The value of a startup is in its people (the founder/s and the key employees), the product(s) or service(s) and the main income sources (e.g. material contracts with key customers).

We live in times when entrepreneurs are celebrated and their successes widely recognized. Times when startup companies can accelerate (thanks to factors such as new technologies and increased visibility/publicity) their growth to market leadership in an unprecedented speed. Naturally investors (individual and institutional) would not miss the opportunity to invest in fast-growing startups in an environment where peers and media generally hunt for the next unicorn company and loudly praise the unimaginable returns on investment. Of course, all would admit that with startups statistical data and their own empirical experience show a huge probability of failure (that is a loss of investment, a write off, partial or in full).
So, M&A process relating to a startup company starts with the fundamentals – first, identifying and understanding them, and only then the investor could look into the valuation and projections. A valuation and projections (of future revenue, profitability, cash flows etc.) would be worthless and in any case misleading and inaccurate whenever the fundamentals have been wrongly defined and assessed.

The value of a startup is in its most valuable assets: the people (the founder/s and the key employees, say the senior architect/s in a software company or the designer of a breakthrough consumer product), the product(s) and the main income sources (e.g. material contracts with key customers).
The best lawyers will start their due diligence with those three aspects and will quickly, within days, identify the red flags and alert their clients. Then they will, without delay, work on the feasible strategies to mitigate and reduce the identified risks and suggest the appropriate remedies. And where necessary input the relevant legal and contractual solutions in the transaction documents.

When the advisers start investigating and swiftly report on the fundamentals, the investor will be able to understand very early in the process what the startup’s weaknesses and the potential threats are and if any of those, after proper analysis and assessment, would qualify as a deal breaker. Just to illustrate this point, it has often happened that a startup’s key assets (such as intellectual property rights) would be owned by a founder or a related person to her. Hence, related party contracts and transactions are of critical importance and a top priority in a due diligence. A recent and well-publicized example is WeWork’s infamous downfall. Shortly before the intended IPO the company was to rebrand itself as The We Company, but a major issue that surfaced in the SEC pre-IPO filing was that the ownership of the underlying IPR/trademarks stayed indirectly with the founder, CEO and key shareholder Adam Neumann. Hence, the company was to pay significant amounts in annual royalties for the use of the new protected trademarks/brands. Have we found similar cases in Bulgarian target companies, where the founders have registered in their name important IP (trade marks/brands, product designs, domain names, etc.) used in the target’s business? We have, repeatedly.

There is another common red flag trait in technology startup companies. Due to limited and insufficient resources and personnel (engineers and software developers), the startup company would outsource some or substantial parts of the work on their product to third parties (companies or freelancers). Often absent a comprehensive written contract that would clearly state the scope of the work assigned, specifications, and assignment of the related copyrights to the target company and not to the contractor. Consequently, such bad practice dramatically increases the risks of third party challenges against the copyrights and related economic rights in the company’s product and opens the door for title claims and compensation / damages claims against the target company.  You can easily see how that red flag could and should negatively affect the startup’s valuation and the purchase price. 

Other basic questions include: is the startup built and operated as a sustainable business? Can it grow continuously – if it were to acquire and integrate other/third party products, teams, add-on companies? Could it retain or increase its value if it were to be added on to another (portfolio) company (a competitor or non-competitor active in a neighbouring or upstream or downstream market)? Are its engines of growth unencumbered and transferable? Could third parties have title claims, or unrestricted rights to use, or claim damages and compensation for infringement of their rights? Could such claims be legally settled reasonably before the closing/investment round and what would be the resulting implications (legal, financial and operational)?