Key Legal Aspects In The Acqusition Of Start-Up Companies With Innovative Technologies

Acquisitions have long been established as a preferred route for accelerating the growth of companies both in India and abroad. Acquisitions of start-up companies with innovative technologies further provide larger companies with several advantages apart from inorganic growth. Such acquisitions provide larger companies with inroads to a new market of an innovative technology at a substantially lower cost.

However, there are several legal aspects in the deal making process which have to be taken into consideration when negotiating acquisitions of such smaller companies with innovative technologies. This article seeks to examine such legal aspects.

The legal aspects can be categorised into two: (1) Important Deal Aspects and (2) Regulatory Aspects.

I. IMPORTANT DEAL ASPECTS

Deal aspects are those which have to be taken into consideration when negotiating the acquisition deal. Such aspects vary depending upon various factors such as the size of the target company, the nature of the innovative technology etc. The list of items below is an illustrative list and not meant as an exhaustive one.

  1. Due Diligence and Intellectual Property

Like any other acquisition and even more so perhaps, a thorough due diligence of the target company is critical. Start-up companies being relatively young companies may not always have their regulatory compliances up-to-date. Any failures in compliances must be rectified by the date of closing of the deal or appropriate representations, warranties and indemnifications must be incorporated into the transaction documentation.

Furthermore, and very crucially to the acquisition is determining whether the legal ownership of the intellectual property in the innovative technology vests in the name of the target company. In this regard the acquirer must conduct a patent search in order to confirm that the ownership in the invention and/or the patents in the innovative technology does in fact vest with the target company. Patent registration certificates must also be reviewed in order to confirm the ownership of granted patents.

  1. Confidentiality and Non-Disclosure Agreements

As the acquisition centres around an innovative technology, it is absolutely pertinent from a seller’s perspective to ensure that the acquirer and its representatives sign confidentiality and non-disclosure agreements ensuring that they are legally bound not to disclose the details of the technology which is the crux of the acquisition even in case the acquisition falls through.

  1. Break Away Fees

Start-up companies are often founded by a set of young friends from university or elsewhere and it is too often the case that they do not have a formal promoters/founders’ agreement. They also usually lack mature expertise in deal making. Consequently, there may be several instances when the acquisition deal falls through due to lack of mature collective judgement from the founders. It is therefore advisable for the acquirer company to provide for a penalty in the form of a break away fees payable by the sellers in the event they walk away from the acquisition deal.

This will ensure that the time and the money spent by the acquirer company in the deal making process is compensated for in the event the deal does not fructify.

II. REGULATORY ASPECTS

The regulatory aspects being examined below are those that arise in an Indian law perspective vis-a-vis start-up companies engaged in the technology sector.

  1. FDI Policy

In the event the acquisition is a foreign investment into an Indian start-up company it is necessary to examine the Foreign Direct Investment Policy of the Government of India dated August 28, 2017 (“FDI Policy“). The FDI Policy permits investment under the automatic route (i.e. without any prior approval of the government of India) in case the acquisition is in the technology sector. However, pricing guidelines pertaining to the valuation of the shares of the target Indian company will have to be adhered to when making the acquisition. Additionally, post-closing requirements must include the filings of the details of the acquisition with the Reserve Bank of India.

Furthermore, it is important to note that should the target Indian company be engaged in a regulated sector such as the e-commerce sector then the sectoral rules applicable to such sector under the FDI Policy may also apply and will therefore have to be examined.

  1. Income Tax Act, 1961

Rule 11UA (2) of the Income Tax Rules, 1962 prescribes methods for the valuation of the fair market value of unlisted equity shares of Indian companies in case of their acquisition. The methods prescribed under Rule 11UA(2) are either a book value method of determination of fair market value as prescribed under the said section or the fair market value of the unquoted equity shares as determined by a merchant banker using the discounted free cash flow method.

Thus, in case of an acquisition of an Indian target company which is not listed by an Indian acquirer, the aforesaid provisions will have to be complied with.

CONCLUSION

To conclude, while the acquisitions of start-up companies may look attractive it is pertinent to keep the regulatory and deal making aspects such as those listed above in the deal making process in order for the acquisition to be successful.


Article by Mini Raman, 1st published on Mondaq.

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