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M&A deals: What tech startups need to know

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Christina Wojcik, vice president of legal services at Seal Software, breaks down the steps to consider throughout the M&A process.

With over $5tn in deals signed in 2015, it was a record breaking year for M&A activity. However, 2016 does not appear to be following suit.

Over the first eight months of this year global M&A dropped to $2.2tn with 28,720 deals compared to $2.9tn with 30,894 deals at the same time last year.

In fact, 2016 appears to be a record year for broken deals instead. Between Brexit concerns and antitrust regulations in the US, an increasing number of deals are breaking down before they become official.

The unknown

M&A deals are complex events that require overcoming a hefty number of obstacles, including corporate governance, form of payment, legal concerns, contractual issues, regulatory approval and tax issues. So it’s not a huge shock that there are a lot of unknowns when understanding what kinds of contractual risks, restrictions and exposure companies will have to take on post-deal.

There are three main options in the M&A space when you’re a startup. You may be the target of a much larger tech organization, you may be courted by a similarly sized startup, or you may be the acquiring company looking to grow quickly.

During an acquisition, the acquiring company assumes all the opportunities, obligations, legal liabilities and risk of the target company. If a larger company is looking to acquire you, they will be looking at the strategic and financial value you bring to their vision as well as the risk you may pose. If you want to close the deal quickly, you’ll need to have your house in order so the acquiring company can immediately see the value you bring based on your contractual relationships. If a similarly sized startup is courting you, they’re going to need to understand the value your organization brings to their growth strategy. Finally, if you’re looking to acquire another company, you will really want to know what you’re getting yourself into.

But uncovering all of these opportunities and risks requires many hours of manual contract review work from either your law firm or a lower-cost legal service provider. Before they can even begin reviewing the documents, you first must find and centralize the relevant contracts. This may sound simple, but tracking down thousands of contracts, which have been created in varying formats and locations over the years, is an arduous and sometimes overwhelming undertaking.

The real work

Once all contractual documents are collected, the real work begins. Legal teams must review provisions such as restrictive assignability, change of control, liability, auto-renewals, non-solicits and non-competes, and nonstandard indemnifications, just to name a few. Not properly understanding assignment or change of control provisions can be especially detrimental to the dynamic of the acquisition. If your contracts cannot be assigned or if change of control triggers automatic termination for cause, the strategic value of the acquisition may be called into question, leading to many hours of renegotiation. For example, a software company we work with purchased a competitor to try to ‘immediately’ double its size. Upon further investigation it discovered that the acquired company had many risky provisions, like unlimited liability, acceptance and most favored nation provisions. Now, instead of having its legal operations teams focus on integrating the business to drive revenue, it must prioritize renegotiating contracts to avoid risk. To avoid a similar issue, it’s important for tech startups to be conscious of specific terms in contracts before closing a deal.

In addition to assignment and change of control, here are a few more to consider:

  • Be aware: Auto-renewal
    Every sales organization that gets a strong price on a deal wants an auto-renewal and every procurement department dreads tracking an auto-renewal provision. From a sales perspective, an auto-renewal with a high penalty for early termination is great! However, if the goal is to terminate a contract within the specific notification period, you must know which contracts contain the provision and the window for cancellation. Overall, a missed auto-renewal can result in hidden costs that most startups hadn’t considered. One of our customers, a large energy company, discovered they were auto-renewing a lease costing $400,000 per year on property they didn’t need, three years after a takeover.
  • No nonsense: Non-competes & non-solicits
    Monetary damages can also occur if a company breaks a non-compete or non-solicit clause. It’s important to know whether or not contracts include these provisions, as the majority of contracts in pre-acquisition deals do. In plain terms, a non-compete is a promise from both the buyer and seller to refrain from engaging in activities with competitors. A non-solicit clause prohibits a company from trying to lure or hire the other company’s customers or employees. This is particularly relevant when two companies in the same industry merge, as many of each company’s existing customers or partners are likely competitors.
  • In the tech space, non-solicit and non-compete provisions become increasingly relevant as many acquisitions are consummated not only for the intellectual property of such company, but also for the talent it employs. Contracts need to be carefully reviewed to ensure that the combined entity will not violate the obligations created prior to the transaction and that the activities to be performed by the combined entity will not create a breach.
  • Identify: Indemnity
    In addition, indemnity in contracts is often complex and should be heavily negotiated prior to closing an M&A deal. The acquiring company should clearly understand what the target company has agreed to indemnify. One major issue is that these provisions typically have cross-references, which makes them difficult to fully comprehend. Careful review of the indemnification provisions of each contract is needed to ensure that these provisions align with the combined entity’s indemnification standards and practices.
  • Limit: Unlimited liability
    When startups are motivated to close a new deal, especially with big, recognizable brands, they will often accept potentially unacceptable provisions. This is commonly seen with limitation of liabilities. Accepting unlimited liability does not necessarily pose a large risk to a startup, because they have nothing to lose. However, it can pose a significant risk to an established organization that may have significant exposure if they accept unlimited liability. Therefore, it become very important that the acquiring company quickly identifies the contracts containing unlimited liability and look to renegotiate amend or possibly terminate the contract. For example, only after a software giant we work with bought a startup did it discover that it had inherited an unlimited liability provision – a small problem for the $1.5 million startup, but a much bigger problem for the $1 billion company.

The silver lining

As M&A activity increases, especially within the startup world, knowing what’s in your/their contracts is more important than ever, and having easy access to and visibility into those contracts is absolutely essential. Due to the time sensitivity on many M&A deals and the manual labor often required to analyze contracts, most companies resort to sampling just a small portion of the target company’s contracts with the assumption that if the sample passes the test, the rest will as well. But countless cases prove that this approach exposes the acquiring company with risk they had not anticipated.

Luckily, there is silver lining. Current contract technology offers machine learning and natural language processing solutions so that organizations going through the M&A process can streamline the due diligence process to consolidate contracts, pinpoint and understand risk, and uncover vendor consolidation opportunities. No need for extra water or Advil, because understanding contract terms will prevent the post-deal hangover that so many rushed deals result in.

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