Intellectual Property Due Diligence

Conducting Effective Corporate Due Diligence - November 5, 2008

Osgoode Hall Law School of York University
Professional Development Program

2003-2008 Bereskin & Parr














Isis E. Caulder
(416) 957-1680

icaulder@bereskinparr.com
40 King Street West, Suite 4000,
Toronto, Ontario, Canada, M5H 3Y2





www.bereskinparr.com
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INTELLECTUAL PROPERTY DUE DILIGENCE

Isis E. Caulder
1
Bereskin & Parr, Toronto, Canada
icaulder@bereskinparr.com



I. Introduction

Whether you are acting for the buyer or the seller of a business that is the owner
of substantial intellectual property rights, the issues of concern are virtually identical.
The terms of the deal can be substantially impacted by the condition of a company's
intellectual property assets ("IP Assets").

If a buyer is not thorough in performing the due diligence, disastrous results can
ensue after buying the business. For example, being named a defendant in a patent
infringement suit or experiencing unexpected vulnerability in market competition due to
weak patent or trade mark rights. Conversely, the seller will want to maximize the terms
of the deal by demonstrating the high value of their company's IP Assets and the
unlikelihood of any infringement.

In this way, both parties to the sale of a business must perform similar due
diligence by evaluating the business's intellectual property rights and any associated
potential risks or liabilities. The buyer and seller should both perform due diligence, not
only on the intellectual property rights of the business at issue itself, but also on those
rights of the business's main competitors in the marketplace.

This paper provides an outline of the essential due diligence steps for both buyer
and seller, which basically constitute an intellectual property audit. This paper also aims
to cover the fundamental steps needed to identify and characterize the nature of any
intellectual property related legal issues that are material to the deal.

1
Isis E. Caulder is a partner at Bereskin & Parr, 40 King Street West, Suite 4000, Toronto, Ontario, Canada, M5H
3Y2 - www.bereskinparr.com.



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II. The Six Basic Steps of IP Due Diligence

The nature and scope of IP due diligence will vary from transaction to
transaction. As with other aspects of corporate due diligence, IP due diligence is
affected by the type and size of business, the business culture, and the age of the
business. For example, a startup computer business having little or no legal counsel to
date will present much different due diligence challenges than an established company
which has benefited from legal counsel over the years. Regardless of the above-noted
factors, IP due diligence for all businesses generally includes the following six steps:

A. Understand the Core Business
B. Gather Information On All Intellectual Property Rights
C. Confirm Intellectual Property Rights Held by the Business
D. Compile Unregistered Intellectual Property Assets
E. Intellectual Property Asset Valuation
F. Confirm the Company's Right to Use Intellectual Property


A. Understand the Core Business

The first goal of IP due diligence is to consider all potentially relevant IP Assets
for a business. Before actually investigating and confirming ownership of IP Assets (see
steps B and C below), it is critical to assess the nature of the business, potential
expansion plans and the core technology of the business.

The business plan, other business description, or business offering documents
usually will identify the primary products and/or services of a business. However,
secondary or support products or services should also be considered, and, thus,
associated hidden value or uncontemplated risks may be involved. A buyer or seller
should carefully identify all products, processes and services, no matter how
insignificant they might appear, before starting due diligence and/or negotiations of the
deal.




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B. Gather Information On All Intellectual Property Rights

Once the fundamental aspects of the business have been understood, the
identification of the business's IP Assets is the next critical step in predicting the future
value of a business. Only when IP Assets have been identified and catalogued, is it
possible to form a comprehensive understanding of their impact on the transaction. As
part of this process, it is important to consider which stage of evolution the business is
at. For example, a business may be a mature company with a mature and static
technology, a mature company with ever-changing technology, or an emerging
company that is just beginning to realize the financial benefits of its technology.

Practically speaking, a list should be prepared to enumerate all IP Assets
associated with the business. IP Assets typically fall into the following categories:

patents
trade marks
industrial design
copyrights
confidential information

These types of intellectual property are briefly described below. It should be
understood that many of these forms of intellectual property are territorial in nature and
thus rights may be held in some countries and not in others. It should also be kept in
mind that intellectual property requires careful management to ensure that rights are not
lost through improper acts or omissions.


PATENTS

A patent carries the right to exclude others from making, using or selling an
invention in the country in which it is granted. Inventions may be for products, methods
of making products, methods for doing things or product compositions. In order to be
patentable, an invention must have a useful purpose and be new or novel. A patentable
invention must also be inventive, that is, it must not be obvious to a person having
ordinary skill in that area. In order to obtain patent protection, it is necessary for an
application to be filed with the appropriate national government office in each country

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where protection is desired (e.g. United States, Canada, Europe, etc.) The non-
renewable term of a patent in most countries is 20 years from the date of filing of the
patent application.

The value of patent is determined by the scope of protection defined by the
"claims" of a patent which are located at the end of the patent. If the claims of a patent
are "narrow" in scope then it will be relatively simple for competitors to design
competing products that do not fall within the scope of the patent. Broad claims that are
considered to be valid may not be easily designed around and thus a potential
competitor would be required to obtain a license from the patent owner or face a
potential patent infringement suit.


TRADE MARKS

A trade mark is a word, symbol or shape, or a combination of them, used by a
person to distinguish his or her goods or services from those of others. Trade marks
include word marks (e.g. HUMPTY DUMPTY); design marks (e.g. McDonald's
GOLDEN ARCHES DESIGN); sound marks (e.g. the NBC chimes) and distinguishing
guises (e.g. the COCA-COLA bottle shape). Generally, trade mark rights can be
acquired through use of the mark in association with goods or services in the
marketplace. Trade marks can last indefinitely and may become the most valuable
assets owned by a business.

In order for trade mark rights to exist, a trade mark must be used in association
with goods and/or services in such a way as to clearly indicate that the business is the
source of the goods and/or services. It is also important that the trade mark be
distinctive so that it cannot be readily be confused with trade marks for related products
or services.

Trade marks are protected under the common law and under statute. Common
law rights are acquired through use of trade marks and are enforceable to the extent
that the trade mark has developed goodwill or reputation in the marketplace. Under the
common law, such rights are limited to the local area where trade mark use has
occurred (e.g. in Ontario only). In contrast, statutory protection (i.e. when a trade mark
registration issues from a national trade mark office) allows a trade mark owner to enjoy
national protection (i.e. Canada-wide) of the mark regardless of the extent of

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geographical use (as long as there has been some use). Trade mark registrations can
generally be periodically renewed and can exist indefinitely (e.g. in Canada, trade mark
registrations last for 15 years from registration date, renewable every 15 years).


INDUSTRIAL DESIGNS

Registration of an industrial design may protect certain reproducible shapes and
patterns that have an original shape, configuration or ornamentation applied to a useful
article. Examples of designs that may be registered are furniture designs (e.g. Global's
chair designs) and car grill designs (e.g. the Rolls Royce car grill design).

Industrial designs must be registered to be protected and an application must be
filed within a year of the first publication or sale of the design in Canada. Industrial
registrations are granted in Canada for a five year term and may be renewed for
another five year period. A Canadian design registration provides the owner with an
exclusive right to exclude others from making, importing, selling, renting or offering for
rent or sale any product embodying the protected design in Canada.


COPYRIGHT

Copyright is the sole right to reproduce, publicly perform or publish literary,
dramatic, artistic and musical works. The essential concept of copyright is that only the
form of expression is protected, that is no other person is entitled to copy the form of
expression used by the original copyright owner. Copyright does not protect the
underlying idea, concept or subject matter of a work.

In certain industries, such as the music, publishing and motion picture industries,
copyright is a critical asset. However, the value of copyright in other business should not
be overlooked. For example, databases, manuals, software, catalogues and advertising
materials are protected by copyright and can all form material assets of any business.
Copyright exists automatically from the date that a work is created. Registration with the
government copyright office is not required but is recommended to obtain certain
presumptive advantages. Copyright generally has a term which lasts for the life of the
author plus seventy years.


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CONFIDENTIAL INFORMATION

Confidential information is information that is not general public knowledge and
that required some degree of labour, skill or money to produce. Protection for
confidential information can last indefinitely provided that the information remains
confidential. Once the information becomes publicly disclosed, the information is free for
anyone to use.

In order to identify the confidential information of a business, it is necessary to
consider all aspects of the business. Specifically, financial, record keeping and data
processing operations, supplier, distributor and customer lists, operational procedures
and manuals, and most importantly research, development, processing and
manufacturing operations.


C. Confirm Intellectual Property Rights Held by the Business

In order to determine a business's IP Assets, it is necessary to conduct IP
ownership and status searches to verify that the IP Assets are in fact owned by the
seller and are not encumbered or have not become abandoned due to a failure to pay
maintenance fees or other reasons. If a business does not aggressively monitor, protect
and maintain intellectual property rights, it may be required by a third party IP owner to
pay license fees, to stop using the protected IP rights, and/or be forced into expensive
and time consuming litigation over disputed IP rights.

First, it is necessary to obtain a complete and detailed inventory of the sellers
intellectual property assets. In addition to obtaining a detailed listing of all applications
and registrations for patents, trade marks, industrial designs and copyrights, efforts
should be made to obtain copies of any other materials which might qualify for
intellectual property protection yet which may not have been registered. This information
may require a search of the business's files, or may be obtained by conducting
interviews with various legal advisors, officers and employees associated with the
business.

Second, all IP-related agreements to which the seller is a party to, should be
obtained and examined to ensure that ownership of IP Assets has been properly

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conveyed. In addition, copies of any actual or threatened claims by third parties (e.g.
infringement claims, etc.) with respect to intellectual property, a list of key employees
involved in the development of intellectual property, and any written agreements relating
to their employment should also be obtained.

Finally, title to recordable rights (patents, trade marks, copyrights, etc.) should be
verified through government office searches. Searches should be conducted at the
appropriate government offices (including PPSA searches and searches at Canadian
and foreign intellectual property offices) to verify the ownership and status of the rights
being acquired. Any licenses, assignments, government rights, and liens (secured or
unsecured) also should be verified by searches. In addition, any new intellectual
property interests arising from an investment, acquisition or sale should be recorded in
appropriate federal and state/provisional offices. Ownership interests in foreign
countries require separate title searches, as well as separate assignments or other legal
instruments for perfecting rights in those foreign countries.

There is a problem, however, with conducting up to date searches at Canadian
and foreign intellectual property offices. Generally, there is a look back period of several
months during which time assignments or documents granting security interests may
have been filed with the respective intellectual property offices and not yet recorded.
Such documents would not be locatable by the search and accordingly, a buyer or a
seller cannot be certain that the records at the intellectual property offices accurately
reflect the current title status. This is problematic since an assignment or other relevant
document that may have been filed during the look back period may have priority over a
later transaction even though the later transaction was prior to the recording of the
assignment. This problem can only be adequately addressed by requiring the seller to
give representations and warranties of title in respect of the intellectual property and by
the buyer conducting a follow-up investigation at a reasonable time in the future to
confirm that no documents affecting title were recorded during the look back period.


D. Compile Unregistered Intellectual Property Assets

For IP Assets not identifiable as an issued patent, a registered trade mark or a
registered copyright, detailed listings and explanations also should be provided. Such
assets or rights may include trade secrets, know-how, common law trade names, trade
dress (unique appearance), trademarks and unregistered copyrights.

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For each of these, the inventors, authors and uses of the rights should be
identified and the dates of first use recorded. In some businesses, these rights can be at
the heart of a business and never should be ignored. Often, the dates of creation of first
use are critical in protecting and preserving the rights. For example, dates and evidence
of use of common law trademarks are important to preserve superior rights over a later
user.


E. Intellectual Property Asset Valuation

Not all intellectual property rights may be of significant value to a business.
Therefore, it is necessary to scrutinize all aspects of the business, consider what
intellectual property is key to the successful operation of a business, and consider the
validity and scope of the intellectual property. Mature products and services often are
the most important source of the current financial state of a business. However, a
changing market demands that much more due diligence be performed in order to
understand any future product changes or improvements that are being implemented or
planned. The more important the rights are to the future vitality of a business, the more
due diligence that will be necessary.

It is nearly impossible to determine the exact quantitative value of a particular
item of intellectual property due to numerous considerations that will affect its value,
some of which are impossible to predict or quantify. Those unfamiliar with intellectual
property may mistakenly assume that a registered patent, for instance is an asset that
may be easily and broadly enforced or sold for value. It is often the case, however, that
patents are obtained on narrow improvements in technology that may have little or no
value to third parties. Also, patents and trade marks may be subject to validity
challenges that would not be immediately apparent to those conducting general
ownership and status searches of the register.

Some considerations that should be borne in mind include: the strength of the
rights in the marketplace (e.g. scope of patent claims or distinctiveness of trade marks);
whether rights extend to jurisdictions that represent important markets (e.g. United
States, Europe, or Asia); the probability that unregistered rights will be successfully
registered in the future and enforceable against third parties; and whether rights have
been licensed or sub-licensed to other parties.

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Another important consideration is the level of competitive activities and third
party ownership of intellectual property. Accordingly, due diligence should also be
directed toward understanding a close competitors intellectual property position. This
will provide a map of hazardous areas, as well as areas ripe for development, and thus
ensure the ability to carry out relatively unobstructed product improvement and
subsequent sale in the market.

While some businesses may choose to compete in the market without obtaining
patents or aggressively protecting trade mark rights, a competitor in a market may be
working toward reducing the competitive advantage of a business by securing
substantial patents, trade marks or other intellectual property rights. It is quite common
for at least one player in a multi-firm market to follow such a strategy in an attempt to
force competitors to either take licenses or stop making or using the proprietary
technology. Such tactics are frequently successful in securing a superior competitive
position and should be anticipated.


F. Confirm the Company's Right to Use Intellectual Property

In addition to determining what intellectual property assets are held by the
business itself, it is also important to explore the right-to-use question. While it is
important that a business develop a position of strength for its products and services, it
is not always guaranteed that a holder of a patent has the right to make, use or sell its
own patented product or service. A competitor may be quietly pursuing patents, trade
marks or copyrights on products or services that are under parallel development by all
businesses in a market niche.

The unfettered right to use, make or sell certain technology, or to use trademarks
or material subject to copyrights, is often crucial to the health of any business. If a
competitor holds patents, trade marks, copyrights or other related rights that dominate a
successful product or service of a business, the profitability of a business, and even the
ability to survive, may be at stake.

A simple example of this concept is the case of a company that obtained a patent
on the stapler. A competitor then followed up by obtaining a patent on a stapler with an
easily loadable cartridge. The second company did not have the right to make, use or

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sell reloadable staplers because the first company already had the patent on the
stapler. The second company must try to obtain a license from the first business or face
the prospect of likely losing a patent infringement suit.

A business should periodically monitor the intellectual property rights held by
competitors. When a business generally is unaware of, or deliberately ignores,
intellectual rights of third parties, it is highly likely that a competitor will, when least
expected or desired, apply unwanted strain or even life-threatening pressure on the
business (such as when one is selling the business or expanding into its competitors
market). When trying to sell a business, a healthy business must show that background
investigations and clearance searches have been periodically conducted in the
development of any new or improved products and/or services.

The fact that a business has undertaking such planning not only will add value to
a company in the eyes of a buyer, but will also provide clear evidence to a potential
purchaser of the overall health of the company and the prospects for a sound future. In
addition, the level of due diligence required to close the deal will be greater reduced. On
the other hand, the lack of such planning may be indicative of shortsighted business
practices and the presence of hidden dangers.


III. Doing It Right Avoiding Common IP Due Diligence Pitfalls

When conducting IP due diligence, numerous pitfalls can be encountered. If
these pitfalls are not anticipated, and intellectual property rights are not properly
identified and evaluated, the value of a business cannot be correctly assessed. Failure
of the buyer or a seller of a business to perform proper due diligence on the associated
IP Assets can therefore give rise to diminished value in a business deal or result in
some very unpleasant surprises for the buyer after closing. The following is a high-level
summary of some of the kinds of mistakes that are commonly made along the way.


UNDERSTAND THE CORE BUSINESS

As discussed above, it is critical to understand the core business of the target
company in order to properly assess the importance of the company's IP Assets. For
example, it is possible to receive a large amount of documentation on a company's

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patent portfolio that on the surface would indicate that the portfolio is in order (i.e.
patents have issued, maintenance fees have been paid and are in force, etc.) However,
a closer inspection of the actual technology covered by those patents can reveal that
the (very strong and impressive) patent portfolio has very little to do with the company's
present and future products. Accordingly, it is recommended that IP counsel with the
appropriate (technical) background be retained in order to ensure that a targeted and
proper overall assessment of the IP Assets can be obtained.


ALWAYS CONSIDER THE IP

Intellectual property rights can be a serious issue, not only for high technology
industries such as computer and pharmaceutical businesses but can also in the more
traditional, commodity-oriented fields. In most businesses, patents, trademarks, trade
secrets and copyrights can come into play as competitive weapons.


AGGRESSIVELY EVALUATE PATENT ASSETS

It is a common mistake to leave certain IP-related "stones" unturned. For
example, in the case of a technology company whose primary business asset is
technology and the associated patent rights, it is critical to conduct comprehensive and
far-reaching analysis of all patent rights. First, patent searches (or updated patent
searches if earlier searches have been conducted in-house) can provide important
information concerning third party competitive activities, prospects of the business
actually obtaining patent protection in respect of inventions for which there are only
pending applications, and potential infringement risks.


USE MORE THAN ONE SOURCE

Another important part of IP due diligence is to carefully verify all incoming
information by consulting more than one source. For example, it is a common
occurrence for computerized IP ownership records to contain typographical errors (i.e.
data entry errors). In some cases, an initial computer search may indicate that the
ownership of certain IP Assets is in order but a manual inspection of the actual
documentation in fact indicates that the ownership interests are not what they were

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expected to be. Accordingly, it is important to verify information by checking more than
one source (i.e. conducting simultaneous manual and computer searches).


CONSIDER THE INTERNATIONAL FLAVOUR OF IP

Finally, since the markets and potential markets of a business are generally
international in character, it is important to investigate the international coverage of all
IP Assets. IP searches should in some cases be extended to cover various foreign
jurisdictions and IP opinions may have to be sought from foreign counsel. It should be
understood that while the IP laws of many countries have been largely harmonized
under international treaties, national IP laws still differ.