Todd Rumberger is a corporate partner with Foley & Lardner LLP and is VentureBeat’s corporate counsel.
Early-stage companies that have plenty of engineering talent but insufficient investment capital to keep going continue to find opportunities to monetize their talent pool and early efforts by selling to a cash-rich larger technology company. Smaller “acqui-hire” deals (perhaps less than $10 million) are often viewed as no more than veiled, albeit rich, sign-on packages for scarce top-tier talent; larger deals, however, made as part of a “buy vs. build” strategy, allow the larger company to pick up not only a proven team but a product that may fit nicely or even critically into its product development plan.
But whether, just ‘team” or “team and technology,” many acquisition deals fail to close. A number of factors can play into a failed exit deal, but here are the five most common deal-killers I’ve witnessed for startup teams. For the purposes of this article, I have focused my summary primarily on the larger team and technology deals:
1) An important constituency — founders, key employees (i.e., key engineers), or investors — does not support the ‘early’ exit plan.
The critical first question to answer in this regard: Are your key developers/technologists or other key co-founders prepared to continue to work with the technology, the business, and, most critically, the acquirer post-acquisition? Where early-stage exits are involved, the acquirer typically views inventors/developers/visionaries of the acquired company’s technology as a “must have.”
2) The company’s ‘IP house’ is not in order.
In other words, the company has done a poor job in one or more of a number of critical areas relating to its intellectual property, or worse, does not have rights to the IP it is using in its products. At founding, the company should have valid and vetted assignments of any technology the founders are “contributing” to the startup. Signed agreements assigning IP thereafter created in the course of work for the company should be secured from all existing and former founders and employees (e.g., invention assignments and confidentiality agreements). Your team must also obtain similar agreements from independent contractors (the language should be in the consulting or development agreement); without specific assignment language, the contractor typically keeps most IP rights. It’s also critical to maintain a record of consistent use of non-disclosure/confidentiality agreements with third parties to protect the company’s trade secrets, which for many technology companies, is software code.
Best case: There is nothing to disclose to the acquirer about your company’s IP representations or, if there is something to disclose, a thoughtful explanation is provided.
Worst case: During due diligence, the acquirer discovers significant problems that the company was not even aware of.
For many Internet and mobile companies where the technology is code, it is unlikely that patents will have been pursued or, if filed, have progressed very far or are attributed much value at any early-stage exit. So most early-stage companies will rely primarily on trade secret and copyright protection for their IP. For this reason, an acquirer will want well-documented software code that can be integrated with the acquirer’s own technology and understood by the acquirer’s technology team. The acquirer will expect the company’s developers to have tracked and complied with inbound IP licenses (open source, freeware, “copyleft,” off the shelf, and so forth). Note that free software and open-source software often create the most concern, as it can be difficult to observe complicated license terms, and lax documentation can possibly be a “show stopper” for a large enterprise acquirer due to risk.
Similarly, the company’s compliance with well-thought-out and implemented information privacy, processing, and security practices and policies is particularly important to an online business.
3) The company’s capitalization table, which is supposed to be a reflection of its current ownership and rights to acquire ownership, is incomplete and inaccurate.
Issues arise where undocumented promises of equity to contractors or employees have never been reduced to actual grant or purchase documents, approved by the company’s board of directors, and signed by the grantee. A failure to get the “paperwork in order” can lead to serious issues, leaving verbal discussions (or worse, email exchanges) open to interpretation and risking claims by the employee or contractor of greater “promised” equity, better vesting terms, and so forth. Former disgruntled co-founders, contractors, and employees can only compound these complexities during an intensive due diligence process.
4) Assignment/change-in-control provisions in key company material contracts require third-party consent.
If consent from the other party to a key company contract is required, failure to obtain it could jeopardize the acquisition, or certainly any higher purchase price range. It can be tricky to approach a key customer or strategic partner ahead of the acquisition, particularly if it involves IP that’s key to the business, and the selling company is usually reluctant to do so. Not knowing, though, could cause the deal to stall midstream after you’ve already gone through a lot negotiation, incurred significant attorney and advisor costs, and worse, possibly foregone important other business.
Regarding Nos. 2, 3, and 4 above, each situation involves the selling company identifying potential problems and working to remedy them before engaging in the sale process. Once the acquirer offers up the proposed acquisition LOI or term sheet and the selling company’s board and shareholders have negotiated and finally accepted it, however, these issues, which can often be remedied if dealt with ahead of time, are now unaddressed and, when exposed during due diligence, can put the deal in jeopardy.
5) The company engages, sometimes unwittingly, with a single potential acquirer or builds its technology and/or business with a single acquiring company in mind, often due to an early key strategic partnership.
A team wanting to sell (emphasis on “wanting”) and embarking on serious acquisition discussions with only one realistic acquirer is often bound for disappointment. A happy exit for the selling company shareholders does not typically result from acquisition discussions being initiated by the selling company; more often, it develops out of some variety of strategic partnership, customer, or other commercial arrangement.
That said, in spite of the best and often good-faith intentions of the acquirer’s corporate development sponsor of the deal, the acquirer’s CFO or similar deal-approval committee is prepared to push back hugely on price if they think they can, so a more competitive environment can help offset that. Pause as the discussions begin to shift from commercial deal to potential acquisition, and take a good look around. Starting a dialog with other potential acquirers can lead to a much better exit.
Exit sign photo via fmua/Shutterstock
Todd Rumberger is a corporate partner with the Palo Alto office of Foley & Lardner LLP where he focuses his practice on private equity, mergers and acquisitions and venture capital, and Internet, software, mobile, digital media and financial services companies through all stages of their growth. He is a frequent speaker on topics involving startup and venture-backed companies, foreign technology companies relocating to the U.S. and mergers and acquisitions. He is author of The Acquisition and Sale of the Emerging Growth Company: The M&A Exit, published by ThomsonReuters/West Publishing (2012).