THE BLOG
01/28/2016 02:59 pm ET | Updated Jan 21, 2017

Why You Need to Select Your Investors with Care

2016-01-21-1453390738-8984757-StevenBuchwald.pngSteven Buchwald is a startup lawyer and founding partner of Buchwald & Associates in New York, focusing on representing tech startups. Steven frequently counsels emerging growth companies on business formation, equity distribution, startup financing and intellectual property law matter.

Due diligence: it's a term used with such frequency that it's nearly lost all meaning. Perhaps it's because -- on the surface -- it's a basic step that every business should see to. Investigate an investor prior to signing a contract with them; investigate a business prior to establishing a partnership; investigate an individual prior to welcoming them into your startup. These are all simple, basic steps that one would be foolish to ignore.

And yet it seems that more often than not, many entrepreneurs do. Consider a story told back in 2012 by VentureBeat of a startup founder who, after courting a large enterprise for several months, found himself and his business tossed out into the cold. His startup has since dissolved and the team has disbanded and sought position elsewhere in Silicon Alley. It's a horror story that's distressingly common in the startup space.

"In the last days of January, I get a phone call while I'm in the middle of cooking dinner," the anonymous founder recounts to VentureBeat. "It's from my contact at The Company. He tells me, 'I'm sorry, but the CEO changed his mind. We're not moving forward with you guys.' What? I was furious and trying not to panic. 'Why not?' He gave me several reasons, including uncertainty about how our product would integrate into their suite of offerings and disagreement on the roadmap we presented."

"The one that stuck with me the most was, 'Our engineers looked at what you showed us during due diligence and told our CEO, it doesn't look so hard, we can build it ourselves,' he continued. '[It was] information that we had shared under NDA.'"

The founder goes on to remark that his company lacked the capital to enforce that NDA and that the larger organization knew that full well. He doesn't think he'll ever know if his contact was negotiating in good faith, or simply looking to siphon information. And at the end of the day, it hardly seems to matter. He'd find himself in the same position regardless.

So, what can you do to avoid your startup befalling a similar fate?

Dig Up Dirt on Prospective Partners


 

Admittedly, it's rare to make one's way so far down the M&A pipeline before being cast aside. At the same time, it's a sad fact that there are businesses that will use acquisitions as an excuse to steal intellectual property from startups. Here's the good news, though: such organizations are a rare breed and tend to quickly develop a negative reputation in their field.

Ask around about any potential purchasers or investors. Check with other organizations in your field (and theirs), and question their fellow investors on their conduct. If there's a scandal to be found, you're sure to eventually dig it up.

Insist on Drafting a Letter of Intent


 

Perhaps the most important document in any merger or acquisition, the Letter of Intent spells out -- in detail -- the agreement that's been established between buyer and seller. Although generally non-binding, it outlines the key terms each party has agreed to honor. Should the acquisition proceed, it will act as the basis for the official purchase agreement. Do not move down the acquisitions pipeline without one. And don't draft one up without having lawyers present.

Be Discerning and Don't Get Ahead of Yourself


 

In a situation where your startup seems likely to be acquired by a large enterprise, it can be tempting to give them as much information about your product as possible. After all, the more they know, the better your chances of impressing them, right? Wrong.

By disclosing proprietary information before it's absolutely necessary to do so, you're giving the buyer leverage over you, and creating a potential situation where they might decide it's easier to create a stand-in product rather than acquire yours. In short, don't share freely. Share intelligently.

There are many horror stories in the startup space associated with failed mergers and the theft of intellectual property. By practicing due diligence, being discerning on what you share, and ensuring that there are clear boundaries and responsibilities for both parties, you reduce the likelihood of your own business becoming the next victim.