Co-authored with William B. Payne, and Rhona E. Schmidt

In a prior issue of Intellectual Property Update (Volume 2, No. 11), we explored intellectual property due diligence issues in M&A transactions, notably trademarks and patents. This issue extends the prior discussion to trade secrets and copyright (in particular, software).

In many businesses, trade secrets, and not formal intellectual property, constitute the most important and valuable asset of the business. But their identification and evaluation are far more difficult than registered property. Software is essential to every business, but the aggressive positions taken by some software licensors may be a trap for the unwary.

A few points from the prior article —

  • Due diligence is simply an investigation into the status of a business, essentially what’s right and what’s wrong.
  • There is always a significant disparity between what is known by a seller and what is known by a buyer.
  • Due diligence is always a team approach, involving counsel, business executives and other advisors.
  • What is important in a particular deal will drive an approach to due diligence.

The reports for the first half of 2003 are in — merger and acquisition activity is down once again. Thomson Financial, which tracks various financial market indicators, has just released first half information. Looking just at the U.S. experience, it reports that the dollar value of announced deals slid 17.4% from the comparable period in 2002, although the number of announced deals was essentially flat. M&A activity peaked three years ago (based on the number of deals rather than dollar volume).

Dorsey & Whitney’s M&A Group is a national leader in mergers and acquisitions. We completed more M&A deals than any other law firm in the country during the ten years ended December 31, 2002. Members represent corporate clients, individuals, investment banks, management buyout groups and others in transactions involving the purchase or sale of businesses and related financing — acquisitions, divestitures, leveraged buyouts, mergers, tender offers and more. Transaction sizes range from small to billions of dollars, and includes the purchase and sale of both public and private companies.

Deals are led by experienced M&A practitioners supported by our breadth of experience. Approximately 200 lawyers from Dorsey & Whitney’s national and international offices devote substantial amounts of time to M&A transactions.

Trade Secret Due Diligence

Hypothetical: In an asset purchase of the GIZMO (See Intellectual Property Update, Volume 2, No. 11), while GIZMO is protected by certain U.S. patents, the method of manufacturing GIZMO is not protected by patents. The seller has developed highly sophisticated proprietary software to run the GIZMO manufacturing process. This software process provides the seller with a competitive edge in GIZMO’s reliability and cost of manufacture.

If the seller agrees to sell all “trade secrets and know-how” associated with the manufacture of GIZMO, do you have any concerns about the purchase?

A trade secret is any information, not generally known in the industry or trade, that provides the business with an opportunity to obtain an advantage over a competitor who does not know or use that information. Trade secrets include formulae, patterns, compilations, devices, methods, techniques, processes, plans and designs, customer lists, and application of computer software.

Whether purported trade secrets are valuable becomes a combination of practice and legal limitations, which need to be investigated and understood. Trade secrets are primarily protected through secrecy. The existence of written agreements and procedures does not necessarily assure trade secrecy is maintained.

Practical issues to think about are:

  • What is the culture of the seller? Are trade secrets highly regarded within the seller’s organization?
  • Will the employees who have the trade secrets be hired by the buyer?
  • Are the trade secrets already used in the manufacture of products other than GIZMO that are not covered by the sale?
  • Are the trade secrets documented in written form (and particularly in electronic form) and therefore susceptible to theft through reproduction?
  • Has there been significant employee turnover of employees possessing trade secrets and is migration to competitors likely because of geographical concentration or other factors?

Other issues may involve a mix of legal issues and facts.

Confidentiality. Does the seller have confidentiality agreements in place with all employees?

Procedures. Are there procedures in place to prevent taking trade secrets, such as sign-in procedures for visitors? Allowing third parties to view trade secrets and not informing them that it is considered intellectual property has been found to nullify the owner’s ability to later recover for theft of trade secrets by the entity that viewed the trade secret.

Enforceability. No one can stop an employee from leaving and joining a new employer. Sometimes confidentiality agreements are coupled with noncompete agreements. To the extent that such agreements are regarded as unreasonable, they will not be enforced. Lengthy non-compete periods and an overly broad geographical reach are typically reasons that courts will not enforce these agreements.

Assignability. Can the obligation of confidentiality be “assigned” to the purchaser? Courts have found that non-compete agreements cannot be assigned.

Practicality. After closing the deal if you discover that trade secrets have been misappropriated can you effectively sue third parties? The answer depends. Has the past breach of trade secrets been assigned to you? What is the cost of litigation? Will the litigation itself call attention to and destroy any remaining value in the trade secret?

With these problems, the potential purchase could have a substantially diminished value, notwithstanding important trademarks or patents.

Part of a comprehensive intellectual property due diligence includes the consideration of what trade secrets are expected to be part of the business to be acquired and whether in fact they are trade secrets. Any concern will require further work to analyze their importance, alternatives and value. Problems with trade secrets may kill a deal or result in a reduction of the purchase price.

Software Due Diligence

Continuing the hypothetical, not only does proprietary software run the manufacturing of GIZMO, but numerous third party software programs support such manufacturing. What are your concerns?

1. Communicate Strategy and Plans

The first step in performing software due diligence is for you to advise those in the due diligence front lines:

  • which software you must obtain in order to run the business being purchased, and whether alternatives are available in the marketplace if the software cannot be transferred;
  • which software you would like to obtain, but which may be easily available in the marketplace if the software cannot be transferred;
  • how the software will be used post closing.

Following the hypothetical, if you determine that your own software cannot accommodate the manufacture of GIZMO post closing, you must clearly communicate to the deal team that fact. Given the facts, obtaining the software should become a condition of closing because the purchase is worthless without it. On the other hand, if you already use some of the software systems used by the target and can add to your own licenses, or if some of the target’s software is redundant because you will not be using it going forward, you should communicate that to those doing the due diligence so that time is not wasted focusing on the wrong software.

2. Identify Rights and Verify Ownership

Once the need for particular software is identified, the due diligence effort can identify which software is held or used by the target and who owns such software. In the hypothetical, there are two types of software used, proprietary software and third party software. Whether the seller owns the proprietary software must be determined. If employees developed the software within the scope of employment, then the software is owned by the seller. If the software is developed by a consultant, however, the seller only owns the software if the work for hire rule applies or the developer assigned the software to the seller. The third party software will either be owned by the licensor (subject to the same concerns over development addressed above) or the licensor’s licensor if the third party software is sublicensed to the seller.

3. Unique Third Party Software Concerns

The acquisition of third party software as part of a transaction raises some unique concerns. Third party vendors often extract fees to consent to the transfer of software, may not permit the expansion of a license grant to meet the buyer’s new needs, and can cause delay in delivering consents. Negotiations with vendors often take on a life of their own, and may result in last minute expensive decisions if not carefully monitored.

Obtaining consents from vendors of third party software is the biggest issue facing buyers. Consent is required in all nonexclusive software licenses (even shrinkwrap and clickwrap licenses in many cases) being assigned unless a license explicitly states otherwise (this differs from the usual non-personal services contract rule where silence means no consent is necessary for assignment). Consent may also be required if a change in control clause exists in the license. The licenses must be reviewed in light of the type of transaction involved to determine if consent is necessary. The buyer must determine which consents, if any, it will close without, bearing in mind that failure to obtain consent may void a license or may result in infringement.

The buyer should be aware of who actually uses the software being purchased. If the seller is selling software that is used by seller and its affiliates (whose business is not being purchased), seller may desire to negotiate use of the software by its affiliates post closing, through transition services agreements, sublicenses and the like. Of course, vendors need to be consulted to achieve such options where the license does not otherwise permit them. In addition, buyers should be mindful of the scope of use of the software by seller and the anticipated scope post closing. For example, in the hypothetical seller uses software to run the manufacturing of GIZMO. If the software could be used to run the manufacturing of other products, buyer may desire to expand the use to cover those other functions. Where the licenses are based on a per seat or per computer basis, expanded use by a buyer may not be an issue for a vendor who can recover additional fees through selling more seats or per computer licenses to buyer post closing. However, here the original license fee negotiated by the seller was based on “internal use” by seller, which use will now be considerably different, vendors may be less willing to freely grant consent for little or no fee, basing such refusal on lost opportunity to sell to a bigger customer. Such negotiations with vendors can be very time consuming.

A buyer must be very aware of ongoing obligations under the licenses, such as maintenance, warranties, indemnification, caps on liability, insurance requirements, restrictions on use and any payment obligations. Otherwise, payment dates could be missed, software may not be updated post closing, and remedies may not be available for faulty systems.

4. Assess Quality of Title

The final step in the due diligence process is ascertaining whether (a) the seller has granted any licenses in the software, and if so, what rights were retained and what obligations were incurred, (b) there are liens or security interests in the software, (c) others are infringing on the software, and (d) seller has infringed on the software, so the buyer knows how good the title is.

Because of the universal use of software in business, having a lawyer experienced in identifying the software issues and negotiating with third party vendors is an important part of any transaction. Note that software is only one copyrighted work, and similar due diligence must be completed for other copyrighted works.

For more on this topic, see You Acquired Trade Secret Assets. Now, Can You Enforce Them?
Intellectual Property Update Vol. 3 | No. 5