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June 11, 2015

IP Risks in M&A: Have You Bought a Company or a Lawsuit?

» This article originally appeared in Kaye Scholer's report on the legal impact of technology on M&A. Read the full report.

Intellectual property risks in business transactions can undercut the value of the deal and lead to unexpected and harmful business results. This article addresses the IP risks that arise (1) when one company buys another company; (2) when the key asset in a corporate transaction is an IP or technology asset; (3) when the joint development of new technology and IP can create a competitor for one or both of the companies engaged, unless the IP is handled properly; and (4) when the use of open source software can destroy a proprietary information technology system a company wants for competitive advantage. This article also outlines solutions to these risks.

Have You Bought a Company or a Lawsuit?

Risk: In M&A, joint venture and similar corporate transactions where a larger company acquires a smaller company or venture partner, the risk is that although the smaller company has not been sued for IP infringement, the larger company may be sued once it acquires and/or uses the smaller company’s technology. (For convenience, the large company will be referred to as the “acquiring company” and the smaller company as the “target company.”) This risk increases where the technology or IP is the key asset and the reason to do a private equity or other transaction.

The risk arises in several business contexts. One is where the target company infringes but is under the radar of the third-party company that owns the IP, especially where the third party is a market leader. A second is where the company owning the IP (the IP company) knows of the infringement but has refrained from bringing suit. For example, the target company’s IP creates a demand for products or services that outweighs the gain of winning an IP suit. A third is that the target company’s technology standing alone does not infringe a patent, but because of patent rules, the combination of the target company’s technology with the acquiring company’s will infringe. (Note that IP does not infringe IP; products or services infringe IP.) In each scenario, the acquiring company runs the risk of being sued for infringement. This may be because the acquiring company will be a bigger competitor than the target company, has deeper pockets or believes it can monetize its IP by forcing a license on the new company.

Solutions: Uncovering the IP risk and assessing its scope requires that IP due diligence be integrated with corporate due diligence. IP due diligence should start early enough so that the deal can be canceled or abandoned if the risk of suit is too great. Specific patent analysis will be needed in the third scenario discussed above (in which the target company’s technology standing alone does not infringe a patent). In addition, appropriate representations and warranties can be obtained from the target company to address the risk if their need is known. A cautionary note is that IP reps and warranties should be coordinated with the general reps and warranties so that protection is not inadvertently weakened.

Will the Corporate Transaction Create a New Competitor?

Risk: A new competitor can be created when companies work together or remain separate companies and use collaborative efforts to create technology or IP that did not exist before their cooperative efforts. This collaboration is often required as a matter of business necessity in outsourcing agreements, to transform business operations, and when the new technology itself is used as part of a company’s product and not merely to provide back-office support. These developments reflect today’s environment where technology and IP are becoming core to even nontechnology companies’ products and services. A conventional business approach is to provide that jointly developed property will be jointly owned. However, under IP laws, this can lead to unexpected adverse business results.

A joint owner of a patent can grant a license to a third party without the approval of — or even advance notice to — the other joint owner. The third party can be a competitor of one joint owner, not the other, and by giving the third party a license to technology or IP, a company has in effect created its own competitor or made an existing competitor stronger.

Solutions: One set of solutions is to have the joint owners covenant to each other that neither will grant a license, or to allow licensing, but not to competitors. A middle ground where one or both of the joint venturers want to increase their ability to monetize the IP is to place a time limit on the period when licensing is restricted. A second solution is to allow one company to own the jointly created IP and then grant a broad license to the other joint developer. This can have advantages when one company is better positioned to handle the process of patenting the new IP or better able or more willing to bear the costs. In this scenario, the same forbearance of licensing or restrictions discussed above can be made part of the business arrangement for the handling of IP.

An issue that must be addressed in both scenarios is which party will act or be required to act to enforce the patent and bring infringement suits. Joint development creates special problems in outsourcing, where the outsource vendor will want to incorporate the new technology provided by the new patent (or copyright or trade secret rights) into its standard service offering and make it available to future customers. Restrictions on providing the technology to competitors can be negotiated. However, in this circumstance, the customer in outsourcing should pay a reduced fee because the technology it helped develop will be resold at a profit by the vendor.

Another factor in joint development is that the joint development may not be purely joint. This is because both parties can be simultaneously protected by copyright, trade secret and patent rights, but each form of IP protects a different aspect of the technology. As a result, ownership will not be equally divided. For example, if the joint development involves hardware and associated software, the party that developed the software may be the sole owner of the copyright of the software and the party that developed the hardware may be the sole owner of the applicable patent rights. This is because copyright authorship is not the same as patent inventorship, thus each party will own different parts of the technology taken as a whole. In such case, the parties may need to grant cross-licenses so that each can use all of the technology, or one party can assign its IP rights to the other, thus vesting all IP ownership in the receiving party, and then each party’s right to grant IP licenses can be subject to the restrictions discussed above.

The overarching points are that joint development is increasingly common and that IP creates special issues in corporate transactions. IP lawyers should be involved in the transaction to ensure that business drivers are used to allocate ownership and license rights, and that the business terms agreed to accord with the requirements of IP law. IP law is flexible and can be used to give effect to the parties’ business objectives.

Will Using Open Source Software Result in a Loss of Proprietary Rights?

The use of open source software is a complex subject, but at its core it refers to distributed software being made available in source code form so that third parties can use it without charge, and further, use it without charge to develop new software, which in turn is made available to others. Software has two forms. The “object” code is the software in 1’s and 0’s, which computers read but which cannot be read by human beings. The “source” code version is the human-readable version. Open source software is considered “open” because the source code is open and available to anyone to whom it is distributed.

Risks: While “open source” is the term that is generally used, in reality open source software comes in different flavors, which are subject to different licensing rules. The risk to a company is when the particular source code it uses is the type that prevents the company from building a proprietary system on an open source base. This happens when any party can see the source code of the proprietary system, hence effectively putting it in the public domain, and thereby causing a loss of its proprietary status. This risk can arise when a company’s internal programmers use open source software because of the speed and convenience it can provide when developing software.

In this sense, open source is like a “virus” that contaminates software that incorporates it because it precludes the development of a proprietary IT system. If a company wants to use proprietary technology to achieve a competitive advantage — as is often the case, especially in light of the cost — its business objective can be undercut by the use of open source software. When a company hires a software company to develop software, the same issue can arise, namely the commissioning company wants proprietary software but the external software company’s use of open source software will preclude this.

A further risk arises out of the prevalence of open source software in today’s software development, especially in cloud-based services and mobile computing. It is difficult to determine the business outcomes that may result from this software whose components are subject to different license rules. Some may prohibit and some may permit proprietary systems, but the combined business and IT problem is that it is difficult to determine which part of the software is subject to the different licenses and, once the licenses are identified, it can be difficult to navigate through the combination of different open sources to create proprietary software.

Solutions: The different scenarios and risks outlined above can be addressed in different ways. With respect to internally developed software, a company should adopt a corporate open source policy to control its employees’ use of software. A policy can prohibit open source entirely, permit some open source (provided it is subject to license terms that meet the company’s business objectives), and prohibit open source that is subject to licenses that do not meet business objectives. The policy must account for the fact that the company may develop different software to meet different sets of business directives. Thus, different rules for different open source needs may be in the company’s best interest. Creating and enforcing a corporate policy is complex and should be undertaken with care. It should be developed in a way that ties IT to the company’s business needs.

With externally developed software, the commissioning company needs to conduct open source due diligence and take a practical approach that does not prohibit all open source software but does prohibit the use of open source software in a manner that will prevent the creation and protection of a proprietary system. Thus, the company’s open source policy should be formulated for both internally and externally developed software, taking into account that corporate business objectives may be different for software developed in-house and by third parties. Further, where software is created externally, the contracts with the software development company need to address open source software in a more comprehensive manner than has often been done in older software development arrangements. Put simply, it may undercut business goals to use old contractual provisions without change.

A practical point about open source software is that while it can be used without charge, there is often a cost to using “free” software. Like all software, open source software must be subject to maintenance and support, which unless done internally, will cost money to obtain. In fact, many for-profit software companies distribute the software in open source form and then earn revenue by providing ongoing maintenance and support, which customers believe they cannot provide themselves, or else they believe that the value of using open source software is precisely because it can be maintained and supported by a third party whose business it is to know the software.


Today’s corporate transactions involve IP to a greater degree than a few years ago. An important part of corporate deals is thus identifying and addressing these IP risks.

Read the full article on Law360 (with subscription).