The problem with patent due diligence in mergers and acquisitions and how to fix it

As a business or investment professional involved in mergers and acquisitions (“M&A”), do you perform patent due diligence in accordance with the standard practices of your M&A attorneys and investment bankers? When patents form an important aspect of transaction value, you are probably getting the wrong advice on how to conduct due diligence. The due diligence process must take into account the competitive landscape for patents. If competing patents are not included in your vetting process, you may be significantly overvaluing the target company.

In my many years of experience in intellectual property and patents, I have been involved in various M&A transactions in which patents formed a significant part of the underlying value of the deal. As a patent specialist in these transactions, I received the direction of highly paid M&A attorneys and investment bankers who were recognized by C-level management as the “real experts” because they completed dozens of deals a year. To this end, patent specialists were instructed to check the following 4 boxes on 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?
  • Did the seller’s patent attorney make some stupid mistake that would make patents difficult to enforce in court?

When these boxes were checked as “complete” on the due diligence checklist, M&A attorneys and investment bankers had made “CYA” effective on patent issues and were free of patent-related liability in the transaction.

I have no doubt that I performed my patent due diligence duties highly competently and that I also became a “CYA” in these transactions. However, it is now clear that the patenting aspect of M&A due diligence basically fit someone’s idea of ​​how not to make stupid mistakes in a transaction involving patents. In truth, I was never very comfortable with the “flyover” feeling of patent due diligence, but I had no decision rights to contradict the standard operating procedures of M&A experts. And I found out how incomplete the standard patent due diligence process is when they let me pick up the pieces of a transaction conducted under standard M&A procedure.

In that transaction, my client, a large manufacturer, was seeking to expand its non-core product offering by acquiring “CleanCo,” a small manufacturer of a proprietary consumer product. My client found CleanCo to be a good target for acquisition because CleanCo’s product met a strong consumer need and, at that time, was asking for a higher price in the marketplace. Due to strong consumer acceptance for its unique product, CleanCo was experiencing tremendous growth in sales and that growth was expected to continue. However, CleanCo had only a small manufacturing facility and was struggling to meet the growing needs of the market. CleanCo’s venture capitalists were also eager to collect after several years of continued funding from the company’s somewhat marginal operations. My client and CleanCo’s marriage seemed like a good match, and the M&A due diligence process got under way.

Due diligence revealed that CleanCo had few assets: the small manufacturing plant, limited but growing sales and distribution, and several patents covering the single CleanCo product. Despite these seemingly minimal assets, CleanCo’s sales price was over $ 150 million. This price could only mean one thing: CleanCo’s value could only lie in the sales growth potential of its proprietary product. In this scenario, the exclusivity of the CleanCo product was correctly understood as essential for the purchase. That is, if someone could eliminate CleanCo’s differentiated product, competition would invariably emerge and then all bets on the growth and sales projections that formed the basis of the financial models that drove the acquisition would be canceled.

Following my instructions from the M&A attorney and the lead investment bankers in the transaction, I conducted the patent aspects of the due diligence process in accordance with their standard procedures. Everything checked. CleanCo owned the patents and had kept the fees paid. CleanCo’s patent attorney had done a good job with patents – the CleanCo product was well covered by patents and no obvious legal mistakes were made in obtaining patents. So I gave the go-ahead to the transaction from a patent perspective. When everything else seemed positive, my client became the proud owner of CleanCo and its product.

Fast forward several months. . . . I started getting frequent calls from people on my client’s marketing team focused on the CleanCo product about competitive products seen in the field. Given the fact that more than $ 150 million was spent acquiring CleanCo, these marketers unsurprisingly believed that competing products must be infringing on CleanCo’s patents. However, I found that each of these competitive products was a legitimate design of the patented CleanCo product. Because these knockoffs were not illegal, my client had no way to remove these competitive products from the market through legal action.

As a result of this increasing competition for the CleanCo product, a price erosion began to occur. The financial projections that formed the basis of my client’s acquisition of CleanCo began to unravel. The CleanCo product is still selling strongly, but with this unforeseen competition, my client’s expected margins are not being achieved and their investment in CleanCo will require much more time and cost to market to pay off. In short, to date, the CleanCo acquisition for $ 150 million appears to be a fiasco.

In hindsight, competition for the CleanCo product could have been anticipated during the M&A due diligence process. As we later discovered, a search of the patent literature would have revealed that there were many other ways to address the consumer need served by the CleanCo product. CleanCo’s success in the market now appears to be down to the first-mover advantage, as opposed to any real cost or technological advantage provided by the product.

Had I known then what I know now, I would have strongly discouraged the expectation that the CleanCo product would be priced higher due to market exclusivity. Rather, it would demonstrate to the M&A team that competition in the CleanCo product was possible and indeed highly likely, as revealed by the myriad solutions to the same problem shown in the patent literature. The deal may still have been finalized, but I think the financial models driving the acquisition would be more grounded in reality. As a result, my client could have formulated a marketing plan based on the understanding that competition was not only possible, but also probable. So the marketing plan would have been on offense, rather than defense. And I know my client didn’t expect to be on the defensive after spending over $ 150 million on the CleanCo acquisition.

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