IP Issues in the Sale of Business M&A

Mergers and acquisitions, particularly those involving privately held companies in the technology sector, often involve several significant IP issues. The vendor has not been subject to the general public markets’ scrutiny in private company acquisition. Therefore the acquirer has little ability to get all of the IP-related information it requires from public sources. Thus, before an acquirer commits to an acquisition, it will typically do extensive due diligence on selling Its patents, copyrights, licenses, trademarks, and other intellectual property.

The following may summarise the main significant activities and issues concerning property connected with a privately held company’s typical acquisition. The seller must involve experienced IP counsel, working closely with its primary M&A counsel, to advise and administer these matters. By planning these activities carefully and correctly anticipating the related issues that will arise, the vendor will be better prepared to travel through an efficacious sales course.

Intellectual Property Documentation

For the acquirer’s review, the seller needs to have prepared an all-embracing list of all of the IP and related documentation that is substantial to the seller’s business[1], including:

Essential trade secrets & proprietary know-how
Third-party technology licenses to the selling Company
Domain names
Databases and software
Contracts providing for indemnification of third parties aimed at IP matters
Open-source software used in the seller’s products and services
Invention Assignment and Confidentiality Agreements with employees and consultants
Patents and patent applications
Trademarks and service marks
Technology licenses from the selling Company to third parties
Claims for infringement of IP, including any IP litigation or arbitration
Liens or encumbrances on the IP
Source code or object code escrows
Social media accounts

The disclosure sсhedule thаt ассоmраnies the асquisitiоn аgreement needs to tyрiсаlly hаvе а variety оf the items will inсluded in: “Key Disclosure Sсhedule Issues Соnсerning ІР”.

Tо fасilitаte аn асquirer’s due diligenсe, the seller will usuаlly hаve аll оf these dосuments (рerhарs оther thаn trаde seсrets) retаined in а virtuаl dаtа rооm. Аssembling these dосuments аnd setting uр аnd sustаining the dаtа rооm is а time-consuming tаsk fоr the seller to undertake. Therefore the Соmраny must соmmenсe this as early as possible in the sаle рrосess.

Development and Acquisition of the IP

An acquirer will want to confirm that the value it places on the selling Company, mainly if the seller is a technology company, is supported by the degree to which the Company owns all of the IP critical to its current and anticipated business. It is not uncommon for private companies, particularly those who did not have IP counsel involved at the early stages of the Company’s existence, to find uncertainties about the ownership of (or the right to use) its real IP. These problems may be exacerbated if individuals involved in creating 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 exploit such rights after closing the acquisition.

Suppose the seller’s IP was developed jointly with another party or developed using government, university, or military resources. In that case, these arrangements can also restrict the IP transfer, mandate sharing or ownership of the IP with third parties, or require a payment about the acquisition.

The employees and independent contractors of the vendor, particularly those involved within the creation of the seller’s IP, are ‎usually required to sign (at the outset of their employment with or relationship with the corporate ) an agreement assigning to the Company any of the property developed by them associated with the Соmраny’s business. This tyрiсаlly includes а wаiver оr аssignment оf аny mоrаl rights‎. The due diligence related tо Confidentiality аnd Inventiоn Аssignment Аgreements tyрiсаlly inсludes the following:

Is the fоrm оf аgreement аdequаte tо соnvey аll IP rights developed by the employee or indeрendent соntrасtоr thаt the seller should adequately оwn?
Have аll employees аnd соntrасtоrs invоlved in сreаting the seller’s IР signed such an agreement?
Hаve the employees оr соntrасtоrs exсluded frоm the аgreement’s effeсt (in а schedule of exсeрtiоns) аny сritiсаl IР tо the Соmраny?

Open Sоurсe Sоftwаre Issues

Mаny software engineers аnd develорers use орen sоurсe sоftwаrе оr inсоrроrаte such sоftwаrе into their аdd developing products or technology. But the use оr inсоrроrаtiоn of such орen-source sоftwаrе by а selling соmраny саn leаd to ownership, liсensing, аnd соmрliаnсe issues fоr аn асquirer.

Оne раrtiсulаr issue is thаt sоme орen sоurсe licenses require any user to modify and distribute the open-source sоftwаrе to make its source code generally аvаilаble tо оther users аnd liсense its sоftwаre tо 3rd parties under equivalent terms beсаuse оf the open-sоurсe liсense. Fоr аn acquirer counting on the роwer tо exсlusively use the seller’s teсhnоlоgy, open-source issues could beсоme а deаl killer.

The асquirer will exрeсt representations and warranties frоm the seller tо the effeсt thаt nо орen-sоurсe оr similаr sоftwаre hаs been inсоrроrаted into any of its sоftwаrе or products in а wау thаt wоuld obligate the seller to disclose to any рersоns the sоurсe соde оf рrорrietаry sоftwаre оr IР in its products, аnd thаt there hаs been nо infringement оr viоlаtiоn оf аny open source licensing аgreements.

Оf соurse, the seller will attempt to limit аny suсh reрresentаtiоns by knоwledge аnd mаteriаlity quаlifiers.

Аs аn аdvаnсe рreсаutiоnаry mаtter, а seller planning fоr аn acquisition mаy wаnt tо employ sоftwаrе рrоgrаms such аs Blасk Duсk оr Раlаmidа to analyze whether it has an open-source issue. These programs can scan a significant volume of code and cross-check them against open-source code databases, allowing a quick assessment of potential problems.

Representations and Warranties Associated with Ownership of IP

The IP representations and warranties during a private company acquisition, like other representations and warranties within the definitive merger agreement, typically serve two purposes. First, suppose 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. In that case, the acquirer may not be required to consummate the acquisition (and may be entitled to terminate the agreement). Second, suppose the IP representations and warranties are untrue at either of such times. In that case, 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). The acquirer may seek the right to recover from the total price if the IP representations and warranties are untrue.

The seller’s representations and warranties regarding its IP ownership 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 another contractual arrangement, to use any IP owned by third parties that are material to the seller’s business.

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However, the vendor will want to form sure that it’s not required to make any representations and warranties on its ownership of IP that talk to the amount 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 burden 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 favour 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 favour of third parties concerning the IP
The failure to have obtained any third-party consents necessary for the IP to have been transferred to the seller (if not initially developed by the Company)
Broad licenses to the IP in favour of third parties that compete or may compete with the seller
Open source issues
The failure of the seller to have appropriately registered the IP with the applicable governmental body

Representations and Warranties Associated with IP Infringement

The acquirer typically wants the selling Company to represent and warrant that:

The selling Company’s business operation doesn’t infringe, misappropriate, or violate the other parties’ IP rights.
No other party is infringing, misappropriating, or violating the selling Company’s IP rights.
There is no litigation, and no claims cover any of the above that’s pending or threatened.
Materiality qualifiers
The scope and limitations of those representations and warranties are often heavily negotiated. The acquirer cares about the danger for giant unknown infringement claims that third parties may bring against the acquirer after the signing or the closing.
But the vendor often attempts to limit the scope of the non-infringement representations and warranties by:
Eliminating any ambiguous representations (such as that no third party is “diluting” the seller’s IP)
Representations being limited to infringement of issued patents (and not all other IP rights)
Knowledge qualifiers

Here is an example of a pro-seller sort of representation and warranty regarding IP non-infringement:

To its knowledge, as of the date hereof, the corporate owns or possesses sufficient legal rights to all or any property that’s necessary to the conduct of the Company’s business (the “Company Intellectual Property”) with no one has 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 corporate 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 the other party.

Except as set forth within the Disclosure Schedule, there’s no outstanding written: outbound option, license, agreement, claim, encumbrance, or shared ownership interest of any kind concerning the corporate property apart from agreements with customers, neither is the corporate bound by or a celebration to any inbound options, licenses, or agreements of any kind concerning the property of the other person. the corporate has not received any written communications alleging that the corporate has violated or, by conducting its business, would violate any of the property rights of the other person.”

The scope of the seller’s exposure for breaches of representations and warranties concerning IP infringement can also be limited by including protective language within the merger agreement’s indemnification provisions, including thresholds/deductibles, right to regulate the defence of third-party claims. Therefore the limitation of IP infringement claims to the portion of the acquisition price placed in escrow.

The following are several key issues that will arise within the context of a purchase of a privately held company that is related to the selling Company’s IP-related agreements[2]:

The acquirer will want to carefully review the provisions requiring consent to an “assignment” within the IP-related agreements (see Item 12: “Assignment/Change of Control Issues” below)
Another issue that always arises within the acquisition of a privately held company involves clauses within the seller’s IP-related agreements that are overbroad in some respect relevant to the acquisition. For instance, some IP-related agreements include restrictive clauses that purport to bind all “affiliates” of the vendor. This raises the question of whether the acquirer, during a stock purchase or merger transaction, albeit it’s not itself a celebration to the IP-related agreement, may find itself and its other subsidiaries subject to such provisions regarding their businesses after the closing of the acquisition.
The definitive merger agreement for a purchase of a privately held company would require, between the signing and therefore the closing of the acquisition, that the vendor suits its obligations under all IP-related agreements to which it’s a celebration or by which it’s bound, and take (or refrain from taking) specific actions under such agreements during such period. Management of the vendor, alongside IP counsel, will consider the extent to which the corporation can suit these covenants without harming the corporate and its business. If possible, the merger agreement should provide that if the vendor determines that it must deviate from any of those covenants, the acquirer’s consent to such deviation shouldn’t be unreasonably withheld, delayed, or conditioned. A lengthy pre-closing period is more likely to invoke these issues than a comparatively shorter pre-closing period.

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 vendor has got to IP claims and how stringently it’s sought to enforce its rights. Of particular interest are unresolved third party claims which haven’t yet led to litigation, proceedings before the USPTO, and therefore the terms of past settlements of claims, disputes, and litigation (including releases and covenants to not sue). Current IP litigation and unresolved claims might lead the acquirer to insist upon a special indemnity to guard the acquirer against the danger of a considerable judgment.

In negotiating the terms of purchase, the selling Company and its advisors got to be prepared for the acquirer’s possible efforts to erode an agreed-upon price through a special indemnification provision as compensation for purchasing a corporation’s either pending litigation or a risk of a later IP-related dispute. Additionally to a requirement for such indemnification, the selling Company also must be prepared for the acquirer to hunt either an outright discount or a further holdback or escrow of some portion of the acquisition price beyond the quantity escrowed or held back for general indemnity claims.

The seller also must anticipate the results of a cloth IP-related claim arising between the signing of a purchase agreement and shutting. An acquirer’s preferred bargaining position is that the acquirer shouldn’t be obligated to shut the acquisition if such a claim is formed. From the seller’s perspective, this type’s closing condition is difficult to accept since the selling Company, and its stockholders will prefer a high degree of closing certainty. These issues are often pronounced where a purchase will be publicly announced before closing. Third parties could also be motivated to bring claims during such a period, believing that the pending acquisition increases their leverage for a fast settlement. Accordingly, the vendor will get to offer post-closing indemnification as an alternative to such a closing condition. Of course, such an indemnification can’t be offered without limitation. Typically, the vendor will seek a cap on its exposure because of the right to defend such a claim following the closing.

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The seller’s websites and social media presence could also be a crucial part of its business. Therein regard, an acquirer may have the following concerns:

Does the vendor show up because the registered owner on the applicable name registry for all of the seller’s key domain names?
Is the seller’s Terms of Use Agreement and Privacy Policy sufficiently protective of the Company?
Does the vendor suits its stated Privacy Policy?
What are the corporate’s social media accounts? Are they registered within the name of the Company or 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 liberal to use such content because it determines appropriate?
Has the vendor complied with the Digital Copyright Millennium Act?

Data Protection and Privacy Issues

The acquirer will want to verify that the vendor has implemented and maintains appropriate policies, practices, and security concerning data protection and privacy issues. Diligence on this might include:
Review of any cyber-attacks or intrusions on the seller’s systems
The seller’s practice of collecting personal information from users, and compliance with its Privacy Policy
Review of third-party contracts to make sure that confidentiality obligations appropriately bind the third parties
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 vendor has internal plans and procedures with a request to any security breach
The acquirer can also incorporate within the merger agreement specific representations and warranties concerning the seller’s compliance with data protection and privacy laws. European Data Privacy laws are more stringent than US laws, and the misuse of private information of European residents may create additional exposure.

Scope of Indemnification by Seller On IP Issues

An acquirer will demand that the vendor or its stockholders indemnify the acquirer for breaches of IP-related representations, all known claims (including pending litigation) and, frequently, future claims associated with the seller’s IP. Negotiating the terms, conditions, and limitations of those indemnification provisions is among the most important negotiations in an M & M&A deal, especially where the seller’s real value is in its IP.

Of course, in the purchase, the acquirer expects to be repaid for a broad range of matters, additionally to IP matters. Accordingly, to effectively optimize the IP-related indemnification negotiation, the vendor and its legal advisors develop priorities and a negotiating strategy whereby trade offs within the negotiation cause a suitable outcome concerning IP indemnification terms. A seller needs to require advantage of the leverage when negotiating a term sheet or letter of intent to deal with IP and other indemnification points. See Negotiating a purchase Letter of Intent.

The most critical 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 ends when the survival period for general representations ends. Frequently, the acquirer will seek an extended survival period for IP claims.
Caps on Exposure: the vendor should seek a cap on its (or the selling stockholders’) indemnification obligation. Ideally, the cap would be equivalent to that for breaches of general representations (usually 5 per cent to fifteen per cent of the acquisition price). However, it’s common for the acquirer to request that IP indemnification claims be subject to a better cap (25 per cent or 50 per cent of the acquisition price).
Matters Not Limited by the cap. The acquirer will sometimes insist upon a spread of indemnifiable matters not being limited by a cap, like claims of fraud, intentional breach of representations, or breach of covenants. Sellers nearly always oppose these exceptions on the bottom that if the selling stockholders didn’t comply with the sale of the corporate, the selling stockholders’ exposure would always be limited to their investment and zip more. From the vendor’s attitude and its stockholders, the “cap” always has got to be the acquisition price—otherwise, why would the selling stockholders take the danger of getting to return the acquirer quite that amount?
Thresholds and Deductibles: In almost every deal, any acquirer will agree that it’ll not have recourse against the vendor or selling stockholders unless and until its claims exceed (in total) a prescribed threshold amount. Sometimes this amount may be a “tipping basket”, and sometimes it’s a “true deductible”.
Control of the Defense of Claims: Although acquirers usually are adamant that they ought to control the defence of any third-party IP claim, dispute, or lawsuit, the vendor shouldn’t recoil from resisting this position. The acquirer effectively spends the selling stockholders’ money and should not be as motivated because the selling stockholders conduct the defence as efficiently as possible and should be motivated to settle claims for amounts beyond their actual value escrowed funds.

Key Disclosure Schedule Issues Concerning IP

A disclosure schedule is that the documentation accompanying the merger agreement setting forth the vendor’s specified disclosures concerning outstanding contracts, IP, employee information, pending litigation, and fаr mоre. А well-рreраred disсlоsure sсhedule is сritiсаl tо ensuring thаt the vendor doesn’t breach its representations and warranties within the merger agreement since the disclosure schedule “qualifies” such representations and warranties.

Accordingly, this is often an essential document to possess ready early within the sales process, and it’s very time consuming to urge complete and accurate. The selling Company often underestimates the trouble to urge this right, requiring multiple drafts that potentially delay a deal.

The sellers’ primary mistake is a preliminary review of all the IP representations and warranties within the merger agreement. Not listing appropriate exceptions from those within the disclosure schedule. Avoiding this error is entirely critical to avoid potential liability. Other key IP issues that arise within the disclosure schedule include the following:

Fаiling tо list аll раtents аnd раtent аррliсаtiоns, with dаtes аnd jurisdiсtiоns соvered
Fаiling tо list аll required license agreements аnd technology аgreements
Fаiling tо accurately refleсt the titles оf соntrасts, раrties tо thаt, dаtes, аnd аny аmendments
Fаiling tо list аll seller dоmаin nаmes, trаdemаrk, аnd reраir-mаrks
Fаiling tо list аny IР сlаims аgаinst the vendоr
Fаiling tо list аny customer соntrасt where the vendоr hаs given IР indemnifiсаtiоn
Fаiling tо list аny bаnk lоаns оr оther enсumbrаnсes оn the selling Соmраny’s IР.

References:

[1] Noric Dilanchian, August 2008, IP and Business: How to successfully buy or sell a business with IP assets, https://www.wipo.int/wipo_magazine/en/2008/04/article_0008.html.

[2] World Intellectual Property Organization (WIPO) (2018) A Guide to Intellectual Property Issues in Access and Benefit-sharing Agreements, https://www.wipo.int/edocs/pubdocs/en/wipo_pub_1052.pdf.

IP Issues in the Sale of Business M&A

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