Key Legal Considerations in Mergers and Acquisitions for Startups

Startup success is measured in a variety of ways, including internal rate of return and achievement of goals such as income and company growth. Among different types of success, an exit through mergers and acquisitions (M&A) is regarded as a viable and important strategy for startups. Understanding the mergers and acquisitions definition is essential as it plays a crucial role in the growth and exit strategies of startups as they enable them to enter into new potential markets, expand into different business areas and access critical resources. However, these transactions are not just financial decisions; they also involve complex legal, strategic and operational challenges that must be diligently navigated at every stage of the process, as the decisions made shape the future of the companies involved.

Successfully navigating an M&A process requires a deep understanding of corporate law, due diligence, and regulatory requirements to mitigate risks and ensure compliance. For startups, which often operate on limited resources and face intense competition, mastering mergers and acquisitions strategies can be a game-changer. This guide outlines key legal aspects, from M&A definitions to compliance, helping startups prepare for successful M&A transactions.

What are Mergers and Acquisitions?

The mergers and acquisitions law terms are often used interchangeably, however, they have different meanings. When one company takes over another and establishes itself as the new owner, the purchase is called an acquisition. Therefore, in an acquisition scenario, one company takes over all of the operational management decisions of another. The smaller company is often absorbed and ceases to exist, with its assets becoming part of the larger company. On the other hand, in a merger scenario two or more organizations combine forces to create a new organization. In other words, a merger is the legal activity in which two or more organizations combine. When this occurs, the stocks of both companies are surrendered, and new stocks are issued under the name of the new business identity.

In startup ecosystems, several common M&A applications can be observed through various strategic approaches, shaped by the dynamic nature of technology markets and evolving business needs. While not exhaustive, here are some of the main applications commonly seen in startup M&A transactions:

1) “Acqui-hires” (Talent Acquisition): It refers to the purchase of a company primarily to recruit its key employees and team members. In an acquihire transaction, the purchaser is typically a larger, more established company, frequently backed by a venture capital firm. The primary focus of such a business is not necessarily the products or services offered by the target company, but rather the talent and expertise within its team. Major tech companies such as Google, Facebook, and Apple are some of the biggest players in the acquihire space.[1]

2) Intellectual Property (IP) M&A: This refers to the process where a company purchases another entity primarily for its intellectual assets, such as patents, trademarks, copyrights, or proprietary technologies. Since IP assets are often a significant component in M&A transactions within the technology sector, this strategy is commonly used particularly in technology-driven industries like software, biotech, and artificial intelligence. IP merger or acquisition provides many benefits for the purchaser, the most prominent of which is the acquisition of unique technology that the other company has. Technological innovation can be a resource exhausting venture (one of the most important resources consumed is time); therefore, IP M&A strategy lowers the risk of investing in new technology.[2]

3) Market Expansion and User Base Growth-Driven M&A: Market expansion M&A involves entering new geographic markets by acquiring or merging with a company with an established presence in those regions. This strategy enables the purchasing company to rapidly expand by gaining immediate access to new customers and markets of the target. By combining resources, capabilities, and market reach, companies can achieve synergies that drive growth, increase market share, and create value for shareholders. Facebook's acquisition of Instagram and WhatsApp exemplifies this strategy, instantly expanding their social media footprint.[3]

Structures of M&A Transactions

· Horizontal M&A: In horizontal mergers, two companies combine their operations to consolidate market share and reduce competition, while in acquisitions, one company takes control of another to expand product offerings or gain larger market presence. Both approaches aim to achieve economies of scale, increase market power, and enhance operational efficiency by combining similar business operations.

· Vertical M&A: In vertical mergers, two companies at different stages of the production vertical combine their operations, such as when a customer and supplier merge. In vertical acquisitions, a company takes control over different stages of its supply chain by acquiring suppliers or distribution channels, gaining direct control over additional stages of production or distribution without creating a new entity.

· Congeneric M&A: Congeneric M&A occurs when two businesses that serve the same consumer base in different ways merge or one acquires the other. For example, a TV manufacturer and a cable company might merge or one might acquire the other to combine their complementary products and services.

· Conglomerate Mergers: It is a merger between firms that are involved in totally unrelated business activities. These mergers typically occur between firms within different industries or firms located in different geographical locations.[4]

M&A Process For Startups[5]

1) Develop an M&A Strategy and Define Search Criteria: The strategy should begin with a deep understanding of why the M&A is being pursued, ensuring that the purpose is clear: whether it’s to accelerate growth, enter new markets, enhance technology, or consolidate market position. For instance, if market expansion is the goal, the strategy should prioritize targets with a strong geographical presence. If acquiring advanced technology is the objective, the strategy should focus on startups with complementary intellectual property. To develop a solid M&A strategy, collaboration with internal leadership teams, the board, and external advisors is essential. As a result of this strategy, the startup should define clear criteria for potential targets or buyers, focusing on companies that complement their business model through technology, talent, or market access. The ideal target’s profile should include factors like size, revenue, geographical presence, and cultural compatibility, ensuring that it aligns with the strategic goals of the M&A.

2) Research Potential Targets or Buyers: Once the strategy is determined and the search criteria are established, the startup should research and identify potential targets or buyers that meet these requirements. It should use market analysis, industry reports, and networking to compile a list of candidates and evaluate each based on the established M&A criteria, helping to filter out unsuitable options and focus on the most promising opportunities.

3) Initiate Acquisition or Sale Process: The startup should initiate contact with potential targets or buyers by sending a Letter of Intent (LOI), expressing interest and outlining the basic terms of the potential deal. This initial communication helps to gauge the target’s interest and ensures both parties are aligned in their intentions.

4) Valuation Analysis: After establishing initial contact, the startup should conduct a thorough valuation of the target or itself using various methods, comparable company analysis, and precedent transactions. This helps determine the target's financial standing and ensures that the transaction is financially viable.

5) Negotiation Phase: During the negotiation phase, both parties should be prepared to discuss the key terms of the transaction, such as price, payment structure, contingencies, and post-transaction conditions. The startup should be flexible, as negotiations often require compromise to move forward. The terms of the deal should be carefully considered to ensure that the interests of both parties are met and that the transaction can proceed smoothly.

6) Due Diligence:[6] This is the most critical step in an M&A transaction. Due diligence is a process of verification, investigation, or audit of a potential deal or investment opportunity to confirm all relevant facts and financial information and to verify anything else that was brought up during an M&A deal or investment process. Understanding the due diligence meaning is essential as this step involves a thorough investigation and assessment of every aspect of the business, from finances and operations to legal matters, human resources, infrastructure, assets, liabilities, compliance, customers, and taxes. It also checks if the companies align culturally, as differences here could create post-merger integration challenges. Due diligence further helps to understand whether the M&A goals can realistically be met. Due diligence is a comprehensive process and should involve a deep dive into the following aspects of the target company:

· Legal Due Diligence: This involves a comprehensive review of the target company’s legal standing and obligations, and includes:

o Reviewing any contracts, intellectual property, litigation history, employment agreements, and regulatory compliance.

o Identifying any potential legal risks and liabilities that could impact the M&A

· Operational Due Diligence: This consists of a thorough evaluation of a target company’s operational capabilities and efficiency, including:

o Evaluating the target company’s operations, supply chain, and technology infrastructure.

o Identifying potential integration challenges and synergies.

· Financial Due Diligence: This is crucial to assess the financial health and viability of the target company, and involves:

o Thorough reviews of financial statements, projections, and debt structures. This lets the acquiring company identify risks or liabilities. Some of the records that may be requested during due diligence include income statements, balance sheets, tax returns, cash flow statements, employee payroll and benefit records, equity structure and shareholder agreements etc.

There are high chances of mistakes or miscalculations being committed if due care is not adopted during the due diligence stage. The due diligence team may for example;

· fail to undertake prior approval of third parties or government authorities to proceed with the transaction;

· fail to discover non-compliances of the target company;

· ignore discovered information which is relevant;

· overlook expiry or non-transferability of certain licenses;

· fail to detect potential liabilities;

· over-value or under-value assets or securities of the target company;

· overlook non-transferability of intellectual property rights; or

· neglect mismanagement or fraudulent practices undertaken by the target company.

The outcome of the entire transaction heavily relies on a due diligence process. Any error, omission or oversight committed during a due diligence process can have disastrous effects.

7) Financing: The startup should secure the necessary funding to complete the transaction, whether through cash, stock exchanges, or debt financing, ensuring that the financing strategy aligns with its financial capacity and the deal terms. Before finalizing the purchase agreement, all financing arrangements must be confirmed.

8) Drafting of the Transaction Agreements: Once due diligence is complete, the startup should proceed with drafting the final transaction agreement set which would include the purchase and sale agreement. The agreement(s) should outline the terms and conditions agreed upon during negotiations, including the price, payment terms, contingencies, and any other relevant provisions.

9) Closing the Deal: The startup should ensure that all conditions have been met, including obtaining any required regulatory approvals, such as antitrust (competition) or securities compliance. The final purchase agreement must be signed, payment should be made according to the agreed terms, and all necessary documents should be filed with the relevant authorities to facilitate the ownership transfer as stipulated in the deal.

10) Post-Merger/Acquisition Integration: Once the deal is closed, the startup should focus on integrating the merged or acquired companies’ operations to realize synergies and achieve the objectives of the transaction. It should develop a detailed integration plan that covers operations, personnel, systems, and processes. Any post-closing actions foreseen in the signed transaction agreements should also be completed to ensure that no contractual liabilities arise.

[1] https://onlinelibrary.wiley.com