Knowing what you buy: the importance of IP audits in the transaction process

Due diligence is fundamental to any major business transaction, whether an acquisition, sale, merger, investment, debt issue or initial public offering. Traditionally, due diligence includes financial and management audit or analysis, and may extend to include production and information systems audits. However, what is often lacking in transactional due diligence is a comprehensive audit of the business’s intellectual property. Given that intangible assets now constitute 80% of the assets of most businesses, and that intellectual property is itself considered a major and critical asset class, its absence should be deemed conspicuous during any major business transaction due diligence.

In this article I discuss why intellectual property should be included in any comprehensive due diligence process; why IP audits should be undertaken independently for at least one, if not both, of the parties to a transaction; and who should be undertaking these audits so that they generate value for both parties.

Why include intellectual property in due diligence?
The purpose of due diligence in a transaction is to allow decision makers to make informed decisions by providing them with accurate, high-quality information at appropriate levels of detail. So what does this mean when the transaction includes or is focused around intellectual property?

The intangible nature of intellectual property presents some unique challenges for due diligence. First, unlike physical products, intangible assets (especially those that are unregistered, such as trade secrets) are difficult to inventory or audit, so even bare identification can be problematic. Second, accounting standards are often unhelpful, frequently grossly overstating or understating the true value of intangible assets to the company – hence, financial impact can be difficult to assess. Third, financial valuations frequently fail to capture the real relevance or importance of intellectual property to the business. This is particularly relevant in the case of:

• intellectual property that is forward looking and relevant to revenue streams or market positions that may not crystallise for two to five years (eg, a key patent on a next-generation technology); and
• the background knowhow and confidential information that permeates every business – their nebulous and undocumented nature often means that they are not seen as relevant until they are no longer available. A good test here is the question: “Could I run this business without this body of information?”

Hence, to conduct effective transaction due diligence, it is critical to undertake an audit of intangible assets that may be affected by the transaction or that form part of the overall business. A comprehensive IP audit involves:

• systematically reviewing and assessing all intangible assets relevant to the transaction;
• assessing how those intangible assets are managed (ie, the systems, processes and policies used by the business to manage these assets) to ensure quality; and
• identifying opportunities and risks that may affect these assets in the future.

Depending on the outcomes, it may also be necessary to value some or all of the intangible assets.

Valuation is beyond the scope of this article and is a whole subject area on its own, but one important point should be made: valuing intellectual property or intangible assets solely on the basis of quantitative factors and in the absence of an investigation into the quality of these assets (eg, the strength and scope of claims in the case of a patent) does not produce meaningful outcomes. With intellectual property, more than most asset classes, the quality and strength of the asset cannot be assumed and can often have a binary impact on valuation.

These judgement calls are the domain of skilled practitioners who can combine the legal, financial, technical and business aspects of valuation practice together to reach a meaningful valuation.

Who should instigate an IP audit in a transaction?
The benefit of an audit can flow both ways. For both parties it reduces the risk associated with the transaction, answering questions such as the following:

• What is the true extent of the assets?
• How much impact do they have on the transaction?
• Does the target’s intellectual property fit with the acquirer’s IP strategy?
• What encumbrances are associated with the assets? These could have a substantial impact on operating aspects in an M&A transaction, for example.
• Does the target have stringent IP systems and policies in place to identify and manage intellectual property?
• How certain are future revenue flows against the assets?
• How clean (or dirty) is ownership of the assets?

From the seller’s or target’s perspective, provision of this information can reduce risk in the transaction and drive increased value. In addition, information provided to an acquirer that demonstrates how IP savvy the target or seller is helps to build credibility and trust. Further, by controlling the release of this information, a seller can tell the story of the business’s intellectual property or assets in its own way. In many instances this makes acquirers more likely to corroborate the data presented to them than to go through an identical process to draw their own conclusions.

If all of this information is provided to a buyer or an acquirer, does it need to bother completing its own audit? The answer is clearly yes. Acquirers need to audit intellectual property assessed from their point of view, unsullied by the desires or characterisations of the other party. However, working from a comprehensive and well-constructed audit conducted by the other party means that such an audit should take considerably less time and resources than one conducted in isolation.

Who should carry out the IP audit?
This leads us to who should undertake the IP audit for either party. Ideally, it should be conducted by a party which is truly independent of both the buyer and seller – that is, someone that will not benefit from the transaction itself or the outcomes of transactions, including potentially existing service providers. Real value comes from a genuinely independent party with an expert specialisation in intellectual property which can handle the technical, IP and commercial issues that such audits typically present. Intellectual property permeates every business and should be considered seriously when undertaking due diligence for any transaction. By undertaking an IP audit as either a seller or a buyer, you minimise many of the risks associated with such deals and can build a strong picture of potential opportunities and value derived from the transaction in the future.