Automotive technology (“auto tech”) has become one of the hottest and most innovative sectors. The question “Where are the flying cars?” was famously but unsuccessfully raised in an IBM commercial in 2000. It seems to have been answered now: Uber plans to test fly its car designs in L.A. by 2020 and launch a commercial flying car service in 2023. The range of technology in the auto tech sector seems to be unlimited. At least four sources of change are currently sweeping across the industry: electric vehicles, autonomous vehicles, connected cars and personal mobility services. The auto tech market is growing. An Allied Market Research study recently concluded that the global market for autonomous vehicles will be worth $54.23 billion in 2019 and increase to $556.67 billion by 2026. So, with the flying car well underway, the more relevant question is: Where are the investment opportunities and how to succeed in their realization?
Numerous stakeholders are involved in the auto tech market. Major OEMs and suppliers are focusing on developing and integrating high-tech features into their products and aim to reposition themselves as mobility service companies as opposed to carmakers. Major tech companies, such as Google, Apple, Microsoft and Amazon, are focusing on developing auto tech. Simultaneously, OEMs and technology companies enter into strategic partnerships to integrate technology into cars and finally, a growing number of auto tech startups is driving innovation. This all creates a highly active investment climate.
VC Investments: A few years ago, it was difficult to find a VC-backed auto tech startup. This has significantly changed: there has been a sharp increase from 20 auto tech investments in 2012 to over 100 in 2016. In 2018, Vision Fund led a $1.9 billion funding round in Manbang Group and a $2.25 billion funding round in Cruise Automation. Investments have come from a growing number of auto tech-focused VC firms as well as big automotive and high-tech companies.
M&A Deals: The automotive sector has experienced a robust M&A activity for decades. However, it was rare for OEMs or suppliers to acquire an early stage company for its technology and for technology companies to acquire automobile-focused companies. This has changed significantly. In the German market for example, Tesla acquired Grohmann Engineering for more than $100 million and Daimler bought 60% of Hailo, a ride sharing company, and merged it with MyTaxi, another ride-hailing company, creating one of the largest ride hailing companies in Europe.
Typical deal drivers in auto tech transactions
As is typical for most technology savvy businesses, the value of a target company’s business in the auto tech sector is most often determined by three key factors:
- its technology,
- its intellectual property rights, and
- its key personnel.
The value of the business depends heavily on its technology, its intellectual property rights (“IP rights”), in particular available copyrights and patents, and the possibilities for their commercialization. Additionally, the key personnel are also a highly important contributor to the value of the business. In most cases, this includes the founders for their in-depth knowledge of their business and its technology as well as the key engineers as developers behind the target’s technology, especially any of its proprietary software. Potential investors are therefore typically on the lookout for these value drivers.
How to protect the value of auto tech deal drivers
Any investor should seek to ensure these value propositions hold true and protect these deal drivers at least on two levels. Firstly, it should carry out a technology and IP centric technical and legal due diligence. Secondly, it should aim to negotiate a deal which protects as much of the value associated with these deal drivers as is possible. The latter will require that the investor achieves a reasonable level of comfort with a view to the representations, warranties and indemnities the seller provides regarding the technology and IP rights to be sold and that the investor succeeds in maintaining the key personnel on board after the transaction is completed. This is crucial given that the talent shortage in the digital economy is only increasing.
Carrying out auto tech due diligence
In any due diligence process preceding an investment in the auto tech sector the investor will consider in particular the following:
- Ability to integrate into investor group: A strategic investor will typically examine how and to which extent it can successfully integrate the target company’s technology into its own technology and will usually be less interested than a financial investor in a simple gain of revenue or market share.
- Interoperability with investor technology: The strategic investor will also assess the interoperability of the target company’s technology, products and services with its own as to avoid costly adaptations and evaluate their positioning in the market.
- Regulatory issues: Investors will assess whether there is sufficient potential to distribute the company’s technology in target markets. For example, the development of autonomous vehicles is still held back by a restrictive legal framework internationally. Whereas Germany has amended its Road Traffic Act in late 2017 to enable the operation of highly or fully autonomous vehicles in Germany, there are no firm federal rules in the US governing testing self-driving cars on public roads. However, 33 US states accommodate self-driving cars on public roads.
- No privacy law violations: If the target company is doing business in jurisdictions protecting privacy and is processing personal data, especially in a manner material for developing or using its technology or doing its business, investors will closely look at the target company’s compliance with applicable privacy laws such as the Californian CPA or European GDPR. Legal consequences of non-compliance, e.g. fines, may be severe for the target company.
- Clear chain of title: The target company must be able to demonstrate a clear chain of title to its IP rights. This is a requirement of the investor to ensure its investment results in the legal and economic benefit of owning existing IP rights. If, e.g. the founders have filed applications for IP rights, it should be verified that the target is actually the holder of these and not the founders.
- Sufficient protection of IP: The target company must have sufficient measures in place to protect its IP and IP rights in its technology, e.g. no IP should have been disclosed to third parties.
- No problematic use of open source software: Many companies use open source components in their own software development, which means that the terms of the respective open source license agreements apply. The use of certain open source code, and the violation of certain open source code license terms, can create a significant risk. Investors will particularly assess if the target may be affected by any so-called “copyleft” effect. This effect ensues where the target company developed technology (or derived products therefrom) using items of open source code in respect of which the applicable open source code license terms restrict the future use of the technology so developed (or product so derived). Under such license terms companies might also have to distribute their own products at no charge which prevents commercial distribution. Use of open source components may therefore reduce the commercial value of a target’s intellectual property, and hence, have a detrimental effect on the value of the target itself. Any investor should therefore carefully review whether open source software has been relevant to the development of the target company’s technology, and if so, review applicable license terms and assess whether the future intended use of the technology post-closing may breach such terms. Should that be the case, the investor should determine how material this is, if there are workarounds available and how the issue may impact the timing of the investment process and the financial valuation of the target company. The target company should be aware of any open source components used in its code base and how any resulting license obligations may affect the commercial distribution of its products.
- Employee and contractor works and inventions: Special laws apply to employee and contractor works and inventions in any jurisdiction. It should be verified that the target company holds at least comprehensive use rights over these works and inventions in accordance with such laws.
Negotiating the auto tech deal thoughtfully and getting the deal done
Assuming the due diligence process is completed bringing to light only such risk which is manageable by contractual agreement, getting the deal done will require the investor to negotiate thoughtfully and to compromise on an agreeable allocation of risk.
The investor can and should typically expect the seller to represent and warrant in the investment agreement as to the legal and beneficial ownership and to the absence of encumbrances regarding technology, including in particular any computer systems and proprietary software, and IP rights which the seller indicates as owned by the target company. Moreover, the investor can and should expect the seller to represent and warrant as to the (unrestricted) availability of technology and IP as well as comprehensive use rights necessary to consistently carry on the target company’s business post-closing. Furthermore, the investor would usually require the seller to represent and warrant in principle to the absence of infringements, and related claims, of IP rights, i.e. those of third party IP rights by the target company and those of the target company’s own IP rights by third parties. However, the investor should understand that a seller would usually not commit to representations and warranties regarding any integration ability or interoperability of its technology on the end of the investor, as it is unable to assess them. The investor has to address respective risks and opportunities in the course of its technical due diligence.
Beyond these basic considerations, the investor seeking to negotiate a deal which protects as much of the value associated with the auto tech deal drivers as possible, should aim to also obtain representations and warranties relating to the following aspects:
- Adequate protection: The seller should represent and warrant as to the adequate protection of the target company’s technology and IP as well as its confidential information, in particular the non-disclosure to any third parties. If proprietary software is available, the seller may e.g. warrant that the target company is in possession of a complete copy of the source code for each item of its proprietary software, and that only authorized persons have been in possession of the source code and no escrow agreements were in place granting third parties access to it.
- Functionality: A representation and warranty as to the functionality of the target company’s computer systems would encompass a warranty that over a certain period, even beyond closing, there were and will be neither any malfunctioning nor any viruses or other software or hardware components in the target company’s technology that permit unauthorized access, disabling or erasing software, hardware or data.
- Compliance with privacy laws: If the target company processes personal data, the seller should represent and warrant as to the compliance of the target company with applicable privacy laws. Depending on how material the processing of personal data is to the business of the target company, this may be a lean and qualified compliance warranty, or a more detailed one spelling out specific compliance requirements. These requirements may relate to the target company’s processing activities, such as collection, storage, use, disclosure and transfer of personal data, any appropriate technical and organizational data protection measures, such as concluding data processor agreements or appointing a data protection officer and recording of processing activities, and any dealings with data protection authorities and data subject information requests etc. While it may be controversial whether spelling out specific compliance requirements increases the enforceability of a general compliance warranty, the specification will usually assist in pointing the investor to areas of concern of the seller and facilitate a proper negotiation of the risk allocation intended between the parties.
- Adequate protection: The seller should represent and warrant as to the adequate protection of the target company’s IP rights, in particular, as to their orderly registration and maintenance of these registrations in applicable IP registers.
- Open source software: Depending on the relevance of this issue (see above), the seller should either represent and warrant that no open source software is contained in the business critical or proprietary software of the target company and no respective restricting license terms apply. Alternatively, the seller should represent and warrant that proper disclosure of open source components and applicable license terms was made, and that these terms do not materially limit the continued use or distribution of the target company’s products or services and have also not been breached in the past.
- Founder, employee and contractor works and inventions: Founders, employees and contractors have most often contributed to the creation and development of IP pertaining to the business of the target company. Hence, the seller should represent and warrant that all IP in their works either vests in the target company or is the subject of sole and exclusive use rights to the benefit of the target company respectively and that none of the contributors have any outstanding remuneration claims with respect to it.
The investor should also bear in mind that seller representations and warranties will not be the appropriate means to enhance protection of the deal drivers at all times. Where applicable, remedial measures may need to be taken, e.g. where ownership in relevant IP rights lies outside the target company, respective transfer agreements may have to be concluded. Where concrete risks have been identified, indemnities may have to be negotiated to properly allocate it between the parties.
During negotiations, the investor and seller will typically agree on a suitable timeline during which the investor can communicate and negotiate with key personnel on employment conditions post-closing. Typical incentives in investment agreements include:
- Incentive schemes for key employees: These schemes shall motivate staying on with the business and shall reward performance post-closing, e.g. share option schemes, restricted stock units or phantom shares.
- Incentive schemes for founders having sold their business: These usually encompass incentives such as earn-outs, equity participations in the investor post-closing, retentions or holdbacks, i.e. staggered releases of purchase price portions based on lapse of time the founders stay on board post-closing.
Any investor will also have to ask itself what the negotiation experience for the key personnel should look like and balance the understandable need to win on certain negotiation points with the need to ensure that arriving talents continue their work with sufficient motivation and goodwill. This consideration is even more compelling given the general scarcity of talent. In many cases, the challenge for the investor will also go beyond thoughtful negotiation of incentives and will require providing for a corporate environment supporting the talents in reinventing the purpose of their professional mission in alignment with the investor’s mission.
The auto tech sector promises to be one of the most buoyant markets for investments over the next decade. Understanding typical deal drivers in auto tech transactions and how to protect their value is a key consideration for successfully participating in this market. Recognizing the significance of technology, IP rights and key personnel and considering the ways described here as to how to safeguard value associated with these when executing an auto tech investment, will ensure a further step forward on the path to success.