Preparing for a Merger or Acquisition? Why You Can’t Overlook Intellectual Property Insurance
COVID-19 has challenged every single industry sector, and the mergers and acquisitions (M&A) market is no different. Even before the disruption caused by the pandemic, uncertainty around the global economy, trade tensions and the presidential election in the U.S. had already stalled a lot of M&A activity.
However, there has been something of a resurgence in M&A activity over the summer months as deals put on hold in the midst of the first wave of the pandemic resumed; U.S. deal making led the rebound, with M&A values totaling $415 billion in the third quarter.
While this sharp recovery should not mask the fact that deal making is still down overall on previous years, there are areas showing strong pockets of resilience — particularly in the lower middle market in the U.S., where private equity investors and trade buyers are still pursuing acquisitions and taking advantage of discounted company valuations and emerging sectors such as health care and technology.
Intellectual property (IP) will often play a significant role in an acquisition, as for many businesses, much of their value lies in their IP — which is what makes them unique. It is estimated that intangible assets, including IP, now make up anywhere from 70 to 90% of a typical company’s balance sheet.
Recent studies show that intangible assets contribute twice as much to the total value of manufactured goods sold than other forms of tangible capital. Businesses are also investing more in IP — like research and development, software, branding and design — than they are in physical assets, creating more value in IP.
And IP can also represent a valuable revenue stream for businesses that sell or license IP rights to other companies.
So given the fact that IP is becoming an increasingly important driver of corporate value, how can buyers undertaking a merger or acquisition protect their investment for IP infringement allegations that might arise from past or future activities?
When an acquisition takes place, the buyer will obtain representations and warranties (R&W) from the seller regarding the company or assets being acquired. Representations are essentially statements of fact at a point in time. The seller will only represent certain historical, not future issues. Accordingly, the buyer would only be able to claim for a breach of an R&W if the issue arose prior to the transaction. If any R&Ws are untrue, the buyer will have a claim for damages against the seller.
In most cases, these R&Ws will include statements in relation to the target company’s IP, and it is common for the seller to represent that the operation of the target business does not infringe, misappropriate or violate any other party’s IP rights.
To protect against financial loss resulting from a breach of an R&W, buyers are increasingly turning to R&W insurance.
Whilst R&W insurance affords IP infringement protection, its extent varies depending on the scope of the IP R&Ws negotiated between the seller and the buyer. Differences in bargaining positions can impact the scope and breadth of all representations, including IP, especially relevant when acquiring a company in a competitive auction. As a result, there can potentially be a gap between the protections provided under the IP representations (and consequently under the R&W insurance policy) and the exposure brought about by an IP infringement allegation made against the acquired company.
Filling the Gaps
IP infringement R&Ws are heavily negotiated in transactions, and for good reason. The extent to which a company infringes a third party’s IP rights is unknowable. However, due diligence is usually undertaken to reduce the risk of infringement.
Commissioning an attorney to undertake an IP analysis known as a ‘Freedom to Operate’ search is an option. Such searches are a legal review of patents and/or trademarks in existence that are owned by third parties. The attorney will offer a legal opinion on the extent to which these third party rights are relevant or a concern in relation to the products and services sold by the company.
While due diligence will help reduce liability risks, it will never eliminate infringement risk; this is primarily because of resource constraints in searching for relevant IP rights from a sample of millions, but also because it is not possible to anticipate infringement allegations that could be deemed spurious or opportunistic.
Consequently, sellers of businesses are cautious in providing broad IP representations in respect of the target company’s infringement of third party IP. Including qualifiers such as “…to the seller’s knowledge…” and materiality qualifiers is a common way of significantly reducing the ability of the buyer to claim against the seller for a breach of representation.
IP insurance is a useful solution in this instance because it will respond to any allegation of IP infringement, regardless of whether the seller’s representations are limited in any way.
Prospective IP Infringement Exposure
The forward-looking (prospective) IP infringement exposure of an acquired business is also an important consideration. Acquired companies are exposed to IP infringement allegations relating to new products and IP in a similar way as they are on their existing products and IP.
In what way do these exposures occur?
1) New products and services
Acquisitions are often undertaken for the purpose of ‘scaling up’. Investors, particularly private equity buyers, will apply proprietary investment and operational strategies to grow a business, increasing value, over a short period of time. Typical strategies often include developing new products and services and entering new markets to compliment or diversify those products and services already sold by the acquired business.
New products and services are not only exposed to IP infringement allegations, but also are not protected by R&W insurance policies for these allegations due to the retrospective nature of representations described earlier. Consequently the new products and services have no protection for an IP infringement allegation; this is where a separate standalone IP infringement insurance policy can be of value.
2) New markets
Rolling out an existing product into a new market or jurisdiction can be more challenging than expected. It is possible to develop and sell a product or service in one country without infringing a third party’s IP, but as soon as that same product or service is offered in a new jurisdiction, a different set of IP rights and rules will apply.
This is because IP rights are granted nationally, managed by IP offices in their respective jurisdiction. Because this is a new strategy pursued following the acquisition of a company (i.e. on a prospective basis), it is unlikely there is any protection available to the buyer under the R&W insurance policy. Moreover, because the product or service is new, it is unlikely the sellers provided any representation concerning the IP relating to such product or service.
However, a standalone IP infringement insurance policy can ensure that companies following these sorts of commercial strategies have infringement protection in new territories.
3) New third-party IP
In the USA, more than 300,000 new patents are granted each year and 400,000 new trademarks are filed. The IP landscape is not only constantly evolving but also accumulating, and the same trends are happening in other major economies.
An allegation that an acquired business is infringing a new patent, granted after the transaction closed, is not something which would be represented and, therefore, there would not be any coverage under an R&W insurance policy. Fortunately IP insurance is available to cover infringement allegations relating to new IP rights.
In the case of distressed M&A transactions, which could well be on the rise given the uncertain economic environment caused by the coronavirus pandemic, buyers often agree to purchase a target business on an ‘as is’ basis and the seller provides very limited or sometimes no R&Ws.
The buyer has limited contractual recourse under the acquisition agreement and it’s unlikely that R&W insurance would be available.
The combination of R&W insurance and IP insurance is a powerful one. Not only does it protect the buyer against financial loss resulting from breaches of the R&Ws made by the seller, but also against any IP infringement allegations relating to the target’s new business activities going forward.
In addition, it can fill in any gaps where the R&Ws fail to provide sufficient cover in respect of third party IP infringement allegations.
It can act as a deal facilitator, smoothing the negotiation of IP R&Ws, and peace of mind for both the acquisition and integration stages of a transaction. &