The Problem with Patent Due Diligence in Mergers and Acquisitions and How to Fix It

I have no doubt that I conducted my patent due diligence duties highly competently and that I, too, had “CYA’d” myself in these transactions. However, it is now evident that the patent aspect of M & A due diligence basically conformed to someone’s idea of how not to make stupid mistakes on a transaction involving patents. In truth, I never felt quite comfortable with the “flyover” feel of patent due diligence, but I did not have decision rights to contradict the standard operating procedures of the M & A experts. And, I found out just how incomplete the standard patent due diligence process is when I was left to pick up the pieces of a transaction conducted according to standard M & A procedure.

In that transaction, my client, a large manufacturer, sought to expand its non-commodity product offerings by acquiring “CleanCo”, a small manufacturer of a patented consumer product. My client found CleanCo to be a good target for acquisition because CleanCo’s product met a strong consumer need and, at that time, commanded a premium price in the market. Due to strong consumer acceptance for its sole product, CleanCo was experiencing tremendous growth in sales and that growth was expected to continue. However, CleanCo owned only a small manufacturing plant and it was having difficulty in meeting the growing needs of the market. CleanCo’s venture capital investors were also anxious to cash out after several years of continued funding of the company’s somewhat marginal operations. The marriage of my client and CleanCo thus seemed a good match, and the M & A due diligence process got underway.

Due diligence revealed that CleanCo had few assets: the small manufacturing plant, limited but growing sales and distribution and several patents covering the sole CleanCo product. Notwithstanding these apparently minimal assets, CleanCo’s asking price was upwards of $150 million. This price could only mean one thing: CleanCo’s value could only be in the potential for sales growth of its patented product. In this scenario, the exclusive nature of the CleanCo product was properly understood to be fundamental to the purchase. That is, if someone could knock-off CleanCo’s differentiated product, competition would invariably result and all bets would then be off for the growth and sales projections that formed the basis of the financial models driving the acquisition.