IP due diligence and management during investment

By Wu Yixing, DOCVIT Law Firm

China’s former paramount leader, Deng Xiaoping, once remarked that “science and technology constitute a primary productive force”. His words ring even truer today, with S&T a critical driver in economic development, universally changing production, business and distribution models.

Along with the growing importance of enterprise development and market competition, intellectual property rights (IPR) protection is likewise gaining traction in China. Capital forces greatly value the technological strength of target companies, and scrutinise their IPR in the investment and financing process to ensure they are on the right side of the line.

This article discusses the role of IP due diligence and management during the investment process, based on the author’s experience in several pre-investment IP due diligence cases in high-tech industries.

The hurdles

Many new high-tech enterprises in China choose to generate research results first and startup afterwards, with teams of many senior R&D personnel. Some are former researchers from key national R&D programmes, foundation committee projects, universities and research institutes, with a mind for switching from scientists to entrepreneurs. Others have long been dedicated to a particular field of expertise in high-tech enterprises, and are trying to set up their own business with their skills.

Wu Yixing
Senior Counsel

In the early stages of those new high-tech companies, they manage to bring in external investment, with the IP they own being a key factor in attracting investors. However, the history of the startup team can lead to conflicts with their former employers over ownership of the company’s core IP, raising doubts among investors about the core assets of the newly created company.

Investor concerns about the IPR status of the invested company include: (1) whether its IPR is of legal origin; and (2) whether IPR ownership is sound and solid.

The latter is primarily determined by: whether the target company’s IP is the service invention of R&D personnel’s former employment; whether the R&D personnel have infringed on trade secrets of the former employer; and whether IP ownership is clear and unchangeable, and if there is a business risk of losing it in the future.

The main factors contributing to the above-mentioned disputes include: (1) R&D personnel are unclear on the issue of IPR ownership and even use their former employers’ IP directly for the production and operation of their newly established enterprises; (2) some R&D personnel are so eager to industrialise IP that they circumvent relevant regulations regarding industrialisation of the former employer, and transfer scientific research result to the new entity; and (3) some investors, aiming to grab projects and maximise publicity, hold a results-oriented attitude and blindly encourage such ill-fated development while ignoring the pitfalls.

Enterprises operate capital to continually contribute to reproduction, thus enhancing its capital appreciation, which also fulfils the very purpose of investment. However, the mere chasing of profit or blind pursuit of short-term gains can lead to a disorderly flow of capital, possibly against the direction of national policy and relevant provisions of laws and regulations.

R&D personnel, for their part, may show weak awareness of IPR protection, disrespecting their previous employers’ R&D investment and conversion policies. As a result, a higher risk of IPR dispute, and investment failure, will occur, which ultimately leads to the squandering of resources.

In addition, ignoring substantial investment by a former employer in the early stage of basic research – and denying their rights and interests – will frustrate the enthusiasm of enterprises for R&D.

The tactics

Investing in a company with IPR that is in dispute will exponentially increase the possibility of failure. For risk-averse reasons, investors need to strengthen pre-investment due diligence and reinforce the IPR management of target companies. The tactics to meeting this challenge are as follows.

Strengthen awareness of IPR protection for both parties. Proactively check the IPR held, clarify their ownership, ensure the licence chain is complete and effective, and eliminate potential IPR disputes in time. Also, companies needing IPR for production and operation, but having no ownership, should obtain the rights to legally use IP via licensing or transferral, so reducing the risk of litigation in future operation and financing.

Promote R&D commercialisation. Many universities and research institutions have already introduced commercialisation policies. On this basis, if the authorities on science and technology, education, industry and IT jointly formulate rules and regulations on the conversion of achievements, a top-down regulatory management system can be established. The securities regulators should also co-ordinate and match the various pre-requirements for the capitalisation of R&D results, and provide comprehensive guidance over the industrialisation of S&T achievements.

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Consult external legal counsel. Both the investor and target company can actively request help from external lawyers during the trade process, in terms of researching their IP status and strategic arrangement. This can promptly and reassuringly identify management loopholes, avoid the risk of disputes, troubleshoot the R&D direction, and gradually establish a sound, effective IPR protection system.

Wu Yixing is a senior counsel at DOCVIT Law Firm

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