Legal Opinion on Due Diligence of IP rights for a Software Product

I. Introduction

Due Diligence is a thorough and comprehensive process, it is a vital stage in any merger and acquisition as we walk through all the stages of any company before getting involved. It is a very auxiliary and exhaustive process as it gets extensive with time. It involves high stakes for everyone and the jobs and capital of both the companies are at the line. Due Diligence is now finding a deserved place in Indian Statues. It is a sophisticated task which requires special skills. By following these activities and checklist carefully and appropriately, one can anticipate the issues that may arise. Below mentioned is the checklist required to carry out detailed Due Diligence, while the list can vary depending upon the nature of the transaction.

II. Agreements required

The following agreements are required while undertaking a Merger and Acquisition between two companies:

1. Development Services and its Specifications

An agreement which clearly mentions the completed development services. Usually, this is in the form of a services description in the main agreement, with an attested schedule of specifications that describe the final product/software in detail.

2. Time and Cost Guarantees

So Basically, you want both cost certainty and quality products. Development time has a significant influence on cost. Unfortunately, software development times and costs can easily blow out. Therefore, you should check the software development agreement to determine whether the developer has given fixed pricing and delivery times, or simply guidelines. Guidelines are only estimating, while fixed pricing gives you better certainty.

3. Software Development Scheduling and Acceptance Testing

Software development is mainly done in staged phases. This gives a chance to see each phase of the software and approve/verify it before moving to the next. The software development agreement should have a development schedule that contains agreed specifications that the developer must meet in each phase.

4. Warranties and/or Indemnities

A software development agreement should compulsorily include a warranty from the developer that the product/software will work as prescribed in the specifications. This warranty should include a promise to remedy if there are any defects/errors in the product at their own expense. Therefore, it is best to see that the software development agreement clearly sets out the warranties.

5. (IP) Intellectual Property

The agreement should mention the details of the intellectual property in the software from the developer over to you. This ensures that you have the right to use/license the software. In order to facilitate this assignment, the agreement will also include a warranty that the software developer has the rights to the tools that are used in your project and thus they can legally transfer/license these rights to you. This protects/gives immunity to you if other parties allegedly claim that your software infringes on their IP. Similarly, the developer will get a warranty from you that you have the rights to any material you provide.

6. Confidentiality/ Privacy

The developer may require access to your business material and networks. Therefore, the development agreement should have a confidentiality/ privacy clause that requires the developer to keep your business materials secret.

7. Termination

Termination means the end of the agreement before the developer completes the final software. The termination clause should set out:

• who can terminate/end agreement;
• in what circumstances and for what reasons a party can terminate; and
• mode of communication of the termination.

Note:

• Establish that all Parties to the agreement are obligated to assign IP rights. Verify against the employee list.
• Obtain copies of all Confidentiality agreements and/ or Trade- Secret agreements.
• Obtain identification/disclosure of IP rights being transferred from a third party. Obtain copies of agreements related to such transfer.
• Obtain a disclosure of transfer and IP created by consultants and determine their ownership status or rights to the technology, as well as any outstanding payments which may be required under an agreement or under national laws.
• Identify all agreements whereby the Party's IP rights are or were licensed to others and identify the duration of the contract or agreement.
• Identify any warranties or representations made in prior agreements that affect the IP rights subject to the transfer.
• Identify whether the rights under any agreement or contract are affected by a change in ownership (i.e. non-assignable or non-transferrable).
• Obtain a list and copy of all assignment agreements in which IP assets are transferred and assurance and/or warranty that each assignment has been properly recorded with any and all national agencies required.
• Obtain a list and copy of all Joint Venture and/or Joint Development agreements which include a transfer or sharing of intellectual property rights between Party and another party to the JV or JD agreement.

III. Legal requirements and procedures

Ideally, IP due diligence ought to be performed at the beginning of the negotiations as it helps to recognize any legal issues which may influence the value of the IP.

Though each business transaction is different from one another and will have an individual set of requirements for executing an IP due diligence. Some of the general requirements that should be incorporated in an IP due diligence are:

1. Identify IP assets

In all businesses, patents, domain names, trademarks and brand names are the impalpable resources, and these are the immaterial subject matter that must be identified.

2. Verify Ownership and existence of IP

Ownership is generally one of the first issues to be investigated while performing an IP due diligence. A progression of questions are inquired about each IP asset to establish the target company’s rights in it and whether those rights are free of any strains and can be easily transferred. If the ownership of the IP asset is questionable, the dealer cannot transfer the title and rights of the asset to others. If the seller does not possess the intangible asset, the assessment will be done to check whether proper steps were taken to obtain the rights from the actual owner.

3. Check for applicable territory and terms

It is imperative to check the legitimacy of each IP asset i.e., their term and territory. Most IP rights are constrained to a specific region only. So, it is essential to ascertain the territories in which the IP rights are protected.

4. Check for any Third-party claims

Along with the ownership check, it is reasonable to check any third-party claims or interests with respect to the seller’s IP asset. In some cases, rights can accidentally accrue in favour of a third party. So, examination of all license and franchise agreements, joint venture agreements, memorandum of understandings ought to be done to identify if any exclusive rights have been granted with respect to relevant IP.

5. Evaluate potential IP infringements

Further, while performing IP due diligence it is essential to check whether a third party is encroaching a company’s IP right, or it is the company that might encroach a third party’s right. In both cases, if the significant IP rights are subject to any impediment, a dispute is probably going to emerge with the consequence of disrupting the business operations. A freedom to operate (FTO) search ought to be performed to check whether the investor could make, use or sell the IP assets without encroaching any third-party rights. This gives a more extensive knowledge into patent rights of others and identifies any expected barriers.

Steps to be followed for conducting an IP due diligence in order to comply with the above requirements:

• Set an appropriate IP due diligence team and discuss fully with IP professionals your expectations from the exchange
• Prepare and send an IP due diligence checklist
• Identify and separate the IP assets of the target significant for the transaction– at the outset, segregate IP rights or protectable elusive assets relevant for the transaction from those which are not so; the IP due diligence should feature the significance of connecting such additional IP rights with the fundamental IP rights for the transaction; this will guarantee that the focus of due diligence for the transaction is clearly set.
• Commission an intensive inquiry of the ownership of the IP, assemble information on other IP rights which may influence the use or sale of these rights in the future. Analyse if there is any litigation or encroachment included.
• Further, it is the obligation of the due diligence team to verify facts and confirm information received from the target, if and when any discrepancy is found, going back to the target with the further set of issues and questions must not be dodged at any cost.
• Analyse protected and protectable IP rights – Status check, validity check, ownership check, claim check and conflict check should be conducted, in the manners specified above.
• Provide a final diligence report on risks involved along with the methodologies to alleviate the risks and liabilities involved.
• Document, execute and record the IP agreements

IV. Legal issues and challenges

The major challenges that are faced while undergoing due diligence pose a potential threat to the businesses. Usually in Merger and Acquisition transactions the challenge revolves around the technology and planning aspect for the same. The same have been enlisted and the same should be severely considered before acquiring any other business:

1. Lack of Experienced IP Counsel: If XYZ LLC has an experienced Intellectual Property (IP) Counsel, the same would go against our Client ABC Pvt. Ltd. The coordination between the IP and M&A counsels is of core importance as well. There should be a proper study conducted on the working of the company and its future endeavors as well.

2. Improper IP Documentation and Value: An extensive list should be prepared of the acquired company especially the IP material; the same should include the patent details, confidentiality agreements, software’s, technology license, contracts, etc. Uncertainty of the IP related rights might prove to be fatal as well. Missing out on even a few of these might prove as a major challenge for the acquiring company as it may turn the asset into a liability and it may add towards the losses of ABC Pvt. Ltd.

3. Open Source Issues and Lack of Warranty: Many a times the software engineers use open source software and this poses a challenge to the licensing, ownership etc. Open source issues would remove the exclusivity of the same. Warranty of the same would remove a huge barrier, if the seller is not in favor of providing warranty over the same the M&A needs to be reconsidered.

V. Ways to ensure best result

To ensure the best results of the Intellectual Property Merger and Acquisition the following points must be ensured:

• Proper IP documentation and Estimation of Value: It is of utmost importance that the company has reviewed each and every IP related document of the business being acquired. These would also be included under the disclosure schedule while the acquisition is taking place. There should be proper certainty as to the rights related to the IP products and a proper evaluation of their value should be undertaken as well. This step should be taken as soon as possible so as to properly analyze whether the business is going to be an asset or add to the liabilities of the company.
• Need for Warranty: In order to remove any confusion and threat of open source issues obtaining a warranty on the same would be favorable. This would also provide a ground to avoid the M&A if the warranties were untrue. This would also guarantee the rights are exclusively held with the acquirer. It should also be warranted that XYZ LLC does not violate the IP rights of any other party. This would help in ensuring no legal complications relating to the ownership and other IP issues.
• Proper Control over the Changes: ABC Ltd should have proper expertise to deal with the changes that have occurred over a period of time. IP protection at times also contains the change of control and the consent granted to be made clear. This would help to avoid any IP infringement from the company's side. A disclosure schedule should also accompany the same.

VI. Conclusion

Due Diligence refers to conducting investigation procedures regarding acquisition of shares, assets and other pre-contractual inquiries. The due diligence aids the companies and investors to know more about the risks involved, the nature of a deal and whether the deal fits with their portfolio. The due diligence process is having greater significance as it enables the buyer to understand the business of selling and to know the business model. The outcome of the activities of due diligence is that both the buyer and seller transact the business of mergers and acquisitions in a quicker and smoother manner. In order to ensure the best results, the buyer needs to apply due diligence in several matters particularly in cases of intellectual property, material contracts, sales, matters of litigation, insurance. By exercising due diligence, benefits such as accuracy, complete analysis and finding out of risk involved areas can be attained. Though there are various challenges presented in due diligence such as disclosure of documents and absence of data, can however be sweep over by the due diligence process with the proper professional project management. The report of the due diligence should contain the basic information such as:- personnel information, accounts information, company information, directors and their interests, compliance by the company with the labor law legislations such as Industrial Disputes Act, 1947, Payment of Gratuity Act, 1972, Payment of Bonus Act, 1965 and others, information relating to shares and shareholders. The instruments in conducting the due diligence are analyzing the business of sellers including the legal risks involved in that business, presenting a questionnaire to the seller business and making warranties and representations by the buyer. There are totally five steps involved in the process of due diligence. Procedures involved in conducting the due diligence are: (1) The target company provides the planned data via ‘Data Room’ (2) The target company provides the data as a response to the questionnaire submitted by the acquirer. They are: (1) Initial testing of the target company’s customers and suppliers; (2) Choosing the teams of due diligence to enforce the agreements of confidentiality; (3) Conducting preliminary detailed investigation in order to find out the risk-involved areas; (4) A thorough procedure of inquiry; (5) The target company should provide a declaration certificate of the disclosed information and document’s completeness to the team of due diligence. Thus, due diligence enables the buyer to make decisions either to borrow finance or not, acquire the shares or not, make an investment or not. The due diligence also influences the decisions of the buyers. The golden principle of “caveat emptor” (buyer be aware) still holds the preponderant importance. Therefore, in every business transaction, due diligence is a vital component particularly in Merger and Acquisition transactions (M&A).

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Footnotes

1. Author is a student at Amity Law School, Noida, India.

2. Author is a student at Amity Law School, Noida, India.