A
medical devices manufacturer was seeking a large amount of expansion
capital, and the investment looked attractive. The company had received
Food and Drug Administration approval of its diagnostic system, which
would allow it to enter a $1 billion-plus women's health-market
segment. Major distribution agreements were in place.
Attorneys for the potential investor completed due diligence on the
company's intellectual property in the traditional manner and found it
had valid, enforceable patents covering its core technology -- the
diagnostic system. They also completed a product-clearance search and
rendered a favorable freedom-to-operate opinion; the system did not
appear to infringe the patents of others.
But a green light to invest was not in order. A more comprehensive
look at the company's IP position identified significant business
risks. The business plan and financial statements indicated the company
was pursuing a razor-and-blades business model whereby the diagnostic
system would be sold at or near cost and the main source of profit
would be high-margin consumables. Yet there was minimal IP protection
of the consumables or of the way the consumables interacted with the
diagnostic system. Competitors could easily enter the market with
cheaper consumables and take advantage of the company's installed base
of diagnostic systems.
What's more, the company had not filed any additional patent
applications for several years. Interviews with the senior management
team revealed that the founder-CEO -- the main inventor -- was
increasingly occupied with running a growing business. The company had
missed many opportunities to protect technologies valuable to its
future; now competitive patents were blocking its technology road map.
The investor brought these issues to light by taking a strategic
approach to intellectual property due diligence -- linking the
company's intellectual property to its business. That goes well beyond
the legally focused approach many investors and acquirers rely upon,
which is necessary but often not sufficient for making a good
investment decision.
The primary purpose of any due diligence is to obtain sufficient
information regarding the target company -- including its strengths,
weaknesses, and critical business drivers -- to allow an investor to
decide whether to proceed with an investment, and if so, on what terms.
In many cases, the intellectual property of the company is reviewed,
since it, too, is a key asset of the company.
Legal counsel typically performs a due diligence review of the
intellectual property assets of a target company. This very important
review considers issues such as identifying the specific intellectual
property assets, determining their ownership rights, assessing the
breadth of intellectual property coverage, evaluating the validity of
the intellectual property rights and reviewing any licensing rights the
target company grants or bestows. This review is critical to the
success of many deals, and many transactions have either been
terminated or terms have been significantly altered as a result of
lawyers' findings.
Still, this is a tactical review that considers the strengths and
weaknesses of the discrete intellectual property assets, and possibly
the portfolio as a whole. What dealmakers also need to consider is how
the IP assets relate to the business of the target company and the
investment thesis itself. The IP profile of a company is more than just
a portfolio of legal rights to be used as a defensive tool. A strategic
review of intellectual property considers not only whether the target
company has good patents, but more importantly, whether it has the
right ones.
Strategic IP due diligence consists of four key analyses. These
analyses examine how IP is aligned with the target's business
objectives; the strength of the target's IP portfolio; the IP positions
of competitors; and how well the target company manages its
intellectual property. Let's look at each in turn.
1) Assessing intellectual property alignment. This is an
evaluation of whether a company's IP portfolio aligns with or supports
its business objectives -- more specifically, whether it supports the
technological competitive advantages associated with current and future
revenue sources. Assessing the state of alignment can provide valuable
insight as to whether a company has a sound strategy for developing,
managing, and exploiting its intellectual assets. Alternatively, the
assessment may show whether an organization has an ad hoc IP portfolio
that leaves it exposed to competitive risks.
For example, a syndicate of venture capital investors had executed a
term sheet to invest in an early-stage consumer electronics company,
New Co. New Co. had developed an innovative suite of products that
would revolutionize the industry and had already received early
indications of product acceptance. However, it would be three to five
years before meaningful revenue would be generated. So an entry level,
near-term product had been developed that would generate revenue today,
begin to establish New Co.'s brand in the marketplace and establish
distribution partnerships necessary for the successful launch of its
flagship product in the future.
Strategic IP due diligence performed on behalf of the investor
syndicate found substantial opportunities to further enhance the
investors' potential returns. New Co. had adequately protected its
flagship product through several issued patents and pending patent
applications. However, many opportunities for intellectual property
protection were identified across its value chain. By better protecting
the entire value chain rather than just the core product, New Co. could
then strategically leverage its intellectual property portfolio in
agreements with suppliers and distributors. This would lower its cost
basis and provide it with additional competitive advantages.
On a less favorable note, New Co. had no IP protection for its
near-term products and resulting revenue stream, and they were to be
launched into a competitively active patenting environment. There was
no certainty as to what, if any, patent protection New Co. would
receive for its entry-level product.
The upshot was that the syndicate made the investment under revised
terms, providing funding in tranches contingent upon the development of
an IP strategy that addressed both the IP opportunities and risks.
2) Assessing intellectual property strength. Assuming the IP is
aligned with business objectives, is the portfolio also strong? The
strength of a patent (and patents are what we're usually dealing with)
should be assessed in two ways. A legal analysis, conducted by
attorneys, includes an opinion interpreting the issued claims of the
patent and indicating what the patent can reasonably be presumed to
protect, and how well.
This is complemented by a technical strength assessment, which
includes a methodical analysis to determine whether the problem solved
by the patented invention can be solved in any other way. In other
words, how likely is it that a competitor could invent around the
technical embodiments of a company's patent?
For example, Big Co., a large, established consumer products
organization, had agreed to acquire Small Co. on the basis of a
particular consumer product. Big Co. was very interested in this
product because it filled a valuable need in a large and growing
market. Furthermore, Small Co. had indicated that the product was
patent-protected and that it essentially owned the technology space.
Upon completion of a strategic intellectual property due
diligence, it was confirmed that Small Co.'s patent portfolio was
aligned with its business -- the patents clearly protected its
products. However, a detailed evaluation of the patents by engineers
skilled in the relevant technology revealed a significant concern:
Small Co.'s patents protected the exact technical embodiment of the
product down to the number of gears, screws, levers and springs. Small
Co. had successfully executed an intellectual property strategy that
had provided it with the freedom to manufacture and sell its products,
but it did not have the intellectual property protection to stop others
from commercializing similar products.
The story ends badly for the target. Big Co. realized it could
easily invent around Small Co.'s patents, manufacturing a product with
an alternative arrangement of gears, screws, levers and springs, at a
similar cost basis and without sacrificing quality.
Since it could enter the market without incurring the costs of acquiring Small Co., Big Co. ended all acquisition discussions.
Identifying an invent-around doesn't always produce a negative
outcome. Often, an invent-around can be used proactively as the basis
for powerful new patent filings.
3) Assessing competitive intellectual property. The picture's not
complete without a review of competitive IP. This means more than an
examination of patents directly in the prior art that may either read
on the company's products or invalidate its patents.
What's needed here is a comprehensive competitive analysis of the
technology space derived from the patent literature. There are four
main goals: to identify which companies are IP competitors; to
establish trends in the patenting activity; to evaluate what
technologies are being patented; and to determine where along the value
chain patenting activity is taking place.
For example, a large technology company was spinning off a division,
Spin Co., whose technology and products no longer aligned with the
parent's business strategy. Patent counsel had conducted a prior art
assessment with positive results, and patents were applied for based on
Spin Co.'s new technologies.
But a broader analysis revealed some risks. Spin Co. was entering a
heavily patented space with well-capitalized, litigious companies, many
unknown to Spin Co. A positive prior art opinion from legal counsel is
no guarantee against infringement litigation in such a situation. Spin
Co. had no issued patents to bring to such a fight, only pending patent
applications. Realizing that Spin Co. faced a tougher launch than
anticipated, the parent company wisely postponed the spinoff until a
more secure IP position could be established.
Fortunately, several of the previously unknown competitors were also
potential strategic acquirers of Spin Co. By examining the portfolios
of these potential acquirers, Spin Co. was able to develop an
intellectual property strategy that not only aligned with and supported
its own business objectives, but also resulted in a portfolio valuable
to and complementing several of the potential future strategic
acquirers.
4) Assessing intellectual asset management processes. Sound
intellectual asset management processes are critical to the continued
development and strategic use of existing and future intellectual
property. Without them, the pipeline of ideas within a company does not
systematically result in the codification of intellectual assets
(invention disclosures, patents, trade secrets, etc.) that can be
protected, managed and leveraged by executives.
Formal IAM process implementation by an IP-savvy
organization reduces ad hoc IP development and increases the
potentially valuable intellectual assets that get documented, managed
and ultimately monetized. The quality of a company's IAM processes
reflect its ability to protect and commercialize its innovation.
For example, a venture-backed medical devices technology company,
Med Co., had received Series A funding based on FDA approval for its
tissue-engineered medical device. The company had perfected stringent
manufacturing practices to the specifications the FDA demanded. No
changes were planned, because the company wished to avoid any
subsequent FDA review.
Although Med Co. was conducting fundamental research for its
next-generation product, it was no longer pursuing intellectual
property protection of advancements to its current product, which would
help establish additional barriers to entry. Med Co. had no strategy to
guide its intellectual property development or management, had not
documented trade secrets or put in place adequate measures to prevent
their disclosure and was unaware of the competitive patenting
environment.
Even with its limited resources, though, Med Co. was able to develop
a high-level intellectual property strategy and establish basic IAM
processes. Ad hoc, undocumented intellectual capital was translated
into intellectual property supporting the company's business objectives
-- a tremendous source of untapped value.
Private equity investors and corporate dealmakers alike are driven
by their desire to earn above-market returns on investment while
protecting against downside risks. Due diligence allows them to
identify and understand all of the business assets of a target company
and how these assets can be aligned with and support the business
objectives and investment thesis.
Intellectual property is a strategic asset and in many cases
represents a sizable proportion of a company's market value. The
insights derived from strategic intellectual property due diligence
allow investment and M&A professionals to make more informed
decisions, as well as identify areas of opportunity that can improve
returns. - Douglas J. Roth and Michael R. Bielski
Douglas J. Roth (DRoth@ipCG.com)
is a senior manager at ipCapital Group Inc., an intellectual property
strategy consultancy in Williston, Vt. His practice includes work on IP
strategies, transactions and investments. Michael R. Bielski (MBielski@ipCG.com)
is a senior associate at the firm whose practice includes IP due
diligence for private equity investors and work on IP strategies, with
a focus on the life sciences industry.
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