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The growing role of IP diligence in corporate formation, funding, IPOs

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After a successful IPO in 2007, San Diego-based Orexigen Pharmaceuticals (Nasdaq: OREX) raised an additional $76 million in early 2008. Orexigen has two weight loss drugs in advanced clinical trials.

In January, the Tech Coast Angels led a Series A investment round in Traversa Therapeutics, a new San Diego company, which raised $2 millon. Traversa's technology promises to revolutionize the way that new RNA drugs are delivered into a patient's cells.

Newly founded CardioCreate Inc. completed a licensing transaction with a local university this week. CardioCreate uses stem cells to repair and replace damaged heart tissue after a heart attack.

These and dozens of other recent San Diego transactions all have at least one thing in common: Intellectual property diligence was critical in closing the deal.

Intellectual property owned by or licensed to a high-tech business can be a significant asset, and the IP of a biotech or pharmaceutical venture could well be the company's most important asset. A recent study of startup companies by Rosemarie Ziedonis at the University of Michigan Business School showed that those with aggressive patent filing strategies were much more likely to survive and obtain venture financing.

For example, while only a third of biomedical device startups had filed patents, 90 percent of those that survived and got financed had done so. In recent years, intellectual property has assumed an increasingly prominent role in company formation, licensing, angel financing, venture financing and in IPOs. As a result, intellectual property due diligence is a gating event in an increasing number of deals.

A first step in intellectual property diligence is to evaluate the company's own IP; that is, how well it protects the company's proprietary position and provides barriers to entry for competitors. This is an important value question for high-tech investments. For pharmaceuticals, lack of patent protection is usually fatal to the venture, given the high cost of obtaining FDA approval for a new drug (estimated at $800 million), and the low cost of launching a generic copy (a few million dollars). Without effective patent protection, or some other form of market exclusivity, an otherwise promising drug will not attract investment capital and will likely never be marketed.

Another common part of IP diligence is a review of third-party patents to spot potential infringement issues. Although few investments are completely free from risk (including the risk of patent infringement), a significant infringement issue may well deter further investment until it is resolved. In a classic lemons-to-lemonade scenario, entrepreneurs can sometimes license or buy patents found in a diligence review, simultaneously eliminating the infringement issue and building the company's IP portfolio.

Ownership of intellectual property is often a component of IP diligence. Common issues include whether patents have been assigned to the company by the inventors, whether licenses have been properly drafted and whether license terms are favorable. One sometimes hidden issue is whether any third party has a claim to the invention. Inventions made by academics could be owned by the academic institution. Government-funded research often has IP strings attached. Inventions conceived while working for a former employer may be problematic.

From the perspective of the investor, IP diligence is an exercise in compromise. The project is typically performed on a limited budget, often under severe time constraints. This makes it impossible to fully analyze all of the prior art, all of the third-party patents, and all potential licensing and ownership issues.

As a result, IP diligence focuses first on those areas of the most concern, and the underlying search and analysis focuses on the areas most likely to yield results. In the end, spending more time and money on IP diligence can increase the level of confidence in the results, but rarely if ever fully answers all IP issues or eliminates all IP risk.

Typically, the level of diligence at the angel investment stage is relatively limited. Tech Coast Angels, for example, forms volunteer diligence teams to look into the deal points, including IP. The diligence team may or may not include a patent attorney. Venture capital diligence is usually more extensive, often involving a detailed analysis of patent strength, third party rights and ownership, typically costing between $10,000 and $25,000. (These costs are usually paid by the target company when funding closes.) Diligence in connection with an IPO can be significantly more extensive.

For companies that are the target of IP diligence, the best advice is "be prepared." Clean up any ownership issues ahead of time. Lock in your licenses. File your key patents. Know the prior art, and be familiar with the third-party patents that are most likely to be problematic. Be able to explain why you don't infringe, or why the patents are invalid. This type of preparation is comforting to investors, builds credibility, can shorten the diligence process and can increase the likelihood of closing the deal.

Israelsen is managing partner of the San Diego office of Knobbe, Martens, Olson & Bear LLP, and is also an active member and investor with the San Diego Tech Coast Angels. He represents companies in the pharmaceutical, biotechnology and medical device areas, and numerous venture capital firms in conducting IP due diligence.

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