Feature
Effective Due Diligence
In brief: Rebecca Sadleir examines the circumstances in which a biotech company will be subjected to due diligence and when it is necessary. Rebecca also outlines some of the key areas of a due diligence review, with a focus on IP rights, and gives some practical pointers in dealing with common issues.
- Introduction
- When and why is due diligence necessary?
- Intellectual property due diligence
- Conclusion
Introduction
Due diligence is a detailed investigation into the affairs of a business, particularly aimed at identifying risks and potential problems. All aspects of the business will be investigated. For example, accountants will examine the financial status, lawyers will review the contracts and actuaries will assess the pension arrangements. As IP Rights are key assets of any biotech company, they will inevitably be subject to close scrutiny.
When and why is due diligence necessary?
Acquisition or merger
Before acquiring or investing in a business, a purchaser will want to know as much as possible about what it is getting. Therefore, acquisitions and mergers are invariably preceded by extensive due diligence. Information and documentation is generally assembled in a 'data room', to which the purchaser and its advisers will have access under suitable obligations of confidentiality.
However, due diligence is not solely the province of purchasers. On a disposal, the seller will typically have to give contractual warranties as to the current state of the business which, if untrue, may lead to a claim for damages. This may lead the seller and its advisers to carry out investigations of their own into certain aspects of the business.
Problems identified during due diligence may cause the purchaser to rethink its valuation, seek an indemnity from the seller or even withdraw from the transaction. However, it is generally preferable for both sides to be aware of potential pitfalls at the outset, rather than bear the risk of unexpected and unquantified liabilities in the future.
Licensing and collaborations
Before entering into a collaboration, joint venture or licensing arrangement, either or both parties may carry out some level of due diligence. This will be particularly important for, say, a major pharmaceutical company forming a new relationship with a relatively small biotech company, where the larger company will want reassurance that the biotech company has the IPRs, personnel and resources to perform its obligations.
Major commercial agreements also typically contain warranties by one or both parties. Again, before giving warranties it is advisable to conduct a thorough investigation of the relevant facts to ensure (as far as possible) that they are accurate. In the worst case, failure to do so can result in repayment of hard-earned licence fees in damages for a breach of warranty claim.
Initial Public Offerings
Due diligence also plays a key role in an IPO or subsequent listing of shares, although for different reasons. In this case, the business itself must tell its story to potential investors through its prospectus. The rules of the Australian Stock Exchange impose detailed requirements about the information which must be disclosed in a prospectus, with strict civil and criminal penalties for non-compliance. It is therefore essential to ensure, through the process of verification, that the contents of the prospectus are accurate and not misleading. Thorough due diligence is the lynchpin of this exercise.
In addition, on a listing of securities, one or more financiers may be involved as well as brokers/underwriters. These institutions have responsibilities as to the contents of the prospectus and will also require reassurance that investment in the company does not entail unacceptable risk. As a result, financiers and brokers/underwriters and their respective advisers will also carry out due diligence prior to an IPO.
Intellectual property due diligence
This section expands on some of the areas which will be investigated in a thorough legal due diligence exercise, with a focus on IPRs. A due diligence investigation into a company's IP assets is essentially a methodical audit which covers at least the following areas:
-
patents
-
know-how
-
copyright
-
trade marks
-
infringements
-
licences and collaboration agreements
Patents
Patents are the foundation stone of any biotech business. Due diligence will cover at least the following areas:
-
Coverage: Are core technologies adequately protected? How many years do the key patents have left to run? Valuation will depend to a large extent on the unexpired term. Will patent term extensions be available for products? Where applications are pending, is it likely that granted patents will result with sufficiently broad claims? This is particularly an issue for gene and protein patents, where the law is still developing and it is by no means certain that adequate protection can be obtained in all cases.
-
Territory: Have core technologies been protected in key markets?
-
Ownership: Is the company the sole legal and beneficial owner of the patents in its portfolio? Common problems include inventions made by employees where it is unclear whether they were acting in the course of employment (e.g. directors who are also university professors), inventions made by third parties (e.g. contract research organisations) and not assigned to the company, and joint ownership with no clear agreement as to the rights of each owner.
-
Validity: Have there been any actual or threatened oppositions or challenges to validity of any key patents? Is the company aware of any relevant prior art, or anything else, which may cast doubt on the validity of key patents?
-
Infringement: Is the company aware of any third party infringers and, if so, what steps has it taken? Competitors may interpret inaction as an invitation, and the value of patent rights may be diluted if not vigorously enforced against infringers.
Know-how
Know-how is critical to any biotech business, and companies should be keenly aware of the need to protect confidential materials. Issues for due diligence in connection with know-how include:
Third parties: Many companies have standard form confidentiality agreements for dealing with third parties. In addition to checking that adequate legal obligations are in place, a thorough due diligence exercise may investigate procedures for ensuring compliance (e.g. checking that third parties return or destroy confidential materials when required). Breaches of confidence and unauthorised disclosures of know-how, whether by third parties or the company itself, will be a key focus area.
Employees: Are employees bound by adequate obligations of confidentiality, and are those restrictions applied in practice? Are employees aware of the consequences of disclosing confidential information (including the risk of an invention becoming public before patent filing)? This is an area where opportunities for dissemination via the internet can be particularly damaging.
Record-keeping: It is important that know-how is reduced to writing where possible, and that contemporaneous records of the creation process are kept. Procedures for creating and archiving records, marking documents as confidential, backing-up data and disaster recovery plans are all areas which may be reviewed on due diligence. Of particular interest will be the extent to which these records are maintained to the standard required by the US Patent and Trade Marks Office for laboratory notebooks.
Copyright
Copyright is significant to biotech companies because it is often the major means available to protect computer software. It also protects operating manuals, design drawings, laboratory notebooks and the like.
With the advent of bioinformatics, biotech companies are increasingly investing in the development of proprietary or customised software. It is important to be aware that copyright works (including software, but also marketing materials, logos and so on) developed by external consultants will not automatically belong to the company which paid for the work – copyright in these works must be expressly assigned to the Company. It is not uncommon for due diligence to uncover that the Company does not legally own key elements of 'proprietary' software or logos.
A due diligence investigation will also seek to verify that the business has all necessary third party software licences and is not breaching their terms, e.g. by exceeding the permitted number of users.
Trade marks
Trade marks may be less of a priority for an early stage biotech company than other IPRs. However, the importance of brand protection should not be underestimated. Once patents expire and generic alternatives become available, a well known brand name may still confer a significant competitive advantage.
In addition to checking that trade mark protection has been obtained for significant brands in key territories, issues of validity and infringement (whether by the company or by third parties) will also be investigated on due diligence. Also, as noted above, ownership of the copyright in key logos should also be investigated.
Infringement of third party rights
An IP infringement action is one of the most devastating situations a company can face. At worst, it can be left facing an injunction and thousands, or even millions of dollars in damages and legal costs. A due diligence review will include a detailed analysis of any pending or threatened actions, and areas of potential risk. A prudent potential purchaser, investor or licensee may also wish to consider carrying out its own patent searches, rather than relying solely on information provided by the company.
Questions answered at this stage of the due diligence include: Is the company already involved in litigation? Has it received letters or notices offering a licence or threatening to sue? Because the bio-science field is heavily populated with patents, patent clearance searching is an important element of risk management for most biotech companies, and the company's patent searching policies may also be scrutinised on due diligence. Is the company aware of any relevant third party rights and, if so, has it obtained legal advice on infringement and validity?
It is important to be aware that disclosure of legal opinions (even in circumstances of confidentiality) can lead to loss of privilege, meaning that advice is no longer protected from discovery in court proceedings. Companies should be alert to the need for caution in responding to information requests or compiling data rooms, to ensure that disclosure of privileged documents is properly controlled.
Licences and other agreements
Biotech companies typically have a whole range of agreements covering the development and/or exploitation of IPRs. Companies may rely on rights which are licensed-in and/or extract value from their IPRs by licensing them to third parties. R&D and collaboration arrangements will also deal with ownership and use of IPRs. Due diligence will involve a review of the key terms of all material agreements, including:
-
IPRs: What rights are included, who has the right to use them and for what purposes? How are new developments and improvements treated?;
-
Exclusivity: Is the licence exclusive, non-exclusive or sole;
-
Territory: What is the market for licensed products and/or are there any other territorial restrictions?;
-
Payments: What royalties, milestone payments and/or up-front fees are payable, and at what levels?;
-
Term and termination, including the disposition of IPRs post-term;
-
Assignment, change of control and sub-licensing, and particularly whether the agreement will be affected by the transaction in question.
The feature article in the next edition of Biotech News, "Collaborations and Licensing – Key Legal Issues", will address these points in more detail.
Further, where the Company has licensed in IPRs, these IPRs should be subject to the same analysis as described above to determine, for example, the Coverage, and Validity of any Patents and the Ownership of the IPRs generally.
When negotiating a commercial licensing deal, companies should always try to bear in mind how the agreement will be perceived by third parties conducting due diligence in the future. This is not always easy, particularly where there is an imbalance in negotiating strength, or where the company desperately needs to secure the deal. Nevertheless, unfavourable terms in key contracts can cause significant problems, and more than one acquisition has fallen through after due diligence because the buyer was not prepared to accept, for example, a licence which would unacceptably fetter its future activities. The importance of legal advice should not be underestimated. It goes without saying that a business whose relationships are properly documented will be much more attractive to a potential purchaser or investor than one which has to disclose, for example, that its main product is based on materials provided by a third party, but a formal licence was never signed.
Conclusion
As anyone with personal experience will testify, due diligence can be a lengthy and difficult process, taking up resources and management time. At first sight, due diligence can appear an unwelcome distraction for a business which is preparing for an acquisition, collaboration or IPO. However, it should be clear from the above that the outcome of the due diligence process can be critical to the success of almost any major transaction.
This article seeks to emphasise that preparation is the key to successful survival of a due diligence exercise. A company which has its affairs properly in order will not only have a less onerous task on a merger/acquisition or an IPO, but will find that by following good management practices, it has enhanced the value of its intellectual property assets. The current slow-down in acquisition and IPO activity may represent an ideal time for businesses to take stock, tidy up loose ends and ensure that they are prepared to take full advantage of opportunities wich arise when the economic situation improves.
For further information please contact Andrew Wiseman on 02 9230 4701