There are many steps a founder goes through during an acquisition, from finding the right acquirer to closing a deal. This blog is focused on one specific (but very important) aspect: due diligence.
The requirements are similar for both an investment and an acquisition, but with some important differences. In fact, if an entrepreneur thinks they will have a painless acquisition because the due diligence materials they used as part of an investment process are still in good shape, they are most likely kidding themselves.
It can be overwhelming for an entrepreneur to keep their business running smoothly while also satisfying the seemingly endless requests that a buyer makes during the due diligence phase. Too often, the time a CEO spends on due diligence is distracting, leading to missed revenue goals or product development deadlines, which then causes lower valuations or unfavorable terms, or even kills the deal entirely.
To make sure a startup entrepreneur is ready and the acquisition process will not derail business activities, the seller should start off with an understanding of how the deal structure will determine the extent of due diligence.
Type of Acquisition
There are many types of acquisitions and mergers. This blog dives into an asset purchase, since that’s the one I’m most familiar with, having just been through one recently. In February 2018, EMC School purchased the assets of my company, Zulama.
The main document which forms the crux of an asset purchase is an Asset Purchase Agreement (APA). The two parties involved are the buyer (often a mid-sized or large company) and seller (often a startup). The APA finalizes terms and conditions related to the purchase and sale of some or all of a company’s assets.
The structure of an asset purchase favors the buyer in the sense that they are only purchasing a set of assets, and [generally] not assuming any liabilities. In contrast, in an equity purchase or merger acquisition, the purchaser receives all of the seller’s assets, and also assumes all of the seller’s liabilities (known and unknown).
Due Diligence is Related to the Type of Acquisition
If a buyer is only purchasing assets, the due diligence process will center around the assets, and not other aspects of the seller’s business such as loans, payroll, or other liabilities. If a buyer is purchasing an entire company, they will want to know about all aspects of the business. They will dive into current liabilities as well as any anticipated future liabilities. For example, the buyer will want the seller to prove they own every aspect of their Intellectual Property (IP), so the buyer cannot be sued for IP infringement at some point in the future.
Asset Purchase Due Diligence
Due diligence for an asset purchase will most likely be hyper-focused on the seller’s authority to sell the asset. What does that mean, and how can the selling CEO proactively get ahead of the process? The three most time-consuming issues we experienced were:
- Defining in exact detail the assets being purchased, as well as the assets that are not being purchased (a.k.a., the excluded assets);
- Proving that the purchased assets were owned by Zulama;
- Identifying any “change of control” issues. For us, this was mostly making sure that relationships with any critical third-party contractors, such as our software developers, would continue seamlessly after the acquisition.
Define the Purchased (and Excluded) Assets
One of the Zulama assets was a software platform, which could simply be defined as the source code. But where does that source code live? If any of it is on local laptops or computers, be prepared for that equipment to be included in the list of purchased assets.
Don’t forget that it’s just as important to define the excluded assets. Don’t make any assumptions! For example, are all (or only some, or none) of your accounts receivable being paid to the acquirer?
Proof of Ownership
We may have incorporated open source or paid software into our code base. The licensing agreements from the open source and third-party softwares needed to be provided to the buyer to prove that those licenses didn’t prohibit us from selling our software platform, and to prove that the third parties can’t make any ownership claims.
Change of Control
This was by far the most time-consuming process for Zulama. We had numerous contracts in place with software developers, curriculum designers, sales partners, and others. Some of those contracts were not part of the asset sale. Yet many of the contracts were critical to a seamless transition, such as with our software developers. We examined each contract to find the assignment terms, and then dealt with each depending on those terms. If the contract was “assignable without consent,” we could include that contract in the asset sale “as is.” If the contract required one or both parties to “consent to assignment,” we had to obtain written consent in order to include the contract in the asset sale. Imagine how stressful it was to negotiate new contracts, even with long-term reliable and trusted partners, during the heat of an acquisition!
One note on change of control is that it is less common that this type of consent will be an issue during an equity sale or merger.
Final Bit of Advice
If you take nothing else from this blog, examine all of your contracts for the assignment clauses and figure out if action needs to be taken—well in advance of acquisition. Discuss the content of this blog with your advisers, investors, lawyers, and other key people involved in your business. Surely there are due diligence items unique to your company that you can begin to proactively address. A few minutes spent now is well worth avoiding the hassle (and expense) later.