By Richard D. Harroch, David A. Lipkin, and Richard V. Smith
Mergers and acquisitions, particularly those involving privately held companies in the technology sector, often involve a number of significant intellectual property (IP) issues. In a private company acquisition, the seller has not been subject to the scrutiny of the public markets, and the acquirer has little ability to obtain all of the IP-related information it requires from public sources. Thus, before an acquirer will definitely commit to an acquisition, it will typically do extensive due diligence on the selling company’s patents, copyrights, licenses, trademarks, and other intellectual property.
The following is a summary of the most significant activities and issues relating to intellectual property connected with a typical acquisition of a privately held company. It is critical that the seller involve experienced IP counsel, working closely with its primary M&A counsel, to advise on and administer these matters. By planning these activities carefully and properly anticipating the related issues that may arise, the seller will be better prepared to go through a successful sales process.
1. Intellectual Property Documentation
The seller needs to have prepared for the acquirer’s review an extensive list of all of the IP (and related documentation) that is material to the seller’s business, including:
- Patents and patent applications (including patent numbers, jurisdictions covered, filing, registration and issue dates)
- Confidentiality and Invention Assignment Agreements with employees and consultants
- Trademarks and service marks
- Key trade secrets and proprietary know-how
- Technology licenses from third parties to the selling company
- Technology licenses from the selling company to third parties
- Software and databases
- Contracts providing for indemnification of third parties for IP matters
- Open source software used in (or used to create) the seller’s products and services
- Claims for infringement of IP, including any IP litigation or arbitration
- Domain names
- Liens or encumbrances on the IP
- Source code or object code escrows
- Social media accounts (Twitter, Facebook, LinkedIn, etc.)
A variety of these items will typically need to be included in the disclosure schedule that accompanies the acquisition agreement (see Item 13 below: “Key Disclosure Schedule Issues Concerning IP”). To facilitate an acquirer’s due diligence, the seller will usually have all of these documents (perhaps other than trade secrets) housed in a virtual data room. Assembling these documents and setting up and maintaining the data room is a time-consuming task for the seller to undertake, and therefore it is critical that the company undertake this as early as possible in the sale process.
2. Development and Acquisition of the IP
An acquirer will want to confirm that the value it places on the selling company, particularly if the seller is a technology company, is supported by the degree to which the company owns (or has the right to use) all of the IP that is critical to its current and anticipated business. It is not uncommon for private companies, particularly those that did not have IP counsel involved at early stages of the company’s existence, to find that there are uncertainties as to the ownership of (or the right to use) its key IP. These problems may be exacerbated if individuals who were involved in the creation of such IP are no longer with the company (or worse, now work for a competitor). The acquirer will also want to know that the seller will continue to be entitled to exploit such rights after the closing of the acquisition.
If the seller’s IP was developed jointly with another party or developed using government, university, or military resources, these arrangements may also restrict the transfer of the IP, mandate sharing or ownership of the IP with third parties, or require a payment in connection with the acquisition.
The employees and independent contractors of the seller, particularly those involved in the creation of the seller’s IP, are usually required to sign (at the outset of their employment with or relationship with the company) an agreement assigning to the company any of the intellectual property developed by them related to the company’s business. This typically includes a waiver or assignment of any moral rights. See Key Issues Associated with Confidentiality and Invention Assignment Agreements with Employees. The due diligence associated with Confidentiality and Invention Assignment Agreements typically includes the following:
- Is the form of agreement adequate to convey all IP rights developed by the employee or independent contractor that should properly be owned by the seller?
- Have all employees and contractors involved in creating the seller’s IP signed such an agreement?
- Have the employees or contractors excluded from the effect of the agreement (in a schedule of exceptions) any IP that is critical to the company?
3. Open Source Software Issues
Many software engineers and developers use open source software or incorporate such software into their work in developing products or technology. But the use or incorporation of such open source software by a selling company can lead to ownership, licensing, and compliance issues for an acquirer.
One particular issue is that some open source licenses require any user modifying and distributing the open source software to make its source code generally available to other users and to license its software to third parties under the same terms as the open source license. For an acquirer relying on the ability to exclusively use the seller’s technology, open source issues could become a deal killer.
The acquirer will expect representations and warranties from the seller to the effect that no open source or similar software has been incorporated into any of its software or products in a way that would obligate the seller to disclose to any persons the source code of proprietary software or IP in its products, and that there has been no infringement or violation of any open source licensing agreements.
Of course, the seller will attempt to limit any such representations by knowledge and materiality qualifiers.
As an advance precautionary matter, a seller planning for an acquisition may want to employ software programs such as Black Duck or Palamida to analyze whether it has an open source issue. These programs can scan significant volume of code and cross-check them against databases of open source code, allowing a quick assessment of potential problems.
4. Representations and Warranties Related to Ownership of IP
The IP representations and warranties in a private company acquisition, like other representations and warranties in the definitive acquisition agreement, typically serve two purposes. First, if the acquirer learns that the IP representations and warranties were untrue when made (or would be untrue as of the proposed closing date), to a degree of materiality as agreed to in the acquisition agreement, the acquirer may not be required to consummate the acquisition (and may be entitled to terminate the agreement). Second, if the IP representations and warranties are untrue at either of such times, the acquirer may be entitled to be indemnified post-closing for any damages arising from such misrepresentation by the seller. The seller will want to limit this exposure to a small portion of the purchase price (held in escrow by a third party), and the acquirer may seek the right to recover up to the entire purchase price if the IP representations and warranties turn out to be untrue.
The seller’s representations and warranties as to its ownership of IP are among the most significant IP representations and warranties. The acquirer wants comfort that the seller is the sole and exclusive owner of each item of IP purported to be owned by the seller, and that such IP is not subject to any encumbrances or limitations that unduly restrict the seller’s ability to exploit such IP or give third parties rights to such IP that are inappropriate or materially detract from its value. The acquirer will also want to know that the seller has the appropriate right, through a license (exclusive or otherwise) or other contractual arrangement, to use any IP owned by third parties that is material to the seller’s business.
However, the seller will want to ensure that it is not required to make any representations and warranties as to its ownership of IP that speak to the period following the closing, when there may be factors beyond its control (including prior agreements entered into by the acquirer) that limit the right of the seller or the acquirer to exploit the IP.
The following are several examples of matters that may encumber or limit the seller’s ability to exploit its owned IP following the closing of an acquisition:
- Claims by third parties that patents are invalid (as a result of the existence of “prior art” or otherwise)
- Liens on the IP in favor of banks or other lending institutions
- Claims by third parties that the IP infringes their patents or other IP rights
- Inadequate evidence that the employees or contractors who contributed to the creation of the IP assigned their rights in the IP to the seller (see Item 2: “Development and Acquisition of the IP” above)
- Rights of first refusal, exclusivity or similar rights in favor of third parties with respect to the IP
- The failure to have obtained any third-party consents necessary for the IP to have been transferred to the seller (if not originally developed by the company)
- Broad licenses to the IP in favor of third parties that compete or may compete with the seller
- Open source issues (see Item 3: “Open Source Software Issues” above)
- The failure of the seller to have appropriately registered the IP with the applicable governmental body
5. Representations and Warranties Related to IP Infringement
The acquirer typically wants the selling company to represent and warrant that:
- The selling company’s operation of its business does not infringe, misappropriate, or violate any other parties’ IP rights.
- No other party is infringing, misappropriating, or violating the selling company’s IP rights.
- There is no litigation and there are no claims covering any of the above that is pending or threatened.
The scope and limitations of these representations and warranties are often heavily negotiated. The acquirer is concerned about the risk for large unknown infringement claims that third parties may bring against the acquirer after the signing or the closing.
But the seller often attempts to limit the scope of the non-infringement representations and warranties by:
- Materiality qualifiers
- Knowledge qualifiers
- Representations being limited to infringement of issued patents (and not all other IP rights)
- Eliminating any ambiguous representations (such as that no third party is “diluting” the seller’s IP)
Here is an example of a very pro-seller form of representation and warranty regarding IP non-infringement:
“Intellectual Property. To its knowledge, as of the date hereof the Company owns or possesses sufficient legal rights to all Intellectual Property (as defined below) that is necessary to the conduct of the Company’s business (the “Company Intellectual Property”) without any known violation or known infringement of the rights of others. To the Company’s knowledge, as of the date hereof, no product or service marketed or sold by the Company violates any license or infringes any rights to any patents, patent applications, trademarks, trademark applications, service marks, trade names, copyrights, trade secrets, licenses, domain names, mask works, information and proprietary rights and processes (collectively, “Intellectual Property”) of any other party. Except as set forth in the Disclosure Schedule, there is no outstanding written: outbound option, license, agreement, claim, encumbrance, or shared ownership interest of any kind relating to the Company Intellectual Property except for agreements with customers, nor is the Company bound by or a party to any inbound options, licenses, or agreements of any kind with respect to the Intellectual Property of any other person. The Company has not received any written communications alleging that the Company has violated or, by conducting its business, would violate any of the Intellectual Property rights of any other person.”
The scope of the seller’s exposure for breaches of representations and warranties relating to IP infringement can also be limited by including protective language in the indemnification provisions of the acquisition agreement, including thresholds/deductibles, right to control the defense of third-party claims, and the limitation of IP infringement claims to the portion of the purchase price placed in escrow (see Item 10: “Scope of Indemnification by Seller on IP Issues” below).
6. Key Issues Associated with IP-Related Agreements
The following are several key issues that may arise in the context of an acquisition of a privately held company that are associated with the selling company’s IP-related agreements:
- The acquirer will want to carefully review the provisions requiring consent to an “assignment” in the IP-related agreements (see Item 12: “Assignment/Change of Control Issues” below)
- Another issue that often arises in the acquisition of a privately held company involves clauses in the seller’s IP-related agreements that are overbroad in some respect relevant to the acquisition. For example, some IP-related agreements include restrictive clauses that purport to bind all “affiliates” of the seller. This raises the question of whether the acquirer in a stock purchase or merger transaction, even though it is not itself a party to the IP-related agreement, may find itself and its other subsidiaries subject to such provisions with respect to their own businesses after the closing of the acquisition.
- The definitive acquisition agreement for an acquisition of a privately held company will require, between the signing and the closing of the acquisition, that the seller comply with its obligations under all IP-related agreements to which it is a party or by which it is bound, and take (or refrain from taking) certain actions under such agreements during such period. Management of the seller, together with IP counsel, will need to consider the extent to which the company can comply with these covenants without harming the company and its business. If possible, the acquisition agreement should provide that if the seller determines that it must deviate from any of these covenants, the consent of the acquirer to such deviation should not be unreasonably withheld, delayed, or conditioned. A lengthy pre-closing period is more likely to invoke these issues than a relatively shorter pre-closing period.
7. IP-Related Disputes
An acquirer will undertake a careful review of the seller’s involvement in any current or past IP litigation or other disputes. This review can involve discovering any exposure the seller has to IP claims and how stringently it has sought to enforce its rights. Of particular interest are unresolved third party claims which have not yet led to litigation, proceedings before the USPTO, and the terms of past settlements of claims, disputes, and litigation (including releases and covenants not to sue). Current IP litigation as well as unresolved claims might lead the acquirer to insist upon a special indemnity to protect the acquirer from the risk of a substantial judgement.
In negotiating the terms of an acquisition, the selling company and its advisors need to be prepared for possible efforts by the acquirer to erode an agreed-upon purchase price through a special indemnification provision as compensation for buying a company where there is either pending litigation or a risk of a later IP-related dispute. In addition to a demand for such indemnification, the selling company also needs to be prepared for the acquirer to seek either an outright price reduction or an additional holdback or escrow of some portion of the purchase price beyond the amount escrowed or held back for general indemnity claims.
The seller also needs to anticipate the consequences of a material IP-related claim arising between the signing of an acquisition agreement and closing. An acquirer’s preferred bargaining position is that the acquirer should not be obligated to close the acquisition if such a claim is made. From the seller’s perspective, a closing condition of this kind is difficult to accept since the selling company and its stockholders will prefer a high degree of certainty of closing. These issues can be pronounced where an acquisition will be publicly announced before closing, since third parties may be motivated to bring claims during such period, believing that the pending acquisition increases their leverage for a quick settlement. Accordingly, the seller will need to offer post-closing indemnification as an alternative to such a closing condition. Of course, such an indemnification cannot be offered without limitation: typically, the seller will seek a cap on its exposure as well as the right to defend such a claim following the closing.
8. Websites and Social Media
The seller’s websites and social media presence may be an important part of its business. In that regard, an acquirer may have the following concerns:
- Does the seller show up as the registered owner on the applicable domain name registry, for all of the key domain names of the seller?
- What are the company’s social media accounts? Are they registered in the name of the company or in the name of an employee or consultant?
- Are there any issues with users uploading content or adding comments to the company’s websites or social media accounts?
- Who owns the content posted to the company’s websites or social media accounts? Is the company free to use such content as it determines appropriate?
- Has the seller complied with the Digital Copyright Millennium Act?
9. Data Protection and Privacy Issues
The acquirer will want to confirm that the seller has implemented and maintains appropriate policies, practices, and security concerning data protection and privacy issues. Diligence on this may include:
- Review of any cyber-attacks or intrusions on the seller’s systems
- Review of third-party contracts to ensure that the third parties are appropriately bound by confidentiality obligations
- Review of any claims or complaints involving privacy or data breaches
- Review of the seller’s IT business continuity plan
- Review of the seller’s security guidelines in hiring personnel, including whether background checks, drug tests, credit checks, or other screening processes are undertaken
- Confirmation of whether the seller has internal plans and procedures with request to any security breach
The acquirer may also want to include in the acquisition agreement specific representations and warranties relating to the seller’s compliance with data protection and privacy laws. In particular, European Data Privacy laws are more stringent than U.S. laws and misuse of personal information of European residents may create additional exposure.
10. Scope of Indemnification by Seller on IP Issues
An acquirer will demand that the seller or its stockholders indemnify the acquirer for breaches of IP-related representations, all known claims (including pending litigation) and, frequently, future claims related to the seller’s IP. Negotiating the terms, conditions, and limitations of these indemnification provisions is one of the most important negotiations in an M&A deal, especially where the seller’s real value is in its IP.
Of course, in an acquisition the acquirer expects to be indemnified for a broad range of matters in addition to IP matters. Accordingly, in order to effectively optimize a negotiation of the IP-related indemnification, the seller and its legal advisors need to develop priorities and a negotiating strategy whereby tradeoffs in the negotiation lead to an acceptable outcome with respect to IP indemnification terms. It is especially important for a seller to take advantage of the leverage it has when negotiating a term sheet or letter of intent to address IP and other indemnification points. See Negotiating an Acquisition Letter of Intent.
The most important indemnification points are:
- Scope and Survival of Indemnification: The selling company should seek to limit indemnification to breaches of IP representations and have the indemnification obligation end when the survival period for general representations ends. Frequently, the acquirer will seek a longer survival period for IP claims.
- Caps on Exposure: The seller should seek a cap on its (or the selling stockholders’) indemnification obligation. Ideally, the cap would be the same as that for breaches of general representations (usually 5% to 15% of the purchase price), although it is common for the acquirer to request that IP indemnification claims be subject to a higher cap (for example, 25% or 50% of the purchase price).
- Matters Not Limited by the Cap. The acquirer will sometimes insist upon a variety of indemnifiable matters not being limited by a cap, such as claims of fraud, intentional breach of representations, or breach of covenants. Sellers almost always oppose these exceptions on the ground that if the selling stockholders did not agree to the sale of the company, the selling stockholders’ exposure would always be limited to their investment and nothing more. From the perspective of the seller and its stockholders, the “cap” always has to be the purchase price—otherwise, why would the selling stockholders take the risk of having to return to the acquirer more than that amount?
- Thresholds and Deductibles: In almost every deal, an acquirer will agree that it will not have recourse against the seller or selling stockholders unless and until its claims exceed (in total) an agreed upon threshold amount (e.g., 1.0% of the purchase price). Sometimes this amount is a “tipping basket” (once the amount is exceeded, the acquirer is entitled to be indemnified for all damages, back to the first dollar), and sometimes it is a “true deductible” (the indemnity is limited to amounts over the threshold).
- Control of the Defense of Claims: Although acquirers usually are adamant that they should control the defense of any third-party IP claim, dispute, or lawsuit, the seller should not shy away from resisting this position. The acquirer is effectively spending the selling stockholders’ money and may not be as motivated as the selling stockholders to conduct the defense as efficiently as possible, and may be motivated to settle claims for amounts beyond their true value out of the escrowed funds.
11. Disclaimers by the Seller
One of the most significant claims that an unhappy acquirer can make against a seller is that the seller committed fraud. An acquirer may complain that information provided to it in due diligence sessions with management or documents made available in a data room were false or misleading. Unfortunately, if buyer’s remorse sets in, it’s all too easy for an acquirer’s lawyer to launch a lawsuit which includes an allegation of fraud, no matter how clean a seller’s business might have been or no matter how meritless the claim really is.
Recognizing that post-closing lawsuits are brought from time to time by unhappy acquirers (as opposed to acquirers truly harmed by seller misconduct), sellers are well advised to implement some important precautions which have been sanctioned by the courts:
- First, make sure that the acquisition agreement includes an express disclaimer made by the seller and acknowledged by the acquirer that the seller is only making the representations and warranties set forth in the acquisition agreement. In particular, the seller should disclaim making any representations or warranties as to any projections, forecasts, or possible future operating results.
- Second, the acquirer should expressly state in the acquisition agreement that it has conducted its own investigation of the business of the seller and is not relying upon any representation or warranty of the seller (or any of its officers, employees, or advisors) other than those set forth in the acquisition agreement.
Here is an example of a disclaimer that the Delaware court in Abry Partners V, L.P. v. F&W Acquisition LLC deemed enforceable:
“Acquirer acknowledges and agrees that neither the Company nor the Selling Stockholder has made any representation or warranty, expressed or implied, as to the Company or any Company Subsidiary or as to the accuracy or completeness of any information regarding the Company or any Company Subsidiary furnished or made available to Acquiror and its representatives, except as expressly set forth in this Agreement … and neither the Company nor the Selling Stockholder shall have or be subject to any liability to Acquiror or any other Person resulting from the distribution to Acquiror, or Acquiror’s use or reliance on, any such information or any information, documents, or material made available to acquirer in any “data rooms,” “virtual data rooms,” management presentations, or in any other form in expectation of or in connection with, the transactions contemplated hereby.”
Further, sellers are well advised to define exactly what is meant by the term “fraud.” Without limiting the scope of this term, a seller might have exposure beyond customary notions of “actual fraud” (such as liability for reckless statements, constructive fraud, or even statements not relied upon by the acquirer). In this regard, a seller should consider defining “fraud” consistent with typical state law definitions:
“ ‘Fraud’ means actual fraud under [Delaware] law (including the requisite elements of (A) false representation, (B) knowledge or belief that the representation was false when made (i.e., scienter), (C) intention to induce the claimant to act or refrain from acting, (D) the claimant’s action or inaction was taken in justifiable reliance upon the representation and (E) the claimant was damaged by such reliance and as established by the standard of proof applicable to such actual fraud).”
With clauses of this kind in the acquisition agreement, the seller will reduce the chances that an acquirer having second thoughts about the business that it acquired will prevail in alleging that it was misled into buying by the seller.
12. Assignment/Change of Control Issues
IP licenses and other IP-related agreements typically contain provisions requiring the consent of the other party to a change of control of the selling company or an assignment of the agreement by the selling company. The extent to which such consent is required frequently turns on the structure of the acquisition transaction. Almost always, an asset sale structure will require third-party consent. In contrast, whether third-party consent is required for a sale of stock of the selling company, or a merger involving the selling company, will require a careful review of the contract language as well the relevant case law.
Failure to obtain a required consent might result in breach of the IP license or other IP-related agreement by the selling company. Consequently, an acquirer will require the selling company to represent in the acquisition agreement whether the transaction requires any such consents. Further, an acquirer will seek to have closing conditioned upon receipt of the most important consents and, further, might seek indemnification if failure to obtain a material required consent will result in a loss of the IP license or related IP agreement.
Given these possible consequences, a seller and its counsel will need to thoroughly review the “anti-assignment provisions” included in all of the selling company’s IP licenses and other IP-related agreements. In addition, the seller will need to consider which transaction structure poses the least risk to the selling stockholders if such consent cannot be easily obtained at no significant cost to the seller.
For example, a stock purchase or merger structure may be preferable to an asset purchase if the seller’s agreements with third parties require consent to an “assignment” of the IP but not to a “change of control” of the seller. In a stock purchase or a transaction structured as a “reverse triangular merger,” there is typically no “assignment” of the IP assets, but still there may be third-party rights triggered by the “change of control” inherent in such a transaction.
If the seller has key IP that is only transferable to the acquirer with the consent of third parties, the seller may wish to obtain such consent prior to entering into the definitive acquisition agreement. However, the effort to obtain such consent necessarily requires disclosure of the proposed acquisition to a third party, invoking issues of confidentiality. The failure to obtain such consent prior to signing the acquisition agreement may result in the seller running the risk that the transaction may ultimately fail if the third party later refuses to grant its consent. Moreover, the third party may require the payment of a fee, or may demand material changes to its IP agreements with the seller, as the price for granting its consent.
13. Key Disclosure Schedule Issues Concerning IP
A disclosure schedule is the document accompanying the acquisition agreement setting forth the required disclosures of the seller concerning outstanding contracts, IP, employee information, pending litigation, and much more. A well-prepared disclosure schedule is critical to ensuring that the seller does not breach its representations and warranties in the acquisition agreement, since the disclosure schedule “qualifies” such representations and warranties.
Accordingly, this is an extremely important document to have ready early in the sales process, and it is very time consuming to get complete and accurate. Very commonly, the selling company underestimates the effort to get this right, requiring multiple drafts that potentially delay a deal.
The primary mistake made by sellers is an inadequate review of all the IP representations and warranties in the acquisition agreement, and then not listing appropriate exceptions from those in the disclosure schedule. Avoiding this mistake is absolutely critical to avoid potential liability. Other key IP issues that arise in the disclosure schedule include the following:
- Failing to list all patents and patent applications, with dates and jurisdictions covered
- Failing to list all required license agreements and technology agreements
- Failing to accurately reflect the titles of contracts, parties thereto, dates, and any amendments
- Failing to list all seller domain names, trademark, and service marks
- Failing to list any IP claims against the seller
- Failing to list any customer contracts where the seller has given IP indemnification
- Failing to list any bank loans or other encumbrances on the selling company’s IP
For related articles, see:
Richard D. Harroch is a Managing Director and Global Head of M&A at VantagePoint Capital Partners. He has been involved in over 200 M&A transactions.
David A. Lipkin is a partner in the Corporate Department at the law firm of Morrison & Foerster LLP in Palo Alto and San Francisco, Calif., specializing in mergers and acquisitions.
Richard V. Smith is a partner in the Mergers and Acquisitions and Private Equity Group of Orrick, Herrington & Sutcliffe, resident the firm’s San Francisco and Menlo Park Offices and specializing in mergers and acquisitions.
Copyright © by Richard D. Harroch. All Rights Reserved.