Author: Huang Haiming, Intellectual Property group, King & Wood Mallesons
In recent years, with the development and maturity of emerging technologies such as artificial intelligence and big data, China has ushered in an upsurge of high-tech entrepreneurship. With the timely launch of the Science and Technology Innovation Board, domestic high-tech start-ups have become the most popular investment targets in the capital market. Since intellectual property (“IP”) rights are the core value of high-tech start-ups and the high risk of investment, it has become the most concerned issue for investors before making investment decisions. Therefore, more and more investors choose to entrust intermediary agencies to conduct specific due diligence on the target company’s IP rights before making investment decisions to understand the target company’s IP rights and provide extremely important information support for investment decisions.
In view of the increasing importance of IP due diligence in the business activities of customers, the following briefly introduces the key points that need to be paid attention to when conducting IP due diligence.
(1) Investigation on Basic Information on IP Rights
In the IP due diligence of a target company, it is first required to investigate the basic information on the target company’s IP rights, including the list, ownership, legal status, encumbrances and invalidation lawsuits, etc., of various IP rights (patents, trademarks, copyrights, proprietary technologies) of the target company. Such information is the basic information for other in-depth analysis and evaluation, and it is necessary to ensure the accuracy and completeness thereof.
When investigating the completeness of the list of IP rights, it is necessary to conduct a targeted investigation in light of the transaction purpose. If the transaction purpose is for the equity investment of the target company, the list of IP rights should generally include all the IP rights of the target company. In this case, it should be noted that IP rights (such as patent applications) that the target company has applied for but have not been disclosed to the public and proprietary technologies should be included in the list. Since these two types of IP rights cannot be accessed through external channels, they need to be provided by the target company. If the transaction purpose is to purchase the ownership or use rights of relevant IP rights from the target company, it is necessary to assess whether the list of IP rights provided thereby completely contains all the IP rights of the target technology to be traded, and whether the list contains other IP rights unrelated to the target technology. The completeness of the list of IP rights has a material impact on the realization of the purpose of the relevant commercial transaction and the transaction consideration, so that it is necessary to conduct an independent evaluation instead of relying solely on the unilateral information of the target company.
In general, it is also necessary to include the IP rights under the names of the founders of the target company and the core technical personnel in the list of IP rights. In addition, if the target company has been renamed, but the name of the registered owner of the relevant IP rights has not been changed, the IP rights under the former name of the target company must also be included in the list of IP rights. Moreover, according to the requirements of investors, it is also necessary to consider whether to include the IP rights of the target company’s affiliates (especially its subsidiaries) in the list of IP rights.
(2) Investigation on Source of Technology
The source of technology of the target company is an important source of risk for the target company, and is the focus of investors’ attention, and therefore the focus of IP due diligence. For technology companies with technology as the their core assets and core competitiveness, if the source of technology is not developed independently, e.g., licensing from a third party, or unauthorized use of the technology of a third party or even theft thereof, it will at least impose many constraints on the target company’s business independence and its sustainable development, and in serious cases, it will expose the target company to a huge risk of litigation and compensation, and may lead to the bankruptcy of the company.
It is particularly important to investigate the source of technology for target start-ups. Start-ups can obtain market-leading technology that attracts investors’ attention soon after they are established, which may mean that related technologies have been created before such companies are established, or developed by the companies on the basis of existing results. Common sources of technology for a start-up may include: research achievements of its founding team members in schools and scientific research institutions; technology that its founding team or R&D members have mastered at a former employer; technology obtained from an acquired company by its acquisition of another company; technology obtained from a parent company after its spin-off therefrom; and technology obtained from a third party after its business collaborations therewith. If the source of technology of the target company falls into one of the above situations, the risk of whether the acquisition and use of the target company’s related technology are legal and restricted will become so high that it requires careful investigation.
In order to investigate the source of technology, the investigation can be conducted from the following three aspects: the development history of the target company (foundation, mergers and acquisitions, division); the background of the core technology team members of the target company (whether they have any working and studying background in the same field in universities, research institutes or former employers); and the history of technical cooperation between the target company and third parties. Through the investigation of the above three aspects, combined with the analysis of the registration date of relevant IP rights (patent and software copyright) of the target company, it is possible to roughly determine the source of technology of the target company and assess the risks therein.
(3) Investigation on Quality of IP Rights
The quality of IP rights directly reflects the technical strength of the target company and is therefore the most concerned issue for investors. In this regard, it is possible to analyze whether the distribution of different types of IP rights is reasonable according to the characteristics of the target company’s technical field and the length of its research and development history, so as to judge the overall quality of its IP rights. It is also possible to evaluate the technological advancement of the target company by analyzing the stability of its core patents, as well as the invalidation and lawsuit of the patents. In addition, the quality of patent drafting can also be investigated through such indicators as the scope of protection of the target company’s patent claims, the circumvention of the patent, and the detectability of the claim features, so as to assess whether the target company can obtain an effective scope of IP protection for the relevant technology.
(4) Investigation on Relevance between IP Rights and Business
The relevance between the target company’s IP rights and its core business directly influences its current and future profitability and its sustainable development potential, which is also the focus of investors’ attention. When conducting an investigation on the relevance between IP rights and business, it is necessary to first investigate the business situation of the target company and understand which products, services and related technologies the core business of the target company mainly involves. By investigating the corresponding relationship between the target company’s various IP rights and related products, services and technologies, it is possible to assess the extent to which the target company’s IP rights cover its core business, and to understand whether the target company’s core technology has been applied to its business and contributed to its profitability.
In addition, by investigating the timeline of the target company’s patent applications, it is also possible to understand the historical path of its technology research and development, thereby judging the research and development cycle of the technology adopted in its current business. In addition, it is able to learn about the target company’s technical reserves and future business directions from the company’s technology research and development path, so as to judge its future business growth.
(5) Investigation on Independence of IP Rights
The independence of the target company’s IP rights is also a focus of IP due diligence, because it will affect the continuity of the target company’s future business, and may even affect the achievement of the current transaction purpose. To this end, investigation can be conducted from the following aspects: investigating whether the target company has obtained IP licenses from a third party and assessing the impact of such licenses on its business; investigating whether the target company’s IP rights have been licensed to a third party and assessing the impact of such external licenses on its business; investigating whether the use of the target company’s IP rights is restricted based on any contractual agreements with a third party; and assessing the impact of the IP rights jointly owned by the target company and a third party on the business and the transaction purpose. Such investigation needs to carefully review relevant clauses in the relevant technology contracts between the target company and third parties, and evaluate the impact of relevant restrictions in the technology contracts on the target company based on the investor’s development expectations of the target company and the transaction purpose.
(6) Overview of Industry IP and Investigation on Infringement Risks
Investors generally also pay more attention to whether the target company’s technologies have the risk of infringing on the IP rights of others. In this regard, the complexity of modern technology is in fact no longer possible for a single company to control all the IP rights of one product or technology. For target start-ups that have just been established, it is less likely to avoid all the potential risks of IP rights infringement. Investors actually value the target company’s technological advantages in the industry and its ability to monopolize the market more. Therefore, for equity investment projects, it is generally not necessary to conduct strict infringement risk investigation and search (i.e., FTO analysis) on related products or technologies of the target company in the IP due diligence. Moreover, the cost and time cycle required for FTO analysis are unaffordable for general investment projects. As an alternative, investigation may be made on the IP profile of related industries or designated competitors during the due diligence to understand the current technology status of the industry, the business/technology direction of competitors, the relative technical strengths and weaknesses of the target company, and the profile of patent barriers, so as to give investors a general idea of the IP profile of the target company in the industry, and thus the investors can roughly understand the risk level of IP rights infringement the target company may face in the future. In the case that the target company has technological advantages, it may enhance its ability to cope with IP litigations initiated by others through business cooperation and technology cross-license with third parties so long as it can achieve commercial success in the future.
If the subject of IP due diligence is a technology license or transfer that is to be purchased from the target company, it may be necessary to conduct an FTO analysis of the subject matter of the technology to ensure that the purchased technology can be implemented freely, or that the buyer has the ability to deal with potential infringement risks associated with implementation of the purchased technology.
IP due diligence is a very professional task that requires assessing the value and risk of a target company or target technology from investors/buyers’ perspective based on the needs of the client, the characteristics of the target company and the characteristics of the relevant technology. A good IP due diligence can help the investors/buyers understand the target company or target technology more clearly, and provide important information support for them to make correct business decisions. Therefore, it is very necessary to choose IP specific due diligence in investment projects for high-tech target companies.