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08 January 2019

Start-up acquisitions & exits - where expectations meet reality

Start-ups generally

A typical start-up is usually founded by three or four individuals as a limited liability company or a joint stock company focused on IT or online businesses. As the start-up grows, a number of investors (ten or more) come on board (venture capital funds and angel investors) by acquiring convertible loan instruments, newly issued or existing shares. The start-up company is focused on building up and investing in its team of specialists, which is often its main asset. This explains why employee share option plans are so common. Gradually, the client network expands and the brand is established. And then, a strategic company comes along with a lucrative offer to acquire the start-up.

Facing reality when planning to acquire or exit a start-up
Sometimes what should be a simple deal turns into a costly and time-consuming exercise if the following issues are not handled properly:
1 Cost-cutting above all – Although start-ups (or rather the sellers) generally prefer to avoid the cost of hiring a reputable (or any) lawyer, engaging experienced m&a lawyers on both sides is key to completing the transaction and could save a huge amount of hidden costs in the form of legal fees to the buyer. Sellers often have difficulties understanding standard document request lists, are unable to structure virtual data rooms and/or have no experience in reviewing and negotiating sale and purchase agreements.
2 Start-ups rarely use a lawyer in the early days of business – If the start-up has not been advised and supported by a lawyer for a number of years following its incorporation, there are usually various legal gaps to be filled din and internal issues to be tidied up before entering into a binding sale and purchase agreement with a prospective buyer, such as bringing the book of shareholders up-to-date or arranging for a GDPR gap analysis.
3 Title to shares is key – If there have been partial endorsements of shares in a start-up registered as a joint stock company, the entire chain of transfers of shares to investors could be invalid, as partial endorsements are invalid under Bulgarian law. The inability to prove valid title to shares would affect the transaction structure. Whilst indemnities, retention amounts and other contractual mechanisms may mitigate the financial risk to the prospective buyer, these tools would not resolve the title issue. Possible solutions (to avoid complexity and problems with registration of the transfer with the Bulgarian Commercial Register) are: (i) the purchase of the business as a going concern; or (ii) the transfer of the going concern into another company and a share sale of the new company.
4 Too many shareholders – It is difficult to negotiate with over ten counterparties (founders, funds, angel investors, option holders) based all over the world. Usually, the founders or one of them leads the transaction on behalf of the sellers, and the investors appoint a representative to sign and/or negotiate on their behalf. Given that the signature collection process may be very time-consuming or impossible in case of a notary certified sale and purchase agreement for transfer of shares in a limited liability company, it is advisable that the shareholders either sign for themselves or grant an explicit notary certified power of attorney.
5 Liability of the sellers – Unlike the founders, investors are usually not involved in the day-to-day business and are reluctant to give warranties regarding the business. They would normally warrant their title to shares and capacity to enter into the transaction documents. Moreover, they often hold a firm position that each investor's liability should be limited to the warranties given by them and to such proportion of the purchase price as received by each of them.
6 Retention amount – A retention amount to cover warranty and other claims of the buyer is typically agreed. The sellers' preference is usually to keep such money in escrow, preferably with a bank. Banks, however, are reluctant to assume any responsibility for interpreting an arbitral award or a court judgment in case of a dispute. A joint instruction by both the buyer and the sellers or an instruction by either of them could be difficult to agree on, as one of the parties would always be at a disadvantage. A fair compromise could be an instruction from the buyer only, if any money is awarded to the buyer, and in all other cases, an instruction from the sellers only.
7 Enforceability of indemnities is questionable under Bulgarian law – The English law concept of indemnity is unknown to Bulgarian courts and there is no case law to provide guidance. Under an indemnity, the seller is obliged to compensate the buyer for all damages, loss and expenses suffered by the buyer as a result of an event or breach occurring irrespective of the seller's fault and irrespective of whether the buyer was aware of the potential risk. The closest concept under Bulgarian law is the liquidated damages clause. The only similarity, however, is that the buyer need not prove the amount of the damages suffered das a result of the seller's breach – it is pre-determined or pre-determinable in the sale and purchase agreement. The differences are as follows: (i) a liquidated damages clause ensures the seller's performance of the agreement, but does not protect against a potential liability the buyer knows about; (ii) the amount of the damages to be indemnified dis not known at the time of entering into the sale and purchase agreement, unlike the amount of the liquidated damages, which is usually known at the outset.
8 Employee retention plan – Where the start-up is an IT company, often the buyer is mainly interested in acquiring the employees and retaining them for at least three years, which could be crucial to the buyer's business plans. Negotiating an employee retention plan is a key part of the process and could even be linked to the payment of the second and third instalments of the purchase price. The earlier this is agreed, the better, because it may turn out to be a deal breaker. Another point to consider is how to address the loss of employees in the period between signing and completion of the deal. A mechanism could be agreed to allow the start-up company to terminate the employment contracts of certain employees and hire replacements, but only with the buyer's prior approval. While the latter may delay the hiring process, it is necessary to protect the buyer against random selection of employees to fill in numbers.
9 Oral arrangements – Start-up companies often work based on oral arrangements either with regular clients or with their employees about bonuses (including exit bonuses) and share options. Last-minute disclosures before signing a sale and purchase agreement, such as a table of names and promised payments to employees with underlying written contracts, could be an unwelcome surprise.  
10 IP rights – Often there is a complete lack of documents about the author and owner of a website and its contents, or a lack of proper transfer/licence documentation in respect of IP rights over software, databases, etc. An IT company's value would be affected if its employment agreements do not contain a specific clause allowing it to become the owner of – and hence sell or licence – the software produced by its employees.
11 Conversion of loan instruments into shares – Many investors prefer to use convertible loan instruments to invest in start-ups. These instruments are convertible into shares upon a liquidity event, including an exit. The investor's preference may be either to receive repayment of the outstanding principal and interest, together with a surplus (the liquidity preference) upon completion of the exit, or to have its loan converted into shares first and then receive payment of the purchase price for the shares. If the latter option is selected, completion will be subject to a share capital increase, which may further delay completion. Having an idea of what the investors' preferences may be from the very beginning of the process is good for planning the transaction timewise.
12 Difficulties with registration of the transfer with the Bulgarian Commercial Register – Registration of the transfer is required in case of a share sale to a single buyer or changes in the management (which is often the case). In its recent practice, the Bulgarian Commercial Register has been diligent in checking all title documents to prove valid transfer of shares. The start-up company should be prepared to provide originals of trade registry excerpts, powers of attorney, resolutions, cancelled share certificates etc. relating to all past transfers of the shares, especially where these involved a foreign entity. Also, due to the large number of documents filed in case of a single transaction, it takes much more time for the Bulgarian Commercial Register to process the applications for registration.

Being aware of the typical issues which arise in start-up m&a transactions is key in order to avoid (i) unrealistic expectations on both sides, and (ii) any of those exacerbating issues that could become a deal breaker.


This article was up to date as at the date of going to publishing on 10 December 2018.


Attorney at Law