Deal Makers or Deal Breakers? How Commercial Contracts Can Impact M&A

In a startup’s early years, securing customer deals and negotiating key vendor and partner agreements are big priorities. Done right, these deals give startups both the foundation and the momentum they need to grow and meet key growth milestones. But there are risks, both actual and perceived, in these commercial contracts, and they can have serious unintended, and long-term consequences for your business if not identified and addressed.

In the context of a financing or an exit transaction, an investor or an acquirer will perform due diligence on your contracts to determine the related risks and help them value your company. As a result, you should keep in mind future due diligence when negotiating key provisions in your commercial agreements.

Understanding Risk Perspectives

When negotiating commercial contracts, you should always consider your risk profile to determine what terms and obligations you will agree to in a contract. When an investor invests in your company, they will become partial owners, and their risk profile and willingness to take on certain risks in a contract may not align with your risk profile. Similarly, an acquirer of your company will likely be taking on all the risks created by your contracts.

Both investors and acquirers will have attorneys help them review and analyze your contracts to determine risks related to your agreements. The attorneys that you use to help you negotiate your commercial contracts should be aware of and be able to advise you on other attorneys’ possible perspectives related to your agreements from a future due diligence standpoint.

Reasons for Conducting Due Diligence and Intellectual Property Representations

An acquirer of your company is buying your intellectual property (IP), among other things. The risks related to your intellectual property will become the risk taken on by your acquirer. A buyer conducts due diligence for technical, legal, and financial analysis of the seller’s technology, and underlying intellectual property. They are looking for “red flags” from the buyer’s perspective related to ownership, license rights, and protection of the intellectual property (including confidential information), assignability of the IP, and ability to integrate the IP into the acquirer’s company.

Knowing the issues that a buyer will see as a red flag and handling them appropriately ahead of time can prevent these red flags from derailing a deal (permanently or temporarily) or giving the buyer leverage to renegotiate the economics of the deal (to seller’s detriment).

In an M&A deal, the contract between the buyer and the seller will likely include some form of the following seller IP-related representations. By negotiating the terms of your commercial contracts with IP representations in mind, it will be much easier for the seller to make some of the representations required by a prospective buyer in an exit transaction. Exceptions to these representations will require the seller to create schedules listing the exceptions, which can complicate negotiations and may be unfavorable to the seller.

• The company has listed all the intellectual property and intellectual property rights the company owns:
  • Patent registrations and patent applications
  • Trademarks both registered and unregistered
  • Copyright registrations
  • Material software
  • All other material intellectual property
• The company has listed all the material intellectual property the company in-licenses.
• The company owns all its owned IP.
• The owned IP and licensed IP used in connection with the company’s business.
• The company has not licensed its core IP to any third party (excluding licenses as part of seller’s business).
• The company has not infringed the IP rights of any third party.
• The company doesn’t know of any third party that has infringed the IP of the company.
• The company has taken reasonable steps to protect the confidentiality of the company IP.
• All material IP developed by the company was developed by employees or contractors who have assigned all their rights, title and interest in and to all such IP.
• The company has listed all open-source software that the company incorporates into its IP.

For example:

• Making sure that when you hire a non-employee contractor, you have in place agreements that include provisions expressly assigning the IP and IP rights to the company will make it easier to make a representation that the company owns all of the IP that it will be assigning to the buyer.
• Having NDAs and confidentiality provisions in place with potential customers, customers and other third parties with whom you will be sharing confidential information will allow the company to make the representation that the company has taken reasonable steps to protect the confidentiality of the company IP.

Business System Representations

In addition, an agreement in an M&A transaction will likely also include some form of the following representations regarding the company’s systems and data security. It’s important to ensure that these elements reflect what you actually have in place, and don’t commit you to provisions that are inconsistent or difficult to maintain:

• The company has in place all contracts, assets, and other rights that comprise or are used to operate or maintain the company’s current business systems.
• The company’s business systems have not suffered any failures during an agreed upon past number of years that caused any substantial disruption or interruption or caused the company to incur substantial additional costs or expenses to avoid such a disruption or interruption.
• The company has in place commercially reasonable security, disaster recovery and business continuity plans and procedures with respect to its business systems.
• The company has taken commercially reasonable actions to protect the security and integrity of the company’s business systems and the data stored therein.
• There has been no unauthorized access to the company’s business systems or such data.
• The company has implemented commercially reasonable procedures intended to prevent unauthorized access and the introduction of any virus.

Understanding early in a company’s existence what a buyer will be interested in and concerned about during the M&A process will give that company meaningful insight in how to draft, structure and negotiate its commercial contracts to future-proof them from major red-flags.

Get Good Advice 

Hire an attorney who specializes in business law for early stage and growth companies and can help you properly structure commercial contracts that enable growth now, and protect you later. While a generalist might seem like a cost-effective alternative, there is a higher likelihood of a non-specialist missing something, and the consequences could be substantial. By contrast, an expert who understands your business priorities now, and can help you anticipate and minimize future risks can serve as a valuable advisor for years to come.

Additionally, consider spending the time earlier in the company’s life creating good forms for your higher volume or important contracts.  Having contracts that are vetted and approved is a terrific tool to help avoid signing contracts that will catch the attention of a buyer for all the wrong reasons. As they say, an ounce of prevention is worth a pound of cure.