IP Briefs: IP Due Diligence: Key to Success in M&A Transactions

The biotechnology sector enjoyed a banner year for building capital during 2006—raising $29.6 billion, compared with $20.2 billion in 2005. Although this fundraising activity is a positive sign for emerging companies seeking capital to support drug development programs, the challenges that early stage companies face today are more daunting than ever.

Sergio Garica

The costs to bring a successful drug candidate to market from discovery through launch continue to escalate. Moreover, the IPO window has not been an inviting one for most emerging life sciences companies. On the regulatory front, the FDA has adopted a more conservative approach requiring life sciences companies to meet additional regulatory hurdles to get product candidates approved. This environment is forcing companies to spend more on drug development.

To support their products in development, emerging biotech companies need to obtain global clinical, regulatory, and medical affairs expertise. This has led to multimillion dollar partnering deals and a record number of acquisitions of emerging biotech companies by large pharma or big biotech firms. Over 300 merger and acquisition (M&A) deals were completed during the year 2006.

For large pharma and biotech companies, acquisitions of emerging biotech companies allow them to expand their product pipelines with new, cutting-edge technologies, or drug candidates that were not invented through internal R&D efforts. This strategy—to grow pipelines through acquisitions—was stimulated, in part, by the American Jobs Creation Act of 2004. This legislation has enabled US-based pharmaceutical companies to repatriate approximately $100 billion of dererred foreign income, at a 5.25% US corporate tax rate and many of these pharma companies are using these repatriated earnings to finance M&A deals.

Merck Pays Big Dollars for Sirna Acquisition

ACQUISITIONS OF EARLY STAGE COMPANIES BECOMING MORE AND MORE COMMON

In the not-too-distant past, pharmaceutical companies were interested only in licensing or acquiring biotechnology products that had substantial validation in human clinical trials. This is no longer the case, as indicated by a couple of recent acquisitions: Merck's acquisition of Sirna and Amgen's acquisition of Avidia. Both transactions involved the payment of a substantial premium for early stage, platform technology.

IP DUE DILIGENCE AS A KEY ELEMENT IN M&A TRANSACTIONS

As M&A activity continues to shatter records, the due diligence process has assumed greater significance in biotech deals. Life sciences M&A transactions present unique challenges in investigating and valuing products in development. These transactions also present critical regulatory and antitrust issues that must be dealt with early in the process. Also, the early diligence process must focus on intellectual property (IP) considerations. Although IP due diligence is relevant to virtually any transaction between biotech companies, a detailed investigation into IP assets is particularly critical in M&A transactions. Properly conducted IP due diligence provides a potential acquirer with information that is critical in assessing the value, price, or other key elements of the proposed transaction. These transactions require a thorough process for identifying all intellectual property assets, confirming ownership over those assets, and ensuring that the assets are free of technical defects or encumbrances.

FOCUS AREAS OF IP DILIGENCE

The nature and scope of the IP diligence inquiry will vary widely, depending on the maturity of the target company and the nature of its products or its core technology. An initial IP diligence request may list a broad range of IP assets, including copyrights, trademarks, trade secrets, patents, patent applications, and know-how. The focus of the IP diligence investigation for biotech transactions is on patents, patent applications, and know-how.

To assess the value of a target company or its intellectual property, the acquiring company will be concerned with the proprietary nature of the IP, how the IP is protected, and the extent of the target company's rights over the IP. The acquiring company needs to determine whether it can effectively develop and commercialize the target company's products and technologies going forward. The IP diligence process also enables the acquirer to better understand the value of the IP assets and this valuation often has a direct impact on the price of the overall transaction.

IP RISK ASSESSMENT

As part of the IP diligence process, the target generally must provide detailed documentation on the nature and scope of patent rights and the validity, enforceability, and transferability of such rights.

If the target's technology is not covered by patents, the company should describe how the technology is protected—is it through trade secret, trademark, copyright, or other protections? It is expected that all registrations protecting the company's proprietary technology have been adequately documented.

Finally, the target must address any risks to the value of the IP. Is there any pending litigation or risk of future litigation associated with the use of the technology that can be identified and quantified? Additionally, the target should expect potential acquirers to undertake a litigation review to assess any potential claims, infringement, or insurance issues.

In addition to addressing the general IP risk issues described above, IP diligence also requires the review of several key areas, including ownership issues, freedom-to-operate considerations, scope, validity and enforceability concerns, and the transfer of rights to third parties.

Ownership Issues

Ownership is one of the most important issues to explore in the IP due diligence investigation. The most critical questions will focus on the target's rights in the IP and whether those rights are free of any encumbrances and whether the rights may be cleanly transferred.

Not having clear rights over the IP can be a deal-breaker. To avoid issues that may disrupt the transaction, the target should be able to explain and document how IP rights have been assigned to the company; the company's rights to transfer and assign the IP; and whether there have been any third party challenges to the IP rights.

Freedom to Operate

In the past, acquiring companies have focused on ownership issues when valuing a target company and assessing long-term product or technology viability. However, recent deals demonstrate that acquirers are eager to fully understand freedom to operate (FTO) issues. In general, an FTO analysis evaluates whether the acquiring company will be able to make, use, or sell products without infringing on the IP rights of a third party. An FTO analysis fully explores potential legal roadblocks, such as valid patent claims of third parties. Any potential significant FTO issues often mean further diligence and analysis before the deal moves to the next stage.

Scope, Validity, and Enforceability

The scope, validity, and enforceability analysis is related to the strength of the company's IP assets. Claims must be evaluated and validated for compliance with formal requirements (for e.g., the written description, enablement, and best-mode requirements). Also, the analysis should include an investigation of enforceability issues, particularly under the US patent law, such as potential inequitable conduct issues.

Transfer of Rights to Third Parties

The company seeking to acquire a biotech firm needs to examine any transactions involving the transfer of rights relating to intellectual property. Any such analysis includes an examination of licenses, material transfer agreements, collaboration agreements, or any other transaction that involves a transfer of IP rights. For each of the agreements involving transfer of IP rights, several issues will have to be examined:

• Patents licensed to a third party, including the specific patents licensed, any exclusivity rights, and specific inclusions or exclusions related to each party's ability to use the patents.

• Issues related to prosecution and maintenance of the licensed patents, including reimbursement of costs.

• Issues related to enforcement of the patents.

• Commercial diligence obligations and service level commitments.

• Financial terms, including milestones payments and royalty obligations.

• Third party and company termination rights.

CONCLUSION

The number and magnitude of recent M&A transactions indicate that another dynamic year could be in store for biotechs. IP due diligence is a key component in any merger and acquisition. The considerations outlined in this article—ownership issues, freedom to operate, scope, validity, enforcement, and transfer of rights to third parties—are areas to explore early in the parties' deal negotiations. Throughout the process, it is important to identify and resolve IP issues in a constructive manner, seeking to resolve issues early on, with minimum disruption to the overall transaction.

Sergio Garica is cochair of the life sciences group, and partner, corporate and intellectual property group, at Fenwick & West LLP, San Francisco, CA, 415.875.2366, sgarcia@fenwick.com