As a business or investment professional involved in mergers and acquisitions (“M&A”), do you conduct patent due diligence in accordance with standard practice of merger and acquisition attorneys and investment bankers? When patents are an important aspect of the value of a transaction, you are likely to receive incorrect advice on how to conduct your due diligence. The due diligence process must take into account the competitive patent landscape. If competitive patents are not included in your audit process, you may be significantly overestimating the target company.
During my years of experience in intellectual property and patents, I was involved in a number of mergers and acquisitions transactions where patents constituted a significant portion of the underlying value of the deal. As a patent specialist on these transactions, I received guidance from highly paid M&A lawyers and investment bankers who were recognized by C-level management as the “true experts” because they completed dozens of deals annually. To this end, we patent professionals have been directed to check the following four boxes in the patent due diligence checklist:
- Are patents paid at the patent office?
- Does the seller really own the patents?
- Do at least some of the patent claims cover the seller’s products?
- Has the seller’s patent attorney made any stupid mistakes that would make patents difficult to enforce in court?
When these boxes were ticked “completely” on the due diligence checklist, M&A attorneys and investment bankers had effectively “CIA’d” the patent issuance and were free of patent-related liability in the transaction.
I have no doubt that I did my patent due diligence very efficiently and that I also had “CYA’d” myself in these transactions. However, it is now clear that the patent aspect of due diligence for mergers and acquisitions is fundamentally consistent with someone’s idea of how not to make stupid mistakes in a transaction involving patents. In truth, I’ve never been comfortable with the “bridge” feeling of due diligence under patents, but I didn’t have decision-making rights that conflict with M&A experts’ standard operating procedures. And it discovered how incomplete the standard patent due diligence process was when it was left to pick up the parts of the deal that were done under the standard M&A procedure.
In that transaction, my client, a large manufacturer, sought to expand its non-commodity product offerings by acquiring “CleanCo,” a small manufacturer of a patented consumer product. My client found CleanCo to be a good acquisition target because the CleanCo product met a strong consumer need and, at the time, required an excellent market price. Due to strong consumer acceptance of its single product, CleanCo has been experiencing exponential growth in sales and this growth is expected to continue. However, CleanCo only has a small factory and has been struggling to meet the growing needs of the market. CleanCo’s venture capital investors have also been eager to cash in after several years of continuous financing of the company’s somewhat marginal operations. And so my client and CleanCo’s marriage seemed like a good match, and the merger and acquisition due diligence process began.
Due diligence revealed that CleanCo has few assets: a small manufacturing plant, limited but growing sales and distribution and several patents covering the single CleanCo product. Despite these seemingly meager assets, CleanCo’s asking price was more than $150 million. This price could only mean one thing: CleanCo’s value could only be in the growth potential of its patented product. In this scenario, the exclusive nature of the CleanCo product was correctly understood as essential to the purchase. This means that if someone manages to ditch CleanCo’s premium product, competition will always occur and bets will then be on the growth and sales forecasts that formed the basis of the financial models driving the acquisition.
On my instructions from the M&A attorneys and investment banker leaders in the transaction, I conducted the patent aspects of the due diligence process according to their standard procedures. Everything was checked. CleanCo owned the patents and kept paying the fees. CleanCo’s patent attorney has done a good job of patenting: The CleanCo product is well covered by patents and there have been no obvious legal errors in patenting. So, I gave the deal a thumbs up from a patent perspective. When all seemed positive, my client became the proud owner of CleanCo and its products.
Advance rapidly for several months. . . . I started getting frequent calls from people on my client’s marketing team focused on the CleanCo product about the competitive products seen in the field. Given the fact that more than $150 million was spent on the acquisition of CleanCo, these marketing professionals did not surprisingly believe that competitive products should infringe CleanCo’s patents. However, I found that each of these competitive products was a legitimate design around the patented CleanCo product. Since these counterfeit products were not illegal, my client had no way to remove these competitive products from the market using legal action.
As a result of this increased competition for the CleanCo product, price erosion is beginning to occur. The financial outlook that formed the basis of my client’s acquisition of CleanCo has begun to unravel. The CleanCo product is still selling solidly, but with such unexpected competition, my client’s expected profit margins are not being met, and his investment in CleanCo will take much longer time and expensive marketing to pay off. In short, so far, the $150 million acquisition of CleanCo appears to have been bankruptcy.
In hindsight, competition for CleanCo’s product could have been anticipated during the merger and acquisition due diligence process. As we later found out, a search of the patent literature would have revealed that there are many other ways to meet the consumer needs of a CleanCo product. It now appears that CleanCo’s success in the market is due to the first mover advantage, as opposed to any actual technical or cost advantage the product offers.
If I had known then what I know now, I would have strongly recommended against the expectation that the CleanCo product would command a premium price due to market exclusivity. Instead, I’d like to make it clear to the M&A team that competition in a CleanCo product was possible and, in fact, very likely as evidenced by the myriad solutions to the same problem described in the patent documents. The deal may still be going, but I think the financial models driving the acquisition will be more realistic. As a result, my client was able to craft a marketing plan based on the understanding that competition was not only possible but also potential. The marketing plan then was about offense, rather than defense. And I know my client wasn’t expecting to be on the defensive after spending over $150 million on the acquisition of CleanCo.