Buyout firms spent more than $39.38bn acquiring technology businesses in H1 2016, accounting for 28% of all global deal value and making technology the preferred sector for investment during the period. With investment flooding into tech, private equity is facing competition and increasingly high deal valuations. Tech companies pose unique diligence issues and failure to fully understand and price risks leaves buyout firms at risk of overpaying.
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Investing in technology carries specific risks relating to the creation and ownership of intangible rights that cannot always be registered. Understanding these risks requires a combined legal and technical approach when conducting diligence. In the world of intellectual property, brand is about goodwill, recognition, avoiding dilution and ensuring registration: pharma is the world of patents and generic manoeuvring, but in the world of software, who created your code, where, and using what, are fundamental questions of value.
Examining the usage of open source software by any prospective tech focused target is crucial. Software development can involve the use of free and widely available “open source” software tools. This is code that can easily be downloaded but its use is subject to particular terms and conditions. The terms and conditions of open source tools vary. Permissive licences usually only require onward transfer on the same terms as those under which the open source software was provided. Restrictive licences (also known as “copy left” licences) restrict the ability of the owner of the developed code to commercialise software incorporating the open source code. Software that could be integral to commercialising a target company’s assets could be limited by such terms and conditions, which will lessen that company’s value and future prospects.
Where restrictive terms apply, deal teams must have visibility over how the software was developed and how it is used. Additional technical expertise may be required alongside legal analysis in order to conduct the necessary diligence. Failing to spot these issues early in the process can cause significant deal delays and runs the risk that a software developer could have to undertake a complete (and costly) rewrite of its code.
In our view, in order to maximize value private equity deal teams must understand the implications of open source code usage and where restrictive terms apply, have visibility over how the software was developed, how it is used and satisfy themselves that there are no impediments to distributing the code to third parties for licence fees.
Other Key Legal Issues for Tech Investments
Deal teams should:
- Establish a clear chain of title for all key software products. Seek sellers’ confirmation on how, when and by whom each product was developed. Review provisions in consultancy agreements and employment contracts. An employer whose employees create copyright in the course of their employment will generally either own, or have an option to own, that copyright in most European jurisdictions. However, unless there are active assignment provisions in a consultancy agreement, external consultants will retain ownership of rights to any intellectual property they create (although a licence to use may be implied)
- Where licensing or copyright issues are of concern, establish whether a “clean room” has been employed. This entails developing technology in an environment from which all trade secrets and know-how obtained from a competitor under licence, or all copyrighted materials, have been excluded, ensuring independent development of technology
- Consider whether the intellectual property rights position exposes the target to disputes and what level of exposure to accept. Disputes which most commonly arise include intellectual property ownership challenges, infringement of third-party intellectual property rights and breach of licences (including open source software licences). Consider whether action can be taken post-completion to reduce the risk of infringement
- Establish and understand the cause of any gaps in the registered intellectual property rights portfolio – any trade mark or patent portfolio deficiencies should be addressed or the approach to non-registration confirmed