Introducing Startups & Entrepreneurs to legal due diligence (Part 1)

In statesmanship, get the formalities right and never mind the moralities. - Mark Twain

An interesting parallel can be drawn between the worlds of statesmanship and entrepreneurship. Given the only constant – change, it is quite logical that in either world, the players would desire change for the better – that is growth. Growth is life – as the famous Reliance motto says. Indeed it is so, because that's where the money lies. Godzilla's tagline, 'Size does matter', seems to be the trend of the day.

Corporate growth can be of two types – organic and inorganic. Corporates can opt either for the greenfield path or the brownfield one. Greenfield projects, though they may be cheaper, often take time to implement. On the other hand Brownfield Expansion - which involves buying an existing company or asset, facilitates a quick entry into a new market segment and helps the acquirer to hit the ground running.

The IT Boom in India has heralded the era of startups. IT professionals with 3-4 years of work experience are getting more and more adventurous as they leave the comfy environments of the mega corporates and hit the road with their startups.

While few startups may go on to become the Google or Facebook of the future, most will inevitably become the target for brownfield expansionism by mega-corporates, who will offer lucrative sums to get hold of their businesses.

In order to achieve a quick and smooth takeover, it is important that the management of the startup streamline their processes in order to facilitate a quick and efficient due diligence process by a potential acquirer. The due diligence is typically carried out by legal professionals employed by the acquirer. Due diligence may be carried out by as few as two persons or as many as twenty or more. A due diligence team will examine various aspects of a target company such as licenses and permits, litigation, intellectual property, revenues, debt position and very importantly, deal breakers.

Steps for Initiating Due Diligence (DD)

The Non Disclosure Agreement:

It must not be forgotten that the final decision whether to acquire a company or not is taken only after the DD process is completed and a clear picture of the state of affairs of the target company is presented to the acquirer. During the DD, the entrepreneur will be revealing confidential information such as revenues, ownership structure, technological secrets and other information which could compromise the integrity of the enterprise. To prevent any leakage, it is an absolute must that the entrepreneur enters into a non-disclosure agreement with the prospective acquirer which will bind him and his appointed agents (his lawyers for DD being among them) into keeping such details confidential. The entrepreneur will have to maintain a balance between sharing adequate information with the acquirer and safeguarding his corporate secrets.

Setting Up the Process

The 'Data Room' in legal parlance, refers to a place, physical or virtual, where all the relevant documentation of the company would be available for inspection to the DD team. It is advisable to set up a secure file account on a server where all documents can be uploaded in digital format. This will result in enormous savings in the form of boarding and lodging expenditure for firm employees, who otherwise may have to travel in from outstation for the task.

Another advantage of a virtual data room is that it can be accessed by multiple parties. In case four companies are bidding for a startup, then all of them would like to send in their DD teams to examine whether the target is worth bidding for or not. A virtual data room will erase the need to make four separate document copies for each of them.

Detection of deal-breakers

“Black holes” in the form of undisclosed risks, hidden liabilities or onerous commitments are latent in most acquisitions. Every lawyer doing due diligence will look into this first. A deal-breaker is a situation which makes the entire DD unnecessary. A simple example of a deal breaker can be illustrated in the form of an advocate starting a business.

Therefore, any legal team will first probe for deal-breakers – certain factual circumstances which can make the entire transaction fruitless. Examples of deal breakers could be conflict of interest on part of director, or the declaration of the business carried on by the startup business as illegal. A deal-breaker renders the transaction pointless. Therefore law firm associates will probe for deal-breakers first. They find no point in detecting them after completing the entire DD process. The DD proceeds ahead only if the target business is found to be free from deal-breakers.

Litigation History

This is probably one of the most important aspects of the due diligence. It is advisable for a startup to avoid litigation as much as possible. Litigation casts a cloud over the legitimacy of the enterprise and its people. It hangs like the sword of Damocles over the head of the entrepreneur, waiting to fall at the whim of the judge.

An entrepreneur must avoid widespread litigation while doing DD of litigation. The team will typically set a threshold amount, say rupees three lakhs. Claims above this limit will be described in detail, whereas those below will merely be mentioned in a table and their claim values will be added up. Excessive litigation has the potential to sink the deal.

Restrictive Covenants

An entrepreneur who is the target of a startup acquisition must be careful of any agreements which involve restrictive covenants. A 'Restrictive Covenant' is a clause which places restrictions on the owner's ability to transfer his interest in the business. For example, some aircraft leasing agreements stipulate that after the aircraft has been leased, the lessee(or the company which has rented the aircraft) cannot sell any stake to a third party without approval from the lessor(the company owing he aircraft). Such agreements, if left undetected, can have a devastating effect on the new entity after takeover.

Licenses & Permits

Licenses are not to be taken in the ordinary sense of routine procedure. The DD guys will definitely do a cross-checking of what is mentioned in the documents vis-a-vis the actual scenario. If you have got a license for any business activity, they will verify that your operations are in conformity with your license and that you have not strayed beyond its stipulations. Their quest for information won't stop here.

The DD team will still further inquire into whether you have made any attempts to renew the license and if you have done so, what is the status of the renewal application. Having charged their clients a bomb, they won't hesitate to drill their deepest into your organisation, fishing out the minutest of details and probing for the smallest of glitches.

Roundup

All said and done, the buzzword is simple: get your formalities right! Diligently maintain and index all records and papers. The lawyers doing the DD will not show you any leniency. They are paid by the acquirer and will engage in ruthless transparency. Therefore, the entrepreneur is advised to maintain his integrity and cooperate to the fullest. Cater to their demands adequately, for non-cooperation can result in a negative opinion being delivered to their client.

This is a guest piece by Aditya Singh. Do let us know what you think of this story by writing to us at [email protected].

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