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What Startup Founders Wish They’d Done Before the M&A Deal

I recently moderated the Mergers and Acquisitions panel at the annual meeting of startup founders from Europe and the U.S. backed by Bertelsmann’s Digital Media venture fund, which  our law firm represents. While the discussion covered numerous topics, I was struck by how many questions our panel received when we ticked through the litany of the most common mistakes we’ve seen founders regret during M&A deals.

Interestingly, few of these mistakes had been made during the deal. Rather most would be filed under “ounce of prevention/pound of cure” because they’d been made long before the deal. Our panel consisted of a founding CEO and a CFO from two different companies that the fund had backed to a successful sale of each of those two startups, as well as an M&A investment banker (formerly a VC). There were definitely times when either the CFO, the CEO/Founder and/or the banker nodded and uttered something to the effect of “we did that” in response to mentioning these issues, however, I am not attributing these problems to any specific company, founder or fund.

Scraps from the cap table 

All too often, founders or management have promised equity to executives without having executed on that promise. I had one day in the last month in which this issue arose in three separate new M&A deals and a venture deal. While this issue emerges regularly, four new instances of it in one day is way more than usual.

Failure to document equity grants raises a few issues. The price at which you can grant equity will change over time due to tax issues, including the marvelously complex and non-intuitive rule 409a of the tax laws, which I’ve previously written about in the startup context. As you near a financing or a sale of the business it will become very difficult if not impossible to give equity to your employees or consultants or at least to give them equity in a way that captures the value the startup had way back when you had promised them the equity. It’s easier to give the employee equity at the deal price in a sale of the company but that also means the employee isn’t making any money on the sale. This ends up depriving the owed employee of the value she was promised. Acquirers don’t love being saddled with the problem of having to re-equitize these employees and they certainly view it as mismanagement when the founder’s failure to follow through on promised equity grants results in disgruntled employees, especially if the acquirer believes that the employees will resent the acquirer as much as they resent the founders.

In some instances, the founders have made the promise but have failed to inform the board and it becomes a board problem, resulting in some fairly unhappy board members. In venture-backed startups, the board largely consists of the same people who collectively own enough of the company to have a true say in matters, so upsetting those folks is a misstep on multiple levels.

Acquirers typically solve these problems by taking the new equity or cash out of the purchase price, which results in more dilution to everyone else than likely would have been necessary had the stock or options been granted when promised. In addition, acquirers also get a little anxious about the rest of the capitalization table – if this problem was out there, what else did the team get wrong and are they ‘sloppy’? This often leads the acquirer to do a deeper dive into due diligence (I’ve previously written about pause points in diligence), which can create a bit more friction in the deal and consume more of the founder’s time and more of the deal team’s time.

Intellectual property up for grabs

Pretty much every venture deal is conditioned on the founders and employees signing agreements that convey the intellectual property to the company. “NDA/IP Transfer Agreements” (non disclosure and intellectual property transfer agreements) are documents which give the company whatever rights the employee had to the intellectual property. These agreements also contain representations from the employee that, for instance, she or he didn’t infringe or violate prior employer’s rights in creating and transferring this intellectual property. Absent the NDA/IP Transfer Agreement signed by the creator of intellectual property, there can be questions about who owns it or at least as to who has the right to use it (even with patents (which I wrote about years ago in the New York Law Journal). Sometimes, founders conclude that employees who are not part of the technical team need not sign these. Other times, founders just delay signing them and the relationship has now soured to the point of being unable to get them signed. We watched a CTO hold up a company for quite some time because the founder had operated on a ‘handshake’ and had misjudged the CTO’s willingness to grant the company the IP rights – imagine a job interview in which the startup said “if you come here as our CTO, will we get to own the intellectual property you create for us?” Now imagine the CTO saying “no you won’t.” The CTO had his side of the story, which was that the founder had promised equity and had been very, very late in getting it papered. Things devolved from there.

Not only does non-technical staff need to sign these NDA/IP Transfer Agreements, but often they create intellectual property that people don’t always consider to be important intellectual property. For instance, your startup’s business plan and logo are ‘intellectual property’ and you’d far rather not be fighting over those with a disgruntled former employee or with the friend who you took out to dinner a few times to thank for creating your logo (but with whom the founder never documented logo ownership).

When the startup is very new, people often rush to register a domain name and do so in their own names rather than in the startup’s name, especially if the registration predates forming the entity. We’ve negotiated to buy domain registrations in venture and M&A deals because people had forgotten that the departed founder had registered it personally and hadn’t signed an NDA/IP Transfer Agreement.

Cut & paste

We had a situation recently in which the founders had done a great job getting every single employee and contractor to sign the NDA/IP Transfer Agreement. As in most deals, they said that the company would be “clean from a diligence perspective” on that issue (and others). When someone actually read all the forms, however, it was clear that while they had signed up everyone, only the first several dozen employees had signed the right form. At some point along the way, someone had used the wrong document. While this new document may have had some legal impact, it certainly didn’t accomplish locking down the intellectual property. This document had then become the template for all new hires in the company (and some of those employees undoubtedly took it with them for use in new startups). In order to close the deal, the company had to move swiftly to get new signatures from well over 100 employees.

This also raises an interesting question as to whether in the given state in which you are employed, must the employer provide new additional consideration (like money) in order to have employees who are already working for the company to sign over rights like this? In New York, continued employment is enough, assuming the employees are “at will” employees (meaning that the employer can terminate the employee without having to establish just cause and can do without notice). In some states, it may not be enough and you’d actually have to provide value to the employees in order for the document to be binding on the already hired employees.

We sometimes think of this as the “Prego Sauce” problem. In the 1980s, Prego ran a series of classic ads, like this commercial, in which a home cook kept exclaiming to a doubting parent or guest “it’s in there” to assure them that Prego sauce was just as good as homemade. I recently began representing a client in a co-founder dispute and was told that the original equity holder documents contained a grant to the company of all intellectual property rights: “it’s in there,” the CEO told us. Well, it wasn’t…not even a little. So while Prego may be just as good as homemade sauce in your house, it isn’t in my house! Acquiring company’s counsel will check and double check and if your form was a cut and paste, it is likely to cause problems.

We’ve seen this especially applicable to privacy policies and terms of use. Startups often crib the text of these from web sites of companies they admire or at least resemble. That’s a pretty big mistake as the privacy policy has to explain your actual practices, rather than what another company is actually doing with personally identifiable information, for example.  Again, no Prego sauce here, you do have to make this one yourself!

There are plenty of other issues like the failure to enter into a stockholder agreement with a drag along clause, but that’s a topic for a future column!

This article was written by Ed Zimmerman from Forbes and was legally licensed through the NewsCred publisher network.

The strategies mentioned in this article may often have tax and legal consequences; therefore, it is important to bear in mind that First Republic does not provide tax or legal advice. Investors’ tax and legal affairs are their own responsibility and readers should consult their own attorneys or other tax advisors in order to understand the tax and legal consequences of any strategies mentioned in this document.

The views of the author of this article do not necessarily represent the views of First Republic Bank. 

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