Demystifying Legal Diligence in Tech Deals

You are about to strike a deal with an industry partner to develop an exciting new product. Or maybe you have identified the perfect opportunity to acquire an upstart company whose tech would allow you to expand into a lucrative market.

Smart companies do their diligence and plan ahead to ensure they maximize the benefits and mitigate the risks of the deal. Fortunately, diligence into technology assets and intellectual property is not that different from the diligence you would do when buying a house.

The goals are similar:

1. Determine whether there are any serious defects hiding behind walls or under floorboards;
2. Confirm you are actually getting all the property you think you are buying; and
3. Ensure you will have the rights to enjoy the property in the way you envision.

Not everyone is fluent in technology and intellectual property, though—these are complex areas with their own sets of issues. This article lays out five simple questions a company should ask itself throughout the diligence process to help tease out and navigate red flags, with the assistance of an experienced IP transactional attorney.

1. Who really owns the technology and associated intellectual property?

Believe it or not, ownership issues are some of the most common legal issues that delay, devalue, or kill tech deals altogether. After all, nobody wants to pay good money for a shiny new product only to have somebody else come along later and claim it.

Many ownership issues arise when technology is developed collaboratively, with persons both internal and external to the company playing a role. It may seem natural that the company would own the resulting IP, but this is often not the case. Absent agreement to the contrary, the general rule is that IP ownership vests in the creator (though there are exceptions).

Thus, be on the lookout for the following situations in which ownership questions frequently arise:

• IP developed before company formation – has the IP been assigned to the company?
• Employee leaves – will the former employee later assert an ownership stake in the IP?
• Investor and customer feedback adopted into product – are they part owners now?
• Outsourced development – was the project work-for-hire or does the vendor retain rights?
• Joint development – is ownership of new (and preexisting) technology shared?
• Use of open source software – some licenses require public disclosure of improvements.

Fortunately, companies can mitigate ownership-related risk by:

• Asking thorough questions about circumstances surrounding the conception and development of the technology;
• Requesting and reviewing all related agreements (e.g., employment agreements, development agreements, purchase/license agreements); and
• Reviewing IP chain of title and possible encumbrances (e.g., security interests) recorded with the USPTO and other databases.

2. What is the actual scope of the target’s rights?

Just like real estate, technology and intellectual property can be subject to various encumbrances and other restrictions. Many of these restrictions arise from prior deals and collaborative development efforts. If a company overlooks such restrictions, it risks potentially not being able to use the technology in the way it initially envisioned.

One common constraint relates to how the technology can be leveraged. Often, the target may only have the right to use the technology but may not have the right to do things like make changes or improvements, make and sell the technology, and/or allow others (e.g., customers) to use it. The target’s rights to use the technology may even be limited to a specific permitted purpose, such as using it only in connection with a particular project.

Another common constraint relates to the field in which the technology can be leveraged. Companies often divvy up rights to technology and IP to maximize return and/or prevent competition, so it may be advisable to make sure the target has a suitable slice of the pie. For example, the rights can be divvied up by industry, with Company A having exclusive rights to use the technology in one industry and Company B having exclusive rights in another industry. The rights can also be divided up by geographic area, with Company A having exclusive rights in the United States and Company B having exclusive rights abroad.

Thus, a company may consider requesting—and closely reviewing—any agreements the target can provide related to the development and commercial leveraging of the technology. This is especially true of those agreements containing any (i) outbound licenses conferring (potentially exclusive) rights to third parties or (ii) inbound licenses in which a third-party grantor has expressly reserved certain rights to the technology. Further, it may be useful to review USPTO records for any such licenses (if recorded), as well as for any challenges to the validity or scope of underlying IP.

3. Are the target’s rights transferable to your company?

Many agreements, including tech agreements, do not allow for one party to transfer its rights and obligations to a third party without first obtaining permission. This is understandable, as many companies choose their partners carefully and do not want just any third-party gaining access to their technology. This is especially true when there is potential that one party could assign its rights and obligations to a competitor of the other party.

Likewise, companies may wish to confirm that the rights being acquired are broad enough to cover any permissions needed by the company’s customers, distributors, suppliers, and the like. Some agreements include license grants that expressly cover such related parties, while others may allow for rights to be sublicensed to these related parties. Either way, it is wise to confirm that your umbrella is big enough to keep you and yours out of the rain.

4. Does the technology infringe third-party IP rights?

Imagine taking a victory lap around the public relations circuit, telling the world all about your amazing new opportunity – only to be approached the next day by a company accusing the technology you just bought of infringing its intellectual property. Not good, right?

While it is practically impossible to eliminate all such risk, there are several actions a company may consider during the diligence process to potentially mitigate the risk:

• Asking thorough questions about circumstances surrounding any actual or threatened litigation concerning the technology, and reviewing any associated court records, demand letters, legal opinions, and settlement agreements;
• Performing a freedom-to-operate (FTO) assessment, which usually involves searching for relevant third-party IP (especially that of competitors) and evaluating whether the technology is likely to infringe; and
• Reviewing the litigation history of relevant patent holders to assess litigiousness.

5. Is the technology compliant with legal regulations?

Companies may wish to consider whether the technology complies with various legal regulations—and if not, what it will cost to become compliant. The details are well beyond the scope of this article, but three areas commonly associated with technology are data privacy, environmental and safety, and cross-border regulations.

Data privacy in particular is front-of-mind for many companies in the wake of several high-profile breaches, Health Insurance Portability and Accountability Act (HIPAA) violations, and passage of the European General Data Protection Regulation (GDPR), which implements strict regulations concerning the handling of personal data. Non-compliance with relevant laws can result in stiff civil and criminal penalties, your products being sidelined, and immeasurable damage to your brand, among other negative outcomes.

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