Patent due diligence: The hidden risks in M&A transactions

In M&A transactions involving entities focused on innovative technology, tech-transfers, research and development models, etc. the inventions’ portfolio or formally known as patents portfolios, often command significant attention in valuations. Yet, in practice, patent due diligence is frequently treated more as a verification exercise, i.e., how many patents does the target entity own? How many applications are in the pipeline? Are the patents granted or grantable? Are they in force? Ongoing disputes? etc.

These questions no doubt are important, but some of the major concerns or merits, for that matter, are often hidden in fine details like prosecution history, acquisition or assignments of inventions/ patents, handling of the confidential R&D data, maintainability of patents, disputes or deals with vendors, licensees, or actions and inactions by the patent owner against known infringements.

Experienced transactions lawyers know that the most significant patent-related issues are rarely found on the face of a patent certificate. They are usually discovered in patentability searches, freedom to operate (FTO) analysis, how the employment agreement or service agreements ensure that the inventions are rightfully transferred to the employer entity, assignment records, prosecution histories, annuity records, opposition proceedings, internal R&D documentation and innovation-related policies, if any. A patent portfolio often appears attractive and projects a robust innovation base of the target company during negotiations, but it presents a very different picture once subjected to closer scrutiny. A patentability and/ or FTO analysis with similar technology terms presents a clear picture, beyond the façade of the impressive patent portfolio of the target entity.

In several transactions, the first concern is patent ownership, especially if the target entity has a chain of acquisitions or an R&D section. Issues relating to inventor assignments and historical transfers often surface only when the deal enters the diligence phase.

During diligence exercises, it is not unusual to find gaps in the chain of title, particularly in businesses that have undergone restructuring, received external investments, or developed technology through consultants and contract researchers. Inventor assignments may be missing, executed assignments may never have been recorded, or rights may have passed through multiple entities without adequate documentation. While Sections 68 and 69 of the Patents Act, 1970, govern assignments and registration of title, the commercial concern for an acquirer is straightforward: can ownership be established without dispute? This issue gains significance when the patent constitutes a core business asset. A patent may have substantial commercial value, but if ownership is uncertain, enforcement and transferability become equally uncertain.

The next big question is whether the patent rights are as broad and/or enforceable against others as the seller believes them to be.

Parties often focus on granted claims and overlook the examination record. However, the prosecution history frequently reveals a different story. Many patents proceed to grant only after substantial amendments to distinguish prior art or overcome objections under Sections 2(1)(j), 2(1)(ja), or 3 of the Patents Act. As a result, the commercial scope of protection may be considerably narrower than what was originally sought. In several transactions, buyers have valued patents based on broad technological descriptions, only to discover during diligence that the granted claims offer much narrower protection than anticipated.

A pending patent application requires the same, if not higher, level of scrutiny

Particularly in technology-driven businesses, a substantial portion of the projected value may be linked to applications that have not yet matured into patents. It is therefore important to assess not only the existence of those applications but also their prospects of a grant. Applications facing significant patentability objections may never deliver the exclusivity assumed in the transaction model.

Compliance-related issues present another recurring challenge

Patent portfolios are often built over many years and across multiple jurisdictions. During due diligence, discrepancies involving renewal fee payments, inventorship details, recordals of assignments and other administrative requirements are not uncommon. While many such deficiencies can be rectified, they frequently require additional time, cost and negotiation. More importantly, they often emerge at a stage when parties are working towards deal completion and have limited appetite for unexpected complications.

Closer scrutiny of the patent portfolio

Another misconception encountered in patent-heavy transactions is the assumption that a patent grant automatically translates into exclusivity, and every patent so granted by the Patent Office is a 100% guarantee of monopoly over the technology. It is imperative for the acquirer entity to conduct patentability searches even though a patent has been granted, every patent is subject to revocation proceedings and/ or scrutiny of patentability by the Courts. The alleged infringer would not concede hands down when brought to the challenge. The patentability search, while performing due diligence and/or valuation of target entity, opens up a strong-looking patent portfolio especially by highlighting infirmities in the grant and/ or any prior art document that is missed by the Examiner. Even a procedural oversight, such as failing to inform the Patent Office of refusals in other countries, might result in a granted patent getting revoked/ cancelled; hence the value instantly becomes zero. Further, a higher scrutiny on patentability is required for pending patent applications.

Utilisation of patented technology and keeping clear of infringements

It is also to be seen as to what ratio of the patent portfolio is actually utilized by the target company in its products and if there is any licensing of patented technology. The valuation is greatly affected by the real-world utilisation of the patents; it is often seen that the target entity tries to pump up the valuation based on “paper-patents” which are basically technologies that do not make business sense and are not utilised or have not scope to be utilised in business. Further, a company may own patents covering aspects of its products while remaining exposed to third-party patent rights. This distinction becomes particularly important in sectors where products incorporate multiple technologies and components. Patent due diligence should therefore examine not only the target's patents but also ongoing and/ or possible infringements, opposition proceedings, cease-and-desist notices and known third-party risks.

From a transactional perspective, this assessment is imperative, often more valuable than the patent count itself. A patent portfolio that cannot be commercially exploited without exposing the business to infringement claims may offer less value than initially assumed. Equally important is the tendency to equate the size of a patent portfolio with its strength.

In practice, a portfolio of 10% patents protecting commercially significant products may be more valuable than 50% patents covering technologies that are no longer relevant to the business. The key question is not how many patents exist, but whether they support products, processes or technologies that contribute to revenue and market position. This is where patent due diligence serves an important commercial purpose. It helps separate strategic assets from peripheral ones and enables parties to assess whether the valuation attributed to the portfolio is justified.

The basic take away is that the patent valuation is not a mere financial assessment based on count or patent portfolio boasted by the target entity. The true valuation of the patent portfolio during M&A transactions are often hidden in patent specifications, R&D documents, products or services of the target entity, their relationships with employees, vendors, etc. that should receive adequate attention during preliminary negotiations along with, of course, an impressive line-up of patents and inventions by the target entity. If some of the issues as briefly described above are discovered during a later stage or after agreeing on the consideration, remedial options may be limited and quite expensive. For that reason, patent due diligence is not simply a process of verifying registrations and pending applications. It is an exercise in determining as reasonably as possible the value of innovative technologies in true sense attributable to the target entity.

About the author: Shrimant Singh is a Senior Partner at S&A Law Offices.

Disclaimer: The opinions expressed in this article are those of the author. The opinions presented do not necessarily reflect the views of Bar & Bench.

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