IP Issues In Mergers & Acquisitions
Buyers and sellers need to approach M&As with a strategy to maximize
the value of intellectual property assets
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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.
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- 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.
- 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.
- 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.
- An issued patent is a right to use a patented invention.
- 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.
- Inventions conceived with state or federal research funding may be subject
to governmental or university rights.
- A trademark registered in the United States protects the rights of the registrant
in all common law jurisdictions.
- 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.
- Trademarks may not be effectively transferred or licensed without the goodwill
associated with the trademark
- Ownership rights in work made for hire vest in the employee.
- Independent contractors hired by seller may own the copyrights in works
created for seller’s use.
- Trade secret protection is largely a matter of state law.
- There are no federal laws protecting trade secrets.
- Trade secret protection can be lost through failure to demonstrate reasonable
efforts to maintain a trade secret’s confidentiality.
- Trade secrets lose their protection if the same trade secret is known by
more than one company.
- Among the reasonable procedures a company might follow to protect its trade
secrets is requiring employees and consultants to sign confidentiality agreements.
- 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.
- A separate intellectual property infringement indemnity is sometimes necessary
if good title cannot be ascertained before closing.
- Seller’s disclosure schedules provide all of the information necessary
to identify the material intellectual property assets being acquired by buyer.
- Resolving litigation is an unreasonable closing condition.
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