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Due Diligence a Way to Say ‘Do Your Homework’

Due diligence is one of those corporate terms, like best practices and corporate governance, but it seems pithier than “getting all your ducks in a row.”

It’s also very, very important if you’re a company with assets to protect and are trolling for venture capital.

Ned Israelsen, managing partner for Knobbe Martens Olson & Bear in San Diego, is an expert in matters of licensing, patents and intellectual property. That’s another one of the corporate terms, but it really refers to those top secret and potentially lucrative inventions and discoveries that researchers conjure up for biomedical and high-tech companies.

“Anybody who wants to play in the venture capital arena needs to be prepared for due diligence,” he said. “If you’re on the investor side, you need to conduct it, and if you’re on the company side, you will be a target.”

How things have changed.

“Years ago, a prominent vice president called me and asked if so-and-so company had any patents,” he recalled. “I said they had applications pending. He asked, ‘Do they look good?’ And I said, ‘Yes.’ He said, ‘Thanks.’ And that was the end of it.

“Now, when I represent a venture capitalist, they will spend thousands of dollars combing through the IP of the target company that they might invest in,” he added. “We’re looking for clues, problems that might pop up, an invalid or a too-narrow patent, or one that might infringe, or one that a university might have ownership claims to. All those things have a major impact on the value of a company and the future success of that company.”

That gets us back to those ducks.

“If you are a company that wants to get venture capital, you have to plan for due diligence right from the start,” said Israelsen. “If you have a good story to tell, be prepared with all the right answers, and discover the problems before somebody else brings them up.”

And don’t take anything for granted, he added. If there are problems, somebody is indeed likely to dig them up.

“There have been 7 million U.S. patents issued since the dawn of time,” said Israelsen, “but 2 million still are enforced, more or less. Each of those patents may have, on average, 20 claims, and there only has to be one valid claim of infringement for you to have a problem. It’s a very real issue.”

Due diligence is not cheap figure about $10,000 to $20,000 in a three-week period, with a team of attorneys, depending on the scope, Israelsen said. Unless you’ve got very deep pockets, you’ve got to prioritize your search.

“A lot of judgment calls have to be made,” he said. “We can’t search through every patent to see if there is a problem. We have to look in the most likely places first, given the budget and time constraints. Both parties understand that. This is not the same complete answer they’d get if they had an unlimited budget and we could work on it for months.”

Looking at it from the perspective of a venture capitalist, he said, they have a lot at stake and much to consider before they write that check.

“They’re typically going to put in five, 10, 50 million dollars, and they’ve already done the initial diligence on the company , the business opportunities, the science and market opportunities. Then they call us up.”

That’s where the real work starts, he said, because “IP presents the biggest risk.”

“There are levels of uncertainty and potential problems that would completely destroy the value of a company or the investment,” Israelsen added.

Even with due diligence, it’s all a crapshoot, he said.

“Only one in 10 investments turns out to be a home run for the venture capitalists,” he said. “They recognize going in that most of their investments aren’t gong to be successful, but they are willing to take the risk and invest money, even when the IP is not perfect. There are some occasions when they will back out because of the IP, or drive a harder bargain because of the IP. Still, others will swallow hard and jump in anyway.”

A pound of prevention can save a load of loot, said Israelsen.

“The biggest risk is patent infringement,” he said. “If there is a serious infringement problem, that is a company-threatening event. You can be out of business.”

Defending yourself against infringement charges is not cheap either.

“Patent litigation these days can cost multimillions just to pay for attorney fees and costs, so if you’re a venture capitalist who put $5 million into a company, you’d want the company to use that to be successful, not to spend on litigation.”

While there may be some venture capitalists out there who budget for a lawsuit, “it’s pretty rare,” said Israelsen. “Usually, a high-risk company will be sued for infringement and investors will stay away.”

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Spotlight On NAFTA:

The California Western School of Law in San Diego is launching a three-week program June 6 examining the impact of the North American Free Trade Agreement during its first 10 years.

The program will take students to a dumpsite filled with corroding batteries in Otay Mesa, an Asian-owned factory in Tijuana, and a migrant labor camp, where they will meet those who live and work along the border. Among the issues covered will be social dumping, and health and public safety concerns over cross-border pharmaceutical sales.

“It’s a combination of a legal laboratory, corporate annual meeting, trade union action and performance art exhibition,” said professor James Cooper, the program’s director.

The program, which runs from June 6 to 28, is open to law students from all over the world and is organized through a partnership of the California Western School of Law, New England School of Law, and William Mitchell College of Law in Minnesota.

A second session is set to follow in Toronto from July 5 to 14.

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On Board:

Amie Goble has joined Foley & Lardner’s Downtown San Diego office as an associate in the litigation department, specializing in bankruptcy and litigation.

A graduate of Michigan Law School, she previously worked in the firm’s Chicago office.

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BeatTheBar:

Law students, we are told, are now in the process of high-anxiety attacks , waiting for the results of the dreaded bar exam, which, we also hear, is very tough to pass on the first try.

But BeatTheBar.com wants to change all that. The Web site is sponsoring the “Lower the Bar” contest, which is looking for the most unsuccessful bar exam entrant in the United States as measured by how many times he or she failed to pass the test. We are undoubtedly talking about someone with very high self-esteem and very low test scores, right?

If you’re game, submit your pathetic history of failures to Darren@popculture.com. The winner gets bragging rights and Web exposure, and a free copy of BeatTheBar.com learning products, which carries a “guarantee to pass the exam.”

Let the lawyer beware.


Contact Pat Broderick at pbroderick@sdbj.com or call her at (858) 277-6359, Ext. 3112.

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