Technology is so ever present in our lives and our businesses that nearly any deal could be described as a “tech deal”. Acquisitions of a software company, the manufacturer of a drillship’s dynamic positioning system, or healthcare information technology provider involve some similar legal issues despite the differences in their industries. This brief article will highlight just a few of the legal issues in acquiring technology or technology-oriented companies.
The acquisition process starts when the buyer identifies a potential acquisition target, conducts some preliminary due diligence from publicly available information, then extends an offer in a letter of expression, term sheet or letter of intent (“LOI”). However, most LOI’s state that the LOI is not legally binding. As a result, it is common for the parties to enter into a separate confidentiality agreement or non-disclosure agreement (“NDA”). Alternatively, the LOI may state that certain provisions of the LOI, such as a confidentiality or non-solicitation of employees provision, are legally binding even if the negotiations do not result in a closing.
Throughout the due diligence process, the seller will be disclosing confidential and proprietary information, trade secrets, key performance indicators and possibly even software source code. A properly drafted NDA ensures that the prospective buyer may not use any of the buyer’s confidential or proprietary information for any reason other than due diligence evaluation, and must return or destroy all copies of documents and electronic data if the parties fail to close the deal.
Enhanced Measures to Protect Trade Secrets.
In some instances, the seller has heightened sensitivity about confidentiality. Heightened concerns may exist because the crown jewel of the company may be software source code that is only protected as a trade secret rather than protected by patents. Also, the seller may be concerned because the prospective buyer is a competitor, or the buyer has determined that it will compete in the seller’s sector once it acquires the seller or one of the seller’s competitors. Where such sensitivities exist, the seller might consider establishing a clean room where proprietary data and code are made available to the buyer’s due diligence team under strict security protocols.
Non-Solicitation of Employees.
The NDA or LOI should include a legally binding prohibition on the prospective buyer soliciting the employees of the seller. For some tech or IT companies, the crown jewel is really its people. The seller must ensure that the prospective buyer not be allowed to poach its best people and key developers. Otherwise, the prospective buyer could plunder the seller of its human capital without paying the seller a dime.
During the due diligence process, the buyer will become familiar with the seller’s technology. Buyer may even discover new innovations derived from seller’s intellectual property. Buyer will want residual rights to the ownership or use of such innovations. On the other hand, seller will not want to grant buyer any residual rights. Rather, seller will not want any cloud on the title of its intellectual property. So, the parties should consider addressing whether or not the buyer has any residual rights to innovations from the buyer which derive from seller’s intellectual property.
The due diligence process is one of the key components of tech deals. Like any corporate acquisition, due diligence of a technology company will involve financial, tax, HR and legal inquiries. But, this article will focus on technological and intellectual property due diligence.
Technological Due Diligence.
Simply put, the buyer has to verify that the technology that it thinks it is buying works, is reliable and has been commercialized. Do other companies offer competing technology that is more effective or popular with consumers? In the case of software or software-as-a-service companies, does the source code actually function, and can its performance be duplicated on the buyer’s or a third party’s computers? Even if the buyer is familiar with the seller and its products, the buyer may need to field test the seller’s products and interview key developers and technicians to fully understand the sellers products.
Intellectual Property Due Diligence.
Assuming the buyer is satisfied with the quality and reliability of the seller’s technology, the buyer must investigate seller’s legal rights to the technology. Without reciting a full intellectual property due diligence questionnaire or representations and warranties in the purchase agreement, here are a few key areas of inquiry and disclosure for tech deals.
Patent Rights. One of buyer’s first intellectual property inquiries will be whether the technologies are patented. If the seller has patents, how strong are the patents? Does the seller have patent protection globally, or only in the U.S.? Has the seller defined the fields of use for the patent broadly enough to protect the current and anticipated uses of the patented technology? Do competing patents exist that may block the seller from further developing the technology or its applications? Does another person have competing patent claims that could lead to litigation? Also, the buyer must ensure that the seller, not the shareholder(s) or an affiliate, actually owns the intellectual property (whether registered or not).
Trade Secrets. If the seller’s intellectual property is only protected as a trade secret, has the seller taken necessary steps to protect those trade secrets? The buyer should inquire as to whether employees have signed agreements assigning their intellectual property rights to the company and prohibiting the use or disclosure of the proprietary information by the employee. The buyer should also inquire into the functionality of the proprietary information or source code to determine if the trade secrets have inadvertently been disclosed to a third party at any point. A third party disclosure could undermine the trade secret protection of the seller’s proprietary information.
Employee Assignments. In the absence of an assignment, the law assumes that intellectual property rights vest in the inventor of technology. Thus, if a company hires developers but does not require the developer to assign his or her intellectual property rights, the developer may have a claim to the technology used by the company. Buyer must inquire whether seller’s employees assigned to the seller any and all intellectual property rights developed by the employee or independent contractor during the term of the employment at the time the employee or independent contractor joined the seller’s company. In the absence of such an assignment, the buyer should require each worker to sign an assignment and release of claims for any technology developed by the worker as a condition to closing.
Freedom to Operate. Even if the seller does not have patent rights, a patent search may be necessary. The buyer will need to determine if the seller has freedom to operate. In other words, does any third party have a potential claim that the seller’s technology infringes on that third party’s patent rights. It is not enough to search the litigation history of the seller. In some instances, a third party patent holder may not notice that a small tech company is technically infringing on its patent rights. However, if a larger company acquires the infringing technology, this may draw the attention and ire of the patent holder. So, it will be necessary to conduct a patent search to determine the buyer’s freedom to operate once it has acquired the technology.
Licensed Rights. In many instances, tech companies operate using licensed technology, rather than technology they developed or acquired. In such cases, the seller would not be able to convey full right, title and interest in the technology or the corresponding intellectual property rights. If the buyer is acquiring licensed rights, the buyer must determine that the license is assignable and sufficient for buyer’s intended purposes. If the seller’s most valuable asset is merely a license, buyer should be very cautious with proceeding on a deal and should discount the purchase price accordingly.
Co-Developed Technology. It is common practice for companies to enter into joint ventures or joint development agreements with respect to research and development initiatives. The ownership of co-developed technology may not be clear. In a joint venture or commercial contract, the seller may have retained the rights to “background intellectual property”, but granted an irrevocable license for the use of the background intellectual property to another party. By doing so, the third party may have some rights for the on-going use of the seller’s intellectual property. In addition, the joint venture or commercial contract may contemplate that new intellectual property is developed. The buyer will need to clearly understand whether the seller retains legal ownership or any assignable, irrevocable right to use the innovations arising under that contract. Suffice it to say, joint development agreements and licenses of background intellectual property can put a cloud on the title of a seller’s intellectual property and should be scrutinized carefully.
Data Security and Cyber Risk Due Diligence.
A growing area of concern for technology companies is cyber risk. Buyer should inquire whether the seller maintains any personally identifiable information, health information or personal financial information of its employees, customers or third parties. If so, buyer must understand seller’s policies and procedures to ensure the data security of such personal information. With the growth of the internet of things, buyer should also investigate seller’s exposure to cyber attacks against physical assets. For example, does the seller utilize electronic, remote controls over physical assets (power plants, refineries, oil rigs, etc.) that may be subject to cyber attacks, including criminal and terror attacks that could cause catastrophic failures to physical assets.
A variety of employment issues come up in corporate acquisitions. Employee retention can be of particular concern in technology deals. In some instances, the seller’s human capital may be one of its greatest assets. This can create problems when a larger company acquires a smaller that has a relaxed culture. Seller’s key employees may have enjoyed seller’s culture, and may fear joining the corporate culture of a larger conglomerate. This problem is accentuated where the key employees are expected to make a lateral move without a signing bonus and do not have equity in the seller. To mitigate these risks and to welcome seller’s employees into the fold, the buyer may insist that the seller carve out a portion of the purchase price as retention bonuses for key employees. This would help prevent a non-equity employee holding a good deal hostage by insisting on a change of control bonus. It also creates goodwill with the buyer’s newest employees.
Doug McCullough with the assistance of Katie Evans. Published on February 2 2016 in B&V Capital Advisors “Capital Talk”