Common Legal Hurdles In M&A Transactions Involving Tech Startups

August 13, 2023
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Mergers and acquisitions (M&A) can prove to be a critical point in the life of any business, especially when that business is the target of the transaction. The way such deals are constructed and conducted can have a huge effect on the future of all the parties concerned.

For tech companies and startups in particular, M&A can be pivotal in their development, whether the goal is adding on capabilities or accessing the greater resources available to an acquirer. Ensuring that the desired outcome is reached requires an awareness of the common legal hurdles that may arise during the process – and how to clear them.

Here, I am going to give a few examples of the challenges that may need to be recognised and addressed (by either side) when any tech startup is considering going down the M&A route.

Intellectual property (IP) rights

It almost doesn’t need to be said that IP is a key asset to many different sorts of companies. But tech startups often rely heavily on their intellectual property assets. Assets such as patents, trademarks, copyrights and trade secrets can be a huge component of their activities – and their value. This is why any would-be acquirer of such a company needs to conduct thorough due diligence to ensure that the startup’s IP rights are valid, enforceable and properly protected. Any issues with IP ownership or infringement can significantly affect the deal. Startups looking to close a deal that involves merging with or being acquired by another have to be able to demonstrate the value of the IP assets they hold.

Regulatory compliance

Tech startups may operate in highly-regulated industries, such as fintech or healthcare. In such sectors, there is great emphasis on compliance with specific laws and regulations. As a result, any acquiring company will need to examine the startup’s compliance with applicable regulations and evaluate any potential risks or liabilities prior to the close of any deal. Such factors have the ability to affect the exact terms of any acquisition and, in some circumstances, whether it actually goes ahead.

Data privacy and Security

Startups dealing with user data face stringent data protection laws, like the General Data Protection Regulation (GDPR) in the European Union. Anyone looking to acquire such a company must evaluate the startup’s data privacy practices, cybersecurity measures and any past data breaches to ensure compliance and mitigate potential risks of a breach in the future.

Employment and labor issues

M&A transactions will usually have implications for those who are employees of a target startup. The changing status of the business may necessitate a review of – and possible changes to – its employment contracts, as well as its non-compete agreements, intellectual property assignments and incentive equity arrangements. Changes will need to be made carefully and with a full awareness of all relevant issues. A failure to comply with employment laws or manage matters that risk employee disputes can be damaging to the company.

Contracts and vendor agreements

Tech startups will have various contracts in place with suppliers, customers and other third parties; some of which may even be part of its appeal to a potential acquirer, while others may present material liabilities or risks. The acquirer should, therefore, carefully review and assess all of the startup’s existing contracts – including their terms, rights and obligations. If any obstacles become apparent during this process, it may be necessary to renegotiate those contracts or seek the consent of the counterparty to protect both the target and the acquirer.

Founder and shareholder agreements

As startups commonly have agreements among founders and other shareholders that address issues such as equity ownership, voting rights, restrictions on transfers and other important matters, any party aiming to acquire such a business will need to examine these agreements very closely. They may contain provisions affecting the transaction, such as rights of first refusal or drag-along provisions. Ensuring compliance with such agreements and addressing any potential conflicts that may arise must be seen as an essential part of the M&A process.

Due diligence challenges

Conducting comprehensive due diligence on a tech startup may be far from simple for any company looking to acquire or merge with it. The very nature of many tech startups’ work, the technological assets they possess and the often complex financial structures involved can prove problematic for outside parties to fully understand. Regardless of this difficulty, identifying all material risks, liabilities and potential legal issues is necessary in any M&A process, even if it may require specialized expertise and the drafting of experts in particular fields.

Regulatory approval

Some M&A transactions involving tech startups may require regulatory approval. This is particularly likely if their work involves sensitive industries, such as telecommunications or biotechnology. Antitrust and competition law considerations may also come into play, especially if the transaction results in a large proportion of a particular market being held by a small number of companies. Such issues have to be addressed before any merger or acquisition is completed.

These are just a few of the most common legal hurdles that can arise in M&A transactions involving tech startups. Each transaction is unique, and the specific challenges will depend on the nature of the startup, the industry sector in which they operate and the deal structure itself.

Ensuring that any M&A transaction is conducted smoothly will always involve identifying all such hurdles and recognising the best way to manage them. This usually means engaging experienced legal counsel who can ensure that all such hurdles do not prove an obstacle to progress.

Author Bio

Chris Spillman is the Managing Director (Americas) at Biztech Lawyers.

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