Structures and Strategies: Maximizing the Value of Intellectual Property Assets in Mergers and Aquisitions

Intellectual property assets – patents, copyrights, trademarks and trade secrets – are an increasingly significant portion of the value that buyers acquire in mergers and acquisitions today. In order to exploit fully the value of intellectual property assets, both buyers and sellers need to formulate effective transaction structures and strategies grounded in an understanding of intellectual property law. This article discusses some of the key intellectual property issues buyers and sellers encounter in mergers and acquisitions.

The structure of the proposed transaction is the first issue that buyer and seller must consider. The three basic transaction structures are asset purchases, stock purchases and mergers.

Asset purchases may be preferable to buyers for two reasons. First, an asset purchase generally provides the buyer with the opportunity to select assets and liabilities to acquire and to leave behind others. Also, an asset purchase generally results in a step up in basis of the acquired assets, which may be attractive to the buyer. Asset purchases however sometimes prove to be more costly for the buyer because they may require numerous individual assignments of intellectual property assets, sometimes in multiple jurisdictions, as well as consents to the assignment of intellectual property assets by secured parties, licensors, licensees and other parties. Also, an asset purchase may result in two levels of taxation, both at the seller’s level and at the stockholder level.

Stock purchases have advantages for both the buyer and the seller. Stock purchases tend to be simpler for buyers because title to all the seller’s assets are transferred with the ownership of the seller and fewer consents are generally required. For the seller, a stock purchase will generally result in only one level of tax to the seller, at the level of the seller’s stockholders, and generally at the favorable capital gains rate. But stock purchases also have disadvantages for the buyer. When the buyer acquires the seller it acquires all of the seller’s liabilities.

The most common merger structures are a reverse triangular merger, in which the seller survives as a subsidiary of the buyer, and a forward merger, in which an acquisition subsidiary formed by the buyer survives as a subsidiary of the buyer. A merger may be an attractive alternative to a stock purchase because the buyer will not need to get stockholders to sign a stock purchase agreement. The seller’s stockholders will have to approve the merger, usually by a majority, although a greater percentage may be specified in the seller’s charter documents. However, like a stock purchase, the buyer is confronted with having to acquire all of the seller’s liabilities and may also have to obtain consents.

An important structural consideration is whether the transaction may receive tax treatment as a tax free contribution of intellectual property under Section 351 of the Internal Revenue Code. In order for a contribution of intellectual property to be a tax-free exchange of property for stock under Section 351, the rights granted to the contributed intellectual property must be exclusive within a defined "field of use" with respect to both third parties and the seller.

As its next consideration, the buyer must organize its due diligence investigation of the seller’s intellectual property assets. It is essential that the team conducting this part of the due diligence investigation have expert knowledge of intellectual property law in order to advise the Buyer competently. Each intellectual property due diligence investigation should be tailored to fit the specific transaction. Sometimes extensive intellectual property due diligence is not possible because of time constraints or the need to maintain the secrecy of the proposed transaction. If extensive intellectual property due diligence is not possible, the crafting of the seller’s representations and warranties in the purchase agreement will become more critical. Issues unique to each type of intellectual property are discussed below.

Patents. United States patents are governed by federal law.¹ Patentable subject matter includes any apparatus, composition of matter, method (including business processes)² or improvements to the foregoing.³ An issued patent is not a right to use a patented invention. An issued patent allows the patentee to prevent others from using the patented process or practicing the patented method.

If the seller’s patents are important to its business and are used to enforce the seller’s rights against its competitors, the seller’s patents and patent applications should be carefully reviewed by buyer’s patent attorneys to evaluate their strength. Although an issued patent is presumed to be valid, many patents are found to be invalid when challenged, and defending a suit challenging the validity of a patent can be very expensive.

Patent applications are filed in the name of the their inventor. If an assignment from the inventor to the seller is not recorded in the United States Patent and Trademark Office (the "U.S.P.T.O."), the inventor is presumed to be the owner. To avoid ownership issues, the buyer should ensure that all assignments have been obtained and that all of the seller’s employees should promptly execute invention assignment agreements.

Inventions conceived with state or federal research funding or, almost as equally often, university research funding, may be subject to governmental or university rights. If the buyer wishes to exploit intellectual property rights developed with government or university funding, the scope of the government's or the university’s rights should also be carefully evaluated.

Another issue complicating a transaction with patent owners is joint ownership. For example, sometimes a seller is the joint owner of a patent with another corporation through a joint venture, or a parent spinning off a division may wish to retain joint ownership of a key patent. Whatever the circumstances, if the seller is the joint owner of a patent, it is important for the buyer to understand that each joint owner has an equal and undivided interest in the patent and is free to exploit the patent independently. This may be a significant issue for the buyer in determining the value of the transaction.

Trademarks. In the United States, trademarks are governed both by state⁴ and federal⁵ statutes and case law. Trademarks may include any word, symbol or device used to identify the source of goods or services.

Trademark protection is territorial; a trademark registered in the United States does not protect the rights of the registrant in a foreign jurisdiction. Some foreign jurisdictions observe very different legal doctrines from United States law. Common law countries like the United States recognize trademark rights based on use of the mark in connection with goods or services, whereas civil law countries recognize trademark rights based on registration. In common law countries, the first person to use a trademark to identify specific goods or services can later prevent others from using the same trademark if their use would create confusion in the minds of consumers as to the origin of the goods or services. In civil law countries, the results would be very different: the first person to file a trademark registration has the right to prevent others from using the trademark if it would lead to consumer confusion, even if the other party has been using the trademark to identify its goods and services for years.

In the United States, trademarks do not have an existence independent of the goodwill they symbolize. As a result, trademark licenses must include appropriate quality control provisions or valuable rights may be lost and trademarks may not be effectively transferred or licensed without the goodwill associated with the trademark.

It has become increasingly common to encounter companies with international operations which have established offshore intellectual property holding companies to manage their intellectual property assets and as reduce their tax burden. The tax advantages of offshore holding companies can be substantial for companies with international operations, but certain formalities must be observed. For example, with respect to trademarks, if the offshore intellectual property holding company is the trademark owner, it will be responsible for exercising quality control over the use of the trademarks it owns. Failure to do so could result in the loss of valuable intellectual property rights.

Another issue that arises in an international context concerns joint ownership of trademarks. It is not unusual for companies with international operations to spin-off foreign operations and transfer trademark rights to the foreign spin-off. However, the Internet has dramatically lowered the cost of doing business in remote jurisdictions and many companies have tried to re-enter foreign markets without foreign facilities. Unfortunately for them, they may now be barred from shipping goods into jurisdictions where they no longer own the rights to their trademark.

Copyrights. In the United States, copyrights are governed by federal law.⁶ Internationally, the Berne Convention for the Protection of Literary and Artistic Works and the Universal Copyright Convention have been widely adopted. Copyright protection extends to any original work of authorship fixed in a tangible medium of expression,⁷ and includes the exclusive right (1) to reproduce a copyrighted work, (2) to prepare derivative works based on the copyrighted work, (3) to distribute copies of the copyrighted work, (4) to perform the copyrighted work (e.g., a play), and (5) to display the copyrighted work (e.g., a painting). Not every expression reduced to tangible form however is copyrightable. The United States Supreme Court has held that in order for a work to be protected by United States copyright law it must be sufficiently original.⁸

Ordinarily, copyright ownership vests in the author of the work. An exception to this rule arises in "works made for hire," which are works either prepared by an employee within the scope of his employment or works specially ordered as a work made for hire, and ownership rights in which vest in the employer. Buyers need to be particularly cautious when encountering independent contractors who are have been hired to develop copyrighted works (for example, custom software) and who may have own the copyrights in these works. Buyers should be assured that each independent contractor has executed a work made for hire agreement assigning the copyrights in their work product to the seller.

Trade Secrets. In the United States, trade secret protection is largely a matter of state law. Under California law, trade secrets include any information, such as a formula, pattern, compilation, program, device, method, technique, or process, that (1) derives independent economic value, actual or potential, from not being generally known to the public or to other persons who can obtain economic value from its disclosure or use, and (2) is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.⁹ Additionally, federal law makes the misappropriation of trade secrets a federal crime under certain circumstances.¹⁰

Reasonable efforts must be made to maintain a trade secret’s confidentiality. Trade secret protection can be lost through failure to demonstrate such efforts. Trade secrets do not, however, lose their protection merely because the same trade secret is known by more than one company, provided the secret is not generally known to the public.

Among the procedures a company should observe is the execution of confidentiality agreements with all employees, consultants and outside parties. Confidentiality agreements are common in most technology-based businesses and can be critically important in emerging technology business where technology evolves faster than patent protection can be obtained.

The Purchase Agreement.

Representations and Warranties. Buyers and sellers have divergent goals in negotiating and documenting the actual purchase agreement. The buyer's goal is for the seller’s representations and warranties to address all material issues concerning the seller’s intellectual property assets. The buyer’s objective is to obtain all of the seller’s intellectual property assets necessary to operate the business after the closing. This cannot always be accomplished solely through a purchase agreement and sometimes requires a combination of a purchase agreement with separate agreements providing for transition services and intellectual property rights.

Moreover, the buyer needs assurance that its conduct of the business will not infringe upon or misappropriate the intellectual property rights of third parties after closing and that the seller can validly transfer all necessary rights to use the intellectual property assets necessary to operate the business after the closing. A separate indemnity may be necessary if the scope of a potential liability for intellectual property infringement or good title cannot be ascertained before closing.

In contrast, the seller needs to distinguish between intellectual property assets that it is selling and the intellectual property assets that it is retaining. Frequently, sellers own intellectual property rights that are necessary for retained business lines as well as the business that is being sold. If the seller intends to continue to operate a business which relies on intellectual property rights common to the business to be sold, it may need to retain ownership and license rights to the retained intellectual property to the buyer.

It is also frequently difficult for the seller to identify which particular intellectual property rights may be implicated in a particular product and so language may need to be crafted to protect the seller's ability to continue using certain intellectual property rights after the closing.

Disclosure Schedules. The seller’s schedules should provide all of the information necessary to identify the material intellectual property assets being acquired or excluded, and will need to be reviewed by the buyer carefully to determine how they may impact the seller’s representations and warranties. Because the schedules are often the seller's last opportunity to impact the scope of coverage of the representations and warranties it will make in the purchase agreement, sellers often try to include on disclosure schedules broad exceptions from the scope of the negotiated representations and warranties.

Covenants and Closing Conditions. To the buyer, the most important covenants of the seller are those that require the seller to fix problems identified in due diligence, obtain necessary consents, address access to intellectual property assets that will not be sold and to continue to operate the business between signing and closing as at has been operated in the past. For the buyer the most important closing condition is that the seller correct any problems that are deal breakers, obtain necessary consents and execute ancillary agreements needed to provide buyer with the use of all of the intellectual property assets necessary to operate the business after closing. Some particularly difficult problems for the seller to fix before closing may include successfully resolving or settling litigation, executing third party contracts that are material to the merger or acquisition or contracting on favorable terms with suppliers for goods or services after closing.

Indemnification. The seller’s general indemnity should apply to the intellectual property specific representations, warranties and covenants and is generally subject to agreed upon time limits, baskets and caps. Typically, the purchase agreement will also include separate indemnification for problems identified during buyer’s due diligence investigation. Such indemnities are frequently not subject to the general indemnity’s cap and basket, although they are often subject to a time limitation.

Intellectual property assets that can not be transferred by the seller to the buyer as part of the purchase agreement can often be made available to the buyer in a number of other ways. For example:

Transition Services Agreements. Many services such as payroll, human resources and benefits are often provided by the seller to the buyer on a transitional basis. It is important for both the buyer and the seller to identify what services will need to be provided by the seller for an interim period after the closing. With respect to intellectual property rights, the seller’s in-house legal department may have provided patent prosecution and maintenance services that will need to remain in place for a transition period to ensure an orderly transfer as well as other employees whose residual knowledge may be required after the closing. Reasonable terms of transitional will need to be agreed to between the buyer and the seller.

Intellectual Property Licenses. Frequently, all of the intellectual property needed to operate the new business cannot be transferred because it is inseparable from the intellectual property of the business retained by the seller. Under such circumstances, it may be necessary to license the intellectual property rights to the new business.

Manufacturing and Supply Agreements. Finally, manufacturing and supply agreements may be necessary from both the seller's and the buyer's perspective in order to maintain both the business levels of the business being sold to the buyer and the business being retained by the seller. Often the seller is the most significant customer of the business it intends to sell, which is a financial boon to the newly independent business but also makes a continuing relationship between the two parties critical.

Increasingly, intellectual property assets are used as collateral in securing financing. Under U.S. law, these security interests are governed both by the bodies of federal intellectual property law described above and federal bankruptcy law, which provides that Article 9 of the Uniform Commercial Code is not applicable to "a security interest subject to any statute of the United States to the extent that such statute governs the rights of parties to and third parties affected by transactions in particular types of property."¹¹

A U.C.C. filing may be ineffective to perfect a security interest in intellectual property subject to a federal statute. A U.C.C. filing is "not necessary or effective to perfect a security interest in property subject to . . . a statute or treaty of the United States which provides for a national or international registration or . . . certificate of title or which specifies a place of filing different from that specified in this Article for filing of the security interest."¹²

Case law has interpreted federal statutes such that: federal copyright law is viewed as entirely preempting the U.C.C.,¹³ and lenders should file a security agreement in the United States Copyright Office; federal patent law is somewhat preemptive,¹⁴ and lenders should file both in accordance with the U.C.C. and in the U.S.P.T.O.; and federal trademark law is not preemptive,¹⁵ so filing in accordance with the U.C.C. is sufficient, although lenders also frequently file in the U.S.P.T.O. As a result, lenders frequently make both U.C.C. and federal filings.

It is unclear whether security interests in unregistered copyrights may be perfected by a U.C.C. filing, so lenders frequently require borrowers to register material copyrights prior to closing so that security filings may be made in the United States Copyright Office.

By statute, a security interest may not be filed on an intent-to-use trademark application until a statement of use or an amendment to allege use has been filed has been filed on the application.¹⁶ An intent-to-use trademark application allows an applicant with a bona fide intention to use a trademark to reserve its use with the U.S.P.T.O. for up to three years before actual use. A trademark is registered following the filing of a statement of use or an amendment to allege use with the U.S.P.T.O. The U.S.P.T.O. has reasoned that no trademark right exists before that time and as a matter of policy wishes to discourage commerce in such applications.¹⁷

Collateral assignments as security instruments raise issues for both lenders and borrowers under federal trademark law, as they require a license of the trademark rights back to the borrower to allow it to use the assigned trademarks. As with any trademark license, the licensor (i.e. the lender, in this case) must enforce quality control over the goods and services identified by the trademarks. This is an unusual role for almost all lenders and can create liability issues if the collateral assignment isn’t carefully crafted.

Because there is no "floating lien" under any body of federal intellectual property law, after-acquired federally-issued patents, registered trademarks and registered copyrights must be added to security agreements through supplemental filings.

Outside of the United States, perfecting a security interest in intellectual property assets can be both complicated and expensive. Each foreign jurisdiction has its own system with respect to the formation and maintenance of liens, and some jurisdictions have very different concepts of what security interest a lender receives and what is required to perfect that security interest.

Post-closing, several matters will typically require the buyer’s attention.

In the United States, an assignment or security interest in a patent or trademark must be recorded in the Patent and Trademark Office within three (3) months of its execution in order to have priority over later executed documents that are recorded first. An assignment or security interest in a copyright must be recorded in the Office of the Copyright Registrar within one (1) month of its execution. Also, patents and trademarks require maintenance fees at regular intervals in order to remain in force.

As a consequence, as a part of the merger or acquisition process, buyers need to formulate a plan for monitoring the timely filing of assignments and security interests and the payment of maintenance fees for acquired intellectual property assets in order to avoid the inadvertent loss of valuable rights.

Intellectual property assets can have significant value in mergers and acquisitions, and buyers and sellers need to approach these transactions with a strategy to maximize the value of these assets.