Buying Big Ideas

GOVERNMENTAL & LEGAL AFFAIRS

It is common for large medical device companies to purchase start-up or small medical device companies. Finalizing a deal may prove difficult, however, when intellectual property (IP) issues exist.

While outside counsel may be tasked with assessing and mitigating the IP risks involved in such transactions, it is important for medical device company executives to understand these issues and the mechanics of the due diligence involved. Company leaders can play a vital role in expediting the retrieval of critical information concerning ownership of IP rights and agreements, patent due diligence, and litigation and claims threatened. The sooner that IP issues are identified, the faster risks can be managed and allocated to move the transaction forward (see sidebar).

Identifying Risks

There are many strategic reasons why a large medical device company would seek to purchase a start-up or a small company. The start-up or small company may own strategic intellectual property in a particular field, or it may have a product in development or a current product that will enable the large company to expand its product lines or enter a new market.

Regardless of the strategic reasons driving the transaction, IP issues always arise. The goal of IP due diligence is to identify these issues as early as possible in order to evaluate the risks associated with the transaction. Only after the risks are known can counsel provide sound advice about managing and allocating the risks in order to move the transaction forward.

Although the parties may be able to resolve ownership and chain-of-title issues prior to closing their transaction, in many instances such issues can be avoided completely. To make this possible, the start-up or small medical device company, in conjunction with patent counsel, should perform its own internal due diligence regarding ownership and chain of title prior to entering into any negotiations with a third party regarding sale of the company. Identifying and correcting any ownership or chain-of-title issues prior to negotiations will help the seller ensure that it receives optimal value for its patent rights.

Once negotiations are under way, the buying company will undertake its own intellectual property due diligence, which should always include an analysis of the ownership and chain of title of the seller's patent rights that are included in the transaction, and any potential exposure to third-party patents. Focusing on these areas will assist in identifying problems related to the seller's patent rights and identify any posttransaction risks related to third-party patents.

Ownership in the IP. Ensuring that the seller owns the patent rights to be transferred in a transaction is critical. Start-up or small medical device companies frequently lack formal documentation or proper assignments relating to ownership of patent rights. The seller and buyer are best served by correcting such deficiencies up front if possible.

In the medical device arena, it frequently happens that a physician has a stake in the selling company's technology—or even in the selling company itself. A typical scenario goes as follows.

The physician indicates that he or she wants a new device to treat a certain type of injury, such as wrist fractures. The small medical device company spends hundreds of thousands of dollars to conceive and design such a device. The physician consults along the way to the finished product.

In the end, the physician believes the final invention is his or her idea. But under current patent law, one of the seller's employees—the person who conceived the design—would be considered the inventor. In such a scenario, ownership of the invention may be claimed by three parties: the physician, the small medical device company, and the company's employee. As a result, the buyer's desire to acquire exclusive rights to the IP is jeopardized.

Such IP ownership and chain-of-title issues generally arise because the seller has failed to have all physician-consultants and employees assign all IP rights to the seller. The seller's deficient documentation can range from poorly drafted agreements that raise questions about the scope and content of the IP rights assigned, to the complete absence of documents verifying the assignment of IP rights from a physician-consultant or employee. Consequently, it is important that the buyer scrutinize all agreements with employees and all consulting or nondisclosure agreements with physicians to identify provisions relating to invention ownership and assignments.

The seller and buyer often need to satisfy the physician. The easiest way is to pay the physician some of the acquisition proceeds or a royalty based upon future sales of the product. In some cases, physicians are satisfied if their names are placed on the commercial product for recognition. In other cases, the buyer might satisfy the physician's claims by entering into a paid consulting agreement with the physician for an ongoing period of time.

Dealing with the employee is easier. Normally, the employee will assign his rights to the seller for no additional or very nominal payment. The law strongly favors the employer as to IP ownership in these situations.

Joint Development with Universities or Professors. Joint development is another source of ownership issues. It is essential to review and analyze any joint-development agreements with third parties for invention ownership and assignment provisions.

A special area of concern relates to joint-development efforts with universities or third-party professors. These types of arrangements are common with start-up or small medical device companies. Such joint collaboration will almost always implicate the university's guidelines regarding the ownership of IP rights. Thus, the buyer should review and analyze these guidelines and any agreement governing the collaboration with the university or third-party professor to determine their impact on the ownership of patent rights. If the guidelines or any agreements implicate ownership in patent rights, a deal that exchanges ownership in the IP rights for future research funding can often be struck with the university or third-party professor.

IP Licensing Agreements Involving the Seller. The buyer should review all license agreements in which the seller has granted rights to its IP. The buyer would certainly want to know, for example, if the seller had previously granted an exclusive license to a key competitor of the buyer.

Whether such an agreement survives the transaction will be governed by each respective licensing agreement. If such a licensing agreement survives and does not involve a key competitor, the buyer may decide to allow it to remain in effect. If the agreement involves a key competitor and it is not practical to expect a release from its obligations, then the buyer must weigh the competitive impact of such a license and negotiate the acquisition price accordingly.

The buyer should also analyze any pertinent licenses that grant to the seller any rights to a third party's patent. Typically, such licenses do not adequately account for a large medical device company to buy or take over the seller. Accordingly, these agreements must be analyzed to determine whether the license will transfer as part of the transaction. If not, the parties must identify ways to resolve any issues that might prevent the buyer from using the IP or selling the products acquired in the transaction.

In such a situation, potential solutions include the seller seeking the right to transfer its license, or conditioning the deal (or the amount of the acquisition price) upon the buyer's success or failure in obtaining a new license or cross-license with the third party. In alternative situations, the buyer may not want the license to transfer because it lacks value to the buyer when compared with the obligations it would impose.

Third-Party Patent Rights. Start-up or small medical device companies often downplay or underestimate the seriousness of third-party patent issues. Consequently, investigating third-party patents is a key component of any due diligence. A chief concern is whether a third-party patent could block the buyer from commercializing the product or technology to be acquired. A buyer will not buy the seller's product or technology if it will later be enjoined from using them as a result of patent or other litigation.

The buyer should make every effort to review all attorney opinions or product clearances received by the seller relating to third-party patents. This is one of the greatest sources of potential IP problems. Of course, the seller must identify all threatened litigation and claims involving any alleged infringement by the seller of any third party's patent rights.

The seller often balks at disclosing attorney opinions for fear of waiving its attorney-client privilege. A simple solution is to have the seller's attorney draft a proposed motion for summary judgment on the legal disputes and disclose it as a draft document to be filed in court if a litigation dispute arises. Additionally, disclosures can be limited to the buyer's counsel under a confidentiality agreement.

The buyer should also independently evaluate the risks associated with third-party patents through a product-clearance or freedom-to-practice analysis. This involves identifying the products to be cleared, searching issued patents and published applications, and assessing the risk of infringement of any relevant patents. It is especially important for a buyer considering a company in a new field or product category to assimilate fully the seller's knowledge of competitors, competitive products, and third-party patent rights.

Funding Sources. Additionally, the buyer should analyze financing agreements the seller may have entered into with multiple third parties. The goal is to determine whether any patent rights were granted to the investing entity, and the scope of any such patent rights. The agreements should also be analyzed to determine if they include any limitations on the transfer of patent rights developed from the financing.

Sharing the Risks to Make the Deal Happen

When negotiating for the sale of a company or its IP, medtech sellers sometimes downplay known deficiencies in their holdings because they assume that such issues will kill the deal. However, such an assumption is often incorrect.

Because the buyer has usually invested a great deal of money and resources in identifying and investigating the seller, the buyer is motivated to work around issues such as third-party patent rights in order to make the deal happen.

The best procedure is for the parties to jointly develop and implement a strategy to address such issues, negotiating with third parties as necessary to ensure a favorable outcome. In this regard, success tends to hinge on whether the seller discloses all such known issues as early as possible so that they can be addressed.

Upon completion of the buyer's due diligence, the difficulty and challenge lie in providing sound advice about the risks associated with patent issues and, in particular, about who should bear those risks—the seller or the buyer. The common answer is that the seller should bear the risks because the seller caused the problems in the first place.

But if the buyer adopts this hard-line position—that the seller should indemnify it for all patent problems—the deal often will not occur. In deals involving a large medical device company as the buyer, the liability for such potential indemnification could exceed the purchase price of the deal. For example, a billion-dollar medical device company could use its army of salespersons to increase annual sales of the purchased technology to levels approaching or surpassing the selling price of the deal. A seller would never undertake that level of indemnification for a purchased medical technology.

Instead, the risks identified during due diligence need to be shared and allocated between the buyer and the seller in order for the transaction to move forward. The sections that follow highlight several different mechanisms for sharing and allocating risks related to ownership and third-party patent issues.

Patent Holdbacks. The deal agreement may include a provision that holds back a certain amount of the purchase price to address any future patent claim brought by a third party against a product involved in the deal (a patent holdback). In turn, the buyer releases a portion of this patent holdback on certain anniversaries of the commercial-release date of the product unless a third party brings a patent claim against which the funds need to be applied.

In other words, as time passes and the risks related to nonasserted third-party patents diminish, the patent holdback monies are released to the seller. When a patent holder delays bringing suit for more than six years, courts generally presume that patentee to be negligent under the doctrine of laches—that is, neglectful in enforcing the patent rights by great delay and lapse of time. Because the laches defense can bar damages prior to suit, the length of time over which patent holdback monies are released naturally extends through six years (i.e., if no claim arises, 25% of the holdback is released after the one-year, two-year, four-year, and six-year anniversaries).

Freedom-to-Practice Holdbacks. If a significant time period exists between the closing of the deal and the commercial release of a product involved in the deal, the deal agreement may include another key provision to address newly discovered patents. Within a certain amount of time after approval of the product for commercial release, the buyer conducts a freedom-to-practice analysis on patents or patent publications that issued after completion of the buyer's initial due diligence. If the buyer identifies a freedom-to-practice issue, it consults with the seller regarding any remedial action to be taken.

The agreement may provide that the seller is responsible for a majority percentage of the costs and expenses related to any remedial action. The buyer may be responsible for a minority percentage. The agreement may further provide that the amount paid by the seller for any remedial action would be capped as a percentage of the purchase price.

Special Indemnification for Attorneys' Fees. Often, a deal involves a seller with a commercially released product where a third party has sent a letter identifying a patent that the seller should analyze with respect to the seller's product. Due diligence should eventually uncover the letter, but it may also show that little or nothing has been done about it. Although the parties may develop strong defenses against the third party's assertions, litigation may ensue.

To account for the costs related to such litigation, the parties may include in their deal agreement a special indemnification with respect to such claims. For instance, the agreement may note that the seller will be responsible for full attorneys' fees incurred by the buyer when defending any such claim up to a certain amount, and then responsible for half of the attorneys' fees up to a total capped amount.

Fair Target Patent Claim. The buyer may seek to purchase a start-up medical device company that only has patent applications on file and no issued patents. At this stage, there is uncertainty about the scope of patent claims to be allowed. While the seller is expectedly optimistic on a broad scope of patent protection, the buyer may be unsure. Thus, both sides generally have different views as to the value of the patents. This results in a different understanding of what the purchase price should be.

One solution is to draft a fair and objective target patent claim that provides the buyer the claim protection it seeks, but to hold back a certain amount of the purchase price (another type of patent claim holdback). If the seller obtains an issued patent claim that is identical or equivalent to the target patent claim, then the seller will receive the patent claim holdback. If the seller fails to obtain an identical or equivalent claim, then the patent claim holdback will be retained by the buyer.

If this strategy is used, it is important that the seller be responsible for obtaining allowance of all patent claims that trigger any payouts. The buyer would not want to put itself in the awkward position of controlling these proceedings.

Conclusion

To complete the purchase of a start-up or small medical device company, a large medical device company must be aggressive and innovative.

The buyer should be aggressive in immediately identifying IP ownership issues and third-party IP rights that may risk the value of the purchase. Identifying problems related to chain- of-title and ownership issues regarding the seller's patent rights and third-party patents enables patent counsel to evaluate the risks associated with a proposed transaction.

The buyer must be innovative in developing ways to share the risks with the selling company. Once identified, IP hurdles and obstacles generally need to be shared and allocated between the buyer and the seller in order for the deal to move forward.

The buyer should also be prepared to assist the seller, which may have trouble supporting due diligence and other sale-related activities because of its lack of funding or sophistication. Together, these strategies will enable the buyer to accomplish its key goal, which is to get the new product or technology into the hands of its sales force so that it can begin making money for the company.

Gregory J. Vogler is a cofounder and shareholder, and Robert A. Surrette is a shareholder, in the law firm of McAndrews, Held & Malloy Ltd. (Chicago).

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