The Big Four Due Diligence Issues – (from the buyers side)
I have been the part of over thirty transactions totaling more than $4 billion; most of them were purchases where I represented the acquiring party. When we started the due diligence for the deal we would typically look for certain things and expect to find problems in a few areas. A few of the problems could kill the deal, most would have to be corrected to move forward and some required steep escrow funds to give us enough comfort to move forward. Here are a few of the things that caused our due diligence team to raise the red flag:
- Messy Capitalization Tables – by messy I mean a wide variety of equity issues – warrants, options, common, preferred, convertibles, and more. Often you would find from reviewing the company’s legal agreements that there would be a vendor who could lay claim to having warrants or other equity of some type. I actually found on several occasions where a provider of broadband bandwidth would have warrants as part of their standard agreement and ding dong business types would always miss that they were giving equity away. Now that was expensive! In another instance the founder’s ex-husband held a portion of the company and the divorce decree was not specific to the equity and the matter was complicated because he was the patent holder to the company’s great technology. Very messy.
- Messy Contracts – The thing that can sink a deal the fastest is screwed up contracts. Contracts that give most favored nation pricing. Contracts that give licensing of technology to or from other companies. Contracts that have no assignment rights. Contracts that have “change of control” provisions. I had a deal blow up (Billion dollar deal for that matter) due to a contract that gave an unrestricted license of not only the company’s technology on a change of control but also the acquiring company’s technology.
- Everyone gets rich on the deal – It is expected that people should get rewarded for their efforts – that is why entrepreneurs set out on the dangerous road of a startup. The problem happens when all the key people – needed to extract the value from the company make so much money from the deal that they have little or no incentive to continue after the transaction. I had one deal actually go through where each of the key management team members were paid well and no one was left standing after the deal was completed. The CEO went missing in action. The kid was 23 years old and my acquiring company handed him $23 million. What did we think was going to happen! We had to fire him, once we found him on a rented yacht in the Caribbean. If there is no one left to man the ship the ship does not have much value.
- Messy rights to invention – In technology I have experienced companies where you have a difficult time substantiating the company’s claim that they actually own the technology that is the key to the value. This usually comes about because the company does not ask its engineers to sign what is called a “right to invention” agreement. These agreements establish that what the employee creates while employed by the company is owned by the company. I had one deal where a former employee claimed ownership rights to the company’s flagship product and the deal did not go through until the current owners reached an agreement with the employee, signed a large escrow agreement, and warranted to more than the deal value that they owned the technology.
Four main areas to think about if you are trying to sell your company. Keep the capitalization table as clean as possible. Watch your contracts and keep in mind that you can actually damage your company’s value by agreeing to whacky terms. Develop a transition plan and make sure you own your key assets. Do all of these and you should protect the value you worked so hard to create.