Emerging growth companies (EGC) bring new innovations and services to the economy – and opportunity to the capital markets. They also are sparkling, bedazzled targets for acquisition, fueling corporate and earnings growth.
By default, the DNA of the startup environment is high risk and (nose to the grindstone) high reward. However, regardless of the speed that the working teams want the deal closed, the acquirer the must cautiously evaluate the EGC’s technical and marketable “reality.” Deep, thorough due diligence will separate the real Unicorns from those creepy Thestral horsey-things from Harry Potter. (Google it)
This first phase of diligence involves the entire senior team: technical, accounting, marketing and legal. Our M&A quick overview sheet highlights the five stages of an acquisition, for both buyer and seller. Download it here.
Technical caveat emptor:
A fundamental and slightly paranoid review of the EGC’s technology, products or services is vital to guarantee that it delivers the products and promises as advertised. Also, the buyer needs to know exactly what it is buying… including IP. Most importantly, it is precarious to under assess the commercial practicality of the EGC’s offering.
If the acquirer’s goal is to purchase the business and assets, including the all-important intellectual property, the working team must be sure to know why they are considering the acquisition. Do not assume that because the target’s back-office and technology is tangible, that target’s offering fulfills a real need in the market.
With IP rights, it is core that a buyer evaluate the exact ownership details of the IP being acquired. Often the case with tech and pharma EGCs, they have incorporated specifically to commercialize technologies created by someone other than their founders and with third-party funding. All diligence into the IP ownership must begin with the IP’s originator to clarify the scope of their ownership and rights, including any ownership rights their employer has. If the originator developed the IP while utilizing the resources of another employer or a third-party, diligence of restrictive covenants need great precision to assure there is no IP infringement.
The buyers IP diligence should be conducted by technical and legal teams with patent and employment law expertise, especially if the IP was originated with grant monies, medical laboratories, university grants… including any rights of professors and students.
Diligence with a legal lens is essential to expose any possible obstacles to the target’s legal stance to be acquired – critical for venture capital-backed companies.
- Duly authorized and validly issued shares
- Share transfer restrictions
- First refusal rights and encumbrances
- Representations and warranties towards founders or key stockholders
- Indemnities or escrows
With financial due diligence, the buyer must dig deep:
- Additional research and development costs
- Product and service production
- Sales and marketing expenses
- Licenses and contractual obligations
- Market, competitive and pricing analysis
- Forecasting and budgeting
EGC, unicorns or not, often are generally built on a wing and a prayer i.e. short on resources. This may create a financial environment of unsophisticated if not creative accounting and reporting.
A great start-up can bring its acquirer into expanded markets with new products, services and hopefully a pipeline of “next gen” ideas. Proper, methodical business, technical and legal diligence is essential – not to reign in any enthusiasm, but to build upon it.