-risk, early stage ventures with the hope of realizing returns on their investments that are commensurate with the risks undertaken. Because of the substantial risk of their investments, venture capitalists sometimes expect annual return on investment rates of 30 percent to 70 percent. The risks undertaken by VCs are often parallel to the risks of commercializing emerging technologies and IP. (In fact, venture investments increasingly entail investing funds in companies specifically formed to bring new technologies to market.) As a result, the rates of return required by VCs—30 percent to 70 percent, depending on the state of development—may be used as an appropriate discount rate in the context of IP valuations.15 PRICING CONSIDERATIONS IN LICENSING

The premise of value (fair market value), valuation approaches (market, cost, and income), and the sources of value are generally applicable to a number of situations in which IP is to be valued. There are also a number of considerations that are more specific to licensing transactions. (Please note, however, that some of the these considerations may be relevant in other contexts.) The following sections discuss a number of pricing considerations in licensing. In a licensing situation, the parties can reach an agreement only if there is overlap in the ranges of their acceptable outcomes. That is to say, a fair price will be reached if the licensor’s theoretical floor is below that of the licensee’s theoretical ceiling. Within this range, both parties can reach a price that allows them to be better off by entering a license compared to other alternatives. The following sections briefly describe the considerations that influence the licensor’s floor and the licensee’s ceiling.16 The Range of Negotiations: The Floor and the Ceiling.

The Licensor’s Theoretical Floor. The theoretical floor the licensor or transferor of intellectual property may be willing to accept is the cost to transfer the property plus the opportunity cost forgone by the transfer. The cost to transfer the property may include the out-of-pocket costs incurred by the licensor/transferor, such as legal fees during the negotiation. Opportunity costs may include forgone profits if the technology was to be commercialized by the licensor or foregone royalties that may have been earned from another willing licensee. The R&D costs to develop the technology may be considered in determining the licensor’s floor; however, they are often considered sunk costs that do not affect the licensing decision. Strategic reasons may also play a role in deter-

PRICING CONSIDERATIONS IN LICENSING 4.17

mining a licensor’s potential floor. For example, a licensor may accept a lower royalty to encourage market adoption of a new technology. The Licensee’s Theoretical Ceiling. The theoretical ceiling that a licensee may be willing to pay includes the potential costs avoided by licensing the technology and the additional profits received due to the license. Potential avoided costs include costs to design around the IP, costs to acquire a similar license, and the costs and risks associated with infringement litigation. Additional profits over alternatives may result from increased volume or market share, selling price premiums, manufacturing cost savings, and convoyed or derivative sales. Strategic reasons may also play a role in determining a licensee’s potential ceiling. For example, the licensee may pay a higher royalty to obtain an exclusive license that prevents entry of competition into the market place. Industry Royalty Rates. As discussed, negotiations sometimes rely on industry royalty

rates as a starting point because they are easy to apply and are perceived to be in the ballpark. A licensing survey conducted by IPC Group in 1991 asked companies to assess the relative weight they place on established royalty rates in their industries versus profit-based analyses. The results are summarized in Exhibit 4.2. Interestingly, when licensing-out, respondents placed a greater weight on established royalty rates than on a detailed profit review. However, when licensing-in, survey participants emphasized profit analysis over established rates. That licensees should focus more on profitability is not surprising, since they will be making investments to prepare a technology for market and bearing risk in the process. Licensors, on the other hand, may view licensing-out transactions as low-risk, incremental sources of revenue, and therefore, may not feel the need to perform profit analyses. In addition, licensors may feel that they do not have the data to perform useful profit analyses.

Weight 160

Established Rates

140 Licensor Profit Analysis

120 100

Licensee Profit Analysis

80 60 40 20 00

•Relative weight importance on a scale of 30 Licensing-Out

Licensing-In

Exhibit 4.2 Established Rates versus Profit Analysis

Source: “Licensing Practices, Business Strategy, and Factors Affecting Royalty Rates: Results of a Survey,” by McGavock, Haas and Patin, Licensing Law and Business Report, March/April 1991, Vol. 13, No. 16. For a more recent survey, see “A Survey of Licensed Royalties,” les Nouvelles, June 1997.

4.18 VALUATION OF INTELLECTUAL PROPERTY ASSETS Royalty Rate Category

Primary Industry Aerospace Automotive Chemical Computer Electronics Energy Food/Consumer General Mfg. Gov’t/University Health Care Equip. Pharmaceuticals Telecommunications Other

0–2%

2–5%

90.0% 52.5% 16.5% 62.5%

90.0% 45.0% 98.1% 31.3% 90.0% 66.7% 100.0% 28.6% 25.0% 51.7% 32.1% 37.3%

45.0% 25.0% 3.3% 23.6% 40.0%

5–10% 10–15% 15–20% 20–25% Over 25%

2.5% 24.3% 6.3% 25.0%

0.8%

0.4%

25.0% 33.3%

12.1% 90.0% 45.0% 20.3% 23.6%

14.3%

12.5% -

1.1% -

0.7% -

0.7% -

Exhibit 4.3 Licensing—in Royalty Rates—by Industry

While industry rates may be a guide, they should be used with caution. First, negotiators must recognize that there can be significant variation in royalty rates within an industry. Exhibit 4.3, compiled from the results of the previously mentioned IPC Group survey, illustrates the range of royalty rates within industries. Because of this variation in industry royalty rates, negotiators must ensure that comparable royalty rates are not blindly relied upon. Participants must consider the unique circumstances of the transaction at hand and adjust the industry rates accordingly. Other Pricing Factors. In a licensing negotiation, a number of qualitative considera-

tions may affect the ultimate pricing decision. Specific agreement terms and conditions (e.g., exclusivity) can be used to shift risk from one party to another, thereby affecting pricing. The scope of this chapter does not allow comprehensive discussion of each pricing factor.17 CONCLUSION

Valuation of IP in mergers and acquisitions is still often considered an overwhelming task. However, a valuation that focuses on the IP of the target company can help to identify key assets (or the lack thereof) that could make or break even the best deals. Further, with a significant portion of Fortune 100’s market capitalization represented by intangible assets, IP valuations will become more commonplace during M&A deals in the not too distant future.

ENDNOTES 4.19 ENDNOTES 1

For a more in-depth analysis of the benefits of licensee investigations see Burgis and Koppel, “Getting the Most for Your IP,” les Nouvelles (December 1996). 2 See The Federal Register, July 8, 1994 edition or the Tax Management Transfer Pricing Report, July 6, 1994 edition, for a copy of the full text of the Final 482 Regulations. 3 For a more detailed discussion on this topic, see Robert Carney and Daniel McGavock, “Tax Strategies for Protecting the Value of IP,” les Nouvelles (March 1997). 4

DeAnn Christinat, “The Benefits of Donating Patents,” CFO (May 1999). See note 3. 6 See Michael Douglass, “Tangible Results for Intangible Assets: An Analysis of New Code Section 197,” Tax Lawyer 47, no. 3 for a more complete discussion of this topic. 7 For a more detailed discussion on the Bowie Bonds, or asset-backed securitizations in general, please go to www.fahnestocksas.com. 8 See Bruce Rubenstein, “Patent Auction: The Property Isn’t Real but the Money Is,” Corporate Legal Times (July 1995). 9 Revenue Ruling 59-60, Section 2031, Sec. 3.01. 10 Revenue Ruling 59-60, Section 2031, Sec. 2.02. 11 Kevin G. Rivette and David Kline, “Rembrandts in the Attic: Unlocking the Hidden Value of Patents,” Harvard Business School Press (1999). 12 For a discussion of this topic, see Avinash K. Dixit, “The Options Approach to Capital Investment,” Harvard Business Review (May-June 1995). 13 For a more detailed discussion of this topic, see Marcus B. Finnegan and Herbert H. Mintz, “Determination of a Reasonable Royalty in Negotiating a License Agreement; Practical Pricing for Successful Technology Transfer,” The Business of Licensing (Clark Boardman Company, Ltd., 1978), p. 3D–17. 14 Razgaitis, Early Stage Technology Valuation (New York: John Wiley and Sons, 1999). 15 For additional information about required rates of return in the venture capital industry, see Blaine Huntmann and James P. Hoban, Jr., “Investment in New Enterprise: Some Empirical Observations on Risk, Return, and Market Structure,” Financial Management (Summer 1980). 16 See note 11. 17 For a more detailed discussion of factors that may affect the IP pricing decision, see Arnold, White, and Darkee, “100 Factors Involved in Pricing the Technology License,” The 1988 Licensing Law Handbook (1998), Appendix C. 5

CHAPTER

5

ACCOUNTING FOR INTELLECTUAL PROPERTY DURING MERGERS AND ACQUISITIONS Andrew W. Carter InteCap, Inc.

INTRODUCTION

Intellectual property currently enjoys a position of great significance to many businesses and industries—in fact, it is often a primary factor leading to many of today’s business mergers, acquisitions, and joint ventures. While the financial markets and dealmakers recognize intellectual property as a key driver to many businesses and business combinations, current accounting and financial reporting requirements in the United States poorly reflect these assets in a company’s financial statements. This chapter discusses three main topics. First, a general overview of how intellectual property is accounted for in mergers and acquisitions is given. Second, several proposed changes are discussed, as the accounting treatment of mergers and acquisitions in general is currently in flux. Third, the current hot topic in this area—the treatment of inprocess research and development costs—is discussed in depth. ACCOUNTING FOR INTELLECTUAL PROPERTIES IN MERGERS AND ACQUISITIONS

Intellectual property is an asset. When a business combination occurs, all assets must be accounted for in some fashion. In order to understand the accounting treatment of intellectual property in mergers and acquisitions, it is fundamental to understand the accounting nature of assets, the objectives of the accounting system, and the accounting for business combinations in general. Asset Recognition. Financial Accounting Standards Board (FASB) Statement of Concepts, No. 6 states that “assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.” An asset has three essential characteristics:

1.

It embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows. 5.1

5.2

ACCOUNTING FOR INTELLECTUAL PROPERTY

2. 3.

A particular entity can obtain the benefit and control others’ access to it. The transaction or other event giving rise to the entity’s right to or control of the benefit has already occurred.

There are two broad types of assets—tangible and intangible. Intellectual property is considered an intangible asset—that is a nonmonetary asset lacking physical substance that is held for the continuing benefit of the business. There are two types of intangible assets: those that are specifically identifiable and those that are unidentifiable. For specifically identifiable assets, costs associated with obtaining a given intangible asset can be identified as part of the cost of that intangible asset. In general, intellectual property, such as patents and copyrights, is grouped into this class. Before recognition of an asset as such, U.S. accounting standards require that there be an ability to measure the asset and provide information that is both relevant and reliable. FASB Statement of Concepts, No. 5 states that to be reliable, information must be “sufficiently free of error and bias to be useful” to financial statement users. This need for both relevancy and reliability quite often, as acknowledged in FASB Statement of Concepts, No. 6, requires some tradeoff if the perceived relevance warrants a tolerable amount of uncertainty. It is this balance between relevance and reliability that must be weighed carefully when the recognition of intellectual property is considered. Objective of Accounting System. The accounting system for intellectual property has the same objectives as that for financial reporting in general—to provide readers of financial statements with useful and reliable information to facilitate their investing and lending decision-making processes. In order to facilitate the investing and lending decisions of potential investors, accounting information must be relevant, understandable, and reliable. Moreover, its usefulness is almost always enhanced if the information is prepared consistently with comparable information of similar enterprises. However, identification and measurement uncertainties surrounding intangibles have made it difficult to develop accounting information that reflects all these attributes. Financial Reporting of Business Combinations—General. The accounting treatment of

business combinations can vary, depending on the deal; therefore, the accounting for intellectual property can also vary. Accounting Principles Board (APB) Opinion No. 16 (APB 16), issued in August 1970, governs the accounting treatment for business combinations. APB 16 currently provides for two methods of accounting for business combinations: (1) the pooling-of-interests method (pooling method)1 and (2) the purchase method. From the standpoint of accounting for intellectual property in mergers and acquisitions, the pooling method is relatively easy, but the purchase method can be complex. The Pooling Method. Under the pooling method, the financial records of the combin-

ing entities are pooled together to create the financial records of the resulting combined company. The income statement of the combined entity for the year of combination is compiled and presented as if the entities had been combined for the full year. No other assets or liabilities are recorded as a result of the combination, and the excess of the purchase price over the book value of the net assets acquired is not recognized in the financial statements. As will be discussed later, use of the pooling method does not result in any changes to the accounting expression of intellectual property for either company.

FINANCIAL REPORTING FOR ACQUIRED INTANGIBLE ASSETS 5.3 The Purchase Method. Under the purchase method, the fair market values of all assets and liabilities, including those that may not have been recorded on the financial statements of the acquired entity, are recognized by the acquiring entity. Any excess of the cost of the acquired entity over the fair value of the net assets acquired is recognized as goodwill and is capitalized as an asset on the balance sheet. The income statements do not include the results of the acquired entity until after the acquisition. As noted later in this chapter, use of the purchase method can have an impact on the accounting treatment of current intellectual property. Which Method to Use. These two methods of accounting for business combinations are

not alternatives or substitutes for one another. Rather, APB 16 specifies 12 conditions that must be met in order for a business combination to be accounted for under the pooling method. Recently, however, creative lawyers and investment bankers have been structuring transactions so that the 12 criteria for using the pooling method have been met. Why? Because using the purchase method often results in a significant amount of goodwill, or purchase price in excess of fair value of net assets acquired. This goodwill is amortized over a specified period of time, which results in an expense that lowers reported earnings.2 Generally speaking, companies desire higher, rather than lower, reported earnings and, if possible, would like to avoid amortizing goodwill charges associated with an acquisition. Therefore, the use of the pooling method has increased significantly over time. FINANCIAL REPORTING FOR ACQUIRED INTANGIBLE ASSETS

Acquisition of intangible assets can be either direct (e.g., cash for a patent) or indirect (e.g., cash for an entire company that holds land, equipment, and patents). APB Opinion No. 17 (APB 17), issued in August 1970, governs the accounting treatment for the acquisition of intangible assets, even when acquired as part of a business combination. Intellectual property is a form of intangible asset and, therefore, falls under APB 17. When intangible assets are acquired directly, the cost is measured by “the amount of cash disbursed, the fair value of other assets distributed, the present value of amounts to be paid for liabilities incurred, or the fair value of consideration received for stock issued.” In other words, what someone pays is what the asset costs. Indirect acquisition of intangible assets typically occurs as the result of a merger or acquisition. How the merger or acquisition is accounted for has a significant impact on the accounting treatment for the acquired intangible assets. If the pooling method of accounting is used, balance sheets of the two companies are combined, and no changes are made to the way the acquired intellectual property is accounted for. If the purchase method of accounting is used, then several rules govern the accounting of the acquired intangible assets. APB 17 requires that all intangibles acquired as a result of a business combination be recorded as assets. APB 17 also requires that the costs recorded for intangible assets, including goodwill, be amortized over the economic useful life of the asset. Exhibit 5.1 is a flowchart that provides a general overview of the treatment of intangibles under APB 17. According to U.S. accounting standards, similarly to long-lived assets, intangibles— including goodwill—are required to be recorded at cost on the day of acquisition. Costs

5.4

ACCOUNTING FOR INTELLECTUAL PROPERTY Is the intangible object identifiable?

No

Recognize as part of goodwill

Amortize over useful economic life, ≤ 20 years

Yes Can it be reliably measured?

No

Yes Recognize as separate intangible asset

Estimate useful economic life

Amortize over useful economic life

No

Is the useful economic life > 20 years?

Yes Is it exchangeable or based on contractual/ legal rights?

No

Yes No

Amortize over 20 years

Clearly identifiable cash flows for > 20 years?

Yes Amortize over finite useful economic life > 20 years

No

Is the useful economic life finite?

Yes No

Is there an observable market?

Yes Do not amortize unless the useful life becomes finite

Exhibit 5.1 Treatment of Intangibles under APB 17

should be assigned to all specifically identifiable assets. Thus, the cost of unidentifiable intangible assets, or goodwill, is “measured by the difference between the cost of a group of assets or enterprise acquired and the sum of the assigned costs of individual tangible and identifiable intangible assets acquired, less liabilities assumed.”3 For

FINANCIAL REPORTING FOR ACQUIRED INTANGIBLE ASSETS 5.5

example, assume that Company A pays $10 million for Company B, and the purchase method of accounting is used to account for the acquisition. If Company A can specifically identify only $8 million in assets (property, plant, patents, etc.), the remaining $2 million is termed goodwill. One significant result of using the purchase method is that a valuation of the intellectual property of the acquired firm is frequently performed. As a result of that valuation, the intellectual property of the acquired firm is often carried at a greater value (higher asset value) on the accounting books of the new or acquirer firm. For example, trademarks, which are often carried at $0 on the accounting statements of the firm that develops them, often have value. If a firm with valuable trademarks is purchased, those trademarks can be specifically valued, then accounted for on the books of the acquiring company. The end result is the creation of an accounting asset where there was none previously. Amortization. U.S. accounting standards require companies to systematically amortize

the cost of each type of intangible asset (which includes intellectual property) over the period of estimated future benefit or its economic useful life. This useful life is dependent on a number of the following factors: • Legal, regulatory, or contractual provisions may limit the maximum useful life. • Provisions for renewal or extension may alter a specified limit on useful life. • Effects of obsolescence, demand, competition, and other economic factors may reduce a useful life. • A useful life may parallel the service life expectancies of individuals or groups of employees. • Expected actions of competitors and others may restrict present competitive advantages. • An apparently unlimited useful life may, in fact, be indefinite, and benefits cannot be reasonably projected. However, the Financial Accounting Standards Board states that goodwill should never be written off immediately or amortized for a period greater than 40 years. The 40-year requirement is based on the assumption that few intangible assets last forever. Goodwill amortization should be computed using a straight-line method unless another method is deemed more appropriate. Tax Treatment. The amortization lives of intangibles are different for taxation than for

financial reporting purposes. The Financial Accounting Standards Board favors a shorter life for purposes of accuracy and integrity, but the IRS prefers a longer amortization life to increase the amount of taxable income. Under Section 197 of the Internal Revenue Code, all intangibles acquired in connection with a business combination may be amortized over a 15-year period using the straight-line method beginning the month the asset is acquired. Section 197 includes, but is not limited to, goodwill and intellectual property of various types. Section 197 contains a provision with respect to claiming an intangible asset as worthless. Even if an intangible that falls under Section 197 is deemed worthless, it cannot be written off

5.6

ACCOUNTING FOR INTELLECTUAL PROPERTY

before the 15-year period unless all other Section 197 assets that were acquired in the same transaction are deemed worthless. For example, if a patent expires and was acquired in connection with a customer list, it cannot be written off prior to the 15-year period unless the patent and customer list are deemed to have no value. Impairment of Intangibles. Impairment, or loss of value, applies to all types of intangi-

bles, including intellectual property and goodwill. APB 17 states that companies “should evaluate the periods of amortization continually to determine whether later events or circumstances warrant revised estimates of useful lives.” A change in useful life should be coupled with a change in the resulting yearly amortization value. FAS (Financial Accounting Standard) 121, Accounting for the Impairment of LongLived Assets and For Long-Lived Assets to be Disposed of, also applies to intangibles. According to FAS 121, “An entity shall review long-lived assets and certain identifiable intangibles to be held and used for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.” For example, if a company has a patent, and competitors design around that patent, the patented technology may be unprofitable, and the recoverability should be analyzed. In order to evaluate the recoverability, the company would estimate the future cash flows expected to result from the use of the asset and its disposition. If the future net cash flows (not discounted and before interest) were less than the book value of the asset, an impairment loss would be recognized. The impairment loss is the amount by which the carrying amount of the assets exceeds the fair value of the impaired asset. Goodwill is unique in that it can be identified only with the business as a whole. Because goodwill is a going concern, valuation cannot be separated from the entire business entity. Thus, goodwill impairments involve a grouping of net assets. In situations where goodwill is associated with assets that are subject to impairment loss, the Financial Accounting Standards Board requires the carrying amount of the associated goodwill to be eliminated before the carrying amounts of impaired long-lived assets and identifiable intangibles are reduced to their fair values. FAS 121 is effective for financial statements for fiscal years beginning after December 15, 1995. Earlier application was encouraged; however, restatement of previously issued financial statements is prohibited. PROPOSED FINANCIAL ACCOUNTING STANDARDS BOARD CHANGES AND RECENT DEVELOPMENTS

There are currently a number of proposals pending before the Financial Accounting Standards Board that will alter the landscape for the treatment of intellectual property in a merger or acquisition. The most important of these are (1) the proposed elimination of the pooling method for business combinations, and (2) the proposed elimination of the amortization of goodwill. A brief outline of each of these follows. Proposed Elimination of the Pooling Method. In August 1996, the Financial Accounting

Standards Board began to reconsider APB Opinions No. 16, Business Combinations, and No. 17, Intangible Assets. In addition to wanting to improve international comparability, the Financial Accounting Standards Board and the Securities and Exchange

PROPOSED FINANCIAL ACCOUNTING STANDARDS 5.7

Commission (SEC) have received several inquiries about the APB Opinions in question as a result of the increase in merger activity. In September 1999, the Financial Accounting Standards Board issued an exposure draft of a proposed statement, Business Combinations and Intangible Assets. The proposed amendment to APB 16 would require all business combinations to be accounted for under the purchase method, thus eliminating the use of the pooling method. In January 2001, the Board voted to accept this proposal, and a final ruling on the subject is anticipated in late June. Companies can continue to elect the pooling of interests method for mergers, including those mergers announced but not completed by the final date, until the final ruling. The Financial Accounting Standards Board contests that the pooling method provides investors with less relevant information than does the purchase method. Members argue that the pooling method ignores the value of the business combination from a financial reporting perspective, which makes it increasingly difficult for users of financial statements to identify the amount invested in the acquisition. Those hesitant to eliminate the pooling method are concerned about how the markets for mergers and acquisitions will be affected. Respondents argue that eliminating the pooling method will discourage the beneficial consolidation occurring in the nation’s economy. For certain industries, intangibles are a significant part of a deal value, which results in a significant writeoff. Corporate executives argue that goodwill is not always a depreciating asset and that it truly is the basis for products and services that create future cash flows. Others advocate that the purchase method would damage financial statement comparability because internally developed intangibles are not recognized on the balance sheet, whereas purchased intangibles are. Regardless, the Board’s final decision will have significant ramifications for how future mergers and acquisitions in general are accounted for. The decision will also significantly impact the accounting for intellectual property if the pooling method of accounting is eliminated. Goodwill and Amortization. In response to concerns that the elimination of the pooling

option could have an adverse effect on the market for mergers and acquisitions, the Financial Accounting Standards Board reconsidered its position on the treatment of purchased goodwill. In January 2001, the Board reconfirmed that goodwill should be initially recognized as an asset and should be measured initially as the excess of the cost of the acquired enterprise over the sum of the amounts assigned to the identifiable assets acquired, less liabilities assumed. Second, the Board proposed the elimination of the amortization of goodwill, instead allowing the asset to remain at cost on the balance sheet until such time when the asset was impaired. If goodwill was determined to be impaired, the asset would be reduced to the impaired value. Determining the impairment value of goodwill could prove troublesome, however, as companies would be required to conduct an impairment review whenever their market value fell below book value for an as-yet unspecified period; whenever their stock price decreased significantly relative to overall economic or market changes; or when one of several other indicators pointed to an impairment. Final adoption of these decisions was expected to occur in the summer of 2001.

5.8

ACCOUNTING FOR INTELLECTUAL PROPERTY

IN-PROCESS RESEARCH AND DEVELOPMENT CHARGES

A trend that has developed recently is the immediate writeoff of purchased R&D. Inprocess research and development is an intangible asset, as no hard, physical assets have yet been derived (which is why the research is “in-process”). The average charge has grown from $101 million in 1991 to $382 million in 1998. Acquisitive companies favor this charge, as the immediate deduction lowers the company’s earnings, creating the illusion of greater earnings growth in the future. Definition of In-Process Research and Development Charges. Financial Accounting Standards Board Interpretation, No. 4 (“Applicability of FASB Statement, No. 2 to Business Combinations Accounted for by the Purchase Method”) defines in-process research and development as costs assigned to assets to be used in a particular research and development project and that have no alternative future uses in a current product or other ongoing R&D activities. These costs include materials and supplies, equipment and facilities, and specific research projects in process. As with other assets acquired, costs allocated to in-process research and development should be based on an appraisal of the fair value of these assets, not their original cost. Obviously, recording in-process research and development is very attractive to corporations because it reduces the amount of goodwill recorded in an acquisition and the drag on future earnings that accompanies the amortization of goodwill. Attracted by the ability to avoid goodwill’s drag on earnings, corporations are allocating increasing amounts to in-process research and development. Historical Treatment of Research and Development. Historically, costs identified with

research and development activities would be expensed during the time period in which they occurred. Disclosure of these costs would be made in the financial statements under total research and development expense each time an income statement is prepared. Potential Changes. The Financial Accounting Standards Board announced its intentions in February 1999 to enforce gradual writeoffs of purchased R&D, rather than immediate writeoffs at the time of acquisition. Although this new method of accounting would decrease the use (and some say abuse) of in-process research and development writeoffs, some say it may have an adverse affect on investors and acquisitive companies. In this regard, one possibility is that investors would be less inclined to invest in a company with lower earnings for a longer period of time. In addition, companies who purchase research and development in an acquisition would be treated differently than companies who generate their own research and development internally. A company that purchased another company with large in-process research and development costs would then be expected to gradually write off this purchased research and development, but a company with only internally generated research and development charges could immediately write off these charges. Despite the Financial Accounting Standards Board and Securities and Exchange Commission support of a new method for writing off purchased in-process research and development, there has been no final action taken as of this writing.

IN-PROCESS RESEARCH AND DEVELOPMENT CHARGES 5.9 Increased SEC Scrutiny of In-Process Research and Development Write-Offs. In recent years, both the frequency and magnitude of in-process research and development writeoffs have increased dramatically. For example, in the WorldCom/MCI merger, MCI Worldcom planned to write off as much as $7 billion of the $37 billion purchase price as in-process research and development. In addition, examples exist in which the entire purchase price of an acquisition was allocated to in-process research and development. Due to this heightened activity, the Securities and Exchange Commission (SEC) has significantly increased its scrutiny of in-process research and development writeoffs, believing that amounts that exceed its fair value are being allocated to in-process research and development. In the WorldCom example, the in-process research and development writeoff was reduced to $3.1 billion, partly to win SEC clearance. The Securities and Exchange Commission has focused on two areas—the allocation of the purchase price to in-process research and development and the determination of the fair value of in-process research and development. First, the SEC is scrutinizing the allocation of the purchase price among in-process research and development costs that are expensed, core technologies that are capitalized and amortized over the life of the technologies, and other assets that are also capitalized and amortized. In determining this allocation, the value of other acquired intangibles such as patents, the engineering workforce, and licensing agreements, must be considered. Consistent with the FASB, the SEC has stated that only amounts with no alternative uses may be expensed as inprocess research and development. In addition, the SEC has discussed at length the treatment of rights to enhance or embellish an existing product or technology that has alternative future uses. The SEC maintains that these rights are not separable from the product or technology itself and should therefore be capitalized and amortized over the life of the technology. The SEC gives the following example to illustrate the proper treatment of research and development costs:

Assume that at the time of acquisition, an acquired company had developed and released Version 1 of a product. In addition, it had completed 10% of the research on Version 2. The acquiring company also received the rights to develop all future versions of the product. According to the SEC, only the costs associated with the 10% research completed to date on Version 2 can be classified as in-process R&D and expensed. All other amounts, including the rights to develop all future versions of the product, should be classified as assets and capitalized.

The second area of SEC scrutiny is the determination of the fair value of in-process research and development. The SEC has stated that in-process research and development should be recorded at its fair value, which represents the amount that would be exchanged in an arm’s length transaction. The investment value to a particular investor does not represent fair value. Both the Income Approach and the Relief from Royalty Method (both discussed in Chapter 4) are deemed to be acceptable methods of valuing in-process research and development. The SEC believes that, under the Income Approach, the discounted cash flows expected from the research project, net of estimated costs to complete the project, should be calculated. These cash flows should then be reduced based on the percentage of completion of the research project. The SEC has expressed that the

5.10 ACCOUNTING FOR INTELLECTUAL PROPERTY

assumptions used in these analyses must be carefully reviewed for reasonableness, with consideration for factors such as stage of completion, complexity, difficulty of completion, costs incurred to date, and projected costs to complete the project. The Securities and Exchange Commission has also expressed concerns regarding the Relief from Royalty Method. Although it views this approach as an acceptable valuation method, it does not view the use of an “industry” royalty rate in this analysis as acceptable. The SEC has explained that it views research and development projects as being highly unique and specific in nature. Therefore, the SEC believes it is difficult to support the application of an industry, or average, royalty rate to these projects. Finally, the Securities and Exchange Commission expects companies to disclose more information about the calculation of in-process research and development writeoffs. Specifically, the SEC expects disclosure of the material assumptions and estimates used in the in-process research and development valuation. Along with these efforts, the SEC is increasing its policing of merger and acquisition consulting work performed by accounting firms for audit clients. Specifically, the SEC has expressed concerns regarding accounting firms completing valuations used in mergers and acquisitions, then subsequently reviewing these calculations as part of the audit process. These valuations include areas such as in-process research and development. BIBLIOGRAPHY “Acquisitions of In-Process R&D,” Journal of Accountancy (February 1999): 8. “APB Opinion No. 16: Business Combinations,” Accounting Principles Board, August 1970 “APB Opinion No. 17: Intangible Assets,” Accounting Principles Board, August 1970 Arthur Andersen LLP, “SEC to Increase Scrutiny of In-Process Research and Development Charges in Business Combinations,” 1998. “Arthur Levitt Addresses ‘Illusions’,” Journal of Accountancy (December 1998): 12–13. “Current Projects of the Office of the Chief Accountant,” Remarks by Lynn Turner, Chief Accountant, U.S. Securities and Exchange Commission, to the Colorado State Society of Certified Public Accountants, 1998 SEC Conference, December 3, 1998. “FASB Interpretation No. 4: Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method,” Financial Accounting Standards Board, February 1975. “FASB Statement of Concepts, No. 5: Recognition and Measurement in Financial Statements of Business Enterprises,” Financial Accounting Standards Board, December 1985. “FASB Statement of Concepts, No. 6: Elements of Financial Statements—a replacement of FASB Concepts Statement No. 3 (incorporating an amendment of FASB Concepts Statement No. 2),” Financial Accounting Standards Board, December 1985. Financial Accounting Standards Board, “Business Combinations,” from website (http://www.rutgers .edu) “Financial Accounting Standards No. 121: Accounting for the Impairment of Long-Lived Assets and For Long-Lived Assets to be Disposed of,” Financial Accounting Standards Board, March 1995. Garver, Rob, “FASB Closes the Window on Pooling,” American Banker (New York, January 25, 2001). MacDonald, Elizabeth, “Merger Write-Offs Prompt SEC Drive For Full Disclosure,” Wall Street Journal (January 13, 1999): A8.

ENDNOTES 5.11 MacDonald, Elizabeth, “SEC Steps Up Scrutiny of Accountants: Agency Warns Major Firms About Possible Conflicts Over Merger Consulting,” Wall Street Journal (January 8, 1999): A3. MacDonald, Elizabeth, “SEC Weighs Wide Review of Write-Offs,” Wall Street Journal (January 22, 1999), A2, A7. “The ‘Numbers Game.’” Remarks by Chairman Arthur Levitt, Securities and Exchange Commission, New York University Center of Law and Business, September 28, 1998. Roberts, Ricardo, “How Will FASB Ring in the New Year?: M&A Tax Experts Sound Off on Upcoming Changes to Accounting Rules,” Mergers & Acquisitions Report (New York, January 1, 2001). “Section 197 Intangibles,” Internal Revenue Code. Securities Exchange Commission, “Letter from the Office of the Chief Accountant Regarding the 1998–1999 Audit Risk Alerts,” October 9, 1998. Shaffer, Leslie. “High-Tech Firms Are Upset Over an SEC Crackdown,” Wall Street Journal (February 1, 1999): B4. “Statement of Financial Accounting Standards No. 2: Accounting for Research and Development Costs,” Financial Accounting Standards Board, October 1974. “Statement of the AICPA in Response to SEC Chairman Arthur Levitt’s NYU Address,” September 28, 1998, AICPA website. Weil, Jonathan, “Goodwill Hunting: Accounting Change May Lift Profits, But Stock Prices May Not Follow Suit,” The Wall Street Journal (January 25, 2001).

ENDNOTES 1 On July 5, 2001, the Financial Accounting Standards Board (FASB) formally moved to eliminate the pooling-of-interests method of accounting for most business transactions. The final rules are expected to contain certain exclusions for the combination of two or more mutual enterprises, formation of joint enterprises, and potentially other types of transactions. The final rules are not expected to be published until sometime later in 2001. 2 The FASB has voted to eliminate the requirement to amortize goodwill. Under the proposed regulations, goodwill will remain on the purchaser’s balance sheet at the purchase price until its value is in some way impaired, at which point it would be written down to the impaired value. 3 Laymen often refer to goodwill as what is “left over” after everything else has been accounted for.

CHAPTER

6

INTELLECTUAL PROPERTY ASPECTS OF ACQUISITIONS Glenn A. Gundersen Dechert

INTRODUCTION

Every business uses some form of intellectual property, and the buyer of a business will typically need to acquire the intellectual property used in the business along with other types of assets. Lawyers who specialize in mergers and acquisitions usually take the lead role in these transactions, but intellectual property counsel are often called upon to assist transaction counsel in drafting and negotiating the documents that relate specifically to intellectual property. This chapter is designed to allow intellectual property specialists to understand their mission in the context of the overall transaction and to analyze the issues that IP specialists and nonspecialists encounter in these negotiations. ACQUISITION AGREEMENT

Almost any acquisition of a business involves an agreement between buyer and seller that spells out the terms of the transaction. Occasionally very short, often more than 100 pages long, this document is usually captioned either as a “stock purchase agreement” (the stockholders of a corporation are selling the stock of the corporation that conducts the business) or “asset purchase agreement” (a corporation sells the assets it uses in operating the business). The agreement details the terms and conditions under which the stock or assets will be sold and is usually negotiated and signed weeks or months in advance of the actual sale. It is the central focus of counsel’s activity in the course of the transaction and the “bible” that both parties will consult after the transaction is done. The acquisition agreement will usually include provisions that relate specifically to intellectual property. In fact, as patents, trademarks, copyrights, trade secrets, and other forms of intellectual property have become more important to businesses, they have received greater scrutiny from buyers in acquisitions. As a result, the intellectual property provisions of these documents have grown in length and complexity and can be the subject of extensive negotiation.

6.1

6.2

INTELLECTUAL PROPERTY ASPECTS OF ACQUISITIONS

Contents of the Acquisition Agreement. The acquisition agreement is intended to comprehensively detail all of the terms and conditions of the transaction. Such agreements typically include provisions that cover the following issues:

• The date on which the transaction will be consummated. The closing date is usually weeks or months in advance of the signing of the agreement but sometimes simultaneous with signing. • The consideration. These provisions detail the price to be paid for the business (which, depending on the circumstances, may consist of cash, stock, the assumption of liabilities, and other considerations), the timetable for payment (all at closing or in installments), and any adjustments to be made to the purchase price for contingencies determined after closing. • A description of the property (stock, assets, or a combination of both) to be transferred at closing. This language can be relatively simple in a transaction in which the buyer acquires the stock of a company: The agreement specifies the stock to be acquired, and by acquiring that stock, the buyer, in effect, takes control of all of the assets of the corporation. Buyers need to be careful, however, that the corporation does, in fact, own all of the assets relative to the business. In some cases, certain assets are held by particular shareholders or affiliated companies, and the buyer will need to make sure that the stock purchase agreement calls for the buyer to acquire or license those other assets. The description of the property being transferred is likely to be considerably more complex in an acquisition of assets, especially when the buyer is only buying one division or line of business and the seller is retaining other businesses and assets. In such situations, the definition of assets to be sold (and those that the seller will retain) is sufficiently precise to avoid confusion and dispute about what is intended. The parties usually negotiate a fairly detailed description of the assets (e.g., “all of the assets used or held for use by Seller and its Affiliates in the manufacture of spatulas”) that is supplemented by detailed lists of specific assets (e.g., spatula manufacturing plants and equipment, patents on spatula technology, etc.). • An allocation of the existing liabilities of the business. In stock acquisitions, the buyer takes on all of the company’s liabilities by acquiring its stock. In asset acquisitions, the parties must negotiate which liabilities the buyer will assume and which the seller will retain. • The representations and warranties about the business. In either type of agreement, the seller is typically called upon to make certain representations and warranties about the assets of the business. Buyer and seller negotiate the nature of these disclosures and representations, often at length. • The seller’s indemnification of the buyer. If the buyer discovers, after closing, that one of the seller’s representations about itself, the business, or the assets was inaccurate, the acquisition agreement sometimes allows the buyer to seek indemnification from the seller to compensate for the diminished value of the business or the unexpected liabilities the buyer incurred. • The covenants of the parties. Buyer and seller typically promise to do certain things and refrain from certain acts before and after the closing. Some of these

OTHER DOCUMENTS 6.3

covenants are fairly standard (e.g., seller agrees not to engage in any asset sales between signing and closing the deal except in the ordinary course of business). Other covenants will only arise in particular transactions (e.g., a seller agrees not to compete with the buyer in the acquired business for a period of time after the deal closes). • The conditions to closing. Buyer and seller typically specify conditions that must be present or events that must occur before they are obligated to consummate the deal. A seller makes representations about the business as of the date that the acquisition agreement is signed, but that date may be weeks or months prior to closing, especially if antitrust or other regulatory approvals are required in order to close the transaction. The buyer will typically require that at closing, the seller warrant that the representations are still true. If certain statements are no longer true, the buyer might have the option of declining to go through with the transaction as specified. Other conditions of closing may reflect issues that come to light during the negotiation of the agreement. For example, in a stock sale, if the buyer learns certain intellectual property is not owned by the corporation whose stock is being acquired, it may require that those assets be either transferred to the corporation before closing or directly to the buyer at closing. If the seller does not comply, the buyer will not be obligated to buy the stock of the corporation. OTHER DOCUMENTS

In most cases, the acquisition agreement does not actually effectuate a transfer of stock or assets from seller to buyer. Instead, it merely embodies the seller’s promise to sell stock or assets to the buyer under certain terms. The consummation of the transaction takes place at the closing on a later date when the parties execute transfer documents and any ancillary agreements and take other steps. Transfer Documents. If the buyer is acquiring stock, the seller typically effects the transfer by signing stock powers and delivering stock certificates. An asset transaction is more complicated. While most assets will be transferred via the seller’s execution of a bill of sale at closing, a buyer will usually require that separate assignments be prepared for all patents and patent applications, trademark registrations and pending applications, and U.S. copyright registrations and applications. The buyer will usually want to record these assignments in the applicable offices in each of the jurisdictions where the patents have issued or are pending, marks have been registered, or applications are pending. Patent, trademark, and copyright assignments each require different transfer language, and the parties will typically prepare a different assignment document for each type of intellectual property. It is also preferable to prepare and record separate assignment documents for each country jurisdiction because each country has particular language, format, and signature requirements for the assignment form. In addition, special considerations apply when assigning patent applications that have been filed under the Patent Cooperation Treaty or trademark registrations issued under multicountry registration systems such as the Madrid Agreement. In transactions involving the transfer of intellectual property

6.4

INTELLECTUAL PROPERTY ASPECTS OF ACQUISITIONS

rights in multiple countries, the parties may agree that master patent, trademark, and/or copyright assignments will be executed at closing and that the preparation and execution of individual country assignments will occur as part of the post-closing cleanup. The bill of sale is usually not recorded because it is likely to be lengthy, contain confidential information, and not contain language necessary to comply with various national recording requirements. Transfers of domain names pose special issues. A bill of sale is insufficient to fully effect the transfer of a domain name since it does not effect a change of title in the domain name registrar’s records. Counsel for the buyer first needs to determine which domain name registration organization (Network Solutions, Register.com, or another) registered the name, then determine how to comply with that organization’s requirements for transferring the domain name. Such transfers are an aberration from the M&A lawyer’s expectation that all transfers can be effected by the execution of hard copy documents in a conference room on closing day because domain transfers may also require the electronic filing of domain name transfer instructions. In addition, from a practical standpoint, if the buyer is not acquiring the seller’s servers or other hardware and software used to operate the website, the buyer will need to make plans prior to closing for a smooth technical transition to its own facilities on closing day or for having the seller provide transition services until the buyer’s facilities are operational. The transfer of intellectual property is discussed in greater detail in Chapter 16. Obtaining Assignments of Licenses. Many businesses use intellectual property, such as computer software, trademarks, and technology, that is licensed from third parties. In most acquisition agreements, the seller provides the buyer with a list of intellectual property licenses used in running the business. As part of its due diligence, the buyer will obtain and review copies of these licenses. Often, such licenses are not readily assignable. This is not a problem in a stock deal (unless the license prohibits a change of control of the licensee) since the identity of the licensee does not change. However, it causes headaches in an asset purchase in which the buyer must step into the seller’s shoes as licensee. The buyer will need to determine whether it wants to assume these licenses and, if it does, whether it can obtain the licensor’s consent to the transfer without a renegotiation of its terms. As a general rule, intellectual property licenses are not transferable from one licensee to another without the licensor’s consent. Some licenses permit transfer, but most do not. The buyer and seller will need to determine whether the obligation to negotiate and obtain such consents falls on the buyer or the seller. The acquisition agreement may even provide that the buyer is not obligated to close the transaction if consents from key licensors cannot be obtained or cannot be obtained without considerable expense. Ancillary Agreements and Obligations. The acquisition agreement often specifies other

obligations of the parties related to the acquisition. In the intellectual property area, the most common type of ancillary agreement is a license from the seller to the buyer, or vice versa. This is commonplace in situations in which the seller is parting with one of its businesses but has certain intellectual property that is used in that business and the businesses it is retaining. In such situations, the buyer either retains the shared intellectual property and licenses it to the buyer post-closing or sells it to the buyer and

DRAFTING THE DESCRIPTION OF ASSETS 6.5

takes a license back. The parties may also conclude that short-term licenses are needed to allow a party to phase out its use of certain intellectual property post-closing. Examples would be a license to the seller to allow it to use up packaging or materials bearing the marks it has sold or a license to the buyer to allow it to continue using a mark the seller has retained until the buyer adopts a new mark and deletes the seller’s mark from packaging and advertising. DRAFTING THE DESCRIPTION OF ASSETS

The first task for buyer’s and seller’s counsel in an acquisition is to agree on the definition of what property will be transferred. This is obviously an easy task if the seller is selling itself, lock, stock and barrel. It can be considerably more difficult if the seller is selling only a portion of its assets. Following are several possible scenarios. Identifying the Intellectual Property Being Transferred as Part of a Stock Sale. When the

stock of a corporation is sold, the assets of the corporation do not change hands—they remain with the corporation. The buyer of the stock, in effect, acquires the intellectual property owned by the corporation because it has acquired the corporation. However, the buyer should not assume that all of the intellectual property used by the corporation is, in fact, owned by that corporation. With smaller companies, in particular, it is not uncommon for individual shareholders to own patents on the inventions they developed, copyright registrations on software they wrote, or trademark registrations of marks they coined. To the extent feasible, the buyer should make sure that the seller’s disclosure schedules indicate which intellectual property is owned by the corporation and which is owned by other entities and licensed to the corporation. To the extent that ownership is public record (in the case of issued patents and trademark registrations and applications), the buyer will want to conduct its own independent due diligence search to verify that the seller’s schedules are accurate. Identifying the Intellectual Property To Be Transferred in an Asset Sale. When all the assets

of a business are sold and the parties neglect to specify that trademarks are being transferred, the general rule is that the seller is nevertheless presumed to have transferred the marks of that business to the buyer. However, it is not always clear which marks relate to the business being sold and which do not. Moreover, this rule does not necessarily apply to other forms of intellectual property. The Copyright Act, for example, requires that a transfer of copyright ownership be in a written instrument executed by the copyright owner unless the transfer occurs through operation of law.1 A bill of sale that neglects to reference copyrights or include other catch-all language arguably fails to effect a transfer of copyrights. Domain names definitely cannot be transferred by the same implied grant. Thus, to avoid doubt about what the buyer has acquired and what the seller has retained, the parties typically list or otherwise define which intellectual property assets are being transferred and which are not. From a drafting standpoint, the typical agreement will begin by defining “Intellectual Property” along the following lines:

6.6

INTELLECTUAL PROPERTY ASPECTS OF ACQUISITIONS

All patents, industrial design rights, trademarks, service marks, trade names, trade dress, copyrights, mask works, inventions, technology, know-how, industrial design registrations, formulae, trade secrets, confidential and proprietary information, computer software programs, domain names, and other intellectual property, and all registrations and applications for registration of any of the foregoing.

Although such definitions sound comprehensive, by their nature they leave some ambiguity. For example, if the seller agrees to transfer “all Intellectual Property used exclusively in the Business,” the buyer will not necessarily know whether particular patents or trademarks fall within that definition or are used in other seller businesses as well. Thus, the parties rely in large part on schedules that list identifiable items of intellectual property being transferred. Thus, the agreement would specify that the previous definition of “Intellectual Property” includes, but is not limited to, the items listed on an attached schedule. Thus, in most transactions, both parties’ counsel should recognize that schedules are not all-inclusive, but a subset of all of the intellectual property to be transferred. The buyer can reasonably expect such schedules to include issued patents and pending patent applications, registered trademarks and pending applications, registered copyrights and applications, and domain name registrations. The buyer will also want the schedules to list unregistered marks and tradenames, although most sellers will be reluctant to characterize any such list as comprehensive. The seller and its counsel prepare these schedules, and newcomers to M&A transactions are often surprised to discover that they are frequently incorrect, incomplete, or out of date. A buyer will want to conduct its own due diligence search to verify that the seller’s schedules are accurate. Buyers should not expect that schedules will list every item of intellectual property, in part because it is virtually impossible to exhaustively list (or even accurately describe) certain categories of intellectual property, such as trade secrets and unregistered copyrights. The larger the company, the more cautious counsel should be about the comprehensiveness of schedules. Even if a company has sophisticated in-house intellectual property lawyers, chances are that they are not aware of every brand or slogan used in the company and that some errors, even if slight, have found their way into docket lists of patents and trademark registrations over time. The Internet domain name is a new kind of property right, combining elements of trademark, property right, and vanity phone number. As such, it will not appear in formbook asset purchase agreements as part of the list of intellectual property assets that are typically transferred in M&A transactions. Most asset purchase agreements would call for the transfer of the seller’s trademarks to the buyer, but that does not necessarily cover domain names. This is for two reasons. First, the registration of a domain name, in and of itself, does not create trademark rights in that name, and as a result, one cannot assume that the terms “trademark” and “domain name” are interchangeable or synonymous. Many domain names do consist of a trademark followed by “.com,” “.net,” or the like, and if a buyer neglects to list domain names among the assets to be transferred, an agreement that calls for the sale of trademarks could reasonably be interpreted to also contemplate the sale of the corresponding domain names. However, some domain names consist of generic terms followed by .com. These, arguably, don’t fall within the definition of trademarks (especially if they do not lead to an active website). Moreover, the courts disagree over whether a domain name is a

THE SUBSTANCE OF INTELLECTUAL PROPERTY REPRESENTATIONS 6.7

property right at all or merely ancillary to a contract with a domain name registrar. Thus, a buyer will want to make certain that “domain names” are listed among the assets to be transferred in the sale of a business. The buyer will want the seller to provide a comprehensive list of all Internet domain names held or used by a company (if the entire company is being purchased) or all Internet domain names used or held for use by a business (if only one of the company’s businesses is being acquired). The buyer will want to do its own due diligence review of whether the domains are registered in the company’s name or that of another party (e.g., an employee, website developer, or web-hosting firm). Determining the Disposition of Jointly Used Intellectual Property. In many cases, certain intellectual property may be used both in the business being sold and in the business that the seller is retaining. For example, the seller may sell its products using the seller’s overall house mark in combination with individual product line brands. Similarly, the same patented technology or manufacturing know-how may be used in both businesses. If both parties will need or want to continue using certain intellectual property after the sale, they will need to negotiate whether the seller will retain such intellectual property and license it to the buyer post-closing or whether the buyer will acquire it, subject to an obligation to license it back to the seller. They will also need to decide whether the license will be a short-term transitional arrangement, long-term (but terminable) license, or perpetual, and whether it will be royalty-free.

THE SUBSTANCE OF INTELLECTUAL PROPERTY REPRESENTATIONS AND WARRANTIES

As with the other assets of the business being sold, the buyer in an acquisition will want information about the intellectual property needed to conduct its operations. The buyer’s checklist will typically include the following questions: • What intellectual property is necessary to operate the business? Does the seller own all the intellectual property necessary to operate the business? If so, does the seller own it free of any liens, security interests, and other encumbrances? • If the seller does not own all the intellectual property necessary to operate the business, does it have sufficient licenses from third parties? • With respect to intellectual property that the seller owns, is the seller in a position to transfer to the buyer all of the intellectual property used in the business, or does the seller need to retain some of it for use in the seller’s other businesses? With respect to intellectual property that the seller licenses from third parties, can the seller freely assign those licenses to the buyer, or must consents be obtained? • Has the seller granted licenses of any of the intellectual property to third parties? If so, what are the terms of those licenses? Do they contain exclusivity provisions or other terms that would restrict the buyer’s ability to use the intellectual property? • Has the seller entered into settlement agreements or consents, or is it bound by judgments or consent orders restricting the use of its intellectual property?

6.8

INTELLECTUAL PROPERTY ASPECTS OF ACQUISITIONS

• Would the buyer’s use of the intellectual property infringe any third party? Have any infringement or dilution claims been made against the seller with respect to the intellectual property? Has the seller made any infringement or dilution claims against third parties? Is there ongoing litigation involving the intellectual property? Are there interferences, oppositions, or similar proceedings pending in patent and trademark offices at home or abroad? • Have any pending applications for patents, trademarks, or copyrights been rejected or refused registration? A buyer has two ways of getting answers to these questions. One is to conduct its own due diligence review of the seller’s intellectual property (see Chapter 8). The other is to request that the seller make representations and warranties about the intellectual property. Depending upon the language negotiated by the parties, these representations will answer some or all of the previous questions. In some cases, the seller will be able to provide a clean representation, for example, that no infringement claims have been made with respect to its use of the intellectual property. More often, however, the seller will be unable to honestly make an unequivocal representation as to every aspect of its intellectual property, especially if the buyer has proposed language that makes sweeping generalizations. Thus, the seller will either attempt to modify the representation so that it is accurate or will make the representation subject to exceptions, which are typically set forth in a disclosure schedule. In entering into the acquisition agreement at a given price, the buyer will be relying on the accuracy of these representations. What if they prove to be inaccurate? The agreement often provides that the seller will partially or fully indemnify the buyer if the seller’s representations and warranties prove to be inaccurate, as discussed later in this chapter. HOW INTELLECTUAL PROPERTY LAW AFFECTS REPRESENTATIONS AND WARRANTIES

The complexity of intellectual property law poses challenges to sellers in making representations for several reasons. First, it is difficult to make simple, broad-brush statements about intellectual property in general because different rules apply to the different categories of IP. What is true for patents is not necessarily true for trademarks, copyrights, trade secrets, industrial designs, mask works, or rights of publicity; and what is true in one country is not necessarily true in another (despite the worldwide trend toward harmonization of IP laws). Internet domain names raise an entirely different set of issues. Following are some examples of how differences in legal principles between categories of intellectual property law and between jurisdictions can complicate what sellers can say, and what buyers want sellers to say, about an intellectual property portfolio. Patents. Patents create the single biggest concern for buyers in today’s environment because of the uncertainty about exposure for infringement. The contents of patent applications are kept secret for at least a portion of the prosecution process, such that other companies have no knowledge of what an applicant is claiming as patentable.

HOW INTELLECTUAL PROPERTY LAW AFFECTS REPRESENTATIONS 6.9

However, any unlicensed users of that technology become liable for patent infringement at the point that the patent issues. Thus, users of technology are generally in the dark about what others may be seeking to patent. The advent of protection for business methods has created substantive uncertainty about what can and cannot be patented under the law. All of this doubt is exacerbated by the fact that a plaintiff’s patent infringement victory, unlike a trademark infringement claim, often results in a significant damage award. Similarly, patent suits that are settled rather than litigated often result in the defendant entering into a royalty-bearing license for the life of the patent. Therefore, potential exposure for patent infringement can carry a substantial financial risk. The representations in an acquisition agreement allocate this risk. Companies considering the purchase of a multinational business must be aware that patent protection is acquired on a country-by-country basis and that the monopoly afforded by a patent exists only in those countries in which the seller has obtained or is likely to obtain patent protection, and then only if the seller has paid the requisite patent annuities. This makes disclosure schedules critical to understanding where a seller enjoys exclusivity with respect to an invention, and where it does not. Trademarks. Trademark infringement claims pose a different set of risks than patents

and raise different concerns for buyers about the exposure they may inherit. Like patents, a trademark user lives with uncertainty because it can be liable for infringement of a third party’s mark, even if it was completely unaware of the mark. A trademark user can conduct a search to attempt to identify these risks, but searching is not foolproof. One cannot simply search a single database and discover all relevant thirdparty rights. In the United States and some other countries, trademarks exist at common law and need not be registered to be protected. Occasionally, such marks leave no footprint in the databases that are commonly used for searching. In addition, such databases have inherent blind spots. The primary goal of most plaintiffs in trademark litigation is to enjoin the infringing use. Also, damages tend to be less frequently awarded and of lesser gravity. This means, however, that defendants are less likely to settle litigation by taking a license of the plaintiff’s mark and face the prospect of business disruption from having to change or modify an existing mark and discard all of the marketing materials used with the mark. The parties to an acquisition must determine who bears the risk of these uncertainties. Trademark claims are complicated by the fact that owners of famous marks can allege two different grounds for relief—infringement (asserting that the defendant’s mark is likely to cause confusion) and dilution (asserting that the defendant’s mark causes dilution of the distinctive quality of the famous mark). Dilution is relatively new as a federal claim, and confusion exists about the standards for relief, most notably about what constitutes a famous mark. Compounding the confusion is the fact that more than half the states have dilution statutes that set different (and sometimes more lax) standards for relief. The concept of dilution is also more inherently amorphous than infringement, and one can determine more intuitively whether two marks are confusing than whether one mark dilutes another. Therefore, sellers are likely to have less comfort in making representations about dilution, and buyers more likely to have anxiety about their potential exposure.

6.10 INTELLECTUAL PROPERTY ASPECTS OF ACQUISITIONS

Companies that are considering the purchase of a multinational business must be aware of the differences between patent protection (which either exists or does not exist in a country, depending on the issuance of a patent) and trademark protection, the existence of which is less obvious. Like patents, protection is acquired on a country-bycountry basis, and the fact that a seller has registered a mark in the United States does not mean that the mark will be afforded protection anywhere else. Moreover, the requirements for protection vary significantly between types of legal systems. Unregistered common law trademarks are recognized in the United States, United Kingdom, Canada, and other countries with legal systems based on British law. Other countries do not afford trademark protection unless the mark is either registered locally or protected as a famous mark under international treaties. These differences mean that trademark rights are more difficult for a seller to comprehensively schedule because rights in marks and trade dress and rights that the seller has never attempted to catalog and are unregistered may exist. Copyrights. Copyright law inspires less fear about being blindsided by a hitherto-

unknown claimant than patent or trademark law because liability for copyright infringement arises only if the author had access to the copyrighted work and copied it. Nevertheless, companies can be liable for copying done by individual employees, even if their bosses are unaware of the copying. However, copyright law raises a wealth of peculiar title issues, and the rules of copyright ownership are unique and sometimes counterintuitive. For example, if someone commissions a copyrighted work, he or she does not necessarily own it. Copyrighted works created by regular, full-time employees belong to an employer without the need for a written agreement, but a freelancer retains copyright in his or her work unless he or she executes a written assignment. Many companies have the mistaken notion that they own computer software, advertising, photography, website designs, and other works that they have paid free-lancers to create, but in fact, have only a license on undetermined terms. Even if a copyright owner makes a valid and outright transfer of copyright, the assignee may not receive irrevocable and complete title to the work. Some works can be subject to a reversion to the original author. Authors of works created under some foreign legal regimes can retain “moral rights,” restricting the new owner’s freedom to modify the work. U.S. copyright law underwent a major revision in 1976 and has seen several major amendments since then. The rules surrounding works created under the new act can differ significantly from those governing older works. The most significant example is that older works may have been lost to the public domain for failure to comply with statutory formalities, such as copyright notice and renewal, that no longer exist. The term of copyright is not uniform for all U.S. works, nor is it uniform between U.S. and foreign copyright laws. For U.S. works created on or after January 1, 1978, copyright protection is calculated based on the death of the last surviving author. In the case of anonymous works or works made for hire, copyright protection lasts for 95 years after publication or 120 years from the date of creation, whichever expires first. The term of copyright for older works was originally 28 years followed by an equal renewal term, but the renewal term for works still under copyright has been repeatedly extended by Congress.

HOW INTELLECTUAL PROPERTY LAW AFFECTS REPRESENTATIONS 6.11

Copyright law recognizes the concept of coauthorship by two otherwise unrelated parties. A company that believes it is the sole owner of a mark may be subject to a claim that a contributor to that work is a coauthor, and therefore, a co-owner. A seller needs to take all of these principles into account in making representations, and a buyer needs to understand these principles in order to ask the right questions. Trade Secrets. Trade secret protection in the United States is a creature of state law,

although the enactment of model laws provides some uniformity. Some countries outside the United States provide little or no protection for trade secrets. Thus, multinational companies will have to consider carefully what representations they can make about trade secret protection. Rights of Publicity. The right of an individual to prevent the commercial use of his

name and likeness is also a creature of state law in the United States, with considerable variance in scope from state to state. Some states provide no protection for the deceased, and those that do provide it for varying terms after death. Laws outside the United States can be very different. Multinational companies that have endorsement licenses from celebrities or may use celebrity names and likenesses in some markets without permission are dealing with multiple conflicting legal regimes in making representations about compliance with right of publicity law. Industrial Design Rights. Many countries afford protection for the appearance of products in the form of industrial design registration, which is analogous in some ways to a U.S. design patent. For some businesses, this type of protection can be important, but because it does not exist in the United States, American lawyers sometimes neglect to include it in the definition of intellectual property or to ask for a schedule of the seller’s design registrations. Internet-Related Assets. The advent of websites has raised new complications for the

drafting and negotiation of representations and warranties. While most websites began as static, electronic versions of a company’s hard copy brochure, today’s sites contain sophisticated features, graphics, and audio-visual content. As the content has become increasingly complex, the amount of intellectual property used in creating and operating a website has increased dramatically, and the potential for infringement disputes has grown. For example: • The high-tech features of state-of-the-art sites require sophisticated software, which may be protected by both copyrights and patents. If the software was not developed in-house, the buyer will require licenses sufficient to permit current and intended uses. • Certain aspects of the way a website business operates may be sufficiently innovative to merit patent protection, and the seller’s website may inadvertently infringe upon an existing patent or may later be discovered to infringe upon an invention that, at the time of the sale, appears only in a pending, nonpublic patent application.

6.12 INTELLECTUAL PROPERTY ASPECTS OF ACQUISITIONS

• Music, photography, text, graphics, and other creative website content are protected by copyright. Some companies take inadequate measures to acquire the third-party permissions necessary to incorporate such material into the website. • Websites that incorporate chat room or bulletin board features may create opportunities for users to post infringing or defamatory content. While many of these potential challenges will be covered under the traditional representations that a seller makes about whether its business is infringing upon the intellectual property rights of others, such language does not cover all the potential claims. Many domain name disputes are framed as trademark dilution claims or administrative proceedings rather than trademark infringement claims, which means that disclosures or representations that refer only to “infringement” may be incomplete. Real-time use of hot news information compiled by others may even draw a claim of misappropriation. Finally, the global nature of the Internet creates new hazards. Offering goods for sale in all 50 states, and beyond the United States, creates exposure under state and foreign consumer protection, tax, and obscenity laws. Buyer and seller will need to negotiate responsibility for those past liabilities. NEGOTIATING REPRESENTATIONS AND WARRANTIES

The parties’ lawyers typically spend more time in negotiating representations and warranties than in any other part of the acquisition agreement. From the buyer’s standpoint, this language is important because the buyer has made certain assumptions about the business, and the wisdom of entering into the transaction hinges on those assumptions being correct. If those assumptions prove wrong, the buyer may discover that it cannot make money at the business, or at least that it overpaid. From an intellectual property standpoint, the buyer may be making a whole range of assumptions about the extent to which it can use the acquired technology, trademarks, and copyrighted works without interference from others. The due diligence process will help shed light on the limitations of the seller’s intellectual property portfolio, but the reps and warranties are often used to smoke out the problems that require further investigation. The list of questions that buyers want answered is fairly standard, but the manner in which those questions are answered via representations varies considerably from transaction to transaction. The clarity and detail of the answers depends upon the structure of the transaction, the parties’ relative bargaining power, and counsel’s negotiating and drafting skills. For example, in an auction situation where a seller puts itself or its business up for bid, the potential buyers may have very limited opportunities to negotiate disclosures. In contrast, reps and warranties are likely to be more hotly contested in a one-on-one negotiation. The typical transactions lawyer has two standard form agreements to be used as the starting point in negotiating the sale of a business—one form whose terms are favorable to the company selling the business and another, which favors the buyer of the business. In general, the buyer will want blanket statements that give it comfort that, among other things, (1) it will be acquiring all of the intellectual property it will need to run the business going forward; (2) the seller has good title to the intellectual property and can convey title to the buyer free of any encumbrances; (3) the seller has provided complete

NEGOTIATING REPRESENTATIONS AND WARRANTIES 6.13

and accurate lists of all intellectual property; (4) the seller’s use of the intellectual property does not violate any third-party rights, and the seller has not received any claims to that effect; (5) the buyer’s use of the intellectual property will not violate any thirdparty rights; and (6) there are no licenses, consents, judgments, settlements, or other constraints on the use of the intellectual property. If life were so simple, lawyers would have nothing to do. For a variety of reasons, the seller will often want to modify or qualify the representations that the buyer proposes, including the following: • Intellectual property law has become an increasingly contentious field. For large companies in particular, it will be rare that a seller has nothing to disclose in terms of claims, disputes, licenses, consents, judgments, or settlements. • Intellectual property is often subject to liens, and the seller typically discloses that such encumbrances exist, linked with the condition that the debt will be satisfied at closing and the lender will release the lien. • The buyer’s proposed language may be so sweeping that it does not accommodate the quirks and inconsistencies in intellectual property law. • The seller may not wish to become the buyer’s guarantor as to the soundness of the intellectual property portfolio and may resist making certain representations on that principle. Sellers sometimes try to qualify the content of representations either by limiting them to the client’s knowledge or by limiting them as to materiality. For example, rather than asserting that its use of certain intellectual property does not infringe, a seller may offer to qualify the fact by representing that no infringement exists to the best of its knowledge. A materiality qualification can be used in two different ways. A seller may resist a representation that a schedule of trademarks or license agreements is complete and accurate, and offers, instead, to provide a list of marks or licenses that are material to the business. A different type of materiality standard is applied to representations involving breach or liability. For example, rather than stating that it is in complete compliance with all licenses, a seller may represent that it has not committed any material breach (or perhaps even limit that statement to material licenses). The reps and warranties in a buyer-oriented agreement are, needless to say, often over-reaching and likely to be more extensive than in the seller-oriented form. However, they sometimes contain serious omissions, failing to ask the right questions about the intellectual property being acquired. Many commonly used representations fail to take into account the substantive differences between the different types of intellectual property assets, asking the buyer to make broad-brush statements about intellectual property that may be relevant to patents, for example, but not trademarks or copyrights. Thus, some seemingly innocuous representations in acquisition agreements are in fact, wildly overbroad and impossible for a seller to make. Other representations, which appear at first glance to be adequate, are in fact deceivingly narrow and fail to elicit important information about particular types of intellectual property. The following are examples of provisions from acquisition agreements that are not what they seem at first glance. First are examples of those that are over-reaching.

6.14 INTELLECTUAL PROPERTY ASPECTS OF ACQUISITIONS The attached schedule sets forth an accurate and complete list of all of Seller’s intellectual property.

As noted, if a buyer is acquiring the assets of a particular business rather than the entire corporation, it will want as exhaustive and detailed a list of those assets as possible in order to avoid future disputes about what was acquired and what the seller retained—thus, the request for an “accurate and complete list.” It is virtually impossible, however, for a seller to make this representation if the acquisition agreement defines “intellectual property” to include such categories as trade secrets and copyrights. Few, if any, companies could define and catalog every item of confidential information and business know-how that they consider to be proprietary. The same goes for copyright, which protects every work of authorship created by an employee, including such prosaic items as internal memoranda, and therefore applies to countless works at the typical company. (Corporate lawyers sometimes assume that this representation is easy to make because they mistakenly assume that copyright protection only attaches when the copyright is registered). Even trademarks can be difficult to exhaustively schedule, since a company may use minor brand names and advertising slogans that it has not bothered to register or catalog. In addition, the appearance of products, packaging, and perhaps even retail facilities may constitute trade dress that is difficult to describe on a schedule. Thus, among these traditional categories of intellectual property, only patents can be exhaustively listed, since patents only come into existence when issued by a governmental office. In contrast, copyrights, trade secrets, and trademarks are products of the user’s creation or use, at least in the United States, without the need for registration. What is the typical solution? The seller represents that the schedule contains a complete list of all patents, registered trademarks, copyrights (including pending applications for registration), and perhaps material unregistered marks, as well. Even with patents and trademark registrations, however, many very large companies whose portfolios number in the thousands are reluctant to present their records as precisely and accurately cataloging every issued patent and registered trademark, and are willing to represent only that the list contains material patents and trademarks. The use of the intellectual property in the business does not infringe upon any patent, trademark, copyright, or other intellectual property of a third party.

In order to infringe upon another party’s copyrights or trade secrets, a company must first have access to those copyrighted works or secret information. This is not so with patents and trademarks. A company could infringe upon a third party’s trademarks or patents without even being aware that such rights exist. Most companies do conduct searches of prior third-party rights as part of the process of adopting a new trademark, and searches are an integral part of the process of securing a patent. However, such searches have significant blind spots at the time they are conducted and can rapidly become obsolete, making it impossible to know for certain whether a patent or trademark infringement claim is lurking. Even with copyright and trade secret claims, a company cannot be certain whether an employee has engaged in copyright or trade secret infringement without management’s knowledge.

NEGOTIATING REPRESENTATIONS AND WARRANTIES 6.15

Finally, a determination of infringement inevitably involves subjective determinations. Thus, a seller that is asked to represent that its intellectual property does not infringe is, in effect, issuing a guarantee to the buyer. The seller instead seeks to represent that it has not received any claims or that it is not aware of the basis for any claims. Seller has taken such actions as are necessary to ensure full protection of the intellectual property under any applicable laws.

The fundamental problem with this representation is that it does not define what actions the seller must have taken “to ensure full protection,” leaving the potential for future dispute about what was required. A logical interpretation is that this phrase means that the seller has registered its trademarks in every jurisdiction in which they are used, obtained patents wherever it sells, and registered its copyrights in the United States. This is seldom likely to be true for any seller, for several reasons. Trademark registration is discretionary in the United States and other common law countries. While registration confers certain benefits, a company could reasonably conclude that the expense of registering every mark is not commensurate with the benefits. Registration can be much more important in countries that afford little or no protection for unregistered marks, such that it will be important for the buyer to know if a mark is unregistered in major markets such as continental Europe or Southeast Asia. Similarly, since no patent protection is available except where a patent has issued, the buyer will want to know where the seller has obtained such protection. However, few companies have chosen to shoulder the expense of registering every mark and extending every patent to every country. Copyright registration is a creature of U.S. law and is discretionary—whether to register is very much a judgment call, depending upon the nature of the work and the nature of the business. A publishing or media company might be expected to have a large number of copyright registrations, but other types of businesses might reasonably have none. In sum, a seller should refuse to give this representation on the grounds that it is ambiguous and highly unlikely to be accurate, and the buyer will want to tailor it more precisely to reflect the nature of the business and its geographic scope. The following are examples of provisions that appear to provide the buyer with broad assurances, but in fact fail to elicit important information. Seller owns or possesses licenses or other rights to use all intellectual property necessary to conduct its business.

Most companies are not in a position to create and develop all of the intellectual property required to operate the business and must license some of it from third parties. Most standard-form warranty language recognizes this, but it does not always require the seller to clearly distinguish between what is owned and what is licensed. The buyer will want detailed disclosure of what is licensed so that it can determine which of those licenses are transferable to the buyer without the licensor’s permission, how long each license lasts, what royalties are required, and what limits are imposed on use. The seller may have been asked elsewhere in the agreement to disclose certain contracts and agreements, but that warranty may not necessarily encompass all of the company’s licenses of intellectual property.

6.16 INTELLECTUAL PROPERTY ASPECTS OF ACQUISITIONS Immediately after the closing, Buyer will own or have the exclusive right to use all of the intellectual property free from any liens, mortgages, or similar encumbrances.

Intellectual property often comes with strings attached, and those strings aren’t just liens or other encumbrances on title. As previously discussed, intellectual property that is licensed to the seller has various limitations. While this representation seeks to uncover any restrictions on assignability of licenses, it misses the sometimes significant strings attached to the intellectual property that the seller owns. For example, in order to resolve disputes, companies often enter into settlement or consent agreements that restrict the use of intellectual property. A company may have agreed to refrain from using a mark in a particular geographic or product market, only with a particular logo, or in combination with another mark. Similarly, the company may only have the right to use a licensed patent in connection with the manufacture or distribution of certain specific goods. This warranty does not require the seller to disclose such restrictions. Though the acquisition agreement most likely contains a separate section calling for disclosures on litigation, asking the seller to disclose court judgments, it may not call for documents such as trademark consent agreements, which often result from trademark prosecution, rather than litigation. Seller has not received any claims from third parties alleging that its use of any intellectual property infringes upon the rights of any third party.

This clause requests information on “incoming” infringement claims but fails to ask about “outgoing” infringement claims (i.e., third parties who are allegedly infringing upon the seller’s intellectual property rights). These claims sometimes can be as troublesome as claims against the seller, and often as expensive. In addition, using the term “infringe” is too limiting, since it does not encompass other types of incoming intellectual property-related claims such as trademark dilution. Finally, by focusing only on third-party claims, this representation fails to seek the disclosure of problems that may have arisen in patent or trademark prosecution (e.g., refusals to register marks on the grounds that they are not protectible or are confusingly similar to other marks). The buyer will need this information to get a complete picture of the intellectual property portfolio it is acquiring. INDEMNIFICATION

What happens if the seller’s representations turn out to be inaccurate? Often, but not always, the acquisition agreement provides that the seller will indemnify the buyer if the seller’s representations and warranties prove inaccurate. Although the typical indemnification clause does not specifically refer to intellectual property issues, counsel should be aware of the terms of the indemnification provision when negotiating intellectual property representations and warranties, since this provision will determine the consequences of breach. Although indemnification obligations can be mutual, the buyer generally stands to lose much more from the other party’s misrepresentations, so the buyer depends more heavily on the protection afforded by an indemnification clause.

ENDNOTE 6.17

Broadly speaking, a misrepresentation by the seller can injure the buyer in two ways. First, the buyer may not receive an asset specified in the acquisition agreement, such as a scheduled trademark that was previously sold to a third party. Second, the buyer may inherit a liability that was not disclosed, such as a royalty due on an inbound patent license. Although contract law may provide a remedy even in the absence of an indemnification provision, the buyer will likely insist on an indemnification clause in order to specify the duration of the seller’s representations, to ensure that the seller’s liability extends to expenses such as attorney’s fees, and otherwise to define the scope of the seller’s obligations. In negotiating representations and warranties, intellectual property counsel need to understand the nature of the transaction and the indemnification provisions, if any. There is no indemnification in acquisitions of public companies, and the representations evaporate after closing. The significance of the buyer’s preclosing due diligence (discussed in Chapter 8) is thus magnified. In other transactions, the seller may continue to be liable, but subject to various types of limitations. In negotiating the indemnification clause, the seller typically looks to include a basket that will limit its liability to material misrepresentations. The term “basket” can refer to one or both of two distinct types of arrangement, so it is important to examine the indemnification provision carefully to understand the seller’s obligation. In one type of arrangement, the buyer is not obligated to indemnify the seller unless damages reach a certain threshold amount. When the threshold is exceeded, the seller is liable for the first dollar of damages and every dollar thereafter. By contrast, if the parties structure the basket as a deductible, the seller will be liable only for damages in excess of the specified amount. On the other end of the liability spectrum, the seller may request a cap or ceiling that sets a maximum amount of liability under the indemnification clause. Because the agreement may specify that baskets and caps apply to certain types of claims but not to others, misrepresentations relating to intellectual property may have different consequences than misrepresentations in other areas. Just as the seller will seek to limit liability with a basket and cap, it will also try to negotiate a cut-off time to limit the period during which the indemnification obligation endures. If, for example, the seller remains liable for third-party intellectual property infringement claims arising prior to closing, it will want to limit the time during which the buyer can assert an indemnification claim. In addition to terms defining the scope of the indemnification obligation, the acquisition agreement may include provisions for ensuring collection, including escrows and procedures for offsetting against a deferred purchase price. The agreement may also specify which party controls the defense of a third-party claim covered by an indemnification obligation. ENDNOTE 1

17 U.S.C. § 204(a).

CHAPTER

7

U.S. ANTITRUST AND INTELLECTUAL PROPERTY IN MERGERS AND ACQUISITIONS Thomas G. Jackson Phillips Nizer Benjamin Krim & Ballon LLP

INTRODUCTION

The intellectual property laws—in particular, the patent and copyright laws and trade secrecy protection—and antitrust laws share a common purpose: namely, to promote innovation and enhance consumer welfare.1 Yet, as former Federal Trade Commission Chairman Robert Pitofsky recognized in a recent address, the relationship between antitrust policy and intellectual property is very much an unresolved issue “at the heart of the ‘New Economy.’”2 Although antitrust policy has made significant progress in understanding the New Economy and taken into account the need to protect incentives and opportunities to innovate, Pitofsky acknowledged in his address that “much remains to be done.”3 He noted that products and services based on intellectual property are typically characterized by large initial investments (fixed costs) and relatively low costs associated with producing goods or providing services (variable costs), thereby encouraging sellers to reduce price to acquire additional sales. This, in turn, requires potential competition to acquire intellectual property and increase sales beneficial to consumers. Despite this, however, the fundamental nature of competition in markets based on intellectual property often tends toward single firm dominance and, possibly, monopoly. This is largely a result of the patent and copyright protections provided for intellectual property, which preclude competition for a period of time, and the fact that individual demand for a particular product or service is often driven by its use by others, making the product or service more useful as a greater number of individuals begin to use it.4 A central theme given increasing emphasis over at least the past decade in antitrust policy, generally, and merger regulation, in particular, is the need to balance efforts aimed at protecting incentives to innovate with policies directed toward ensuring that consumers are given a reasonable range of choices in the marketplace and are protected to the extent practical from higher prices. Summarizing the principles governing antitrust policy in the area of intellectual property, former Assistant Attorney General, Antitrust Division, Anne Bingaman said: 7.1

7.2

U.S. ANTITRUST AND INTELLECTUAL PROPERTY

The intellectual property laws and the antitrust laws share the common purpose of promoting “innovation, industry, and competition.” The intellectual property laws provide incentives for innovation by establishing enforceable property rights for the creators of new and useful products and more efficient processes. The antitrust laws promote innovation and consumer welfare by ensuring that owners of intellectual property rights do not abuse those rights, for example, to suppress competition in alternate technologies and adjacent markets. . . . The bedrock principle of our policy towards intellectual property is that we treat it as we treat any other form of tangible or intangible property. Intellectual property is not exempt from the application of the antitrust laws, nor particularly suspect under them. While an owner of intellectual property is given certain rights to exclude competitors by intellectual property law, the right to exclude is bounded by the prohibitions of the Sherman and Clayton Acts, which can prohibit the owner from using those rights to suppress competition from alternative technologies. This limiting of rights is no different than the case for any other property owner. We will not presume monopoly power solely from the existence of an intellectual property right. If a specific form of intellectual property does confer a significant competitive advantage on its owner, that advantage is no more in conflict with the antitrust laws than one created by any other asset that enables its owners to earn supracompetitive profits. Judge Leamed Hand’s statement in Alcoa made more than fifty years ago that the Sherman Act is not violated by the attainment of power solely through “superior skill, foresight and industry”5 remains apt today with respect to the types of innovation protected by intellectual property rights.6

Although a variety of efforts have been made to address these often-competing interests, the concern still exists that a considerable degree of uncertainty that may, in itself, at times create a disincentive to innovate, remains as to the application of antitrust policies to intellectual property rights.7 ENFORCEMENT AGENCY POLICIES Horizontal Merger Guidelines. The U.S. Department of Justice and Federal Trade

Commission Horizontal Merger Guidelines issued in 1992 were reissued in revised form in 1997 to give a greater degree of importance in merger analysis to the potential of generating significant efficiencies resulting in the development of new and improved products and the ability to introduce innovative products more efficiently. At the same time, the guidelines recognize that efficiencies relating to research and development, although potentially significant, are inherently less susceptible to verification and may be the result of anticompetitive reductions in output.8 Under the Horizontal Merger Guidelines, the less likely anticompetitive effects are found to be, in the absence of efficiencies, the greater the weight that is likely to be given to potential efficiencies in the merger analysis. Non-Horizontal Merger Guidelines. Originally issued in 1984 as section 4 of the U.S. Department of Justice Merger Guidelines, all other sections of which were superceded by the Horizontal Merger Guidelines, the Non-Horizontal Merger Guidelines, dealing with the prospective harm to actual or perceived potential competition of the merger of a firm in a relevant market with a potential entrant to the market, recognize that expected efficiencies will be considered in determining whether to challenge a vertical merger. Also, because a substantial degree of vertical integration may be indicative of

INTELLECTUAL PROPERTY ISSUES IN MERGER CASES 7.3

resulting efficiencies, claims of such efficiencies will generally be given greater weight in determining whether to challenge a vertical merger than in analyzing a horizontal merger.9 Antitrust Guidelines for the Licensing of Intellectual Property. Unlike nonexclusive licensing arrangements, complete or exclusive acquisitions of intellectual property rights are analyzed under the U.S. Department of Justice and Federal Trade Commission Guidelines for the Licensing of Intellectual Property (Intellectual Property Guidelines), issued in 1995, by applying the principles and standards of the Horizontal Merger Guidelines.10 On the other hand, where a nonexclusive licensing arrangement is found to have, or be likely to have, an anticompetitive effect, the enforcement agencies will first consider whether the restraint is reasonably necessary to achieve procompetitive efficiencies, and, if the restraint is found to be reasonably necessary, will balance the procompetitive efficiencies and anticompetitive effects to determine the probable net effect on competition in a relevant market.11 Antitrust Guidelines for Collaborations Among Competitors. In nonmerger contexts, the

U.S. Department of Justice and Federal Trade Commission Antitrust Guidelines for Collaborations Among Competitors issued in 2000 recognize that most joint research and development agreements are procompetitive and “[t]hrough the combination of complementary assets, technology or know-how, an R&D collaboration may enable participants more quickly or more efficiently to research and develop new or improved goods, services, or production processes.”12 INTELLECTUAL PROPERTY ISSUES IN MERGER CASES Horizontal Mergers and Joint Ventures. Horizontal mergers and joint ventures between companies with overlapping or complementary intellectual property are typically defended on the ground that the combined entity will be able to introduce innovative products more efficiently. The argument is most effective where levels of concentration and barriers to entry are relatively low, and the potential anticompetitive effects are therefore limited. Where market shares and levels of concentration are high, effects on innovation are far less likely to justify the proposed combination. For example, in Lilly-Sepracor, Eli Lilly, the manufacturer of the widely used antidepressant Prozac, sought an exclusive license to the rights to R-fluoxetine, a followon and allegedly superior product, to which Sepracor, a relatively small pharmaceutical company, holds the patent. Among the concerns with the transaction was the possibility “that Lilly could introduce R-fluoxetine shortly before its own patent is due to expire in 2004, and attempt to shift its Prozac market share to the new antidepressant drug, on which the patent is not due to expire until 2015, thereby reducing the potential effect of generic competition on Lilly’s overall market share.” A second concern was the potential effect on competition of a market leader such as Lilly acquiring the exclusive rights to a similar, potentially competing product that would otherwise be marketed by a separate, smaller firm. Following a lengthy investigation, the Commission ultimately voted not to authorize a complaint.13 Largely based upon the uncertainties as

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U.S. ANTITRUST AND INTELLECTUAL PROPERTY

to whether the follow-on drug would receive FDA approval, when it would come to market, whether and to what extent Lilly’s patent on Prozac would have blocked marketing of the follow-on drug, and whether it represented a meaningful advance over Prozac, the arrangement was not challenged. Not only did Prozac face other competitors with significant market shares, but other generic manufacturers were ready to challenge Prozac when Lilly’s patent on the drug expired in 2004, and Lilly’s distribution resources and scientific expertise made it likely that it would bring this new drug to the market more promptly than would otherwise be the case. Therefore, the proposed transaction was not challenged.14 In another case, Ciba-Sandoz,15 Ciba-Geigy and Sandoz, the two leading developers of gene therapy products, agreed to merge to form Novartis A.G. Although at the time of the proposed merger, no gene therapy products were on the market, potential treatments were being evaluated in clinical trials. In one of the relevant markets, the Commission alleged that Ciba and Sandoz controlled the intellectual property rights needed to commercialize gene therapy products and asserted that the four other relevant markets were highly concentrated; that entry into the relevant markets was costly, timeconsuming and difficult, requiring patent rights, significant capital, and FDA approval; and that Ciba and Sandoz were the dominant developers. The majority of the Commission concluded in these circumstances that preserving long-run innovation was critical and that the development of potentially life-saving therapies could be hindered if the combined firm were permitted to control virtually all of the intellectual property rights needed to commercialize the products. In the settlement agreement that was reached, Ciba and Sandoz were required to license gene therapy technology, knowhow, and patents to another firm, Rhône-Poulenc Rorer, to ensure that it would be able to compete against Novartis, thereby resolving the agency’s antitrust concerns. In Glaxo-Wellcome,16 another case involving the research and development of pharmaceuticals, the Commission challenged a proposed acquisition in what it alleged was the highly concentrated market for a specific type of treatment of migraine headaches. It alleged that the acquisition would eliminate competition between the two companies in the research and development of migraine remedies. In a settlement with the agency, the two companies agreed that the combined firm would divest patents, technology, manufacturing information, testing data, research materials, and customer lists relating to the research and development of migraine remedies to a third firm, Zeneca Pharmaceuticals, to ensure continued research and development of Wellcome’s potential product in the same manner as if the proposed acquisition had not taken place. In United States v. Compuware Corp.,17 the Antitrust Division sued to enjoin Compuware—the leading producer of mainframe production testing and debugging software and fault management software—from acquiring Viasoft—Compuware’s closest rival in the testing/debugging software market and a recent entrant in the fault management software market. The complaint alleged that at the time of the proposed acquisition, Compuware had a market share of over 80 percent of the fault management market and approximately a 60 percent share of the testing/debugging software market. Viasoft’s SmartTest software, which generated approximately $20 million in revenues, was one of only two competitors to Compuware in the testing/debugging software market, with total revenues from its XPEDITER software of approximately $33 million. Compuware’s Abend-AID fault management software accounted for over $230 million in revenues and, according to the complaint, Viasoft’s SmartQuest fault management

INTELLECTUAL PROPERTY ISSUES IN MERGER CASES 7.5

product, which had been introduced earlier the same year, had begun to attract customers away from Compuware. In addition, Viasoft was preparing to integrate its testing/ debugging and fault management products to compete with Compuware for customers who prefered integrated testing/debugging and fault management software. The complaint alleged that the proposed acquisition would eliminate the closest of Compuware’s only two significant competitors in the testing/debugging software market and the only rival posing a potentially significant competitive threat in the fault management software market, lessening competition and resulting in higher prices, lower levels of service and support, and less innovation in product development. In addition, the complaint alleged that the markets for mainframe systems software are mature with relatively static demand, dominated by an entrenched incumbent. A new entrant, therefore, would require substantial time and money to develop and test competitive products and acquire a sufficient reputation to overcome user reluctance to switch to an unproven vendor, which would make new entry unlikely, untimely, or insufficient in scale to prevent an increase in prices or reduction in service, support, or product development in the relevant markets. The parties abandoned the merger approximately three months after the action was commenced, shortly before the date when the trial was scheduled to begin. Vertical Mergers. In Silicon Graphics,18 the Commission challenged the proposed acqui-

sition by Silicon Graphics—the largest producer of entertainment graphics workstations, which according to the Commission’s complaint had a 90 percent share of the market—of Alias Research and Wavefront Technologies, two independent producers of entertainment graphics software. The two companies, with a combined market share of a highly concentrated market in excess of 90 percent, had only one competitor—a subsidiary of Microsoft. The Commission’s primary concerns were the foreclosure of rival workstation manufacturers in competing effectively if Alias and Wavefront designed their software to be compatible with Silicon Graphics’ workstations, and the foreclosure of rival entertainment graphics software producers from 90 percent of their market if Silicon Graphics closed its open software interface so that only Alias and Wavefront were permitted to design compatible software. The Commission was also concerned that if Silicon Graphics continued to permit Alias and Wavefront to work with rival workstation manufacturers to develop complementary products, Silicon Graphics could use proprietary information disclosed in the course of product development to obtain an unfair competitive advantage over its rivals. The Commission also recognized that there was strong evidence that the proposed combination of companies with complementary offerings would lead to important innovation. To permit these potential efficiencies to be achieved while, at the same time, maintaining competition, the Commission negotiated a consent order allowing the merger to proceed, subject to the conditions that: (1) the merged entity would be required to enter into an approved porting agreement with a rival workstation manufacturer and use its best efforts to ensure optimal interoperability of Alias’ software programs with the rival’s workstations; (2) Alias and Wavefront would be prohibited from transferring proprietary information from rival workstation manufacturers to Silicon Graphics; and (3) Silicon Graphics would be required to maintain an open architecture, publish its application programming interfaces (APIs) for its workstations, and refrain from discriminating against Alias’ and Wavefront’s rivals.

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U.S. ANTITRUST AND INTELLECTUAL PROPERTY

Mergers Involving Horizontal and Vertical Restraints. In AOL-Time Warner,19 the

Commission challenged the proposed merger of America Online (AOL)—the largest Internet service provider (ISP), with a share of approximately 50 percent of dial-up (narrowband) subscribers—and Time Warner—a media conglomerate that operates cable television systems serving approximately 20 percent of U.S. cable households. Through a controlling interest in its partially owned Road Runner subsidiary, Time Warner provided broadband Internet access service to subscribers in areas served by its cable television systems. The Commission’s complaint alleged that Time Warner was a significant competitor in each of those areas. AOL also provided broadband Internet access, primarily over noncable broadband transmission facilities using digital subscriber line (DSL) technology to connect its broadband subscribers to the Internet. AOL was also a recent entrant in the Interactive Television (ITV) market, which blends data with video signal for display on televisions to combine Internet functionality with television and cable programming. AOL was perceived by many industry observers and regulators as likely to become the leading provider of broadband Internet access and positioned well to become a leading provider of ITV services. The Commission alleged that the proposed merger would lessen competition in the residential broadband Internet access market, undermine AOL’s incentive to promote DSL broadband Internet service as an emerging alternative to cable broadband in areas served by Time Warner’s cable television systems, and restrain competition in the delivery of ITV services. The merger was permitted to go forward, subject to the terms of a consent order that (1) required AOL-Time Warner to open its cable systems to competitor ISPs; (2) prohibited it from interfering with content delivered by nonaffiliated ISPs and the ability of nonaffiliated providers of ITV services to interact with signals, triggers, and content carried by AOL-Time Warner; (3) prevented it from discriminating on the basis of affiliation in the transmission of content; (4) prohibited it from entering into exclusive arrangements with other cable companies with respect to ISP or ITV services; and (5) required it to offer and market AOL’s DSL services in areas served by Time Warner’s cable systems where affiliated cable broadband ISP service is made available in the same manner and at the same retail pricing as it does in those areas where affiliated cable broadband ISP service is not available. Under the terms of the order, AOL-Time Warner was required to make the competing cable broadband service of Earthlink, the second largest ISP, available to subscribers in its largest cable markets before it could make AOL’s cable broadband service available to those subscribers. AOL-Time Warner was also required to enter into agreements with at least two other nonaffiliated ISPs within 90 days of making AOL’s cable broadband service available to subscribers in those markets on terms comparable to its agreement with Earthlink or any other agreement between AOL and a nonaffiliated cable company to provide AOL’s broadband service over that company’s systems. Another requirement was that AOL-Time Warner negotiate in good faith and enter into arms’ length agreements with other ISPs seeking to provide cable broadband service on its systems. These agreements would be subject to refusal only on the basis of capacity, business, and technical constraints, other than the potential decrease in AOL’s subscribers that might result from adding competing ISPs. Other provisions require AOL-Time Warner’s noninterference with competing ITV services and its charging the same or comparable prices for its DSL service in areas

ENDNOTES 7.7

where it provides cable broadband service to areas where it is not offering cable broadband service, subject to pricing differences that reflect actual differences in its transmission costs. A particularly striking aspect of the settlement is the limited duration of the consent order—five years—which is believed to be the shortest duration of any consent order entered into by either the Commission or the Antitrust Division.20 Taking into account both the actual and the likely future increase in competitive offerings, the fact that ITV is largely in its infancy, and the uncertainty of the competitive effects of future developments in these markets, the Commission attempted to strike a balance between protecting incentives to innovate and providing consumers with a degree of protection from higher prices while ensuring consumers a reasonable range of choices in the marketplace. Exclusive Licensing. Under the Intellectual Property Guidelines, exclusive licensing agreements and transfers of intellectual property rights are analyzed under standards similar to the analysis of the actual and potential anticompetitive effects of mergers and acquisitions.21 The acquisition of an exclusive license—one that precludes all other persons, including the licensor, from using the intellectual property—is treated as the acquisition of an asset for purposes of the reporting and waiting period requirements of the Hart-Scoft-Rodino Antitrust Improvements Act of 1976, if the other requirements of the statute are met.22 The Intellectual Property Guidelines state that, absent extraordinary circumstances, the Antitrust Division and Commission will not challenge a nonexclusive licensing arrangement if (1) the actual or potential restraint is not of a kind that always or almost always would tend to reduce output and increase prices (i.e., “facially anticompetitive”) and (2) the licensor and its licensees account for no more than 20 percent of each relevant market significantly affected by the restraint. Under this rule, the so-called antitrust “safety zone” does not apply to exclusive licenses and outright transfers of intellectual property rights.23

CONCLUSION

As global economic and regulatory pressures continue to mount, and the importance of technology in driving economic growth continues to grow, the attention given by antitrust enforcement agencies to intellectual property issues continues to increase while the treatment of intellectual property in merger analysis continues to evolve and mature. ENDNOTES 1

U.S. Department of Justice and Federal Trade Commission, Antitrust Guidelines for the Licensing of Intellectual Property § 110, n. 8., citing Atari Games Corp. v. Nintendo of America, Inc., 897 F.2d 1572, 1576 (Fed. Cir. 1990). 2 Robert Pitofsky, “Antitrust and Intellectual Property: Unresolved Issues at the Heart of the New Economy,” Address at the Antitrust Technology and Intellectual Property Conference of the Berkeley Center for Law and Technology, University of California, Berkeley, March 2, 2001. 3 Ibid. 4 Ibid.

7.8 5

U.S. ANTITRUST AND INTELLECTUAL PROPERTY

United States v. Aluminum Co. of America, 148 F.2d 416, 430 (2d Cir. 1945). Anne K. Bingaman, Report from the Antitrust Division, Spring 1994, Address at the American Bar Association Antitrust Spring Meeting in Washington, D.C. (April 8, 1994). 7 Anne K. Bingaman, “Competition and Innovation: Bedrock of the American Economy,” Address at the University of Kansas Law School, Lawrence, Kansas (September 19, 1996). 8 U.S. Department of Justice and Federal Trade Commission, Horizontal Merger Guidelines § 4 (Rev. 1997). 9 U.S. Department of Justice, Non-Horizontal Merger Guidelines § 4.24 (1984). 10 U.S. Department of Justice and Federal Trade Commission, Antitrust Guidelines for the Licensing of Intellectual Property § 5.7 (1995). 11 Intellectual Property Guidelines, § 4.2. 12 Federal Trade Commission and U.S. Department of Justice, Antitrust Guidelines for Collaboration Among Competitors § 3.31(a) (2000). 13 “FTC Completes Review of Lilly Agreement With Sepracor; Votes to Allow Transaction to Close,” PRNewswire, Apr. 13, 2000) . 14 Pitofsky “Intellectual Property and Antitrust.” See also Sheila F. Anthony, “Riddles and Lessons from the Prescription Drug Wars: Antitrust Implications of Certain Types of Agreements Involving Intellectual Property,” Address at the American Bar Association “Antitrust and Intellectual Property: The Crossroads” Program, San Francisco, California (June 1, 2000). 15 In re Ciba-Geigy, Ltd., 123 F.T.C. 842 (1997). 16 In re Glaxo P.L.C., 119 F.T.C. 815 (1995). 17 United States v. Compuware Corp., No. 1:99CV02884 (D.D.C., filed Oct. 29, 1999). 18 In re Silicon Graphics, Inc., Dkt. No. C-3626 (Nov. 14, 1995). 19 In re America Online, Inc. and Time Warner Inc., Dkt No. C-3989 (Dec. 14, 2000). 20 Pitofsky “Intellectual Property and Antitrust.” 21 Intellectual Property Guidelines, § 5.7. 22 See Edward G. Beister, III, Overview of Intellectual Property and Antitrust American Bar Association Section, Antitrust Law Intellectual Property Committee Newsletter 7 (Spring 2000); American Bar Association Section, Antitrust Law, Premerger Notification Practice Manual, Interpretations 49, 129 and 151, 2d ed. (1991). 23 Intellectual Property Guidelines, § 4.3, 5.7 n. 38. 6

CHAPTER

8

INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE IN BUSINESS TRANSACTIONS Sheldon Burshtein Blake, Cassels & Graydon LLP

INTRODUCTION

This chapter discusses intellectual property and technology, including information technology due diligence in business transactions.1 This chapter is meant to provide an overview of the types of issues that should be considered in relation to intellectual property and technology during the due diligence process in a commercial transaction. There is no legal analysis; instead, the focus is on assembling a summary of the considerations that arise in the two most typical types of commercial transaction purchases: share and asset. More specific types of transactions require special consideration. This chapter does not consider transactions in which intellectual property and technology are the primary focus, such as license and technology transfer agreements, although many of the considerations discussed also apply to those arrangements. The chapter looks at intellectual property and technology due diligence from a broader, more international approach, without focusing on issues in any particular jurisdiction (although in some cases reference is made to U.S. statutes). A brief checklist of issues to be considered in the due diligence process is presented at the end of most sections. Need for Intellectual Property and Information Technology Due Diligence. There are an

increasing number of corporate divestitures, acquisitions, and reorganizations. Divestitures are now an accepted way to reduce overhead, remove stagnant business lines, restructure a company to avoid hostile takeovers, and increase the value of a company’s stock. Acquisitions diversify businesses, expand product lines, reduce competition, expand markets, and reduce the possibility of a hostile takeover. Reorganizations of corporate groups may be effected either before or with other transactions to satisfy creditors, for tax reasons, or to ready an entity for a subsequent deal. The sale or purchase of a business or product line can be complicated and costly, with tens or hundreds of millions, or even billions, of dollars of shares or business assets changing hands. Often, the seller prepares information packages, due diligence 8.1

8.2

INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

briefs, and even draft documentation for a purchaser in preparation for a sale. After the parties have agreed on the basic terms of the agreement, including the price, the purchaser often has a fixed period of time in which to review all the assets, liabilities, and any other information pertinent to the business prior to execution of the share purchase or asset purchase agreement. This activity is typically referred to as due diligence. (See the legal definition in the next section.) The situation may be the same in a borrowing or share issuing situation. The borrower or issuer, in anticipation of seeking financing or issuing equity, may prepare information packages, due diligence briefs, offering circulars, and prospectus materials. Once a lender or underwriter agrees to pursue the loan or the issue, the lender or underwriter often has a limited time to do due diligence. The due diligence period is usually 30 to 90 days. Therefore, lawyers representing the seller, borrower, or issuer often seek to anticipate the questions and needs of the purchaser, lender, or underwriter. Lawyers for the purchaser, lender, or underwriter must decide which assets and liabilities require the most thorough review. Since the lawyers who are negotiating the transaction on behalf of the parties are usually merger and acquisition and corporate and securities lawyers, their expertise leads them to focus on matters most familiar to them. They often do not appreciate the value or complexity of intellectual property and technology. However, front and center in many of these deals are intellectual property and technology issues with a very visible and important role to be played by the intellectual property and technology lawyer. Historically, minimal, if any, effort was spent reviewing the intellectual property and technology assets and liabilities of the acquired business. This was due primarily to the short duration of the due diligence period, the unfamiliarity of many corporate and securities lawyers with intellectual property and technology matters, and the very subjective nature of assessing such assets and liabilities. Further, in many historical instances, a detailed review of intellectual property and technology rights would be too time-consuming, expensive, and cumbersome for the value received. However, intellectual property and technology rights are often among the most important assets of the acquired business in technology-driven industries (electronics, telecommunications, biotechnology, and pharmaceuticals); brand namebased businesses (food, clothing, and other consumer products); and copyright-based enterprises (software, publishing, entertainment, and the Internet). Intellectual property and technology rights have importance in virtually every other business, too. A hot dog stand on the corner uses a trademark to distinguish its goods and services from those of its competitors on the street and to encourage return trade. A medical clinic licenses a computer program to maintain patient records and to keep track of billings and payments. A Web-hosting business operated by an individual in a basement or a garage may involve not only domestic, but also foreign intellectual property and technology rights. It is not appropriate, and perhaps negligent, to say a business has no intellectual property or technology rights or to give it a too-short shrift in a commercial transaction. Further, the legal liabilities that may result from the infringement of intellectual property or violation of technology rights of others can directly and materially affect the long-term profitability of the business and thus the eventual purchase price, loan value, and share value. This may also affect the liabilities to the seller or borrower under its representations and warranties, the liabilities of the issuer under its offering document, or the ability of the lawyers to sleep at night.

INTRODUCTION 8.3

As the value of intellectual property and technology increases, both inherently and as a percentage of the value of a business’s assets, the significance to business persons and the responsibilities of lawyers related to intellectual property and technology due diligence in a commercial transaction increase. Therefore, purchasers, lenders, and underwriters, as well as advisors to the parties, are increasingly focusing on both the value and strengths and the weakness of the intellectual property and technology portfolio. For this reason, sellers, borrowers, and issuers are also focusing on these issues. What Due Diligence Is. Due diligence may be defined as the “measure of prudence,

activity, or assiduity, as is properly to be expected from, and ordinarily exercised by a reasonable and prudent [person] under the particular circumstances; [Due diligence is] not measured by any absolute standard but depending on the relative facts of this special case.”2 The term has different meanings depending upon the context in which it is used. In the sense used in this chapter, due diligence refers to the process of investigation into the business, legal, and financial affairs of a business sufficient to permit parties to make informed decisions. In the context of acquisitions, for example, it is the process in which the purchaser verifies the claims made in relation to the business, allowing the purchaser to determine whether to make the acquisition. Due diligence also serves to assist the lawyer in drafting or negotiating the agreement of purchase or sale. Identification of the Nature of Primary and Related Transactions. The first step in the due

diligence process is to identify and understand what the deal is. The two most useful questions an intellectual property and technology lawyer can ask a client when first retained on transaction are simple: “What are you doing?” and “Why are you doing it?” The answers to those questions will reveal the client’s perception of the transaction; the value, assets, liabilities, and perceptions of the business being sold, purchased, or financed; and will guide the due diligence inquiry. Sometimes there are a series of transactions. The primary transaction may have related and post-closing transactions. It is important to identify and understand the structure and motives for these. For example, a sale of shares of target company T from seller company S to purchaser company P may be followed by a sale of the assets of T to subsequent buyer company B. The sale of assets, including intellectual property such as trademarks, may be done simultaneously with a license back from B to T to use a key trademark for a transitional period. Lender company L may finance all or some of these transactions as well. If the overall deal is considered only from the perspective of a single transaction, the full picture may not be appreciated and difficulties may result. Therefore, the intellectual property and technology lawyer should request, and the client or commercial lawyer should provide, a complete overview of the whole series of transactions so the intellectual property and technology due diligence strategy can be developed with the big picture in mind. • • • •

Identify the deal. Determine the primary transaction. Determine whether there are related transactions. Determine whether there are post-closing transactions.

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INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

Share Purchase. In a share or stock purchase agreement (a share deal) the purchaser purchases most or all of the shares of the acquired business (the target) from the current shareholders. The agreement is usually between the seller and the purchaser. In a share deal, it may appear that it is not crucial to identify all of the intellectual property and technology assets because they are not changing hands. However, there may have been an intimate flow of technology, proprietary rights, and employees between the target and the seller (as often occurs in large corporate families with interrelating technology). Similarly, the target may have operated using the intellectual property and information technology of a related company without a formal license agreement in place. A careful review should be conducted to assess which intellectual property and technology assets are comprised within the assets of the target. Sometimes, asset transfers or licenses flow from the due diligence findings. It is also crucial to ensure that all contractual relationships survive the transaction, because many intellectual property and technology agreements have provisions that terminate or otherwise affect the relationship upon a change of control.

• Determine whether there is a flow of technology, proprietary rights, and employees between the target and the seller. • Determine whether the target operates using the intellectual property and technology of a related company without a formal license agreement in place. • Determine whether the contractual relationships of the target and the seller will survive the transaction. The other common avenue for acquiring a business is through purchase of assets (an asset deal). In an asset deal, either all or a portion of the assets of the acquired business is transferred to the purchaser. The identification and listing of specific intellectual property and technology assets and liabilities must be complete and accurate. It is crucial to ensure that all contractual relationships can be assigned without termination or other adverse consequences. If not, the agreement may not provide for the transfer of all the assets and rights. Because of this, due diligence becomes even more crucial to identifying all intellectual property and technology assets, rights, and liabilities, whether of record in a public office, contractual, or otherwise. Comprehensive appendices identifying all intellectual property and technology assets and liabilities to be transferred therewith usually accompany the asset purchase agreement.

Asset Purchase.

• Identify and list all specific intellectual property and technology assets and liabilities. • Prepare comprehensive appendices to accompany the purchase of assets agreement. • Determine whether the contractual relationships of the target are assignable. Purchase from Receiver or Trustee. In the case of an intellectual property and information technology purchase from a receiver or trustee, all the issues inherent in an asset deal are present, with a few additional complicating factors. First, one deals with an intermediary and must ensure that the receiver or trustee has title in the assets it pur-

INTRODUCTION 8.5

ports to sell. Second, the deal is usually on an as is, where is basis so that the purchaser buys without any, or with very few, representations and warranties. Third, there are usually a number of creditors to whom money is outstanding who seek any opportunity to grab some asset, right, or value. Fourth, if there is a rare opportunity for due diligence, there is usually very little information or assistance forthcoming because of the state of the financial affairs of the insolvent or bankrupt debtor business. The trustee or receiver may sell all of its rights to the intellectual property and information technology. However, the trustee or receiver may not have all, or even any, rights in the intellectual property or the information technology. One should take particular care if the purchaser expects to obtain an assignment of, or interest under, license or similar agreements. Such agreements frequently do not survive insolvency, bankruptcy, or even the appointment of a receiver or manager. Accordingly, a purchaser may not be getting what it thinks it is. A purchaser must take special care to confirm what portion of the intellectual property and information technology, if any, is covered by the transaction. Otherwise, a purchaser may be in for a nasty surprise, especially if the intellectual property or information technology is an important part of what the purchaser assumes it is getting. When a purchaser buys the assets of a financially troubled, insolvent, or bankrupt business, a review of all the contracts of the insolvent company should, if possible, be done to confirm that the trustee or receiver has the right to sell the assets which are purportedly for sale. • Determine whether the receiver or trustee has title in the assets it purports to sell. • Determine whether there are any representations or warranties, or if the deal is on an as is, where is basis. • Determine whether there is an opportunity for due diligence. • Determine whether there is any information or assistance forthcoming. • Determine whether the agreement has survived insolvency, bankruptcy, or the appointment of a receiver or manager when the receiver or trustee is selling interests under a license or similar agreements. Financing. A financing transaction involves the loan of money to finance an acquisi-

tion of shares or assets. The lender must be concerned about a number of different aspects of the overall transaction. First, it must view the transaction from the perspective of the purchaser to ensure that the purchaser gets the assets it intends in an asset deal or that the target has the assets the purchaser anticipates in a share deal. In addition, the lender must ensure that its interests are protected through both contractual arrangements governing the borrowing and repayment of money and the taking, recordal, and perfection of security interests against the collateral. This ensures that the lender is adequately protected in the event that the borrower defaults on repayment. Financings involving securities also often raise intellectual property and technology due diligence issues. In order to circulate an offering memorandum or a prospectus or to apply for a stock exchange listing, securities legislation requires that the offeror or applicant conduct reasonable investigations into the affairs of the business. Further, the memorandum, prospectus, or application must set out information about the business. Where such assets as brands and technology are material to the business, the position

8.6

INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

of the business must be assessed and reported. In many cases, such as new technology businesses involved in an initial public offering, forecasts and projections (sometimes termed future-oriented financial information) may be relevant. In such cases one must assess not only legal issues, but also business issues related to the intellectual property and technology, such as the true value of the technology, the market environment, the timetable for product introduction, and revenue projections. If the projections turn out to be incorrect, liability for misrepresentation may attach to the issuer, its directors and officers, and their advisors. A defense to such liability is that reasonable investigations were conducted and reasonable projections were made. Therefore, when an intellectual property and technology lawyer represents a lender or an issuer, he or she must look at the transaction from multiple perspectives, including those of a borrower, underwriter, securities regulator, and purchaser of equity. He or she must ensure that the intellectual property and technology assets of the business are properly dealt with and then, if acting for a lender, must ensure that the lender has the appropriate security interests in them. • View the transaction from the perspective of the purchaser to ensure that the purchaser gets the assets it intends. • Check that the lender’s assets are protected through contractual arrangements governing the borrowing and repayment of money. • Check that the lender’s interests are protected through security interests against the intellectual property and technology collateral. • Check that the lender’s interests are protected through the recordal and perfection of security interests against the intellectual property and technology collateral. Due Diligence by Parties Other than the Purchaser Due Diligence by Seller. Intellectual property and information technology due diligence

is increasingly imposed on the seller’s counsel and starts even before a deal is made. Except in those instances where the purchaser approaches the seller offering to purchase a business or product line, the process may begin when the seller decides that it is time to shed a particular business. Often the seller begins by preparing an offering memorandum, which is a document that provides prospective purchasers with an overview of the business. Although preparation of an offering memorandum is principally the responsibility of the commercial lawyers, this is where an intellectual property and technology lawyer may first become involved. Because many companies have discrete businesses operated as divisions or components within divisions, much of the technology and intellectual property supporting these businesses may have migrated into other divisions or businesses. Thus, an accurate definition of the business—and its intellectual property and technology—is needed before the offering memorandum is made available to avoid overlaps with the businesses of other divisions or components being retained by the seller. The intellectual property and technology lawyer needs to carefully review the offering memorandum. For instance, many offering memoranda refer to the intellectual property and technology assets of the business (such as patents, key trade secrets, trademarks, and copyright) and important licensing arrangements. Also, since confidential

INTRODUCTION 8.7

information is sometimes set forth in the offering memorandum, the intellectual property and technology lawyer should advise the seller to require a secrecy agreement from prospective recipients prior to the offering memorandum being sent. The intellectual property and technology lawyer should make certain that there are adequate disclaimers concerning the intellectual property and information technology information disclosed to protect the seller. • Check that any offering document has accurate information on intellectual property and technology issues. • Check that the seller has enough information to support representations and warranties in the agreement. Due Diligence by Borrower. A financing transaction involves the loan of money to

finance an acquisition of shares or assets, or for general business purposes. Where intellectual property or technology is a key asset of the business, these rights will be an important part of the collateral for the loan. Therefore, if it is prudent, the lender will do due diligence on the intellectual property and technology assets. Where the loan is for the purpose of financing an acquisition, the lender must also be concerned about a number of different aspects of the overall transaction. First, it must view the transaction from the perspective of the purchaser to ensure that the purchaser gets the assets it intends in an asset deal or that the target has the assets the purchaser anticipates in a share deal. In addition, the lender must ensure that its interests are protected through both contractual arrangements governing the borrowing and repayment of money and the taking, recordal, and perfection of security interests against the collateral. This ensures that the lender is adequately protected in the event that the borrower defaults on repayment. To facilitate the lending transaction, it will clearly be in the borrower’s interests to have its intellectual property and technology house in order. • Check that the lender has enough information to properly and in a timely fashion effect its intellectual property and technology due diligence. • Check that the representations and warranties in the loan agreement have accurate information about intellectual property and technology. Due Diligence by Issuer. Financings involving securities often raise intellectual prop-

erty and technology due diligence issues. In order to circulate an offering memorandum or a prospectus or to apply for a stock exchange listing, securities legislation requires that the issuer conduct reasonable investigations into the affairs of the business. Further, the memorandum, prospectus, or application must set out information about the business. Where such assets as brands and technology are material to the company, the position of the business must be assessed and reported. In such cases, not only must legal issues be assessed, but also business issues related to the intellectual property and technology (such as the true value of the technology, the market environment, the timetable for product introduction, and revenue projections). If the projections turn out to be incorrect, liability for misrepresentation may attach to the issuer, its directors and officers, and their advisors. A defense to such liability is that reasonable investigations

8.8

INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

were conducted and reasonable projections were made. When an intellectual property and technology lawyer represents an issuer, he or she may also have to consider the perspectives of underwriters, securities regulators, and purchasers of equity. He or she must ensure that the intellectual property and information technology assets of the business are properly dealt with. • Check that any offering document has accurate information about intellectual property and technology issues. • Check that the underwriter has enough information to properly and in a timely fashion effect its intellectual property and technology due diligence. Scope and Cost of Work for Intellectual Property and Technology Due Diligence.

Determining the scope of due diligence is often one of the most difficult decisions but it may be appropriate to a specific transaction. The quantity and quality of review of the intellectual property, technology assets, and liabilities depend on the length of the due diligence period, the financial resources of the client, the importance of intellectual property and technology assets to the business, and other issues. • Determine the value of the transaction. • Determine the importance of intellectual property and technology assets to the target or other client. • Determine the financial resources of the purchaser or other client. • Determine the time period for due diligence. • Determine the scope of due diligence. Time. An obvious constraint in the due diligence process is time. Time is generally not on the side of the purchaser’s counsel. Someone has already decided it wants the business, and most likely wants it yesterday. The seller wants to expedite matters, too. Not only does a fast deal get the seller its money sooner, it reduces the uncertainty among employees and the parties and also exposes the target and the seller to less probing. If the intellectual property and technology lawyer is brought in during the early stages of a 30- or 90-day due diligence period, the type of activity and the quality of due diligence will obviously be very different from that which would be expected when one receives a call for a closing on the same day.

• Determine the time period for due diligence. Cost. The cost of due diligence is usually the most important constraint. The cost of

due diligence is most often dictated by the value of the transaction. For example, if the total legal fee for a transaction is not to exceed $100,000, it would be difficult to argue that the value of the intellectual property and technology component of the work should be $50,000 unless the nature of the business or the transaction is heavily dependent on intellectual property or technology. A few factors should be kept in mind when establishing a budget for due diligence in addition to those discussed in the following sections. One is that intellectual property and information technology due diligence is

INTRODUCTION 8.9

often highly dependent on searches, both locally and abroad. Therefore, disbursements comprise a significant component of the cost in most cases. A second consideration is that intellectual property and technology is, in most cases, likely to be viewed by anyone but the intellectual property and technology lawyer as an annoying factor in the transaction and as relatively unimportant until a problem arises. • Determine the importance of intellectual property and technology to the target and the client. • Determine the value of the transaction. • Consider the expected value of total legal fees. • Consider the high expense of disbursements for intellectual property searches, both domestically and abroad. Nature of the Transaction. The nature of the transaction plays a major role in determin-

ing the approach that should be taken in due diligence. For example, if the transaction involves a management buyout the purchasers presumably know, or at least should be aware of, what the strengths and weaknesses of the target are. The type of transaction may also affect the type and quantum of due diligence. In a share deal, the assets are not being transferred, so one may be interested in determining what the intellectual property and technology of the target is to avoid problems and set value. In an asset deal it is essential to ensure that all of the intellectual property and technology is captured by the transfer. Of course, these are general propositions that do not apply to every situation. • • • •

Determine the nature of the transaction. Determine if the transaction is a share deal. Determine if the transaction is an asset deal. Determine if the transaction involves a management buyout, and if so, what management knows. • Determine if the transaction is another type of deal. Ancillary Agreements. A major transaction may also have a series of ancillary arrange-

ments, some of which relate to intellectual property or technology. They may have been foreseen by the parties at the time of the original negotiations or may come up as a consequence of the due diligence review. The following examples illustrate the types of issues that may arise. The seller may want to keep ownership of certain intellectual property and technology assets that are essential to the target because the seller’s other businesses will use them in continuing operations. This will necessitate licenses of shared assets so that the purchaser can run its business without having the benefit of ownership. A second example is the need for an operating secrecy agreement, where the purchaser will lease or purchase a portion of the seller’s facilities. Having a tenant operate a plant-within-a-plant can give rise to a host of problems, confidentiality being only one of many. Another example of an ancillary agreement is a transitional license. For example, a purchaser of a portion of the seller’s assets may want to have the right to continue using

8.10 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

the seller’s trademark until it can develop its own and effect a smooth transition. In the absence of a license, the purchaser would have no right to use the seller’s mark and will have no market recognition for its business after closing. A fourth example is the need for the seller to continue processing data for the purchaser, or vice versa. This raises licensing and confidentiality issues. There are many other situations that call for different types of ancillary agreements. Defining the need for these ancillary agreements is part of the due diligence process. In an asset deal there are typically a host of intellectual property-related implementing agreements. The most significant and common ones are short agreements for recording the assignment of intellectual property rights to the purchaser. • Determine whether ancillary arrangements relating to intellectual property and technology are considered part of the original negotiations. • Determine whether ancillary arrangements relating to intellectual property and technology have been identified as a consequence of the due diligence review. • Determine whether there are any shared assets that are essential both to the target or purchaser and to the seller. • Determine whether the target or the purchaser will lease or purchase a portion of the seller’s facility so that the parties will share facilities. • Determine whether there is a need for a transitional license, such as for trademarks or confidential information. • Determine whether there are ongoing information technology services provided by one party to the other. • Determine whether there is a need for agreements for recording the assignment of intellectual property rights of the purchaser. • Determine whether there is a need for agreements for recording security interests. Nature of the Business. Transaction lawyers often take comfort from the assumption that all businesses are more or less the same. All businesses are not more or less the same. Each business is different, and there are different issues associated with each. Businesses in which intellectual property and technology play a key role or form key assets are less the same than others. Pharmaceutical companies, for instance, work within a highly regulated industry. Many of the products are covered by patents and licensed, but in some countries compulsory licenses may be available to competitors. Electronics companies may not patent all new technology because it changes so quickly. Consumer product companies, of course, rely heavily on brand names. Publishing and software businesses are heavily dependent on copyright. Financial services businesses are heavily dependent on data processing and software. Furniture manufacturers may rely on design protection. One must find out what businesses the target is in and what reliance it places, or should place, on intellectual property and technology, including information technology.

• Determine the business of the target. • Determine how important a role intellectual property and technology plays in the business of the target and the industry.

INTRODUCTION 8.11 Value of Intellectual Property and Information Technology. One must try to get a sense of

why it is that the purchaser wants a particular business and what it sees as the real value in the business. The investigation and analysis have to concentrate on the valuable assets and aspects of the business. By way of illustration, suppose you are acting for a lender contemplating a loan to the purchaser of a manufacturing business. In answer to your first question, your client responds that the target company is desirable because it holds down a 50 percent market share in a product line which is synergistic to that of the purchaser. This is valuable information, but it is not the end of the inquiry. Why does the target hold a predominant market share? Is it a low cost producer? Does it offer a superior product? Why can’t the competition compete? In answer to these subsidiary questions you learn that there are two further elements to the answer: 1. Brand name loyalty is a powerful element in the particular marketplace and the target has the most well-recognized brand name. 2. No one can compete because the target has a lock on some element of its product design and on the production process for the product. In that bright and shining moment you come to see the transaction in a dramatically different legal light. This is not a bricks and mortar business turning out commodity widgets by the gross. Now you understand that the key to value lies not in the real estate and fixed assets, but in the status and extent of its intellectual property. You understand that your client’s foremost interest is in taking a real and effective security interest over the intellectual property assets of the target business. While a first charge over the physical assets will be a necessary part of the security package, it will prove to be pyrrhic unless the [Intellectual Property] security package carries with it the right to use trade names and patents after the appointment of a receiver.3

Therefore, you must identify why the purchaser wants the particular business and what it sees as the real value. Structure of the Business. It is essential to determine the structure of the business, as that will play an important role in determining what and how much intellectual property and technology due diligence may be required. By way of illustration, issues that arise when the target is one of a series of related companies, a small business, or a partnership are discussed.

• Determine the structure of the business of the target. Related Companies. Because of its intangible nature and the fact that so few people understand intellectual property and technology, it is not uncommon for the intellectual property and technology rights belonging to or used by a target to be owned by, or of record in the name of, a related company. For example, in some corporate families it is a policy that all intellectual property and technology is owned by the parent company or by a holding company specifically set up for such purposes. In some cases, the holding company may be located in a tax haven jurisdiction so that a standard search of corporate records in the United States or any other major commercial jurisdiction may not even reveal the existence of the holding company. The more multinational in nature the

8.12 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

corporate family is, the more likely the diversity in arrangements will be in respect to ownership and licensing of intellectual property and technology. Because of the relationship between the target and the owner, it is often the case that there is no written license authorizing the target to use the intellectual property and technology when intellectual property and technology is owned by a holding company. Therefore, where a transaction involves one of a related group of companies, it is essential to identify all of the related companies. It may be necessary to conduct intellectual property and technology due diligence for all of them and their intercompany arrangements. • Determine whether the intellectual property and technology rights owned or used by the target are owned by—or are of record in the name of—a related company. • Determine whether it is a policy or a practice of the target or its corporate family that all intellectual property and technology is owned by a parent company. • Determine whether it is a policy or a practice of the target or its corporate family that all intellectual property and technology is owned by a holding company. • Determine whether there are any written licenses authorizing the target to use the intellectual property or technology of its related companies. • Identify all of the related companies. • Conduct intellectual property due diligence for all of the related companies and their intercompany arrangements. Small Business. A small business or one dominated by its founder or other key executive presents peculiar issues. Often the key player is also a key source of intellectual property and technology in that the business may be based on an invention that he or she made or a computer program that he or she has authored. Such individuals usually do not conceptually separate the rights of the target from their own personal rights so that a key patent may, for example, be on record in the name of the individual, as opposed to the target.

• Determine whether the target is dominated by its founder or other key executive. • Determine whether the intellectual property of the target is on record in the name of the founder or other key executive. • Determine whether an assignment of intellectual property and technology rights from an individual to the target or purchaser is necessary. Partnership. If the target is a partnership, there are important issues that must be

resolved to ensure proper transfer or ownership of the intellectual property and technology. When an individual operates a business using his or her own intellectual property and technology and then enters into a partnership, title to the intellectual property and technology developed prior to entry into the partnership may remain in the individual in the absence of an express transfer of the intellectual property and technology by the individual partner. A determination of whether a partner or the partnership owns the intellectual property and technology should be made prior to the acquisition of a partnership or its assets.

INTRODUCTION 8.13

• Determine whether the target is a partnership. • Determine whether the intellectual property and technology of the target is owned by one or more individual partners. • Determine whether an express transfer of the intellectual property and technology to the partnership by one or more partners is necessary. Domestic Issues of Multinational Transaction. Lawyers in one jurisdiction are often

called upon to perform the domestic component of a multinational transaction. If the transaction is being driven locally, the local lawyer usually quarterbacks the deal and has control and coordination responsibilities. However, where the local component is a small part of a transaction being driven from abroad, the local lawyer is frequently instructed to do very specific tasks and to conduct very specific searches. This can be misleading and is worthy of careful attention by both local counsel and the coordinating counsel. For example, a target in the United States may have a wholly-owned Canadian subsidiary, Canco. A commercial lawyer in New York may ask that intellectual property searches be conducted in Canada for Canco, never thinking that the target or an intellectual property holding company may own all or most of the organization’s intellectual property and technology in Canada. Similarly, nobody in the United States may consider that Canco owns intellectual property and technology there or in other countries. Other similar investigative cracks may arise in such transactions. One must identify and raise potential issues like these with the client or the commercial lawyer. • Determine whether the intellectual property and technology in a particular jurisdiction is in the name of a local subsidiary or a foreign parent. • Determine whether a local subsidiary owns intellectual property or technology abroad. Multiple Location Business. A target having a head office in one location and plants or other significant premises elsewhere presents different problems for intellectual property and technology due diligence than for most other aspects of the due diligence process. For example, although all of the target’s corporate and tax records are likely to be centralized in the head office, widgets may be produced or services performed in the other locations. In fact, different types of widgets may be produced in each plant or different services performed in each location. Local places of business may have developed and may use technology that has not been communicated to, and may not be known at, the head office. Therefore, it may be necessary to sometimes visit each significant place of business of the target to properly conduct intellectual property and technology due diligence.

• Determine whether local offices or local plants have developed technology that has not been communicated to the head office. • Visit each significant place of business of the target. International Businesses. It is rare that any business does not have, or at least intend to

have, sales outside the local jurisdiction in this era of globalized trade. Exceptions,

8.14 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

though few, may include domestic service and retail companies—however, even they may sell products on the Internet or have long-term goals of expansion. If the target is based in one country and conducts all its manufacturing operations there, a commercial lawyer may not appreciate the need to conduct intellectual property and technology due diligence investigations in foreign countries. However, it would be awkward for a purchaser in an asset deal not to capture foreign intellectual property assets. It would be disastrous for a target to learn that it could not export its products to another country because, for instance, someone held a foreign patent that would be infringed by the sale of the products there. Therefore, it is necessary to identify all foreign jurisdictions that may be relevant to the target’s present and future operations and sales for intellectual property and technology due diligence. • Determine whether the target sells goods or performs services outside its local jurisdiction. • Determine whether the target intends to sell goods or perform services outside its local jurisdiction. • Determine whether the target owns intellectual property or technology outside its local jurisdiction. • Determine whether there is intellectual property or technology owned by a third party in a foreign jurisdiction that would be material to the target’s ability to sell goods or perform services in a foreign jurisdiction. Plans for the Business. In reviewing the nature of the business, one should have in mind the plans for that business. For example, the purchaser may plan to drop certain brands and emphasize others. Similarly, a purchaser may intend to introduce a new product line embodying recently developed technology. The purchaser may wish to revive a dormant trademark or product line, or it may wish to expand geographically and sell goods or services in new markets. If the business is currently a traditional bricks and mortar business, it is important to determine the purchaser’s plans with respect to ecommerce. Being aware of such plans is essential and should assist in targeting more important investigations and downplaying others in due diligence. The same issues arise where a business is borrowing money or issuing stock to expand its operations.

• • • •

Determine whether the purchaser intends to drop certain brands or products. Determine whether the purchaser intends to introduce new brands or products. Determine whether the purchaser intends to expand sales to new jurisdictions. Determine whether the purchaser is involved or intends to expand into e-commerce.

The Marketplace. One must also have an appreciation for the market, who the target’s

competitors are, and, in a general way, what challenges they pose to the target. • Identify the target’s key competitors. • Identify the key intellectual property and, where possible, technology of the target’s competitors.

INTRODUCTION 8.15 Assistance. It is crucial to identify at a very early stage those contacts on both sides of the transaction who may have information that one needs or who may assist in obtaining it. The process by which the necessary understanding can be achieved starts with the client. There may be a number of different people to speak to when dealing with the client. It may be necessary to speak to the business people driving the deal; in-house technology people; in-house general counsel; in-house intellectual property and technology counsel (if the client has them); and those who will be concerned with the marketing, technology, and other operational aspects of the target. In many instances, the questions will go beyond the purchaser’s knowledge. One needs to ask the seller a lot of questions. One may have to speak with the seller’s business people, in-house technology people, in-house counsel, marketing people, technology and operational people, contract administrators, and people in different plants and related companies. In the case of some businesses, it may be necessary to work with a technical expert. In an e-commerce business, it is important to speak with the chief information officer or the chief technology officer. In some cases, it may be possible to get information on record in government files through access of information legislation.

• • • • • • • •

Identify contacts who may have relevant information. Meet with in-house counsel. Meet with key marketing management. Meet with technology and operational people. Meet with information technology officers. Meet with contract administrators. Meet with people in different plants. Consider the relevance of information on record in government files through access of information legislation.

Secrecy Agreements. Prior to providing any oral or documentary assistance, the seller, borrower, or issuer may require execution of a nondisclosure agreement to protect any confidential information that may be disclosed, especially in the event that the transaction is never closed. A reciprocal secrecy agreement may be advisable if the purchaser intends to disclose any of its confidential technical and business information. A nondisclosure agreement should be executed by the parties well before the due diligence period and prior to disclosure of any confidential information, be it financial, technical, marketing, or otherwise.

• Consider the need for a nondisclosure agreement prior to due diligence activities. Representations, Warranties, and Opinions. Sometimes the representations and war-

ranties contemplated by the purchase or other agreement, as well as the opinions to be delivered on closing, serve to define and focus due diligence activities. For example, if the negotiated representations and warranties are narrower than what the purchaser originally hoped for, additional due diligence may be required. If the representations and warranties specifically exempt certain issues, that should be a red flag that there

8.16 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

may be a problem or that the seller does not have specific knowledge of those issues. If the intellectual property and technology lawyer knows that he or she will be required to give an opinion in a certain form, it is necessary for the due diligence to be sufficient to put the lawyer in a position to provide the requested opinion. • Consider the representations and warranties contemplated by the agreement as a basis for due diligence. • Consider the opinions to be delivered on closing as a basis for due diligence. Transitional Issues. The due diligence review should also assess whether or not any

actions or fees relating to the target’s intellectual property portfolio become due during the due diligence period. This will assist in avoiding any abandonment of rights during the review period. Sometimes there is a need for bridging services, especially in those deals where the seller may be transferring assets, such as patent and trademark applications, or proceedings like trademark oppositions that have responses or fee payments due during the transitional period or shortly after closing. The payment of maintenance fees, outstanding agent and counsel bills, and the like also needs to be addressed. These issues should be raised to facilitate the smooth transfer of the business. • Consider whether or not any actions or fees relating to the target’s intellectual property portfolio will become due during the due diligence period. • Consider who is responsible for looking after management of the intellectual property portfolio of the target pending closing. • Determine who is to look after payment of government and legal fees during the period prior to closing.

INTELLECTUAL PROPERTY RIGHTS Overview of Intellectual Property. It is important that one understand the different types of intellectual property in order to conduct intellectual property due diligence properly. Different aspects of the same product may sometimes be protected by various types of intellectual property. This is illustrated with reference to a table lamp with an ornamental base:

• A patent protects any new and unobvious functional features of the lamp or its electrical circuitry. • Copyright protects any original design drawings of the lamp. • The author of such design drawings has moral rights to prevent certain types of modifications to the drawings in some countries. • A design patent in the United States, or an industrial design registration elsewhere, protects any novel and unobvious (original in some countries) aesthetic design of the lamp. • A trademark protects a distinctive word or design denoting the brand of the lamp on the lamp itself or on a label, tag, or package.

INTELLECTUAL PROPERTY RIGHTS 8.17

• Trade dress protects the shape of the lamp or its packaging if distinctive of the source. • A tradename is the corporate name, partnership name, or business name under which a corporation, partnership, individual, or other entity conducts business, and may appear on the lamp or its packaging to identify its source. • A semiconductor chip registration protects any original topography of a semiconductor chip in the lamp’s circuitry. • The method of making the lamp is proprietary information or a trade secret if that method is known only by its manufacturer. • Personality rights protect the right of publicity of any celebrity whose persona is used to market the lamp. • A performing right would protect the performance of a jingle used to advertise the product in some countries. • The producer of a sound recording of the commercial has a producer’s right in some countries. • In some countries, a broadcaster has a broadcaster’s right in the communication of its signal if the commercial is broadcast. • In some countries, database rights protect the database of lamp customers and their pertinent information. • Plant rights are not applicable. Often, clients and commercial lawyers assume that all intellectual property rights are on record and that all that needs to be done to get a handle on a target’s intellectual property is to conduct searches in one or more key jurisdictions. However, in many cases pending applications to acquire such intellectual property rights are not available for searching, and in many cases even important intellectual property rights that should be registered or otherwise formally protected are not. There are a number of other intellectual property rights for which searches of public registers are of no assistance, because they need not be registered. These include moral rights, personality rights, and proprietary information. Therefore, while searches of public records will provide some very important information, they are by no means reflective of the whole picture. Through corporate name changes, mergers, acquisitions, and other transactions, the records relating to title of intellectual property in the public offices are not always up to date. This is especially true for jurisdictions other than the one that the target is based in. This is because, either through ignorance or indifference on the part of clients or commercial lawyers or in a desire to save costs, the somewhat expensive task of recording changes in names, structures, and ownership of companies in intellectual property offices is often not done. Also, intellectual property rights are not uniform from country to country. For example, copyright covers different bundles of rights in different jurisdictions. The trade dress of a product may be protectable under the law of one country, but not under the law of another. It may be harder to get a patent in one country than in another, so that the scope of a patent in one country may be somewhat narrower than in another, or there may not even be a patent in one country corresponding to a patent granted in another.

8.18 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

Searches are time-consuming and expensive. Therefore, it is preferable for a company to have good current records of its own intellectual property, whether formally protected or not. A prudent seller, borrower, or issuer will organize and maintain a compilation of all intellectual rights. However, in any intellectual property due diligence in a commercial transaction, at an absolute minimum one must check publicly available records of intellectual property in the Patent, Trademark, Copyright, and other offices in those countries that are material to the target’s business or rights. With the foregoing general concerns in mind, and subject to the specific limitations identified later in connection with each of the different types of searches, a search strategy should be planned that will develop a meaningful response. For example, if the target is Acme, Inc., but you are aware that there are a dozen or so companies within the corporate family having “Acme” in their names, you may wish to conduct intellectual property searches for all companies having the word “Acme.” The incremental costs of doing broader searches are generally not significant, but the potential cost of missing some key intellectual property, especially in an asset deal, may be significant. The following discussion considers each of the forms of intellectual property in turn. First, a brief summary of the relevant rights is provided. Second, a summary of available searches for each significant type of property, where appropriate, is set out. Third, the limitations of each of these searches are set out so that one can be aware of where the gaps are in the information. Finally, some comments are made on follow-up. • Remember that searches do not tell the whole story. • Remember that intellectual property rights are not uniform from country to country. • Develop a search strategy. • Consider searches in the names of predecessors. Through corporate name changes, mergers, acquisitions, and other transactions, it is often the case that records relating to title of intellectual property in public offices are not up to date. • Consider rights that are not on record in intellectual property offices. Patents. A patent issued by the government grants the right to exclude others from

making, using, or selling an invention in the relevant country.4 It can only be obtained for certain classes of new, useful, and unobvious inventions. These include methods, such as a process for refining petroleum; devices, such as a motor; and compositions of matter, which include chemical compounds like a plastic. In some countries, like the United States, computer software and business methods may now be patented. In order to be patentable, an invention must have a useful purpose5 and be novel. Novelty is measured against certain criteria in the patent legislation, which differs from country to country.6 A patentable invention must also be inventive—that is, it must not be obvious to a person having ordinary skill in that field.7 A patent is always susceptible to attack on the basis that it is invalid for failing to satisfy any of these criteria. Patent applications may only be filed within narrowly prescribed time limits. In almost all countries, an application must be filed prior to any availability of the invention to the public. In the United States and Canada there is a one-year grace period.

INTELLECTUAL PROPERTY RIGHTS 8.19

Patent applications are rigorously examined and may be pending for a long period of time.8 In many countries, recently including the United States, the application is made available to the public 18 months after the filing date of the first application for the invention.9 The terms of patents vary in each country. In most countries, the term of a patent expires 20 years after the date of filing the application from which the patent was granted,10 but this should always be verified because of numerous variations to this general rule. In some countries, for example, the United States, the term of patents may be extended to compensate for regulatory delays in approvals for certain products like pharmaceuticals.11 It is also possible for one to file an international patent application pursuant to the provisions of the Patent Cooperation Treaty (PCT). Such an application is filed through the World Intellectual Property Organization (WIPO) in Switzerland,12 and well over 100 PCT member countries may be designated.13 The application first passes through an international phase before the applicant chooses to enter the national phase in some or all of the member countries designated in the application. The national phase may be entered before either the 20- (or 21-) or 30- (or 31-) month anniversaries of the original filing, depending on whether or not the international application is examined. The application is treated as an ordinary national application within the country it chooses to enter in the national phase.14 It is also possible to file an application for a European patent, which covers one or more European countries that are members of the European Patent Convention. It is important to appreciate that many valuable inventions may not be the subject of patent protection in any or all countries. The most common reasons are that the invention does not satisfy the criteria to obtain a patent, the target that developed the invention did not want to make the investment to seek a patent, the target pursued patents only in selected countries, the target missed the very limited window in which a patent application must be filed, a patent application or a patent was not maintained through the payment of fees, or a patent has expired. Types of Searches. Several types of searches may be done in the Patent Office (the Patent and Trademark Office in the United States) records of each relevant jurisdiction. An index search is the most common in a commercial transaction. It seeks to determine what patents and, where available, published applications, have been granted to, filed by, or transferred to a particular person. An index of inventors, applicants, patentees, and recorded owners is kept by the Patent Office. Again, if there is a series of related companies, it may be prudent to conduct such a search in the names of all of the relevant companies. An inventor search is made to locate all patents and published applications granted in the name of a certain inventor. Such a search is often advisable in the case of a small business where there is a single directing mind or key technical person. It may also be helpful in the case of a major business where all or most of the technology derives from the work of one or few key people. If information on the patent position of one or two key competitors is desired, it may also be worthwhile to conduct an index search in the names of the competitors or an inventor search for the competitors’ key technical people.

8.20 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

A PCT application that has not yet entered the national phase in a particular country will not be found in a search of records of that country. A European application may not be identified in a search of a national patent office. One may conduct PCT index and inventor searches for pending international applications that have not yet entered the national phase and for European applications. Most patent laws require the recordal of all exclusive licenses and permit the registration of other licenses. In some countries the patent law also provides for compulsory licenses, particularly for pharmaceuticals. A license search against certain patents may provide insight into important contractual or compulsory arrangements affecting key patents. A state-of-the-art search is made to find the current technology in a particular field quickly and relatively economically. Such a search is often done once a business has identified a need and wants to begin product design. However, such a search may also be conducted to determine whether a target is developing technology that may already be obsolete or to identify potential patent impediments in getting that technology to market. This is sometimes done prior to a decision being made in a financing deal, especially when equity is being injected into a recent startup business. The problem with this type of search is that, in certain industries like electronics and biotechnology, developments occur very quickly and the information available through Patent Office searches may be out-of-date. A novelty search is a preliminary search made prior to filing a patent application to determine whether the invention is patentable. Such a search may be appropriate when the target has developed new key technology on which future business prospects depend and one wishes to determine the patent prospects for that invention. For new inventions that are not yet the subject of a patent application, it must be borne in mind that all countries have statutory deadlines or bars within which patent applications must be filed. Most bars are triggered by the public availability of the invention. The United States15 and Canada have limited grace periods before a deadline within which an application must be filed, but most other countries do not. An infringement search seeks to locate patents and potential patents that might be infringed by the proposed manufacture, sale, or use of a device, composition, or method. It is limited to patents that have not expired and, in those countries where available, published applications. A patent only provides a negative or exclusionary right, not a positive right. Even if one has a patent, exploitation of a patented invention may still infringe other patents. This search is often impractical because of the expense involved, but if a particular product line—especially a new or proposed one—is material to the success of the target, it might be advantageous to conduct such a search. A validity search seeks to locate patents and published applications that may affect the validity of claims of a specific patent. The results are used to assess the strength of a patent. Because private resources are usually greater, the patents and other documents found in a validity search often include some not found by the Patent Office examiner during the application process. Such a search might be conducted when the strength of a target’s patent is crucial to the success of the business because the target relies on that patent to maintain its dominance of the market or competitive position.

INTELLECTUAL PROPERTY RIGHTS 8.21

In some countries, one may also conduct a search to identify grants of security interests against patents and published applications. • • • • • • • • • • • • • • •

Consider an index search. Consider an inventor search. Consider an index search in the names of competitors. Consider a search in the name of an inventor who is one of the competitors’ key technical people. Consider a search of recorded voluntary licenses. Consider a search of compulsory licenses, where appropriate. Consider a state-of-the-art search. Consider a novelty search. Consider an infringement search. Consider a validity search. Consider a search for pending applications, where published. Consider a search for pending applications that have not yet been published. Consider a PCT index search for pending international applications that have not yet entered the national phase. Consider a PCT inventor search for pending international applications that have not yet entered the national phase. Consider a search to identify grants of security interests against patents and published applications.

Limitations of Searches. There are many limitations to patent searches. First and fore-

most, a search of the records of the U.S. Patent Office will not reveal reference to any inventions for which a patent has not been issued. In many countries, including the United States,16 a search will not reveal an application that has not been published. If the application was withdrawn or refused, the application would never become available to the public. Even if a country is designated in an international application at the time of filing, until the application enters the national phase there is usually no ability to locate the application in the local Patent Office. Therefore, it may also be necessary to search for international PCT applications or regional applications in Europe. It is possible to obtain information on expired patents in an index search. Information on expired patents may be relevant in a number of situations. An example is when a patent has recently expired and the market position of the target has been dependent on the monopoly afforded by the patent. The fact that the patent has recently expired may be a reason why the seller is interested in selling the target. In most countries pending applications and patents are subject to the payment of annual maintenance fees. In the United States, only granted patents are subject to periodic maintenance fees. It is possible that an application or patent that is key to the target has lapsed due to failure to pay such fees. It is sometimes possible to reinstate such applications and patents within certain time limits. Therefore, it might be helpful to expand the search to cover recently lapsed patents and published applications.

8.22 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

An index search will only reveal the issued patents and published applications on record in the name being searched. Therefore, the search may reveal rights that are still in the name of the target but have since been assigned, or may not reveal rights actually owned by the target but for which assignments or other documentation may not have been recorded. In the case of state-of-the-art, novelty, infringement, and validity searches, there is much subjectivity that goes into the search and any resulting analysis. In conducting any such searches, the searcher must rely on the classification system maintained by the Patent Office, and the classification of each application as it is filed in the Patent Office within the system. If an application is incorrectly classified and does not appear in those classes in which one would expect that technology to appear, it is possible to miss a relevant reference. The records of the Patent Office are also known to contain many errors and omissions that may affect the reliability of all searches. • Understand the limitations of patent searches. • Understand the PCT filing regime and the limitations as to accessibility of international applications that have not yet reached the national phase. • Understand that pending patent applications may not be available for searching in some circumstances. Follow-up. It is necessary to correlate the information obtained in patent searches with

that obtained through meetings with people who are familiar with key technology in the target. If there are other key inventions and proprietary information of the target that might be patented, or major problems are posed by a patent of a competitor, they should be identified. All relevant information about the key technology, its inventors, and the relationship of the inventors, whether through employment or consulting contract, should be identified. It is important to note that, at least in the United States, patent applicants have a duty of candor to the Patent Office to disclose all relevant prior art known to them.17 The target’s files should be considered in relation to this duty. One should try to work from the bottom up and find out how the target handles new ideas, whether it has a research and development department, and where that is. One should attempt to identify what kind of documentation is produced when an employee or consultant comes up with a new idea. It is essential to tour the research and development facilities, plant, warehouse, stores, systems control centers, and other locations where the real business is done to see, in a general way, what technology the company is using. No plant or other premises tour can ever totally familiarize an intellectual property and technology lawyer with the details of technology. It will give one a general idea of the processes used in the plant and elsewhere, and it may also give one an idea as to which technology is home-grown and which is licensed-in. All relevant inventions, patented or unpatented, should be listed with all pertinent related information, including dates of invention and deadlines for the filing of applications, the prosecution of applications, and the payment of maintenance fees for applications and patents. • Correlate the information obtained in patent searches with that obtained through meetings with people who are familiar with key technology in the target.

INTELLECTUAL PROPERTY RIGHTS 8.23

• Consider other key inventions and proprietary information of the target that might be patented. • Consider major problems posed by a patent or application of a competitor, if identified. • Determine if the target has complied with its duty of candor to the U.S. Patent Office. Designs. A design patent, or in many other countries a design registration, may pro-

tect certain reproducible shapes and patterns that have a new and unobvious (or, in some countries, original) shape, configuration, or ornamentation applied to a useful article.18 The design must have an aesthetic affect—entirely functional features may not be the subject of a design protection. Examples of designs that may be registered are furniture designs and telephone casings. A design application may only be filed within narrowly prescribed time limits. In almost all countries, an application must be filed prior to any availability of the design to the public. There is a one-year grace period in the United States and Canada.19 A design patent or registration grants the right to exclude others from making, selling, or using a product embodying a design. The terms of corresponding protection vary by country. In the United States, a design patent extends for a term of 14 years.20 It is important to understand that many valuable designs may not be the subject of design protection in any or all countries. The most common reasons are that the design does not satisfy the criteria to obtain a patent or registration; the target pursued design protection in selected countries; the target that developed the design did not want to invest in an attempt to patent or register the design; the target missed the very limited window in which a design application must be filed; a design application, patent, or registration was not maintained; or the patent or registration has expired. Types of Searches. Several types of searches may be done in the Industrial Design

Office (the Patent and Trademark Office in the United States) records. An index search, done to determine what patented or registered designs have been transferred to a particular person, is the most common in a commercial transaction. Again, if there is a series of related companies, it may be prudent to conduct such a search in the names of all of the relevant companies. If information on the design position of one or two key competitors is desired, it may also be worthwhile to conduct an index search in the names of the competitors. An inventor (or author) search is made to locate all patents or registrations and published applications granted in the name of a certain inventor. Such a search is often advisable in the case of a small business where there is a single directing mind or key design person. It may also be helpful in the case of a major business where all or most of the designs derive from the work of one or a few key people. In many countries, the laws require the registration of exclusive licenses and permit the registration of other licenses. A license search may identify any such licenses on record against particular registrations. A state-of-the-art search is made to find the current design art in a particular field quickly and relatively economically. Such a search is often done once a business has identified a need and wants to begin product design. Such a search may also be conducted

8.24 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

to determine whether a target is developing designs that may already be obsolete or to identify impediments in getting that design to market. A novelty search is a preliminary search made prior to filing a design application to determine whether the design is patentable or registrable. Such a search may be appropriate where the target has developed a new key design and one wishes to determine the patent or registration prospects for that design. An infringement search seeks to locate design patents or registrations that might be infringed by the proposed manufacture or sale of a product embodying a design. It is limited to design patents and registrations that have not expired. If a particular product line embodying a design—especially a new or proposed one—is material to the success of the target, it might be advantageous to conduct such a search. A validity search seeks to locate design patents and registrations that may affect the validity of a patent or registration. The material located is used to assess the strength of a patent or registration. The patents, registrations, and other materials found in a validity search often include some not found by the examiner during the application process. Such a search might be conducted if the strength of a target’s design patent or registration is crucial to the success of the business because the target relies on that patent or registration to maintain its dominance of the market or competitive position. In some jurisdictions, one may conduct a search to identify grants of security interests against design applications, patents, and registrations. • • • • • • • • • •

Consider an index search. Consider an inventor search. Consider an index search in the names of competitors. Consider a search in the name of an inventor who is one of the competitors’ key design people. Consider a search of recorded licenses. Consider a state-of-the-art search. Consider a novelty search. Consider an infringement search. Consider a validity search. Consider a search to identify grants of security interests against applications, patents, and registrations.

Limitations of Searches. There are many limitations to design searches. A search of the records of the Patent Office or, outside the United States, the Industrial Design Office, will not reveal reference to any design for which an application has not been filed. A search will generally not reveal reference to any application that is still pending because in most countries, all applications are kept confidential throughout prosecution until a patent or registration issues. If an application is withdrawn or refused, the application would never become available to the public. As in the case of patent and trademark searches, an index search will only reveal the patents and registrations on record in the name being searched. Therefore, the search may reveal rights still in the name of the target but which have since been assigned, or may not reveal rights actually owned by the target but for which assignments or other documentation may not have been recorded.

INTELLECTUAL PROPERTY RIGHTS 8.25

It is possible to obtain information on expired patents and registrations in an index search, but this information must generally be specifically requested by the searcher. Information on expired patents and registrations may be relevant in a number of situations. An example is when a patent or registration has recently expired and the market position of the target has been dependent on the protection afforded by the patent or registration. In the case of state-of-the-art, patentability, registrability, infringement, and validity searches, there is much subjectivity that goes into the search and any resulting analysis. In conducting any such searches, the searcher must rely on the classification system maintained by the Patent or Design Office, and the classification of each application as it is filed within such a system. If an application is incorrectly classified and does not appear in those classes in which one would expect that art to appear, it is possible to miss a relevant reference. The records are also known to contain many errors and omissions that may affect the reliability of all searches. • Understand the limitations of the searches. • Understand that pending applications are not available for searching. Follow-up. It is necessary to correlate the information obtained in design searches with

that obtained through meetings with people who are familiar with key products and product and packaging configurations in the target. If there are other key designs that might be patented or registered, they should be identified and carefully considered. All relevant information about the key designs, its inventors or authors, and the relationship of the creators, whether through employment, consulting, or other contract, should be identified. All relevant designs, whether or not patented or registered, should be listed with all pertinent related information, including deadlines for the filing of applications, the prosecution of applications, and the maintenance of patents and registrations. • Correlate the information obtained in design searches with that obtained through meetings with people who are familiar with its key products and product and packaging configurations in the target. • Consider other key designs that might be patented or registered. • Consider relevant information about the key designs, their creators, and the relationship of the creators, whether through employment or consulting contract. Trademarks. A trademark is a word, symbol, shape, or a combination of them used by a person to distinguish his or her goods or services from those of others.21 Trademarks include word marks such as Coke, design marks such as McDonald’s Golden Arches, shapes such as the familiar Coca-Cola bottle, characters such as Mickey Mouse, and getups such as the well-known Howard Johnson Orange Roof.22 Trademarks may identify goods, such as Crest for toothpaste; services23 such as Holiday Inn for hotel services; or both, such as McDonald’s for hamburgers and restaurant services. The goods or services themselves are not protected by a trademark. Rather, the trademark may not be used by others in a way that would confuse the public into thinking that the goods or services of the trademark owner were being obtained. For instance, anyone may sell film, but only the owner of the Kodak trademark may identify it as

8.26 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

Kodak film. Every business has some type of trademark right, even if it is only in the name under which it does business. In a consumer-based business the value of trademarks will be even higher, but one should not discount the value of trademarks in businesses that cater to other businesses. For example, a very sophisticated manufacturer of electronic equipment may distinguish its components in the marketplace by a trademark, as opposed to referencing the component by its technical specifications. In the United States and some other countries, trademark rights can be acquired through use of the mark with goods or services.24 In such countries a trademark need not be registered, but registration usually ensures protection throughout the country. A prior user of a mark may have superior rights to a person who subsequently uses or registers the mark. However, in other jurisdictions, such as many European countries, trademark rights must be registered to be enforceable. In such countries, the superiority of rights is generally determined by the first filing of an application and trademark use is less important in establishing rights. The term of a registration varies from country to country. In the United States, the term is 10 years25 and is renewable indefinitely.26 The rights granted by a registration are generally limited to a national jurisdiction. It is possible for one to file so-called international applications to register trademarks through conventions such as the Madrid Agreement or regional trademark applications through the European Community Trademark Office. These applications cover a group of regional national jurisdictions. They first are treated as international or regional applications, and then become a series of national applications or registrations, depending on the rules of the specific arrangement. Types of Searches. There are a number of different types of searches one can conduct

in the Trademark Office of each relevant country (the Patent and Trademark Office in the United States). An index search is the most common type of search and the usual starting point in a commercial transaction. This search is made to determine what trademark registrations and pending applications for registration of trademarks are on record in the name of a particular person. An index search should be conducted in the name of the target and all relevant predecessor and related companies. In the case of an index or name search, a search strategy should be planned to get a meaningful response. For example, if the company is called Acme, Inc., but you are aware that there are a dozen or so companies within the corporate family having in their names the word “Acme,” you may wish to conduct your searches for all companies having the word “Acme.” An application that has not yet been made of record in a specific national jurisdiction will not be found in a search of records in that country. One may conduct searches of regional indices for such international and regional applications and registrations. If after investigation it becomes apparent that an important trademark of the company has not been registered, it may be advisable to conduct a registrability search. This search will identify prior filed applications and issued registrations for trademarks similar to the mark for which the search is made. This will provide some idea as to whether the particular trademark may be registrable in a particular jurisdiction. In a business where there is a significant major competitor and one wishes to assess the trademark rights of that competitor, one may conduct similar searches in the name of the competitor and its related companies for its key trademarks.

INTELLECTUAL PROPERTY RIGHTS 8.27

One may conduct an opposition search to locate pending oppositions in which the target is opposing applications of third parties. One may also conduct a search for cancellation proceedings which may lead to possible expungement of a registration. In some countries it is also possible to look for documentation relating to security interests recorded against trademark registrations and applications. All trademarks of public record, all other trademarks which are identified during the process, and their various script and design versions should be listed together with the goods and services with which they are used, the dates of first use in each jurisdiction, and all relevant deadlines for the prosecution of applications and the renewal of registrations in each relevant jurisdiction. • Consider an index search in the name of the target and all relevant predecessor and related companies. • Consider a registrability search. • Consider a search of trademark rights of major competitors. • Consider an opposition search. • Consider a search for cancellation proceedings. • Prepare lists of all relevant registrations and applications. • Consider a search for documentation relating to security interests recorded against trademark registrations and applications. Limitations of Searches. It is just as important for one to understand what information is

not revealed in a search as what is revealed. There are a number of important limitations on the information that one may obtain in a search of the records of the Trademarks Office. A search normally will not reveal cancelled registrations but can be expanded to identify these. A registration may be cancelled for a variety of reasons. This includes the failure to file an affidavit of use prior to the sixth anniversary of the registration in the United States27 or the failure to renew a registration. Therefore, a registration of a valuable trademark may have been lost due to administrative inattention. This is common. A search may be expanded to identify cancelled registrations. A search will normally not reveal abandoned applications. An application may have been abandoned for a number of reasons, including voluntarily in response to an adverse examiner’s report, as a result of an opposition by a third party, or as a result of overlooking a deadline. A search can be expanded to identify abandoned applications as well. A search will also not reveal recently filed pending applications. This is because there is a brief period between the time an application is actually filed and the time when it first appears in the indices of the Trademark Office or in any commercial database. It is also possible for persons in other countries to file an application in one country within six months of the date of an earlier application abroad and obtain the benefit of that earlier date in the former country. In some countries licensees of trademarks must be registered as users. In such countries, a search of user registrations may reveal important contractual arrangements regarding key trademarks. Obviously, a search is only as good as the data. A search of the records of the Trademark Office will not reveal any information on trademarks that may have been

8.28 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

extensively used but are not the subject of a pending application or issued registration. It is possible that a very material trademark of the target has not been registered, either because no one has made the decision to file an application or because the trademark may not be registrable. When conducting an index search, it is important to understand that the search will only reveal trademark registrations and applications of record in the name of the party for which the search is conducted. In other words, if the trademarks are currently owned by party B through an assignment from party A but that assignment has never been recorded in the records of the Trademark Office, it will not be possible to locate those marks merely by doing a search in the name of B. Similarly, it may identify a mark in the name of A which A assigned to B long ago, but for which B did not record the transfer. The records of the Trademark Office and the related commercial databases are known to contain errors and omissions. Therefore, even in respect of rights that are properly recorded, the information available for searching is not always accurate. This may affect the reliability of all searches. It may be advisable to conduct a more comprehensive search by specific trademark. It is possible to search trade directory, telephone directory, tradename, domain name, and other trademark and tradename uses through private databases. It may be prudent to conduct a search of this type for the most important trademarks of the target. • • • •

Consider the limitations of each type of search. Consider a trade directory search. Consider a telephone directory search. Consider a corporate name search.

Trade Dress. Trade dress is the distinctive getup of goods, packaging, and other materials which function as a trademark to distinguish the source of goods or services. Examples are the Coca-Cola bottle design for beverages and the Howard Johnson Orange Roof design for restaurant services. Not all countries recognize rights in trade dress and of those that do, some limit the scope of rights in trade dress. Rights are often based on use where trade dress is recognized. However, in some countries, rights may be based on registration. Any registered trade dress rights will usually be identified in trademark searches. It is important to attempt to identify unregistered trade dress rights where they exist.

• Consider conducting trademark searches for trade dress. • Understand that different countries treat trade dress differently. • Consider identifying unregistered trade dress rights where they exist. Domain Names. Domain names are the pseudonyms given to alphanumeric combinations that represent addresses on the Internet. An example is targetcompany.com. Because of the way the commercialization of the Internet has evolved, domain names have become very important identifiers and are often based on important trademarks of the target. A domain name itself is probably not a property right because the registrant holds the domain name subject to a contract with the domain name registry, much as a

INTELLECTUAL PROPERTY RIGHTS 8.29

business uses a telephone number subject to a contract with a telephone company. However, it is clear that trademark rights will arise if the domain name or the telephone number is used as a trademark. A search should be conducted for all domain names registered by the target. In addition, searches should be conducted for all domain names which include important trademarks of the target. Searches should be conducted through all top-level domain (TLD) registries. In addition to the .com registry, these generic TLDs include specialized TLDs, like .org and .net. Searches should be conducted in all national TLD registries like .ca for Canada and .uk for Britain. These searches should also look for domain names that may tarnish the target such as targetcompanysucks.com and typo variations, such as targettcompany.com. In each case, the website of a registrant other than the target should be visited to determine how the domain name is used, the location(s) of the business, and the nature of the business, wares, and services offered. In some cases, third-party domain names comprising similar marks will not be an issue. In other cases, either cybersquatters who have registered the target’s domain names in advance of the target, or legitimate businesses with similar marks in different industries or in other countries, may pose issues. • Consider a search for all domain name registrations of the target in all generic top-level domain registries. • Consider a search for domain name registrations of the target in key national top-level domain registries. • Consider a search for domain name registrations incorporating, or similar to, key trademarks and tradenames of the target. • Identify those registrants of relevant domain names who may be cybersquatters. • Identify those registrants of relevant domain names in unrelated businesses. • Identify those registrants of relevant domain names that are actual or potential competitors. • Identify those registrants of relevant domain names with websites directed to criticizing the trademarks, website, goods, services, or business of the target. Follow-Up. It is important to compare the results of the trademark and domain name searches with the activities of the target to identify any inconsistencies between the trademarks that are being used and those that are of public record, and to determine what additional marks are of value to the company. During this exercise, one should focus on the manner in which trademarks are used. For example, there may be registrations for old logos or design versions of word marks. Those marks or versions may no longer be in use, and their registrations may be susceptible to attack while currently used versions may not be properly protected. A preliminary discussion with the target’s marketing and personnel is helpful in discerning the trademark position for key products. During the market review, one should also inquire about the role of trademarks of the target in the markets it participates in for the purpose of assessing competitiveness in those markets. One should also attempt to identify those countries in which registered trademark rights may be subject to cancellation for nonuse. In a few specific industries there are prohibitions or limitations against the use or registration of some trademarks. These should also be considered.

8.30 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

One should differentiate between house marks, which are used with most or all goods and services, and specific product marks. Each product that is material to the target’s business should be considered from the perspective of trademarks, trade dress, packaging, and advertising. It is helpful to obtain specimen advertising materials, including video and audio tapes, print advertising, and website pages. It is advisable to obtain and review copies of product packaging and labeling to identify any regulatory issues and all relevant trademark rights that may not have been revealed in the course of Trademark Office searches. Each of the relevant domain names registered by the target or by a third party should be assessed in light of the target’s business. These materials may also suggest contractual arrangements that should be carefully considered in the contract review. Before the preparation either of formal assignment documentation in an asset deal or of schedules relating to representations and warranties in a share deal, all trademarks of public record, all other trademarks that are identified during the due diligence process, and their various script and design versions should be listed. The assignment of trademarks often presents particular problems. In some countries, such as the United States, trademarks must be assigned together with the goodwill.28 In many countries where a division of a business is to be sold, the difficulty in splitting ownership of a trademark when both the vendor and the purchaser wish to own the trademark for their respective activities is more problematic. In many of these countries, trademark rights cannot be split in this way. • Compare the results of trademark and domain name searches with the activities of the target to identify any inconsistencies. • Determine what additional marks and domain names are of value to the target. • Consider the manner in which the trademarks and domain names are used. • Prepare lists of all relevant marks and domain names. • Consider assignment issues. Tradenames. A tradename is the name under which any business is carried on, includ-

ing the name of a corporation, a partnership, or an individual. In most countries, absent use of a tradename or registration of a trademark, the mere registration of a business name, a fictitious name, or the incorporation of a company whose name includes a trademark provides no positive trademark rights. In some countries, trademark rights may be acquired through the use of tradenames or portions thereof. The information obtained through a corporate or tradename search will identify names under which the business or particular divisions thereof operate. A search of incorporated companies and business names familiar to all commercial lawyers will generally identify all tradenames of record that are identical or similar to a key tradename. The information contained in such a search is minimal. It may be necessary to order corporate or business name records to obtain additional information. An important limitation of a tradename search is that in some jurisdictions it is not possible to search business names by registrant. Another important limitation is that a target may not have registered a key tradename under which it operates. Investigations should be conducted to determine what other tradenames are of value to the target. All tradenames of public record and all other tradenames that are identified during the process

INTELLECTUAL PROPERTY RIGHTS 8.31

should be listed together with all relevant deadlines for the renewal of registrations in each relevant jurisdiction. • Consider a tradename search of incorporated companies and business names. • Understand the limitations of the searches. Copyright. Copyright29 is the exclusive right, among other things, to reproduce or dis-

tribute copies of, and display or publicly perform, certain works.30 These works include literary, musical, dramatic, artistic, choreographic, audiovisual, and architectural works.31 In some countries, including the United States, copyright protects other works such as sound recordings.32 The essential concept of copyright is that only the form of expression is protected. Copyright does not protect the idea, concept, or subject matter of a work.33 For example, if a physicist writes an article on lasers, anyone else can use the information contained in the article to write an article on lasers, among other things. However, no other person is entitled to copy the words, or any other form of expression, used by the original author. The moment a copyrightable work has been created and fixed in a tangible form such as writing, it has copyright protection. Notice is not necessary for this protection to automatically extend to many other countries of the world. However, in some countries, including the United States, there are advantages to having copies of the work which are distributed to the public bear the familiar copyright notice “©, year of first publication, the name of the owner of the copyright.”34 Copyright automatically exists on an original work without the need for registration. Some countries, such as the United States, operate a registration system. Registration often perfects rights or adds to remedies that arise automatically.35 However, very few businesses actually register copyright unless the work is particularly valuable, there is a need to register in light of a financing (such as for a film), or in anticipation of litigation. This is especially true of works, such as technical drawings, catalogues, and manuals, that are used on a day-to-day basis. Copyright is a fundamental asset in certain industries, such as the publishing, music, motion picture, television, and software businesses. However, the value of copyright in most other businesses should not be overlooked. Copyright protects databases, such as those relating to suppliers and customers; manuals, such as those containing operational, sales, and technical information; technical drawings; software; catalogues and advertising materials; and trademarks, labels, and character designs. Therefore, copyright is usually a material asset of any business. In most countries, copyright protection generally extends for the life of the author plus 50 years thereafter.36 In many countries, including the United States, there are numerous variations from and exceptions to that general rule for certain types of works.37 In the United States, there are also different terms for older works.38 The rules on authorship and ownership of copyright are not uniform. In most countries, the person who created the work is the author.39 The United States has its work made for hire doctrine that governs the authorship and ownership of certain types of works authored by those in certain types of relationships.40 There are numerous variations to these rules from jurisdiction to jurisdiction, often based on the nature of the work.41 What further complicates an assessment of title in copyright is the fact that

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copyright statutes around the world generally provide for an automatic reversion of title to the heirs of the author(s), at a specified time after the death of the author(s) despite any assignment.42 The terms and conditions of such reversions vary from country to country. Types of Searches. Several types of searches may be done in the Copyright Office

records. An index search is made to determine what copyright registrations have been granted to or transferred to a particular person. One may conduct a title search to identify licenses on record and grants of security interests against copyright. Such documents are recorded in the Copyright Office. A work search seeks to identify whether a certain work has been the subject of copyright registration or not. This may be relevant if a certain work is material to the business. An author search seeks to locate all works for which copyright has been registered in which a particular author has been named. This is often of assistance when, for example, a particular individual has been responsible for developing most or all of the computer software in the company. • • • •

Consider an index search. Consider a title search. Consider an author search. Consider a work search.

Limitations of Searches. While copyright searches are necessary from the lawyer’s perspective, they often yield very little information, except in particular copyright-dependent industries because copyright is rarely registered. Because of the additional advantages given to a copyright registrant in the United States, there is more incentive to register copyright there than in most other countries, so searches in the U.S. Copyright Office may be of some assistance. In the case of an index search, as in the case of patents and trademarks, the search will only identify registrations on record in the name of the person for which the search is conducted. A work search can only identify works by title, and the titles used are often misleading or vague (like “Computer Program 1”). Applications for registration are not available for searching during their pendency. This is not generally a significant problem, as applications usually pass through to registration within a few weeks in most countries. The Copyright Office search records are also known to contain errors and omissions that may affect the reliability of any search.

• Understand the limitations of these searches. • Understand that most copyrights are not on record in the Copyright Office. • Understand that applications for registration are not available for searching. Moral Rights. In some countries, authors have moral rights that may restrict the modification or exploitation of a work after it has been sold or licensed.43 In some countries these rights are broader and stronger than in the United States, where they apply only to

INTELLECTUAL PROPERTY RIGHTS 8.33

works of visual art.44 For example, in Canada, moral rights apply to all works (including computer software, technical specifications, compilations of data, and advertising copy). In some countries, unlike other intellectual property rights, moral rights may not be assigned, but may only be waived.45 Therefore, any assessment of the rights in literary, artistic, and other copyright-protected works of a target must consider the impact of authors’ moral rights. Of primary importance is the issue of whether or not an author’s moral rights could interfere with the future modification or exploitation of those works (such as software) and if appropriate waivers have been obtained. • Consider the impact of moral rights. Neighboring Rights. There are a number of so called neighboring rights that are related

to copyright. These rights vary significantly from country to country and relate to works such as broadcast signals and performers’ performances.46 These rights are usually not susceptible to registration and, therefore, are generally not revealed in searches. When these rights are relevant in businesses, one must carefully consider them on a country-by-country basis. • Consider neighboring rights. • Identify relevant rights on a country-by-country basis. • Consider title issues. Database Rights. In some jurisdictions, there are separate rights governing the use of databases that are in addition to those rights in compilations that are provided by copyright.47 For example, Europe has legislation governing the selection and arrangement of data in databases. In other countries like the United States, legislation has been contemplated. Registration is not required to acquire rights under these laws. Therefore, searches of intellectual property offices will be of no assistance. Databases are relevant to most businesses in many ways but present the most issues when they are licensed or shared, in whole or in part, with others.

• Consider relevant databases of the target. • Consider application of relevant database laws in relevant jurisdictions. Follow-up. In light of what was said previously, the key limitation on a copyright

search is the fact that copyright is registered in so few works, and related rights generally cannot be found in searches. Therefore, one must generally rely on discussions with the target’s personnel and other investigations to identify works that are material to the business. For such works, authorship and all other relevant particulars should be identified and listed. • Consider discussions with the target’s personnel and other due diligence activities to identify key works, including databases, that are material to the business. Semiconductor Chip Rights. A mask work 48 is a three-dimensional pattern embodied in

silicon chips. The resulting chip is a semiconductor chip product.49 In some countries,

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creators of such chip designs may, through registration, protect either a mask work or a chip embodying the mask work against reproduction and commercial exploitation.50 The rights granted prohibit even a substantially similar mask work. A topography must be original to be protected. These types of rights are obviously of concern to only specific types of businesses. If one is dealing with a business for whom semiconductor chip rights are important, one must conduct appropriate searches in the appropriate offices in relevant countries and relate the findings of these searches to the actual activities of the target. • • • • • • • • • • • •

Consider an index search. Consider a search of recorded licenses. Consider a state-of-the-art search. Consider a novelty search. Consider an infringement search. Consider a validity search. Consider a search to identify grants of security interests against issued registrations. Understand the limitations of the searches. Understand that pending applications may not be available for searching. Correlate the information obtained in semiconductor chip right searches with that obtained through meetings with relevant people in the target. Consider other key mask works that might be registered. Consider relevant information about key semiconductor chips, their authors, and the relationship of authors, whether through employment or consulting contract.

Plant Rights. Plant rights protect certain new varieties of plants in certain countries.51

In the United States, one can obtain a plant patent. In many other countries, a plant breeders’ right may be registered. These rights are of relevance only to very specific businesses. If one deals with one of these businesses, appropriate searches should be conducted and related to the activities of the target. • • • • • • • • • • •

Consider an index search. Consider a search of recorded licenses. Consider a state of the art search. Consider a novelty search. Consider an infringement search. Consider a validity search. Consider a search to identify grants of security interest against issued patents and registrations. Understand the limitations of the searches. Understand that pending applications may not be available for searching. Correlate the information obtained in plant right searches with that obtained through meetings with relevant people in the target. Consider other key varieties that might be registered.

INTELLECTUAL PROPERTY RIGHTS 8.35 Personality Rights. Celebrities, including political, athletic, and entertainment figures have rights in their personas, which are commonly referred to as personality rights. These include their names, their representations, and other distinctive features associated with them. The unauthorized commercial use of such features may be prohibited. A number of jurisdictions, including some countries, a number of states in the United States,52 and a number of provinces in Canada, have statutes prohibiting the commercial use of certain distinctive attributes of individuals without authorization. In other countries, such uses may be protected under more general laws. Creators of fictitious characters such as Mickey Mouse may have rights of a different type. Personality rights may be material to a business in one of two general situations. The first is when the business is based primarily on personality rights (such as a film, music, or sports business) where significant revenues are generated as a result of the use, direct or indirect, of the attributes or other indicia of famous real or fictitious personalities. The other situation arises when a business uses a personality as a spokesperson for the business or a particular product. There is no central registry in any federal jurisdiction to obtain information on personality rights. A few states maintain registries, such as California. If the participation of a personality on a continuing basis is seen as a significant asset of the business, these issues should be addressed. If a use is made of a personality’s indicia without consent, this should also be addressed.

• Determine whether the business is based primarily on personality rights. • Determine whether the target uses a personality as a spokesperson for the business or a particular product. • Identify relevant personality rights. • Review all contractual arrangements relating to personality rights. Proprietary information is any information that gives the possessor an advantage over those who do not know it. While the terms trade secrets and know-how are generally used to refer to technical information, proprietary information is not restricted to technical information. Business and sales techniques, customer and supplier lists, databases, sales manuals that are distributed on a restricted basis, franchise manuals and such all constitute proprietary information that may be of great value to a business. Rights in proprietary information may be enforced in some jurisdictions by statute.53 Either alternatively or in addition, the general law of many jurisdictions provides recourse against the misappropriation or the unauthorized disclosure or use of proprietary information. Contractual rights restricting disclosure may supplement these rights. It is not possible to obtain information on proprietary information through searches of public records. Proprietary information by its very nature is not documented or recorded. Rather, one must derive knowledge of the proprietary information of the business, its value, and the care taken to protect it from meetings with representatives of the target. In order to identify the proprietary information that is material to the target, one must probe all aspects of the business. Key areas are financial, record keeping, and data processing operations; supplier, distributor, and customer lists; operational procedures and manuals; and most importantly research, development, processing, and manufacturing operations. In assessing trade secret protection, one should consider information Proprietary Information.

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(such as specifications) that may have been provided to governments and may be available to third parties under access to information legislation. In an asset deal, provision must be made, either in the asset purchase agreement or in an ancillary technical assistance agreement, for full disclosure of the trade secrets to the purchaser. However, one must be careful to avoid violating statutory, contractual, or other obligations by such disclosure. In a share deal, obligations may be violated through the change of control of the target. In some cases, consent may be required. • Consider all information that might be proprietary, including technical information, business and sales techniques, customer and supplier lists, databases, sales manuals, franchise manuals, and so on. • Determine all relevant proprietary information from discussions with the target. • Determine whether it is necessary to obtain disclosure of the trade secrets to the purchaser by way of an ancillary technical assistance agreement. • Consider financial, record keeping, and data processing operations. • Consider supplier, distributor, and customer lists. • Consider operational procedures and manuals. • Consider research and development operations. • Consider processing and manufacturing operations. • Consider information that may have been provided to governments and may be available to third parties under access to information legislation. • Consider statutory, contractual, and other legal obligations that may be violated by disclosure to the purchaser or a change of control of the target. Foreign Rights. Most businesses have some interest in foreign markets. Many already

have commercial interests or rights in other jurisdictions. At the very least, most now advertise on the Internet. As trade becomes more globalized, intellectual property rights in foreign countries become more important as a method of acquiring and preserving competitive positions. Depending on the nature of the target’s business, it may not be sufficient merely to conduct intellectual property searches or identify intellectual property rights in the United States, or even in a few select countries. It is also important to understand that intellectual property rights may automatically arise in multiple jurisdictions. For example, through various international treaties (commonly referred to as conventions), as soon as a work is created in the United States or any other country that is a member of the convention, copyright in that work automatically is generated in the country of origin and all other countries that are members of the convention (for example, the Convention for the Protection of Literary and Artistic Works—the Berne Convention). International rights arise differently in the case of other intellectual property. To obtain patents or design protection in other countries, formal applications must be made, and those applications prosecuted until grant of a patent or a registration. Absent such an application in a particular country, there is no protection for the invention or design in that country. In the case of trademarks, rights are acquired in some countries merely through performance of a service or the sale of goods in association with the mark in that country without any formal application having been made; in other countries registration of the mark is necessary to acquire rights. Therefore, if the target exports widgets, performs

INTELLECTUAL PROPERTY RIGHTS 8.37

services in foreign countries, or advertises abroad, it may have acquired trademark rights in those countries. Conversely, if someone else has obtained rights in the same trademark in those countries through registration or prior use (depending on the nature of the country’s trademark system), the sale of such widgets, performance of such services, or advertising in such countries by the target may constitute an infringement or other violation of the trademark rights of a third party. In certain countries there are different forms of intellectual property. For example, many European countries have protection (with no equivalent in the United States) for what is known as a utility model. An invention that may not meet the stringent criteria for patent protection may qualify for utility model protection. The scope of intellectual property rights also varies from country to country—for example, the rights included within copyright vary significantly from one jurisdiction to another. There are also terminology differences. For example, many countries do not have a design patent system. Instead, their systems grant registrations for designs with different criteria, rights, and terms for designs. One should be careful about foreign rights, as their rules can be quite different in many other ways. If there are significant foreign rights, it is advisable to retain local counsel to find out what questions one should be asking and what searches should be conducted. Here are three of many examples: 1. 2.

3.

In some countries, a holding company cannot own trademarks. In some countries, there is no examination of trademark applications against previous registrations. The application is filed and the registration issues unless there is some formal defect. Thus, the registrations themselves may be less reliable than registrations in countries with substantive examination. In some countries, inventions must be worked in order for patent rights to be maintained beyond an initial period.

Therefore, when dealing with foreign rights, focus on the following: • Consider the effect of international treaties. • Consider the effect of international and regional applications. • Consider searches in those countries in which the target sells or advertises goods or advertises or performs services. • Consider different forms of intellectual property in different jurisdictions. • Consider peculiar foreign rights and rules. Secured Intellectual Properties. The existence of security interests granted against the

intellectual property of the target will obviously be of vital concern to any potential purchaser or lender. There may be general security arrangements governing all assets of the business (bank financing, for instance). There may also be specific security interests directed to some or all of the intellectual property of the target. This is particularly true where the intellectual property and technology assets of a target are among the most important assets. An example is a software development company that operates through leased premises, has no inventory, and very little equipment or cash. The key assets of the business are the know-how of the employees and copyright or patent rights in the software that they develop. In such cases, a lender may have obtained and

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recorded a security interest against all assets, against specific intellectual property rights, or both. It is also possible to take security in agreements relating to intellectual property. For example, lenders often take security in the proceeds pursuant to a license. These should also be considered. National intellectual property statutes generally do not expressly contemplate the granting of security against intellectual property. The intellectual property statutes define the rights of creators and owners of certain types of intellectual property. They also establish registration systems and govern the priority of conflicting claims of applicants rather than creditors. They also provide for the recordal of assignments and licenses. However, the intellectual property laws of most countries usually do not adequately define the types of assignment or interest governed by their recordal provisions and leave much to be desired as systems for governing security interests in intellectual property. The legal situation is complicated by the fact that security interests in intellectual property are generally subject to the same regime as other intangible property. In some countries, commercial personal property security laws, such as the Uniform Commercial Code (UCC) in the United States,54 legislate with respect to intangibles (including intellectual property rights) as if the intellectual property statutes do not exist. Even in the context of intellectual property, personal property security laws generally fail to distinguish between security interests in intellectual property that are subject to application and registration from intellectual property (such as trade secrets) that is protected in other ways. Over these are layered issues regulated by the banking, bankruptcy55 and insolvency, reorganization, and related laws of each jurisdiction. In some countries it is not even possible to record a security interest in intellectual property, either under the intellectual property laws or the personal property security laws. In many jurisdictions there is some doubt about which system governs in the case of conflicting priorities governing the security interests that have been recorded in the intellectual property offices and the personal property security regimes. For these reasons, some feel it is necessary to register security interests in intellectual property under both the intellectual property regimes and the applicable personal property security regimes. Lenders who are cautious sometimes record the same interests under both systems. Others feel that this is not necessary. In some cases, commercial lawyers who are more familiar with the personal property security regimes choose to record security interests under that system. Intellectual property lawyers, who are more familiar with the intellectual property statutes, when possible, only record interests in the intellectual property offices. These different approaches obviously impact on decisions about where to look for such recorded interests. For the purposes of due diligence, one must look in both locations in those jurisdictions where it is possible to record security interests in both systems. When it is procedurally possible to record a security interest against intellectual property in intellectual property offices, there are limitations, as previously discussed, in searching some pending applications to identify them for the purpose of listing the collateral and in locating recorded security interests. A creditor, when identifying the relevant collateral in its security agreement, may not have identified then-pending applications. As a result, there may appear to be a patchwork of patents, registrations, and applications, some of which may or may not be identified in the grant of the secu-

INTELLECTUAL PROPERTY RIGHTS 8.39

rity. In other cases, even when the rights are identified in the security agreement, recordals may not have been made against all properties or in all jurisdictions. The usual personal property security searches, such as under the UCC and other equivalent foreign types of searches familiar to all commercial lawyers, should, of course, be conducted, and the results of those should be reconciled with the information obtained through the searches for security interests in intellectual property offices. • Consider conducting searches under the UCC and other personal property security legislation. • Consider conducting searches in relevant intellectual property offices. • Reconcile the information in these searches. On-Site Technology Investigations. Once the searches have been ordered, one should go to the premises of the target to try to find out what intellectual property and technology rights it uses and owns. With respect to technology, one should try to work from the bottom up by determining how the target handles new ideas, if it has a research and development department, and where that is. One should attempt to identify what kind of documentation is produced when an employee or a freelance contractor comes up with a new idea. It is essential to tour the plant, warehouse, stores, and other locations where the real business is done to see, in a general way, what technology the target is using. No plant or other premises tour can ever familiarize a lawyer with the details of technology. It will, however, provide a general idea of the processes used in the plant or other premises, and it may also give one an idea about which technology is homegrown and which is licensed-in. It is often helpful to tour the plant with the purchaser and the seller’s counsel so that all parties can see the issues at the same time and in the same setting.

• Determine how the target handles new ideas. • Determine whether the target has a research and development department. • Determine what kind of documentation is produced when an employee comes up with a new idea. • Tour the plant, warehouse, stores, and other locations. • Consult with the technical and marketing executives of the target. Products, Advertising, and Packaging. A preliminary discussion with the seller’s marketing and technology personnel is helpful in discerning the proprietary position, if any, of key products and identifying the intellectual property associated with these key products. During the market review, the intellectual property lawyer should also inquire about the proprietary position of the target in the markets in which it participates for the purpose of assessing competitiveness and exclusivity in those markets. Each product that is material to the target’s business should be considered from the perspective of manufacture or other production, brand names, packaging, advertising, and electronic commerce. It is helpful to obtain specimen advertising materials, including video and audio tapes and print and Internet advertising. It is advisable to obtain and review copies of product packaging, labeling, and copies of website materials in order to identify any regulatory issues and all relevant trademark rights that may not

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have been revealed in the course of Trademark Office searches. These materials may also suggest violations of the rights of third parties or contractual arrangements that should be carefully considered in the contract review. It is during the review of these materials that one obtains a real sense of the target’s business, and can hopefully reconcile real-life activities with the information obtained from intellectual property office searches to identify and fill in the gaps. • • • • • • • •

Determine the proprietary position, if any, of key products. Inquire about the proprietary position of the target in the marketplace. Meet with the target’s marketing and technology personnel. Consider each product that is material to the target’s business from the perspective of manufacture or other production, brand names, packaging, and advertising. Obtain specimen advertising materials, including video and audio tapes, print advertising, and website materials. Obtain and review copies of product packaging and labeling to identify any regulatory issues and all trademark rights. Consider these materials in the context of violations of the rights of third parties. Consider these materials in the context of contractual arrangements.

Intellectual Property Maintenance Costs. One should also assess the costs of maintaining the company’s intellectual property portfolio. It is helpful to review prior costs and consider what major expenses (such as those relating to litigation) are anticipated in the future in addition to more routine expenses. One should focus on government fees, local counsel costs, and the costs to coordinate maintenance.

• Inquire about intellectual property maintenance costs and foreign agent and outside counsel expenses. • Assess routine annual expenses for maintenance of the intellectual property portfolio. • Identify anticipated major expenses relating to intellectual property. CONTRACT REVIEW Agreement Review. One must identify, obtain, and review copies of all contracts that

involve intellectual property and technology. Agreements are usually available from the target but may also be referenced in other sources, such as filings made pursuant to securities laws. One should also have an understanding of the important products of the target. The essential thing is to concentrate on the business relationships that are built around intellectual property and technology and try to find the contracts that govern those relationships. In doing so, one should attempt to identify all schedules, appendices, and side letters. Intellectual property and technology assets can be uncovered in contracts such as license, joint venture, consulting, joint development, manufacturing, and sales agreements. Contractual review should not be overlooked as a source of identifying relevant owned or licensed intellectual properties. All relevant agreements should be reviewed sufficiently to determine whether they contain a restrictive assign-

CONTRACT REVIEW 8.41

ment provision preventing transfer to the purchaser in a sale of assets or whether they will be materially affected by a sale of the shares of the target. One will also need to assess how diverse the target’s technology and other intellectual property rights have become—for instance, if the target has licensed most of the technology to its competitors and under what terms (such as exclusivity). An evaluation of the grants both into and out of the target needs to be undertaken to understand if the business of the target will have the freedom to grow or whether it is contractually boxed into its present form. This may shed some light on whether the target is a net developer or acquirer of technology or not something that may prove useful if the purchaser is considering retaining key research and development personnel and facilities. It will be necessary to find out whether the agreements are in good standing, how long they run, what happens when they end, and whether or not they can be terminated earlier. In the case of copyright, statutory reversions may effect automatic terminations.56 Agreements should also be considered from the perspective of problems in the context of the transaction as a whole. For instance, if the target will be wound up into the purchaser, the purchaser may not be happy with the trade secret restrictions because they may be unworkable. Contracts should also be considered from the point of view of provisions providing for indemnification of intellectual property infringement. These may potentially involve significant liabilities. The intellectual property and technology lawyer must also pay attention to the money flow to identify the royalties to be paid out and received annually for the foreseeable future. • Review relevant contracts to identify intellectual property and technology. • Obtain copies of all contracts that involve intellectual property and technology. • Concentrate on the business relationships that are built around intellectual property and technology. • Identify all schedules, appendices, and side letters to contracts relating to intellectual property and technology. • Review all relevant agreements to determine whether they contain a restrictive assignment provision preventing transfer to the purchaser in an asset deal. • Review all relevant agreements to determine whether they will be materially affected by a share deal. • If there are restrictive covenants or consent is required, request appropriate waivers. • Consider how diffuse the target’s technology and intellectual property has become. • Evaluate all license grants into the target to determine how reliant the target is on licensed intellectual property and technology. • Evaluate all the grants out of the target to determine whether the business of the target will have the freedom to grow. • Determine whether the target is a net developer or acquirer of technology. • Determine the money flow to identify amounts to be paid out and received annually for the foreseeable future. • Determine whether the agreements are in good standing, how long they run, what happens when they end, and whether or not they can be terminated earlier.

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• Determine these questions from the perspective of problems in the context of the transaction as a whole. • Consider the agreements from the point of view of provisions providing for indemnification of intellectual property infringement. Secrecy Agreements. One also needs to review all secrecy agreements to determine

whether they also contain provisions that prohibit the assignment of rights and obligations. Most secrecy agreements restrict assignment unless written permission is first obtained. Therefore, the purchaser must request that the seller obtain written waivers prior to transferring confidential information to the purchaser. These agreements should be reviewed to ascertain whether information disclosed is already in the possession of the purchaser. If so, the agreement may be terminated. Assignments, waivers, and terminations should be executed before the confidential information is passed from the seller to the purchaser. • Review all secrecy agreements to determine whether they also contain provisions that prohibit the assignment of rights and obligations. • Review these agreements to ascertain whether information disclosed thereunder is already in the possession of the purchaser. • Determine whether any agreements should be terminated. • Determine whether assignments, waivers, or terminations should be executed before the confidential information is passed from the seller to the purchaser. License Agreements. A review of license agreements is crucial in any commercial transaction. License agreements will often reference intellectual property and technology that may not be located in searches of public registers. In certain businesses, license agreements may be material: for example, a key product line may be based on a trademark or patent license. The financial and other terms of such license may be crucial to the financial viability and success of the target. When the core or a material aspect of the target’s business is dependent on licenses, either as licensor or licensee, the need to carefully review and consider the material aspects of the license agreements, such as exclusivity grants, financial considerations and restrictive covenants, becomes even more important. One should carefully review the quality control provisions in trademark license agreements. In an asset deal, one must be sure that the agreement is assignable without the need for consent or one must obtain the consent of the other party. This is because most licenses, unless otherwise specified, are personal to the licensee and therefore cannot be assigned without the consent of the licensor. This is different from the rule for most contracts. In certain competitive situations, depending upon the wording of the assignment provisions in the license agreement, it may be possible for consent to be refused or for the other party to extract some concession, financial or otherwise, in exchange for a consent. In a share deal, one must carefully examine the change of control provisions of license agreements to ensure that, in each case, a change of control or other material share transfers do not terminate or otherwise affect the agreement. Restrictions on

CONTRACT REVIEW 8.43

assignments and termination for improper assignments and changes of share control are quite common in licensing arrangements. • Review all license agreements. • Determine whether a key product line or service of the target is based on a license. • Determine whether a license agreement is assignable without the need for consent in an asset deal. • Determine whether a change of control or other material share transfers will terminate or otherwise affect the agreement in a share deal. • Consider quality control provisions in trademark license agreements. Assignments. A review of intellectual property and technology assignments and other transfers is crucial in any commercial transaction. Assignments will often reference intellectual property and technology that may not be located in searches of public registers. In certain cases an assignment may be very material. For example, a key product line may be based on a trademark or patent purchased from someone else, but the assignment was not recorded in the relevant intellectual property office. The financial and other terms of such assignment may be crucial to the financial viability and success of the target. Determine if goodwill has been assigned with trademarks where required.

• Review all intellectual property assignments. • Determine whether a key product line or service of the target is based on the assignment of an intellectual property right. • Determine whether goodwill has been assigned with trademarks where required. Franchise Agreements. Franchise agreements present many of the same issues as do license agreements, with some twists. In the case of a franchisee, the company’s business is totally dependent on the franchise agreement. There are usually a variety of ancillary agreements relating to a franchise agreement. These may include lease or sublease arrangements, guarantees, and so on. Restrictive covenants in franchise agreements are usually far more onerous than in license agreements. The assignment and change of control provisions in franchise agreements are also typically more onerous than in ordinary license agreements because the franchisor wishes to ensure that the franchisee or its principals are capable of running the franchise.

• Review all franchise agreements. • Identify all ancillary agreements relating to franchise agreements, including lease or sublease arrangements, guarantees. • Carefully consider restrictive covenants. • Carefully consider assignment and change of control provisions. Distribution and Supply Agreements. Distribution and supply agreements present many of the same issues as license agreements. While distribution and supply agreements

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may be characterized more as commercial agreements, they often include provisions relating to intellectual property and technology rights that may make them more like license agreements. • Review distribution and supply agreements in the same way as license agreements. Co-packing and Toll Manufacturing Agreements. A co-packing or toll manufacturing

agreement authorizes a manufacturer to manufacture and package a product in the name of some other entity so that, as far as the outside world is concerned, the product is manufactured and packaged in the name of the other entity. A co-packer or toll manufacturer is a contract manufacturer who packages and labels the product for the ultimate seller. Co-packing and tolling arrangements, like distribution and supply arrangements, often also include intellectual property and technology provisions and restrictive covenants. These should be carefully reviewed for the same issues as license agreements. • Review co-packing and toll manufacturing agreements in the same way as license agreements. Joint Venture and Strategic Alliance Agreements. Joint venture and strategic alliance agreements usually involve many aspects of commercial arrangements. However, most joint venture arrangements include some reference to intellectual property rights and often include specific licensing arrangements. The other party to the arrangement may enjoy a very good relationship as a joint venturer or alliance member with the target, but the possibility that this party may have no interest in continuing that relationship with the purchaser for competitive or other reasons may be a particular concern in a joint venture or strategic alliance arrangement. Therefore, the other joint venturer or alliance member may look at ways to terminate the joint venture relationship. These agreements should be reviewed in the same way as license agreements.

• Review joint venture and strategic alliance agreements in the same way as license agreements. Research and Development Agreements. It is important to review both current and terminated research agreements. Terminated agreements are important because the target may have contracted for research or other development work with third parties and such agreements may not have properly dealt with the transfer of intellectual property rights from those third parties to the target. Therefore, while the target may be operating on the assumption that it owns such intellectual property rights, in fact, it may not. Current research agreements are of importance for the same reasons. In addition, all of the issues discussed in respect to license agreements are material.

• Review current, expired, and terminated research agreements in the same way as license agreements.

CONTRACT REVIEW 8.45 Government Agreements. Government procurement contracts and government-funded

research and development agreements may provide for ownership or rights in favor of the government or a government agency. In addition, all of the issues discussed in respect to license agreements are material. Further, there may be relevant statutes and regulations that govern such rights.57 • Review current expired and terminated research agreements. • Consider any statutory or regulatory overlay. Sponsorship and co-promotion agreements should be reviewed for all the same types of issues as those to be considered in license, distribution, and personality rights agreements.

Sponsorship and Co-promotion Agreements.

• Review sponsorship and co-promotion agreements in the same way as license agreements. Advertising Agreements. There are many different types of agreements relating to

advertising. One key type comprises agreements with advertising agencies. These should be reviewed to ensure that all intellectual property, including copyright, is transferred to the target by virtue of those agreements. Without a written transfer of copyright, in some jurisdictions the target may not own copyright in the works (such as television commercials, radio commercials, jingles, copy, and so forth) developed for it. Because advertising agencies often subcontract portions of campaign development out, it is also essential to check that the advertising agency has itself obtained those rights from third parties in order to be in a position to effectively transfer them to the target. It is advisable to assure oneself that these agreements adequately deal with intellectual property issues. They should also be considered for those issues referenced in the discussion of licensing agreements. • Ensure that all intellectual property, including copyright, is transferred to the target. • Review advertising agreements in the same way as license agreements. Employee and Contractor Agreements. Often overlooked in a target’s contractual

arrangements, and therefore in the due diligence process, are employee and independent contractor agreements. Policy manuals should also be reviewed as many policies are set out in manuals and incorporated in the terms of employment by reference. Generally, intellectual property or technology developed by an employee in the course of his or her duties is owned by the employer. However, in some countries employees may retain some rights to the intellectual property or technology. Alternatively, if the intellectual property or technology derives from activities not directly related to an employee’s activities, there may be an argument that it is not owned by the employer. Further, in most countries, there is no automatic waiver of moral rights in a work by an author merely by virtue of the employment relationship. Therefore, it is advisable to have, at least from all employees who are involved in work

8.46 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

that is likely to yield intellectual property or technology rights, an assignment of all intellectual property or technology resulting from their activities and a waiver of moral rights in all copyright works. In light of increased mobility among employees, it is also advisable to have very clear restrictions on the disclosure or use of confidential information, restrictive covenants, and continuing obligations to assist in the protection of intellectual property and technology rights, such as in the case of patent applications. It is equally necessary to determine whether any material intellectual property or technology has been developed by current or recently departed employees or by independent contractors who have not signed intellectual property transfer agreements and to assess the consequences of such gaps in the documentation. Contractor agreements have taken on even more importance as more companies have retained third parties to do contract work in order to keep their payroll and fixed costs relatively low. It is necessary to review these documents to ensure that they deal with the transfer of all relevant intellectual property or technology rights, have appropriate confidentiality and restrictive covenant provisions, and contain waivers of moral rights. These agreements should also be reviewed from the perspective of all the issues discussed with respect to licensing agreements. It is also possible that former employers of current employees of the target may be in a position to assert rights in proprietary technology on the basis that the technology was developed while the employees were employed by the former employer. Such employees may be bound by nondisclosure agreements or restrictive covenants. Nondisclosure provisions and restrictive covenants are material to a consideration of these rights in a commercial transaction. Many purchasers of businesses often terminate a number of employees immediately after the acquisition, or in anticipation of the acquisition they require the target to terminate the employees. If this is done in the absence of a clear transfer of intellectual property and technology rights and restrictions on what can or cannot be done with intellectual property, this may leave the target exposed. These agreements should be looked at from the perspective of this possibility as well as for continuing employees. • Identify and review all employee and independent contractor agreements. • Identify and review policy manuals. • Determine whether such employees or contractors have signed intellectual property and technology transfer and confidentiality agreements, and assess the consequences of any gaps in the documentation. • Determine whether any material intellectual property and technology has been developed by current or recently departed employees. • Review all contractor agreements relating to intellectual property and technology. • Obtain assignments of all intellectual property and technology and waivers of moral rights from all relevant employees. • Obtain restrictions on the disclosure or use of confidential information, restrictive covenants, and continuing obligations from all relevant employees. • Obtain assignments of all intellectual property and technology and waivers of moral rights from all relevant independent contractors. • Obtain restrictions on the disclosure or use of confidential information, restrictive covenants, and continuing obligations from all relevant independent contractors.

INFORMATION TECHNOLOGY ISSUES 8.47 Settlement Agreements. All agreements relating to the settlement of intellectual prop-

erty and technology disputes should be reviewed. Such agreements often include licenses, payment obligations, limitations on the right to use or protect intellectual property, limitations on the right to challenge the use or protection of intellectual property of the other party, acknowledgements of the intellectual property rights of others, agreements to co-exist, and various other provisions that may be material from a financial perspective or may limit the value of the target’s intellectual property and technology. Such agreements arise out of both threatened and actual litigation and administrative proceedings such as patent interferences and trademark oppositions. Often such agreements are in letter form and may, therefore, be difficult to identify. • Review all agreements relating to the settlement of intellectual property and technology disputes. • Consider such agreements from the perspective of licenses, payment obligations, limitations on the right to use or protect intellectual property and technology, limitations on the right to challenge the use or protection of intellectual property, acknowledgements of the intellectual property rights of others, and agreements to co-exist. Information Technology Agreements. These are discussed in detail in the next section.

INFORMATION TECHNOLOGY ISSUES

Every business uses computer and information technology in some form. Common examples include accounting systems, inventory control, manufacturing processes, word processing, telecommunications systems, websites, other Internet activities, and electronic commerce. The following briefly discusses each of the most relevant areas for information technology due diligence. Hardware. One should prepare a complete inventory of equipment to be transferred,

including: personal computers, minicomputers, mainframes and servers; peripherals such as terminals, printers, and scanners; and telephone systems, including handsets, facsimile machines, and switching equipment. A determination should be made as to whether the equipment is owned or leased. Lease agreements must be reviewed to determine whether the consent of the lessor is required to assign the equipment. Similarly, maintenance contracts for the equipment must be reviewed to determine whether they are assignable or if a transfer of control of the company will trigger a termination or penalty. These agreements often contain intellectual property provisions. • Prepare a complete inventory of equipment to be transferred. • Determine whether the equipment is owned or leased. • Review lease agreements to determine if the consent of a lessor is required to assign the equipment. • Review service and maintenance contracts for the equipment to determine whether they are assignable or if a transfer of control of the company will trigger a termination or penalty.

8.48 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

• Review these agreements for intellectual property issues in the same way as license agreements. Software. Copyright in most general-purpose software used by a company is licensed by the company and not owned. Copyright in software that has been custom developed for the target may be owned by the target or thought to be owned by the target but actually owned by the developer. A complete inventory of software should be completed and an audit conducted to ensure that all software other than that developed in-house and owned by the target is properly licensed. One should also review accounting procedures, since those are most often done by computer. This may also lead to software that is used in the accounting process. Bank agreements may involve information technology and software licenses. Examples include payable and cash management systems. In some cases, accounting and data processing may be done by a related company or an independent service provider. The same approach should be followed for all other computer-driven activities, such as manufacturing processes. Many companies are very lax about the use of software and have many illegal copies of personal computer software. All copies should be verified as licensed. All of the software licenses should be reviewed to verify compliance and to determine whether the consent of the licensor is required to assign in an asset sale or if a sale of shares will trigger a termination or penalty. Software support agreements should be reviewed for the same issues. These agreements should also be reviewed for restrictions relating to specific sites and prohibitions against off-site removal and use. If there is any custom-developed software, it should be determined whether it was created by employees or independent contractors. In both cases, because modifications may have been met in the past or may be made in the future, moral rights issues should be considered. In addition, if the software was developed by an independent contractor, the contract should be reviewed to ensure that all rights, especially copyright, have been assigned to the target. One must also find out if the target has safeguards for its source code. All source code escrow agreements should be identified and reviewed. Careful attention should be paid to the importance of the use of software and hardware in the operations of the business. If, as is the case for most businesses, it is virtually impossible to function without operational software or in the event of data loss, it is important to identify what plans there are for disaster recovery. Often businesses have contracts with disaster recovery service providers. These should be reviewed and assessed in the context of the target’s business. Copyright law provides that only a computer program is protectable and that the underlying ideas and processes are not. However, courts have had a great deal of difficulty in articulating a workable method of separating protectable expression from the unprotectable elements. This is particularly the case where software is designed to have the same “look and feel” or “structure, sequence, and organization” as a competitive product. Such programs and their origins should be carefully considered.

• Prepare a complete inventory of software. • Conduct an audit to ensure that all software other than that developed in-house and owned by the target is properly licensed.

INFORMATION TECHNOLOGY ISSUES 8.49

• Determine whether any software used by the target is unlicensed. • Review all software licenses to verify compliance. • Review all software licenses to determine whether the consent of the licensor is required to assign in an asset deal or if a share deal will trigger a termination or penalty. • Review maintenance and service agreements. • Determine whether the target has safeguards for its trade secret rights and its source code. • Review all source code escrow agreements. • Review all software support agreements for the same issues. • Determine whether any custom-developed software has been generated by employees or independent contractors. • Review disaster recovery plans and contracts. Data. If the company makes extensive use of databases, the source of the information should be reviewed. If the data is licensed from third parties, the agreements should be reviewed in the same way as other license agreements. If the data is internally developed, ownership, copyright, and moral rights issues should be considered and assessed. One should determine whether data is processed by a related company or independent service provider and review all relevant agreements. As previously discussed, some jurisdictions (such as Europe) have separate laws governing databases. Other jurisdictions have privacy laws that regulate the use of personal data. (See the section on Privacy and Personal Information Issues.) Privacy issues in data compilation, protection, use, and disclosure should be considered along with the potential liability for the content and use of the data.

• Determine the source of information for all databases. • Review all relevant agreements when data is licensed from third parties. • Consider ownership, copyright, and moral rights issues when data is internally developed. • Consider issues relating to data protection legislation where relevant. • Consider issues relating to privacy. • Review data processing agreements. Internet Issues. The Internet is becoming increasingly important as a business tool. One should first identify all the servers on which the target’s website(s) reside(s). It is important to describe the servers, their location, and who owns and operates them. All other material equipment and software used in website hosting and operation should be identified. One should obtain copies of all contracts with equipment lessors, server providers, Internet backbone or bandwidth providers, Internet service access and hosting providers, and telecommunication companies. Domain names were discussed previously. If there are any technological limitations on the access to the target’s website, they should be identified. One should review the website development and agreements with website designers and those who maintain the website to ensure that copyright and other rights in all relevant materials have been assigned or licensed. People frequently assume that information

8.50 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

may be uploaded or downloaded from a website without regard to the rights of copyright owners. The website should be reviewed carefully to ensure that it does not contain or permit access to materials that would violate the intellectual property rights or would defame others. All agreements relating to linking other websites should be reviewed. It is often helpful to identify all search engines, files, databases, hyperlinks, browsers, and tools used on the website or by the target. It is important to obtain copies of all current and prior website legal notices and disclaimers, Internet and website use policies, including privacy policies, and online agreements, including the dates of posting and implementation of each. One should identify all products and services offered or provided on the target’s website. If the website is viewed as a significant aspect of the target’s business, it is helpful to obtain information about the number of visitors to the website, tracking methods, and information about how revenues are generated through the website. For sales through the website, it is important to understand the payment mechanisms and the contractual relationships with credit card companies, third-party payment agencies, outsourcers, certification authorities, and customers. All relevant contracts should be reviewed. If the target is an Internet service provider, one should focus even more on the services provided, including forum/bulletin board access services and posting/chat room services. One should obtain copies of all contracts relating to the development, supply, or use of these services. • Identify Web servers on which the target’s website resides, including description, quantity, where located, and who owns it. • Identify all material equipment and software used in website hosting and operation and review all contracts relating thereto. • Review copies of all contracts with server providers, Internet backbone or bandwidth providers, Internet service access and hosting providers, and telecommunications companies. • Consider any technological limitations on access to the target’s website by Internet users. • List all hyperlinks, search engines, and databases. • Consider all text, art, graphics, and sound used on the website and the intellectual property rights therein. • Review copies of all contracts relating to the development, maintenance, supply, acquisition, assignment, distribution, or use of the site and its content. • Identify all products and services provided on the website, including the ability to download images, content, or software; forum/bulletin board access, services and posting; and chat room services; review all contracts relating thereto. • Review copies of all current and past website legal notices and disclaimers, Internet/website use policies (including privacy policies), online agreements, and dates of implementation. • Review all linking agreements authorizing the target to link to other sites or others to link to the target’s site. Electronic Commerce. Today, much business is conducted by way of electronic data

interchange (EDI) and electronic commerce (e-comm). E-comm may be business-to-

INFORMATION TECHNOLOGY ISSUES 8.51

business (B2B) or business-to-consumer (B2C). Transactions are paperless in many cases. Therefore, a careful review should be made of all electronic trading agreements and practices. For B2B applications, one should determine whether there is a formal trading partner agreement where orders, invoices, and possibly payments are processed electronically. If there is not such a formal agreement, the legal basis for such transactions should be determined. One should carefully identify all payment procedures and the contractual trail of responsibility. For B2C transactions, compliance of agreements with consumer protection legislation should be checked.58 • Review all EDI and e-comm agreements and practices. • Determine whether there is a formal trading partner agreement where orders, invoices, or payments are processed electronically. • Where there is no agreement, determine the legal basis for such transactions. • Review accounting procedures, including software used in the accounting process, bank agreements that may involve information technology, data processing, and software licenses. • Determine whether data processing or accounting services are performed by a related company. • For Internet sales, review all payment mechanisms and copies of relevant contracts with all credit card and financing companies, outsource providers, certification authorities, security controls, and customer contracts. • For online consumer transactions, verify compliance with consumer protection legislation. Computer and Information Technology Industry. When information technology is a core

business asset, such as in the case of a hardware manufacturer, a software publisher, a data compiler, an Internet business or a service provider, or where website or e-comm activity is material to the business, even more careful attention must be paid to a number of key issues. If the target sells or leases hardware, it must be determined whether the products were developed internally. Intellectual property for the equipment should be assessed. Supply, co-packing, and distribution agreements should be reviewed. Related agreements such as software licenses and maintenance contracts must also be reviewed. The representations and warranties in such agreements must be considered. If the target distributes software, one must assess who has developed the software and related documentation. If it has been done internally, employee contracts relating to intellectual property must be reviewed. The review process is even more important when the rights have been acquired from outside the company. One should consider copyright and trade secret protection and, in some circumstances, patent protection. Related agreements such as distribution agreements, user licenses, and support contracts should be reviewed for issues similar to those in hardware agreements. Interface and protocol issues must be addressed. If the target markets information in the form of data, whether in electronic or printed form, a number of considerations arise. The sources of the data should be determined. If databases are created internally, one must determine whether steps have been taken to ensure copyright protection and review employee agreements relating to, among

8.52 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

other things, nondisclosure. If, on the other hand, the data is obtained from other sources, the rights to use, manipulate, or supply the data should be assessed. Contracts and license agreements should be reviewed to ensure that the business has the necessary rights to use, modify, and distribute the data. This should also be considered from the point of view of laws relating to accuracy, privacy, and database use in various jurisdictions. If the data is ultimately distributed by others, the distribution and end-user contracts should be reviewed to ensure that the rights to data will remain protected, among other things. If the business provides services relating to information technology, whether hardware, software, or data, a number of other issues should be considered. One issue is if the business has contractual rights with the owners of the intellectual property rights in the products that are necessary to provide the services. This is because maintaining the equipment or software may infringe the intellectual property rights of others in certain cases. Contracts with manufacturers or publishers and customers should be carefully reviewed for proprietary rights, confidentiality, termination, and change of control provisions. If e-comm or website aspects are crucial to the business of the target, particular emphasis should be placed on the issues discussed in the earlier section. • • • •

Review intellectual property issues and agreements relating to hardware. Review intellectual property issues and agreements relating to software. Review intellectual property issues and agreements relating to databases. Review intellectual property issues and agreements relating to information technology. • Focus on these issues for an electronic commerce based business. LIABILITIES Infringement Risks. The intellectual property liabilities of a company usually stem

from violation of the intellectual property rights of third parties. Attempting to assess all of the known and unknown potential liabilities could take a lifetime. However, there are very good reasons for reviewing intellectual property liabilities. The primary reason is to avoid the seller unwittingly breaching a representation or warranty to a purchaser of the shares or assets of a target whose long-term profitability or market position may be jeopardized by the infringement of the target’s or a third party’s proprietary rights, or invalidity of the target’s intellectual property rights. Similarly, a review will help avoid the failure to disclose a material risk to an issuer’s business in a prospectus or to avoid the breach of a representation or warranty to a lender in a loan transaction. Although a determination of future infringement or invalidity of intellectual property rights is extremely difficult, identifying red flags can assist in identifying truly imminent liabilities, in which good business judgment can be exercised in deciding how to deal with any issues that may arise. Intellectual property liabilities can be identified through infringement searches. Liabilities also surface in license agreements, other agreements of the type previously discussed, and those containing indemnification provisions. The indemnification provisions in all such agreements of the target should be reviewed to assess the potential

LIABILITIES 8.53

liabilities posed by them. Sufficient information needs to be gathered to explain to the purchaser where the known risks are, what products or processes are involved, and what dollar amounts and business activities are at stake. This may require more information than any schedule or backup material provides. The intellectual property and technology lawyer’s objective is to avoid having the purchaser acquire a target whose very viability is jeopardized by present or future litigation against the target or by aggressive third parties encroaching upon the target’s market share. A sensible approach is to conduct interviews with the target’s intellectual property counsel, general counsel, and internal administrator (who is primarily responsible for the intellectual property and technology of the target). The interviews should focus on any current or anticipated lawsuits and on letters, memoranda, and opinions regarding the actual or potential infringement or validity of any intellectual property asset of the target, or of a third party that would directly affect the target’s business. Attention should also be given to administrative proceedings, like trademark oppositions, nonuse cancellation proceedings, patent interferences, and so on. The discovery of any infringement or validity issue involving key products or important intellectual properties raises a red flag and must be reviewed in detail. Lawyers for both the purchaser and seller should be careful to disclose to each other all actual and potential liabilities concerning the infringement of intellectual property that may affect the target. Disclosure by the seller may satisfy many of the warranty provisions in the purchase agreement, thereby preventing any redress other than that specified in the agreement itself. Disclosure of infringement liabilities uncovered by the purchaser’s lawyer may prevent a catastrophic event for the target, allow for the negotiation of better terms and conditions in the purchase agreement, or reduce the eventual selling price. Liability for ongoing infringement litigation may be left with the seller or protected by an escrow arrangement. • Review the files of the target and speak with its lawyers. • Consider intellectual property liabilities and indemnification obligations in license and other agreements. Litigation. The intellectual property and technology lawyer should determine whether

it is worthwhile conducting a search in the courts of relevant jurisdictions to see if the target is a party in any intellectual property proceedings. In addition to litigation in the courts, one should check to see whether or not there is any administrative litigation in the Patent and Trademark Offices. One should not overlook material foreign jurisdictions when conducting such searches. Usually, though, one can get a good idea of what actions the target is involved in through discussions with the target’s lawyers and a review of its files. • Consider a search in the courts of relevant jurisdictions. • Consider a search to determine whether there is any administrative litigation in the Patent and Trademark Offices. • Consider a search in the courts and Patent and Trademark Offices of material foreign jurisdictions.

8.54 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

• Conduct interviews with the target’s intellectual property counsel, general counsel, and internal administrator (who is primarily responsible for intellectual property of the target and litigation). • Inquire about administrative proceedings with the target’s lawyers. • Focus on current or anticipated lawsuits and memos and opinions directed to intellectual property issues. INDUSTRY-SPECIFIC ISSUES

Certain industries are very dependent on intellectual property and technology rights. The following are some brief comments on intellectual property and technology due diligence issues in a few such industries. Franchise Industry. In theory, the purchase of a franchisor’s business should be no dif-

ferent than any other business. However, in practice, the franchisees, who are fundamental to the franchisor’s business but may have very different priorities, can have a major impact on the transaction. There is nothing inherent in the relationship between franchisee and franchisor that prevents the franchisor from transferring its rights and obligations to someone else. Most franchise agreements expressly reserve the franchisor the right to assign the agreement. However, franchisees are naturally apprehensive when they learn that the franchisor may be sold. There are concerns over whether or not the franchise system will continue to operate successfully. A sale may also bring long-simmering disputes between the franchisor and franchisees to a boil. In some situations, one or more franchisees may want to buy the franchisor and seek to frustrate the deal for their own benefit. Franchisees can cause serious problems for both the purchaser and the seller of the business. It may be advisable to meet with a representative group of franchisees. There are three basic strategies that may be undertaken by franchisees to impede a transaction. First, they may try to obstruct the deal by relying on the terms of the franchise agreement itself or on laws against anti-competitive transactions. Second, the franchisees may claim damages for fraud or misrepresentation arising out of the dealings between purchaser and seller, or between either of them and the franchisees. A third approach of franchisees is based on allegations of improper conduct by the franchisor prior to the sale, such as not disclosing its intent to sell the business. The potential purchaser of a franchisor must be concerned about the past conduct of the seller. A purchaser will try to ensure that it does not assume any unexpected liabilities to the franchisees. The first step will be to verify that all of the liabilities are disclosed by the seller. The second is to check representations and promises made in disclosure documents, copies of which are filed in those jurisdictions having franchise legislation. Lawyers for the seller should anticipate these issues and review those materials in advance. • Consider interests and rights of franchisees. • Consider interests and rights of franchise associations. • If acting for a franchisee, consider the restrictions on transactions involving the franchise.

INDUSTRY-SPECIFIC ISSUES 8.55

• Consider compliance with disclosure requirements. • Consider related agreements. Merchandising Industry. A number of industries now have as their primary aspect, or as a material collateral aspect, the merchandising of intellectual properties. Certain industries are particularly dependent on the merchandising area; these include the sports, entertainment, and toy industries. The merchandising aspect of a target’s business should be considered and all license agreements in that area reviewed for the strength of the underlying intellectual property and contractual terms.

• Consider license agreements. Pharmaceutical Industry. Companies in the pharmaceutical industry present specific issues for a variety of reasons. First and foremost is the regulatory environment they function within.59 Second is the fact that such businesses are strongly reliant on patent protection. Third, in some countries, is the effect that the compulsory license regimes have. Fourth, in a number of countries, such as the United States, there is what is commonly referred to as patent term extension or restoration legislation.60 When a portion of the monopoly granted by a patent has not been available to a patentee because the manufacture and sale of the patented product has been held up by regulatory approvals, it is possible to extend the patent monopoly to offset the delays encountered by the regulatory process, subject to certain limitations. Finally, it is necessary to check carefully supply agreements because of the importance of the supply of raw materials for pharmaceuticals. Because of the patchwork of patents and compulsory license regimes around the world, there may be only limited supply sources for certain raw materials necessary to the production of a pharmaceutical. Therefore, losing a supply agreement as a result of a transaction may prove to be material to a pharmaceutical company’s business.

• Consider a search for compulsory licenses. • Consider the effect of patent term extension and restoration. • Consider supply and license agreements. Biotechnology Industry. The biotechnology industry presents specific issues relating to

the ownership of living organisms. For example, there may be questions regarding ownership of tissue samples and blood by-products obtained from patients and organisms developed as a result of research. These should be considered. • Consider issues relating to living organisms in the biotechnology industry. Publishing Industry. Among the most crucial assets in any publishing business are the

copyrights that are owned by the publisher, copyright licenses through which the publisher is entitled to publish and distribute works, and licenses to local and foreign publishers and distributors in other media. Careful attention should be given to copyright and moral rights issues in this industry, particularly those of employees and freelancers.

8.56 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

In some countries, employees of periodicals have a right to restrain use of their works authored for such periodicals for any other use than as part of periodicals. Defamation issues are also of major importance. Computer databases and electronic and Internet publishing are generally important to publishers today. License agreements should be reviewed for any restrictions relating to online or website activities. • • • • • • •

Consider copyright ownership issues. Consider moral rights issues. Consider defamation issues. Consider licenses with authors and others. Consider other licenses. Consider database issues. Consider online and website activities.

Entertainment Industry. The entertainment industry presents difficult issues in connec-

tion with intellectual property. First, intellectual property rights in this industry tend to be layered. Using an example of a motion picture, an author may own copyright in an underlying novel. Someone else may have adapted the novel into a play for theatrical purposes. A third person may have adapted the play into a screenplay for a motion picture. The director, producer, cinematographer, soundtrack composers, arrangers, and many others may have contributed to the final movie. Often the agreements dealing with the ownership or licensing of the intellectual property rights created by each “author” are less than satisfactory. Different authors may have retained and given up different components of their rights. For example, the author of the original novel may have assigned or licensed to his or her publisher not only the book rights, but also all other rights on an exclusive basis. It may be necessary for the movie’s producer to obtain rights from the publisher. Second, exploitation of any property in the industry usually involves a number of licenses, sublicenses, and other agreements. Again using a motion picture as an example, there will be a series of agreements relating to domestic theatrical exhibition, foreign exhibition, television performance, satellite distribution, home video release, merchandising, and other issues when the movie is finally produced. There are often complicated intervening agreements to take advantage of tax sheltering and, in many jurisdictions, government grants. Guilds and other unions may also have rights. There is now an additional overlay of online activities. The music, television, and similar businesses pose similar, but slightly different issues. As intellectual property and, increasingly, technology are crucial to the music, television, motion picture, and related businesses, these complex situations cannot be ignored. • Consider layering of intellectual property. • Consider division of rights, for example, movie, television, and music, through multiple licenses. • Consider the rights of guilds and other unions. • Consider online activities. Sports Industry. The sports industry presents different types of layering issues. One

must first consider the rights relating to franchises in a peculiar type of franchise

REGULATORY ISSUES 8.57

arrangement. However, one must also consider the multitude of rights of different persons in relation to broadcasting, merchandising, and endorsement arrangements. The team sports industry has a number of different components. These components include the relevant league or other central organization, the individual team franchises, often a players’ association, and the rights of individual players and player groups. One must assess first the inherent rights of each component of the industry, and then the contractual arrangements in place among them to organize exploitation. For example, there will usually be agreements governing the interface between national or international broadcast rights held by the league and local broadcast rights that might be held by an individual team. Similarly, with merchandising, one must determine whether the league, the individual teams, the individual players, or the players’ association has or have the right to exploit various insignia and personality rights relating to the sport. Often, various agreements (including individual player contracts and league-wide collective bargaining agreements) deal with these issues on a compromise basis so that certain rights are retained by individuals, others are transferred from individuals to the players’ association and exploited by them, and still others are transferred to the league or its member teams. The teams’ rights to merchandise their own trademarks, logos, and other identifying indicia may be licensed or assigned to the league or an arm of the league specially set up for licensing purposes. The issue of websites and other online activities is now layered above these issues. All of these rights and related agreements must be considered. • • • • • •

Consider franchise issues. Consider league issues. Consider team issues. Consider player issues. Consider collective bargaining agreements and players’ association issues. Consider online activities.

REGULATORY ISSUES

Many industries today are heavily regulated. In addition to ones that one might identify most easily, such as utilities and financial institutions, there are a number of regulated industries that rely to a great extent on intellectual property and technology. In addition, there are general regulatory provisions that may affect intellectual property and technology transfers. Technology Transfer Restrictions. Most countries have legislation restricting the export

to or import from certain defined countries of goods, services, or technology. The United States probably has the most restrictive of such laws.61 Such legislation restricts, among other things, exports of certain types of sensitive technology and exports to certain jurisdictions of broader types of technology. The motive for this legislation is political. As a result, the legislation is frequently amended. If the target conducts or anticipates conducting business in jurisdictions that have sensitive political relations, or if the target is involved with sensitive technology like encryption software or atomic energy, such legislation should be considered. Some countries have boycott provisions

8.58 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

pursuant to which one must certify that one does not do business in or with those in select other countries. • Consider the impact of legislation on the export and import of products and technology of the business. • Consider the impact of boycott provisions in some countries. Access to Information. Under access to information legislation in some jurisdictions, it is possible for any person to obtain copies of documents in the possession of the government unless they fall within the specific exemptions to disclosure in the legislation.62 If the target has significant government dealings, this valuable information may not be protected against disclosure to third parties. Appropriate precautions should be taken when filing materials with governments, and lists of these filings should be compiled. In some cases, it is possible to benefit from this right of access during the due diligence process.

• Consider the impact of access to information legislation in various jurisdictions on materials filed by the target. • Consider accessing information filed by the target under access to information legislation. Privacy and Personal Information Issues. A number of jurisdictions have legislation that

strictly limits the use and transfer of data relating to individuals. Europe is one example. Recent federal legislation to the same effect has been enacted in Canada, and the Province of Quebec has for some time had very limiting statutory protection for individual data. Several bills were pending in the United States at the time of this writing.63 The use of personal data by the target in customer and mailing lists, employment records, and otherwise should be carefully considered against the relevant statutory limitations. This is especially true for those businesses that are highly dependent on dealing with and transferring this type of information. It should be borne in mind that this information may often be easily transferred across borders within corporate groups or to and from service providers electronically without much effort or thought by those who make these arrangements. Therefore, it is important that the full geographical scope of the activities with this information be assessed, then compared against the legislation in relevant jurisdictions. In some industries, such as health care, there is specific legislation.64 In other industries, such as the financial services industry, standards and codes of practice have developed with respect to the handling of this personal information. Copies of these codes and guidelines should be obtained and reviewed. • Identify all personal information that is relevant or material to the target’s business. • Consider the use, movement, and geographical reach of this personal information. • Review the activities of the target with this information against relevant privacy industry codes and legislation. Competition and Antitrust Issues. The laws of some countries impose restrictions for

competition or antitrust law purposes on the leverage that one can obtain through intellectual property.65 Most often, these restrictions are based on licensing practices that

REGULATORY ISSUES 8.59

offend the local competition laws of the jurisdiction. For example, in a number of jurisdictions it is improper to attempt to extend the term or scope of patent or other intellectual property rights through an agreement. In many countries it is similarly inappropriate to engage in various other practices, such as tied selling (in which one conditions the grant of a license of one intellectual property right to the taking of a license under another, perhaps less desirable, intellectual property right). All license and similar agreements of the types discussed previously should be considered from these perspectives. • Consider the impact of competition and antitrust issues in various jurisdictions on relevant license and other intellectual property agreements. Franchising Industry. Many state governments within the United States and a few other

countries have franchise legislation requiring the filing of franchise disclosure requirements.66 These disclosure documents often contain relevant and complete financial information. One should ensure that all regulatory approvals have been obtained and maintained through the filing of updated information or that any exemption obtained earlier is still effective in order to avoid the need for filing or further filings. • Consider the impact of disclosure legislation. • Consider publicly available materials. • Ensure that all filings have been made and are accurate. Pharmaceutical Industry. The pharmaceutical industry is very heavily regulated.67

Careful attention must be paid to regulatory approvals, or applications for regulatory approvals, in countries where there is a significant market for particular products. Because requests for approval and approvals may be obtained at different times and subject to different requirements in different countries, they must be considered on a product-by-product and country-by-country basis. In some cases, a proposed transaction or a relocation may trigger the need to reapply for approvals or registrations. When, for example, a pharmaceutical company sells off a product line, it may be necessary for the purchaser to apply for a new registration number. Approvals must be obtained to manufacture a pharmaceutical at a specific plant in certain countries. Therefore, it is necessary to carefully consider regulatory approvals for specific plants. Any plans to relocate production of a pharmaceutical will be impacted by these regulatory considerations. As part of the regulatory approvals, searches should be made among the records of the Food and Drug Administration (FDA) and equivalent bodies of other jurisdictions to determine what information may be publicly available. Much of the information that is submitted to such bodies is kept confidential, but significant portions are available. In some countries, such as Canada, patented drugs may be subject to price controls. These may directly impact the prices at which products may be sold. These issues should also be considered. Drugs that are in the course of development or clinical trial stages may also present specific issues. • Consider compliance with regulatory legislation. • Consider the impact of price controls on patented medicines. • Consider drug registration issues.

8.60 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE THE RESULTS OF DUE DILIGENCE Interpretation. After having considered all of the issues in the foregoing sections and

having taken those steps in the due diligence process appropriate to the deal, an evaluation of the target’s intellectual property and technology position can be undertaken. At this stage, the intellectual property and technology lawyer should have an overview of the intellectual property and technology assets, the rights and liabilities of the target, and some knowledge about where the important problems and gaps lie. Then it is necessary to assess the results of these investigations in light of the real world and the needs of the client and to report the results of your assessment. For example, if there is a major potential patent infringement action looming that may prove to be disastrous to the target, the transaction might be postponed; the representations, warranties, and indemnities strengthened; the price adjusted; or a certain portion of the selling price in a sale held in escrow pending resolution of the potential liabilities. However, it is only in a rare situation that there will be such a material problem. More often, imperfections or gaps in the intellectual property and technology and the contractual portfolio can be overcome through efforts before or after the closing of a transaction or the filing of a prospectus. The intellectual property and technology lawyer should raise these issues and the need for rectification or clarification, but in a manner that does not suggest that each point poses a fundamental problem with the transaction. In other words, the report of the intellectual property and technology lawyer on the due diligence procedure should clearly set out the findings of that process, but should highlight those problems that are truly material to the target’s business both now and in the foreseeable future. The intellectual property and technology lawyer should focus on what the purchaser is really buying and how the defects in the intellectual property and technology position may affect the purchaser’s acquisition. He or she should focus on material problems and their solution. When problems are identified, the seller’s intellectual property and technology lawyer should recommend ways that they can be cured. In some cases, the seller may be able to satisfy the purchaser’s anticipated concerns through some remedial action prior to closing or shortly thereafter, or through indemnities or other contractual obligations in the purchase agreement. The intellectual property and technology lawyer should also review the acquisition and related agreements or the prospectus to ensure that the provisions concerning the intellectual property and technology rights of the target have been properly dealt with. This includes the schedules listing the intellectual property and technology assets, other agreements that affect those assets, intellectual property and technology liabilities, and the provisions warranting the transfer of such intellectual property rights. Representations and Warranties. Representations and warranties are generally matters

for the asset purchase or share purchase agreement and therefore are another subject. However, they often provide a framework for the due diligence process, so something should be said about their role. In the intellectual property and technology context, representations and warranties have two main purposes. They allocate risk between the seller and the purchaser or the lender and the borrower, and they provoke disclosure by the seller or borrower, thus assisting in the due diligence process. The consequences of a breach of representation may be that the transaction does not close, as the accuracy

THE RESULTS OF DUE DILIGENCE 8.61

of the representation is usually a condition of closing. The consequence of a breach of warranty is a claim for damages. The seller will also usually indemnify the purchaser against the consequences of any breach of warranty—thus, there is real exposure to the seller if it should give one that is not correct. The risk factors that representations and warranties allocate may well include issues that are discovered in the due diligence process. Although the basic warranties may be settled at the letter of intent stage, the exact representations and warranties negotiated should depend on the results of the due diligence investigations. To do proper due diligence, one must review the representations and warranties. One’s view of the contents of those representations and warranties will depend on whom one represents because the purchaser usually wants more than the seller wishes to give. If there are specific problems that are disclosed during the due diligence process, it is often in this area that they have to be addressed. Sometimes they are addressed by way of opinions from lawyers, but it is preferable to deal with a specific problem through a warranty or a representation. The key is to focus due diligence on the representations and warranties, and then address the results of due diligence in the representations and warranties. • Consider the representations and warranties in the agreement in light of the information revealed by due diligence. • Carefully consider certain definitions in the agreement, including “business” and “intellectual property.” • Consider representations and warranties about title in light of the information revealed by due diligence. • Consider representations and warranties relating to validity of intellectual property in light of due diligence and other unknown potential third-party rights. • Consider representations and warranties relating to enforceability in light of the information revealed by due diligence. • Consider representations and warranties relating to noninfringement in light of the information revealed by due diligence and potential third-party rights. Definitions. The definition of the “business” in the agreement is usually crucial to

these representations and warranties. In a purchase agreement, it should be broad enough to cover all of the purchaser’s interests and narrow enough to protect the seller’s interests. A narrow definition of the business will preclude the purchaser from acquiring some assets and may limit the protection the purchaser has from the seller’s activities. It may also restrict the scope of the representations and warranties. The business and technical personnel involved for both parties must understand and agree with the scope of this definition. With a broad definition of intellectual property, the seller will have more difficulty in giving the warranties. The seller may instead wish to limit the warranties to listed intellectual property. This may, in turn, lead the purchaser to ask for a warranty that the list is a complete description of all the intellectual property used by the target. The target will not be able to identify each property, such as every work for which it owns copyright or each trade secret. The target will prefer to refer only to registered rights. In this way, the seller may restrict its representations and warranties to the rights that it can easily identify. However, this may not be sufficient for the purchaser.

8.62 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE Title. Warranties on title are common. A simple one says that the seller is the owner of

the intellectual property. The difficulty with this from the seller’s point of view is that it may not know if it owns the intellectual property itself. For example, the seller may have used a trademark for some period of time and may be confident that it can use it. It may even have a registration for it. Yet, there is always the chance that someone will come out of the woodwork and successfully contest that ownership. Similarly, the seller may not be able to present the chain of written assignments that are necessary to pass copyright from a nonemployee. Another pitfall is that ownership is an indefinite term. It may mean that there is no lien or encumbrance, no co-owner, or no license granted in respect to the intellectual property. The seller will, therefore, wish to be specific in its representations. Validity and Enforceability. The purchaser will want to make sure that the intellectual

property that it is buying is valid and that it can enforce rights against third parties. The seller, on the other hand, will not know and have no practical way of determining whether the rights are invalid or unenforceable. It may be willing to say that, to the knowledge of the seller, the listed intellectual property rights are valid and enforceable. Sometimes there is a question of what “enforceable” means. If the seller warrants that a patent is enforceable, it may be saying that only one claim, but not necessarily all other claims, of the patent may be enforced. For a registered trademark, it may be saying that it is enforceable against third parties using the same mark for at least some wares or services covered by the registration. If the patent or trademark rights are important, the warranty should be specific as to how enforceable the rights are. The seller should keep in mind that it will not control the strategy in litigation for infringement of the rights. The purchaser may choose to assert a broad interpretation of the patent claims, for instance, with the result that the patent is held infringed but invalid. For these reasons, representations and warranties may be subject to intensive negotiation after the due diligence process. Noninfringement. The seller may be asked to give a warranty that the conduct of the

seller’s business does not infringe any intellectual property rights of any third party. The seller may wish to say that, to the best of its knowledge, the conduct of the seller’s business does not infringe the intellectual property rights of any third party. Alternatively, the seller may prefer to say that it has not received any notice, claim, or threat of any claim that the conduct of its business has infringed the intellectual property rights of any third party. Opinions. Legal opinions in commercial transactions are a subject in and of themselves. As a general point, it is essential that the intellectual property lawyer have input into any opinion on due diligence or the transaction that may be issued by the purchaser’s commercial counsel. This is because commercial lawyers use terms like “valid” and “enforceable” (whose meanings are well known to them in commercial practice) in statements relating to intellectual property when they may not be appropriate. Similarly, the language generally used by commercial lawyers to summarize due diligence activities and the effect of the purchase agreement may be broader than it should be in intellectual property and technology aspects of the transaction.

THE RESULTS OF DUE DILIGENCE 8.63

When intellectual property and technology counsel is retained by counsel to the purchaser, seller, borrower, or issuer, intellectual property and technology counsel may be asked to provide an opinion on the intellectual property and technology aspects to be appended to or incorporated into the broader opinion. When the intellectual property and technology counsel is within the same firm as the commercial counsel of the purchaser or borrower, the intellectual property and technology counsel may be asked to prepare a memorandum that may be appended to or incorporated in the opinion on the broader commercial transaction. In both of these situations, it is advisable for the intellectual property and technology lawyer to see a draft of the final opinion to ensure that the opinion has all appropriate limitations and does not opine on matters not dealt with in due diligence or covered in the purchase agreement. Every opinion authored by counsel is expected to meet the minimum standards of a reasonable lawyer in the jurisdiction. Some jurisdictions hold the view that intellectual property and technology counsel, as specialists, may be held to a relatively higher standard. However, there should be no liability for an incorrect opinion when the opinion giver has conducted a reasonable investigation and has reasonable grounds for the conclusions. When there are issues that have not been investigated, they should be expressly noted. The preferred standard is one that is established through communications between the intellectual property and technology lawyer and the commercial lawyer or the client. These discussions should focus on budgetary, time, and other constraints imposed by the transaction as a whole and the due diligence process in particular. The substance of these discussions (the relevant constraints and all external limitations discussed in the preceding sections) should be articulated in any opinion. It is essential to define the purpose for which any opinion is given. For example, an opinion given to a client with respect to whether a product infringes a patent of another or whether a patent is invalid, is very different from an opinion that may be given in the context of an initial public offering or a commercial transaction. In some transactions, the intellectual property and technology lawyer’s only role may be to ensure that assets being acquired or secured are on record in the name of the company and are unencumbered. In other situations, the lawyer may be required to conduct all or some of the searches previously discussed and to consider all or some of the other issues discussed elsewhere. When the intellectual property and technology lawyer will not be giving an opinion or formal report to the client, the intellectual property and technology lawyer should consider using an engagement letter. If the matter is not discussed, the client may assume that the intellectual property and technology lawyer has done everything that was necessary to ensure that the purchaser acquired good title to, or security in, all of the intellectual property and technology relating to or used in the business, that such rights are broad enforceable rights, and that there is no actual or potential liability. When the client wants to restrict the scope of due diligence, the intellectual property and technology lawyer must advise the client of the potential consequences and confirm the client’s instructions in writing. In reporting to a client after a transaction, it may be impossible to list all the searches and investigations that have been conducted in the opinion. However, it is advisable to reference these, at least in summary fashion, in an appended memorandum. In listing the types of searches and other investigations that have been conducted, for all the reasons discussed earlier in this chapter, it is perhaps more essential that one

8.64 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE

set out investigations that were not conducted for time, budgetary, or other reasons, and the limitations of the investigations that were. For example, if one is specifically asked to confine activities to searches in the U.S. Patent and Trademark Office, one should specifically state that no searches were conducted in any other jurisdictions. CONCLUSION

The valuation of intellectual property and technology assets, contracts, and liabilities, while steadily increasing, is very subjective. However, an intellectual property and technology lawyer’s review of these issues can at least provide the following information: the proprietary position of key goods and services; the strength and longevity of certain intellectual property and technology rights; the amount of internally developed intellectual property and technology versus licensed-in intellectual property and technology; the dilution of intellectual property and technology assets via license and other agreements; contractual rights and liabilities; an assessment of potential intellectual property and technology violation liabilities; and a look at key regulatory issues. No two deals are identical and no two clients or commercial lawyers have the same expectations. Thus, the best way to pursue the task is with a solid understanding of what the client or the instructing principal wants to accomplish. Until such an understanding is reached, the choice of routes to get to a successful closing will elude even the most experienced intellectual property and technology lawyer. Commercial and securities transactions will keep the intellectual property and technology lawyer fairly active. There is a lot to accomplish in a short period of time and, given the sums of money that may be involved, it is imperative to get it done right. Hopefully, this chapter will assist in the process. ENDNOTES 1

This chapter is based on a number of earlier papers and articles of the author: “Intellectual Property Due Diligence in Commercial Transactions,” “Intellectual Property in Business Transactions: A Practical Course,” Infonex, November 1993; “Intellectual Property Due Diligence: Asset and Share Purchases: What, Why and How,” “Business Transactions Involving Intellectual Property,” The Canadian Institute, September 1994; “Intellectual Property Due Diligence in Commercial Transactions,” Spring Meeting, Patent and Trademark Institute of Canada, March 1994; “Intellectual Property Due Diligence in Commercial Transactions” (1994), 11 C.I.P.R. 91; “Intellectual Property Due Diligence in Commercial Transactions,” Licensing Executives Society USA-Canada Annual Meeting, October 1994; “Intellectual Property Due Diligence in Commercial Transactions,” Licensing Executives Society Annual Meeting, April 1995; “Intellectual Property Due Diligence for Financing Technology Businesses,” Licensing Executives Society Canadian Regional Meeting, May 1995; “Intellectual Property Due Diligence For Transactions in Converging Businesses,” “Financing Convergence,” The Canadian Institute, September 1995; “Intellectual Property Due Diligence in Commercial Transactions,” “Intellectual Property in Business Transactions—A Practical Course,” October 1995, Insight; “Intellectual Property Due Diligence in Commercial Transactions,” “Due Diligence,” Federated Press, September 1997; “Intellectual Property and Technology Due Diligence in Business Transactions,” “Trademarks in Business Transactions,” International Trademark Association, September 1999; “Intellectual Property and Technology Due Diligence in Business Transactions,” Licensing Executives Society USA/Canada Annual Meeting, September 2000; “Intellectual Property and Technology Due Diligence in Business Transactions,” Osgoode Hall Law School E-Business LL.M. Program, February 2001; and “Intellectual Property, Technology and E-Commerce Due Diligence in Business Transactions,” “Critical Intellectual Property Issues for the

ENDNOTES 8.65 Corporate Lawyer,” Osgoode Hall Law School of York University, May 2001. Another version is being included in a text on Canadian Electronic Commerce Law to be published in 2001 by Carswell. Yet another version is being included in a text on Canadian Biotechnology Law to be published in 2002 by Caswell. The author is a Canadian lawyer and the earlier papers were written with a focus and more detail on Canadian legal issues. 2 Black’s Law Dictionary, 6th ed., (West Publishing Co., 1990), 457. 3 Douglas Kneebone, “Examining Key Transactional Issues,” “Business Transactions Involving Intellectual Property Issues,” Insight (September 25, 1991). 4 35.U.S.C. 5 35.U.S.C. 101. 6 35.U.S.C. 102. 7 35.U.S.C. 103. 8 35.U.S.C. 102(b). 9 35.U.S.C. 122. 10

35.U.S.C. 154. 35.U.S.C. 155–156. 12 35.U.S.C. 361. 13 35.U.S.C. 363–364. 14 35.U.S.C. 371–376. 15 35.U.S.C. 102(b). 16 35.U.S.C. 122. 17 37 C.F.R. 1.56. 18 35 U.S.C. 171. 19 35 U.S.C. 102(b). 20 35 U.S.C. 173. 21 15 U.S.C. 22 15 U.S.C. 1052. 23 15 U.S.C. 1053. 24 15 U.S.C. 1051. 25 15 U.S.C. 1058. 26 15 U.S.C. 1059. 27 15 U.S.C. 1058(b) and 1065. 28 15 U.S.C. 1060. 29 17 U.S.C. 30 17 U.S.C. 106. 31 17 U.S.C. 102. 32 17 U.S.C. 101(a)(7). 33 17 U.S.C. 102(b). 34 17 U.S.C. 401–405. 35 17 U.S.C. 408–412. 36 17 U.S.C. 302(a). 37 For example, 17 U.S.C. 302(b–c). 38 17 U.S.C. 303–305. 11

8.66 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE 39

17 U.S.C. 201(a). 17 U.S.C. 201(b). 41 For example, 17 U.S.C. 201 (c). 42 For example, 17 U.S.C. 203. 43 17 U.S.C. 106A. 44 17 U.S.C. 106A(a). 45 17 U.S.C. 106A(e). 46 17 U.S.C. 1101. 47 17 U.S.C. 103. 48 17 U.S.C. 901(a)(1). 49 17 U.S.C. 901(a)(2). 50 17 U.S.C. 905. 51 35 U.S.C. 161. 52 For example, New York C.L.S. Civ. R.50. 53 For example, 18 U.S.C. 1832. 54 For example, S.N.Y. c.553. 55 11 U.S.C. §1–§1330. 56 For example, 17 U.S.C. 203. 57 For example, 15 U.S.C. 3701 ff; 42 U.S.C. 2181 ff; 42 U.S.C. 2457; and 42 U.S.C 5908. 58 For example, New York C.L.S. Article 22-A. 59 For example, 21 U.S.C. 355. 60 35 U.S.C. 155-155A. 61 For example, 35 U.S.C. 184-188. 62 Freedom of Information Act, 5 U.S.C. 552. 63 For example, Online Privacy Protection Act of 2001, H.R. 260. 64 For example, Pub. L. 104–191, Section 263(2). 65 For example, 15 U.S.C. 1ff. 66 For example, 16 C.F.R. 436.1. 67 For example, see note 59, supra. 40

CHAPTER

9

INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST ISSUES IN MERGERS AND ACQUISITIONS Melvin Simensky Visiting Scholar in Intellectual Property Law New York Law School

William M. Heberer Hall Dickler Kent Goldstein & Wood LLP

Increasingly, the attractiveness of a potential acquisition target or merger partner is due not only to such traditional factors as the value of its tangible assets, cash flow, or market niche, but also to the value of the entity’s intellectual property assets. These assets raise several unique issues in the context of mergers and acquisitions in terms of strategies for conducting due diligence and perfecting security interests. These issues will be explored in this chapter. INTRODUCTION

The term intellectual property is used to broadly encompass several distinct assets including, among others, patents, copyrights, trademarks, and trade secrets. Other assets not traditionally classified as intellectual property, but increasingly considered as such, are domain name registrations. A patent is a monopoly granted to the inventor of a useful process, machine, or composition of matter that is both novel (i.e., not previously known or used by others) and nonobvious to a person having ordinary skill in the relevant art.1 This monopoly allows the patent owner to exclude others from making, using or selling the invention.2 In the United States, patents are governed exclusively by federal law3 and are obtained by filing a patent application in the United States Patent and Trademark Office (PTO). For U.S. patents filed after June 8, 1995, the term of protection is 20 years from the earliest deemed filing date. For U.S. patents filed prior to that date, the term of protection ends after the greater of 17 years from issuance or 20 years from the earliest deemed 9.1

9.2

INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST

filing date.4 The term of protection for foreign patents varies, but, in most countries, also ends 20 years from the application filing date.5 Copyrights, which are also governed exclusively by federal law, are granted to creators of original works of authorship—including literary works, audiovisual works, and dramatic works—upon the fixation of those works in a tangible medium of expression.6 Copyright ownership provides the creator with certain exclusive rights, including the right to display, distribute, reproduce, and publicly perform the copyrighted work.7 Registration is not required in order for copyright protection to attach; however, copyright owners obtain additional benefits and protections by registering their works in the U.S. Copyright Office. For example, registration allows the owner to institute a copyright infringement action in federal court and seek statutorily set damages rather than having to establish actual damages.8 The duration of a copyright varies depending upon the number of authors and whether the initial author is an individual or a corporate entity. For single author works created after 1989, the copyright term is the life of the author plus 70 years. For works created by more than one author (i.e., works of joint authorship), the copyright term is the life of the last surviving author plus 70 years. For a work made for hire,9 the term is 95 years from the date of publication or 120 years from the date of creation, whichever is earlier.10 Unlike patents and copyrights, trademarks are subject to protection under both state and federal law. A trademark is any word, phrase, symbol, emblem, device, or design that identifies the goods and services of a particular person or entity, and distinguishes them from the goods or services of others. Trademark rights are obtained by use of the trademark in commerce and continue in effect for as long as the mark remains in use. Once used in interstate commerce, a trademark may be federally registered under the Lanham Act.11 Applications for federal registration may be filed on one of two bases—prior use of the mark in interstate commerce or a bona fide intention to use the mark in commerce (an intent-to-use application) in the future.12 When an intent-to-use application is filed, the application may not mature into registration until the mark is actually used in interstate commerce and an amendment to allege use or a statement of use to that effect is filed in a timely manner with the PTO. Upon registration, the owner will obtain the benefit of the earlier intent-to-use application filing date (rather than the actual first use date) for priority purposes.13 Though not required to obtain protectible trademark rights, federal registration affords the mark owner with several procedural and substantive advantages, including: (1) a presumption of the validity of the trademark and the registrant’s ownership of and exclusive right to use the mark; (2) constructive notice nationwide of the registrant’s rights in the mark; and (3) the ability to bring an infringement action in federal court in which damages, profits, and costs are recoverable and treble damages and attorneys fees may be sought.14 A federal trademark registration remains in effect for 10 years, but may be continually renewed as long as the mark is in use.15 Trademarks may also be registered at the state level. A trade secret is “any formula, pattern, device or compilation of information which is used in one’s business and which gives [the business owner] an opportunity to obtain an advantage over competitors who do not know or use it.”16 Factors to be considered in determining if particular corporate information qualifies as a trade secret include: (1) the

UNDERSTANDING THE TRANSACTION 9.3

extent to which others already know the information or the ease with which they could learn it; (2) the steps taken by the company, if any, to keep the information confidential; and (3) the value of the information.17 Trade secrets are protected under state law. Finally, a domain name (e.g., acme.com) can be thought of as the alphabetical equivalent of an Internet Protocol (IP) address representing a particular location on the Internet. The domain name is made up of two different levels—a top-level domain (TLD) and a second-level domain. The information to the left of the “dot” is the second-level domain, frequently the company’s name or trademark (i.e., “acme”), and is the portion of the domain name selected by the user.18 The TLD is the designation to the right of the “dot.” There are two basic types of TLDs—generic TLDs such as “.com,” “.net,” and “.org,” and country-code TLDs such as “.co.uk,” which are controlled by national registries in various countries. There are currently over 250 country-code TLDs in which domain names can be registered. These domain names are registered by companies and individuals to identify the location of their Websites. A single domain name (e.g., acme.com) may only be registered to a single entity. However, the same name may be registered as a domain name by different parties in different TLDs. For example, Company A may own the domain name “acme.com,” Company B may own “acme.net,” and Company C may own “acme.co.uk.” Due to the tremendous growth in the Internet as a method of advertising and selling a company’s goods and services, domain names have also become important and valuable assets.19 The existence of these intellectual property assets raises unique issues both as to the due diligence to be conducted in connection with any merger or acquisition, and as the assignment of, and granting of, security interests in said assets. UNDERSTANDING THE TRANSACTION

In order to properly assess the scope of an intellectual property due diligence inquiry and the manner in which it will be conducted, one must first have a clear understanding of both the structure of and parties to the proposed transaction. Form of Transaction. The proposed transaction can be structured in a number of dif-

ferent ways. In an asset purchase, the acquiring company purchases only particular assets and liabilities of the target company20 and leaves the remaining assets and liabilities behind.21 In a stock purchase, shares in the target are sold to the acquirer, resulting in both entities remaining intact with the target becoming a subsidiary of the acquirer. In contrast, a merger of the target and acquirer results in one company surviving as the identified company while the other one disappears. The surviving company can be either the target or the acquirer.22 The deal structure selected will impact upon the focus of the intellectual property due diligence inquiry. For example, as asset purchases and mergers involve the assignment of intellectual property and other assets from one entity (typically the target) to the other, issues concerning the validity and enforceability of these assignments are of critical importance. Conversely, in a stock purchase transaction, the target remains a going concern and retains ownership of the intellectual property at issue, making it unlikely that there will be any significant issues concerning intellectual property assignments.23

9.4

INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST

There are also significant differences concerning the target’s potential liabilities with respect to due diligence. In a stock purchase, the acquirer will succeed to the target’s liabilities subject to any indemnification or representations and warranties by the target at closing. Likewise, the surviving company in a merger assumes all obligations of the constituent companies, whether they are known, unknown, or contingent at closing.24 Thus, due diligence with respect to the target’s liabilities is critical in these transactions. In an asset purchase, however, since only selected assets and liabilities are assumed by the acquirer, due diligence concerning potential unknown liabilities of the target is less important.25 Parties to the Transaction. An understanding of the parties to the transaction and the industries in which they operate will also shape the intellectual property due diligence audit.26 For example, technology companies often count their patent portfolios and proprietary trade secrets among their most valuable assets. Thus, when the target is a technology company, the due diligence inquiry will typically focus on these assets, examining both the manner in which they have been protected in the past and the ability of the acquirer to exploit them in the future without interference from others.27 Alternatively, an entertainment company may have a sizable copyright and trademark portfolio but few, if any, patent or trade secret assets. For these entities, the inquiry might emphasize the copyright and trademark protection and registration programs that the target has in place. Other companies may derive substantial value from the uniqueness of their information database and their ability to control the dissemination of that information. For these targets, a key issue will be the extent to which the database information has been or can be protected by copyright or trade secret.28 Other relevant inquiries relate to a determination of the target’s pretransaction structure. For example, if the target is a public company, its annual report and other required filings will be available to the public, thereby providing a reliable source of information concerning its intellectual property portfolio. When the target is the subsidiary of a larger parent company, certain assets such as trademarks may be held in the name of the parent or another subsidiary, then licensed to the target for use. Thus, the existence of such a parent/subsidiary relationship will call for a close examination of the ownership of intellectual property assets and the licensing of those assets between the target and its related companies.29 Finally, it is helpful to gain some understanding of the acquirer’s motivation in entering into the transaction. For example, if the primary objective is to acquire a particular technology, the intellectual property inquiry will focus on the steps taken to protect that technology and the risks that the technology infringes upon the rights of others. Alternatively, if the primary objective is to increase market penetration or enter new markets by acquiring the target’s goods or services, the intellectual property investigation would likely focus on the steps taken to enforce and protect the target’s trademarks.30

DUE DILIGENCE

The purpose of a due diligence inquiry in connection with a merger or acquisition is to determine the extent of the target’s assets and identify and reduce the risk of potential liabilities that could result in significant losses to the acquirer post-closing.31 Due diligence prevents last minute surprises and arms the acquirer with information that will

DUE DILIGENCE 9.5

aid in determining if, and on what terms, it should proceed with the deal. In this way, the due diligence inquiry differs somewhat from the due diligence investigation conducted with a securities offering, which is intended to demonstrate that the participants in the offering “had, after reasonable investigation, reasonable ground to believe and did believe” that the offering materials provided to potential purchasers were accurate and free of material omissions.32 In the merger and acquisition context, the due diligence inquiry should include a thorough investigation of the history of the target and should seek to uncover all liabilities, claims, liens, pending litigation, and obligations that the target’s business may have, as well as any limitations or restrictions on the target’s ability to exploit its assets. Defining the Intellectual Property Audit. As previously suggested, the comprehensiveness and focus of the intellectual property audit may vary with the goals of the parties, types of businesses involved, and form of the transaction.33 The intellectual property audit seeks to identify and inventory the target’s portfolio of intellectual property assets, assess the strength and enforceability of those assets, and analyze any potential liabilities associated with their continued use and exploitation.34 It also benefits the target by allowing it to determine the extent to which it can make representations and warranties at closing about its ownership of the intellectual property assets at issue.35 Components of an Intellectual Property Audit Identify the Target’s Intellectual Property Assets. A comprehensive inventory of the tar-

get’s intellectual property assets should be taken. This information may be compiled from a number of sources. As a preliminary, a list of intellectual property assets may be obtained from the target. This list should encompass, among other assets, U.S. and foreign patents and patent applications; trademark registrations and applications; copyright registrations and applications; intellectual property licenses and agreements; domain name registrations; website development and hosting agreements; and trade secrets.36 The target should also be asked to provide a list of all upcoming docket deadlines for the filing of documents necessary to maintain and protect recorded assets such as patents, trademark registrations, and copyright registrations. For example, the target should identify upcoming deadlines for the payment of patent maintenance fees and the filing of patent and trademark office action responses,37 trademark statements of use,38 and renewal applications and copyright renewals (if any).39 One effective method of obtaining this information from the target is to have the acquirer’s intellectual property counsel prepare and send a due diligence letter. This letter will typically contain a list of questions and document requests similar in nature to discovery requests that itemize the desired information and documentation.40 Some of the information sought from the target may be confidential in nature. For example, U.S. patent applications are not publicly available until the patent issues. Likewise, trade secret information, by definition, is confidential, and by disclosing the information to the acquirer, the target could run the risk of losing trade secret protection.41 Accordingly, in order for the acquirer to have access to the target’s files about these assets, a signed nondisclosure and confidentiality agreement will likely be required. Under this agreement, the acquirer would agree not to disclose or use the information revealed during the due diligence review pending the closing of the transaction.42

9.6

INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST

Other information is available publicly and may be obtained from outside sources if necessary. For example, file histories for U.S. trademark and copyright applications and registrations are available from the PTO and Copyright Office, respectively. In addition, outside search companies can perform searches of U.S. and foreign trademark and copyright registries, and provide lists of all pending applications and registrations owned by the target on those particular registries. There are also companies that now perform worldwide searches for domain name ownership. Again, note that trademarks and copyrights do not require registration to be valid and enforceable. As such, the acquirer must be sure to identify and schedule any common law trademarks and unregistered copyrights.43 Confirm Ownership Rights. Once an inventory of intellectual property assets has been cre-

ated, the acquirer should review the assets’ chain of title and confirm the ownership status of all known recorded rights such as patents and patent applications, copyright applications and registrations, trademark applications and registrations, and domain name registrations. As previously noted, United States patent and trademark filings are recorded in the PTO, but copyright filings are recorded in the Copyright Office. However, the review of the ownership status of particular assets should encompass both United States and foreign filings.44 By undertaking such a review, the acquirer will be able to discover, prior to closing, any gaps or discrepancies in the recorded chain of title (e.g., unrecorded assignments) as well as any prior liens or security interests placed on a particular asset.45 In addition to determining ownership and current status of the target’s intellectual property portfolio, the acquirer should evaluate the target’s patents and trademarks to determine whether they are valid and enforceable against others and whether the target is potentially vulnerable to thirdparty infringement claims.46 This evaluation is typically performed by intellectual property counsel with the requisite technical expertise. The acquirer should also obtain copies of any opinions of counsel provided to target with respect to the validity of any of its intellectual property assets, the infringement of any of these assets by third parties, or the freedom to use the assets without objection or interference from third parties.47 Assess the Strength and Enforceability of Target’s Rights.

Review Relevant Licenses and Agreements. All of the target’s existing intellectual property licenses—both as licensor and licensee—must be analyzed, since these agreements may well restrict the target’s (and subsequently, the acquirer’s) ability to exploit particular assets. Moreover, the licenses will identify the other parties to these agreements, parties with whom the acquirer may well be entering ongoing business relationships. In reviewing these licenses, the acquirer should take note of (1) any exclusivity provisions; (2) the duration and geographic scope of the license; (3) royalty and performance provisions, including if the license calls for, any minimum royalties or minimum sales targets; (4) the extent of the quality control provisions in the case of trademarks; and (5) the ability of the target to assign and/or sublicense the license.48 Many license agreements provide that an assignment by the licensee without the prior written approval of the licensor will lead to the automatic termination of the agreement. Nevertheless, in light of the imminent enactment of Revised Article Nine of the Uniform Commercial Code (UCC),49 a review of the target’s licenses should

DUE DILIGENCE 9.7

include an assessment of the enforceability of any antiassignment provisions or other limitations contained therein. As discussed in greater detail later in this chapter, Article Nine governs the granting and enforcement of security interests in various types of personal property, including accounts.50 Under the current version of Article Nine, accounts are defined as payment obligations arising out of the sale or lease of goods or the provision of services.51 However, Revised Article Nine broadens this definition to include the right to receive payments (i.e., royalties) under intellectual property (and other) licenses, thereby subjecting the right to receive such payments to Revised Article Nine.52 Moreover, under Revised Section 9–406, any restriction in a license agreement that would prohibit the creation or enforcement of a security interest in the right to receive payment thereunder will be rendered ineffective.53 Thus, Revised Article Nine permits the creation and enforcement of security interests in a licensor’s right to receive royalty payments under a license, even if the license itself restricts the licensor’s ability to assign or otherwise transfer its right to receive payment.54 The revisions to Article Nine also impact the ability of licensees to obtain financing secured by their right to perform under an intellectual property license by “render[ing] ineffective a[ny contractual or other legal] restriction on the transfer of a licensee’s rights under an intellectual property license. . . to the extent the restriction would interfere with the creation, attachment, or perfection of the security interest.”55 Of course, a licensee’s ability to grant a security interest is limited only to its rights as licensee. It has no ability to grant a security interest in the underlying collateral owned by the licensor.56 Moreover, Revised Article Nine does not permit a secured party to enforce its security interest in the licensee’s rights under the license if other law prohibits enforcement or would enforce a contractual restriction on enforcement.57 Analyze Potential Liabilities. In any transaction in which the acquirer will be assuming

the obligations and liabilities of the target, a thorough assessment of potential liabilities associated with the use of the target’s intellectual property assets should be made. In this regard, the acquirer will want to review the files of any pending litigations or administrative proceedings (United States or foreign) involving the target’s intellectual property assets or related agreements.58 For such actions, the acquirer will want to ascertain the nature of the claim, dollar value of the claim, likelihood of injunction, and likelihood of settlement before the closing of the transaction.59 Any opinions of counsel about the likelihood of success in the pending actions and administrative proceedings should also be requested. However, due to potential concerns regarding waiver of the attorney-client privilege, review of such opinions may require the execution of a nondisclosure and confidentiality agreement. Alternatively, the acquirer may request that its own intellectual property counsel evaluate the likelihood of success regarding any pending actions.60 It is also helpful to determine whether the target carries any errors and omissions or other insurance policies covering intellectual property infringement claims. The acquirer should also review any office actions61 or oppositions62 filed in trademark proceedings, office actions or interferences63 filed in patent application proceedings, protest or cease and desist letters involving the target’s intellectual property, and any relevant opinions of counsel. Moreover, the acquirer will want to obtain and review copies of

9.8

INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST

any judgments, decrees, or settlement agreements from prior litigations or proceedings involving the target’s intellectual property assets because these documents may contain provisions restricting the target’s or acquirer’s ability to use certain intellectual property assets.64 Checklists for Specific Assets. Apart from the general considerations previously dis-

cussed, there are issues specific to each particular type of intellectual property asset. Following are checklists of information to be obtained and issues to be considered regarding each type of asset. Copyrights. When compiling a list of the target’s copyrights, the following information

should be obtained:65 • • • • • • • • •

Country of registration Registration number Date of issue Date of publication or, if not published, creation Initial author(s) and prior owners Duration of copyright Presence or absence of any security interests Copyright notices66 Renewal periods67

Of these, a review of the initial author and any prior owners of the work is critical to the issue of copyright ownership and duration. Typically, the author and owner of a copyrighted work are the same person or entity. If, however, the initial author differs from the target (owner), a valid assignment of copyright must be provided. Moreover, the acquirer must ensure that the assignment was properly recorded to establish an accurate chain of title.68 In instances when the work was jointly created by multiple authors,69 each author would have an ownership interest in the work and a right to license the work, subject only to an obligation to account to the other for economic benefits received from the license.70 If the target were assigned rights in the work from only one of multiple joint owners, the acquirer’s ability to exercise complete control over the work would be compromised.71 Moreover, copyrighted works created by employees within the scope of their employment may be considered “works made for hire” whereby the employer is deemed the author and owner of the work.72 The acquirer should determine whether the target has any agreements with employees about the ownership of works created in the workplace. In contrast, subject to limited exceptions, works created for the target by a freelancer or independent contractor are unlikely to be deemed works for hire, and the target will not be viewed as the copyright owner absent an assignment of copyright.73 Finally, as previously noted, registration in the U.S. Copyright Office is not required to obtain copyright protection.74 Thus, the target may have unregistered copyrights in its portfolio. The acquirer should determine whether the target owns any important unregistered copyrighted works and require that these copyrights be registered before closing.75 Due to the uncertainty surrounding the perfection of security interests in unregistered copyrights,

DUE DILIGENCE 9.9

which will be discussed in detail in later sections, lenders may also require that copyrights be registered as a condition to extending loans.76 So as to identify any unregistered copyrights, the acquirer may wish to review all of the target’s sales brochures, catalogs, Websites, software programs, and any computer programs the target uses under license.77 Patents. A list of all patents and patent applications—United States and foreign—

should be compiled containing the following information: • • • • • • •

Patent number Inventor’s name(s) Date of application Date of issue for issued patents Any prior owners and how the patent was obtained by the target78 Remaining patent term Presence of any liens, security interests, or other encumbrances

In addition, periodic governmental fees (maintenance fees in the United States and annuities elsewhere) must be paid with patents and patent applications.79 Failure to pay these fees can cause patent rights to lapse. As such, the acquirer should ensure that all fees have been paid and ascertain any upcoming fee deadlines.80 Each patent should be checked to verify that the claims of the issued patent cover the products, processes, or methods to be acquired. For issued patents, the official prosecution file should be obtained from the PTO and analyzed to determine if any representations made to the PTO during the patent’s prosecution limit the scope of the patent’s claims. For patents of critical importance to the acquirer, a validity search should be conducted to determine if the claims of the patent are valid over prior art.81 Since any potential liability in connection with the target’s patent portfolio must be explored, any third-party protests or allegations of infringement and all opinion letters concerning the patent’s validity or enforceability should be reviewed. If the target has licensed any patents, the license agreements should also be reviewed to determine if there is any risk of patent misuse. Patent misuse is a defense to infringement that precludes the patent owner from enforcing the patent when the owner has improperly attempted to impose restrictions on its patent licensees that exceed the scope of the patent grant.82 Provisions that might give rise to a patent misuse defense include requiring royalty payments after the license term, requiring the licensee to license a bundle of patents rather than a single desired patent, or granting a license on the condition that the licensee refrain from dealing in products that compete with the patented product.83 Finally, the acquirer should determine if the target has entered into any agreements not to assert its patents against third parties, which might restrict the acquirer’s ability to enforce the patent(s) at issue. Trademarks. When compiling an inventory of U.S. and foreign trademark applications

and registrations, the following information should be included: • Country of registration or application • Registration or application number

9.10 INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST

• Goods or services included in the registration or application • Date of application and (if applicable) registration • For pending United States applications, whether the application is based upon use or a bona fide intent-to-use the mark • Any prior owners and how the trademark was obtained by the target84 • Any recordation of the mark with United States Customs • Presence of any liens, security interests, or other encumbrances To aid in gathering this information, the target should provide the acquirer its trademark prosecution files for review. In addition, file wrapper histories for U.S. trademark applications and registrations may be obtained from the PTO.85 Finally, for the most important marks, it is often a good idea to perform a trademark search or scan86 that will provide essential information about the target’s applications and registrations, especially the recorded chain of title and existence of any prior encumbrances.87 In addition, trademark rights in the United States may be obtained at common law without the filing of a trademark application.88 Thus, the target’s trademark portfolio may also include unregistered marks. A review of the target’s catalogs, price lists, brochures, Websites, advertising, promotional material, and annual reports should be performed to identify any common law (unregistered) marks that do not appear on the schedule of registered marks and pending applications.89 Moreover, when compiling a list of the target’s marks, the acquirer should confirm that all marks are still in use. In the United States, failure to use a mark for three consecutive years without an intent to resume use is prima facie evidence of the mark’s abandonment.90 In addition, the PTO requires that affidavits be filed between the fifth and sixth years after registration evidencing continued use of the mark.91 Failure to file these affidavits in a timely way can lead to cancellation of the registration.92 All upcoming deadlines for the filing of these documents should be specified. Likewise, imminent deadlines for the prosecution of pending applications (e.g., deadlines for responding to office actions or filing statements of use) and renewal of trademark registrations should be identified. For pending applications, any PTO office actions93 and relevant search reports should be reviewed to determine the likelihood of the applications maturing to registration. For the same reason, all files of pending PTO proceedings aimed at preventing or canceling trademark registration (opposition and cancellation proceedings, respectively) should also be reviewed. As with all other types of intellectual property assets, any protest or cease and desist letters or allegations of infringement should be analyzed. This also applies to all opinion letters concerning the availability of any marks, the strength of the target’s marks, or any potential infringement claims. The acquirer should also ensure that any prior assignments of material trademarks were proper. Trademarks cannot be assigned without the underlying goodwill of the business that they symbolize.94 Any assignment of a trademark apart from the goodwill of the business it represents constitutes an assignment in gross and will render the trademark abandoned.95 Special attention should be paid to any assignment of intentto-use applications. These applications may not be assigned prior to the filing of a statement of use96 with the PTO except to a successor to the business to which the trademark

DUE DILIGENCE 9.11

pertains, provided such business is ongoing and existing.97 Thus, for all pending intentto-use applications, the acquirer should determine if the mark is in use and, if so, if a statement of use has been filed with the PTO. If the target has licensed its marks to third parties, those licenses should be reviewed to ensure that the target has maintained adequate control over the use of its mark. Trademark law requires that a trademark owner control the nature and quality of the goods and services sold under its mark, including those sold under license.98 Failure to properly exercise control over the manner in which an owner’s mark is used by its licensees represents another ground for abandonment of a trademark.99 Finally, the acquirer should determine if the target has entered into any consent or co-existence agreements with other trademark owners, whereby the parties have agreed that their respective marks can coexist in the marketplace without confusion. These agreements frequently contain limitations regarding the geographic area or product lines in which a mark can be used. Trade Secrets. The value of any trade secret will depend upon the extent to which the target and its employees have protected the secret information.100 Therefore, the acquirer must investigate the practices and procedures implemented by the target to maintain the confidential nature of such information. In particular, the acquirer should examine the target’s internal security procedures, policies, or guidelines (e.g., employee entrance or exit interviews covering intellectual property issues), any confidentiality or nondisclosure agreements with employees, and any confidentiality or nondisclosure agreements with third parties who have been provided access to the secret information.101 In addition, the acquirer should determine if any key employees with knowledge of the trade secret information have recently left the target to join or start a competing business. Further, the acquirer should assess if the target has recently hired any employees from a competitor who may have knowledge of that competitor’s proprietary information, thereby raising the possibility of the target’s liability for misappropriation of the competitor’s trade secrets.102 Domain Names and Websites. The acquirer should obtain a list of all registered domain names and Websites owned or operated by or on behalf of the target. For domain name registrations, the acquirer should determine how each was obtained (i.e., directly from registration with a domain name registrar or via assignment from a prior registrant). For all third-party transfers, copies of the relevant assignment documents should be provided. For each domain name, the acquirer should note the registry with which the name is registered (e.g., Network Solutions or Register.com), the date of registration, and the deadlines for the payment of renewal fees to maintain registration. If the target owns registrations in any foreign country code TLDs (e.g., “www.target.se” in Sweden or “www.target.es” in Spain) the acquirer should review the requirements of the local country registry to determine whether assignment of a domain name registration by the target to the acquirer is possible.103 Finally, the acquirer should determine whether the target has received any communications from third parties challenging its use of its domain names or alleging that said domain names infringe upon third parties’ trademark rights.104

9.12 INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST

With respect to any target websites, the acquirer should identify the developer of the sites and verify ownership of the site content. Any website development or hosting agreements should be reviewed. The acquirer should also ensure that any websites are, in fact, operational.105 REPRESENTATIONS AND WARRANTIES

A schedule of the intellectual property assets owned by the target will typically be incorporated into the closing documents of a transaction, and the target will be called upon to make various representations and warranties at closing regarding the validity, ownership, strength, and transferability of the scheduled intellectual property. The scope of these representations and warranties will be dictated by the due diligence audit and any problems that it uncovers. The following are examples of the types of representations and warranties that a target might typically make: • The target is the exclusive owner of the scheduled intellectual property. • The scheduled intellectual property assets are valid and enforceable. • The target is not aware of any claim of invalidity or infringement respecting the scheduled intellectual property. • The target has not infringed upon, diluted, or misappropriated the intellectual property rights of third parties. • All PTO or Copyright Office recordings and filings necessary to maintain and enforce the target’s intellectual property rights have been made. • There are no pending suits, actions, or other proceedings that threaten or otherwise involve the scheduled intellectual property. • The target is not subject to any judgment, decree, injunction, or court order that limits or restricts its ability to use the scheduled intellectual property. • The target has not entered into any agreement that impairs or limits its rights regarding the scheduled intellectual property.106 Because the acquirer and target will often merge into a single entity or other business combination after the closing, the issue of whether the acquirer will have any recourse post-closing should the target breach its representations or warranties frequently remains. One method used to address this issue is to require placement of a portion of the purchase price in escrow for a specified period of time. This circumstance allows the acquirer to recover against the escrow in the event of a breach of a representation or warranty by the target.107 Alternatively, the acquirer may seek to require that certain large shareholders agree to personal liability for the target’s intellectual property representations and warranties.108 RECORDING OF TRANSFERS Assignments. In the majority of merger and acquisition transactions, the target’s intel-

lectual property assets will be assigned to the acquirer at closing. In the case of registered copyrights, patents, and trademarks, assignments must be publicly recorded to put the world on constructive notice of the acquirer’s rights.

RECORDING OF TRANSFERS 9.13

For example, Section 205(a) of the Copyright Act provides that “any transfer of copyright ownership or other document pertaining to a copyright may be recorded in the Copyright Office.”109 In the event of two conflicting transfers, priority will be given to the first party to record its interest in the Copyright Office, provided the recording is made within one month of its execution in the United States or two months of its execution outside the United States.110 Similarly, both patent and trademark assignments will be deemed void against any subsequent purchaser or mortgagee without notice, unless recorded in the PTO within three months from the date of assignment or before the date of the subsequent purchase or mortgage.111 Security Interests. Like many commercial transactions, corporate mergers and acquisitions frequently require that the acquirer borrow funds to finance the transaction. In these instances, the lender providing the funds will seek collateral—property offered by the borrower (acquirer) to secure the loan—as protection against the risk of default. This collateral frequently takes the form of a security interest in the assets of the target, which allows the lender to foreclose on those assets should the acquirer default. Uniform Commercial Code: Article Nine. The granting and enforcement of security inter-

ests in personal property is governed by Article Nine of the UCC.112 Before the drafting of Article Nine, a number of different nonstatutory or common law devices (e.g., chattel mortgages, conditional sales, trust receipts) provided creditors with recourse against specific personal property assets in the event of a debtor’s default. Each of these devices was governed by a separate set of rules and applied to only a limited range of commercial transactions.113 This multiplicity of security vehicles and governing rules added unnecessary complexity to commercial transactions. Article Nine was drafted to simplify the process of securing commercial loans by enveloping the various common law security devices in a single comprehensive security interest, which is defined broadly as “an interest in personal property or fixtures which secures payment or performance of an obligation.”114 In contrast to certain pre-UCC security devices (such as a chattel mortgage) that required the title for the collateral transfer to the creditor during the term of the loan and then revert back to the debtor upon sati