The Path to Exit – Episode 17

“Common Legal Diligence Issues Founders Face During M&A Transactions”

Host: Mike Lyon, Vista Point Advisors
Guest: Brian Linehan, Co-Chair of the Business Department, Choate
Release Date: May 21, 2024

Overview

This episode delves into the legal pitfalls founders often encounter during M&A (Mergers and Acquisitions) diligence, particularly focusing on software and internet companies. Host Mike Lyon is joined by M&A attorney Brian Linehan to unpack key diligence snafus—around cap tables, employee classification, intellectual property, sales tax, customer contracts, real estate, and rep & warranty insurance—that can delay or derail deals. The episode’s goal is to help founders prep for these challenges in advance, so transactions proceed smoothly and value isn’t lost to legal oversights.

Key Discussion Points & Insights

1. Capitalization and Cap Table Issues

[01:22 – 04:26]

• Documentation gaps: Founders often assume that their cap table reflects reality but informal promises (such as equity to early employees) often lack documentation, creating discrepancies.
  • Quote: “He or she has promised 5% to a particular employee, but there's no documentation—that’s a common thing we see.” (Brian, 01:56)
• Option grants and tax: Many companies have missing evidence of 83(b) filings or insufficient rationale for option strike prices.
• Preference misunderstandings: Founders often don’t fully grasp liquidation preferences and exit waterfalls, potentially leading to surprises at the deal stage.
  • Quote: "A lot of founders don’t really understand what the exit waterfall is going to look like until the end.” (Mike, 03:21)

2. Employee Misclassification

[04:26 – 05:44]

• False contractor status: Many employees paid as 1099 contractors actually meet the legal definition of employees—this can create liabilities for payroll taxes and improper withholding.
  • Example: If someone is working full-time and only for you, they need to be on W-2 payroll.
  • Quote: “We see that fairly commonly where somebody's been on the books as a 1099 for many years, even though they're effectively working as a full time employee.” (Brian, 05:34)

3. Intellectual Property (IP) Assignment and Ownership

[05:44 – 09:15]

• IP and developer agreements: Founders conflate ‘having built the IP’ with legal ownership. If code is authored by contractors or third parties without explicit assignment agreements, the company may not own critical IP.
  • Quote: “To the extent that code is written by employees… it’s owned by the employer. But if you had an independent contractor doing it… you need to make sure [you] have a present assignment.” (Brian, 06:25)
• Domain ownership: Surprisingly common for the company’s primary domain to be registered to the founder personally, rather than the business entity.
  • Quote: “My favorite little one is… the domain name for the company is not owned by the company because it was registered by the founder on GoDaddy.” (Brian, 07:52)
• Timing leverage for contractors: Signing assignment docs is much easier pre-transaction; leaving it until a deal gives leverage to former contractors.

4. Sales Tax Exposure for SaaS Companies

[09:15 – 12:29]

• Sales tax obligations: Many SaaS companies are mid-compliance as state rules expand. 24+ states now tax SaaS, especially if parts are downloadable.
  • Quote: “I don't think I've seen a SaaS deal where this hasn't come up.” (Brian, 09:31)
• Deal impact: Buyers will typically estimate worst-case liabilities and may push for purchase price reductions or escrows if founders aren’t proactive.
  • Remediation: Sellers should get their own analysis done early and negotiate escrows and post-close remediation covenants, not just purchase price deductions.

5. Customer Contract Traps

[12:29 – 15:44]

• Challenge terms: Change of control clauses, rights of first refusal/offer (ROFR/ROFO), MFN clauses, and restrictive covenants can complicate or stall deals.
  • Change of control: Can require customers to approve the acquisition.
  • ROFR/ROFO: Can deter acquirers if they might lose the deal to an existing customer.
    • Quote: “Right of first refusal... really complicates the sales process... and it can particularly complicate it if no one knows about it.” (Mike, 14:57)
• Affiliate issues: Deal lawyers should check that contract obligations (e.g., non-solicits) don’t accidentally extend to the parent or affiliates of a buyer.

6. Affiliate-Owned Real Estate

[16:06 – 17:20]

• Below-market leases: Founders often own business premises through a separate entity and lease it cheaply to the company—this may need to be re-negotiated on-market for buyers.
  • COVID impact: After COVID, real estate issues are fewer with remote work but can still matter for strategic buyers seeking synergies.

7. Reps and Warranty Insurance

[17:20 – 22:10]

• Shift in the market: "Rep & warranty" insurance has replaced traditional indemnities and 10% escrows in most deals over $30M, with a deductible (retention) of ~1% and typical premiums at 3–4% of deal value.
  • Quote: “I can't tell you the last time I did a typical indemnity deal. So what rep and warranty insurance is a buyer can go into… and buy insurance coverage to backstop the representations and warranties that the seller is giving.” (Brian, 18:44)
• Known vs. unknown: The policy covers only unknown risks; known issues like sales tax exposure must be dealt with separately—often through special escrows.
• Leverage for founders: This product preserves more proceeds at close and de-risks the post-closing period for sellers.
  • Quote: “It really takes the temperature down… You're going to basically keep all the money you get at the deal when the deal closes.” (Mike, 20:12)

Notable Quotes & Memorable Moments

• On founders' assumptions:
  "Founders misunderstand the details... it sounds pretty simple, is your cap table your cap table, and then if they have raised a little bit of VC money, just understanding the preferences…that can lead to some misinterpretation around who's getting what part of the proceeds." — Mike Lyon [03:22]

• On IP assignments:
  "If you had an independent contractor doing it... you need to make sure that the company has got what's called a present assignment of all of the intellectual property." — Brian Linehan [06:25]

• On sales tax strategies:
  "If you let the buyer do the calculation...they're going to come up with the most aggressive form of liability...the best strategy here and the best outcome is do your work ahead of time." — Mike Lyon [10:22]

• On rep & warranty insurance:
  "I can't tell you the last time I did a typical indemnity deal...rep and warranty insurance...replaces the need for an identification escrow." — Brian Linehan [18:44]

Timestamps for Important Segments

| Topic | Start Time | Key Points | |--------------------------------------------------|------------|--------------------------------------------------------------------------------| | Introduction & Guest Background | 00:20 | Brian’s profile, episode focus | | Cap Table & Capitalization Issues | 01:22 | Documentation gaps, exit waterfalls, ordinary income tax on options | | Employee Misclassification | 04:26 | Contractor vs. employee, payroll obligations | | Intellectual Property Ownership & Assignment | 05:44 | Contractor IP assignments, patent rights, domain ownership | | Sales and Use Tax Diligence | 09:15 | SaaS taxability in 24+ states, remediation strategy, purchase price impact | | Customer Contract Red Flags | 12:29 | Change of control, ROFR/ROFO, MFN clauses, affiliate issues | | Real Estate Owned by Founders/Affiliates | 16:06 | Lease terms, market rate vs. off-market post-COVID | | Rep and Warranty Insurance | 17:20 | How it works, comparison to old indemnities, impact on negotiation | | Closing Thoughts & Key Takeaway | 22:10 | Recap of major diligence issues for founders |

Takeaways

• Prepare documentation early: Gaps in cap tables, IP assignment, or contract records can cause closing delays or buyer mistrust.
• Employee classification and sales tax are universal traps: Regularly reviewed as part of every deal.
• Rep & warranty insurance is the standard expectation for bigger deals: Sellers should understand its benefits and limitations.
• Know your contracts: Pay special attention to “change of control” provisions and any ROFR clauses that might chill buyer interest.
• Plan for real estate and affiliate transactions: These are less commonly problematic post-pandemic but still relevant.
• Proactivity is leverage: Being organized and transparent about these issues puts sellers in a far stronger negotiating position.

Episode in a Sentence

A practical, candid chat helping tech founders de-risk M&A diligence by illuminating the most common and costly legal pitfalls—so you can prepare, document, and negotiate ahead of the deal table.