Four of Latham & Watkins’ leading emerging company partners in Silicon Valley, Luke Bergstrom, Tad Freese, Jim Morrone and JD Marple, recently hosted a webinar titled “Achieving Successful Outcomes as a Non-US Company Investing in or Acquiring Technology Companies in Silicon Valley”. The webinar can be viewed here.
In this blog we have sought to draw out some of the key observations in the webinar that are relevant to Middle East entities considering investing in US technology companies.
While many of the factors that influence the ‘investment in’ or ‘acquisition of’ technology start-ups is common to other types of companies, technology start-ups present their own unique challenges and opportunities resulting from either the long term goals of the founders or the motivation of the potential investors.
When dealing with a technology start-up, stakeholders should keep in mind (i) the key assets of the start-up and the due diligence focus and (ii) the key investment considerations and factors required for structuring a successful outcome.
Key Assets and Due Diligence Focus
The key assets of a technology start-up include its intellectual property, founders, employees and key customer relationships.
Depending on which asset the start-up derives its key value from, any due diligence exercise undertaken with respect to an investment should focus on such assets with an aim to uncover red-flag issues. More detailed due diligence exercises tend to be conducted in anticipation of full-blown acquisitions. Investors should also remember that start-ups will rarely have the required processes in place to provide timely and efficient responses to due diligence request lists. Instead, management calls often tend to be a useful tool in running the due diligence process.
An investor’s due diligence approach can also often colour how the founders and employees of the company envisage working with the investor and the investor should note this impact in determining and executing its approach to diligencing the relevant target.
Key Investment Considerations and Factors
Start-ups tend to be reliant on equity financing as debt finance is often not readily available. Founders will generally hold multiple fund raising rounds with each round providing capital sufficient for between 12 and 18 months and each new round of financing may involve new outside investors as well as the existing investors.
When investing in a technology start-up, it is important to identify the categories of existing shareholders as each will have different motivations that need to be considered as part of the investment process. For example:
- The Venture Capitalist: Venture capitalists tend to have a short-term investment horizon seeking the highest return for the lowest investment. They also prefer a clean-exit with minimal post-closing obligations.
- The Serial Entrepreneur/Founder: The founder is often the idea generator who dedicated time and commitment to the start-up. Serial entrepreneurs, however, often tend to move onto the ‘next big thing’, which can impact discussions relating to any applicable non-compete provisions.
- Employees: Employees of the start-up are often concerned with issues such as the opportunities available to them in the new organisation structure (which may or may not focus on the developed technology), their role and their compensation structure.
- Other Stockholders: Other stakeholders will be concerned with their return relative to their original investment and the types of obligations they are required to sign up to.
Along with identifying the categories of existing shareholders, it is also important to give consideration to those issues which most often necessitate negotiation between the parties.
The common areas of negotiation vary depending on whether the transaction is being treated as an investment or an acquisition.
In an investment, key areas of negotiation include:
- Governance Rights: Governance rights deal with an investor’s right to manage the company. Governance rights can exist in the form of board representation, observer rights or veto rights with respect to certain decisions.
- Transfer Rights: Transfer rights deal with an investor’s ability to transfer their shares in the company. For example, a minority investor may require tag-along rights pursuant to which if a majority investor sells their stake in the company, the purchaser will also need to make an offer to purchase the minority investor’s shares. Alternatively, a majority investor may have found a purchaser for his shares but the purchaser requires that as part of the sale, he also acquires the shares of the minority investors. Drag-along rights will enable the majority investor to ‘drag’ the minority investors into such sale.
- Rights relating to the Sale of the Company: These are similar to transfer rights and relate to an investor or founder’s ability to sell his shares in the company. For instance, some investors may require that the shares held by the founders of the company be subject to a right of first refusal whereby if the founder wants to sell his shares in the company, he must first go to the market and get a price for such shares and then allow the investor to step into the proposed purchaser’s position and purchase the shares at the agreed price. An alternative to such right is the right of first offer whereby before a shareholder can sell his shares to a third party, the shares must be offered to the existing shareholders of the company.
In an acquisition, key areas of negotiation include:
- Employee Incentive and Retention Mechanisms: These are types of management/key employee incentive schemes meant to incentivise key employees and management to remain with a business after an acquisition and can take the form of cash and/or equity payments.
- Purchase Price Structures and Formulations: A key negotiation point is how the purchase price will be structured and can include discussions around stock v cash payment to the founders, holdback and escrow arrangements.
- Indemnity Limitations: A full blown acquisition may involve the sellers providing certain indemnities in relation to the business which will result in negotiation around any caps and time limitations applying to such indemnities.
- Conditionality Provisions: A full blown acquisition may also be contingent on factors such as the accuracy of any representations made by the sellers, any material adverse effects on the business, any outstanding third party consents or other material factors unearthed during the due diligence process.
We also note that there are certain advantages of investing early in technology start-ups as opposed to making a full-blown acquisitions include (i) greater long term visibility over the team and product (e.g. access to reports, financial statements and board access); (ii) diversification of risk by betting on different companies in their infancy; (iii) early awareness of possible sale transactions; and (iv) the ability to act quickly prior to the final acquisition.