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IP Issues In Mergers & Acquisitions

Buyers and sellers need to approach M&As with a strategy to maximize the value of intellectual property assets

Louis R. Dienes
Dienes

By Louis R. Dienes

Intellectual property assets — patents, copyrights, trademarks and trade secrets — are an increasingly significant portion of the value that buyers acquire in mergers and acquisitions today. In order to exploit fully the value of intellectual property assets, both buyers and sellers need to formulate effective transaction structures and strategies grounded in an understanding of intellectual property law.

This article discusses some of the key intellectual property issues buyers and sellers encounter in mergers and acquisitions.

Intellectual property and structuring the transaction

The structure of the proposed transaction is the first issue that buyer and seller must consider. The three basic transaction structures are asset purchases, stock purchases and mergers.

Asset purchases may be preferable to buyers for two reasons. First, an asset purchase generally provides the buyer with the opportunity to select assets and liabilities to acquire and to leave behind others. Also, an asset purchase generally results in a step up in basis of the acquired assets, which may be attractive to the buyer.

Asset purchases, however, sometimes prove to be more costly for the buyer because they may require numerous individual assignments of intellectual property assets, sometimes in multiple jurisdictions, as well as consents to the assignment of intellectual property assets by secured parties, licensors, licensees and other parties. Also, an asset purchase may result in two levels of taxation, both at the seller’s level and at the stockholder level.

Stock purchases have advantages for both the buyer and the seller. Stock purchases tend to be simpler for buyers because title to all the seller’s assets is transferred with the ownership of the seller and fewer consents are generally required. For the seller, a stock purchase will generally result in only one level of tax to the seller, at the level of the seller’s stockholders, and generally at the favorable capital gains rate. But stock purchases also have disadvantages for the buyer. When the buyer acquires the seller it acquires all of the seller’s liabilities. 

The most common merger structures are a reverse triangular merger, in which the seller survives as a subsidiary of the buyer, and a forward merger, in which an acquisition subsidiary formed by the buyer survives as a subsidiary of the buyer. A merger may be an attractive alternative to a stock purchase because the buyer will not need to get stockholders to sign a stock purchase agreement.

The seller’s stockholders will have to approve the merger, usually by a majority, although a greater percentage may be specified in the seller’s charter documents. However, like a stock purchase, the buyer is confronted with having to acquire all of the seller’s liabilities and may also have to obtain consents.

An important structural consideration is whether the transaction may receive tax treatment as a tax-free contribution of intellectual property under §351 of the Internal Revenue Code. In order for a contribution of intellectual property to be a tax-free exchange of property for stock under §351, the rights granted to the contributed intellectual property must be exclusive within a defined “field of use” with respect to both third parties and the seller. 

Due diligence and transaction strategy

As its next consideration, the buyer must organize its due diligence investigation of the seller’s intellectual property assets. It is essential that the team conducting this part of the due diligence investigation have expert knowledge of intellectual property law in order to advise the buyer competently. Each intellectual property due diligence investigation should be tailored to fit the specific transaction.

Issues unique to each type of intellectual property are discussed below.

PATENTS. United States patents are governed by federal law (35 U.S.C. §101 et. seq.).  Patentable subject matter includes any apparatus, composition of matter, method (including business processes (State Street Bank & Trust v. Signature Financial Group, 149 F.3d 1368, 47 USPQ2d 1596 (Fed. Cir. 1998)) or improvements to the foregoing (35 U.S.C. §101).

An issued patent is not a right to use a patented invention. An issued patent allows the patentee to prevent others from using the patented process or practicing the patented method. 

If the seller’s patents are important to its business and are used to enforce the seller’s rights against its competitors, the seller’s patents and patent applications should be carefully reviewed by buyer’s patent attorneys to evaluate their strength. Although an issued patent is presumed to be valid, many patents are found to be invalid when challenged, and defending a suit challenging the validity of a patent can be very expensive.

Patent applications are filed in the name of their inventor. If an assignment from the inventor to the seller is not recorded in the United States Patent and Trademark Office (the “U.S.P.T.O.”), the inventor is presumed to be the owner. To avoid ownership issues, the buyer should ensure that all assignments have been obtained and that all of the seller’s employees should promptly execute invention assignment agreements. 

Inventions conceived with state or federal research funding or, almost as equally often, university research funding, may be subject to governmental or university rights. If the buyer wishes to exploit intellectual property rights developed with government or university funding, the scope of the government’s or the university’s rights should also be carefully evaluated.

Another issue complicating a transaction with patent owners is joint ownership. For example, sometimes a seller is the joint owner of a patent with another corporation through a joint venture, or a parent spinning off a division may wish to retain joint ownership of a key patent. Whatever the circumstances, if the seller is the joint owner of a patent, it is important for the buyer to understand that each joint owner has an equal and undivided interest in the patent and is free to exploit the patent independently. This may be a significant issue for the buyer in determining the value of the transaction.

TRADEMARKS. In the United States, trademarks are governed both by state (See, e.g., Cal. Bus. & Prof. Code §24200 et. seq.) and federal (15 U.S.C. §1051 et. seq.) statutes and case law. Trademarks may include any word, symbol or device used to identify the source of goods or services. 

Trademark protection is territorial; a trademark registered in the United States does not protect the rights of the registrant in a foreign jurisdiction. Some foreign jurisdictions observe very different legal doctrines from United States law. Common law countries like the United States recognize trademark rights based on use of the mark in connection with goods or services, whereas civil law countries recognize trademark rights based on registration.

In common law countries, the first person to use a trademark to identify specific goods or services can later prevent others from using the same trademark if their use would create confusion in the minds of consumers as to the origin of the goods or services. In civil law countries, the results would be very different: the first person to file a trademark registration has the right to prevent others from using the trademark if it would lead to consumer confusion, even if the other party has been using the trademark to identify its goods and services for years.

In the United States, trademarks do not have an existence independent of the goodwill they symbolize. As a result, trademark licenses must include appropriate quality control provisions or valuable rights may be lost and trademarks may not be effectively transferred or licensed without the goodwill associated with the trademark. 

COPYRIGHTS. In the United States, copyrights are governed by federal law (17 U.S.C. §101 et. seq.). Internationally, the Berne Convention for the Protection of Literary and Artistic Works and the Universal Copyright Convention have been widely adopted. Copyright protection extends to any original work of authorship fixed in a tangible medium of expression (17 U.S.C. §102(a)), and includes the exclusive right (1) to reproduce a copyrighted work, (2) to prepare derivative works based on the copyrighted work, (3) to distribute copies of the copyrighted work, (4) to perform the copyrighted work (e.g., a play), and (5) to display the copyrighted work (e.g., a painting).

Not every expression reduced to tangible form, however, is copyrightable. The United States Supreme Court has held that in order for a work to be protected by United States copyright law, it must be sufficiently original (See Feist Publications v. Rural Tel. Service, 111 S. Ct. 1282 (1991)).

Ordinarily, copyright ownership vests in the author of the work. An exception to this rule arises in “works made for hire,” which are works either prepared by an employee within the scope of his employment or works specially ordered as a work made for hire, and ownership rights which vest in the employer. Buyers need to be particularly cautious when encountering independent contractors who have been hired to develop copyrighted works (for example, custom software) and who may own the copyrights in these works. Buyers should be assured that each independent contractor has executed a work made for hire agreement assigning the copyrights in their work product to the seller.

TRADE SECRETS. In the United States, trade secret protection is largely a matter of state law. Under California law, trade secrets include any information, such as a formula, pattern, compilation, program, device, method, technique or process that (1) derives independent economic value, actual or potential, from not being generally known to the public or to other persons who can obtain economic value from its disclosure or use, and (2) is the subject of efforts that are reasonable under the circumstances to maintain its secrecy (Cal. Com. Code §3426.1(d)). Additionally, federal law makes the misappropriation of trade secrets a federal crime under certain circumstances (18 U.S.C. 1831 et. seq.).

Reasonable efforts must be made to maintain a trade secret’s confidentiality. Trade secret protection can be lost through failure to demonstrate such efforts. Trade secrets do not, however, lose their protection merely because the same trade secret is known by more than one company, provided the secret is not generally known to the public.

Among the procedures a company should observe is the execution of confidentiality agreements with all employees, consultants and outside parties. Confidentiality agreements are common in most technology-based businesses and can be critically important in emerging technology business where technology evolves faster than patent protection can be obtained.

The purchase agreement

REPRESENTATIONS AND WARRANTIES. Buyers and sellers have divergent goals in negotiating and documenting the actual purchase agreement. The buyer’s goal is for the seller’s representations and warranties to address all material issues concerning the seller’s intellectual property assets. The buyer’s objective is to obtain all of the seller’s intellectual property assets necessary to operate the business after the closing. This cannot always be accomplished solely through a purchase agreement and sometimes requires a combination of a purchase agreement with separate agreements providing for transition services and intellectual property rights.

Moreover, the buyer needs assurance that its conduct of the business will not infringe upon or misappropriate the intellectual property rights of third parties after closing and that the seller can validly transfer all necessary rights to use the intellectual property assets necessary to operate the business after the closing. A separate indemnity may be necessary if the scope of a potential liability for intellectual property infringement or good title cannot be ascertained before closing. 

In contrast, the seller needs to distinguish between intellectual property assets that it is selling and the intellectual property assets that it is retaining. Frequently, sellers own intellectual property rights that are necessary for retained business lines as well as the business that is being sold.

If the seller intends to continue to operate a business which relies on intellectual property rights common to the business to be sold, it may need to retain ownership and license the rights to the retained intellectual property to the buyer. 

It is also frequently difficult for the seller to identify which particular intellectual property rights may be implicated in a particular product and so language may need to be crafted to protect the seller’s ability to continue using certain intellectual property rights after the closing. 

DISCLOSURE SCHEDULES. The seller’s schedules should provide all of the information necessary to identify the material intellectual property assets being acquired or excluded, and will need to be reviewed by the buyer carefully to determine how they may impact the seller’s representations and warranties.

Because the schedules are often the seller’s last opportunity to impact the scope of coverage of the representations and warranties it will make in the purchase agreement, sellers often try to include on disclosure schedules broad exceptions from the scope of the negotiated representations and warranties.

COVENANTS AND CLOSING CONDITIONS. To the buyer, the most important covenants of the seller are those that require the seller to fix problems identified in due diligence, obtain necessary consents, address access to intellectual property assets that will not be sold and to continue to operate the business between signing and closing as it has been operated in the past. For the buyer the most important closing condition is that the seller correct any problems that are deal breakers, obtain necessary consents and execute ancillary agreements needed to provide the buyer with the use of all of the intellectual property assets necessary to operate the business after closing. Some particularly difficult problems for the seller to fix before closing may include successfully resolving or settling litigation, executing third party contracts that are material to the merger or acquisition or contracting on favorable terms with suppliers for goods or services after closing.

INDEMNIFICATION. The seller’s general indemnity should apply to the intellectual property specific representations, warranties and covenants and is generally subject to agreed upon time limits, baskets and caps. Typically, the purchase agreement will also include separate indemnification for problems identified during buyer’s due diligence investigation.  Such indemnities are frequently not subject to the general indemnity’s cap and basket, although they are often subject to a time limitation.

Conclusion

Intellectual property assets can have significant value in mergers and acquisitions, and buyers and sellers need to approach these transactions with a strategy to maximize the value of these assets. 

• Louis R. Dienes practices law in Los Angeles, where he counsels investors, businesses and individuals on intellectual property-driven business transactions.

Certification

  • This self-study activity has been approved for Minimum Continuing Legal Education credit by the State Bar of California in the amount of one hour of legal ethics.

  • The State Bar of California certifies that this activity conforms to the standards for approved education activities prescribed by the rules and regulations of the State Bar of California governing minimum continuing legal education.

Self-assessment test

Answer the following true-false statements after reading the MCLE article on Rule of Professional Conduct 2-100. Use the answer form provided to send the test, along with a $20 processing fee, to the State Bar. If you do not receive your certificate within four weeks, call 415-538-2504.

  1. Asset purchases are sometimes more expensive for buyers because they require numerous individual assignments of intellectual property assets, and consents to the assignment of intellectual property assets by secured parties, licensors, licensees and other parties. 


  2. Stock purchases tend to be simpler for buyers because title to all the seller’s assets are transferred with the ownership of the seller and fewer consents are generally required.


  3. In order for a contribution of intellectual property to be a tax-free exchange of property for stock under §351, the rights granted to the contributed intellectual property must be non-exclusive within a defined “field of use” with respect to both third parties and the seller.


  4. An issued patent is a right to use a patented invention. 


  5. Even if a patent assignment from the inventor to the seller is not recorded in the United States Patent and Trademark Office, the seller is presumed to be the owner.   


  6. Inventions conceived with state or federal research funding may be subject to governmental or university rights. 


  7. A trademark registered in the United States protects the rights of the registrant in all common law jurisdictions. 


  8. In civil law countries, the first person to file a trademark registration has the right to prevent others from using the trademark if it would lead to consumer confusion, even if the other party has been using the trademark to identify its goods and services for years.


  9. Trademarks may not be effectively transferred or licensed without the goodwill associated with the trademark


  10. Ownership rights in work made for hire vest in the employee. 


  11. Independent contractors hired by seller may own the copyrights in works created for seller’s use. 


  12. Trade secret protection is largely a matter of state law. 


  13. There are no federal laws protecting trade secrets.


  14. Trade secret protection can be lost through failure to demonstrate reasonable efforts to maintain a trade secret’s confidentiality. 


  15. Trade secrets lose their protection if the same trade secret is known by more than one company.


  16. Among the reasonable procedures a company might follow to protect its trade secrets is requiring employees and consultants to sign confidentiality agreements. 


  17. The buyer’s goal in any transaction is to obtain all of the seller’s intellectual property assets and this can always be accomplished through a well-drafted purchase agreement.


  18. A separate intellectual property infringement indemnity is sometimes necessary if good title cannot be ascertained before closing. 


  19. Seller’s disclosure schedules provide all of the information necessary to identify the material intellectual property assets being acquired by buyer.


  20. Resolving litigation is an unreasonable closing condition.


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