Want to evaluate the IP of a business before you buy it? Want to sell a business at an increased price for its IP? First published by the World Intellectual Property Organisation, this August 2008 remains old gold written by Noric Dilanchian.
Paul Kerin, Professor of Strategy, at Melbourne Business School, wrote that “hundreds of studies have found that about 50 per cent of takeovers destroy the acquirer’s share value.” 1 Though appalling, this high failure rate comes as no surprise to insiders in the mergers and acquisitions game. So what knowledge do buyers and sellers of businesses need to gain to raise their game and improve these statistics?
Both buyer and seller must be smart about all the assets in the business in question. What does this mean for intellectual property (IP) assets in a business? Being smart requires buyers and sellers to use legal and other professional advice at the earliest stage. This is the case for large corporations, SMEs and micro businesses. However, is the legal advice received always practical and useful? How can a buyer or seller make this assessment?
What not to do is simple. A buyer who signs a contract with only a couple of hours of prior enquiry will be exposed to under-assessed – or even unidentified – risks buried in the detail. The list of IP assets in the contract, for example, may lack clarity. So what is the procedure to follow?
Three transaction stages
To be of use to the buyer or seller who is about to make a deal, enquiries should be structured in three stages: pre-contract, contract and post-contract. We will develop these three stages with a focus on IP assets 2 in non-franchise businesses, a source of grievance for many buyers and sellers.
Pre-contract stage: maximizing the sale price for sellers
Before a business is even put up for sale, experienced lawyers can assist sellers in a number of ways in maximizing the sale price. Depending on the business, the following extensive services may be recommended:
- prepare a confidential “selling document,” e.g. a disclosure statement or marketing or profile document;
- prepare a data room or files categorizing all key business documents;
- develop deal points to raise in negotiations;
- take steps to improve perceptions regarding the value of specific assets, for example by ensuring best practice protection for IP assets; and
- compare offers to determine which is the best.
Why a “selling document”
In the absence of a vendor’s statement or selling document, extra money and time must be spent providing prospects with information on demand to attract and maintain their interest. In some transactions, the “supply on demand” approach can save costs. However, in more complex cases the lack of a readily available “selling document” can lead to higher risks, increased stress levels in negotiations, erosion of the buyer’s trust, increased costs, legally actionable misrepresentations and oversights due to haste. A selling document prepared at an early stage will help avoid or minimize such problems.
IP protection best practice
Protection of IP assets builds value for sellers. Before going to market, astute sellers build the quality and level of legal protection of IP assets to at least a minimum or base level of best practice. Ideally this work should be done at least 6 to 12 months before a sale. Best practice includes use of up-to-date IP registrations and documentation. This affects copyright, trade marks, trade secrets, industrial design and patent assets.
Lower levels of protection may lead the buyer and its advisers to discount the price sought by the seller. The effective solution for a seller involves preparation of an intellectual capital register, business documentation and IP registration or codification.
Pre-contract stage: risk management for buyers
In business transfers, buyers usually have greater legal needs than sellers. The first step for a buyer’s legal advisers will be to audit the business, then logically group areas as to how they affect the business now and how they will affect it in the future. This “due diligence” process (a concept which originates in U.S. law) is rarely comprehensive, holistic or integrated – it is purely legal. Its scope, by definition, does not cover technology, culture, management and organizational structure. To “get” the whole picture, buyers additionally need experienced commercial and practical opinions and counsel. This is a challenge for many legal advisors. Here is why.
Myopic professional view
Let us assume that legal advice deals with 10 per cent of the issues involved in a business that is up for sale and accounting 15 per cent. This leaves 75 per cent of the business for the buyer’s team of managers, consultants, shareholders or other principals to sort. This is a relatively high share! To reduce the load, it would be more useful for the buyer and its team to receive advice that takes a holistic or integrated approach rather than slavishly following the legal, accounting or management labelling of issues.
But a multi-disciplinary approach is not easy to achieve. To implement it, legal advisors would have to build on their education, complementing it with accounting, human resource management and other qualifications. Few do! Certainly, the multi-disciplinary approach is not always necessary, but it can greatly reduce buyer failure rates.
“…where IP assets are involved, early, creative and disciplined “outside the box” legal thinking secures value.“
Going beyond legal due diligence
Parts of the 75 per cent can, and probably should, be referred to specialist technologists, financiers or management consultants. However, even if the work is outsourced, a buyer’s risk will increase if the jigsaw puzzle of delivered miscellaneous advice is not pieced together cohesively to create a whole picture of the target business.
All issues forming the 10 per cent, 15 per cent and 75 per cent must be logically grouped through communication and close work between disciplines. Here are some reasons why.
- For the buyer the absence of proper grouping of important considerations would lead to missed signs and warnings regarding the business now or in the future.
- For the advisory team differences in the perspectives, jargon and procedures of lawyers, accountants and consultants create obstacles in communication between and outside such specialist fields of work.
- For both the buyer and the advisory team, if all issues are not addressed, pieces of the puzzle may be missing at the time the buyer signs the contract for purchase.
Extrapolating on Professor Kerin’s statistic, it seems reasonable to postulate that 50 per cent of takeovers are signed by buyers who do not have a complete picture of the target business. Given this record, it is preferable for sellers and buyers to implement a multi-disciplinary process to risk management 3 rather than just applying under-defined (and mostly legal) “due diligence”. Properly implemented, it can broaden and deepen the scope of pre-contract enquiries and become an important factor in mitigating risks. The aim is to rigorously apply and integrate this process with other elements such as:
- intellectual property auditing,
- asset evaluation,
- strategic planning,
- enterprise structuring, and
- knowledge management.
This type of pre-contact report reduces risk and provides to a buyer long-term record keeping and decision making benefits.
In closing, in the pre-contract stage, where IP assets are involved early, creative and disciplined “outside the box” thinking by professionals secures value for both buyers and sellers. Early enquiries deserve a great deal of emphasis and may take four to six months to finalize.
Contract stage – transaction structuring and customization
All business transfers require transaction structuring and contract customization. This is where good lawyers can be particularly useful. In the IP area alone, the lawyer may need to structure and customize the transaction and contract for the buyer or seller to cover the following:
- use of a confidential information agreement or confidentiality provisions in the agreement or memorandum of understanding;
- review of consents and other considerations for moral rights and privacy law compliance;
- tax and other revenue law implications of any apportionment in the contract of the sale price between the various assets being sold, that is apportioning values to specific brands, copyrights, patents or other IP;
- warranties, indemnity, personal guarantees and other security arrangements given by the seller’s directors or principals relevant to title and other risks to the IP assets; and
- non-competition restraints on the seller and its principals, for example preventing hiring of former employees, starting a similar business or soliciting customers of the business.
In the typical hot-house, time-pressured and mission-critical environment of business sale and purchase transactions, these considerations are among many which require efficient treatment.
Post-contract stage – services for avoiding issues
At the post-contract stage, IP is at the root of six common reasons for business failures. These can also affect franchises. Once the deal is done and the transaction finalized, buyers should be cautious of these six pitfalls.
- Failure to address all IP issues properly or fully in the completed contract – issues keep arising after completion of the contract.
- Failure to formally issue written assignment notices – for example the assignment of a business sale agreement, an option, a guarantee for a debt, a trade mark or patent.
- Failure to prepare updated and comprehensive IP and domain name registers, leading to missed deadlines, lost registrations and certificates and wrong addresses on official registers.
- Failure to act on gaps in IP protection such as those evident from a pre or post-purchase partial or full IP audit.
- Failure to appoint appropriate IP specialists to deal with IP issues such as improving the template license or terms of trade.
- A general failure to employ best practices for IP protection, record keeping and general management after the purchase.
Failure 6 is often an outcome of a lack of alignment and integration between the businesses management, commercial, technological and legal processes and systems. This takes us full circle back to the need for pre-contract communication between different disciplines.
BONUS SIDE BAR TOPICS
Four categories of tools: for peace of mind
To help avoid IP issues in business sale and purchase matters and commercial transactions generally, lawyers can develop the following materials:
- Template contracts, clause libraries, and management documents.
- Checklists, questionnaires, and instruction sheets specifically for business sale and purchase matters.
- Intellectual property auditing workbooks.
- Intellectual property register.
Case Study: Statistics of a failed wine industry acquisition
What’s wrong with this picture?
- In 2000 Southcorp Ltd’s had a slate of over 25 well-known wine brands including Penfolds, Lindemans, Wynns, Seppelt, Seaview, and Devil’s Lair.
- In early 2001 Southcorp paid A$1.49 billion in a cash and shares deal for the single-branded Rosemont Estate business.
- The following year Southcorp posted a net loss of A$923 million.
- In early 2005 Foster Group Ltd made a bid which valued all of Southcorp at A$3.1 billion for the whole company.
Did Southcorp pay too much for Rosemont? Commentators have noted the very high level of the purchase price for the Rosemont label (point 2) relative to the many extremely whell-known labels Southcorp owned at the time (point 1). Paying too much is often the price of inadequate pre-purchase assessments as recommended in the accompanying article.
1. Paul Kerin, Professor of Strategy at Melbourne Business School, “Doing what comes naturally” BRW (Business Review Weekly – www.brw.com.au), 27 January – 2 February 2005, p. 10.
2. All businesses have IP assets as they all have goodwill or a name or brand. IP assets are limitless in their categorisation. They include software source codes, secret know-how, customer lists, IP rights in distribution and franchise agreements, domain names and lists of trade marks, copyrights and patents.
3. See AS/NZS 4360:2004 Risk Management, SAI Global.