VCs Get More Diligent About Due Diligence –

Venture capitalists, by definition, never stop learning. Their role as early investors in emerging technologies demands that they stay on the cutting edge, while the ceaseless evolution of business requires even the most non-tech VC firm to be aware of anything that could threaten the success of their investments.

And for a growing number of portfolio companies, anything includes intellectual property. Sure, patents and trademarks are nothing new, but the staggering number of new companies and technologies having been created over the last few years is forcing venture investors to pay closer attention to this area. According to PricewaterhouseCoopers’ Intellectual Property Metrics Report, IP-intensive companies companies that either spend $5 million annually on legal issues pertaining to IP, filed 50 or more patent applications in 1998, or filed 50 or more trademark applications in 1998 filed for 56% more patents in 2001 than they did in 2000. Moreover, these same companies reported a median increase in total legal spending of 4% in 2001.

One of the challenges for VCs is that IP isn’t always easily defined-or disclosed. “The exploitation of IP is becoming a bigger problem. Ten years ago a company used to get a patent for a drug and then try to develop it. Now, one guy develops one part of a drug and enters into 10 agreements to license it and then sells rights to a foreign country. When that company is sold, the owners may not tell the buyer about all of its different agreements,” said Robert Reilly, a managing director with Willamette Management Associates, a valuation consulting, economic analysis, and financial advisory firm.

That’s especially important when investing in a new technology. Consider the case of NanoOpto, a nanotech startup based in Somerset, N.J. Bessemer Venture Partners, Morgenthaler Partners and New Enterprise Associates were readying to invest $12 million into NanoOpto back in 2001. But as the deal was about to close the venture firms learned that NanoOpto’s intellectual property was tied up in Nanonex, another nano startup owned by NanoOpto founder Stephen Chou, a professor from Princeton University. NanoOpto had licensed a chip-printing technique from Nanonex to build chips for the communications industry. The VCs decided to make an investment in NanoOpto anyway, but the situation delayed the deal’s closing and deflated the VCs ambitions for building a stand-alone business.

“I am called to testify in court all the time for companies that thought they were getting one thing and wound up with another, because the selling company licensed away all its IP and didn’t disclose that,” said Reilly.

Protecting Yourself

While IP presents a host of complexities, many of them sector-specific, consultants, lawyers and venture capitalists agree that the best way to protect yourself is exhaustive due diligence. “We make sure the IP is without conflict so we don’t wind up investing in something that isn’t really there,” said Alan Spoon, managing general partner at Polaris Venture Partners, a life sciences and information technology investor. “It is just about making sure you are getting what you think you’re getting and the technology has been reserved.”

ABS Capital Partners, which invests in companies that provide software, services and infrastructure to Global 2000 corporations, healthcare enterprises and media/communications companies, always does additional due diligence when a lot of IP is involved. “We’ve never had to walk away from a deal because of trouble with their IP, but we have made companies add protectant language to contracts so we would not run into problems,” said Laura Witt, a partner in the firm’s Baltimore office.

Witt said ABS has had companies make their employees sign agreements saying that the IP they developed belonged to the company. Additionally, if a patent was issued to an individual, ABS will have the person sign it over to the company. “It saves us from problems. We want to make sure they don’t have the ability to clam anything as their own if they’re not with the company anymore,” she said.

Reilly adds that seeing is believing. “You actually want to look at the patent from the U.S. Bureau of Patents that says this is owned by the company I am buying. If there is any hiccup in the process, bring in an IP attorney. If nothing is wrong a lawyer costs a little as $5,000, so it is a cheap investment,” he said. “If there is a problem and you don’t know before you buy, then you are going to be spending a lot more than $5,000 on lawyer fees.”

Costs Vary

Not surprisingly, the cost of IP-related advice from consultants and law firms varies based on the sector and the degree of complexity, as well as other factors. “An audit for a biotech company with one unpatented product, no extensive commercialization and no other IP may be completed within two to three weeks for $10,000 to $20,000,” said Thomas Halket, a partner at law firm Bingham McCutchen LLP who spends a good amount of his time conducting IP audits for acquirers. “A software company, on the other hand, may be a bigger project. Completing an audit for a developer with several programs covered by patents (and all of which have been marketed for several years with developed trademarks) could take several months and cost $50,000 or more.”

If an investor determines an IP Audit is too expensive there are some basic questions that can help lessen the chance of an IP nightmare. Eugene L’Donne, a partner with Reed Smith LLC, said, “Ask, Does the seller’s intellectual property cover its products?’ Which products are covered?’ Are their gaps in the coverage?’ Confirm that the intellectual property is actually owned by the seller.”

“It may sound like simple stuff,” added Reilly. “You just have to make sure you do it. There are obviously firms out there that don’t.”