How to buy a tech startup to bolt on to your company

6 things you need to know if your company is acquiring a technology startup. John Kirkwood looks at potential pitfalls

How do you buy a tech startup? Increasing numbers of non-tech companies are acquiring tech companies in a growing trend for M&A transactions. The reasons vary from sector to sector, but some common commercial drivers are:

  • Even if a company is not a traditional tech company, more and more businesses find they need a technology offering to help them stay competitive, and the fastest way to obtain a technology solution, together with a skilled tech workforce, is often by acquisition.
  • A business may rely on a key software product that it has developed/commissioned in collaboration with a third-party software developer. In order to protect the IP and have more control over its ongoing development (and to keep it out of competitors’ hands), buying the software developer is often an obvious solution.
  • Customers are requiring a more joined-up service offering/one-stop-shop. A telecoms company for example, which also provides IT support and increasingly cloud hosting services etc. can market itself as a total solutions provider, and so reduce the need for its customers to procure these services separately.
  • Businesses are looking to diversify their operations, particularly companies working in traditionally high volume/low margin sectors, such as hardware manufacturing. Acquiring a software business can offer a fast way to grow the bottom line and/or increase recurring revenue streams.

To help the transaction process run smoothly, it helps if the parties selling the company are as organised as possible. This speeds up the due diligence phase of the transaction, and, if the sellers have identified and hopefully resolved any issues at an early stage in the process, it gives the buyer confidence in what it is acquiring.

In a tech transaction, there are a number of common areas of concern that regularly arise during the legal due diligence process:

Inaccurate statutory books/records of shareholders

As a significant number of startup tech companies go through several investment rounds before they are sold to private equity or a trade buyer, there can often be a wide shareholder base with shareholders having invested in different rounds at different levels. For small, but fast-growing companies, the focus is usually on the day to day operations of the business, so accurate record keeping (cap tables) and following correct legal procedure to issue new shares, are often overlooked. While most issues can be rectified, it can take time as well as an added layer of costs that wouldn’t be necessary if a little more time was taken to get things right first-time round.

Employment contracts

Do key staff have market confidentiality and restrictive covenant provisions appropriate to their importance to the business? In addition, are the intellectual property provisions sufficiently well drafted to ensure that the IP the employee develops in the course of their employment belongs to the company? While startup companies where the shareholders know and trust their workforce (and vice versa) might take a relaxed approach to this, a third-party buyer is likely to take a different view.

Contracts with third-party suppliers

Again, are these sufficiently well drafted to ensure that the intellectual property for the work the supplier produced transfers to the company that commissioned it? This is not just an issue for smaller companies, we have seen plenty of larger businesses fall foul of this, especially when dealing on standard terms and conditions, which don’t always follow the commercial intentions of the parties.

GDPR compliance

Although this is very topical at the moment, it is surprising how many businesses still have looking into their compliance obligations on their “to-do list”.

Open source software

Some open source software is subject to “copyleft” licences. If that “copyleft” code has been used by developers in proprietary software, technically this can require all of that proprietary software to be made available on an open source basis.

Customer licence agreements

Buyers will want to ensure the customer agreements they will be subject to are not too onerous. Broad indemnities, escrow arrangements, or perpetual licences can all be red flags for a potential buyer.

As with any acquisition, acquiring a technology business does not come without its risks (see the ongoing Hewlett-Packard dispute regarding its purchase of Autonomy – although this is very much the exception), and these can be amplified if the acquirer does not operate in the same sector as the target business.

Working with advisors who are experienced in the tech sector and undertaking a thorough due diligence process can help mitigate the deal risks.

Equally as important is gaining an understanding of the ethos and culture of the target company, as tech businesses often have very different ways of working compared to some more traditional businesses.

John Kirkwood is a senior associate at Cripps Pemberton Greenish