Intellectual Property Issues in Corporate Finance Transactions

A Corporate Lawyer’s Perspective

David Kern Peteler, Peteler Law Office

Intellectual property issues are important in many types of corporate transactions, and particularly in financing and mergers and acquisitions transactions. With the IP portfolio of a company seeking to close such a transaction (the “Target”) often comprising a significant portion of the Target’s value, due diligence and proper legal attention to IP issues are critical to a transaction.

In 2014 I had the pleasure of working with IP counsel on two corporate finance transactions, specifically two private placements, in which the IP portfolio of the Target was an important deal term. Through a good understanding of each other’s needs and concerns, we were able to close the two financings smoothly.

My goal in this brief article is to give IP lawyers a brief idea of how the corporate lawyers view these transactions, and give corporate lawyers a brief lesson in IP due diligence, so the attorneys can work more efficiently with each other to close a transaction.

A. Goals of IP Review and Due Diligence

In financing and acquisition transactions involving public companies, the buyer or financier tends to rely on SEC filings, so the IP due diligence process is more streamlined. In a private company transaction, IP due diligence takes on greater importance, and careful drafting of the applicable provisions (such as representations and warranties, indemnities, and limitations on liability) becomes more important. A potential private financing, merger or acquisition transaction requires at a minimum an understanding of the overall goals and process of the transaction as well as a solid due diligence review of the Target’s IP. From the point of view of the buyer and financiers, the assessment of the IP portfolio of the Target is important for at least these reasons:

1. Identifying the IP assets to see if they constitute what is desired or needed out of the transaction;
2. Identifying IP liabilities and exposure in closing the transaction;
3. Identifying IP obstacles to the transaction in advance, to allow time for mitigation prior to closing; and
4. Validating the business case and projected economics of the transaction.

B. The Transaction Process

To give the IP lawyer a sense of context and the process of a transaction of the kind discussed in this article, from the corporate finance lawyer’s point of view the transaction will general have four phases:

1. Preliminary Negotiations and Term Sheet. A Term Sheet (or Deal Memo, or Letter of Intent) sets out the major terms of the deal, after preliminary negotiations by the principals. The Term Sheet generally includes the structure of the deal (stock purchase, merger, asset acquisition); the key assets of interest; the price and economics; and a general statement that “this is subject to negotiation of final documentation, containing provisions that are standard for this type of transaction, and acceptable by counsel for both parties.”

2. Due Diligence. Counsel for the buyer or financier will typically start the due diligence process by sending Target’s counsel a due diligence request list, stating the information and documents sought prior to completing the transaction. Due diligence request lists are frequently updated and additional requests are made as the due diligence process goes on.

3. Drafting the Final Agreement. Usually during the due diligence process, counsel will begin drafting the transaction agreements. These will be revised and honed as the due diligence process brings IP issues to light, and as the business negotiations are completed. Typically this will culminate in a set of transaction documents that will be signed, though the closing will not occur until certain conditions have been completed after signing. There may be post-closing obligations as well. While the corporate lawyer will draft the basic agreement, the IP lawyer will play a critical role in due diligence, identifying IP risks, preparing IP schedules, and co-drafting important IP–related provisions.

4. Closing. The transaction agreements will define the conditions that must be completed before the transaction is “Closed.” Typically money and assets or stock change hands at this time, although there may be post-closing conditions and obligations that must be complied with. Sometimes the signing and the Closing are simultaneous.

Since the due diligence process is critical to finalizing the transaction agreements and closing the transaction, it is important to know what due diligence is typically done in such a transaction. The specific items to be reviewed will change with the context and complexity of the transaction, and industry segment of the Target, but should include at least the basics listed below.

C. Basic Issues of IP Due Diligence

1. Ownership. Establishing that the Target has ownership or valid licenses to the IP is the obvious starting point. This process includes review of the underlying documents. Buyer’s or financier’s counsel will require representations and warranties regarding ownership from the Target. In many cases, a memo or opinion letter from IP counsel will be very important, if not required by the buyer or financier, particularly if the Target owns or licenses IP registered in foreign countries. Both P and corporate counsel should expect the need for at least four schedules: a schedule of the Target’s patents and patent registrations; a schedule of the Target’s trademarks and trademark registrations; a schedule of the Target’s copyrights and copyright registrations; and a schedule of IP that the Target licenses from other parties. Other schedules, such as foreign design registrations, mask work registrations, and internet domain name registrations (not technically IP rights but often included in IP schedules) may also be appropriate. Problems may arise in the case of unregistered IP; the Target may wish to exclude it from a schedule of owned IP, because of the difficulties of proving ownership.

2. Sufficient IP For The Target’s Business. The buyer or financier will want to be sure that the IP listed on the schedules is sufficient for the Target to conduct its business as currently operated and as planned to be operated as described in any private placement memorandum, business plan or other disclosure document (“Disclosure Documents”) provided to the buyer or financier as part of the transaction. If it is not sufficient, the Target will likely need to describe its plan for developing or obtaining the necessary IP.

3. Liens and Encumbrances. If there are liens or security interest on IP assets, they should be identified, and mitigated if possible. Security interests in IP may be filed in the USPTO or the US Copyright Office, and may also be filed as part of a UCC-1 filing. Judgment liens are another item to check.

4. Infringement. IP infringement litigation is costly and to be avoided if possible. For buyers and financiers, an IP infringement risk may be a deal breaker. Counsel will be concerned with:

a. Infringement by the Target of third party IP rights. Due diligence on this topic includes patent searches (which are expensive and may be worked around), interviewing the Target officers to see if they are aware of infringement on third party IP rights, such as communications from third parties alleging infringement, law suites threatened or filed, and letters from patent or other IP counsel discussing potential infringement issues.

b. Infringement of Target IP by third parties. Whether or not the Target chooses to take action against a third party infringer, the infringement should be disclosed.

5. IP Agreements. If the Target has any IP agreements, including licenses granted by the Target of the Target’s IP as well as licenses the Target has obtained to use another’s IP, counsel will want to consider several issues, including: (i) confirmation of ownership of the IP at issue; (ii) the scope of the license and use rights, and whether it is sufficient for the intended purpose or need; (iii) exclusivity, non-exclusivity or other restrictions on the IP rights; (iv) ongoing warranty obligations that the Target may need to fulfill and potential costs; (v) appropriate indemnification provisions; (vi) confidentiality provisions; (vii) termination provisions; (viii) change of control provisions; and (ix) whether there are any restrictions on sale or assignment of the IP agreement, and how to comply with those restrictions.

6. Royalties. A critical aspect of the Target’s IP agreements is any royalty, commission or similar obligations, including (i) amount and duration, (ii) whether the payment obligations current, (iii) whether the payment obligations are subject to change, and (iv) whether they have been properly included in the target’s financial statements and projections, and hence the transaction price.

7. Source Code.

a. Target Ownership of Source Code. The old gold standard was for a Target to own its own source code. This is still desirable, as ownership allows the Target to continue to develop its software, or incorporate its software into other software, creates barriers to entry, and also removes much doubt from potential infringement actions. If the Target owns it source code, counsel will want to determine of any source code is held in escrow, and what the terms of the escrow are.

b. Open Source Software. In recent years, open source software has become the new standard of development. For open source software, the buyer or financier will want to know all the licenses applicable to the open source software. IP counsel should expect to prepare a schedule of the applicable open-source licenses and copies of those licenses.

8. Employee Agreements. All employees, and independent contractors to the extent possible, should, at the time of their engagement, be required to execute a written IP agreement, assigning to the Target all IP they create during their employment or within the scope of their consulting agreement. If this was not done at the time the employees or contractors were engaged, the problem will need to be remedied before closing. Employees and consultants should also sign written confidentiality and non-disclosure agreements that will protect the IP. These agreements should also contain prohibitions on use of the Target’s IP and trade secrets by employees or consultants post-termination; this is particularly important in jurisdictions such as California, where covenants not to compete are not favored.

9. Transfer Issues. Counsel should consider the form of the transaction and the applicable IP transfer requirements. Generally, in a purchase of the Target’s stock, the Target survives and there is no assignment of the IP assets. In a forward merger, the Target ceases to exist, and hence the IP will be assigned. In a reverse triangular merger, since the Target survives as an entity, the question of whether an assignment of the IP assets has occurred must be reviewed under state law. In an asset purchase transaction, issues of valid transfer of the IP elements must be identified and resolved. For example, an intent-to-use trademark applications cannot be assigned until the USPTO has received evidence that the applicant is using the mark in US commerce, subject to certain exceptions. If an IP license is silent on assignment, exclusive licenses are generally assignable by the licensee without the licensor’s consent, but non-exclusive licenses are not; again state law must be consulted.

10. Privacy and Data Security. The buyer or financier will be concerned with whether the Target maintains adequate internal policies regarding collection, use and protection of personal information.

D. Conclusion

This article is intended to give both the IP lawyer and the corporate finance lawyer a basic understanding of the issues involved, and the transactional context in which these issues arise; and provides a non- exhaustive list of factors to be considered in a financing, merger or acquisition transaction involving IP assets. There are many other potential issues on both the corporate and IP side, which can be complex, and all such transactions require the joint cooperation of experienced IP and corporate counsel. It is hoped that, based on this background information, both IP and corporate counsel will be able to work better together to perform due diligence, negotiate, draft, and to close these transactions quickly and efficiently.

About Peteler Law Office

The Peteler Law Office, with offices in California and Minnesota, provides corporate and finance law service to tech companies in the start-up, financing, M&A and operating aspects of their businesses. David Kern Peteler, founder and principal, has over 30 years of experience in the high tech and corporate finance area, starting in Silicon Valley in the early 1980s. For more information, see, e-mail Mr. Peteler at, or call 310.933.5000 (California) or 952.300.6700 (Minnesota).

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