Clifford Chance

Assessing the value of intellectual property as an asset class is essential in private equity transactions. Understanding the risks associated with developing and maintaining IP can significantly influence investment decisions.

When it comes to PE transactions, the value of the intellectual property (IP) assets can significantly impact the structure of the deal, and the overall investment plan.
 

In this article, we will take a look at some key considerations and risks in respect to IP in a PE transaction.

Ownership

One of the first things that needs to be considered is the ownership of the IP. With registered IP (e.g., trade marks, patents, designs), there are public registers and databases that can be accessed and reviewed to determine the owner of such IP. However, this is not always fail-safe and the registers / databases are only as good as the data that has been provided. Whilst is it best practice to record assignments of any IP with the relevant IP office, is not unusual for this step to be forgotten.

The situation becomes harder when it comes to unregistered IP rights (e.g., unregistered designs, copyright, trade secrets), where no such registers exist in the UK and therefore, no register can be reviewed for ownership details.

For both registered and unregistered IP, although particularly when it comes to unregistered IP, the chain of title should be established to ensure that IP has been legally transferred to the desired party.

Another aspect of ownership is the issue of joint ownership. In most situations, subject to the details of the transaction, joint ownership should generally be avoided. It adds additional layers of complexity as each owner will be restricted in their freedom of use of the IP, particularly if there are cross-border elements to the transaction, as joint ownership rights differ in each jurisdiction.

Lastly, in the situation of a founder-based businesses, often a founder has created IP that is fundamental to the business. Regularly a founder will forget or has elected not to assign IP into the corporate vehicle. This not only can lead to tax issues, but it can present issues for the an interested party if the founder is unwilling to assign its IP or cannot be contacted.

Encumbrances

Encumbrances are any burden, interest, right, or claim over the IP that adversely affects it use and value.  Such examples being a licence, co-existence agreement, non-assert agreements, and mortgages. It should always be determined whether any of the IP being transferred / acquired is subject to an encumbrance, especially as some encumbrances may even prevent the ability of the IP holder being able to deal in the IP.  An encumbrance may also impact of the value of the IP. For example, even though a licence is considered an encumbrance because it restricts the licensor's use of the IP, it may include royalty provisions that bring in a revenue stream.

Litigation

It should be determined whether a target has any active litigation in regards to its IP rights. An active litigation is not necessarily bad. In some particular sectors and businesses litigation will be a part of the business plan. For example, businesses in the telecoms, pharmaceuticals or life sciences sectors are heavily dependent on their IP and use of their IP to preserve market share and protect their innovation. As such, litigation is an inherent part of the business and is likely to be present in the transaction.

If an IP litigation is encountered, it is important to get an understanding of a number of details including, whether the litigation is offensive or defensive litigation, the details of the case, the purpose or strategy behind the litigation, and importantly what impact the litigation will have on revenue and costs, as well as the likelihood of success.

Even after establishing all the facts of the case, the interested party should consider what the outcome of the case will entail, and particularly what the business is striving to deliver.

The extent / frequency of the litigation should also be reviewed. If the target is involved in lots of litigation, it could be a sign that a lot of third parties are interested in the technology as it so successful. On the other hand, this also leaves a question over the longevity and valuation of the business if it is always involved in litigation particularly in respect of funding that litigation - will other investments need to be made to fund the litigation, on top of a need to further innovate and differentiate the innovation.

The organisation and structure of the transaction should also be considered in respect to any IP litigation. This is particularly in respect of ensuring that the correct entity is holding the relevant IP to avoid the court having a basis to dismiss a case. Further, it must be ensured that the structure does not lead to a particular remedy (e.g. loss of profit) being lost or becoming unavailable to the target, due to the rules and limitations on which entity has access to those remedies.

Regulatory Landscape

Another important aspect to consider is the regulatory landscape in which a target operates, and in respect of PE transactions how government regulations can impact the ability of portfolio companies to own, acquire, use and enforce their IP rights. There are several regulatory regimes that intersect with IP rights that materially impact IP on PE deals, most commonly being antitrust, bankruptcy and export controls.

Another key point to consider is IP that was created with the support of government backed funds or pursuant to contracts with government agencies. Funding in this situation is usually contingent on the government receiving specific rights, for example, the government will have the option of taking a licence, retaining step-in rights, or it could require products to be made in a specific jurisdiction which can result in conflict with sponsor growth plans.

Sectors

Investing in different industries such as tech and pharmaceuticals will pose their own risks. For example, in regards to tech, some common IP issues that arise are around the ownership of copyright and use of open source software (OSS) in proprietary software. OSS consists of public domain software that is now everyday common use. However, OSS can come with a range of  encumbrances and implications for a company's own proprietary code. OSS, despite being free, remains a licensed software and different licences will apply to different OSS code. The spectrum of restrictions in these licences ranges from permissive licences to restrictive licences that implement licence provisions often known as "copy left" provisions. These provisions can result in derivatives of that OSS, whether modified or implemented into one's own proprietary software, being required to be put back into the public domain, and made available for future users and developers. Such an obligation can erode value in a business' code base.

Summary

All of the above mentioned points of issue need to be taken in consideration when approaching IP in a PE transaction, not only to determine the current position and any present issues, but also any implications the IP will have on development controls, allocation of ownership and use of IP, deal structuring and planning for deal strategy, execution and eventually an exit.

It should also be remembered that the legal and regulatory regimes will differ for each type of IP as well as jurisdiction, and therefore whilst the above provides a starting point, consideration should be had to what type of IP you are dealing with, and in what jurisdictions.