Common Legal Issues SaaS Founders Should Be Aware of When Selling Their Business

Selling a SaaS business is a complex process fraught with potential legal pitfalls. Founders must be aware of various legal issues that can arise during a transaction, from capitalization and employee misclassification to intellectual property and sales tax compliance. Understanding and addressing these issues proactively can make the difference between a smooth transaction and one filled with delays and complications.

Vista Point Advisors collaborated with Brian Lenihan from Choate, Hall and Stewart LLP to address some of the most common legal diligence issues that SaaS founders should be aware of to assist them to be better prepared when selling their business.

Capitalization & Cap Table

When dealing with founder-backed companies that haven't raised institutional capital and thus haven't gone through an institutionally led diligence process, several common issues arise on the capitalization side. Often, the equity backup may not match what the founder believes the ownership to be. For instance, a founder might have promised 5 percent to a particular employee without proper documentation. Other issues include options granted at a specific strike price without backup for the fair market value determination or ensuring that restricted stock has proper 83B elections filed with evidence.

Taxation is another crucial aspect to consider. Many employees and some founders don't realize that options, if not vested and held for a year, are subject to ordinary income tax rather than long-term capital gains tax.

Additionally, founders who have raised venture capital may not fully understand the exit waterfall until the end of the process. This can lead to misinterpretation of how proceeds will be distributed. For instance, if a company has raised a small amount of institutional capital, it often comes in as participating preferred stock. This means investors get their money back first and then participate on a pro-rata basis. However, liquidation waterfalls or cap tables don't always reflect this accurately.

To help avoid surprises and potential legal issues, SaaS founders should:

1. Maintain accurate and up-to-date cap tables
2. Properly document all equity promises and grants
3. Understand the tax implications of different equity structures
4. Clearly communicate exit waterfalls to all stakeholders
5. Conduct regular reviews of capitalization documentation

It’s recommended that founders conduct a confirmatory analysis at the beginning of a process to ensure their capitalization table matches up with the supporting documentation. This helps prevent any discrepancies when presenting the cap table to potential buyers.

Employee Misclassification

Employee misclassification is another common issue that can arise during most transactions. Founders often overlook the details of whether a worker is a contractor or an employee, especially when dealing with different geographies. There are two main areas of concern: employee vs. independent contractor categorization and exempt vs. non-exempt status.

Many founders pay certain workers as 1099 contractors, which may not be legally correct if the person meets the requirements of an employee. If someone works full-time and exclusively for the company, they should be classified as an employee, subject to W-2 regulations, FICA, Medicare, and income tax withholdings.

Misclassification can lead to issues during diligence, as it's crucial for the company to comply with these employment laws.

Intellectual Property Assignment & Ownership

For SaaS companies, intellectual property (IP) ownership is critical. Founders often assume they own the IP simply because their company created it. However, proper documentation is necessary to confirm ownership, especially if the code was written by independent contractors or third-party developers.

Under copyright law, the author of the software code owns the IP, unless there is a "present assignment" of all intellectual property rights to the company. This applies not only to third-party developers, but also to current employees regarding patent rights.

Ensuring proper assignment documentation is in place before entering a transaction is crucial to help avoid leverage issues with contractors or developers post-deal. Most investors or buyers want to see the same contractual language for current employees as well.

Another common oversight is when the company's domain name is registered under the founder's personal account rather than the company's name. This often happens because founders secure the domain before formally establishing the legal entity. It's crucial to transfer the domain ownership to the company at the registrar level.

To ensure proper IP and domain name ownership:

1. Review documentation with employees and developers
2. Ensure all assignment language is in place
3. Obtain present assignments for all intellectual property rights, patent rights, and domains
4. Pay special attention to patent rights, if applicable

By addressing these legal issues proactively, SaaS founders may avoid potential complications during the selling process.

Sales & Use Tax

Sales tax is a recurring issue in almost every SaaS deal. As businesses grow and acquire customers across different states, they may become subject to sales and use tax in various jurisdictions. Currently, 24 states treat SaaS as taxable, either as a service or on another basis. Some additional states consider it taxable if there's a downloadable component.

During diligence, buyers conduct detailed analyses of sales tax compliance, which can result in significant liabilities. To mitigate this, sellers should perform their own analysis and negotiate escrows or voluntary disclosure agreements (VDAs) with buyers to handle potential liabilities post-deal.

Handling Sales Tax Issues

Rather than attempting to resolve all sales tax issues during the deal process, which can be time-consuming, consider this approach:

1. Conduct your own analysis: Hire an accounting firm to assess your potential liability.
2. Share your findings with the buyer: They will likely calculate a higher amount.
3. Negotiate an escrow and remediation plan: Post-deal, agree to hire a firm to achieve compliance, with funds coming from the escrow.

This strategy could result in a lower actual liability compared to a purchase price adjustment, which buyers might prefer but typically overestimates the risk. By addressing these legal issues proactively, SaaS founders can streamline the selling process and potentially optimize their financial outcomes.

Unique Contract Terms to Review

Contract terms with customers can complicate transactions. Some common problematic terms you should look for and bookmark ahead of time include:

• Change of Control Clauses. Large enterprise customers often include change of control consent requirements in their contracts. This helps ensure they know who they're dealing with, especially when engaging with smaller, founder-backed companies. It's important to understand these clauses in advance of a sale to identify which customers need to be consulted.
• Restrictive Covenants. Some contracts may include non-solicitation clauses for customer employees or limitations on doing business with competitors. While less common due to antitrust implications, these restrictions can impact the sale process.
• Most Favored Nation (MFN) Clauses. Enterprise customers might negotiate favorable pricing based on what the company offers to other customers. It's crucial to have a good understanding of these clauses and their potential impact on future pricing strategies.
• Affiliate Language. Contracts often include language binding the company and its affiliates. This can have unintended consequences post-acquisition, especially if the buyer is a larger organization. It's advisable to limit such clauses to just the company to avoid broader implications.
• Right of First Refusal. Some larger strategic partners may include a right of first refusal in their contracts. This can significantly complicate the sales process, particularly if discovered late in the due diligence phase. Other potential buyers may be less inclined to invest time and resources if they know another party has the right to take the deal.

Understanding and addressing these terms in advance is essential to help prevent them from becoming deal-breakers.

Founder or Affiliate-Owned Real Estate

If the company operates in founder or affiliate-owned real estate, it can raise potential issues during a sale. These properties are often leased on favorable terms to the company, which might not reflect fair market conditions. In a post-COVID environment with reduced real estate needs, these issues have become less significant but still warrant attention.

It's advisable to negotiate market terms for leases in advance and consider the potential synergies with strategic buyers who might have existing office space in key locations.

Representation & Warranty Insurance

Representation and warranty (rep and warranty) insurance has become a standard tool in M&A transactions, replacing traditional indemnification escrows. This insurance covers unknown issues post-deal, reducing the risk for founders and simplifying purchase agreement negotiations. While rep and warranty insurance doesn’t cover known issues, it could provide protection against unknown liabilities.

Common for deals over $30-40 million, buyers purchase this insurance to cover the seller's representations and warranties, typically costing 3-4% of the company's enterprise value, with a retention of about 1%. It provides coverage equivalent to traditional 10% escrows, thus protecting buyers and reducing sellers' post-closing risk exposure.

Founders should be aware of the process, including the retention (deductible) and the scope of coverage, to help effectively utilize this tool in their transactions.

Conclusion

Navigating the sale of a SaaS business involves understanding and addressing a myriad of legal issues that can impact the transaction. From ensuring accurate capitalization records and proper employee classification to securing intellectual property rights and managing sales tax obligations, each aspect requires careful attention. Additionally, contract terms and founder-owned real estate must be meticulously reviewed to help avoid complications during the sale.

Given the complexity and potential risks involved, it is crucial for SaaS founders to seek advice from their legal team and investment bankers. These professionals can provide valuable guidance, helping founders to anticipate and mitigate issues, to assist with a smoother and potentially more successful transaction. By proactively addressing these legal challenges, founders can maximize their business’s value and achieve a favorable outcome in the sale process.

This material is intended for informational purposes and should not be construed as legal or tax advice and is not intended to replace the advice of a qualified attorney, tax advisor, and/or financial advisor. Nothing contained herein is intended to provide specific advice or recommendation of a course of action in any situation. Opinions contained herein should not be interpreted as a forecast for future events or a guarantee of future results. Outcomes will vary depending on individual circumstances.

Vista Point Advisors does not provide legal or tax advice. Vista Point Advisors and Choate, Hall and Stewart LLP are not affiliated entities.