Startup’s Legal Due Diligence: 10 Tips for Founders on How Not to Lose in Exit Value

15 - 25% - the average percentages by which the acquisition value of a business gets reduced before exit. One of the main reasons being legal risks that emerge as a result of purchaser’s legal due diligence.  

So, what is legal due diligence and where did 25% come from?

Legal due diligence stands for the process of going through the entire legal documentation of the company. The aim is to identify all possible risks of the business’ acquisition.

Experience has shown, that early-stage start-ups postpone going to a lawyer and seek legal support to the last minute. There are quite a few valid reasons for this: a slow pace of legal work, it’s price, and, quite often – the inability of a lawyer to fully grasp the tech side of a start-up to correctly support it from the legal front. On the other hand, the startup has to be agile and does not want to spend much time on legal.

That is why complex legal issues often appear during the legal due diligence, ”. Here are some of them:

•    -   Unstructured Intellectual Property rights, unregistered trademarks (which leads to problems with licensing, risks to the brand and domain);
•    -   Absence of Personal Data Agreements and Policies (leads to potential fines for violating personal data legislation);
•    -   Unstructured corporate relations (leads to potential fines for violating labour law, as well as potential losses when the key team members leave);
•    -   “Gaps” in financial statements (leads to potential fines from tax authorities).

Before the acquisition, the purchaser adds up all of the risks and potential fines and “discounts” the exit price. Quite often the “discount” reaches up to 15-25% of the deal price, discussed previously. A pretty unfortunate surprise for founders, isn’t it?

To avoid situations like this, start-ups should take care of certain basic, yet vital legal questions on the early stages of their life cycle.

1. Structuring of Intellectual Property Rights

Recommendation: sign a contract to transfer IP rights to your company with every freelancer/contractor/employee who creates anything for your product (computer code, logo, design, texts, etc.). There is no doubt that your purchaser’s lawyer will ask you about each andevery IP object that your product has.

2. Audit of Open Source Licenses

Recommendation: make sure that your developers document every “open license” used in the software development. If your business model includes software distribution, and “open license” requires publishing the whole software code, such licenses can further cause additional costs for rewriting the code.

3. TM Registration

Recommendation: register your brand’s trademark early on to avoid becoming a “victim” of an unscrupulous competitor, who might “squat” your name before you and then register all similar domains on that basis.

4. Developing Customized Terms of Use for Website/App

Recommendation: do not copy Terms of Use from other websites. Not only because this can result in copyright infringement. First of all, such Terms may not comply with the laws of your place of business. Second of all, they will most likely lack relevant disclaimers that are aimed to protect you from unjustified claims. The right way to do it is to order Terms from a lawyer specifically for your business.

5. Specification of Privacy Policy

Recommendation: consult with a lawyer about specific rules for working with personal data in certain countries/regions your product operates. Some of them might limit territory for the data storage, the other impose additional disclosure obligation to be implemented in the Policy.

6. Developing and Implementing Internal Data Protection Policies

Recommendation: you need more than just a Privacy Policy to avoid fines from regulators. Due diligence also covers agreements with third parties with whom the company shares personal data and implementation of relevant internal policies regarding data breaches and how to deal with requests to delete personal data.

7. Signing Founders Agreement

Recommendation: fix all understandings and agreements reached between the founders before you start your company in the Founders Agreement. This agreement is similar to a “constitution” for founders: it covers the distribution of equity, founders’ roles, procedures for “on-boarding” new partners and exits of existing ones. The more detailed the agreement is – the longer and more productive the cooperation will be.  

8. Issuing Stock Options to Employees

Recommendation: develop motivation systems in the format of policies that document what employees have to achieve in order to receive a stock option or get the ownership percentage raised. The purchaser is often interested not only in your product but also in the team that is best positioned to further develop the company. This is why he/she will want to make sure the team is well motivated for future endeavours.

9. Corporate Documentation Structuring

Recommendation: before the exit, make sure all shares are distributed according to the Shareholders Agreement, all meeting minutes are dully structured and all necessary resolutions are filed with the relevant authorities.

10. Exposing All “Substantial Agreements” with Third Parties

Recommendation: when developing your startup, be cautious in promising contractor’s an “exclusive” cooperation, issuing “exclusive” licenses to your product or otherwise limiting your market expansion. Be aware, that your purchaser will ask about these – not disclosing such may result in heavy ‘penalties’ for founders.

Conclusion

Most of the start-up founders dream of an exit that would result in a fair compensation of their tough work. That is why getting a “discount” on the exit price when you are a one step away from a seven-digit deal is definitely not a pleasant scenario.

However, by following these simple rules above, founders would be able to easily provide all necessary information to the potential purchaser when the time is right and receive full compensation from the exit deal.

In one of our recent articles, we have reported that Legal Nodes legal experts have successfully supported Captain Growth AI due diligence for their acquisition for almost 3,75 million U.S. dollars.

In the next articles, we will get into specific details of tech start-up due diligence, such as privacy, intellectual property, and corporate issues. Stay tuned :)

Disclaimer: the information in this article is provided for informational purposes only. You should not construe any such information as legal, tax, investment, trading, financial, or other advice.

Nestor Dubnevych, Co-Founder at Legal Nodes