Due Diligence in Tech IP Transactions

If you read some of our other articles, you might note that we often discuss some of the dicey relationship between forward-facing entrepreneurs and the oft-overlooked (but nevertheless essential) startup legal work. Namely, start-up entrepreneurs typically are working with a limited financial runway, have never worked with experienced transactional counsel and are focused more on building their product. It’s human nature to prioritize the essential work one is familiar with (e.g., developing the code for software that parses restaurant reviews and performs natural language processing), over the work one is not familiar with, and therefore does not see as essential (e.g., ensuring a former employer doesn’t have an IP claim to code someone wrote in their spare-time, but while still in their employ). This reality means that companies that are acquiring a tech company or product must be aware of the complex issues that should be addressed in due diligence.

Ownership issues are the most common problem in tech deals, and it’s a bad idea to rely solely on a representation and warranty clause as to proper ownership. Indeed, it might seem obvious that a company that has been operating some tech for years owns the underlying IP, but a lack of legal problems might just mean they are overlooked (something that is far less likely to happen when your acquisition is announced in a flashy press release). Essential questions include:

• When was the company formed, and when did development of the IP first begin? If the latter predates the former, you will want to ensure the IP has been assigned to the company.
• Who were the principals who developed the tech? Were any of them employed at any time they worked on their idea? Their employment agreements may contain thorny invention assignment language which could give their former employer a claim to the IP.
• If they outsourced development, what did the agreements look like with those vendors? Strong work-for-hire language is essential, or else the vendor may claim they retain some sort of right of ownership.
• What tech is integrated in the solution? Open source integrations may give rise to questions regarding public disclosures of improvements. Other integrated tech may require a formal licensing agreement.
• Have any employees or principal who worked on the tech left the company? There may be a risk that they will claim they have rights in the IP.

To mitigate risks, it is essential that a company (and its counsel) have a full understanding of the development timeline, requests and reviews all related agreements (employment agreements, licensing agreements, assignment agreements, etc.), and fully review the chain of title recorded with the USPTO.

Should the technology you are acquiring infringe upon any third-party IP rights, you may have bought yourself a lawsuit. As with nearly all legal risk, it may be impossible to eliminate all risk, but it can be easy to limit it. You want to ensure that your counsel is thoroughly examining any actual or potential litigation, and that your agreements have explicit requirements that the IP holder disclose any and all legal issues the tech could have. They may have received a demand letter two years ago, didn’t bother to respond to it, and were not contacted about it since then. But if the claim is still within the statute of limitation, for instance, there is nothing preventing a potential litigant from reassessing that threatened litigation (perhaps deciding it worthy of pursuit when deeper pockets are involved and the technology has been market-proven).

Beyond the litigation the IP holder might now about, it is essential for counsel to do their best to explore potential IP litigation the company knows nothing about. Performing freedom-to-operate (FTO) assessments, usually involving thorough searches for relevant third-party IP, can help evaluate potential infringement suits. Similarly, reviewing the litigation history of relevant patent holders can help assess the probability of litigation.

As mentioned, tech entrepreneurs are often focused on problem-solving and not identifying potential issues such as applicable legal regulations. Data privacy acts, cross-border regulations, and safety regulations may all apply to the target. Chief among these are issues of data privacy, as regulations like the Health Insurance Portability and Accountability Act (HIPAA) and the recent passage of the European General Data Protection Regulation (GDPR) are part of a slew of regulations that can impose strict constraints on the handling of personal data. Non-compliance with these regulations can yield civil and criminal penalties, and significant damages (both economic, and to your reputation).

When performing due diligence, it is essential to hope for the best, but prepare for the worst. It is essential to minimize potential risk, but one must have a contingency plan set up in case risk becomes reality. While the exploration of that topic is well beyond the scope of this article, one closely related solution often employed by our clients is the use of a holdback consideration paired with an indemnification agreement. While an indemnification agreement requires the target IP’s holder to defend and reimburse you in situations where IP ownership was not as represented, if they don’t have money, that indemnification agreement may not be worth the paper it is printed on. A holdback consideration helps mitigate that issue, by structuring consideration payout to occur after important temporal or objective-based benchmarks. By implementing a similar structure, you can help mitigate some of the potential financial fallout.

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