Intellectual Property Due Diligence: Are the Seller’s Representations and Warranties an Acceptable Substitute?

What this is: Representation/warranty provisions and intellectual property due diligence (IPDD) are frequently complementary components of risk management in transactions.  

What this means: This article answers “Are representations and warranties an adequate substitute for intellectual property due diligence?” 

Can Representations and Warranties Be a Substitute for IPDD? 

An interesting question was posed to us on this topic which we thought was worth sharing with all of our readers: 

Can “representation and warranty” provisions in acquisition agreements be an acceptable substitute for conducting intellectual property due diligence (IPDD)? 

This question was originally asked in a past webinar on this topic, but we wanted to give it some serious and public thought as other legal professionals may have pondered the same thing. 

In a transaction, IPDD and representation/warranty provisions are often complementary components of risk management. As important as they are, representations and warranties are not an adequate substitute for IPDD, especially when the IP of the seller is essential to the deal. 

The Role of Intellectual Property Due Diligence in a Transaction 

What is IPDD? 

Intellectual property due diligence is the thorough, systematic review of the IP owned and used by an entity involved in a transaction in order to determine the value of the IP being acquired or financed and any risks that may be associated with that IP. The 3 operative words in this definition are owned, value and risks. 

IPDD is Becoming Increasingly More Important in the Pre-Closing Process 

IPDD is Becoming Increasingly More Important in the Pre-Closing Process 

According to numerous reliable sources, over the last 25 years the share of intangible asset market value has increased dramatically, and by some estimates now often accounts for 90% of a company’s overall value. Accordingly, when IP is a fundamental aspect of a transaction, as it is becoming more and more frequent, IPDD is a critical step in the pre-closing process. Before entering into an agreement, a buyer would likely want a clear picture of the ownership/chain of title for a target IP asset. Any ownership issues that would inhibit use of the IP could influence the price of acquiring the target company or be a deciding factor in whether the buyer enters into the agreement at all. Issues related to ownership, registration, licenses and infringements that are uncovered through thorough IPDD can be addressed in the deal documents with representations, warranties and indemnification provisions.

IPDD Informs Representations and Warranties Provisions 

These representations and warranties may present significant ongoing obligations and possible liability for the seller, so they can become hotly negotiated items. In some cases, the parties may negotiate liability caps, set-asides or holdbacks from the deal proceeds with respect to identified potential copyright, trademark or patent IP risks. Such contractual protections generally have a limited effectiveness period, which is why it’s critical to identify and assess any IP risks before the transaction closes. 

Limitations 

While representation and warranty provisions often address the terms of how a buyer can be compensated in the event of a breach, they don’t take into account the time and resources that the buyer may spend on seeking damages or the risk that the seller is not solvent at the time legal action is taken. Furthermore, representation and warranty protection does not guarantee that the buyer will have full (or any) rights in the IP after the legal dispute dust settles. 

Risky Business Without Due Diligence 

I’ve asked seasoned transactional legal colleagues this same question and they too were not at all comfortable with merely relying on the seller’s representations and warranties pertaining to the rights, title, encumbrances and use of any IP that is the subject of a transaction. And, in fact, this belief wasn’t limited to a seller’s IP assets but rather it applies to all of their assets. 

The Main Takeaway 

Regardless of the asset type or class, forgoing proper due diligence (including intellectual property due diligence) and relying solely on the seller’s representations and warranties is considered an unacceptably risky practice. 

This article is provided for informational purposes only and should not be considered, or relied upon, as legal advice.