Due diligence considerations for tech startups when it comes to M&A transactions

Chris Spillman of Biztech Lawyers outlines the areas that have to be covered when conducting due diligence.

For tech startups, M&A (mergers and acquisitions) transactions can be of critical importance, especially with M&A season ramping up again. Beamer, a Colorado based SaaS company recently announced that it was acquiring Userflow for $60 million.

This is after a meticulous due diligence process, where Userflow’s financial metrics, IP assets and an in-depth analysis of the technology stack being offered and its potential product alignment with Beamer’s own product suite was conducted thoroughly to ensure it aligned with Beamers strategic objectives, achieved synergies and that the rewards outweigh the risks.

This critical importance makes it imperative that any company considering a merger or acquisition conducts due diligence to assess the value of the target business and the risks associated with it.

Making the Most of Due Diligence

But it is worth stating that while due diligence is important for M&A, it is also of great value when it comes to financing and other key events in the life of a company.  Companies can benefit from having a mindset that recognises the need to apply due diligence to all key aspects of their activities. A due diligence-based approach can bring benefits and head off potential problems.

Startups, therefore, should look to use due diligence as early as possible. They should not be having to think about using it for the first time when they are facing a major M&A, a financing event or other significant development. At such points, they are likely to have enough to deal with – having to suddenly get to grips with due diligence at such a busy time would be less than ideal.

With this in mind, it is worth keeping an active due diligence data room at all times. This should be updated as and when necessary, so that all key documents and other sources of relevant information are available whenever they are needed.

It is an approach that requires regular maintenance, but it will almost certainly save time and energy in the future. Another potential benefit is that it can make a startup look more mature than it may actually be. This can ensure it creates an extremely positive impression on potential partners, acquirers, venture capitalists and any other individuals or organisations that take an interest in the company. It can be especially valuable regarding M&A.

Due Diligence and M&A

When it comes to due diligence there are a number of key considerations that have to be addressed regarding M&A.

Financial due diligence is essential in order to gain a clear and accurate picture of the target company’s monetary health. There needs to be a carefully-conducted review of the target company's financial statements, including income statements, balance sheets and cash flow statements. Its revenue sources, cost structures and historical financial performance must all be analysed. Any assumptions and methodology used in financial projections, cost estimates, and cash flow forecasts have to be examined in minute detail in order to identify any potential discrepancies or red flags in the financial model.

The all-important issue of intellectual property (IP) makes it necessary to examine the target company's IP portfolio, including its patents, trademarks, copyrights, and trade secrets. Its ownership of IP assets has to be verified and any existing or potential IP-related liabilities - such as lawsuits or licensing agreements – will need to be assessed. The due diligence also has to determine whether the target company’s IP assets align with the acquiring company's strategic goals.

Due diligence also has to cover the target company’s technology and products. Evaluating the technology stack, software code and product architecture of the target has to be seen as a priority, as does assessing the scalability, security and performance of the tech product. Identifying any technical debt or issues that may require significant investment or remediation also has to be done at this early stage.

An equally thorough approach should be taken regarding employment contracts, equity agreements and employee benefits. The target’s talent pool has to be examined, along with its retention strategies and any potential HR-related risks. Similarly, all contracts relating to the likes of customers, vendors and partnerships all need to be scrutinised, as do any change-of-control provisions, exclusivity agreements or other commitments that may affect the transaction.

Analysing the target company’s customer base - including customer concentration and churn rates – its direct or indirect competitors, its position in the market and relevant market trends will help determine whether it is a viable target, as will identifying potential growth opportunities and market risks. There is also a need to ensure that the target is complying with all relevant laws and industry-specific regulations and standards. Checks also have to be made regarding whether the target is – or is likely to be – involved in any legal disputes.

Evaluating the target’s cybersecurity measures, data protection policies and track record when it comes to data breaches should also be a priority. Checks have to be made to ensure that sensitive customer data is adequately protected in compliance with data privacy regulations. Any cybersecurity vulnerabilities or risks that could affect the deal have to be identified and addressed.

The Need for a Plan

Due diligence, however, has to involve more than putting the target company under the microscope. The targeting company also has to take the time to take a look at itself in relation to any proposed merger or acquisition.

It needs to develop a clear integration plan for how it will bring the target company into its structure and operations. Potential challenges and opportunities for synergy in technology, processes and personnel need to be identified and addressed. There may be legal or regulatory risks that could affect the transaction, such as ongoing or potential lawsuits or investigations. Checks will have to be made to make sure that any deal complies with all applicable anti-trust and competition laws.

Due diligence is a complex and multifaceted process – and a necessary one. It will require input from various experts, such as financial analysts, legal advisors and tech and industry specialists. Such input involves their expertise being “put to work’’ to provide a true evaluation of a target company – and its worth to the company looking to merge with it or acquire it.

It is a process that has to be thorough as well as carefully planned and conducted. And it is the only way to ensure that any decisions taken regarding M&A are well-informed and risk free.