Due Diligence

New York Law Journal, May 18, 1999

Copyright 1999 New York Law Publishing Company
New York Law Journal

May 18, 1999, Tuesday


HEADLINE: Due Diligence for 'Dot-Com' Deals

BYLINE: By Jonathan Bick; Jonathan Bick is of counsel in the New York office of Friedman Siegelbaum and is an adjunct professor of Internet Law at Rutgers Law School and Pace Law School.

NEGOTIATING acquisitions of Internet companies can present special challenges for business people and their attorneys. Due diligence n1 is the process most often employed to assist those who are looking to finance technology companies and arranging IPOs for emerging electronic commerce companies.

Due diligence is simply an inquiry of the underlying legal and factual circumstances associated with an acquisition transaction.

By the very nature of Internet firms, most of their value is intellectual property. Because intellectual property is intangible, it is difficult to value due in part because its value is directly related to its owner's ability to enforce its legal rights.

The potential for litigation in Internet company acquisitions increases in proportion to the value of the target's intellectual property. Therefore, Internet deals require more "due diligence" than traditional acquisitions.

In Internet acquisitions, just as in traditional deals, the lawyer's role in reviewing a company's intellectual property portfolio "must include the identification of all relevant rights, an assessment of their worth in the context of exclusivity, validity and enforcement, and an identification of possible liabilities." n2 This task is complicated by the fact that intellectual property rights may flow into and out of a business through many different channels. Licenses, contracts, employee agreements and operation of law are but a few such channels.

n2 See Joseph S. Iandiorio, Intellectual Property in Ownership Transfers, 9 J. Manag. Cons. 21 (1997).

Typically the four elements of investigative due diligence are: business and media database research; public records searches; direct contact with government and industry sources; and a detailed written disclosure and background questionnaire. These usually provide the buyer with the critical information, problem-relationship identification and reference-checking necessary to make an informed decision.

This process is aided by the requirement in the Securities Act of 1933 that issuing companies make information available. The growth of the Internet and other electronic media has greatly reduced the cost for such investors when gathering information.

Due to the novel nature of electronic commerce, obtaining information and interpreting it may be difficult. Consequently, buyers of Internet firms generally hire experts to determine what the due diligence results mean. In addition, these experts are called upon to determine what an Internet company really does and to determine what an Internet company actually produces.

While the business and legal communities are becoming more familiar with the acquisition of Internet firms, no one can claim to have distilled the due diligence activity into a fool-proof process. The reason for this is that the due diligence process when applied to Internet firms depends upon experience and professional evaluation. Since most E-commerce firms did not exist five years ago, neither expert nor legal practitioners can claim to bring "many years of experience" to bear upon Internet firm investigations.

Nonetheless, a team of consultants can be formed to ensure that due diligence investigations are administered by people who are experts in each technology and the markets that comprise the Internet. The selection of these independent experts varies depending on the nature of the Internet firm to be evaluated

As in the case of traditional due diligence efforts an Internet firm inquiry team must have certain characteristics. These qualities include a special knowledge of a particular market; specific Internet experience; and detailed knowledge of the technology associated with the Internet firm being acquired. Like a traditional due diligence process, the team investigating an Internet firm would examination the company, its employees, its products and its market.

An Internet due diligence team, like its traditional counterpart should deliver reliable, traceable reports that the buyer can use to make investment and related decisions. The due diligence should first and foremost assess and detail the financial n3 and legal condition of the firm to be acquired. Due diligence reports should provide a road map and a benchmark for future company development.

n3 When securities are offered the underwriter usually ensures that all the financial disclosures are materially correct. See J. Choi, "Company Registration: Toward a Status-Based Antifraud Regime" 64 U. Chi. L. Rev. 567 (Spring, 1997) and Thomas Gilroy, Due Diligence and 10-K Disclosure enhancement, PLI/CORP (1997).

While the selection of technical competencies is constantly expanding. The following is a list of Internet related skills that have typically been employed when conducting due diligence investigations of Internet firms: web message center technology; communications and network technology; telephony; frame relay; image and multimedia processing; web site hosting services; Internet publishing; Intranet and Integrated Services Digital Network (ISDN) technologies.

When selecting technical competencies it should be noted that Internet businesses generally facilitate the use of the Internet and/or use the Internet to market goods and services. Internet businesses, which market goods -- like the Internet bookseller Amazon.com -- are evolving into something like direct catalogue merchandizing firms, dealing in remote product review and selection, followed by a drop shipment. The Internet facilitator businesses, such as so-called "portals," like Yahoo! are evolving into something like the network television broadcasting businesses, dealing in elements of information distribution and programming, but not producing much original content.

It is generally agreed that the lawyer's primary responsibility in due diligence investigation is to ascertain potential liabilities, such as potential legal defects in the intellectual property assets to be acquired. In the case of an Internet acquisition, this means identifying liabilities with respect not only to traditional forms of intellectual property recognized in the United States, but also with respect to forms of intellectual property that require private action to gain protection.

Proposals abound that would facilitate acquisition data sharing. For example it has been proposed that business sellers be required to secure express approval from each and every licensor of software or information product or copy used in the business; and a buyers' due diligence would be made to include verification that all such approvals have been secured. But such requirements do not exist today. n4 Therefore, attorneys must rely on questionnaires.

n4 See David A, Rice Copyright Owners' Rights And Users' Privileges On The Internet: Digital Information As Property And Product: U.C.C. Article 2B 22 Dayton L. Rev. 621 (Spring, 1997).

The following is a portion of a due diligence checklist highlighting issues of concern for an acquisition of an Internet firm.

Corporate Records

Good Standing Certificates from the appropriate Secretary of State and state registration forms for all jurisdictions in which the states where the Internet firm is qualified and conducting business. Internet firms often own, lease or rent "servers" and other communication equipment located throughout the country; enter into contracts that provide for repetitive transactions, or in some other ways sufficiently satisfy the nexus requirements to require widespread state registration. Particular attention should be paid to jurisdictions where the Internet firm conducts business, but is not qualified to do so. In states such as Alabama, Mississippi and Vermont subsequent qualification will not cure a previous failure to do so.

Tax Status Certificates in all state where the Internet firm conducts business. The application of taxes to Internet goods and services is evolving. Since nexus requirements for Internet transactions are in flux, difficulties may arise, particularly because Internet transactions are often reclassified as communication transactions or are subject to sales taxes.

Copies of partnership, joint venture and other affiliation documents. Due to the nature of the Internet, collaboration is generally considered to be a key element in the success of an Internet business, so additional attention should be paid to partnership, joint venture and other affiliation documents or lack thereof. For Internet purposes agreements to be present on or linked to sites controlled by other Internet firms is executed via agreements known as "impression guarantees." Many of these impression guarantee agreements are found in partnership, joint venture and other affiliation documents.

Business Dealings

Agreements relating to stock, including but not limited to shareholder, buy-sell, voting trusts. Internet firms, more often than other types of firms, use stock or promises of stock to pay for start up cost, so request a list of any oral or written commitments to issue stock to any party, including informal conversations and correspondence.

Information describing the Internet firm's business, including (i) sales and marketing arrangements, (ii) customer base, (iii) pricing and credit policies, (iv) competition and (v) business reputation. Both quantitative and qualitative information regarding Internet sites and hence Internet businesses is available. From a quantitative perspective, one of the most exciting prospects for Internet site evaluators is the potential for using the Internet site itself to collect and analyze evaluative data.

Contact with an Internet site, known as "hits" has been used to measure the success of an Internet business. This measurement has been challenged because anyone who could see a picture-icon, point and click is counted as a hit. Katharine Paine, CEO of The Delahaye Group, Inc, has said "HITS stands for How Idiots Track Success." When BT Alex Brown, which advised NETCOM, Hiway Technologies and others, evaluates Internet firms it considers four major factors: registered users, audience reach, page view traffic and revenue.

The general business due diligence effort should request documents which provide information regarding the following the quantitative data associated with an Internet business's Internet site: How is the site used (e.g., time of day, week, content areas accessed)? Are the targeted users using the site? What are the reactions of users to the site? How responsive is the site (load and demand issues)? What is the success rate for information seekers? How long does it take to find desired content? Do users understand the content/response of the site? How is the site-affecting users' attitudes or beliefs? How is the site-affecting users' behavior or performance? How is the site affecting the organizational culture or performance? What are the short-term net benefits of the site? How is the site affecting long-term outcomes (e.g., learning, sales, return-on-investment)?

From qualitative perspective firms such as SurveySite can provide Web evaluation reports. Such reports provide detailed qualitative diagnostics about a site including content, ease of navigation, uniqueness, visual appeal, visitor experience, and sources of frustration. Such firms can also provide a report, which contains comparisons to similar Web sites, which can allow comparison to the existing competition.

Lists of any business names which the Internet firm has used to conduct business within the last five years. Internet firms usually change names to accommodate acquisitions of other firms and new internet domain names. It should be determined if all the business names and domain names have been properly protected by the filing of fictitious business name statements and/or trademarked. Requests for copies of such filing should be made. Lists of all states and counties in which the Internet firm transacts business or is planning to transact business in the near future, including locations where the Internet firm maintains inventories, owns or leases real property, or has employees, and a list of addresses for all sales or service offices open at anytime since the Internet firm's formation. A legal gap has developed with respect to where an Internet transaction takes place. When acquiring an Internet business it is advisable to know what property is at what risk in which jurisdiction.)

Reports to management for the last five years by: (i) independent public accountants, including all letters and opinions accompanying financial statements, letters issued during the past three years regarding control systems, methods of accounting, etc., including any changes in such systems or methods; (ii) internal auditors; (iii) appraisers relating to valuation of the Internet firm's assets and business; and (iv) other consultants or outside experts, including but not limited to Internet experts and data processing management consultants, hired with respect to business operations. Most Internet firms prepare management reports using the Internet site itself to collect and analyze evaluative data. They usually have software to monitor, analyze and report on the utilization of the site.

A variety of approaches are available to analyzing the utilization log files that are routinely collected by web servers. In fact such software usually is set to run in the background at regularly scheduled intervals, analyze the current log data to show who is accessing the site, at what times, and in what locations. In addition "off-the-shelf" log analysis programs can be invaluable for evaluating utilization

Copies of product and/or service warranties and a report describing the Internet firm's claims experience, product recalls and/or service problems. This should include a list of scheduled and unscheduled outages.

Copies of or on-line access to the Internet firm's standard form of agreements with customers, vendors, suppliers, including but not limited to purchase orders, sales acknowledgments, invoices, warranty disclaimers, together with copies of those agreements that contain material deviations from such standard forms. Depending upon the Internet business, one or more of the following forms will likely be used: Web site development form; Web site hosting form; copyright assignment form; work made for hire form; trademark license form; content license agreement form; software license form; Web site use form; Internet access form; notice/consent form; information collection form; picture and name release form. These forms may be hard copy, "Clickable" or both.

Intellectual Property

Copies or descriptions of the Internet firm's established policies, both written and oral regarding trade secrets and other proprietary rights and actions taken to protect the firm's trade secrets or other proprietary rights. Because of the importance of intellectual property for Internet firm's information should be collected regarding its policy of establishing a standard operating procedure with respect to its ownership of works and inventions developed by independent contractors and employees. It should also be established if the Internet firm complied with its own policies.

Copies of confidentiality and secrecy agreements. Since most Internet firm have everyone sign such forms, securing a copy of a sample form, if it is a standard agreement, and list of those who have signed such agreements is sufficient.

Identification of materials, works, etc. which the Internet firm seeks to protect by copyright, patent or other means and associated documentation of such items. For many Internet firms, intellectual property may comprise a substantial, if not the major, part of its assets. It is crucial to ensuring that information regarding the creation, perfection and maintenance of intellectual property assets is secured.

The following types of documents are typically submitted as a result of this request: license and maintenance agreements; distribution agreements; government contracts; federal registration and recordation documents re: patents, copyright and trademarks; federal registration application files including all correspondence and filings documents relating; source code and object code; flow charts, technical specifications and other design documents; materials referred to during the development process; notes of design meetings.

Some Internet firm acquisitions are subject to intellectual property audits. In general terms, an intellectual property audit attempts to: determine the origin of intangible assets and the extent of the owners' interest in technology and related intellectual property rights; determine the scope of rights that third parties may have, by license, ownership, or otherwise, in the owners' assets; review existing procedures for protecting and perfecting intellectual property rights; detect defects in existing intellectual property assets and the mechanisms and procedures for protecting and perfecting the same; detect instances in which early measures may be needed to avoid some of the more common defenses available to infringes; determine, in contemplation of intellectual property litigation, whether all filings necessary for jurisdictional requirements have been satisfied, what clouds on the owner's title may exist, and what defenses may be asserted against the owner.

A comprehensive audit in the context of a major transaction or an Internet firm-wide audit of all existing intellectual property assets may cost more than $ 10,000.