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The purpose of this article is to give an introduction to the process of due diligence as it applies to businesses in the biotechnology sector. It begins with an overview of the circumstances in which a bio-science company will be subjected to due diligence and the reasons why it is necessary. It then goes on to outline the areas which will be the main focus of legal due diligence, with an emphasis on intellectual property rights.
Due diligence is a detailed investigation of the affairs of a business. The aim of due diligence is to identify problems within the business, particularly any issues which may give rise to unexpected liabilities in the future. Due diligence involves a number of different areas of investigation. For example, the company’s financial status will be assessed by accountants and the pension arrangements will be the subject of an actuarial review. As intellectual property rights are the key assets of any biotech company, the business’s IP portfolio will inevitably be the subject of close scrutiny.
There are three main situations in which a bio-science company is likely to be subjected to due diligence:
* M&A: by a potential purchaser or investor prior to a merger or an acquisition of all or part of the company’s business
* Commercial transactions: by a potential partner prior to entering into a significant collaboration or licensing arrangement
* IPO: by the business itself prior to an initial public offering (or ‘IPO’) or subsequent listing of shares on the stock market
The next section considers each of these three cases in more detail.
Before buying or making a significant investment in a business, a potential purchaser will want to know as much as possible about what it is getting. For this reason, acquisitions are invariably preceded by extensive due diligence by the purchaser.
In a typical transaction, as a first step the potential purchaser will send out a questionnaire to the target company, requesting full details of the business’s patents and patent applications, licences and collaboration agreements, IT systems, confidentiality agreements, employment contracts and a whole host of other information. Alternatively, if the business wishes to attract a purchaser, for example in an auction sale, it will compile this information itself. The documentation will generally be assembled in a ‘data room’, to which the purchaser and its advisers will have access.
However, it is not only the buyer who will carry out due diligence. Although the general rule under English law is caveat emptor or ‘buyer beware’, the sale of a business will invariably include warranties given by the seller in relation to certain aspects of the business. For example, the seller will usually be asked to warrant that so far as it is aware, the activities of the business do not infringe any third-party intellectual rights, and that no third parties are infringing any of the company’s rights. There will also typically be warranties relating to the company’s licences, IT systems and so on.
A buyer may not bring a claim for breach of warranty if the seller discloses information which qualifies the warranties. This means that the seller must carry out a due diligence exercise of its own, to ensure that it discloses all matters which might otherwise result in a warranty claim at a later date. Appendix 1 sets out the areas which would typically be covered by warranties and the types of information required to be disclosed against each one.
Of course, identification of major problems in the course of due diligence may cause the purchaser to rethink its valuation of the business, seek an indemnity from the sellers or even in severe cases to withdraw from the transaction. However, it is always preferable for both parties to be aware of all the potential pitfalls at the outset, rather than bear the risk of unexpected and unquantified liabilities in the future.
Before entering into a major commercial agreement such as a licence, joint venture or other collaboration with a bio-science company, a collaboration partner will want to carry out a certain amount of due diligence. This is particularly likely to be the case where a major pharmaceutical company is forming a relationship for the first time with a relatively small start-up biotech company. While the due diligence is unlikely to be as extensive as on an acquisition, the larger company will be seeking comfort that its investment will be secure and the biotech company has the intellectual property rights, personnel, expertise and resources to perform its obligations.
In addition, where a biotech company is licensing a third party to use a product candidate or platform technology, it may be required to give warranties as to validity, non-infringement of third-party rights and so on. As on an acquisition, the company is advised to conduct a thorough investigation of the relevant facts before giving warranties. Failure by the licensor to carry out sufficient due diligence before giving warranties can be disastrous, particularly if it results in the company having to repay its hard-earned licence fees in damages for a breach of warranty claim.
Due diligence also plays a key role in an IPO or subsequent listing of shares, but for different reasons. In this case, it is the business itself which must tell its story to potential investors through its prospectus or listing particulars. The rules of the Stock Exchange impose certain requirements in relation to the types of information which a company must disclose in its prospectus. The Financial Services Act imposes heavy penalties, including in some circumstances criminal sanctions against individual directors, if the information disclosed is inaccurate. It is thus crucial to ensure that the contents of the prospectus are accurate and not misleading, a process known as verification. Thorough due diligence is the lynchpin of this exercise.
Most UK biotech companies do not have the necessary financial track record to obtain a listing on the Stock Market under the normal rules, which impose a requirement for the business to be supported by its earnings for at least three years before a company can float. However, listing of a biotech company which has not yet achieved profitability can benefit both the company and investors. In recognition of this, Chapter 20 of the Stock Exchange Listing Rules permits scientific research-based companies which are not yet profitable to raise funds in the market, subject to certain conditions. Some of the key requirements of Chapter 20 are highlighted in Appendix 2.
Because investment in a biotech company is comparatively high risk, Chapter 20 imposes additional stringent requirements for disclosure of information in the prospectus. Unsurprisingly, many of these requirements focus on the business’s intellectual property rights. This makes intellectual property due diligence all the more important.
Chapter 20 also requires an independent report from (among others) the company’s patent agent on the company’s patent position to be included in the prospectus. As with all elements of the prospectus, the contents of this report must satisfy the company, the underwriters, their respective legal advisers and the Stock Exchange. This can be a lengthy process. It is important to get patent agents involved at an early stage to begin preparing the report. This will also allow time for any deficiencies in the portfolio to be identified and, if possible, rectified prior to the flotation.
On a flotation or new issue, one or more merchant banks will be involved as sponsors or underwriters or both. The bank has certain responsibilities as to the contents of the prospectus and, as underwriter, will want reassurance that investment in the business does not entail unacceptable risks. As a result, the bank and its advisers will also carry out due diligence prior to an IPO. The following section expands on the main areas which are likely to be investigated in a thorough legal due diligence exercise. The focus is on intellectual property rights in particular, because of their crucial importance to all companies in the bio-science industry.
For all companies, and particularly relatively young biotech companies which are very likely to have an IPO or acquisition, or both, ahead of them, it is important to prepare from an early stage. A business which is aware of the areas which will be investigated, and the types of problem which may arise, will be in a far better position to take steps to avoid the issues which can surface on due diligence.
Whether on an IPO or an acquisition or collaboration, the areas which will require investigation are likely to be the same. For most companies in the bio-science sector, the main intellectual property rights which will be of interest are patents, know-how and confidential information, copyright and trade marks. Other rights may also be relevant, depending on the business in question. For example, a business generating large amounts of information by high-throughput screening may rely on the new category of database rights recently introduced into European law.
Intellectual property rights are creations of national law. Each jurisdiction has a separate set of laws governing each set of rights. In some areas, such as patents, there is considerable convergence of national laws. In others, such as copyright protection, there is very considerable divergence. IP due diligence cannot hope to appraise fully the laws applicable in all relevant markets. However, the laws applicable in important overseas markets do have to be considered to some extent. For example, a business with operations in the United States which has key proprietary software should consider US copyright registration and the rules governing copyright notices.
A due diligence investigation into a company’s intellectual property assets is essentially a methodical audit which will cover at least the following main areas:
* Patents
* Know-how
* Copyright
* Trade marks
* Infringements; and
* Licences and collaboration agreements
Each of these areas will now be considered in further detail
Patents are the foundation stone of any bio-science business. A due diligence investigation will cover at least the following areas:
* Coverage: are the company’s key product candidates and platform technologies adequately protected by patents or patent applications? How many years do the key patents have left to run (valuation will depend to a large extent on the length of a patent’s unexpired term)? Does the portfolio contain patents which are no longer used and are therefore an unnecessary drain on resources?
* Territory: registered intellectual property rights are, generally speaking, expensive to obtain and maintain on an international basis. The benefits of obtaining patent protection in as many countries as possible must be balanced against the costs of doing so. Has the company identified and protected inventions in its key territories? l Renewal fees: non-payment of fees can lead to patents being revoked; are procedures in place to ensure that all renewal fees are paid?
* Ownership – employees: where inventions are made by employees in the course of their employment, in general the rights will belong to the employer. However, it is always preferable for employment contracts to deal with ownership of intellectual property rights specifically. Problems can arise if there is uncertainty as to whether IPRs were developed in the course of employment. For example, if a director who is also a university professor makes an invention, is it possible to determine in which capacity he or she was acting at the relevant time? If the company was spun-off from a university or founded by an individual, was there an assignment of rights to the company at the outset?
* Ownership – third parties: where third parties are engaged to carry out research and development work, it is even more important that there is a contract in place dealing with ownership of IPRs. For example, if the company is sponsoring a PhD student or research in a university, or is collaborating with a third party, who will have the right to exploit the results?
* Validity: have there been any challenges or oppositions to the company’s patents? Where applications have been filed but not yet granted, is it likely that granted patents will result which are sufficiently broad to cover the products? This can be a particular issue in the field of gene and protein patents, where the law is still developing and it is by no means certain that adequate protection can be obtained in all cases.
* Infringement: the value of the monopoly rights conferred by a company’s patents will be diluted if it does not take steps to enforce those rights against third-party infringers. If an infringement is not prevented, competitors interpret the inaction as an invitation and the benefits of the rights can be quickly lost. Infringement by the company of third-party rights is a topic in its own right and is considered further below.
Know-how or confidential information is very important to any bio-science business. There is a delicate balance between patents and know-how. While a patent confers a monopoly right, in some circumstances (for example, where a new process has been developed) there may be a benefit in protecting the information as confidential know-how, rather than seeking patent protection.
Issues for due diligence in connection with know-how will include:
* Record-keeping: research staff should keep records of their work, such as notebooks where entries are signed and dated contemporaneously. There are many advantages to reducing know-how to writing where possible and to having a contemporaneous record of the creation process. For example, contemporaneous records may be necessary to establish priority of invention for US patent purposes. Furthermore, if experienced research staff leave or become ill, it is important to have detailed records to avoid work being lost or repeated unnecessarily. Procedures for archiving records, backing up data held on computers and disaster recovery plans are all areas which are likely to be considered on due diligence.
* Confidentiality: the key to protecting know-how is maintaining confidentiality. Are employees properly aware of the confidentiality of the relevant aspects of the business, both in terms of employment and in working practices? Are confidential reports and other documents properly marked and their circulation restricted? Are key employees covered by restrictive covenants?
* Management: does the company have adequate management procedures to identify new inventions and consider patentability at the earliest opportunity? Are researchers encouraged to report potentially patentable inventions as early as possible, and made aware of the potential consequences of the invention becoming public prior to filing? This is an area where the opportunities for dissemination of information via the Internet can be particularly damaging.
* Dealing with third parties: it is clearly desirable to have a standard form of confidentiality agreement for dealing with third parties. It is equally important to ensure that it is signed and complied with. For example, does the company ensure return of all materials disclosed, and document this, if a transaction does not go ahead, or if it is terminated? Do materials transfer agreements contain adequate restrictions on use of the materials, and provisions for their return? This is especially important for self-reproducing biological materials such as cell lines, where the recipient may have access to a potentially unlimited supply.
Copyright protects original documents from unauthorised use or copying. It will protect operating manuals, design drawings, laboratory notebooks and the like. Copyright has not been the subject of significant harmonisation of international laws. For example in the United Kingdom, copyright arises automatically in original documents. The same is true in the United States, but there is also a registration system for copyright which confers additional rights on the copyright owner, and which has no equivalent under English law.
Copyright is probably most significant to bio-science companies because it is generally the only right available to protect computer software. Any due diligence investigation will aim to ascertain that the business either owns or has a licence to use all the software used in the business:
* Licensed-in software: where the business is using third-party software, the review will check that all the necessary licences are in place and the business is not breaching their terms, for example by exceeding the permitted number of users.
* Proprietary software: to stay ahead of the competition, bio-science companies are increasingly investing large sums in developing proprietary software to assist in the drug discovery and development process. Problems can arise on due diligence where elements of software have been developed for the business by independent IT consultants or university departments. The rights in software written by third parties will not automatically belong to the company which paid for the work, and copyright must be assigned to the company. It is not uncommon for due diligence enquiries to uncover that elements of a business’s ‘proprietary’ software do not belong to the company, or that assignments have been lost.
* Copyright in marketing materials, and so on: similar issues will arise whenever copyright works are produced for a business by a third party. For example, if a design consultancy is engaged to produce a new logo, website or advertising campaign, the engagement terms should provide that copyright in any work produced belongs to the company.
Trade marks are likely to be less of a priority for a bio-science company in the early stages of its lifecycle than other types of intellectual property. However, the importance of brand protection should not be underestimated. As the recent Viagra case demonstrates, a well known brand name may give a product an advantage over the competition once patents on the drug expire or are revoked and generic alternatives become available.
As part of its due diligence, a purchaser of a bio-science business will wish to check that trade mark protection has been obtained for significant product names in the business’s key territories. As with other intellectual property rights, issues of validity and infringement (whether by the business or by third parties) will also be investigated.
An infringement action brought by a third party is potentially the most devastating situation a company can face. Not only are such actions time-consuming and expensive, with the potential for a claim for substantial damages, but they typically carry the threat of an injunction, which could prevent the company from selling its key product.
A due diligence review will include a detailed analysis of not only pending and threatened actions, but also areas where there is a potential risk. Is the business aware that it may be infringing third-party rights? Have any third parties written to the company either offering a licence or threatening to sue? Is the company aware of any third-party patents which may be relevant and, if so, has legal advice been sought as to infringement and validity?
A key issue which the due diligence review will consider is the extent to which the company has patent searching procedures in place. Because virtually all areas of the bio-science field are heavily populated with patents, it is vital that the company’s patent agents carry out clearance searches before a new research project is implemented, and preferably that more general searches are performed on a regular basis in the areas in which the company is operating. It is clearly not desirable to spend time and money on research which cannot be commercialised because there are relevant third-party patents which were not identified at the outset, and defending an application for an interim injunction tends not to enhance a new product launch.
Scientists are often well informed of developments in their field of expertise, and can be a source of valuable information on the activities of competitors. Does the company have a policy of encouraging employees to report potential infringement issues promptly?
It is important that when potential infringements are discovered, management and employees are aware of the need to avoid creating disclosable documents with prejudicial comments like ‘this patent looks very similar to what we are doing’ or ‘they have hundreds of patents in this area so we are bound to be infringing some of them’. Aside from the obvious commercial risk if such a document were to fall into the hands of the patent-owner, there is also the risk that relevant documents (including internal notes and memoranda) might have to be disclosed to the other side in the event of litigation.
Generally speaking, correspondence between a company and its lawyers (including in-house legal advisers) for the purposes of seeking legal advice are protected (or ‘privileged’) from disclosure in court. This is to enable lawyers to give a full and frank opinion on, say, whether a business is infringing a third-party patent. However, privilege will only be maintained if the document is kept confidential. This can cause difficulties, for example on a disposal, where the purchaser will want to see all relevant documents, but the seller will not want to risk losing privilege in potentially damaging legal opinions. This is an issue which commonly arises, and companies should be alert to the need for caution in responding to due diligence information requests or compiling data rooms, to ensure that any disclosure of privileged documents is properly controlled.
Most businesses are dependent on IPRs owned by third parties. Bio-science businesses will inevitably have a range of agreements with third parties under which intellectual property rights are developed and/or exploited.
On the other side of the coin, many bio-science companies extract value from their intellectual property rights by licensing them to third parties. Licensing will also be involved in most research and development and collaboration arrangements. Due diligence will involve consideration of all licences granted by third parties to the business and vice versa. In the main, these will be formal documents, but it is not uncommon (although generally less desirable) for licences to be by exchange of letter or even oral.
The key terms of a licence that should be reviewed on due diligence are:
* Scope: exclusive, non-exclusive or sole
* Territory: market for licensed products and any related restrictions
* IPRs: rights included and treatment of improvements
* Payments: royalty rate, milestones and/or up-front fees
* Term: duration, events and effect of termination
* Assignment: assignability, sub-licensing and change of control
An article entitled ‘Collaborations and Licensing – Key Legal Issues’1 considers in more detail the terms which these types of agreement should contain. A business whose relationships are properly documented will be much more attractive to a potential purchaser or investor than one which has to disclose, for example, that its main product is based on materials provided by a third party, but it is not sure whether or not a formal licence was signed.
When negotiating a licensing deal, the company should bear in mind the long-term objectives of the business, and consider how the agreement will be perceived by a third party conducting due diligence. This is not always easy, as there is often an imbalance in negotiating strength, for instance where a biotech company which requires urgent funding is in discussions with a large pharmaceutical company. Nevertheless, striking a bad deal can pose a real risk, for example where a proposed acquisition falls through after due diligence, because the buyer is not prepared to accept a licence containing especially onerous restrictions.
As anyone with personal experience will testify, due diligence can be a lengthy and difficult process, taking up considerable resources and management time. At first sight, due diligence can appear to be an unwelcome distraction for the management and employees of a business which is in the process of preparing for an acquisition or IPO. However, it should be clear from the above that due diligence is a critical element of almost any major transaction.
The message which this article has sought to emphasise is that preparation is the key to successful survival of a due diligence exercise. A company which has its affairs properly in order will not only have a less onerous task on an acquisition or IPO, but will find that by following good management practices, it has enhanced the value of its intellectual property assets.
Details of all of the company’s registered and material unregistered IPRs (and applications) have been disclosed. The company is the sole owner of those rights.
List all registered and material unregistered IPRs owned by the company. Give details of any rights which are not owned solely by the company (for example, because of joint ownership, or because IPRs have not been assigned to the company).
All renewal and other registry fees required for the maintenance of the company’s IPRs have been paid.
Give details of any renewal payments missed (for example, because unused patents are being allowed to lapse).
Details of all the company’s licences and agreements relating to IPRs have been disclosed.
List all agreements relating to IPRs including licences-in and -out and collaboration agreements.
Neither the company nor, so far as the seller is aware, any third party is in breach of any of the company’s agreements relating to IPRs.
Give details of any breaches of licences or agreements relating to IPRs by the company or the other party.
So far as the seller is aware, no third party is infringing, or has in the past 12 months infringed, any of the company’s IPRs.
Give details of any third parties (for example competitors) who are known or suspected to infringe the company’s IPRs.
So far as the seller is aware, the activities of the company do not infringe and have in not in the past 12 months infringed any third-party IPRs.
Give details of any known or suspected infringements of third-party IPRs by the company.2
So far as the seller is aware, the company has not disclosed any confidential information to any third party except under an obligation of confidentiality, where such disclosure had a material adverse effect.
Give details of any significant instances where confidential information has been disclosed to third parties without appropriate protection of confidentiality.
* In general, a company may only seek a listing if it is, and has been for three years, an independent business which is supported by its historic revenue earning record (§3.6).
* Chapter 20 applies to ‘Scientific research-based companies’, that is, companies which are primarily involved in laboratory research of chemical or biological products or processes, and do not meet the requirements as to the nature and duration of business activities (§20.1).
* To seek a listing under Chapter 20, a company must (§20.3):
– have demonstrated its ability to attract funds from sophisticated investors
– intend to raise at least £10 million from the flotation
– have a capitalisation of at least £20 million
– have as its main reason for listing the raising of funds to bring identified products to a stage where they can generate significant revenues; and
– demonstrate to the Stock Exchange that it has achieved significant commercial milestones, for example by having at least two drugs in clinical trials, having current collaborations or development agreements worth at least £5 million and/or having invested at least £20 million in R&D over three years, resulting in valuable intellectual property rights.
* In addition, the directors and senior management must demonstrate that they have the knowledge and expertise necessary to run the business, including technical, financial, marketing and, if appropriate, manufacturing experience (§20.4).
* Chapter 20 also contains detailed requirements as to the contents of the prospectus, including information on the company’s patent portfolio and product pipeline, risks associated with the exploitation of its products, validations, collaboration and licensing agreements, business plans and future funding requirements, competitors in the field, to name only a few (§20.8 to §20.10).
1) To be published in [2000/2001] 2 BSLR.
2) Note that issues of legal privilege should be considered before disclosing infringements by the company.
This article was originally published in
The article's authors are: Nigel Swycher & Rebecca Sadleir, Slaughter and May, London
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