Technology deals in the UK – the lawyer’s perspective
June 2020 | SPECIAL REPORT: MERGERS & ACQUISITIONS
Financier Worldwide Magazine
June 2020 Issue
The pause button has largely been pressed on M&A activity in the UK due to the COVID-19 pandemic and its consequent economic impact. Some sectors of the economy, such as travel, aviation, sport and hospitality, have been hit particularly hard. However, the technology sector remains comparatively resilient. Cloud computing, online video conferencing and cyber security are all coming to the fore as an increasing number of people adapt to working from home. Technology is increasingly pervasive and as Satya Nadella, the chief executive of Microsoft, said recently: “Today, every company is a technology company, and every organisation will increasingly need to build its own proprietary technology solutions to compete and grow”.
The dramatic change created by the pandemic will most likely act as a catalyst for further innovation and new technologies. There will also be opportunities for cash-rich buyers that may be able to acquire technology businesses at lower valuations than in previous years. In this article we look at some of the key legal considerations when undertaking a technology transaction in the UK. Specifically, we look at a share acquisition of a private limited company governed by English law.
The main value elements of technology companies typically revolve around the intellectual property (IP) that the company owns, the data that it holds and the know-how and expertise of its employees. These areas will be the primary focus of the legal due diligence and of the warranties and indemnities in the share purchase agreement. The buyer’s legal due diligence process will normally consist of: (i) undertaking public searches, such as at the UK Intellectual Property Office (IPO) for registered IP and at WHOIS for domain names; and (ii) obtaining information from the seller via due diligence questionnaires and follow-up questions. To mitigate the risk of IP infringements, relevant clearance searches should also be undertaken.
The buyer will want to verify that the target company owns or has appropriate rights to use the material IP that is used in its business. Registered IP, such as patents and trademarks, is generally easy to identify. Domain names are typically treated as registered IP in transactions and can also be easily verified. Material unregistered IP, such as copyright, know how, database rights and so on, can be more nebulous and so should be clearly set out and described by the seller. Unregistered IP is especially important for a software business as the most important IP is likely to be copyright in its software.
Software due diligence will include identifying any material proprietary software that the target company has developed. The buyer will want to know whether this has been developed by the employees of the target company or whether external consultants have been used. Under English law, the general rule is that copyright created by employees during their employment will be owned by their employers. However, by way of contrast, unless there is a clear written contractual provision to the contrary in a consultancy agreement or other contract, an external consultant will own the copyright that they have created during their engagement, although there are likely to be implied, if not express, licences. Often the purported assignment clause in a consultancy agreement is badly drafted and insufficient to assign copyright legally. As such, buyers will often insist on a confirmatory assignment from the relevant software developer prior to completion. This process will need to be carefully managed as the deal will be at a sensitive stage and confidential.
Best practice is for the buyer to carry out an audit of the code whenever proprietary software is a significant part of the valuation of the target. A third party may be instructed to carry out the scan and provide an audit report to the buyer, as opposed to provision of the actual detail of the source code itself. By identifying open source code and third-party components and licences, an open source audit can help the buyer’s team identify any significant legal and security risks. Open source is commonly used by software businesses as it speeds development and lowers costs, which is important in this fast-moving and competitive sector. Open source components are governed by licences with a varying level of obligations. Some of the more onerous licences such as a ‘copyleft’ licence can ‘infect’ the target company’s code resulting in an obligation to distribute its software with the source code on open source terms. This will obviously set alarm bells ringing. Where the target uses key third-party software under licence, a buyer may also check if appropriate software source code escrow arrangements are in place as part of business continuity good practice.
Registration of domain names will also be checked. It is not uncommon for fast-growing software companies to still have websites registered in the name of the founder as opposed to the actual company. A search of the WHOIS database should be carried out for each domain name used by the target business. The buyer should also review all key licences of intellectual property rights (IPRs), both of any licences granted by the target and any third-party rights licensed into the target. The analysis of licenced-in IPRs should check whether there are any change of control issues, whether they cover the right geographic locations, royalties, durations, the ability to sub-licence to customers, other restrictions and so on.
Increasingly, due to compliance risks associated with personal information, buyers will scrutinise the extent to which target companies comply with data protection laws. The buyer will also want to ensure that the target company has adopted a sufficiently robust strategy in relation to IP protection. For example, have key brands been registered in all relevant territories? Other key areas to be investigated for technology companies will include infringement by the target company of third-party IPRs, the robustness and resilience of the target company’s IT systems, cyber security and confidentiality policies and procedures.
The main legal document for the acquisition will be the share purchase agreement. This will detail the precise terms of the purchase setting out the consideration and how it is to be paid and also the legal and practical mechanics to effect the transfer at completion. The sellers will give warranties about the target company and enter into non-compete obligations to protect the goodwill the buyer has bought. These non-compete obligations will typically last between two and three years. For a technology transaction, the warranties given by the sellers will be more extensive in respect of the IP, IT, data protection and cyber security aspects given this is where the main value of the target company resides. If a specific risk has been identified in the due diligence phase that cannot be remedied prior to completion, the buyer is likely to seek a specific indemnity where it can recover on a pound for pound basis in relation to this risk. However, if this specific risk is very material then a purchase price reduction might be sought. Alongside the share purchase agreement there will be numerous ancillary documentation, such as a disclosure letter, tax deed, IP assignments, consultancy agreements, stock transfer forms, board minutes and so on, that will also be negotiated and agreed as part of the deal process.
This article gives a whistle-stop tour of some of the main areas that the lawyers on a technology deal will be focusing on. Given that today, every company is a technology company, most M&A deals will now involve aspects of these key themes.
Will Axtell and Joanne Vengadesan are partners at Penningtons Manches Cooper LLP. Mr Axtell can be contacted on +44 (0)1865 813 670 or by email: will.axtell@penningtonslaw.com. Ms Vengadesan can be contacted on +44 (0)118 402 3833 or by email: joanne.vengadesan@penningtonslaw.com.
© Financier Worldwide
BY
Will Axtell and Joanne Vengadesan
Penningtons Manches Cooper LLP