Information-Age Acquisitions: Locking Up Assets Part I: Buyers of information technology companies must determine whether they really own and can use everything they have paid for.

Generally, in the standard merger or acquisition there are two primary objectives of due diligence. The first is to clarify what is being acquired. By placing a meaningful value on a target’s assets, including its technology and human capital, one can estimate what in fact is being purchased. The second goal is to anticipate and mitigate any risks of unwelcome post-closing surprises, such as contentious litigation, loss of competitiveness in the market, or diminution of the company’s value. In the case of information technology (IT) mergers and acquisitions, the added difficulties of assessing the value of intangible assets, ascertaining the future viability of a target’s products, and evaluating human resources all make the due diligence process even more complex. Conducting a thorough audit of a target’s intellectual property, personnel, and technology thus becomes a crucial step in due diligence. In any ordinary m&a transaction, due diligence requires the usual mechanics that go with “kicking the tires” of a target company. An examination of the target’s corporate records and physical assets; written requests for material information; interviews with staff and personnel; industry, product, and market analyses; and inspection of public and press records are all common steps in m&a due diligence. But with IT transactions the existence of intangible assets and a highly dynamic market require that even greater care be taken during due diligence. Indeed, because of the rapidity of market changes and the complexity of 1990s transactions, the diligence team should consist of multidisciplinary experts, from accountants and risk managers to investment bankers and actuarial consultants. Even within the legal realm, the acquirer’s counsel should consist of lawyers specializing in various areas of the law, including environmental, real estate, employee benefits, litigation, tax, and intellectual property. Of all the property to be analyzed, intangible assets present the most unique due diligence considerations. First, the ownership of intellectual property is more difficult to ascertain than is ownership of tangible assets, such as plant and equipment. Second, the value of an intangible intellectual property asset often depends on the ability to protect the asset from disclosure something that is not easy to predict. And, finally, certain intangible intellectual property assets, such as software, have particularly short market lives, thus making them particularly susceptible to changing market dynamics. The evaluation of key personnel is also a major consideration in the due diligence process. Information technology companies, unlike many other organizations, are highly dependent on their employees to create and develop competitive products and services. As part of the due diligence process, managers not only must determine which employees are most essential to the future success of the company but also decide how they will retain only those key employees without hindering the morale of the new company. At the same time, acquiring companies must be aware of other employment issues, such as labor contracts and non-compete clauses. The employees of an IT company and the intellectual property they create are the foundations on which the future success of a merger or acquisition rest. That is why an effective due diligence effort of an IT company must begin with these two cornerstones. An audit of intellectual property should focus on three particular areas of potential risk. First, an audit should analyze the adequacy of intellectual property protection for existing products. Second, it should anticipate claims of intellectual property infringement. Third, it should identify postacquisition opportunities for strengthening intellectual property protection and reducing the acquiring company’s possible exposure to infringement claims. A thorough examination of these risks may reveal critical inadequacies, which may in turn reduce the value of the intellectual property, increasing the risk associated with the merger or acquisition and thereby increasing the costs of the transaction. Such inadequacies also may signal other problems with the target, including ambiguities as to the scope of the target’s rights in an intellectual property asset or uncertainty arising from competing or potentially competing claims to the rights, incident to ownership of these intangible assets. The assets at issue usually are protected by patents, copyrights, trademarks, and trade secrets. Basic Patent Principles In the United States an invention is patentable when, among other requirements, it is deemed to be novel, useful, and nonobvious. Computer hardware and other machines, processes, and articles of manufacture are as a general rule proper subject matter for patent protection. There has been much discussion, and some confusion, however, over whether and when software is patentable. Recently promulgated Patent and Trademark Office (PTO) examination guidelines for computer-related inventions subject software invention claims to a more rigorous patentability analysis than they were before. Data structures representing descriptive material per se or computer programs representing computer listings per se are deemed to be non-statutory “functional descriptive material.” Likewise, certain types of descriptive material, such as music or artwork, which are merely stored so as to be read by a computer but do not impart functionality, are deemed to be non-statutory “nonfunctional descriptive material.” The scope of a patent is defined by the numbered claims found at the end of the patent. Each claim is considered under the law to be a separate invention. The patent owner has the exclusive right to manufacture, use, and sell his or her invention; there is no exception for persons who independently developed the claimed invention. The term of a patent is either 17 years from the date of patent issue or 20 years from the date of application. Validity Analysis In analyzing the ownership of patented intellectual property, one must first evaluate the validity of the patent. Although the issuance of a patent creates a statutory presumption of validity, a challenger who can point to serious defects in a patent may succeed in getting the patent invalidated. Therefore, ownership analysis should examine whether the subject matter, novelty, utility, and nonobviousness requirements of patent law are met. By doing so, the acquirer can assess the potentially infringing character of the patent. While the patent examiner may not have found any prior devices that perform “substantially the same overall function, or work in substantially the same way, to obtain substantially the same overall result,” the existence of such prior devices will undercut the patent’s validity. Essentially, the validity analysis allows potential buyers to anticipate postacquisition claims against acquired patents. The extent to which a buyer should perform this analysis depends, of course, on the nature, scope, and importance of the asset in question. The more crucial the asset is to the transaction, the more effort a buyer should expend in this analysis. Strength Analysis Once the buyer has comfortably verified the patent’s validity, it should analyze the strength of the patent in terms of the scope of the patent owner’s rights and the potential infringer’s liability. The interpretation of the claims stated in the patent determines these rights, and thus the strength of the patent. Most claims will have been drafted narrowly enough to describe the parameters of the invention and satisfy the statutory requirement of specificity, but they must not be “so narrow that they give up what is legitimately the property of the inventor.” Courts in general strictly construe the language used to draft patent claims, so this language should be the focal point of a buyer’s due diligence strength analysis. A more broadly drafted patent may appear to encompass a larger invention, and thus obtain a greater value. But such a patent also is more likely to infringe on elements of prior art or patents and be subject to a greater risk of challenge and in actuality obtain a lesser value. Basic Copyright Principles Copyright protection is available for literary, audio-visual, and other works of expression, including computer firmware, software, documentation, and marketing materials. Importantly, however, ideas, procedures, processes, systems, methods of operation, concepts, principles, and discoveries specifically are excluded from the scope of copyright protection. In recent years, the scope of copyright protection for computer software appears to have eroded. In particular, the copyrightability of user interfaces was seriously questioned by the First U.S. Circuit Court of Appeals’ 1995 decision in the Lotus v. Borland case. Moreover, the scope of protection for “non-literal” elements of computer software, such as the structure, sequence, and organization of a source code, also has been limited in recent years. The U.S. Supreme Court’s 1996 affirmance of the First U.S. Circuit’s decision in Lotus by an equally divided court (Justice John Paul Stevens took no part in the consideration of the case) failed to clarify the law and failed to restore a greater level of protection for user interfaces under copyright law; it did no more than affirm the First U.S. Circuit’s opinion that menu structures can be copied, at least within the First U.S. Circuit, and at least for now. Unlike patent protection, copyrights protect expressive works from the moment they are fixed in a tangible medium of expression. There is no required registration or application process. However, registration of a copyright with the Copyright Office provides the following benefits: * Registration before infringement entitles the owner to statutory damages and attorneys’ fees; * Registration is necessary before filing an infringement suit; and * Registration provides evidence of the ownership of the work at issue. The term of a copyright varies, depending on the circumstances surrounding the work’s creation, from 75 years from the year of first publication, to 100 years from the year of its creation, to the life of the author plus 50 years. Ownership Analysis During the ownership analysis of copyrighted intellectual property, the acquirer’s counsel should seek to uncover (and resolve) any uncertainties in the target’s copyright ownership. These uncertainties may adversely impact the exclusive copyright rights. The rights to reproduce, prepare derivative works from, distribute, perform, and publicly display the copyrighted work may all be in jeopardy. Furthermore, copyright ownership becomes complicated in two basic situations: * When a work consists of material created by several people (joint works) and * When an author creates a work for publication by another, either as an employee or an independent contractor (works for hire). Works also may be characterized as collective works, compilations, or derivative works. Because each of these characterizations can cloud ownership, a buyer’s due diligence must take into account each of these possibilities in order for the acquirer to avoid purchasing a copyrighted asset under the mistaken belief that its ownership is complete and unhindered. Registration, Deposit, and Notice Although copyright protection automatically arises when a work is fixed in a tangible medium, certain remedial rights, including the recovery of statutory damages and attorneys’ fees for infringements that occur prior to registration, can be lost permanently through the failure to register. Because the value of an intellectual property right, like that of any property right, depends on the ability to exclude others from certain beneficial incidents of ownership, the buyer’s due diligence must determine whether registration has been properly affected and, if not, what risks attend to a future attempt to register (e.g., denial of copyright on subject matter grounds). Lack of registration may suggest that the asset to be acquired is not worth as much as the parties to the transaction had anticipated. Incident to the registration procedure is the requirement that two “best editions” of all published copyrighted works be deposited with the Copyright Office. To enforce this rule, the Copyright Office may impose a fine on those who willfully and repeatedly fail to make deposit after a demand is made by the agency. The affixation of notice of copyright to a work serves several functions. It informs the public that the work is copyrighted, identifies the copyright owner, and determines the date on which the work was published (thereby potentially affecting the termination date of copyright protection). Such a notice precludes an infringer from claiming a good-faith defense that he or she committed the infringement innocently by relying on the lack of notice. If a buyer’s due diligence uncovers an imperfection in notice, copyright protection is not lost, and the problem may be cured. Licensing Issues The economic benefits of copyrights in high-technology intellectual property assets often are realized through extensive licensing programs. Computer software manufacturers, for example, grant a license to customers who purchase a copy of their copyrighted programs. Licenses range in complexity from a simple, one-time fee for unlimited use to complex transaction-based or workstation-based fee structures. The expected revenue streams from these licensing agreements can give an acquiring company a realistic grasp on the intrinsic value of these assets. The scope of any license in terms of permitted types of use, duration, renewal rights, relicensing rights, and geographical or other limitations must be examined during due diligence. Not only will the buyer acquire the benefits of copyright ownership but it also will be bound by the terms and conditions of the contractual obligations it assumes. In the case of a merger or acquisition in which the target company is the licensee of a copyrighted intellectual property asset, equal attention must be paid to the grant of rights in the license. Proper due diligence can protect a buyer against the postacquisition surprise that a crucial technology asset no longer will be available after an impending license termination or expiration. Consideration also must be given to the assignability of existing inbound licenses that allow the target to use certain key technologies. If the buyer is to acquire stock of the target, for example, with the intention of assigning one of the target’s licenses to itself, the buyer must seek assurance in advance that the license is in fact assignable. Non-Infringement Analysis Finally, the due diligence copyright analysis should examine the target’s potentially infringing use of technology. A target company commits infringement, even if it does so unintentionally, when it exercises without authorization any of the rights reserved exclusively for another party, namely, the copyright owner. For example, a computer software company, unaware that one of its programmers incorporated a copyrighted computer source code into the company’s software product, commits copyright infringement when it distributes such software to its customers. The commission of copyright infringement exposes the target company to a host of liabilities to the rightful copyright owner. Again, proper due diligence by the acquiring company can uncover such potential liability exposure, enabling the parties to the transaction to assign risks in an informed fashion. Basic Trademark Principles Trademark and unfair competition laws protect the trade identity associated with the goods and services marketed and sold by commercial entities. Ownership of a mark at least with respect to the geographic area of use generally is established in the United States by actual “use” of the mark in connection with the sale of goods and services. Registration of marks with the Patent and Trademark Office, however, provides significant benefits. Trademarks can be classified by the following types: arbitrary or distinctive, suggestive, descriptive, and generic. Generally, distinctive and suggestive marks bear little or no relationship to the actual goods and services, and are entitled to a relatively broad scope of protection. Descriptive marks, which merely describe the goods or services in some fashion, are entitled to protection only when there is proof that the relevant consumers associate the name of the mark with the goods and services provided by the owner of the mark. Generic marks are simply words that signify the associated goods and are entitled to no trademark protection because they have become part of the everyday language. Trademark owners have the right to prevent others from using confusingly similar marks. Although trademarks provide protection for an unlimited length of time, those rights can be diminished, eroded, or lost if they are not enforced. The rapid expansion of the Internet has been marked by an increasing number of disputes over rights to addresses on the World Wide Web. As a result of such disputes, the rules governing the registration of World Wide Web addresses have been modified to protect the interests of trademark owners from the opportunistic appropriation of addresses containing their mark. The recently enacted Federal Trademark Dilution Act provides protection for “famous” names as they may be incorporated into World Wide Web addresses. Thus, a target’s mere registration (with Network Solutions Inc. in the case of World Wide Web addresses) of an address does not guarantee trademark rights in the address. The foregoing analysis, therefore, must not ignore the risk that a target’s use of a particular World Wide Web address may be challenged and later enjoined. Aside from World Wide Web addresses, the Internet, an embodiment of a new market itself, provides a practicable means for counsel to discover potentially infringing use of trademarks. Internet search tools allow counsel, at minimal cost, to identify the questionable use of marks by the target, as well as the questionable use of the target’s marks by other firms. Finally, in today’s increasingly international business arena, differences in trademark protection across borders cannot be overlooked. If a target does business using a mark abroad, protection of the mark in those foreign jurisdictions must be secured. The rules, procedures, and extent of protection for trademarks vary from country to country. Thus, an acquirer engaging in due diligence must examine whether the target’s marks are protected abroad and whether another firm’s use of the mark abroad will prevent the buyer from expanding its business after acquiring the mark. Ownership Analysis Like copyrights, the value of intellectual property assets protected by trademark law depend on the extent to which the acquiring company will be able to enforce its newly acquired rights. Common law ownership in a mark, acquired by actual use of the mark in commerce, is required before federal protection of that mark is available. Federal registration of marks with the Trademark Office affords registrants the opportunity to use federal courts without any other basis of federal jurisdiction, and gives them the statutory right of incontestability. In the case of trademarks that the target uses but has not registered, the buyer’s due diligence must determine the likelihood of successful registration. This analysis must consider a variety of factors impacting registrability, such as: * The mark’s level of distinctiveness (ranging from arbitrary to generic, as described above); * The prior use of the mark or a confusingly similar one by another person; * A later user’s establishment of a strong consumer identification in an area geographically removed from the first user; * The use of geographic designations, surnames, or immoral/offensive meanings in the mark; * The extent to which the mark’s primary purpose is to identify and distinguish goods; and * The mark’s possession of functional attributes. In the case of trademarks previously registered by the target, the buyer’s ownership analysis should focus on the risk of loss of protection of the marks through either abandonment, cancellation, or becoming generic. “Trademark rights…are a function of commercial reality,” according to legal experts in the field. “Thus, just as absence of use is a bar to the acquisition of legal rights, failure to use a mark after the acquisition of legal protection may constitute a bar to continued protection.” An owner who discontinues use of a mark with the intent not to resume use, or who does something that causes the mark to lose its distinctiveness, abandons the mark, which can then be appropriated by another person. Therefore, the buyer’s due diligence must look not only for the target’s nonuse of the mark but also for acts by the target that cause the mark to lose its significance, such as the failure to police it. “Naked licensing,” whereby a registrant authorizes others to use the mark without any regard for either how it is used or with what products it is used, will constitute abandonment. Similarly, failure to control licensees’ use of the mark can effect an abandonment. A diligent examination of the target’s trademark licensing program will prevent a buyer from acquiring a trademark that it cannot protect because of an abandonment. The buyer’s due diligence, with respect to registered marks, also must assess the risk of cancellation prior to engaging in the transaction. A party claiming some kind of right to use the registrant’s mark may seek to cancel the mark’s registration in a cancellation proceeding. Generally, cancellation of a mark must be pursued within five years from the date the mark is registered. A mark can be canceled if its registration was obtained fraudulently or in violation of various provisions of the Lanham Act governing registration. A mark also can be canceled if it is used by the registrant, or used by another with permission of the registrant, so as to misrepresent the source of goods. Certification marks also should be checked. These are marks used “to certify regional or other origin, material, mode of manufacture, quality, accuracy, or other characteristics…or that the work or labor on the goods or services was performed by members of a union or other organization.” They can be canceled if the registrant does not control them or improperly uses them. A review of the target’s distribution agreements and its quality review program is the starting point for this portion of the due diligence. Finally, a mark loses its protection by becoming generic. This occurs when a mark becomes the generic name of goods or services. Trademark owners must undertake programs of protecting their marks against becoming generic by preventing the improper use of their marks in advertising, trade literature, dictionaries, and the press. The acquirer’s due diligence must ascertain the extent of damage suffered by a trademark as a result of its use as a generic term and determine whether the mark remains strong enough to survive a cancellation attack based on its having become generic. As part of the continued due diligence, an examination of the target company’s marketing literature also may reveal whether a mark is susceptible to becoming generic. Such an examination should shed light on the significance and strength of the mark as an origin indicator. Where a trademark distinguishes not on the basis of origin but on the basis of “attributing to the product qualities of consumer preference based on advertising,” its value lies in its goodwill to the owner and the loyalty of its customers. “By investing resources in the mark itself as opposed to the product, the owner is developing a symbol of its reputation.” Examination of the target’s marketing literature is merely one indication of the strength and value of this goodwill. Basic Principles of Trade Secret Law Trade secret law may be used to protect computer software, manufacturing processes, customer lists, and other “formulas, patterns, compilations, programs, devices, methods, techniques, or processes.” To qualify as a trade secret, the item must have economic value because of its secrecy, and the owner must take reasonable steps to maintain its secrecy. Trade secret law is uniform in essence but may vary in particulars from state to state, as well as internationally, although a number of developing countries provide little or no trade secret protection. Owners of trade secrets have the right to prevent other persons from using or transferring the trade secrets without permission. Potentially, trade secrets can last forever, as long as they are kept secret and reasonable steps are taken to preserve their secrecy. Efforts to Maintain Secrecy Central to nearly any formulation of what constitutes a trade secret is the element of secrecy. Failing to satisfy the prerequisite of secrecy for trade secret protection is the easiest pitfall to which a misguided or unguided trade secret owner may succumb. Plainly put, companies seeking trade secret protection for their innovations must keep them secret. This secrecy requirement is relative, however, and not absolute. A proprietor of a business may, without losing trade secret protection, communicate a trade secret to others pledged to secrecy. Rather, it is disclosure that terminates trade secret protection; following publication, a trade secret loses its protected status and becomes available for others to use without fear of legal reprisal from the original possessor. Failure to take reasonable efforts to maintain secrecy will result in the failure of a plaintiff’s trade secret claims. Courts will examine the efforts a plaintiff makes to maintain secrecy of an innovation and will judge those efforts against a standard of reasonableness. The reasonableness of efforts required depends on the value of the innovation and the financial ability of the company to expend resources to maintain secrecy. Thus, a buyer’s due diligence must evaluate the extent of the efforts toward secrecy undertaken by the target, for it is these efforts that the acquiring company will rely on in enforcing its newly acquired trade secret rights. Ideally, a company should take countless steps to insulate trade secrets. It should provide access to sensitive data only on a “need to know” basis to key employees. It should include confidentiality provisions in all employment agreements. And most importantly, it should alert employees to the fact that the employer considers certain information or innovations to be trade secrets. Added security measures, such as dividing secret processes into steps and separating the various departments working on them, using unnamed or coded ingredients, and limiting access to innovations are common ways to prevent disclosure of trade secrets. As the acquirer uncovers more and more precautions taken to protect trade secrets, the value of the secrets themselves may increase. The buyer’s due diligence also should include an examination of employment agreements between the target company and employees to whom it has granted access to high-technology trade secrets. Express contracts binding employees to a contractual duty not to use or disclose a trade secret may broaden the protection otherwise available to an employer; restrictive covenants establish the basis for enjoining the competitive employment of ex-employees who would jeopardize the buyer’s newly acquired trade secrets. By binding its employees with express contracts, however, the target company risks the danger of imposing unreasonable, unenforceable restraints on its employees. Software Protection Computer software presents special problems for trade secret protection because innovative elements of software may embody no more than unprotectable concepts, and because software itself may be legitimately reverse-engineered. Courts facing the question of trade secret protection for computer software have focused on four characteristics, or whether: *”The matter involved is not generally known or readily ascertainable; * It provides a demonstrable competitive advantage; * It was gained at expense to the plaintiff-owner; and * The plaintiff-owner intended to keep it confidential.” The competitive advantage and ownership criteria are readily satisfied by proof of a software product’s market share and proof of the manufacturer’s development efforts. The intention to keep confidential criterion can be satisfied by demonstration of efforts to maintain secrecy. As to the knowledge criterion, at least one court has stated that “[s]ome measure of discovery is required. Mere variations in general processes known in the field which embody no superior advances are not protected. But unique principles, engineering, logic, and coherence in computer software may be accorded trade secret status.” A thorough audit of intellectual property also must consider various miscellaneous issues. A target’s use of independent contractors, for example, must be scrutinized. The use of independent contractors both can cloud copyright ownership and pose a threat to trade secrets. Many states grant employees various invention rights, such as patent “shop rights,” that may impose restrictions on the entitlement that the target can pass to the acquiring company. The target company can convey no more than that which it has. The buyer’s due diligence must uncover any imperfections in assignments or transfers of rights to any intellectual property asset to the target company, and the buyer must become fully aware of all restrictions on the interests it plans to acquire. These issues are best resolved through a complete investigation and documentation of the genealogy of each key intellectual property asset. By determining where, when, and by whom an intellectual property asset was created, and by tracing the exploitation, protection, and transfer of ownership of the asset from the time of its creation through the present, the due diligence team should identify all potentially problematic points in the asset’s history. Focusing attention on these potential problem areas will direct the due diligence team’s attention to the relevant parties, transactions, and events that may threaten the target’s interests in the assets. Only after investigating these leads can the buyer be assured that it will acquire “clean” rights in the assets. In sum, the audit of technology assets and intellectual property protection determines three key issues. First, whether the target company has adequately documented its contractual rights and obligations relating to the exploitation of technology assets. Second, whether the target’s technology assets are protected under one or more areas of intellectual property law. And third, whether the target has infringed on any third-party rights. Beyond The promiseCompanies specializing in information technologyor dependent on top-notch information systems are expensive to buy because they are at or near the cutting edge of modern business. Acquirersshould make sure that the assets they get justify the price. Digging beyond promise and opportunity requires an intensive due diligence investigation that starts with nailing down all ofthe intellectual property being acquired. Are patents properly secured and beyond infringement? Are trademarks being enforced? Dothe assets face obsolescence? The answers may suggest that the assets are not as good aspresumed and are being overvalued. Table 1: Common Patent ProblemsIssue Existence of patentable inventions without patents Patents in prosecution or issued are not relevant toproducts of the target Patents likely are invalid Apportioning invested costs and potential proceedsif patent enforcement litigation is pending Seller refuses to sell its patents Seller only has a nontransferable license or a covenant not to sue from a third party whose patent is otherwise infringed by the seller’s product Key patents expire soon cont’d Strategies and Solutions Begin prosecution of patents if statutory conditions are met and not precluded by time Consider licensing opportunities/value, or exclude from the transaction with reduction in price Affects viability and/or value or the transaction Subject to negotiation Could cripple the transaction unless adequate field of use restrictions are feasible Require the seller, at its expense, to obtain consent to transfer, or a new license/covenant from a third party Determine impact on business of combined company and make a value judgment<\TBL> Table 2: Common Copyright ProblemsIssue Software or other works developed by independent contractors without written rights assignment Unlicensed or unauthorized software being used by target Target “jointly” developed technology with one or more customers cont’d Strategies and Solutions Require the target to obtain assignment Require audit and accounting; settle up with rightful licensers;obtain indemnity or escrow funds Require target to obtain clean assignment; obtain indemnity; deduct value of absent ownership rights<\TBL> Table 3: Common Trademark ProblemsIssue Target failed to register trademarks Target failed to enforce against infringers Target is infringing third-party marks cont’d Strategies and Solutions Often not a serious issue unless compiled with lack of diligence and enforcement, or if a competing registration is discovered Need to assess risk that rights are reduced or waived Assess exposure and establish appropriate indemnity and/or reserves<\TBL>