In the corporate world, the phrase “due diligence” is generally used in the same sentence as the word “merger” or “acquisition”, and quite rightly so. Due diligence is the practice of “fact-checking” the representations and warranties set forth in the acquisition documents and/or purchase agreement. It is also a diligent investigation of the acquisition target to make sure no sleeping liabilities are left under the covers.
But due diligence is not inextricably tied to the M&A process. In fact, it should be a routine process in which every company engages for itself, examining its own sleeping liabilities and undiscovered assets. It is, essentially, an organizational process; a method for keeping track of every component of a business entity. Due diligence is a practice that every organization hoping to become an acquisition target should undertake. In conducting routine due diligence, such an organization can keep from appearing like an amoeba, and instead much more like a well-formed entity.
In the context of intellectual property, the duty to perform ongoing IP due diligence is greater now than ever. IP comprises as much as an estimated 80% of corporate value (this has been much debated recently, however). IP laws and norms change almost daily. Nevertheless, IP due diligence is generally left to a last check-the-box on the closing schedule in an acquisition. Why? We are way beyond the story of Volkswagon’s 1998 blundered purchase of the assets of Rolls-Royce Motor Cars Limited. (Yes, they forgot to purchase the trademark.) Mistakes of this kind are now occurring routinely, outside of the M&A context, where companies are neglecting to exercise the very investigatory practices needed to identify, secure, and manage the intangible assets that make up the bulk of their value.
For many corporations, acquisition is the exit strategy. For these companies, IP due diligence can simply be the difference between appearing like an attractive acquisition target and appearing like a cost-consuming operations mess. I have sat through numerous webinars, seminars, meetings, and happy hour discussions where potential private equity and venture capital partners have expressed that they simply want to know that the IP of a target is an advantage and not a risk. If IP due diligence is a routine practice of the target and well documented, that question can be answered in the time it takes to email a spreadsheet. IP is scary to many business persons simply because they don’t understand it. IP due diligence is the very process that helps a company, and others, understand its intangible assets.
Ongoing IP due diligence is not only a practice for benefit, but it is now a practice for compliance. The Sarbanes-Oxley Act and other corporate disclosure requirements have implications on corporate practices dealing with intellectual property. Because intellectual property may hold great value, and this value is directly tied to balance sheet numbers and therefore shareholder value, intellectual property is a financial asset requiring disclosure and reporting. Section 302 of Sarbanes Oxley requires that senior executives be personally responsible for corporate financial reports and other internal processes which control accounting disclosures. Any deficiencies or misrepresentations in these reports can be directly attributable to executives. Therefore, it is important that corporate management stay “in the know” with respect to their company’s assets, including intangible assets. As I have discussed in many posts, valuing intellectual property is never a perfect science, lending even more significance to the role of routine IP due diligence.
Section 404 of Sarbanes Oxley requires corporations to establish and maintain internal processes for identifying and reporting financial assets, including routine publications concerning the efficiency of these processes. A well documented IP due diligence practice can bode well for a company in its attempt to show that it is in compliance with Section 404.
The importance of ongoing IP due diligence was magnified in the most important IP-related case to be decided in the Sixth Circuit in 2009: Cincom Systems, Inc. v. Novelis Corp. In that case, the Sixth Circuit determined that an internal restructuring breached an nonassignable software license and infringed upon the copyright of the licensor, costing the defendant over $400,000 in damages. A well-documented IP due diligence practice could have easily identified the “red herring” in the internal merger and possibly put the defendant on notice to seek modification of the license before executing the internal merger.