As a business or investment professional involved in mergers and acquisitions (“M&A”), are you conducting patent due diligence in accordance with the standard practices of your M&A attorneys and investment bankers? When patents are 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 competitive patents are not included in your research process, you may be significantly overvaluing the target company.
In my many years of experience in intellectual property and patents, I have participated in a number of M&A transactions in which patents were a significant part of the underlying value of the deal. As a patent specialist in these transactions, I was led 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?
- Is the seller really the owner of the patents?
- Do at least some of the patent applications cover the seller’s products?
- Did the seller’s patent attorney make some stupid mistake that would make patent enforcement more difficult in court?
When these boxes were marked as “complete” on the due diligence checklist, M&A attorneys and investment bankers had effectively “CYA’d” the patent issues and were free of patent-related liability in the transaction.
I have no doubt that I carried out my patent due diligence duties very competently and that I was also “CYA’d” in these transactions. However, it is now clear that the patenting aspect of M&A due diligence basically conformed to 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, sought 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 the acquisition because CleanCo’s product met a strong consumer need and, at the time, ordered a higher price in the marketplace. Due to strong consumer acceptance of its unique product, CleanCo was experiencing tremendous growth in sales and that growth was expected to continue. However, CleanCo owned only a small manufacturing facility and was having difficulty meeting the growing needs of the market. CleanCo’s venture capital investors were also eager to collect after several years of continued funding from the company’s somewhat marginal operations. So 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 sale 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 unique nature of the CleanCo product was correctly understood as critical to the purchase. That is, if someone could imitate CleanCo’s differentiated product, competition would invariably ensue and all bets would be off by the growth and sales projections that formed the basis of the financial models that drove the acquisition.
Following my instructions from the M&A attorney and investment banker leaders 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 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 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 seen in the field. Given the fact that more than $ 150 million was spent acquiring CleanCo, it is not surprising that these marketers believed that competing products must infringe 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 unexpected competition, my client’s expected margins are not being achieved and their investment in CleanCo will take much more time and expensive marketing to pay off. In short, to date, the CleanCo acquisition for $ 150 million appears to be a failure.
In hindsight, competition for the CleanCo product could have been anticipated during the M&A due diligence process. As we found out later, a search of the patent literature would have revealed that there were many other ways to address consumer need that the CleanCo product addresses. CleanCo’s success in the market now appears to be due to the advantage of being the first to act, 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 advised against 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 based more on 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 the offensive, rather than defensive. And I know my client didn’t expect to be on the defensive after spending over $ 150 million on the CleanCo acquisition.