Payoffs for BuyersWho Probe a Target’s Intellectual Property:S crutinizing a target’s intellectual property assets before the deal can help you place a meaningful value on the company and mitigate any risks of litigation.

Have you as a buyer overlooked an intellectual property (IP) risk associated with a target that could or should kill a deal? Are there hidden IP assets that make a target a bargain? Does your technology mesh well with that of your proposed target? Or would wasteful redundancies or magnified gaps result? Are you buying an impending patent infringement lawsuit that could bog down your acquisition? Have you been fooled by a seller’s over-hyping of its technology? The acquirer that stops short of developing precise answers to these critical questions is, at minimum, ill-prepared to gain optimum value from some of the most vital elements in the deal and, at worse, is courting expensive and protracted legal troubles, including litigation. Unfortunately, too many buyers allow the critical information to slip through the cracks. Perfunctory due diligence is given to intellectual property matters often just a hastily prepared schedule of IP assets as well as a list of patents and patent applications, trademarks and trademark applications, copyright registrations, and so forth. Their contribution to value creation and competitive advantage is overlooked. However, the IP assets involved in a transaction might be the most valuable assets acquired. A Brookings Institute study has revealed that two-thirds of the asset value of major corporations is in intangibles. A more recent study of the companies in the Standard & Poor’s 500 indicates that of the $4.6 trillion collective market capitalization of those companies, only $1.2 trillion, or 26%, is attributed to fixed asset value. It is understandable that some corporate executives do not fully appreciate the value of their patents and other intellectual properties. Prior to the early 1980s, patents were viewed primarily as defensive weapons. Companies often amassed patents simply to create a taller stack than that of a challenger. Efforts to assert any particular patent usually resulted in the patent’s being held invalid or unenforceable. However, in 1982, Congress established the Court of Appeals for the Federal Circuit (CAFC) to address all patent appeals from the various federal district courts. The new court quickly adopted a pro-patent stance, and reversed a significant number of lower court decisions adverse to patents. The CAFC has become the de facto “Supreme Court of patents,” and its actions are drastically transforming executive attitudes toward patent assets. Corporations now are realizing that their patent properties can be very potent offensive weapons, and are using them aggressively in licensing and litigating strategies. IBM Corp.’s licensing revenues in 1997 exceeded $1 billion. General Electric Co. and Lucent Technologies Inc. have reported licensing revenues in the half-billion-dollar range. Texas Instruments Inc. reported collecting $800 million in 1995, and a total of more than $4 billion in its licensing activities over the last decade. Early Attention to IP Issues The thoughtful buyer sets up an acquisition strategy that necessarily lays out the business objectives to be achieved by purchasing other companies. If the target is a company rich in patents or other intellectual properties, IP factors must be incorporated immediately into the acquisition strategy and objectives. Implementation of the strategy should begin with an introspective self-assessment in any acquisition to determine what the acquirer needs and how the target can fill these needs and add value. But an objective self-examination is even more important in a technology company acquisition. Cultural Fit It is important, for example, for the buyer have a technology culture that is compatible with that of an acquired company. Thus, the buyer needs an objective self-evaluation of its culture regarding technology. Does the buyer view itself as a technology-driven company with a corporate mission and values focused strongly on development and exploitation of the best possible technology? Or is the buyer more focused on distribution and/or cost factors than on having top technology? If the buyer doesn’t know its own technology culture, the stage may be set for a potentially fatal clash with a target’s technology culture that is radically incompatible. Strategic Advantage If the acquired company’s technology assets are to be assimilated with those of the buyer so the acquisition will be most efficient and effective, the buyer’s own intellectual property assets should be reviewed and cataloged. The buyer will be seeking to identify targets having technology, patent, or brand strengths that offset its technology, patent, or brand weaknesses. In some instances it may be wastefully redundant to acquire a company that has the same strengths and/or weaknesses. The buyer may be looking for a company with high profitability resulting from high margins and large market share. If that is the acquisition objective, it is likely that the search will be confined to companies having strong brands and/or a strong enough patent position to maintain an exclusive position in its core products or product features. An internal review of the buyer’s strengths and weaknesses may lead to a conclusion that it would be less costly to achieve the desired business objectives through internal growth than through acquisition. Thus, an audit of the buyer’s technology and other intellectual property assets could prove to be extremely valuable in the formulation of an acquisition strategy and likely would prove valuable beyond pure acquisition activity. Zeroing-In on Opportunities After the buyer has organized its acquisition team and exposed it to the legalities, processes, and mechanics of an acquisition, it should establish a framework for screening and evaluating target opportunities. If the acquisition is intended to represent a portfolio extension or market entry into an industry that is new to the buyer, a survey of target industries may be conducted. It is important that industry culture and market realities align with the buyer’s mission, values, capabilities, and business objectives. In certain industries e.g., pharmaceuticals, telecommunications, and computers advanced technology is critical. In other industries, new technology may not be highly valued, and buyers may place a premium on proven reliability, quality, and low cost. Pump and motor manufacturing would be examples. If the buyer’s business plan is to generate market leadership, elevated margins, and market share through technology and patents, a company in the latter industry probably is not a good fit with a technology-driven target. If the acquisition is intended to expand the buyer’s holdings in its core business, or to acquire a capability complementary to its core business, it may bypass the industry review step and begin screening targets in its core business industry or industries. Screens Based on IP Elements An evaluation should be conducted of the quality of each target’s essential technologies, assessing, among other things, the current dominance of its technology and whether there is a likelihood that the technology will become rapidly obsolete. An assessment should be made of how the technology of each target meshes with the technology of the buyer. A gap analysis resulting from a comparison of the buyer’s technology with a target’s technology will reveal both redundancies and holes. Inventory of Technology A prospective target’s patent portfolio should be assessed for strength and complementary relationship to the patent portfolio of the buyer. The patents of the prospective targets should be mapped to their products to determine whether the target’s products are or will be protected by its patents. The analysis should be extended to determine whether patents of the buyer may complement the target’s patents in critical areas of technology. Star Players A study should be made of the key innovators at the various potential targets the people whose work make the target worth acquiring. An 80/20 rule seems to apply to innovators within a company 80% or more of the key innovations typically will be made by 20% or less of the engineers and scientists in a given company. These studies should determine whether the key innovators are still with the target and whether they are likely to retire or leave the company in the near future. Loss of key innovators at a high-technology target could cause the target’s technology to quickly descend into mediocrity. The personnel audit could suggest incentive compensation or other programs to motivate the key contributors not only to stay with the company but to continue to aggressively innovate. Behind the Smokescreen A thorough technical due diligence is more critical today than at any time in the past. The author is familiar with a situation in which an acquisition candidate touted that it had a revolutionary way to avoid heavy and expensive shielding conventionally believed to be necessary to render a computer terminal “snoop proof,” that is, free from emitting radiation that could give away the data being processed by the terminal. The purported invention was a simple, discrete circuit element said to suppress radiation from the terminal. After the acquisition, it was determined that the silver-bullet element only met the U.S. government’s specifications against radiation in limited test conditions. To fulfill a contract with the government, the buyer was forced to resort to conventional external shielding, thereby frustrating the core reason for the acquisition. A thorough technology due diligence would have detected the limitations of the so-called revolutionary innovation. Metaphors of Change In the past, many observers contended that buyers held the upper hand in the m&a market because of their ability to gather the significant information affecting a transaction. Historical wisdom doesn’t cut it in acquiring a technology company or a firm that is heavy in intellectual property. A technology concept that promises significant advances in the state of the art and a great source of future value may, at the time of the deal, still be in the head of a mid-level or low-level scientist and not readily available for the acquirer’s review. But a thorough technology audit can reveal such critical concepts and ideas. Freedom to Compete Thought should be given at the screening stage to any problems that might be encountered in integrating the technology and other intellectual properties of the target with those of the buyer. The buyer should make sure that the formalities necessary to ensure the viability of the target’s intellectual properties have been followed, that the target’s products or processes are not the subject of an existing or threatened infringement claim, and that the target has the right to transfer its intellectual properties free of claims by third parties. An evaluation of the competitive situation of the target should be made to ensure that sales of the target’s products and services will continue to be strong or will grow after the acquisition without unexpected interference from competitors. It is far better to identify any defects in a target’s intellectual properties during the screening phase than after the acquisition. It is quite possible that a potential impediment can be removed by a license or cross-license agreement with a third party if the target faces a potential patent or copyright infringement situation or will have problems with a product redesign. Conversely, discovery of a truly serious problem that is hard to resolve may justify dropping a target from consideration. If the screening activity is initiated early enough in the acquisition process, the due diligence effort can produce very valuable information that could not be produced in the short time that a typical eleventh-hour due diligence is conducted. The IP Impact on Price The price of an acquisition depends on the purpose of the acquisition, the nature of the target company, the external economy, and market factors. If the acquirer’s purpose is to buy market share, a review of a target’s business may reveal that its patents, brands, and other intellectual properties are responsible for producing a significant market share. If the purpose is to raise the barriers to entry for potential competitors, then again, it may be the target’s patents, copyrights, or proprietary technology that has created the barriers. Or the purpose of the acquisition may be to reduce the power of competitors or eliminate a competitor. Patents are the chief vehicle for eliminating competitors or reducing their power. Witness Polaroid Corp.’s ability to remove Eastman Kodak Co. from the instant photography market by patent infringement litigation. Polaroid recovered nearly $1 billion from Kodak in money damages and got Kodak enjoined from further instant photography commercial activity. Kodak was forced to dispose of potentially infringing cameras and film and to reimburse purchasers of now-useless Kodak instant photography cameras and film. Buying a low-risk, high-market share, high-profit margin, and predictable business with good cash flow is another reason for acquisition. If that is the goal, it is likely that the target enjoys such favorable financial attributes because of its intellectual properties in the form of strong brands, patents, copyrights, and proprietary technology. Risk Levels at the Target As indicated, one of the risks that could significantly impede future profitability and growth of an acquired business is an existing or potential intellectual property infringement claim. Thus, the ability to reach or exceed the buyer’s financial goals for the acquisition could be very strongly affected by intellectual property considerations within the target and in intellectual property relationships between the target and the buyer. The price that a buyer is willing to pay for a target company often comes down to simply adding up the discounted value of projected future royalty streams. These streams in a technology company acquisition could be largely influenced by intellectual property holdings of the target. To reiterate, intellectual property strengths or weaknesses will play a major role in the future revenues of a target company as a result of the ability or inability of the target to garner abnormally high margins and/or market shares. A buyer with knowledge of a target’s patents and other intellectual property assets thanks to a thorough portfolio analysis may, for example, be able to identify probable royalty streams flowing from the licensing of valuable patents, copyrights, brands, and other IP assets. Conversely, the target’s future royalty streams could be greatly impaired by a weak patent position relative to its competitors.’ Scrutinizing the Risks A competitor may view an acquisition as a threat and attempt to block or derail an acquisition with a patent, trademark, trade secret, or copyright infringement lawsuit. A careful review of the target’s products and processes relative to competitors’ patents and other IP holdings may reveal those risks in time for the buyer to take evasive action. Acquisition documents typically require the seller to indemnify the buyer for any breach of a warranty that acquired products or processes do not and will not infringe the intellectual property rights of a third party. Wise acquirers should not depend on contractual indemnification alone to get full protection in all circumstances. Although an indemnification provision is essential, it may not cover litigation costs, even if the acquirer wins the case. Moreover, the buyer must consider the damage in the form of lost opportunity costs, wasted human resources, and lost profits should another litigant obtain an injunction blocking use of the disputed IP asset. Possibility of these adverse outcomes increase the pressure for a complete review and audit of IP assets which can generate knowledge on a wide range of issues, including negotiation of an appropriate indemnification. Calculating the Rewards When due diligence is applied to a target’s intellectual property assets, the examination may uncover hidden “jewels” that could generate significant licensing revenues and, thus, heavily influence the buyer’s perceived value of the transaction. A primary example is the laptop computer manufacturer that was acquired without apparent knowledge by the purchaser that the target owned a patent covering the basic clamshell construction of a laptop. The buyer discovered the patent many months after the acquisition and instituted an aggressive licensing program which produced an unexpected bounty. Ignorance of the potential windfall at the time of purchase may have worked initially to the buyer’s advantage because it limited the price. But think of the time and value lost because of delays in getting the licensing program going. In many instances, moreover, the unknown assets are never discovered and their value is never realized by the acquirer. State-of-the-Art Screening Techniques Natural language information retrieval and analytics technology customized for IP matters recently has been introduced. The technology and associated methodologies have greatly improved the quality, speed, and effectiveness of pre-transaction capabilities, such as: * Auditing the patent and technology portfolios of client and target companies; * Clustering natural technology hierarchies in large portfolios of patents to facilitate access and analysis; * Using an expedited and “no-training” querying capability to handle conversational language and paste-in queries; * Operating a product clearance system that reduces the exposure to infringement claims based on adversely held patents; * Employing a powerful search engine for identifying potential infringers of a company’s patents; and * Mapping of a client’s or target’s patents to its products and processes. These capabilities and the supporting methodologies make it possible to screen and set strategies faster and more effectively than previous technology. Only the Beginning Technology is driving the future of the global economy. Mergers and acquisitions of technology-based companies are running at a rapid pace and will continue to be strong into the foreseeable future. Since acquisitions of technology companies will continue to be critical to the financial health of the acquirer and target companies, it is imperative that both buyer and seller be fully apprised of the full spectrum of intellectual property considerations that could impact the transaction. As buyers, sellers, and the entire community of firms involved in merger and acquisition activities become more sensitized to the importance of intellectual properties, the true value of IP assets and the important roles they play in transactions will be better accounted for and understood.