What investors need to know about IP due diligence

While it has long been appreciated that IP due diligence provides investors with valuable information about an investment target’s intellectual assets, new research shows that venture capitalists themselves believe that IP due diligence provides a valuable proxy for the success of a prospective investment’s overall corporate management. For the IP strategist, due diligence projects tend to be both financially and professionally rewarding.

Clients in the venture capital and private equity markets who invest in the technology sector focus on the technologies of tomorrow. Thus, IP due diligence provides a heads-up on those new developments most likely to have a significant commercial impact in the future. For their part, IP strategists must continually strive to make their due diligence products relevant for their financial clients.

Venture capital and private equity markets

Investors of all types acquire financial stakes in or the complete assets of technology businesses. Each investor has unique motivations and goals. Narrowing the focus to the venture capital and private equity markets, many if not most of the investment targets relate in some way to advanced technologies. Thus the targets often already have a strong set of IP assets but may be in sore need of a solid IP strategy.

The venture capital market reached a new high with $155 billion of investment in 2017 according to a report by KPMG. Although the United States still dominates the venture capital market overall, China accounted for the largest deals, with North America following close behind. The rest of Asia also recorded sizeable deals, while Europe reached a fourth-quarter high of $5.7 billion in investment.

The 2017 trend continued in 2018, despite threats of trade wars and other destabilising elements, although more capital was concentrated into a smaller number of large deals. The initial public offering (IPO) market also improved, giving investors greater opportunities to capitalise on their investments.

In the United States, venture capital accounts for 2% of gross domestic product (GDP), according to the National Venture Capital Association. While this might seem small, it provides a measure of future economic growth. The association also reports that nearly 11% of private sector jobs originate from venture-backed companies, while venture-backed revenue accounts for 21% of US GDP.

Role of intellectual property in venture capital due diligence

Venture capitalists employ a broad mix of external specialists to help them assess new investments. According to industry surveys, the amount spent by investors on professional due diligence services ranges from between 3% and 5% of the amount to be invested, in about 80% of venture capital investments. Investors are willing to spend as much as 10% of the amount invested on professional due diligence services in a small number of potential investments. Put another way, the market for professional diligence services amounts to roughly $8 billion per year. Of course, this includes all the services purchased by venture capitalists, which includes a significant amount of traditional legal work, technical experts and other services. Nevertheless, the market for intellectual asset diligence services is not trivial.

A venture capitalist will obviously not be compensated for the funds spent on due diligence unless the investment goes through (and later becomes profitable). Because venture capitalists kiss a lot of frogs in their quest for a wealthy prince, they tend to expect diligence services to be performed on well-defined and fixed budgets. Intellectual asset diligence also tends to occur towards the end of the diligence period – if the venture capitalist sees something early on that they do not like, they do not need to spend extra funds to confirm a dud.

Intellectual asset due diligence teams typically spot more issues than they resolve. IP strategists should be careful describing the services that they provide to clients. During the diligence phase, investors typically have no right to demand that an issue be resolved, although they may make their investment contingent upon certain issues being fixed.

IP due diligence as a proxy for overall management savvy

Academic research indicates that venture capitalists have learned that intellectual asset due diligence serves a vital role in assessing an investment target’s overall management competency. Thus, IP strategists perform a vital and increasingly appreciated role in performing diligence. This emerging realisation also suggests that intellectual asset due diligence services are likely to grow within the overall diligence process as further understanding permeates the venture capital industry.

Two innovation management professors from Chalmers University of Technology have discovered that the venture capital community uses IP due diligence not only to assess a potential investment’s intellectual assets but also as a proxy for its managerial qualities. In other words, in the collective minds of venture capitalists, if a start-up gets its IP portfolio right, then it is likely to have done other things correctly too. The reverse is also true: if a company’s IP protection has been poorly executed, venture capitalists tend to conclude that the company has likely executed other aspects of management just as incompetently.

More specifically, associate professors Marcus Holgersson and Henrik Berglund at Chalmers University of Technology commented that one of the few tangible ways for venture capitalists to evaluate early-stage venture management is to look at the alignment between what the founders pitch about their venture, its technology and its business model – and what they have actually done with their intangibles in terms of:

• which inventions have been patented;
• which have been kept secret; and
• which have been made open source, published or otherwise freely distributed.

Thus, the alignment between what the founders say about their business and the choices they have made with their intellectual property is seen as a significant indicator of quality.

As a consequence, the intellectual asset due diligence team should understand that their job is not to place a series of pieces of disconnected data before their client and assume that they can join the dots. While some venture capitalists are highly sophisticated and have in-house IP expertise, this is not necessarily a given. The parties involved in a due diligence should agree at the beginning of the engagement what the due diligence team will and will not do. However, a due diligence effort is doomed to fail miserably if experienced IP strategists find or suspect something that they do not clearly convey to the venture capitalists. For example, a report of the company’s patents that notes that their legal owner is the investment target’s chief executive officer and not the company itself but that fails to point out the problems that this could cause does a terrible disservice to the client. “Well, it’s in the report,” is by no means adequate if the venture capitalists are unlikely to understand the issue. The same comments apply to co-owned patents and a host of other problems that IP strategists know about but that their clients may not.

How the venture capital market works

Venture capitalist firms differ in their motivations and approaches. Some focus on specific industries. Others invest in companies that require particular types of support to grow. Venture capitalists have differing expectations regarding levels of return on investment and the length of time they plan to hold a given investment. The IP strategist performing due diligence does not necessarily need to know that investor’s game plan but it does help to remember that all investors are not the same.

Along these lines, IP strategists should also understand that most investors (unless they are extremely large) are unlikely to be in buy mode at all times. Thus, in soliciting due diligence work, it is a good idea to understand where particular investors are in their investment cycles. When an investor is primarily working to make its investments successful, the IP strategist’s pitch needs to be different from when an investor is at the due diligence phase or at the exit phase.

Venture capital typically comprises a number of investment rounds or stages, which correspond roughly to the stages of a young company’s development. Seed funding represents the earliest financing round needed to prove an idea. Because any given investment is typically deigned a longshot, investors tend to limit the depth and duration of IP due diligence. Strategists may thus have some opportunities to carry out general research and to answer an investor’s questions related to an entire field in which it is contemplating investing. Intellectual asset due diligence becomes more relevant for investments in growing companies, such as those found in Series A, Series B and Series C investment rounds. The IP strategist should also understand the ‘first man in’ principle that many investors follow. Secondary investors tend to borrow the diligence work of the first investor and often have limited budgets for diligence work, although on occasion these investors may have some specific questions for an IP strategist – the answers to which may be of interest to the first investor as well.

IP due diligence may also become relevant at expansion or mezzanine financing for newly profitable companies. Mezzanine financiers are sometimes more interested in balance sheets than deep company fundamentals but investors differ. If a mezzanine financier spots a problem in due diligence, it will typically expect the company to fix whatever issues have been discovered. IP due diligence may also become relevant during technology spinouts. It is not uncommon for groups of separate bidders to combine – when this happens, they often share portions of their due diligence team with other investors, especially where the investment is being conducted in a series of rounds or stages in which groups of investors combine in each succeeding round.

From time to time, a venture capitalist will realise that an existing investment has a problem of some sort with its intellectual assets, which may provide an opportunity for an IP strategist. However, venture capitalists tend to require that payment for fixing an investment’s intellectual asset issues come from the investment itself rather than from the venture capital firm. Thus, investor A decides that investment B needs help but requires investment B to pay the bill. This arrangement works fine for an IP strategist, provided that investment B also recognises the need for help. The beginning points of such engagements are often rocky, although investment B’s outlook tends to improve when it realises that it does indeed have a problem that the IP strategist can resolve.

Before an IPO, companies often ask for a pre-diligence review by IP strategists to spot obvious flaws and mistakes, and to prepare cogent and convincing responses to likely investor questions about the company’s intellectual assets and IP issues facing the company or its industry. Large blocks of a company’s stock may be purchased during an IPO by institutional investors, which are likely to review a company’s prospects as intensely as the venture capitalists did in an earlier stage but presumably without the level of disclosure that was available to the venture capitalist.

One final word of caution: venture capital does not operate in a uniform way around the world. The norms of the United States or China are not necessarily the norms of Ireland or Singapore. So, IP strategists will obviously need to adjust its methods of operation to fit local investment conditions.

Due diligence processes and techniques

Intellectual asset due diligence should provide the venture capitalist with an understanding of an investment target’s IP portfolio, the strategy used to construct that portfolio and any business or financial risks facing or likely to face the investment target related to its intellectual assets or those of a relevant third party.

For many IP strategists, especially attorneys outside Silicon Valley, IP due diligence traditionally involves little more than collecting lists of an investment target’s IP rights – just lists, no review, no analysis and no knowledge about the business. Over the past few decades, due diligence has increasingly come to include at least an evaluation of the investment target’s IP rights.

Intellectual asset due diligence can go far beyond merely kicking the intangible tires. If venture capitalists use an investment target’s IP rights as a proxy for overall management success, then IP due diligence should involve more than collecting lists and evaluating the IP rights on them. Commercially relevant analysis should also be provided to test the links between the intellectual assets and the business itself.

For the most forward-thinking venture capitalists and IP strategists, IP due diligence long ago moved beyond merely collecting lists of legal intangibles. The only time these days when a mere list serves the client’s needs may be during diligence associated with seed funding, where the investment is small and the funds available for due diligence are even smaller.

The due diligence team may employ a variety of planned analytical techniques to carry out its task – a few of which are discussed here. A number of other techniques may be employed, and the due diligence team will want to consider the appropriateness of each possible technique for each engagement.

Data to assess regardless of analytical approach

Regardless of the analytical techniques used, the due diligence team will first want to gather publicly available materials about the investment target. In essence, this initial step replicates the effort that has historically comprised the totality of IP due diligence.

The diligence team may next want to evaluate the quality of the IP assets found, particularly the registered IP rights. Patents, especially, often merit close examination. However, in evaluating an investment target’s patents, the team should not spend the entire diligence budget examining patents unless the investor has specifically requested this. This is especially true if the due diligence team determines early on that the patents, whether excellently or poorly constructed, are actually irrelevant to the business.

As well as examining the IP rights, where possible, the due diligence team should examine non-registered intellectual property (eg, trade secrets). It is often interesting to ask an investment target’s executive team for the headline identification of its trade secrets. On occasion, the target’s executives have no idea what a trade secret is, which means that any actual trade secrets have only been protected by luck or accident. On other occasions, the inquiry will be met with a “glad you asked” followed by a detailed explanation about how the target goes about deciding when to patent inventions and when to keep them as trade secrets. The diligence team can then examine whether the selection rationale itself makes sense.

As a minor point, trademarks are often merely listed in the due diligence report and are not investigated or evaluated. While this makes sense for many diligence projects, for others it means that the diligence team risks overlooking or underestimating a critical corporate intellectual asset.

While many due diligence teams are keen to evaluate the target’s patent portfolio, it may be helpful to move this expensive step to later in the process. Among other things, the signalling value of patents in many technical sectors has declined over the past decade. More importantly for due diligence, published academic research indicates that venture capital firms find patents themselves to be less relevant during later investment rounds than they do in earlier rounds. So, a due diligence team does its client a great disservice in evaluating an irrelevant set of patents whose value will make little difference to the investor. In short, a due diligence team should probably not focus early on the evaluation of patents unless it knows from the start that the patents are important and/or the venture capitalist has specifically asked for them to be evaluated. Evaluating a patent portfolio is typically one of the most expensive steps in a due diligence but may not always be of primary relevance.

Beyond conventional diligence

The diligence team will want to learn about the company, its business and its business plans, preferably from the company’s executives themselves. An overall understanding of the value of a company’s IP portfolio almost always requires an understanding of the company’s business plans and environment. The one exception, which is somewhat rare, is when the investor’s intention is that the company’s IP assets be used to collect rents from third parties (eg, IP exploitation will be the company’s business).

If the target company has an in-house IP team, the diligence team will want to speak to this to gain some insight into particular IP matters. However, for many companies, their in-house IP person is typically more of a valued tactical craftsperson than the architect of the company’s intellectual asset strategy. Thus, the diligence team will want to find and interview the person(s) in the company who have been truly responsible for developing its intellectual property, regardless of any particular formal title.

The diligence team may well discover that no one in the company has been responsible for developing an IP strategy or for shaping the company’s IP assets. If this is the case, it should inform the investor early on that the investment target has had no explicit IP strategy, especially since the investor may be using the company’s skill in intellectual asset management as a proxy for overall management expertise.

As for the company’s IP assets themselves, the absence of a strategic direction in protecting intellectual assets is not necessarily fatal. Some companies hit upon a workable IP strategy by accident. So, just because a company has had no explicit strategy does not necessarily mean that the sum total of its IP assets is poor – whether the investor may wish to make a post-investment change in the company’s management is another matter.

Likewise, it is possible for a company to have an IP strategy that is simply wrong for the business. For example, this can occur when a company has deliberately set about on a path of heavy patenting activities without paying attention to things like its ability to:

• detect third-party infringement;
• run a licensing programme; and/or
• litigate against recalcitrant infringers.

This situation can also occur when a company has blindly copied what it believes (probably mistakenly) to be the strategy of another (typically larger) company, whose overall situation differs significantly.

The strategy field abounds with illustrative anecdotes. The author was once on a due diligence of a middle-size company that had survived for some 30 years and claimed to have an IP strategy built entirely around trade secrets. This approach did not seem to make much sense given that the company ultimately aimed to manufacture and sell a physical product that was amenable to being copied. But this strategy really fell down in the implementation phase since no one had been tasked with minding any of the trade secrets.

It was not necessary to ask too many questions or search too many publications to determine that almost nothing that the company thought was a trade secret would legally qualify as such. Some of the purported trade secrets even resided in published journal articles from collaborations with third parties. Fortunately, there were a number of new inventions that had not been publicly disclosed and it was possible to recommend a post-acquisition programme to improve the company’s IP portfolio.

IP asset strategies do make good proxies for overall management skill, as venture capitalists have noticed. One tends to find that when a company makes mistakes related to its intellectual assets, it makes mistakes in other areas as well. The same company from the above example said that it had no patents. Checking the names of the company’s engineering team against a patent database revealed that the company did in fact have one patent, which had been filed by a larger company in whose factory the company began many years earlier.

This particular patent had been sold at some point by the larger company, along with thousands of its other patents to another giant company. One cringes imagining the conversation in which someone from this small company informed a counterpart at the giant company that a patent that it had acquired more than five years previously, bundled with thousands of others, actually belonged to the smaller company and could the giant company kindly return it? The situation was even worse since no one in the company, including the inventor, knew how this had happened.

Once the due diligence team has collected all the relevant material, it should then assess the overall IP strategy and related assets. This step separates well-crafted but traditional IP due diligence from business-relevant due diligence. The IP strategist may follow two general approaches in carrying out this task – an ad hoc approach versus a planned approach. Planned programmes typically succeed better than ad hoc programmes, a fact that has been increasingly true in nearly all areas of human endeavour for many years.

Ad hoc approaches

There is something to be said for the directness of seemingly ad hoc approaches, especially when budgets are tight and time is short. Besides, most ad hoc approaches are not really ad hoc at all; they usually tend to be based around a certain level of common sense. It is like the crime scene investigators who routinely collect and analyse several hundred pieces of data versus the detective who instinctively follows the scent of gunpowder. Of course, the detective could be following the wrong trail if the crime scene investigators discover that the victim was poisoned and not shot.

An ad hoc approach involves reviewing the materials collected and providing an overall assessment of these materials without necessarily following a formal programme in arriving at the assessment. The diligence team will likely focus on obvious successes and failures. Ad hoc approaches typically work best when the due diligence team comprises senior specialists who have worked in the IP area for many years and performed countless diligences. Often senior teams have essentially internalised an analytical procedure that gives the impression of being ad hoc.

Planned approaches

In terms of planned analytical approaches, the community of IP strategists has developed a number of analytical techniques over the years which vary in complexity and sophistication. The phrase “the right tool for the right job” fits well here. Some precise and exacting analytical approaches may be completely wrong for a due diligence project because, among other things, the particular approach requires a level of resources far exceeding the project’s budget.

Many of the analytical techniques developed by IP strategists derive from techniques found in management literature. So, for example, there are techniques based on Porter’s five forces (ie, product/sales competitors, new entrants, buyers, suppliers and substitutes), along with the business model canvas – a tool for analysing a business’s competition by applying the forces that determine competitive intensity. PESTLE – an acronym for political, economic, social, technological, legal and environment – is a tool that identifies critical external factors that may affect a corporation. These factors may range from opportunities that provide a competitive advantage or others that comprise threats to the business. The business model canvas provides a visual chart with elements describing an investment target’s value proposition, infrastructure, customers and finances. This tool can also be applied to the firm’s products and services. In the management context, the tool helps firms align their activities by illustrating potential trade-offs.

The IP community has adapted each of these tools and many others over the years to analyse a firm’s IP assets and how these assets align with its overall business strategy. Obviously, it makes little sense for a firm’s intellectual asset strategy to go in one direction (or no direction at all) while its overall business strategy goes in another.

Put simply, the goal of all these tools is to gauge the extent to which the firm’s intellectual asset strategy aligns with how it intends to make money or how it intends to be acquired by a third party. Of course, there are nuances, such as the situation where the bulk of a firm’s intellectual assets relate not as much to how the firm makes money now but how it foresees making money in the future.

Among the information to collect beforehand is the extent to which the potential investor envisions the world post-investment or post-acquisition. There are several possibilities. The investor may continue to operate the business as is. It may operate the business based on some aspect that is not presently being exploited (eg, a new technology that is on the cusp of market readiness). Or the investor may want the assets of the business for some reason complementary to its other investments. This is often the case where the investor is not a venture capitalist but another larger commercial entity (eg, an operating firm).

The possibility that the investor may want the company to change direction prompts a word of caution. Obviously, the due diligence team will want to focus on analysing intellectual assets most relevant to the investor’s post-acquisition plans. On occasion, a potential investor may require a loan from a third party in order to complete the investment or acquisition.

The author was once part of a diligence team where the investor did not mention that he would need a loan for the purchase. This particular investor was only interested in the target’s new line of business, one in which revenues at the moment were small because the market for this new product was just beginning. The target had a few other lines of business, including one that provided nearly all of its profits at the time. Our diligence team had been told to ignore the presently profitable line of business because the investor wanted to focus on the new, promising line. However, when the diligence documents were provided to the bank to approve the investor’s loan, the bank wanted to know about the intellectual assets associated with the currently profitable part of the business – the part that we had been told not to focus on.

This new task obviously caused some turbulence between the diligence team and the investor, since the diligence budget had already been consumed examining the assets for the new line of business, as instructed. The caveat for the diligence team is thus to understand who all the relevant players are before the diligence begins and to understand whether any other party could possibly ask for information that differs from what the investor has requested.

Report to the investor

The diligence team will ultimately prepare a report that conveys its findings to the investors. For liability reasons if for no other, a written report should be prepared, possibly along with a visual presentation of findings. Of course, as many seasoned IP strategists know, the investor often does not read either the written report or the visual materials but instead discusses the findings in a brief teleconference with the diligence team.

An investor from a well-known firm once complained to my diligence team: “Every time we have a diligence project, our IP lawyers give us a thick report, as if we have time to read it. Don’t they understand how much we’re working on other things when we do one of these projects?”

In the discussion that followed, liability issues were mentioned as one reason why the due diligence reports tend to be so long. The investor accepted this as valid but added that whatever materials he received should be relevant to him given all considerations, including his available time for reviewing them.

The same venture capitalist also complained that the very nature of a typical diligence report was all wrong. “I’ve seen dozens of them, and they’re all words and I have no time to read a long report or even click through a presentation. All of our other experts give us numbers – numbers that we can plug into the master spreadsheet that we have for the deal.”

When asked if he would like to receive something from the IP diligence team that also included quantitative data, the investor responded with an enthusiastic “Yes!” We then discussed what aspects of the project could be turned into data and equations, which might be helpful to his investment team. This particular diligence project lent itself to a variety of quantitative data that could be fed into the investment team’s master spreadsheet. Other aspects of the project were not so amenable. So, where possible, the IP strategist should convey information in the precise format that will be the most helpful to the client, which often involves formats that are historically atypical for lawyers and IP specialists.

Patents in the diligence context

Patents in the due diligence context sometimes remind one of “The Rime of the Ancient Mariner” – “patents, patents, everywhere, but no relevant intellectual property”. As we all know, patents can be fantastic tools for protecting inventions. But they are not the only option for safeguarding valuable innovations – in some cases they are not even the best. The conventional IP due diligence team comprises attorneys whose background lies in patents. This is fine, so long as these patent attorneys understand that patents are not the answer to every IP question facing a company nor are they necessarily the best tool to protect an investment in every case.

The author was once on a large diligence project for an investment worth more than €250 million, where the seller (a large multinational) seemingly intended to distract the buyer’s IP due diligence team by including some 500 patent families in the deal (eg, the seller seemed to have thrown these patents into the offering for no obvious reason). Evaluating these patents would have been a comfortable but irrelevant task that would have consumed the entire diligence budget.

We did not take the bait because the main objective of the project related to a complicated licensing issue. The investor readily agreed that the patents were a minor issue and that we should focus our efforts on the licensing issue. A due diligence team should thus be aware that sometimes sellers may attempt to distract them because, as a group, they are so comfortable focusing on patents to the exclusion of other IP issues.

As research has shown, a successful intellectual asset due diligence also furthers the interests of the financial community by testing a proxy for overall corporate management. An IP strategist will likewise benefit, where possible, from cultivating long-term relationships with the financial community. The service provider should not anticipate that any given venture capitalist will continue purchasing more and more services for the same investment – the engagements are short but rewarding and may possibly repeat with a completely different set of investment targets. The professional fees are not insignificant but exposure to truly new inventions and management styles is even more helpful and serves as a continuous opportunity for professional growth and renewal.