The problem with patent due diligence in M&A and how to fix it
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 a significant aspect of transaction value, you’re 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 competing patents are not included in your vetting process, you may be significantly overvaluing the target company.
In my many years of experience in intellectual property and patents, I have been involved in several merger and acquisition transactions in which patents formed a significant part of the underlying value of the deal. As the patent specialist in these transactions, I was mentored by highly paid M&A lawyers 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 actually own the patents?
- Do at least some of the patent claims cover the seller’s products?
- Did the seller’s patent attorney make some stupid mistake that would make the patents difficult to enforce in court?
By the time these boxes were marked “complete” on the due diligence checklist, M&A lawyers and investment bankers had “CYAed” cash on patent issues and were cleared 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 a “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 “fly-by” 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 just how incomplete the standard patent due diligence process is when I was allowed to pick up the pieces of a transaction done under standard M&A procedure.
In that transaction, my client, a large manufacturer, was seeking to expand its non-commodity product offering 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 priced above market value at the time. 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 had only a small manufacturing plant and was having difficulty meeting the growing needs of the market. CleanCo’s venture capital investors were also eager to cash in after several years of continuous funding of the company’s somewhat marginal operations. My client and CleanCo’s marriage seemed like a good match, and the M&A due diligence process was underway.
Due diligence revealed that CleanCo had few assets: the small manufacturing facility, limited but growing sales and distribution, and several patents covering the single CleanCo product. Despite these seemingly minimal assets, CleanCo’s asking 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 fundamental to the purchase. That is, if someone could eliminate CleanCo’s differentiated product, competition would invariably emerge, 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 M&A attorney and the lead investment bankers in 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 errors were made in obtaining the patents. So, I gave the go-ahead to the transaction from a patent perspective. When all 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 CleanCo acquisition, these marketers unsurprisingly believed that competing products must be infringing CleanCo’s patents. However, I found that each of these competitive products was a legitimate design of the proprietary CleanCo product. Because these imitations were not illegal, my client had no way of taking these competitive products off the market through legal action.
As a result of this increased 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 significantly more time and marketing costs to pay off. In summary, to date, the $150 million acquisition of CleanCo appears to be a fiasco.
In hindsight, competition for the CleanCo product might have been anticipated during the M&A due diligence process. As we later found out, 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 driven by first-mover advantage, as opposed to any real technological or cost advantage provided by the product.
If I had 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 highly likely, as revealed by the myriad of solutions to the same problem shown in the patent literature. The deal may still have gone through, 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 likely. So the marketing plan would have been on offense, rather than defense. And I know my client didn’t expect to be defensive after spending more than $150 million on the CleanCo acquisition.