Heads Up on Startups: What Acquirers Need to Know Prior to the Purchase

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Startup enterprises fuel our economy with innovative new ideas, products, services and solutions. They  serve as the laboratories, think tanks, researchers and developers, and creators of the elusive “next big thing.”  It is no wonder, therefore,  that startups often are attractive acquisition targets, providing product and service pipelines to many of the world’s largest transnational corporations and other consolidators. The very nature of the fast-moving world of startup enterprises and their high risk/high reward profile requires that those considering the acquisition of a startup entity carefully assess the startup’s technological feasibility and commercial viability. To do this, potential acquirers must engage in substantive business, financial and legal due diligence. Appropriate diligence during the acquisition stage may well make the difference between success and failure, and allow the acquirer to achieve the benefit of its bargain in the post-closing implementation stage.

Appropriate diligence during the acquisition stage may well make the difference between success and failure...

Technological Feasibility

If the acquirer’s goal is to purchase the business and assets, including the all-important intellectual property, of the startup, it must be sure to know what it is buying and why it is considering the acquisition. A careful substantive review of the technology, product or service is required to ensure that it works as promoted or advertised. If the acquirer’s intention is to combine acquired IP  with the acquirer’s existing assets, it must assess interoperability of the acquired IP to ensure compatibility. Assuming the startup’s IP passes the test of technological feasibility, it also is critical to consider the commercial viability of the startup’s offering. Just because the technology is sound – that it works – does not mean that there is or will be a market for it. The offering also must meet a real need in the market or provide a cost-efficient solution to the target market. This phase of diligence requires the combined efforts of the acquirer’s technical and business teams, often including accountants and counsel.

Ownership History

It is essential that a potential acquirer carefully assess the ownership history of the assets being acquired, especially in connection with IP rights. Many startups are formed to exploit and to commercialize technologies created by someone other than the founders, or with outside funding or resources. Any inquiry into the ownership history of technology ownership should begin with the creator to determine the extent of his or her unencumbered ownership and exploitation rights, including any ownership rights his or her employer may have. If the creator developed the IP while working for another employer or by utilizing the resources of someone else, this inquiry becomes especially sensitive.

The acquirer should review any restrictive covenants that may have been imposed upon or agreed to by the creator and ask the creator to provide any invention assignments, confidentiality agreements or similar restrictive agreements; these warrant careful review. If the creator was an independent contractor or a consultant, the acquirer must review the applicable contracts to ensure that work was completed on a work-for-hire basis, such that the ownership rights belong to the startup (and not the contractor or consultant). An acquirer must be comfortable that employees and consultants were not using or infringing upon the intellectual property rights of others in their development work for the startup.

IP Rights

To the extent the IP was created using grant money, whether public or private, an acquirer must consider the retained rights, if any, of the grantor. Similarly, innovations associated with university grants, labs or other facilities, or professors and students may be subject to the rights of the university. The acquirer’s IP diligence should be conducted by the acquirer’s technical and legal teams, and it often requires both patent and employment law expertise. Even the most thorough IP diligence, including searches of the state of the art and pre-existing patents, is subject to risk. The acquirer must consider the risk profile of the acquisition and consider how it compares to the acquirer’s risk appetite.

Financial Due Diligence

In conducting its financial due diligence, an acquirer must consider the costs associated with any further research and development, production or provisioning of the product or service, as well as sales and marketing efforts, including any obligations under licenses or other agreements. Financial due diligence must also include analysis of pricing and market acceptance projections. Other critical financial aspects of acquiring a startup include financial forecasting and budgeting. The acquirer’s financial team, whether internal or external, is integral in this analysis.

...must also include analysis of pricing and market acceptance projections.

Startups often are characterized by scarcity of resources, resulting in limited (and sometimes unreliable) financial accounting, reporting, and financial statements. The acquirer’s diligence team must consider the liabilities and obligations, contractual or otherwise, of the startup and, in an acquisition scenario, recognize and consider the acquirer’s potential responsibility for such liabilities and obligations (whether as a direct consequence of the deal structure or under a theory of successor liability), whether reported by the startup or not, known or unknown, contingent or otherwise.

Legal Due Diligence

Legal diligence must be an integral part of the acquisition process as it can uncover impediments to the startup’s (or its stockholders’) legal ability to make the sale. The acquirer’s legal team can determine whether the startup’s shares are duly authorized, validly issued and fully paid and nonassessable. Legal due diligence will determine the extent of any restrictions on share transfers, such as rights of first refusal or other encumbrances, which are especially common for venture capital-backed companies. The acquirer’s legal team also will consider and advise on many issues, among them the representations and warranties to be made by the startup and, especially, its founders or key stockholders, in the acquisition documents, how long such representations and warranties will survive, and any indemnities or escrows that are to be imposed to compensate and protect the acquirer.

Acquiring a startup often provides the acquirer with access to new markets, products, solutions and services, as well as innovative ideas and a pipeline of future products. While the idea of acquiring the “next big thing” is indeed exciting and filled with lofty goals, the acquirer’s enthusiasm and zeal for the acquisition should be tempered by a reasoned, informed, rational review and decision making process that incorporates the combined, but disparate, skills of business, technical, financial and legal experts.

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[Dave Sorin is the managing partner of law firm McCarter & English’s East Brunswick office and the head of the Venture Capital & Emerging Growth Companies practice. Joseph Ferino is an associate of McCarter & English. He concentrates his practice in the areas of transactional and securities law matters, as well as general corporate matters.]

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