Due diligence in M&A transactions aimed at IP

By Zhao Lihui, East & Concord Partners and Zhang Changdan, Renmin University of China
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At a time when artificial intelligence (AI) is making monumental strides, technology and intellectual property (IP) hold the key to victory in business competition. General legal due diligence for any business entity transaction usually involves a comprehensive investigation into the legal aspects of a target company, including its history, relevant qualifications, material assets and liabilities (including intellectual property assets), external guarantees, material contracts, affiliated relations, tax payments, environmental protection performance, and litigation and/or arbitration.

Zhao Lihui Partner East & Concord Partners
Zhao Lihui
Partner
East & Concord Partners

In due diligence for M&A transactions aiming at IP, experienced investors will separately engage IP counsel to look into such IP-related issues as trademarks, patents, know-how, copyright and trade secrets that an investment project may involve.

They may even hire technical experts to work alongside their IP counsel with regard to key technologies involved. This is critical in technology-intensive investment projects. The following three basic principles should be adhered to at all times when such IP due diligence is being conducted.

LOCAL LEGAL ENVIRONMENT

In M&A transactions aimed at IP, IP due diligence should first focus on the legal environment where target IP assets are located. The right to intellectual property is not a natural right in itself and requires the recognition of local law to be protected in a specific setting. The territoriality or jurisdictionality of law determines that a technology is not equally protected everywhere.

It is noteworthy that the legal environment discussed here encompasses government policy, public opinion, the cultural environment, and predictable changes to local laws. For example, Huawei failed in 2011 in its attempt to acquire 3Leaf’s cloud computing IP assets, in part because it had a limited understanding of the control policy of some developed countries with regard to the transfer or exportation of high technology. The deal by Bain Capital to buy 3Com with minority financing from Huawei also fell through, largely for the same reason.

RISKS OF IP

The investigation into intellectual property itself is a core part of legal due diligence for M&A transactions aiming at IP. Though the technical approach in which the investigation is pursued may vary from one type of IP to another, a legal due diligence investigation should focus on the creation, validity and ownership of IP, and based on this determine: (1) whether the counterparty has lawfully acquired and effectively holds the proposed IP assets; and (2) whether any legal hurdle exists with regard to the buyer’s use of the IP assets being acquired.

Specifically, the investigation should focus on IP application, registration, change, filing, licensing/authorization, transfer and the existence of any lawsuit concerning the IP assets. Special attention should be paid to such IP issues as whether it involves co-ownership and work for hire, or whether any other arrangement concerning the IP assets is made by the counterparty through an agreement.

A failed case was Zhejiang-based Holley Communications Group’s acquisition of 600 CDMA patents from Philips Semiconductors in 2001. Failure to find out the patent cross-licensing agreements between Philips Semiconductors, a division of Royal Philips Electronics, and Qualcomm, a wireless technology company, before the deal resulted in Holley not being able to access the patented CDMA technology that it desired in the first place. Holley still needed to pay licensing fees to Qualcomm if it wished to develop and sell CDMA chips and terminals using the technology it acquired.

The investigation into IP legal risks should be based on the legal environment within the jurisdiction where the IP assets are located, while consideration should also be given to the legal environment of the buyer’s own country, and the country or countries where IP-related technology is to be utilized. In this way, the question of whether IP rights protected in one jurisdiction are also protected in other jurisdictions can be properly answered.

The trend of M&A transactions aiming at IP has moved from horizontal to vertical. This shows that more companies are looking to extend their presence in the industrial chain and optimize technology through mergers and acquisitions. This process is not just about the acquisition or sale of technology. The integration of in-house technology and acquired technology is also essential to achieving M&A goals.

This process consists of three stages: before, during and after an M&A transaction. In stage one (before an M&A transaction), a company should base its selection and evaluation of potential targets on its own IP assets and development strategy. In stage two (during an M&A transaction), the company should carefully look into and compare its own IP assets and the IP assets of the target, based on its existing technology and short- and medium-term goals for technological development, to ensure that the target will be used to its advantage. In stage three (after the conclusion of an M&A transaction), the company should consolidate and absorb the acquired IP assets into its existing IP assets to achieve the M&A goals. In a book the author recommends on the topic, entitled Mergers & Acquisitions Strategy for Consolidations: Roll Up, Roll Out and Innovate for Superior Growth and Results, Norman Hoffmann, a well-known American M&A expert, explains in detail the importance of consolidation for realizing M&A goals.

COMPLEX PROCESS

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Most M&A transactions are a complex process of gaming and balancing of interests. The above-mentioned three principles should be adhered to throughout a due diligence process. An M&A strategy and a detailed action plan should be designed with full consideration given to the specific circumstances, M&A goals and corporate strategy of the acquiring or merging party. Blind mergers and acquisitions may end up a disaster. In addition to IP due diligence, enterprises should listen to what independent technical and financial advisers have to say for added caution.

Zhao Lihui is a partner of East & Concord Partners, and Zhang Changdan is a PhD in civil and commercial law at the Renmin University of China

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