United States: Patent Law: Strategic Due Diligence

Originally published in The National Law Journal, May 15, 2000

After a recent multi-million dollar acquisition, a large technology company was shocked to learn that the patents lying at the heart of the deal were virtually worthless. Everything had looked OK. The patents contained drawings and text describing a product that the acquiring company wanted to make. But as the company soon learned, the claims in the patents were not broad enough to keep competitors at bay. Even worse, an after-the-fact investigation revealed that one competitor held a blocking patent, preventing the acquiring company from making the desired product at all.

How could this happen? The acquiring company thought it had engaged in the necessary due diligence. But how much diligence is due? The answers could lie in the methodology of the acquiring company’s due-diligence analysis. Every due-diligence inquiry is unique, requiring an individualized approach. When a company tailors the inquiry to the circumstances, it can identify potential trouble spots and accomplish vital strategic planning. Seeing that approach through requires the thorough education of, and full participation by, the intellectual property counsel performing the due-diligence analysis.

When properly executed, IP due diligence can simultaneously accomplish several objectives. It can provide information sufficient to assure the company that it is receiving value for its investment. It can identify impediments to developing the intended business. It can equip the acquiring company with the means to renegotiate terms of the transaction if there exists less value than was initially perceived. And it can familiarize the acquiring company with the assets it is acquiring so that the acquiring company can manage them appropriately once the transaction is complete.

Most important, the right kind f IP due diligence can lay the groundwork for a strategic plan -- one that minimizes future exposure to charges of patent infringement and develops strategies of patent protection to broaden the exclusivity and dominance in the acquiring company’s technological area.

Of the various types of intellectual property, patents provide the engine that most often drives mergers, acquisitions, and initial public offerings. Copyrights, trademarks and trade secrets are certainly important intellectual property assets, but it is the patent’s power to exclude competitors from selling products or providing services that elevates the value of a patent.

Yet not all patents are created equal. Some are worthlessly narrow and easy to "design around." Others provide a significant barrier to entry by a competitor. Whether a particular patent sits at either extreme of the spectrum, or somewhere in between, cannot usually be discerned by simply examining the patent document. Rather, the true value of a patent is uncovered by digging through its history, studying other patents, looking at the competitive landscape and considering potential alternatives to the patented invention. As a result, patents require the most intensive due-diligence scrutiny of all intellectual property.

Traditional patent due diligence entails scouring the patent document and the patent’s prosecution history. This prosecution history consists of the paper trail created by the patent application during the application process and includes, among other documents, "office actions" by the patent examiner and the responses to those actions by the applicant. Insuch traditional due diligence, patent counsel typically asks some routine questions: Does the patent owner really own the patent? Is there some technical defect in the patent? Is the patent valid?

These are certainly important questions, but they do not go far enough. A properly owned, nondefective and valid patent might nevertheless deliver little value to the acquiring company. The only way to uncover true value is to examine the patent in the context of what the acquiring company hopes to achieve as a result of the transaction. In other words, after defining the objectives of a transaction, the acquiring company must retain patent counsel to test the patents in order to ascertain how well -- or how poorly -- they further those objectives.

In the current business climate, the speed of a transaction is often paramount. Because of deadlines, the executives of an acquiring company might not have the time to educate the patent counsel in the background and objectives of the deal or they might not recognize the importance of doing so. Perhaps they assume that patent due diligence comes in a box marked "one size fits all," when quite the opposite is true.

An acquiring company’s executives often engage patent counsel after the company has already signed a letter of intent. Then they hand counsel a list of patents and ask for "patent due diligence." Without further guidance and, typically, under short time constraints, the IP attorneys often narrowly confine their analysis. The resulting due-diligence report might provide a false sense of security by answering wrong or insufficient questions.

Misconceptions about patents often prompt executives to overlook the right questions to ask in a request for patent due diligence. Even sophisticated businesspeople fall prey to the misunderstanding that a patent gives their company the right to make, use or sell what is described in the patent.

No patent gives anyone the right to make, use or sell anything. A patent only conveys the right to exclude others from making, using or selling what is patented. This distinction, although subtle in on its face, is important. For example, the acquiring company might purchase a patent to make the technologically revolutionary "gizmo." But to make the gizmo, the company has to use a certain manufacturing method. Unfortunately, that method is patented by a third company. So, making the gizmo required infringing the third company’s patent, known as a "blocking patent."

The acquiring company can prevent anyone else from making the gizmo, But it has no right to make it, for doing so infringes the blocking patent. Thus, the nondefective, properly owned and very valid patent is essentially worthless. To salvage its value, the acquiring company will have to negotiate a license to use the patented manufacturing method.

Another example shows how owning a patent does not confer the full bundle of right the acquiring company might have counted on. If the acquiring company purchased the gizmo patent, others might have already patented improvements to the gizmo. Not all businesspeople understand that others can improve on patented technology and receive patents to those improvements. So, again, to salvage the full value of the gizmo patent, the acquiring company might have to obtain licenses from those holding improvement patents.

Thus, a generic, one-size-fits-all approach to patent due diligence might identify problems with the validity of a patent, but it can overlook critical question bearing on the acquiring company’s ability to achieve the objectives of the transaction. The better approach looks first at these business objectives and then works back to the patents. Once the acquiring company identifies the business objectives and brings patent counsel up to speed, counsel can then frame the due-diligence inquiry so that it looks not only at a patent validity and enforceability, but also at the technological landscape, in order to uncover other patents that might thwart business objectives.

A strategic due-diligence analysis should be tailored to cover the following subjects:

• Validity and enforceability. Is the patent invalid, or is there some technical reason it might not be enforceable?
• Strength and breadth. How easy would it be for a competitor to interfere with business objectives by designing around the patent?
• Freedom to operate. Do any competitors’ patents block the company’s ability to achieve its objectives?
• Strategic planning. Are there any offensive or defensive strategies available to position the acquiring company better in the future, or to enhance or broaden the exclusivity?

Even if the U.S. Patent and Trademark Office (PTO) issues a patent, that does not mean the patent is necessarily valid and enforceable. In any infringement suit, the patent will be entitled to a presumption of validity. But the alleged infringer can and will introduce evidence to try to show patent invalidity or unenforceability.

Businesspeople may not anticipate the array of theories of invalidity and other attacks that an alleged infringer will hurl in defense of an infringement suit. These include: Earlier use f the invention by others; invention anticipated by prior-art publication; invention obvious when compared with prior art; invention barred by prior sale; lack of enablement in patent; best mode of practicing the invention excluded from patent document; inventors improperly named on the patent; inequitable conduct in securing the patent; and patent misuse.

Even if a patent ranks as the world’s valid patent, it still might not be enforceable in court. Perhaps the attorneys representing the patent applicant perpetrated a fraud on the PTO by not disclosing certain information. If they did, the patent may be enforceable, and it may carry this taint even if sold.

Other defects are curable. Often, a due-diligence title search reveals problems in the chain of ownership. Such errors, if not corrected, may call into question the seller’s right to transfer the patent in the first place, and the acquiring company’s right to enforce it once acquired. Or perhaps the patent improperly name the inventors. If not corrected, this defect can place an ominous cloud over both ownership and enforceability.

As business grows through mergers, acquisitions or IPO funding, it is important for it and its investors to identify any competitive patent that might get in the way of growth. Therefore, it is imperative that patent counsel understand how the acquiring company intends to operate. Patent counsel must know about products or services in the pipeline and on the drawing board.

Patent due diligence may also be used to gauge the value of a patent by ascertaining how difficult it would be for a competitor to skirt the patent. Such an analysis requires patent counsel to work closely with the acquiring company’s technical staff and outside experts. First, however, counsel should carefully study the patent to ascertain that its scope and pinpoint where potential weaknesses lie. Once the boundaries of protection are ascertained, counsel should brainstorm with technical staff on ways a creative competitor might skirt the patent. Counsel must facilitate the discussions by supplying the expertise in patent law, while technical personnel address the feasibility and likelihood of various potential approaches a creative competitor might take to work around the patent.

Rarely is a patent portfolio examined as closely as when transactional due diligence is conducted. As noted earlier, a proper due-diligence analysis involves examining not only the patents to be acquired, but also the competitive landscape, , including competitor’s patents and product lines. This resulting macroview provides a unique opportunity to conduct a long-range strategic planning. Examining the exclusivity afforded by a transfer’s patents may reveal gaps in protection. If so, pending applications may be modified or new ones filed to patch the gaps. In some instances, it is possible to fill the gaps by reissuing a patent to broaden its protection.

Competitors’ vulnerabilities may also be exposed during a due-diligence analysis. For example, the analysis might uncover the opportunity to modify an existing application to cover a competitor’s product. The acquiring company might have no immediate interest in bringing a patent infringement suit, but even without any offensive interests, holding a patent covering a competitor’s product often provides the best insurance against being sued by that competitor.

A patent due-diligence inquiry is only as good as its methodology. A traditional approach may answer important questions, but it will not go far enough. Only by taking a strategic approach can the company ensure that it is getting the perceived value of the deal. And only by educating patent counsel and bringing them into the process can the company achieve the benefits of a strategic approach.