Common Legal Pitfalls in M&A: Ask a Lawyer with Alex Schmitt
Mergers and acquisitions present exciting opportunities, but they can also come with legal complexities that the parties need to navigate.
Alex Schmitt, Associate General Counsel at Perseus’ Zodiac Division shares some of his expertise on how parties can more effectively prepare for the M&A process, avoid common pitfalls, and help ensure a smooth and successful transaction.
What are some of the most common legal pitfalls that parties face during an M&A transaction, and how can they avoid them?
While every deal has its own stumbling blocks, one of the most common is the lack of preparation, particularly for due diligence.
Before committing to a deal, buyers need to conduct careful due diligence as to potential risks, what obligations will be assumed, the nature and extent of the business’ contingent liabilities, its contracts, intellectual property matters, and much more. These investigations typically include the collection and review of business documents, as well as discussions with management.
Sellers who are unprepared for this process often face delays, increased advisor costs, and added distractions from managing the business itself. All this can lead to deal fatigue and impede success.
It’s therefore crucial for sellers to take stock of diligence matters before diving into a transaction. Sellers should have their financials, contracts, tax returns and other key documents organized ahead of time to avoid disruption during the process. Where feasible, they may also wish to conduct internal “sell side” diligence to identify any red flags and correct or document any material deficiencies.
Are there any potential issues in particular that apply to transactions involving software businesses?
Some of the more common issues we encounter, and that sellers in this space often find helpful to proactively address, include:
Unclear or Problematic Ownership of Intellectual Property
Failing to take proper assignment of intellectual property (“IP”) rights in software code, particularly from consultants or contractors or in respect of joint development projects, can lead to ownership issues. To avoid complications during the deal process, sellers should confirm that the target business owns its intellectual property by ensuring that all material contributors have written agreements and auditing them, as well as those with customers, key vendors, and third-party code and SaaS integrations, for problematic IP ownership clauses.
Open-Source Hygiene
Improper use of open-source components in code can be similarly problematic and potentially expose a company to licensing risks or even forced code disclosure (e.g. through “viral” copyleft licenses like GPL). Sellers often therefore find it helpful to review their codebase for open-source issues (using tools like FOSSA or Black Duck), maintain and comply with an up-to-date open-source inventory and policy, and address—or have a clear plan to address—high-risk components.
Messy Cap Table or Option Grants
Inconsistent equity records, undocumented simple agreements for future equity (a.k.a. “SAFEs”) and convertible notes or unclear vesting schedules are another common issue for software businesses. It’s always a good idea to ensure that the capitalization table is reconciled and matches the company’s legal documents and that stock options and SAFEs are properly documented, board approved, and otherwise compliant with applicable corporate and securities laws.
Weak Data Privacy & Security Practices
Lax data handling or failure to comply with applicable privacy rules (such as HIPAA, GDPR, CCPA, etc.) can be particularly sensitive issues for companies with SaaS products, that collect sensitive data, and/or that operate internationally. For instance, GDPR fines can hit up to 4% of global revenue while data breaches or privacy violations can quickly become public and damage customer trust. It’s why we are always happy to see when a company takes managing its data security and privacy risks seriously.
Employee Misclassification
Finally, a perennial but potentially costly issue is the misclassification of developers and other employees, which can lead to back taxes, IP issues or employment claims. Ensuring your teams are correctly classified under applicable labour laws in always good practice.
Does each party need a lawyer to represent them during an M&A process?
Absolutely. It is critical for a successful M&A process that each party hire experienced and commercially savvy M&A counsel. M&A transactions often involve complex, multifaceted agreements and deal structures and challenging legal issues. They are typically fast-moving and can be contentious if not managed properly.
Even if the purchaser typically takes the lead in drafting the key deal documents, it’s essential for both sides to be properly represented. A good lawyer will help their client focus on the issues that matter, identify the key risks early, and ensure an efficient and smooth transaction overall.
Any final thoughts?
At the end of the day, both buyers and sellers share the common goal of an efficient deal process.
Getting your “house in order” ahead of time will help expedite the process. The better prepared the parties are, the fewer the unforeseen issues, and the faster the transaction can close.
The most crucial advice is to hire competent legal counsel. A knowledgeable lawyer will make the entire process much smoother by providing practical guidance and enabling their client to stay focused on the issues that matter most.
With the right preparation and counsel, parties can navigate a transaction efficiently and with confidence.
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