It is never easy investigating the purchase of a company, buying that company, and assimilating that company’s business into your company. The problems can be particularly challenging, however, when the company you are considering buying is a technology company.

By definition, the principal asset of a technology company is intellectual property. In determining whether it is advisable to purchase a technology company, your due-diligence investigation must include an examination of a multiplicity of intellectual property and related issues.

Patents

It is imperative to identify key technology developed or utilized by the target company. Although it is sometimes preferable to safeguard key technology with trade secret protection, it is usually preferable that such technology be patented. Thus, an examination of the target company’s issued patents and patent applications is necessary. You will need to determine whether the company’s patents protect key technology or only mere minor aspects of that technology which can easily be bypassed by the competition.

If patents have been applied for but not yet issued, you should determine whether the patent applications are provisional or nonprovisional. While a provisional patent application can be very useful as placeholders for a later filing for a nonprovisional patent application, it is important to realize that such applications expire 12 months after filing and may be ineffective if they do not provide a complete explanation of the invention or teach the best mode for practicing the invention.

You should also determine whether there is a patent plan in place and whether that plan is being followed. You should ascertain whether patent applications been filed in key countries where the company is or will be doing business or whether the deadline for filing such patents has expired. Also, you should find out whether the inventors of the patents have formally assigned them to the target company. A particularly troublesome problem would be if any of the inventors have left the employ of the company without formally assigning the patents.

It is also important to find out if there are any third-party patents that must be licensed in order for the company to utilize its technology. If so, you will want to find out whether the holder of such patents has a policy of licensing such patents and the terms of such licenses, including royalties for past and future use.

Copyrights

Probably the most important item in your investigation is to determine whether any of the target company’s technology was developed by independent contractors. It is common for start-ups to use contractors, as young companies often do not want to assume the financial and legal responsibilities which arise from hiring employees for specialized and temporary tasks. A common mistake is for companies to fail to insist on written contracts stating the work product of contractors who develop software and other intellectual property is “work made for hire.” Without such language or similar verbiage in a contract with the contractor, the copyright in the contractor’s work product belongs to the contractor, and the customer has only limited rights to use the work product. Unfortunately, many a company has had to pay savvy (or unscrupulous) contractors twice for the work product – initially for the work and later for the copyrights.

If software or other copyrightable intellectual property is in complete form, it should be registered with the Copyright Office. The cost of such registration is minimal, registration can be accomplished with a minimum amount of the material actually placed on the public record, and such registration gives the copyright holder the right to statutory damages for infringement (without the necessity of proof of actual damages) and attorney’s fees under appropriate circumstances.

Trade Secrets

Technology companies often develop valuable techniques, methods, processes, or software which they would like to keep proprietary to the company and its customers. In order to do so, the law requires that the company take reasonable efforts to maintain the secrecy of such items. Such efforts include the use of employee and contractor secrecy agreements, non-disclosure agreements with potential customers and partners, and licenses with customers with restrictions as to proprietary information.

Particularly valuable intellectual property should be subject to stringent protections. For example, software source code should be password protected, the password should be changed when an employee with access to source code leaves the company, and printed versions of source code should be locked up when not in use.

Licenses

Technology companies often have to license key technology from third parties. You should check to ensure that such licenses to the target company are under favorable terms, that the target company is not in default, that the licenses cannot expire or be terminated without cause by the licensor during the time that the target company needs the licensed technology, that the licenses entitle the target company to receive needed updates, and that a source code escrow is in place, if possible. You should also make sure key licenses are transferable if you are contemplating an acquisition structure which requires a license assignment.

With respect to out-licenses (i.e., licenses from the target company to customers or others), you should check to make sure the licenses are not so broad or generous to impede your plans for exploitation of the technology. For example, a company-wide unlimited usage license of a software product to a large customer or an exclusive marketing agreement with a distributor might severely restrict your plans to grow the target company. If the target company has licensed its patents, do the licenses require the licensees to mark their products with the patent numbers? If not, it may be more difficult to collect damages for past infringement by third parties.

Public-domain and open-source software is becoming increasingly popular as a component for commercially produced software. Such software typically carries certain licensing requirements, including the obligation of developers who use it to provide their licensees with source code for the open-source portion of the software. Under certain circumstances software intended by the developer to be proprietary can become subject to open-source requirements when open-source software is utilized as the base for the developer’s software. Furthermore, the incorporation of public-domain or open-source software into the target company’s products could make those products easier to imitate by the competition. Finally, some open-source software, such as Linux, is the subject of infringement suits, which could affect the target company’s ability to distribute its products. Thus, you should pay particular attention to the target company’s incorporation of public-domain and open-source applications and libraries into products intended to be proprietary.

Employee Issues

It is important that you identify key employees and make an effort to retain them if you decide to buy the company. A buyer may lose important customers if the sales person with the relationship with the customers goes to work for the competition. In addition, the buyer of a technology company can be hobbled by the departure of key engineers with extensive knowledge of the target company’s technology.

Many states, including California, have policies which are hostile to covenants which prohibit a former employee of a company from working for a competitor. In those states, such covenants by an acquired company’s former employees may only be enforceable if the former employee entered into the covenant in connection with the sale of his or her ownership interest in the company.

All states recognize, however, the right of a company to prohibit the use of its confidential information for the benefit of third parties. Therefore, you should ensure that written agreements are in place with the target company’s employees which prohibit such use of the company’s trade secrets during their employment with the company and thereafter.

You should also inquire as to whether employees were restricted by the target company from moonlighting for other employers. Moonlighting employees are a potential source of leaks of trade secrets.

On the other side of the coin, you will want to know if the target company has warned its employees, preferably in writing, not to use trade secrets of prior employers for the benefit of the target company. An employee’s use for the current employer of code developed for a prior employer is not uncommon in the software industry. Such use, if discovered, can result in expensive and embarrassing infringement litigation against the current employer as well as the offending employee.

You should also look for employee agreements that require employees of the target company to assign to the company patents, inventions, and other intellectual property developed in the course of their employment with the company, since there may be a question as to whether such items are automatically assigned to the company by operation of law. These agreements are particularly useful if a formal assignment is sought after the inventor has left the employ of the company.

Marketing Issues

Because new technology products often take a significant time to develop and market, it is important to know if the target company has a viable product road map for future product development and if it is on track under that plan. Very few technology companies enjoy a product monopoly, and most must constantly develop new products to avoid being surpassed by the competition or bypassed by changes in customer tastes. The road of competition is littered with technology products (and companies) that did not improve, evolve, and adapt to changing market demands – for example, Ampex reel-to-reel tape recorders, 8 track tapes, Sony Betamax VCRs, and Osborne computers.

Strong branding is essential to the success of any company, especially if the company is a technology company and does not have a lock on essential technology through patents, trade secrets, proprietary software, or exclusive licenses. Thus, it is important to ascertain whether the company has registered its product and service brand names as trademarks and service marks in the jurisdictions where it intends to sell its products and services.

Documentation Issues

Poor documentation can obviously cause problems in the human resources area (overtime and the like) but is also a factor with technology. Documentation is important in establishing dates of invention of patentable products and processes, proving copyrights, and in confirming that a company has adequate protections for its trade secrets. All too often the signed copies of key agreements and licenses have been lost, or through oversight the agreements and licenses may never have been signed.

If a key asset of the target company is software, you should ask to see programmer documentation, including theory of operation and programmers’ notes. If the code is not fully commented, a buyer of the company undoubtedly will have a tough time working with that code if the programmers with knowledge of it leave the company. There have been instances in which disgruntled programmers have destroyed all or part of the source code of a company in the process of being purchased. Thus, a buyer should require that source code be kept secure and delivered as part of the closing process.

The examination of intellectual property issues in connection with the purchase of a technology company must be carefully accomplished if you are to avoid unpleasant surprises. Hopefully, the information in this article will take some of the mystery out of buying technology companies, will help you avoid some common pitfalls associated with the purchase of such companies, and provide you with a useful checklist.