Tuesday, October 30, 2007

Selling the Startup: Due Diligence Disasters

Last night I spent approximately 10 minutes poking around my right eye, attempting to remove a contact lens that, as it turns out, actually fell out on my first try. You really haven't lived until you've tried to pinch your iris. (Grooming tip: clip your fingernails beforehand. Your cornea knows when you've made an effort.) Damn you and your ultra-thin lenses, Acuvue!

Like me, startups can get all squinty-eyed once they've signed a term sheet to sell the business. They will allow wide-ranging access to their files and records so that due diligence can be completed as quickly as possible. This is a flawed and potentially dangerous strategy. Due diligence is rarely the reason why acquisitions proceed slowly or grind to a halt. The larger the acquiror, the more cumbersome the approval process. Until draft documents start crossing your doorway, it's best to provide phased, careful disclosure.

Consider what could happen if a deal falls apart once an acquiror has seen your customer lists and your customer contracts. What if the acquiror starts contacting your customers? As The Register reports, in a lawsuit filed in Delaware Chancery Court this summer this is exactly what Sunrocket claims happened to it after Vonage ended negotiations to buy the business. You can read more about the allegations, and Vonage's response over at The Register's site.

Other issues: What happens if, in the course of due diligence, your acquiror's team discovers infringing technology? Or trade secrets that are similar to their own? Can these form the basis for an infringement action once the deal is off? In larger transactions, using an outside entity to perform technolgy due diligence can remove this risk, but this is not a tactic regularly used in smaller deals. It should be, if there's a chance of overlapping technologies.

I spend a lot of time on the non disclosure provisions in offers to buy to try and deal with some of these issues. But the best protection, in my view, is controlled, phased due diligence. Don't let someone else stick a finger in your eye. Goodness only knows what might start oozing out.

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