By René Paula
At a certain point in the life of a successful startup, entrepreneurs evaluating their next steps might decide that it’s time to sell to a larger company. As part of the “due diligence” process for a sale, the purchaser will look for a few key elements in the startup to determine whether it is a viable choice for acquisition. Many startups run into a common handful of problems at this stage.
Here are my top five key things that a startup needs to get right for a successful sale.
Equity ownership split among founders, employees, and investors: This may seem obvious, but many companies have issues with proper documentation for their outstanding equity stakes. There are often undocumented promises of equity to co-founders and employees or unclear expectations about equity among friends and family who supported the startup in its genesis. This can lead to negative tax implications for everyone involved—not to mention difficult conversations while you’re cleaning up the mess.
Company ownership/lease of its assets: In the early stages of a startup, the website, logo, or other elements of the company are often created by family and friends. Other times, you’ve borrowed assets or found a physical space to use for free while you’re launching your company. Regardless of how things are working, it is important that every aspect of the startup’s operation is somehow documented. A purchaser needs to understand what would be the true run-rate for the business by assessing the current state versus what would be required to run the operation without freebies from friends and family.
Intellectual property issues: Dovetailing with the previous point, a startup needs to make sure that every element of the startup actually belongs to the company. For example, a brewery needs to own not only trademarks and logo designs but also recipes, trade secrets, techniques, and more. This means that every employee and consultant of the company should sign an Assignment of Inventions agreement. This document states that the company, not the individual, owns the intellectual property. Making sure this is done from the very beginning can decrease the stress of having to track down former employees or consultants who might hold up the deal through an ownership challenge.
Exclusivities, noncompetes, sole-source suppliers, and anything that limits a potential buyer’s decisions on how to run the business: A startup needs to make sure that its contracts with suppliers are in order and won’t hinder the buyer’s growth plans. If, for instance, a startup brewery signed an exclusive purchase agreement with a particular bottle supplier, it might restrict a purchaser from scaling up its bottling operation, thereby limiting its value and growth potential.
Change of control provisions: Many standard contracts include “boilerplate language” stating that the contract cannot be assigned without all parties’ consent. That may become a huge problem down the road if a startup relies on a sole-source supplier (the producer of a proprietary food ingredient, for example) that then holds out consent to assign the contract. This could severely hinder or even kill the deal. It also exacerbates deal-leak risk if you have to start talking to counterparts to get their permission to do a transaction. This is how confidential deals end up publicized in TechCrunch and The Wall Street Journal. My advice to all startups is to avoid change of control provisions to the extent possible.
In the end, the key point for a startup is ensuring that every decision and agreement is properly documented. Since M&A lawyers view potential deals largely through a risk-mitigation lens, proper documentation helps to lower the buyer’s risk, thereby increasing the chance that a company will be interested in acquiring the startup.