ABA Section of Business Law

Business Law Today

Buying a dot-com

Due diligence is trickier

By DAVID E. SWARTS

If your client still wants to buy a dot-com, due diligence is more important than ever.

Whenever two companies decide the time is right to get together, it is because both believe it will be in their own best interest. With the large number of Internet companies now in existence, the likelihood of consolidation is high and roll-ups are possible even though most online concerns have not demonstrated long-term viability.

While uncovering issues that could kill the deal is an important aspect of due diligence, the main objective is to uncover and understand the underlying reasons why the acquiring company wants to buy and why the target wants to sell. Standard due diligence requirements take on new meaning with Net acquisitions and the business lawyer must retake the initiative.

All the standard techniques must still be used in evaluating the acquisition of an Internet company:

• Reviewing financials.
• Talking to customers.
• Understanding the current market strategy.
• Assessing physical assets.

But some aspects require special attention:

• Auditing information systems.
• Performing extensive intellectual property due diligence.
• Assessing whether the firm is continuing to innovate or just living off past successes.
• Ascertaining internal development capabilities for new products and services.
• Determining the cultural fit by talking to employees and understanding the firm’s tribal customs.
• Identifying key employees and securing their retention.
• Evaluating the effect of employee stock options that have been favored by the Internet industry.
• Inquiring about possible noncompete agreements that employees may have with former employers.
• Ensuring that all custom regulations have been followed and duties owed are paid.
• Inquiring into possible international bribery under the Foreign Corrupt Practices Act.

In addition, errors that are commonly made during the due diligence process may in fact represent an even greater risk with respect to Internet companies.

First, there is the tendency to assume that the managers in place are experts in their field and should be in the best position to see whether the deal is a good one or not. Because many Net businesses are relatively new, there is an even greater risk of placing too much reliance on the management of the companies in question.

An example of where a misconception by a target’s current management about future technology turned out to be costly to an acquiring company is Mattel’s acquisition of Learning Co. in 1999. Learning Co.’s product continued to rely on CD-ROM technology in spite of the shift to the Internet and as a result Mattel was forced to "sell" Learning Co. to Gore Technology Group in return for only the possibility of future royalties.

Second, there is often an assumption that there are adequate reserves for any potential liabilities. Most Internet businesses are fairly young and may not have either developed a firm understanding of their potential liabilities or have been in a position to properly fund their reserves.

Third, in the rush to do the deal, there may be a tendency on the part of the acquiring company to want to wait and work out details once the company has been bought. While the opportunities that present themselves are enticing, the level of uncertainty that exists with this burgeoning industry makes this type of strategy even more treacherous than in more settled industries.

The acquisition in 1999 of the old-line auction house of Butterfield & Butterfield by eBay for $260 million is an example of a failed attempt to integrate two distinctly different businesses without understanding how the strategy would be implemented. The result? The target company continued to operate as before without creating any meaningful online impact with eBay.

Also, a study of 100 failed acquisitions revealed that 85 percent of them failed because of differences in management style. Given the free form style of many Net companies, the identification of a cultural "end state" is critical.

Fourth, the due diligence process is often abbreviated or even abandoned in favor of relying on audited financials in order to accelerate the process. In an example from the investment fund management arena, fund managers in the summer of 1999 were so concerned with missing out on the investment opportunity in Webvan’s innovative retail plans that they skimped on the due diligence. However, within one year, Webvan’s shares had fallen 95 percent. Although at least one fund sold its shares within four weeks of the IPO, this would not be a ready option in an acquisition. For all the reasons stated above, this is a shortcut to be avoided.

Therefore, the due diligence process remains an indispensable tool in checking out whether a particular deal is the right thing to do. Lawyers remain the necessary objective element to ensure that their client’s decision is based on fundamental due diligence.

While lawyers have traditionally been the source of expert knowledge in acquisition transactions, the technology experts have taken control of the Internet. Today’s business lawyer must equip himself or herself with a thorough understanding of the Net in general and the business of e-commerce in particular in order to retake the initiative.

E-commerce differs from traditional commerce in that it operates with multilevel efficiencies. It not only includes one-way broadcasting but also two-way communication with interactivity, and does this 24-7-365 anywhere in the world. The objective must be to identify, document and manage the legal issues associated with these new paradigms. A thorough audit of the technology used by an online venture is a good starting point.

At the heart of the information network is the server that runs the Web site. It is critical that there be adequate capacity to effectively operate the site as well as provide reliable uptime. Whether the server is owned or leased, it’s critical to know what warranties were included in the purchase agreement or lease.

A second service issue is the communication links to the Web that will enable e-commerce. This typically entails hosting agreements allowing for online access. A primary concern for serious e-commerce businesses is the security afforded by these links and the significant costs that may be associated with achieving the right level of security.

Less tangible but no less important aspects of an Internet company’s e-commerce business is their Web-site address or domain name along with the visible Web-site pages and the invisible software that coordinates these transactions. A key question is whether the domain name is protected with a valid registration and backed up by a registered trademark.

There may also be complimentary business services such as a virtual storefront or credit services that are unique to this business. A successful audit will ensure that these intangibles are sufficiently protected to allow for a seamless continuation of the business.

A whole series of agreements will likely exist in an Internet business — such as Web marketing, licensing and advertising agreements. It is vital to understand what is being paid for and who owns the work product involved in these agreements. Also, there may be complex relationship agreements concerning site design, such as technology that directs customers from other sites, which may blur the boundaries of accountability.

The key to performing effective due diligence in this area is to understand how these agreements affect the ability of the site to function and what features they add to this functionality.

Maintenance of the site is an area not to be overlooked since a Web site is only as valuable as it is reliable. There should be maintenance agreements or warranties to cover every aspect of the service chain and these should be evaluated for their ability to provide seamless protection. In addition, information-collection capability generally includes off-site storage. This capability should be tested for reliability.

The business of the Internet involves the integration of communications, purchasing decisions and a stream of commerce, and this process requires that the rules of engagement be clearly spelled out. The site should include full disclosure of hyperlink policies. The terms and conditions of use should be properly displayed. Privacy disclosures should include the information required to use the site, what information is being collected, whether it will be shared with others and on what terms, and the retroactive remedies a user may seek once information has been collected. There is the potential for exposure to charges of unfair trade practices by the FTC if the company’s disclosure statement says one thing but the company does something else.

Related to the collection of information is the necessity to fully understand how visit volume (usage) is tracked and the methodology on which the number of transactions is based. Subtle differences in the tracking criteria can lead to a significant disparity in results, possibly affecting value.

Other intangibles associated with an Internet business are not unlike other businesses. These include an understanding of the strengths and weaknesses of management, the strength of the relationships with strategic partners and the participation of the company in trade associations. Particularly important in e-commerce businesses is their participation in associations such as WebTrust and TRUSTe, which are the Better Business Bureau equivalents in the Internet realm. A history of complaints about the target company should be a red flag of deeper concerns regarding customer dissatisfaction.

Some issues are unique to the Net. In the area of B2B transactions, the global nature of these transactions means that they may not be controlled by standard contract principles. Also, many countries are enacting stringent requirements to protect children in their use of the Internet, and require truthful, ethical and meaningful disclosures to protect all users. Net businesses must be equipped to address tax matters as well as show an ability to deal with emerging technology.

However, the most important area of due diligence of an Internet company may be intellectual property.

According to a Brookings Institution study, intangibles represent two-thirds of the asset value of major corporations. Not only is this figure likely higher with Internet companies, but intellectual property may represent a higher percentage of this value. The critical analysis is to identify the relevant rights, determine their value and investigate possible liabilities. That is made more difficult by the nature of Internet business with its many channels through which property rights might flow.

• A standard list of issues to be considered when doing intellectual property due diligence is equally applicable in an Internet acquisition:
• Identify all intellectual property rights, including patents, trademarks, copyrights and trade secrets.
• Evaluate the importance of each to the business and prioritize the level of investigation accordingly.
• Ensure that the protection in place is adequate for current products and services by creating a genealogy of the intellectual property for each one.
• Evaluate each for strategic advantage to the acquirer, including the identification of possible hidden "jewels."
• Secure the title or right to use, including any assignment of rights.
• Investigate the confidentiality of trade secrets.
• Ensure that all required documentation is in order and that formalities have been followed.
• Have proprietary information agreements in place with employees.
• Anticipate possible infringement claims and develop contingency plans.

In valuing the intellectual property of a target, both internal and external elements should be considered as well as elements that affect the value either directly or indirectly.

The internal elements are those that are affected by management decisions. These include elements of profitability, depreciation, additional capital investment and salvage value of the intellectual property. External elements are those affected by factors outside the control of management. These include market conditions, the competitive structure of the industry, the availability of new technology, and the legal or regulatory climate as well as the political or social climate.

In addition, there are direct influences on the value of intellectual property such as licensing agreements. These can include future income streams that could be affected by possible synergies created by combining the assets of the merged companies. Indirect influences on the value of intellectual property would include such things as the earning potential of a trademark. One of the most important indirect influences is goodwill, which is not only part of the business but is dependent on the business itself and could be greatly affected by the company’s intellectual property.

On the other hand, the business lawyer must also identify and evaluate potential liabilities. A key consideration in this evaluation must be potential international liabilities where intellectual property law may be quite different from U.S. law.

First, what type of intellectual property is involved? Important considerations include whether the rights have been secured from the creator, when the works will become part of the public domain and whether the trademarks have been consistently defended.

Second, where will it go and how will it get there? Because intellectual property may be handled differently under the laws of other nations, the difficulty here is to try and predict where it will go. If it is to be conveyed on the Web, are there adequate protection techniques — such as encryption — to guard against piracy? Some countries have proven to be a sieve when it comes to intellectual property distributed on the Web.

Third, is it protectable and will it be protected? That is particularly important when considering international acquisitions, because the value of intellectual property in countries without laws to protect it is zero. However, the presence of statutes may not be enough as shown by the situation in China where laws protecting intellectual property exist yet piracy continues on a mass scale.

If it cannot be protected by established rule of law, then this must be factored into the value of the intellectual property. Given the global nature of the Internet, you could have a situation where your information was uploaded in one country, carried by a server in another and copied by a person in a third. That is a serious problem when the choice of law remains an unanswered question.

Fourth, what protection methods are in place? It is important to identify who in the new organization will be responsible to monitor possible infringements. Many companies have established agreements where they collectively share in the monitoring. It’s important to identify if any such agreements exist. Often, treating the intellectual property as a trade secret is more effective where the legal protections in a jurisdiction may be inadequate. Also, there may be opportunities for direct licensing of these rights with the government of the country involved.

The last and probably the most important question on this subject is whether the client is willing to spend the time and money to find the answers to the above questions. One of the biggest challenges with these types of transactions is keeping the client from becoming emotionally attached to the deal before the due diligence is done. Also, the client should periodically step back and reassess the appropriateness of the acquisition and be prepared to drop it if the deal no longer makes sense.

All this would seem to indicate that the Internet has only added complexity without any direct benefit to the due diligence process. But that is not the case; the Net can be an asset during the process.

One of the benefits of information technology is the ease of access board members have to information. But along with this comes access by nonboard members to some of this same information. Companies must be guided in how to meet the challenges associated with this new level of awareness, both by their employees as well as outsiders. The acquisition team must perform a broad database search for potential liabilities in the information that has been made available.

This spurt in availability has created an even greater demand for speed and a desire for instant answers. But decisions should still only be made after careful deliberation. Therefore, the directors of the client companies should be advised to slow down and acquire all of the available information before advancing to a decision.

How about some specific examples of how the Net can be used in the due diligence process? The most obvious is the target company’s own Web sites. They can provide insight to nuances in the way that a company does business that might not be apparent from financial documents. Also, there are government databases such as the EPA Superfund docket and product liability class action reporter databases that, while perhaps more applicable to brick and mortar companies, should be checked for possible negative information.

Online resources are also useful for disclosure. The Internet might be one method of providing shareholders with relevant information, as required, before submitting a merger vote. Also, the SEC has effectively used EDGAR to facilitate the required disclosure of securities information.

To summarize, the acquisition of a Net-related company certainly requires a higher level of due diligence. At the same time, none of the traditional requirements must be overlooked. Internet companies are still business entities. They are subject to the same liabilities that brick-and-mortar companies face. But the level of information technology and the heavy reliance on intellectual property make close scrutiny of these aspects of the target company necessary.

Lawyers must retake the initiative in evaluating these technology issues because, while the technology itself may be new, the legal issues involved have been with us for some time. To operate effectively, lawyers must gain an understanding of this technology and how it is used in e-commerce. Only in this way can they fulfill the fiduciary responsibility to guide the client through the due diligence process.

The continued growth of the Internet and the companies associated with it offer an opportunity to the business lawyer both in the amount of work that will be generated and the level of complexity that work will offer. The lawyers who understand the differences associated with this industry and develop due diligence tools to address them will be in the best position to provide the service their clients deserve.

Swarts is in his second year at Rutgers University School of Law in Newark, N.J.

Some Web sites

• WebTrust‚ http://www.webtrust.org/