Top 11 legal tips when selling a technology business

Selling a technology business can be an exciting time for shareholders and directors who have worked hard towards an exit.  Because of this, it’s important for the exit to be as smooth as possible.   Below we set out our top 11 tips for selling a technology business which, if followed, will ensure greater protection for sellers and reduce their risk.

1.  Asset sale or share sale?

To complete an exit, a share sale is a better option than selling the assets of a business.   With a share sale, all the assets and liabilities of the company transfer to the buyer whereas with a business sale the seller retains ownership of the company together with the current assets, such as cash, debtors, and liabilities.    There are different tax consequences of each broad method that can cause friction if the path to an exit has not yet been carefully defined.    Also, there are state based transfer duty that may apply if selling assets – read more on this in our article on state-based transfer duty here.

2.  Intellectual property – own it!

Intellectual property (IP) ownership is at the core of most technology businesses.   One of the worst things that can happen during legal due diligence is that the buyer discovers that some part of the IP that the business is based on is not “owned” by the seller.   Because of this the seller has to rapidly obtain an IP Assignment Deed from the owner of the IP which may or may not be forthcoming.  This is discussed further in our earlier article entitled Intellectual property assignments and the right to sue.

3.  Legal and accounting due diligence

The buyer will likely conduct a thorough legal and accounting due diligence of the business.   This is usual and expected.  If managed well, legal due diligence should be an opportunity to ensure that everything is in order.  Of course, the size and scale of the legal due diligence needs to be proportionate to the business being sold.  A data room with view only access to documents at set windows of time is not appropriate for the sale of a business worth a few hundred thousand dollars.   Conversely, it may be very relevant if the buyer is a listed public company and part of the consideration is equity.  Buyers will investigate a business’s operations, financial performance, legal and tax compliance, customer contracts, intellectual property, assets and other details.

As the seller will be providing access to sensitive and confidential information to the buyer, the seller must ensure that the buyer signs a confidentiality agreement which it can enforce in the event that the buyer does not proceed with the purchase and misuses the company’s confidential information.   Unfortunately, this does happen.

4.  Avoid change of control issues

Often contracts will specify that a party can terminate if the other party undergoes a change of control, which is where the majority shareholding of a company changes.  This is a risk with customer contracts, leases, finance agreements and key supplier agreements.  It is imperative that a seller obtains any required consent to the change of control from contractual counter parties early in the sale process so as to avoid the sale being delayed or falling over due to key contracts being terminated or consent not being given.

5.  Manage restraint of trade clauses if the Seller plans to conduct a similar business

A restraint of trade clause is often sought by buyers to ensure that the sellers will not operate a similar business to the business being sold in a certain area and for a certain time.  If the restraint is too broad and burdensome, it may be unenforceable, however it is important that any restraint is tailored to the seller’s future plans so as to not unfairly prevent the seller from being able to trade.

6.   Key personnel

Where a seller is key personnel in the company, such as a CTO or COO, buyers will often want this person to remain as an employee.   Care needs to be taken where the sale proceeds involve the sellers receiving a share of profits over a certain period of time that is conditional on a seller remaining employed as the buyer could terminate the employment agreement, thereby negating the right of the seller to any profit share.  Any such proposed condition should be strongly rejected.

7.   Avoid an “earn out”

“Earn outs” are where the sale involves an earn-out arrangement under which all or part of the purchase price will be paid after completion, conditional upon, and calculated by reference to, the post-completion performance of the company.  They are best avoided as it puts a seller’s sale proceeds at risk.  If they can’t be avoided, sellers can mitigate their risk by retaining as much control as possible over the way the company operates after completion of the sale.  By requiring the buyer to agree to obligations to maintain the company’s financial health, negative covenants that require no change be made to the businesses, and/or take on certain liabilities and for the buyer to provide some form of security for the earn out payment.  These are just a few examples.

8.  Seek a security interest where payments are in tranches

Sometimes a sale will involve payments of the sale proceeds over time, thereby making the seller a creditor of the buyer.  As such, the seller should require that the buyer grants a security interest over the sale shares to the extent of the sale proceeds outstanding on the completion date which is registered on the Personal Property Securities Register.

9.  Review any warranties periods carefully

Warranties in company share agreements given by sellers usually cover the seller, the shares and the company.

Warranties about the company need to be carefully reviewed as they usually cover that it:

  • is not the subject of a dispute and is not aware of any dispute;
  • kept its books are up to date;
  • owns all of its assets, including intellectual property; and
  • has paid or made provision for the payment of all taxes.

Care needs to be given as to when the warranty applies, such as at the commencement date or completion date, and the length of time in which claims can be made.  By limiting the time in which the buyer can make a claim, the seller has certainly that the buyer cannot bring a claim after the claim period has expired.

10.  Absolute warranties

A warranty can be given ‘to the best of the seller’s knowledge’ or be absolute.

An absolute warranty will be breached whether or not the seller knew, or could have known, of the breach at the time the warranty is given.

There are certain warranties the buyer will require to be absolute, such as a warranty as to title to sale shares.   Other warranties might relate to statements about the company and its dealings with third parties, which are unreasonable to accept relating to future performance that need to be qualified so that they are made only to the best of the seller’s knowledge.

In a world where tech companies are using more and more third party and open source, it may be difficult to give an absolute warranty that the company has all the requisite rights to the IP used in its products. In certain circumstances, however, a company can give a warranty that to the best of its knowledge it has the requisite rights to the IP.

11.  Cap liability and avoid indemnities

It is essential that sellers limit their liability for breaches of warranties.  A standard cap is the amount the buyer is required to pay for the shares as the seller should not have to pay more for a breach of warranty than what they received for their shares, though it is important to push for a lower cap as the buyer will still own the shares despite a breach of warranty.

It is also important to avoid indemnities for a breach of warranty as they can prevent the seller’s liability being reduced as the buyer will not have to mitigate its loss.  Therefore, sellers should avoid giving indemnities wherever possible.

Business transactions gone wrong

The case of Semantic Software Asia Pacific Ltd v Ebbsfleet Pty Ltd [2018] NSWCA 12 (Semantic Case) is an example of how business transactions can go wrong.  Semantic Software Asia Pacific Ltd ACN 134 067 691 (Semantic) is a research and software development company.  Semantic entered into ten (10) separate share issue agreements with Ebbsfleet Pty Ltd ACN 117 109 056 and McGee Pty Ltd ACN 119 281 944 as trustees of a self-managed super fund (Ebbsfleet).  The agreements were for the subscription of 6.5 million shares for a total value of $1,652,000.

Semantic made a number of representations as to the potential returns an investment in Semantic may yield.  Semantic guaranteed that the value of the shares would triple within two (2) years of the date of the agreement, and went on to claim the shares would increase tenfold ‘within three years or sooner’.  The agreement included a warranty in clause 46, which guaranteed that, should the shares not triple in value, Mr Bradley, the director of Semantic, would personally provide Ebbsfleet adequate shares to sufficiently effect the tripling that was promised.

Ultimately the shares did not triple in value.  In fact, the value crashed so low that the Court deemed them to be ‘essentially worthless’.  Further, Mr Bradley had sold all of his shares following the execution of the agreements so was unable to fulfil the warranty provided by clause 46.

Ebbsfleet commenced proceedings in the Supreme Court of New South Wales against Semantic, on the basis that Semantic was in breach of the share agreements by breaching the warranty as to the value of the shares.  Ebbsfleet also alleged Semantic had engaged in misleading and deceptive conduct as the representations as to future value were made without reasonable basis.

At first instance, the Supreme Court found in favour of Ebbsfleet on both grounds.  Semantic and Mr Bradley were ordered to pay a total of $4,875,000 in damages.  On appeal, Semantic argued the warranty in clause 46 was made solely by Mr Bradley, and not by Semantic.  This view was upheld by the Court of Appeal, where it was found that the operation of the contract did not have the effect of joining Semantic into the clause 46 warranty.

The Semantic Case serves as a reminder to sellers to ensure any contractual warranties are drafted carefully, so as to avoid being held liable for unnecessarily bold warranties or statements.

Takeaways

Selling a tech company is a potentially exciting and lucrative time. Therefore, it is important that it is coupled with reducing seller’s risk and protecting the seller’s interests during the sale process.

Related articles by Dundas Lawyers

Misleading and deceptive conduct in business dealings

Planning a business acquisition

Part 1 – Assembling the advisory team

Part 2 – Selecting and appointing the lead consultant

Part 3 – Should the Lead Consultant be a lawyer?

Part 4 – Working with Expert Advisers

Part 5 – Getting confidentiality agreements in place

Part 6 – Readying employees and others for the due diligence process

Part 7 – Preplanning for method of acquisition

Part 8 – The valuation process – preliminary checklist

Part 9 – Should you work in the business before you buy?

Further information

If you need assistance with the sale or the acquisition of a technology company, please telephone me for an obligation free and confidential discussion.

Michael Adami - Dundas Lawyers

 

Michael Adami B.A.,LL.B.,GDLP.
Special Counsel
Telephone: (07) 3221 0013
e: madami@dundaslawyers.com.au

 

Disclaimer

This article contains general commentary only.   You should not rely on the commentary as legal advice.   Specific legal advice should be obtained to ascertain how the law applies to your particular circumstances

 

Send this to a friend