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Due diligence vital to support tech-driven acquisitions in oil and gas service industry, says expert

Out-Law Analysis | 04 Feb 2016 | 8:30 am | 5 min. read

FOCUS: The opportunity to gain access to new and innovative technology is a major reason businesses acquire other companies, especially as technology can revolutionise the way organisations operate.

For more in depth analysis on Pinsent Masons' research on oil and gas services, see our Ahead Of The Curve special reports.

In the oil and gas market, technology can serve a range of functions, from acting as an enabler of new drilling projects, to supporting more efficient and effective processes and improving health and safety.

It is little surprise then that a recent survey commissioned by Pinsent Masons, the law firm behind Out-Law, which identified a coming "surge" in company mergers and acquisitions in the oilfield services market also revealed that the desire to access new technology is one of the main drivers of that consolidation.

There are inherent risks in buying companies predominantly for their technology, from legal and contractual issues relating to the ownership and licensing of intellectual property (IP), to fundamental questions over whether the technology is future-proof and worth what it is currently valued at. Prospective buyers must therefore engage in robust due diligence to minimise the risks and help inform decision making.

What does due diligence look like in practice?

Satisfying yourself that technology is worth investing in involves carrying out multi-faceted due diligence, some aspects of which are easier to undertake than others.

One of the issues acquiring companies have to understand when buying technology is who owns the technology and the intellectual property rights in it, as well as reviewing what licensing arrangements the target company is committed to.

Patent registers and other public databases of registered IP rights can help businesses verify the true ownership of technology, as well as whether others have registered similar patents or whether such applications are pending. This desktop analysis can help businesses assess whether the technology they are buying is unique and protectable, or exploited, or about to be exploited, by rivals.

Putting a value on soft IP, like unregistered software code or know-how, is more of a challenge. Often the ownership of soft IP is linked specifically to individual staff members. Acquiring companies will want oversight of the employment contracts at target companies to ensure that ownership of IP resides with the company and not employees.

An examination of existing licensing contracts that the target company has will also help acquiring businesses reassure themselves that IP ownership rights held by the target company are not shared with third parties, like consultants, university researchers or customers. This latter case is particularly relevant where a product has been developed on a bespoke basis. Small, innovative companies sometimes have the problem of not having a proper process of documenting ownership of their IP, particularly where they work with third parties.

Companies find it difficult, and expensive, to get former staff and third parties they have worked with to assign IP back to them. However, this is something that an acquiring business might insist on under the terms of a sale if contracts of employment did not ensure assignment of IP rights to the employer in the first place.

If target companies have not got their IP in order when they come to sell, and the buyer identifies a weakness in terms of ownership or assignment, then it can have a knock-on impact on the sale price, especially where the main asset being acquired is IP or technology.

Another thing acquiring businesses would want to check is a record of the robustness of a target business' technology. They might look for target companies to disclose data on product recalls, failures and bug fixes as well as on software service levels, for example, to check for any history of outages and associated product failures and business disruption.

Acquiring companies should also review the suite of software target companies are reliant on to check for any dependencies on in-bound licenses. Buyers will want to make sure that licensors of any software will not exercise any rights to terminate their contract with target companies on a change of control basis following takeover of the target business. This principle applies more generally to any other major contract the target company is reliant on, such as distribution or customer contracts.

Use of open source software by target companies is another issue that acquiring companies will want to do due diligence on.

Some open source software licenses will not permit the code to be put to commercial use, whilst other licenses will require users to contribute to updating the code. Acquiring businesses might want to ensure that, where open source software is present in target business technology, a third party escrow agent holds the code to minimise the risk of access to the code being cut off if the licensor goes bust.

Technology and IP rights can confer such a competitive advantage that it is often the subject of legal action. Acquiring companies will want to review court records, or annual reports or regulatory filings that target companies publish, to get an overview of ongoing litigations target companies are involved in, and particularly those concerning the validity of important IP rights and actions of infringement.

Representations and warranties can be inserted into sale agreements to account for unknown risks. These indemnities allow acquiring companies the ability to reclaim some of the value they associated with technology at the time of sale if there is loss in that value post-sale, for example because IP rights in the technology are later challenged and successfully revoked.

The 'stickiness' of technology is something acquiring businesses would also want to review. If the technology is personalised to the target business then it might be more difficult for an acquiring business to port that technology and integrate it themselves. On the other hand, the more commoditised the technology is the less value it is likely to have on account that it is not unique.

Knowing what technology competitors are using and looking to use in future is a challenge that all businesses face when making a major decision on what technology they should themselves invest in. Buying technology will always be a risk, but acquiring companies can take action such as carry out market analysis, interview experts in the industry and seek assurances from the seller so as to make a better informed judgment on what value to place on that prospective investment.

One way acquiring companies can address the risk of today's latest technology quickly turning obsolete is to agree a so-called 'earnout' pricing structure in the deal for the purchase of a target company.

This arrangement involves the payment of the purchase price in instalments, with the amount paid in each instalment being determined with reference to agreed benchmarks. In the context of paying for technology, a buyer and seller might agree to instalments based on that technology delivering projected efficiency savings or gaining traction in the market. Under such an arrangement acquiring businesses could end up paying less for technology than market valuations at the time of purchase, or equally pay more if it exceeds expectations.

Earnouts are particularly common in deals for technology companies because they tend to value themselves based on high growth rates and continuing high growth rates in future. This pricing mechanism seeks to mitigate the risk in overpaying for products and services that could be overtaken by the next wave of digital technologies.

Sometimes technology can have wide-application across multiple sectors. An option open to businesses operating in the oil and gas market is to explore the option of buying the right to use another company's technology exclusively in their particular sector whilst not precluding the seller from supplying their technology to businesses in other markets.

This partnership arrangement would fall short of an outright acquisition of a company to gain access to their technology and might be worth considering if the buyer is not concerned about the same technology they are buying being used by, say, banks or retailers.

Andrew Hornigold is a corporate law expert at Pinsent Masons, the law firm behind Out-Law.com. He specialises in mergers and acquisitions in the technology sector.

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