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 the value of the transaction, you are probably getting the wrong advice on how to conduct your due diligence. The due diligence process must take into account the competitive landscape of patents. If competitor patents are not included in your vetting process, you may be significantly overvaluing the target company.
In my many years of IP and patent experience, I have been involved in several M&A transactions where patents formed a significant part of the underlying value of the deal. As a patent specialist in these transactions, I was mentored by 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, we 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 any stupid mistakes that would make the patents difficult to enforce in court?
When these boxes were checked “complete” on the due diligence checklist, M&A attorneys and investment bankers had made “CYA” cash from patent issues and were clear of patent-related liability in the transaction.
I have no doubt that I performed my patent due diligence duties in a highly competent manner and that I also became “CYA” in these transactions. However, it is now apparent that the patent 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” feel 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 I was left to pick up the pieces of a transaction conducted under standard mergers and acquisitions procedure.
In that transaction, my client, a large manufacturer, was seeking to expand its non-core product offerings through the acquisition of “CleanCo”, a small manufacturer of a proprietary consumer product. My client found CleanCo to be a good acquisition target because CleanCo’s product filled a strong consumer need and was, at the time, priced above the market. 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 owned only a small manufacturing plant and was struggling to meet the growing needs of the market. CleanCo’s venture capital investors were also eager to cash in after several years of continued funding of the company’s somewhat marginal operations. My client’s marriage to CleanCo 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 selling price was in excess of $150 million. This price could only mean one thing: CleanCo’s value could only be 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 were to eliminate CleanCo’s differentiated product, competition would invariably arise, and then all bets would be off on the growth and sales projections that formed the basis of the financial models that drove the acquisition.
Following my instructions from the lead M&A attorney and investment bankers on the transaction, I conducted the patent aspects of the due diligence process in accordance with their standard procedures. All checked. CleanCo owned the patents and had kept the fees paid. CleanCo’s patent attorney had done a good job with the patents: the CleanCo product was well covered by the patents and no obvious legal mistakes were made in getting the patents. So, I gave the transaction the go-ahead 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 being seen in the field. Given the fact that more than $150 million was spent on the acquisition of CleanCo, these marketers unsurprisingly believed that competing products must be infringing CleanCo’s patents. However, I discovered that each of these competitive products was a legitimate design of the patented CleanCo product. Since these knock-offs were not illegal, my client had no way to legally remove these competitive products from the market.
As a result of this increasing competition for the CleanCo product, 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 dud.
In hindsight, the competition for the CleanCo product might 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 marketplace now appears to be due to first-mover advantage, as opposed to any real technological or cost 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 command a premium price due to market exclusivity. Rather, it would demonstrate to the M&A team that competition on the CleanCo product was possible and indeed very likely, as revealed by the myriad solutions to the same problem shown in the patent literature. The deal may still be done, 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 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 more than $150 million on the CleanCo acquisition.