Locking in a Target's Software and Trade Secrets

August 3, 2005

Software and trade secrets are critical elements in the operation of virtually all businesses, and in an acquisition are often among the most coveted assets of a target company. But they may not automatically move in lock step with the target's other assets. Assuring that these vital elements don't slip away from the combined company requires the buyer to investigate a broad range of legal, structural, operational, and other issues and determine whether any can impede a timely transfer.

Certainly, there is no argument over the pervasiveness of intellectual property (IP) assets. Chips and related software are inherent parts of many products. The soft underbelly of any business is the software system for operating the business. E-commerce means that many businesses interface with their customers - particularly service businesses - through technology. So while the ultimate significance of IP varies with each business, its existence is universal. Imagine a business without at least one PC on the premises.

How technology issues should be managed in a merger or acquisition depends on the nature of the target, the form of the transaction, and other factors, including whether:

The target is a stand-alone business or is a division or subsidiary of a larger corporation;
Stock or assets are being acquired;
Software is owned or licensed;
Software is incidental to the operation of the target's business or is embedded in products offered; and
The buyer will operate the target as an independent business, expects to use the target's technology for other businesses, or intends to use its own technology to run the target's business.

Additionally, questions may arise as to whether specialized software has been developed by or for the target and whether the target or the developer actually owns the software. Specialized software may be considered a trade secret by either the target or the developer, and who holds the proprietary rights in that software must be determined.

This article focuses on software and trade secret due diligence issues from a legal perspective. A legitimate inquiry will always be whether software works as it is supposed to work and whether it is scaleable with the business.

It is important to tailor IP due diligence to the specific target. A business's dependence on technology and trade secrets varies significantly. However, virtually every business uses software and trade secrets, meaning that some IP due diligence is always appropriate.

IP subject to a formal registration procedure - patents, copyrights, and trademarks - has received most of the attention by M&A practitioners. While software may be subject to protection through patent, copyright, and trade secret laws, and in some respects trademark laws, the focus of software due diligence lies elsewhere - typically in the license or ownership agreement relating to the software. Trade secrets have legal protection not through a system of federal laws but through state laws. The concerns here are more practical.

Software due diligence is similar to other due diligence procedures, but has its own quirks.

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

Which software is necessary to run the business being bought and whether alternatives are available if the software cannot be transferred;
Which software is desirable but may be replicated by products available in the marketplace; and
How the software will be used after closing.

If the buyer's software cannot accommodate the operations of the business being acquired, that fact should be communicated to the deal team. However, if the same software systems are used by the target and the buyer and can be covered by existing licenses, or if some of the target's software is redundant because it will not be used going forward, that fact should be communicated so that time is not wasted on the wrong issues. In addition, if the target uses software that is difficult or expensive to obtain in the marketplace or vital to the ongoing operation of the target's business after closing, obtaining such software should be a condition of closing.

As in a scavenger hunt, the next step is to segregate the software by whether it is owned, used, licensed in, or licensed out by the target. Merely circulating a typical due diligence questionnaire usually will uncover only a list of the main agreements that are known to the target's due diligence team. More penetrating steps are needed, such as:

Locating the relevant people at the target who actually know what software is loaded on each of the target's servers, PCs, and laptops;
Obtaining lists of all of the target's computer hardware and identifying all software programs, including operating systems, that are installed on each piece of hardware; and
Finding the license and other agreements at an early stage in the diligence.

Whether the target owns proprietary software must be determined. Even if major software programs have not been created specifically by or for the target, important custom interfaces often are needed by the buyer to keep the target functioning after closing. If target employees developed the software within the scope of employment, then the software is owned by the target. If the software was developed by a consultant, however, the target owns the software only if the work-for-hire rule applies or the developer assigned the software to the target.

Third-party software will be licensed directly to the target or to the ultimate parent if the software is used on an enterprise-wide basis. If the target is a division or subsidiary of the seller and its assets are being sold, an assignment of the third-party software license will be required. If stock is being acquired, no assignment is required for licenses held directly by the target.

The buyer must prioritize the review of the license agreements based on the value and necessity of each software product to the target and the buyer after the two firms actually merge. The diligence also must focus on the need to obtain consents from third parties such as software licensors when IP will be transferred as part of the deal.

Third-party vendors often extract fees for consenting to the transfer of software, may not permit their licenses to be expanded to meet the buyer's new needs, and may 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 controlled.

Consent is required for assignment of all non-exclusive software licenses, even shrink-wrap and click-wrap licenses in many cases, unless a license explicitly states otherwise. That differs from the usual non-personal services contract rule under which silence means no consent is necessary. Consent may also be required if the license has a change-in-control clause giving the licensor power to bless a transfer if its licensee is acquired. Licenses also must be reviewed on the basis of the form of the transaction - stock versus asset acquisition - to determine whether consent is necessary. If the buyer decides not to seek certain consents, it must bear in mind that it risks voiding a license or being charged with infringement.

It is important to determine who actually uses the software. In a divestiture, the software used by the target business may be used in the seller's operations. The selling company then may negotiate continued use of the software after closing through transition services agreements, sub-licenses, and similar arrangements. Third-party vendor approval is required if the license does not permit agreements providing for continuity.

A buyer should understand the scope of the current use of the software by the target and the anticipated scope after deal closing. Buyers, for example, may want to expand the use of the software to other businesses in their companies in moves to promote synergies. If the licenses are based on a per-seat or per-computer basis, expanded use may not be an issue for a vendor that can recover additional fees through selling more seats or per-computer licenses after the deal closes. But if the license fee is based on a limited use agreement with the seller and the scope is expanded markedly after closing, vendors may be reluctant to grant consent for little or no additional fee.

Another thing a buyer should be aware of are ongoing obligations under the third-party 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 after closing, and remedies may not be available for faulty systems.

For software owned outright by the target, an acquirer should also determine whether the seller has licensed the software to other users. If so, it must be determined what rights were retained and obligations incurred, whether there are liens or security interests in the software, and whether others are infringing on the software or the seller has infringed on other software. The results will help the buyer find whether the title to the software is any good.

Keeping track of all software and relevant licenses held by the target together with the relevant third-party consents provides a useful tool for the target's business going forward, especially when it comes time to centralize technology processes at the buyer's headquarters.

In many businesses, trade secrets, which are not formal IP, constitute the most important and valuable asset of the business. But their identification and evaluation are far more difficult than registered property.

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 depends on a combination of practice and legal limitations, which need to be investigated and understood. Trade secrets are primarily protected through secrecy. Written agreements and procedures do not necessarily ensure that trade secrecy has been maintained.

Practical questions to be asked during trade secret due diligence include:

What is the culture of the target, and are trade secrets highly regarded within the organization?
Will the employees who have the trade secrets be retained by the buyer?
Are the trade secrets used in portions of the business not covered by the sale?
Are the trade secrets documented in written form, particularly in electronic form, and therefore susceptible to theft through reproduction?
Has there been significant employee turnover of employees who know trade secrets and have they migrated to competitors because of geographical concentration or other factors?

Other issues involve a mix of legal issues and facts.

Confidentiality

It is critical for a buyer to determine whether the target has followed a uniform practice of obtaining confidentiality agreements from all employees and consultants. If not, the buyer may not have much recourse if the secrets get out and are used against it.

Security

Are security procedures in place to prevent the taking of trade secrets by outsiders, such as sign-in procedures for visitors? Allowing third parties to view trade secrets and not informing them that it is considered IP has been found by courts to nullify the owner's ability to recover for theft by the entity or people that saw the documents or evidence of the secret. While many companies follow a practice of obtaining non-disclosure agreements from vendors, customers, and others, the forms are often negotiated with lower-level employees, and their terms may be less than ideal.

Enforceability

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

Assignability

If the form of the deal is an asset purchase, can the confidentiality obligation be assigned to the buyer? Courts have found that some non-compete agreements cannot be assigned.

Practicality

If it is discovered after closing that trade secrets have been misappropriated, is there an effective remedy against third parties? The answer is, it depends on such practical considerations as:

Has the claim for the past breach of trade secrets been assigned to the buyer?
What is the cost of litigation?
Will the litigation itself call attention to and destroy any remaining value in the trade secret?

If a buyer has to confront these problems, the value of the acquisition could be substantially diminished, notwithstanding the importance of the trade secrets to the deal.

Because of the universal use of software in business, a lawyer experienced in identifying the software issues and negotiating with third-party vendors is an important player in any deal. Note that software is only one copyrighted work, and similar due diligence must be completed for other copyrighted works. Identification of trade secrets is also an important part of IP due diligence. Often the proprietary nature of the software subject to a trade secret is the best measure of the value of the transaction.

The proper due diligence investigation emphasizes an outline of the buyer's goals and what is most important. Results may refocus the deal structure, objectives, or price, and may even suggest that the deal should not be done.

This article originally appeared in Mergers & Acquisitions: The Deal Maker's Journal.