Starting a company has been compared to jumping off a cliff and building an airplane on the way down—certainly no easy feat. Between overseeing the development process, driving customer acquisition, managing talent and keeping a close eye on competitors, software entrepreneurs have many things to think about at once. Building a software business to the point that it becomes an attractive target to a strategic or a financial acquirer often leaves little time for record-keeping and careful administration.
Unfortunately, it is often a lack of attention to record-keeping and administration that leads to difficult questions from prospective purchasers, purchase price reductions as well as closing conditions and indemnification provisions in favor of the purchaser in the definitive purchase agreement. Conducting your own sell-side due diligence exercise prior to entering into a sale process will help to ensure that potential problems are identified and rectified before you are caught off-guard with tough questions from prospective purchasers. Below is a list of the top five legal considerations (not in order of importance) for your sell-side due diligence exercise.
- Corporate Record Keeping: While not the most riveting pastime, ensuring that your corporate records are in order is an important task. Most prospective purchasers will seek to review your minute books to verify the ownership of your company and to ensure that signatories to the various agreements in connection with the purchase of the business have the proper corporate authority. In addition, prospective purchasers will likely seek to review stock option or stock purchase plans, the related agreements and a current list of holders of rights granted under such plans.
- Open Source Code and Development Policy: Prospective purchasers will undertake to gain an understanding of the open source software embedded in your products, particularly any open source code licensed under a “copyleft” license, such as the GNU General Public License. To this end, it will be helpful to gather and maintain a list of the open source software embedded in your products and to collect copies of the license agreements for the same. In addition, to allay the concerns of prospective purchasers, it would be advisable to have in place a software development policy that governs the incorporation of open source software into your source code. To the extent that this is too time consuming for your team to handle in light of their other responsibilities, there are services that can help you understand and manage the open source software embedded in your products.
- Source Code: In addition to concerns related to open source software, prospective purchasers will seek to gain an understanding of the rights of customers and third parties to the source code. To this end, it would be advisable to compile a list of customers or other third parties that have access to your source code either directly, or through escrow agreements. As well, another list should be prepared that sets out the third party components incorporated into the source code and any royalties related to the use of such components. Prospective purchasers will expect to have access to copies of any source code escrow agreements and distribution or royalty agreements with respect to sublicensed third party components. You will want to ensure that you have a thorough understanding of the release conditions contained in any escrow agreements and the royalty formulas in any distribution or royalty agreements.
- Developers: Confirming that your business has clear title to its intellectual property will be of utmost importance to prospective purchasers. To this end, it is recommended that you gather and maintain a list of all developers who have contributed to the products. You should be prepared to provide copies of all contracts with such developers to prospective purchasers. If written agreements between developers, particularly contractors, are not in place, prospective purchasers may delay closing until a confirmatory intellectual property assignment is obtained, seek a purchase price reduction or, in the worst case, walk away from the deal.
- Customer-Facing License Agreement: Ensure that you have in place a standard license agreement that sets out the customer’s rights to the software, limits your company’s liability, provides for the license fees and recurring fees payable by the customer and includes any service level agreements and/or uptime commitments. Licensing software by way of purchase orders or informal agreements will be frowned upon by prospective purchasers. Also, prospective purchasers will seek to understand the extent to which your company has deviated from your standard license agreement and, as such, it is helpful to prepare a list of non-standard customer contracts.
There is great value in getting organized well in advance of the due diligence investigations of prospective purchasers. Providing clear, complete and organized due diligence materials and responses promptly upon request will instil in prospective purchasers a sense of confidence in your products and your team. Being prepared will ensure that you are able to manage the delivery of bad news carefully and early in the process so that prospective purchasers are not struck with any surprises. Due to the complexity surrounding a number of these suggestions, it is recommended that you seek professional advice in order to ensure that you’re taking the right steps.