From the creation of the first commercial biotechnology company in 1978, the biotech industry has grown dramatically. With more than 400 biotech companies, San Diego is one of the fastest growing biotech regions and has more biotech companies than any other city in the country. All of this activity has attracted investment capital from venture capitalists and commercial opportunities with large pharmaceutical companies.

R. Smith

However, competition among biotech companies for venture capital and big pharma dollars has never been greater. While the total dollars invested in San Diego biotech companies has increased, these dollars are being spread among a relatively small number of companies.

Many factors go into a venture capitalist's decision to invest in, or a large pharmaceutical company's decision to partner with, a biotech company (stage of technology/company, IP protection, market need and size, competition, management team, valuation, etc.). Those biotech companies that (1) understand the due diligence process and (2) have prepared in advance for a due diligence review, increase their chances of securing financing and/or big pharma partnering.

Simply put, due diligence is a detailed investigation of the business, property and affairs of a company and is part of the process undertaken by potential investors to analyze and assess the desirability, value and potential of a business opportunity. A biotech company is subjected to a due diligence review in four different situations:

* The private placement of its securities

* Its merger with, or its acquisition of or by, another company

* A significant commercial transaction with another company (i.e., a research and development, joint venture, collaboration, or licensing arrangement)

* An initial public offering of its securities.

The purpose and scope of due diligence depend not only on the type and size of the transaction being contemplated but also on which party has undertaken the due diligence.

In acquisition or private placement transactions, the potential purchaser will want to know as much as possible about the biotech company so that the purchaser can make an informed decision whether or not to pursue such transaction and, if the purchaser decides to pursue such transaction, what the appropriate price and terms should be. On the other hand, a large pharmaceutical company's due diligence in a commercial transaction, while typically not as extensive as in an equity investment or acquisition, will focus on the biotech company's ability to perform its obligations in such transaction.

In each of these types of transactions, the biotech company should undertake its own internal due diligence review to ensure not only the accuracy and completeness of the materials and information provided to a potential purchaser or business partner, but also of the representations and warranties made by the biotech company to a purchaser or business partner in such transaction.

Every biotech company, especially early stage companies that hope to secure capital or partner with a large pharmaceutical company, should prepare early on for due diligence. A biotech company that is aware of the areas upon which due diligence focuses and the types of problems that arise during due diligence will be better prepared to avoid or, if timely discovered, correct such problems.

Due diligence involves the review of a number of different areas including the company's financial status, employee issues and litigation matters. Since the value of most biotech companies is directly associated with the value of their intellectual property, the due diligence of a biotech company will principally focus on the company's intellectual property rights -- i.e., patents, copyrights, trademarks, trade secrets, know-how and confidential information. Key intellectual property issues include whether the company owns or has valid rights to its intellectual property and whether the company can exploit or use its intellectual property in accordance with the its business plan without infringing upon the intellectual property rights of third parties.

As part of the due diligence review, the biotech company should demonstrate through appropriate documentation that it owns or has valid rights to its intellectual property. The ownership of intellectual property is often more difficult to ascertain than is the ownership of tangible property. Any ambiguities as to the scope of a company's rights in its intellectual property or uncertainty arising from competing or potentially competing claims to rights incident to ownership of the company's intellectual property will be a signal to potential investors and partners of increased risks associated with investing in or partnering with the company.

For biotech companies, intellectual property ownership ambiguities are commonly associated with the failure to timely obtain valid assignments of rights from individuals and entities involved in the development of the company's intellectual property. Individuals and entities commonly involved in the development of a biotech company's intellectual property include the company's founders, directors, employees, consultants, advisers and associated universities and research institutes. The involvement of each of these individuals and entities should be closely scrutinized.

In addition, the due diligence should identify whether the company has sufficient intellectual property rights to make, use and sell its inventions without infringing the intellectual property rights of third parties. A common misconception regarding patents is that an issued patent directed at a product gives the holder thereof the right to make, use or sell the product. In fact, an issued patent only gives the patent holder the right to exclude others from practicing the issued claims -- i.e., making, using or selling products encompassing any of the issued claims. In certain instances, an issued or pending patent owned by a third party may block the desired activities of the company. Since the value of a patent is directly related to the holder's ability to use the patent, part of the due diligence process should include an evaluation of related third-party patents.

In conclusion, due diligence is often a long and arduous process that involves many different parties and can take up considerable resources and management time. Given that due diligence is a critical element to most major transactions involving biotech companies, preparation is vital to a successful completion of a due diligence review.

A company that has consistently followed from its inception good management practices established to facilitate a due diligence review would find the due diligence process a less onerous task. For all other companies, there is no better time then the present to conduct an internal due diligence investigation and put your company in order -- because tomorrow may be too late.

Smith is of counsel in the Corporate Finance Group with Morrison & Foerster LLP in San Diego. His broad-based transactional business practice focuses on the representation of start-up and emerging growth companies and venture capital funds on such matters as intellectual property transactions, venture capital and other financing transactions, venture capital fund formation, and mergers and acquisitions.

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