Legal DD to Prepare Before a Startup Becomes a Seller
Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.
For startups, selling the company through M&A is one of the leading exit strategies. There are several methods, such as a share transfer or a business transfer to a large operating company, but a company on the sell side will undergo full-scale legal DD by the buyer.
In sell-side legal DD, past shareholders' meeting procedures, major business contracts, the ownership of intellectual property and so on are examined. There are aspects similar to legal DD in a financing, but in M&A the structure of the legal risks the buyer takes on changes depending on the form of the acquisition, so the examination tends to go into greater detail. Once you start considering a sale, check the following materials and conditions:
- The shareholder register, the commercial registration and the legality of past share issuance procedures, and the policy for handling unexercised share options and those held by former employees
- Whether major contracts contain change of control clauses, and identification of contracts that require the counterparty's prior consent before the sale
- The scope of the company's ownership of rights in, and licenses to, source code, trademarks and technical information created by outsourcing contractors and members working on a side-job basis
- Organizing the transfer procedures for customer data and user information according to the difference between a share transfer scheme and a business transfer scheme
- A voluntary legal check at the early stage of considering a sale, carried out before the buyer makes disclosure requests
Checking Shares, Share Options and Corporate Governance
In M&A by share transfer, the buyer acquires the shares of the target company and becomes a new shareholder. The company's contractual relationships and potential liabilities continue to exist within the corporation as they are, so the buyer checks the composition of the shareholders, the number of shares held, the legality of past capital increase procedures, and the exercise status of share options.
Cross-check basic materials such as the shareholder register, the certificate of registered matters and the shareholders' agreement. In particular, where there are unexercised stock options or remaining options granted to former employees, coordinate with the parties concerned, in light of the terms of the rights, on whether the buyer will purchase them at the time of the transaction, whether they will be cancelled, or whether they will be exercised.
If oral agreements among the founders on the treatment of shares remain, or promises to grant incentives to early members have been left vague, this could give rise to serious conflict at the negotiation stage of the sale. If such issues come to light once negotiations are under way, they may lead to a reduction in the sale price or a breakdown in negotiations.
Consent Clauses in Major Contracts and Business Continuity
A common obstacle to M&A is change of control clauses in major contracts. These are clauses providing for the counterparty's prior consent, prior notice or a right to terminate the contract where there is a change in the shareholder composition or control, and the required obligations and notice deadlines differ from contract to contract.
Such clauses are found in, for example, master transaction agreements with major customers, outsourcing agreements for core systems and loan agreements with financial institutions. If there are many counterparties whose consent must be obtained before the sale is executed, the practical process from signing to completion of the acquisition (closing) may become longer.
To determine whether the existing business can continue without disruption after the acquisition is completed, the buyer carefully checks termination conditions, non-compete obligations and the validity of the terms of intellectual property licenses.
Ownership of Intellectual Property and Development Outsourcing Relationships
In startup M&A, the ownership of the intellectual property held by the company is at the core of the review. The question is whether the company holds, or has valid licenses to, the rights needed to continue the business in respect of the product source code, registered trademarks, machine learning data and so on.
Where outside contractors or members working on a side-job basis have been involved in development, check whether economic rights such as copyright in the deliverables have been formally assigned to the company, and whether the scope of licenses covers the development of the business. Because moral rights of authors cannot be assigned under the law, also check whether a covenant not to exercise them has been concluded and whether its scope includes the anticipated modifications and secondary uses.
Where products or content are created using generative AI, the company may also be asked to explain the commercial use conditions under the terms of use, the legality of the input data, restrictions on the use of output, and the risk of infringing third-party rights.
Personal Information and Data Transfer Procedures
Procedures for transferring customer information and user data are also an important issue in M&A practice. In a share transfer, the corporate entity itself continues to exist, so the entity to which the personal data held by the company belongs does not change. In a business transfer, by contrast, the provision may fall under the exception to third-party provision requiring the individual's consent, as provision in connection with business succession, but use beyond the scope of the purposes of use before the succession, transfers to foreign countries and restrictions on provision under individual contracts require separate legal examination.
Whichever scheme is adopted, it is necessary to cross-check in advance what has been disclosed in the terms of use and privacy policy and the terms of external services. In SaaS and AI businesses, data itself is a source of corporate value, so make sure you can explain the ownership of the data and the basis for its use through contracts and other documents.
Advance Self-Checks and Where to Consult
In M&A legal DD, if you start responding only after disclosure requests or questionnaires arrive from the buyer, the work may become concentrated in a short period. I think it is desirable to voluntarily check the materials you have on hand at the early stage of considering a sale and identify missing materials and potential risks.
If the materials are organized in advance, responses to the buyer become faster and it becomes easier to confirm the information needed for negotiating terms. Conversely, if serious deficiencies come to light during the investigation, this may result in demands for a price reduction or excessive indemnity provisions.
Also get a sense early on of the materials and costs involved in the advance check. To understand the overall picture of M&A and the likely costs, see What Is Legal Due Diligence? Purpose, Process, Required Materials and Costs, Indemnities, Price Adjustments and Closing in an SPA (Share Purchase Agreement), which explains contract practice, and M&A Attorney Fees and Estimate Items, which summarizes the breakdown of costs.
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