As a enterprise or investment professional involved in mergers and acquisitions ("M & A"), are you conducting patent due diligence according to the common practices of your M & A attorneys and investment bankers? When patents form a substantial aspect of the value of the transaction, you are most likely finding incorrect tips about how to conduct due diligence. The due diligence procedure ought to take into consideration the competitive patent landscape. If competitive patents are not included in your vetting method, you could be significantly overvaluing the target company.
In my various years of intellectual property and patent expertise, I have been involved in a number of M & A transactions exactly where patents formed a important portion of the underlying value of the deal. As the patent specialist on these transactions, I took direction from very compensated M & A attorneys and investment bankers who had been acknowledged by C-level management to be the "actual specialists" considering they completed dozens of deals a year. To this finish, we patent specialists were directed to check the following four boxes on the patent due diligence checklist:
- Are the patents paid up in the Patent Office?
- Does the seller really own the patents?
- Do at least some of the patent claims cover the seller's items?
- Did the seller's patent attorney make any stupid mistakes that would make the patents difficult to enforce in court?
When these boxes were marked "complete" on the due diligence checklist, the M & A attorneys and investment bankers had effectively "CYA'd" the patent problems and were absolutely free from liability relating to patents in the transaction.
I have no doubt that I conducted my patent due diligence duties very competently and that I, too, had "CYA'd" myself in these transactions. Nonetheless, it is now evident that the patent aspect of M & A due diligence fundamentally conformed to someone's idea of how not to make stupid errors on a transaction involving patents. In truth, I in no way felt fairly comfortable with the "flyover" feel of patent due diligence, but I did not have decision rights to contradict the regular operating procedures of the M & A professionals. And, I identified out just how incomplete the common patent due diligence approach is when I was left to pick up the pieces of a transaction conducted according to regular M & A procedure.
In that transaction, my client, a sizeable manufacturer, sought to expand its non-commodity product offerings by acquiring "CleanCo", a little manufacturer of a patented consumer item. My client identified CleanCo to be a wonderful target for acquisition given that CleanCo's item met a powerful consumer need and, at that time, commanded a premium price in the market place. Due to robust consumer acceptance for its sole item, CleanCo was experiencing tremendous growth in sales and that growth was expected to continue. Then again, CleanCo owned only a small manufacturing plant and it was getting difficulty in meeting the growing demands of the industry. CleanCo's venture capital investors were also anxious to cash out soon after numerous years of continued funding of the company's somewhat marginal operations. The marriage of my client and CleanCo therefore seemed a very good match, and the M & A due diligence approach got underway.
Due diligence revealed that CleanCo had couple of assets: the smaller manufacturing plant, restricted but growing sales and distribution and a number of patents covering the sole CleanCo product. Notwithstanding these apparently minimal assets, CleanCo's asking cost was upwards of $150 million. This cost could only mean 1 thing: CleanCo's value could only be in the prospective for sales growth of its patented item. In this scenario, the exclusive nature of the CleanCo product was effectively understood to be fundamental to the obtain. That is, if an individual could knock-off CleanCo's differentiated item, competition would invariably result and ll bets would then be off for the growth and sales projections that formed the basis of the financial models driving the acquisition.
Taking my instructions from the M & A attorney and investment banker leaders in the transaction, I conducted the patent aspects of the due diligence procedure according to their regular procedures. Anything checked out. CleanCo owned the patents and had kept the fees paid. CleanCo's patent lawyer had done a excellent job on the patents: the CleanCo item was covered well by the patents and there had been no obvious legal errors created in obtaining the patents. So, I gave the transaction the thumbs up from the patent perspective. When every thing else looked positive, my client became the proud owner of CleanCo and its item.
Fast forward quite a few months . . . . I began to receive frequent calls from men and women on my client's promoting team focused on the CleanCo product about competitive products that had been becoming observed in the field. Given the reality that far more than $150 million was spent on the CleanCo acquisition, these promoting experts not surprisingly believed that the competitive items need to be infringing the CleanCo patents. Yet, I found that each and every of these competitive merchandise was a legitimate design-around of the patented CleanCo product. Because these knock-offs were not illegal, my client had no way of getting these competitive goods removed from the marketplace employing legal action.
As a result of this rising competition for the CleanCo product, price erosion began to occur. The financial projections that formed the basis of my client's acquisition of CleanCo began to break down. The CleanCo product still sells strongly, but with this unanticipated competition, my client's expected margins are not getting created and its investment in CleanCo will take significantly far more time and expensive advertising to spend off. In brief, to date, the $150 Million acquisition of CleanCo looks to be a bust.
In hindsight, the competition for the CleanCo item could have been anticipated during the M & A due diligence approach. As we discovered out later, a search of the patent literature would have revealed that numerous other methods existed to address the consumer need to have addressed by the CleanCo item. CleanCo's good results in the marketplace now appears to be due to 1st mover advantage, as opposed to any actual technological or cost benefit provided by the product.
If I knew then what I know now, I would have counseled strongly against the expectation that the CleanCo product would command a premium cost due to market place exclusivity. Rather, I would demonstrate to the M & A team that competition in the CleanCo item was possible and, indeed, extremely most likely as revealed by the myriad of solutions to the exact same issue shown in the patent literature. The deal could possibly still have go by way of, but I believe that the the financial models driving the acquisition would be significantly more reality-based. As a result, my client could have formulated a marketing and advertising program that was grounded in an understanding that competition was not only attainable, but also most likely. The marketing and advertising program would then have been on the offense, rather than on the defense. And, I know that my client did not expect to be on the defense immediately after spending much more than $150 million on the CleanCo acquisition.
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