According to a report from Atomico, European tech startups broke records this year with $34bn in funding.
Tech entrepreneurs searching for funding or an exit continue to find their match in tech investors seeking profitable investment opportunities or corporations looking to boost innovation and digital transformation.
Tech M&A is a popular means to achieve this but in order to run a smooth M&A process, investors and tech companies will need to bear in mind some specifics that may play a role when acquiring or selling young and fast-growing tech companies.
Here are five features that set tech M&A apart from other types of M&A.
1. Nature of the assets
Often, the value driver of a tech acquisition is the exclusive ownership of certain intellectual property (IP) rights. It could be proprietary software, an innovative technical invention, proprietary know-how or rights in data. Whatever it is, if it drives the acquisition, you will need to find out who owns the tech.
If the underlying asset can be protected through IP rights, a buyer will need to understand who has created the IP.
The lack of separation between an early stage company and its founders can be a complicating factor. If there is no documentation that clearly transfers ownership of the IP created by the founders to the business, it may be useful to resort to a sweep-up assignment as a matter of standard practice.
If the IP was not created by the founders, check whether it was created by employees or freelancers and whether any co-creation of IP with universities, students or startup labs has taken place. The use of freelancers in particular can lead to ownership issues given that, in certain jurisdictions, IP rights vest with the freelancer automatically.
In the end, you’ll need to establish an uninterrupted chain of title to make sure that the business you’re acquiring actually owns the crown jewels you’re after.
If the acquisition is driven by the data a company holds, your diligence will focus on the question whether the target actually holds the rights in the data it claims it has. Investors should ask themselves: is the target using licensed-in data? Who has access to the data within the target and seller group? Are there any third-party suppliers, partners or customers that have access, and if so on what terms?
An investor would also want to check whether the target is leaking value by giving away rights in data when it shares information with third parties. And you will want to test the target’s GDPR compliance level and ensure that it has appropriate network and security measures in place.
All these questions will help investors assess whether the value attributed to the data is not diminished by a lack of robust exclusive rights in the data or non-compliance with privacy laws.
2. Startup equity structures
One of the features of fast-growing tech companies is that founders often raise capital from friends, family, angel investors and, in later stages, venture capital firms.
In addition, key employees who have been with the company from the start are often incentivised through share plans. This may lead to complicated equity and incentive structures as well as complex governance and exit regimes that will need to be reviewed carefully and perhaps even cleaned up in order to ensure that the investor acquires the desired level of control over the target business.
Investors will therefore need to devise a strategy to engage with any minority shareholders, option and warrant holders, and other stakeholders from the outset to mitigate deal uncertainty later down the process.
3. Competition aspects in a digital age
Seasoned investors are accustomed to traditional merger clearance requirements tied to revenue thresholds. In a tech deal however, the rules are changing as regulators across the globe have seen tech companies with little or no revenue being sold in big-ticket M&A deals.
Realising that turnover may not always reflect the economic value of a company, new merger control thresholds based on transaction value have been introduced for example in Germany. In addition, antitrust authorities are paying particular attention to data-driven deals and are specifically exploring whether the ownership, aggregation, acquisition or certain use of personal data sets may provide an unfair competitive advantage to companies.
Moreover, foreign investment restrictions may impose specific approval requirements in a number of European jurisdictions, including where the target holds particularly sensitive data or operates critical infrastructure or technology relevant to national security.
4. Regulating the disruptors
Regulators are still playing catch-up when it comes to the speed of innovation, new business models, and the impact on the economy and consumers.
Any investor would want to make sure that the business model it’s buying into is a sustainable one from a regulatory scrutiny perspective. Understanding the business model and scanning the regulatory horizon for anything that could constrain the target’s business or materially impact the way the target currently operates is key.
Aside from potential threats to the status quo of the business, any expansion plans into new markets should also be vetted from the outset for any legislative proposals in the pipeline that could negatively impact the business model.
5. Taxation in a digital era
Under proposed new rules by the European Commission, companies would have to pay tax in each member state where they have a significant digital presence upon the fulfilment of certain criteria.
On the basis of these proposed rules, member states would be able to tax profits that are generated in their territory, even if a company does not have a physical presence there.
As an interim measure, the European Commission is furthermore proposing a digital services tax of 3 per cent on revenues from the online placement of advertising, sale of collected user data, and digital platforms that facilitate interactions between users.
France implemented the 3 per cent tax measure earlier this year and more European countries have vowed to follow.
When conducting tax due diligence in a tech M&A context, tech investors will therefore need to carefully consider the impact of potential changes in taxation on the business model of the target.
