Part 1: #Start-up M&A: The (Not-So-Fun) Exit - Distressed M&A in Start-up Land | Legal Ninja Snapshot

When start-ups dream of an exit, they picture ringing the bell at an IPO or celebrating a headline-grabbing acquisition. But what happens when the journey takes a detour through the valley of distress?

In this multi-part Orrick Legal Ninja Snapshot, we shine a light on the tough side of start-up M&A—where liquidity is tight, options are limited, and the "soft landing" is sometimes the best outcome on the table. We’ll break down the interests at stake, the mechanics of bridge financings, the unique quirks of asset deals, and the strategies for keeping key talent motivated when the liquidation preference waterfall looks more like a trickle.

Whether you’re a founder, investor, or operator, this series will arm you with practical tools, market insights, and a few hard-won lessons from the front lines of distressed deals. Because sometimes, the real test of a start-up isn’t how high it can fly—but how skillfully it can land.

This Legal Ninja Snapshot Series

In this two-part mini-series, we present key findings on:

• Part I:
  1. The Interests Involved
  2. Bridge Financings Prior to an Exit
  3. Asset Deal Structures
• Part II:
  1. Asset Deal Contract Issues
  2. Some Tax Aspects of Distressed M&A Deals
  3. Keeping Key Executives on Track in Distressed Exit Processes

OLNS #13

For a comprehensive overview of start-up and scale-up M&A in Germany, we refer you to our Guide OLNS#13 – M&A in German Tech which discusses deal structures, M&A processes, practical challenges and best practices for both the buy- and sell-side in detail.

Preface

Success for start-ups is often framed as reaching a liquidity event, or exit, that provides financial returns for investors, founders, and (hopefully) the start-up’s employees. There are two main ways to achieve an exit: go public or sell the company for live-changing sums. We are not sure why we still say that there are two options but maybe IPOs will make a comeback one day.

Most venture-backed start-ups, however, never reach either of these paths; or if they do, it is in a state of more or less distress. While exact numbers are hard to come by, there is widespread consensus that most start-ups fail, i.e., go out of business or are sold for an amount that doesn’t provide a return to all shareholders. Founders and investors may not expressly call this a "failure" and indeed may work mightily to find a "soft landing" that allows them to characterize it otherwise.

The Interests Involved

Selling a start-up through an M&A deal is generally the first preference for most start-up participants in a venture that does not have a likelihood of continued lifespan as an independent VC-backed start-up.

• Founders and employees might at least be enticed by some deal "carrots" (more on that later) or employment at the buyer. Some kind of "start-up exit" other than outright bankruptcy will also allow these individuals to craft a narrative of success for their individual career paths.
• Investors might be able to recoup at least some of their investment and redeploy their time and capital into more promising ventures. In addition, investors are repeat players in a dense network, and this form of exit preserves their reputation and relationships in the overall ecosystem better than sending the start-up into liquidation – or even worse, insolvency.

However, such a distressed deal is the end of a journey that may pose some particular challenges to the parties involved. In this Snapshot, we will shed light on some of the most relevant issues.

Aligning the interests of all major stakeholders, including common shareholders (read founders), early-stage investors and later-stage investors, is critical. This may require extensive communication and negotiation to ensure all parties understand the financial realities and agree on the sale process. Enforcing a drag-along right provided by the start-up’s shareholders’ agreement is a legitimate option but one that should come only after the failure of negotiations to align all of the sell-side stakeholders.

Bridge Financings Prior to an Exit

In distressed exit cases, the start-up will still be loss-making and have negative cash-flows. Thus, securing sufficient liquidity until the deal can close can become an issue when heading into the exit process. However, existing investors might be reluctant to provide a bridge to an exit when the expected exit proceeds will be underwhelming.

Major investors will also be aware that smaller or earlier investors might have an incentive to look to them for writing just another cheque while themselves adopting a free-rider approach. On the other side, investors who still have the means to keep investing might realize that, while their liquidation preferences will only give them some downside protection, a bridge financing might juice up returns at least a little bit.

Against this background, major investors might be willing to provide bridge financing but only on terms others might consider onerous at the very least. The goals are twofold:

• Incentivize the other existing investors to "do their share." Similar to a pay-to-play down-round, investors who want to benefit from the exit (keep playing) need to pay.
• Even if their prior investments in the start-up are economically "under water," investors can secure a decent return on the bridge financing round through a multiple liquidation preference on that final investment, provided the exit closes.

Such exit bridges can come in the form of a straight equity financing against the issuance of senior-ranking preferred shares or in the form of a convertible loan (note that the tax treatment might be different in the two scenarios). Irrespective of the form of investment, bridge investors will request special conditions for what they consider an above-average risk with a limited equity upside. This might include, among other things:

• Staged financing depending on the start-up’s financial needs or progress with and status of the exit process.
• 3-5x preferred return for the bridge investors on their investment in the exit bridge.
• The bridge investors may also request that a pro rata portion of their existing preferred shares be pulled up into a higher class of shares so that they have a higher chance to participate in the distribution of the exit proceeds through the waterfall.

Asset Deal Structures

Asset vs. Share Deals

In tech exits, we need to distinguish between share deals and asset deals. We explain the two deal types in detail in OLNS#13. Suffice it to say that in a share deal, shares in the start-up are acquired by the buyer who thereby indirectly (economically) acquires all assets and liabilities of the start-up. In an asset deal, the buyer acquires some or all assets of the start-up and usually seeks to only assume selected of its liabilities (if any).

• A share deal is particularly suitable if the focus is on acquiring all rights and contracts quickly and smoothly. Unlike an asset deal, it does not require the transfer of individual assets (such as IP rights) or contractual relationships.

  Instead, the legal entity is acquired with all rights and obligations. In general, the processes and day-to-day business are significantly less affected by a pure change of shareholder than an asset deal. It is also not necessary to obtain the consent of contractual partners of the start-up for the transfer of contracts (although relevant license agreements or R&D contracts may contain change-of-control clauses that might require special attention). The share deal can also be advantageous from the perspective of employee retention, both for the buyer and the sellers. On the one hand, the identification of employees with "their" company is usually less affected by a pure change of ownership than in the case of an asset deal. Secondly, a share deal does not involve a transfer of business, meaning employees have no right to object to a transfer of their employment relationship in accordance with sec. 613a para. 6 BGB (we will come back to this topic).

• An asset deal, on the other hand, can be the method of choice if the start-up contains business areas or risks that the buyer does not wish to take over. The asset deal allows cherry-picking, at least to a large extent.

  This is also associated with increased expense. For example, the assets to be sold must be sufficiently specified and delimited with regard to the principle of certainty under property law. In addition, the consent of the creditor or contractual partner must be obtained for liabilities and contracts assumed in an asset deal, so the takeover is also effective in the external relationship.

(Distressed) Asset Deal Process Considerations

Acquiring the start-up’s business (or parts thereof) via an asset deal becomes particularly strategic when the start-up is facing impending or ongoing insolvency. In these scenarios, assets can often be snapped up at bargain prices. If the buyer swoops in before insolvency proceedings are officially opened, the debts may remain with the target company. But beware: there’s a catch.

If the target still ends up in insolvency proceedings, because the proceeds from the sale don’t cover all its creditors’ claims and the costs for an orderly liquidation process, the insolvency administrator could challenge the asset acquisition for disadvantaging creditors and seek reclaiming the assets if they haven’t been bought at their fair value. The buyer would then only get back the purchase price according to the insolvency quota – not exactly a ninja move. So, the buyer might wait until the insolvency proceedings are underway.

In this scenario, the asset deal is handled directly with the insolvency administrator. While the opening of insolvency proceedings can delay the transaction, destroy value in the start-up’s business or cause important talent to move on, it has some advantages, too: In particular that the buyer won’t be on the hook for employee claims that arose before the insolvency proceedings began and that insolvency law provides tools for simplifying personnel reductions.

Given that asset deals, especially in distressed situations differ significantly from "ordinary" M&A transactions, we want to highlight a few key differences and a few challenges of asset deal processes. We start with some general considerations that characterize many asset deal exit processes before presenting some particularities in asset deal transaction agreements.

Time Pressure: Often, distressed asset deals must happen under extreme time pressure with little time or financial possibilities to properly prepare a divestment process with respect to data room, due diligence process or draft transaction agreements. The time constraints will create a lot of pressure to move into full due diligence right away. That often leaves little room for a staged process that seeks to preserve confidentiality unless the bidder is really interested in the acquisition. The overall process can put a lot of pressure on the start-up’s organization and personnel, especially when several business units are meant to be sold to different buyers more or less in parallel.

(Rationally) Uninterested Shareholder Groups: The purchase price will often not be what parties had hoped for and chances are that most or even all the proceeds will go to the holders of the most senior preferred shares or investors who provided the latest "bridge to exit" financing, often with multiple liquidation preferences. So, if the founders have little to gain and investors will at best get their money back or make a modest return, the question arises: Who shall take the lead on the sell-side and drive the transaction to conclusion?

The problem is that, for most shareholders, doing nothing might seem like a sound strategy, a phenomenon described in organizational behavior as "rational apathy." Where ownership is highly dispersed and no meaningful exit consideration can be expected once the money flows through the waterfall, the perceived costs of involvement (i.e. outside advisors' fees and own time commitment and resulting opportunity costs) outweigh the anticipated benefits.

The small shareholders or those with shares at the bottom of the preference stack will rely on others to take on the burden of searching, organizing and negotiating a deal. They assume that other, more significant shareholders or institutional investors will protect their interests, allowing them to "free ride" on the efforts of others.

The problem is that the large VC investors will also have little incentive to dedicate scarce management resources to an activity that will create little value for their LPs (not to mention the general partners’ carried interest...).

Depending on the specific circumstances, mitigation strategies might include:

• Financial Incentivization: Determining how to allocate proceeds among various stakeholders, especially given the liquidation preferences, is essential. In some cases, it might become necessary to adjust the existing waterfall to bring all relevant stakeholder groups along. This is particularly true for those whose participation in a sale cannot be enforced via drag-along provisions that are standard in most German start-ups’ shareholders’ agreement. The latter group might include key employees who need to be convinced to stay the course.
• Concentration of Decision-making: We consider it essential for shareholders to have at least a tacit agreement on who will lead the negotiations. This will often include the largest institutional investors on the cap table, who will be perceived as the "professionals in the room." Depending on the circumstances, the founders might also play a vital role as they can best present and explain the start-up's business or play a role in the buyer’s post-acquisition plans.
• Enhanced Communication: To the extent the particularities of the exit process (time pressure, confidentiality concerns etc.) allow this, the small shareholders should receive regular information. Comprehensive communication makes it easier for them to stay informed and at least somewhat engaged. It can also reduce potential mistrust of shareholder groups accused of unduly extracting value from the transaction.
• Reducing Participation Costs: Participating in the exit process should be as painless as possible for small shareholders. This might include a centralized process to obtain powers-of-attorney, certificates of representation and KYC packages. It also might include template powers-of-attorney and administrative support to get them executed in a proper form.
• Form Requirements: Unlike the transfer deed for shares in a start-up organized as a GmbH or an UG (haftungsbeschränkt), an asset purchase and transfer agreement usually does not require notarization unless the asset deal extends to (i) real estate or (ii) substantially all assets of the start-up.

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