Anatomy of a Technology Transaction
It’s 2019 and nowadays almost every business has some technological or data component that is critical to its profitability. So, what makes a tech deal different from a standard bricks and mortar deal?
Given the constraints on length, this article assumes you are familiar with basic M&A principles and addresses a handful of concepts that are unique to Technology Transactions.
Consideration: What’s being paid to get the deal done? Most of the time, cash, stock or a combination of both are used as consideration in tech deals (although I have seen other types of quirky forms of payment, such as cryptocurrency, source code, or even automobiles). If cash is used as consideration in the deal, the deal is somewhat simplified (yet you’ll still find elaborate payment structures with earn-outs), but frequently in tech deals, Buyer stock (combined with cash) will be used as a form of payment to incentivize both the Buyer and Seller to ensure in the post-closing success of the Acquired Company to the Buyer. Because of this, the Seller or Acquired Company should also exercise the same level of due diligence on the Buyer to ensure that the value of the Buyer stock is preserved. In addition to the due diligence items, there are a variety of contractual mechanisms such as a Fixed-Exchange Ratio, Fixed Value, Collars, Caps and Floors, to ensure the price of the Buyer stock is preserved during the period between signing and Closing. Otherwise, any decline in Buyer stock could allow the Seller to walk away prior to Closing.
Shareholder Rights/Voting: Often in tech deals, there will be sophisticated investors involved in an emerging growth company (i.e. Angel Investor, Venture Capitalist). Therefore, always review the governance documents of the Acquired Company to determine whether:
- There are any Liquidation Preferences and Participation Features amongst the shareholders, members, or founders;
- The shareholders vote collectively as a single-class or whether each class require a separate vote; or
- There are any Rights of Co-Sale or Rights of Refusal which would motivate the Buyer to acquire all of the outstanding shares of the Acquired Company rather than just a controlling interest.
It’s always advisable to work with the founders, CFO and CPA’s to determine the accounting and distribution of the Closing proceeds for each share and class of stock.
Contracts: The contracts of the Acquired Company are always a strategic asset in a tech deal. In fact, some Buyers disregard the underlying technology, and are solely motivated for doing the deal in order to gain access to the Acquired Company’s customers or vendors so that they can sell more products and services or lower their operational costs with economies of scale. Here is a list of contracts frequently found in tech companies:
- Outbound Licenses: These licenses are the key to gaining access to existing customers and are the revenue stream to the Acquired Company. They allow customers to use the Acquired Company’s technology and products by paying a license fee. As such, always examine the duration, scope, termination rights, and assignment restrictions to these licenses to ensure that these customers stay on-board and associated revenue streams remain intact post-Closing.
- SaaS Agreements: A variation of the Outbound License Agreement is the SaaS (“Software as a Service”) Agreement in which the customer pays a subscription fee to use a product or software product that is virtually hosted in the cloud rather than being installed directly on the customer’s local network. This exemplifies the evolution of software technology and associated business model.
- Inbound Licenses/Open-Source Licenses: It is common practice to combine third party products and code with the company’s IP to build a final product. In software, many of these third-party components are “open-source code” (i.e. snippets of code that are available to the public) which provide certain functionality that are combined to make the final product operational.
- Services Agreements: Once a customer is “locked-in” to using a technology or software product, technology companies often diversify their license revenue by selling additional support and services to maintain their products as the customer’s needs and operating environments change.
- Training Agreements: Training is another common service sold to customers. After all, a company’s products are worthless unless the customer knows how to properly and safely use them.
- Channel Partners and Reseller Agreements: These are basically middle-men which allow a software company to piggy-back onto the partner’s or reseller’s existing relationships and sell products and services to new customers. You’ll need to differentiate whether these relationships are “white label”, in which the channel partner basically sells the company’s products as if it were their own, or “value-added” in which the Value Added Reseller (VAR) adds additional bells and whistles to the company’s product and bundles it into a final product before selling it to its customer base. IP Ownership, branding and customer access are usually the important issues to analyze when performing diligence on these agreements.
- OEM Agreements: Original Equipment Manufacturer (OEM) Agreements are commonly used in hardware manufacturing, and is another variation of the VAR relationship, where the parts and components from several companies are assembled by the OEM into the final product before the VAR distributes them to the market. Branding control, warranty obligations, and IP ownership are common issues to think about in OEM Agreements.
- Joint Venture: Occasionally, software companies will combine efforts with other companies to develop a new product, reduce operating costs, or penetrate a new market. Each party may contribute a variety of strategic items to the venture such as IP, key personnel, hard assets, cash or a combination of the above. These agreements are critical to tech M&A as it is important to understand whether anything, such as IP ownership, has been inadvertently conveyed away into the Joint Venture.
Intellectual Property: Always understand the motives of the Buyer and Seller for entering into a deal. If the Buyer is interested in acquiring a technology and integrating it into its product suite, then IP becomes an important variable to consider. Here are some common issues to look at when doing a tech-focused deal that may have international operations:
- IP Holding Company – Frequently, software companies spinoff a software holding company which houses its core technology and grants licenses/sublicenses to third parties in order to insulate the core technology from claims and liabilities of the business. As such, the definitive agreements must address the structure of the deal and whether the software holding company or its licenses are included as part of the deal.
- International Development – Nowadays, the development and maintenance of technology is outsourced and decentralized to multiple parties around the world. As such, make sure all key parties (employees, contractors, founders, executives, etc.) involved in building the technology have signed the appropriate Confidentiality and IP Assignments, while ascertaining that no technology of a third party has been inadvertently or illegally incorporated into the final product, such as that of a competitor or a prior employer. Additionally, it is always prudent to double check that none of the parties involved in development are subject to any restrictions (such as a Non-Compete, Non-Development or IP assignment) imposed by a third party that could potentially prevent the entire project or final product from being commercialized. Finally, if third party components are incorporated, examine the effect of tariffs and import/export restrictions on the costs of building the final product, and properly allocate this risk under the definitive agreements.
- IP Infringement – An entire article can be dedicated to the topic of IP Infringement. In short, IP rights are often the most valuable assets in tech deals because they can fulfill the Buyer’s objectives of acquiring rights to a better “widget”, the freedom to operate, and the ability to exclude others. Depending on the goals of the Buyer and the history of the Acquired Company’s IP portfolio, due diligence questionnaires should be tailored carefully to suit the situation of the parties while balancing the scope of the representations and warranties to address any risks or assumptions uncovered from due diligence. If there are any blemishes on any IP of the Acquired Company, the valuation of the transaction will ultimately be impacted. As such, make sure the Buyer will be able to freely use the IP without requiring any consents of a third party, and confirm that there are no foundational IP rights in a similar technology that effectively blocks or narrows down the ability to use the acquired IP. If there are defects discovered in the IP, factor in the cost of correcting such defects so that the purchase price can be adjusted accordingly.
- IP Assignments of Employees, Contractors and Founders – Too frequently, I see tech companies forget to obtain something as simple as an IP Assignment document. Everyone is eager to embark on a new project but overlook important legal details at the outset. However, a few years into the project, relationships disintegrate or people may no longer be communicating but each of them may have contributed something significant to the technology of the Acquired Company. When a large sum of money is about to exchange hands, chasing down signatures for an IP Assignment prior to Closing is oftentimes exorbitantly more expensive than getting everyone to sign one before the project commences. It is not uncommon to see co-founders, who are no longer getting along, hold a company hostage by refusing to sign critical deal documents by asking for more money to obtain their signatures. Additionally, you may have co-founders or contributors to the IP who may be “moon-lighting” from their full-time jobs whose employment agreements may grant their employers automatic IP ownership to anything that they’ve developed.
- Transfer Ownership of Domain Name/App/Code – In a digital economy, apps, domain names and websites, when used in conjunction with a trademark, are even more important than your traditional IP. Always obtain a list of domain names, including common spelling iterations that can be poached by a third party, from the Seller and check all domain registries to ascertain that none have lapsed and that they are rightfully owned by the Seller. As a Closing deliverable, you can stipulate that ownership of a domain name or App be transferred and reflected in the appropriate domain name or app registry.
- Obtain a List of IP (Patents, Trademarks, Copyrights, and Trade Secrets): Identify what is being acquired so work with IP counsel to ensure that all filings are current and have not lapsed or are being challenged in all of the countries and markets within which the Seller operates and/or sells its products/services.
- Software Patents: Software patents are rare and narrow. As such, source code are often protected as a Trade Secret, which has a broader scope of protection but is also easily lost if the Seller has not taken the appropriate measures to protect its secrecy (especially when granting access to the Buyer and its representatives to perform due diligence). As such, make sure that: (i) the Seller has put in place reasonable security measure to protect the confidentiality of its source code and IP; and (ii) everyone, including the prospective Buyer, who has come in contact with the critical IP and source code has signed the appropriate NDA’s, IP Assignments and even a Non-Compete/Non-Development Agreements. Additionally, verify whether any source code has been placed into a Source Code Escrow, which could force the Acquired Company to relinquish its code to a customer under certain circumstances, such as bankruptcy.
- Joint Ventures: If the Company is involved with Joint Ventures, we must determine if there is any core or foundational technology that is co-owned by a third party or licensed to allow another party to freely use IP or code that is strategic to the Company. We have occasionally seen companies inadvertently grant away certain ownership rights in core technology underlying their products. On the flipside, it is also imperative to determine whether there is any underlying component required to power the core technology but which is owned by a third party. If development and engineering has taken place abroad, work with local IP counsel to ensure that there are no local laws which would allow the creator to retain any IP ownership in the technology that was built.
- Source Code Review: With software development decentralized around the world, developers frequently build software by plugging in pre-existing snippets of third-party, open source code, rather than building the code from scratch. It is imperative to perform a code review (i.e. Black Duck) by examining the licenses of such third-party code to ensure that the software/technology has not been contaminated by source code that is deemed “viral” or “copyleft” and thereby, jeopardizing the IP ownership of the software by granting unfettered rights for public use.
Cybersecurity: In a virtual world where data is the new currency, the protection of data has evolved into a huge priority and also transformed into a major risk. Commonly, you’ll find a significant portion of a Buyer’s due diligence focused on the Company’s IT security protocols while having the appropriate provisions (“model clauses”) in purchase agreements to address the transfer of data and the protection of the Acquired Company’s IT networks. Ensuring the security of the IT networks not only defends the data of your customers and personnel, but also, the protects against the theft/loss of trade secrets, financials, and intellectual property. Prior to the outset of any deal, the Buyer must closely scrutinize the acquired Company’s IT networks to ensure that there are no vulnerabilities that could compromise the entire IT system and thus forcing the Buyer to absorb any post-closing fines, penalties, or loss of data imposed by a regulatory body. To mitigate any post-closing risks arising from cyber-threats, there are now specialized representations and warranties focused on the allocation of risk from security of the Acquired Company’s software and IT networks, along with minimum requirements of maintaining cyber-insurance to hedge against a breach.
Privacy and Data: In addition to the company’s technology, data is nowadays paramount to the value of the business. The inability to use the existing data may render a company worthless. Depending on the technology involved and the type of data collected, additional regulations may govern a Buyer’s ability to use or own the data collected by the Seller. For example, a FinTech startup may be collecting financial and account information of its customers, so the ability to use and transfer the data will be regulated by the Graham Leach Bliley Act, while a digital health company may be collecting personal health information and therefore, implicating compliance with HIPAA/HITECH as ownership is transitioned.
Additionally, your due diligence should also assess the security measures, data retention practices, and functionality of the software or app for users to opt-out, access, and delete their information to minimize any likelihood of post-closing liability arising from penalties and fines assessed by regulatory bodies such as the FTC or GDPR.
Conclusion: As Moore’s law has predicted, the technology environment is constantly evolving at an exponential rate which also requires business models, regulatory bodies, and lawyers to keep pace with the changes. This article is by no means exhaustive but superficially highlights some of the common issues encountered over the years that have remained somewhat constant. However, it is prudent to note that a new set of issues and risk tolerance seems to be introduced every few years and must be addressed in the various stages of a technology deal.
By: Aaron Woo, Partner