How Not to Lose Value in Your Startup Exit Strategy: 10 Best Practices for Founders

15% to 25% of a startup's value is at risk of being lost when founders put off resolving legal issues. These problems will inevitably arise during the buyer's legal due diligence process, which always precedes acquisition (the so-called ‘exit’).

In this article, we’ll talk about the most common legal issues that arise during a startup's due diligence before the exit and what best practices might help founders protect their initial startup valuation.

What is "legal due diligence" and where does the 25% drop in value come from?

Legal due diligence is the verification of a company's legal documentation to assess its risks prior to acquisition.

Practice shows that startups at early stages do not worry about legal issues for a number of perfectly valid reasons: working with lawyers takes a lot of time, the costs of their services are pretty high, and often lawyers can struggle to understand the technological component of the startup in order to properly formalize it.

As a result, serious legal problems arise during the legal due diligence process prior to acquisition. The most typical of these are:

1. Unformalized intellectual property rights, unregistered trademarks and patents, potentially leading to issues with licensing developments in the future, risks to the brand, domains, and know-hows (e.g., inventions and technologies).
2. Lack of contracts and policies for handling customer personal data. This may cause potential fines for violating personal data protection legislation.
3. Unformalized relationships with the team, which can trigger potential fines for violating labor legislation, as well as potential losses in cases of critical employees leaving.
4. No shareholders or founders agreement, and subsequently no agreed mechanism of exit between the founders, which might delay a deal for many months.  
5. Gaps in financial reporting. Nobody wants to be fined by the tax authorities.

The buyer sums up all potential fines/risks prior to the acquisition deal, and "discounts" the exit value by the resulting amount. Often, the discount amounts to 15% to 25% of the purchase price that was discussed prior to the due diligence. A very unpleasant surprise for the founders.

To avoid this, basic but important legal issues need to be addressed at early stages.

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1. Formalizing the startup's intellectual property

Best practice: sign agreements on the transfer of intellectual property rights with every freelancer/contractor/employee who creates something for your product (code, logo, design, texts, etc.). Don't doubt it: the buyer's lawyer will ask about every object of intellectual property that the product consists of and will want you to provide warranties that your intellectual property does not violate anybody’s rights.

2. Registering a trademark or a patent if applicable

Best practice: register a trademark for your brand. This will protect you from unscrupulous competitors who may register your name earlier, and then use it to take all similar domains. The same goes for the patent for your invention if you have them, which will prevent conflicts with third parties of infringement of rights.

3. Developing Terms of Use for the website/application

Best practice: don't copy ToU from other sites. Firstly, they may not comply with the legislation of the countries in which you operate. Secondly, they are likely to lack the necessary disclaimers that should protect you from unfounded complaints from users. It is better to order a customized ToU from a lawyer.

4. Developing a Privacy Policy for your website/application

Best practice: consult with a lawyer regarding specific requirements for handling the personal data of citizens of individual countries/regions in which your product operates. In some of them, authorization will be required, and in others, additional procedures must be reflected in the policy. It is worth paying special attention if your customers are located within the EU, and their data might be processed in other locations, as the fines are rather high.

💡Worth checking: privacy policy: everything you need to know + Free Template

However, the Privacy Policy on the site will not be enough to guarantee that you will not get fined by the regulator. During due diligence, lawyers also check:

• the presence of contracts with third parties with whom the startup exchanges personal data;
• the implementation of internal policies for employees in case of personal data leaks or requests from users to delete their personal data.

5. Auditing open source licenses used in product development

Best practice: make sure that your product developers document every "open license" when using open-source code in development. If your business model involves distributing software, and the "open license" on the open source code used in development prohibits this, you will either need to change the business model or the source code of the product itself.

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6. Signing an agreement between startup founders

Best practice: document all agreements reached prior to the moment of founding the startup. This document should describe the distribution and issuance of shares, the decision-making process, and procedures for resolving conflicts in the team. In addition, it is advisable to include a "tag-along" clause, which will give minority shareholders the right to join the transaction and sell their shares to the buyer on the same terms as the majority shareholders.

"Buyers usually want to be sure that there’s no outstanding indebtedness or unresolved matters, or other liabilities between the founders and the business"
‍
Daria Kurishko, Head of Startup Legal, Legal Nodes

7. Creating an agreement with investors

Best practice: when attracting investments, it is necessary to sign an agreement with investors that defines the conditions for their entry into the company. The agreement should describe the terms of investment, the rights and obligations of investors, and the procedure for resolving disputes between the parties.

📚 Read more about structuring early-stage startup fundraising agreements

8. Complying with tax legislation

Best practice: it is important to comply with tax legislation from the very beginning of the startup's development. This includes registering with the tax authorities, paying taxes on time, and keeping accurate financial records. Failure to comply with tax legislation can result in significant fines and other legal consequences.

9. Making sure the valuable assets belong to the company

Best practice: when signing agreements in your ordinary course of business with creditors, partners, etc., have the agreements checked by the lawyers to make sure there are no unusual terms or exceptional nature provisions which can lead to loss of the company’s assets or intellectual property. Make sure you do not provide any encumbrances, guarantees, or assignments of your company’s assets and intellectual property. 

10. Regular legal audits

Best practice: regular legal audits can help identify and resolve legal issues before they become major problems. It is advisable to conduct legal audits at least once a year to ensure that all legal documentation is up to date, that the company is in compliance with all relevant laws and regulations, and has all required licenses and permits. It is also important to introduce KYC and AML policies to ensure the company is not in infringement of any sanctions, anti-corruption or anti-bribery laws. 

 📚 Read more on how to approach global compliance when building your startup

By following these ten best practices, startup founders can protect themselves from financial losses and ensure the successful exit of their company. It is important to remember that legal due diligence is a crucial step in the acquisition process, and addressing legal issues early on can help avoid significant discounts on the value of the company.

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