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Will open source close your exit?

The use of open source software, in the developmental stages of a portfolio company, is becoming increasingly problematic for private equity firms when that company comes to be sold. Karen Copenhaver and Ira Heffan outline the key issues that investors and portfolio company management need to be aware of when dealing with open source software, and how it may affect the potential exit opportunities available to an enterprise.

For many private equity investors, the following scenario has begun to play out on a recurring basis: One of the investor’s portfolio companies is a potential acquisition candidate, with a term sheet negotiated and signed. The acquirer begins its due diligence with an inquiry into the origin of the company’s technology, conducting interviews with the development team and running code-scanning tools to identify embedded copyright and license notices. After a few days, the acquirer informs management of the erstwhile target, to its great surprise, that the company’s developers made inappropriate use of "open source" software programs obtained over the Internet in developing the company’s products. The acquirer tells management that it has serious concerns about the impact of these problems on the proprietary nature of the company’s code, and that there is already a significant decrease in the acquirer’s perceived value of the company’s technology. With due diligence review just begun, the negotiating leverage of the parties has quickly tilted away from the target.

How can you prevent this from happening to your company? This article outlines the key issues that investors and portfolio company management need to be aware of when dealing with open source software, and how open source may affect the potential exit opportunities available to an enterprise.

What investors need to know. When considering potential acquisition scenarios for a portfolio company, private equity investors need to have a working knowledge of the fundamental principles of "open source." Such an understanding is critical in assessing both the legal and the practical impact of the use of open source software on the company’s operations as well as the company’s attractiveness as an acquisition candidate. Investors need to be aware of the following:

· There are a number of open source software licenses that permit use of the open source software only if the source code of all derivative and/or collective works that include the open source code is also made publicly available.

· An established commercial software company will not want a target’s use of open source software to require the release of source code for the target’s or the acquirer’s proprietary products.

· Acquirers therefore will want to know that the use of open source software has been carefully controlled so that an obligation to release source code occurs only where intended.

· Acquirers will have varying levels of tolerance for open source usage, and careless use is far more likely to have a negative impact on a transaction.

· Concerns about open source use can fuel internal naysayers at the acquirer who favour an internal solution over acquisition. Embedded open source software may raise questions about maintaining segregation of the acquired code after the acquisition or potential costs to replace portions of the acquired code base.

What company management needs to know. Similarly, management has to be aware of the implications of using open source software. Key decisions regarding the company’s products and potential liquidity opportunities will depend on a thorough understanding of the following key principles:

· The use of open source software is pervasive and is likely to become more so. When used correctly, open source is a low cost alternative to developed code.

· The licenses that govern use of open source software impose a variety of obligations — some, but not all, require that the licensee share the source code for all derivative works.

· Compliance with open source licenses requires focused management attention.

· Demonstration of compliance will be a part of any rigorous due diligence review.

· A compliance failure could cause an acquirer to pass on the opportunity, lower the valuation, or require representations and escrows that make the proposed acquisition unattractive to the investors.

Should Use Be Prohibited? After a discussion of the risks associated with open source software, investors and portfolio company management often state an intention to "just say no" to open source — they take a pledge to prohibit the use of any open source software in the company’s software development. However, in the current environment, it is a rare company that can avoid all use of open source software. The cost and timing advantages of open source and the prevalence of standards that assume open source usage make abstinence unworkable.

Managing The Risk. If both investors and management accept the fact that most companies will use at least some open source software in their operations or products, what steps should be taken to manage the risk? There are several "best practices" that should be adopted to facilitate compliance on an ongoing basis, as well as to enhance the opportunities for a successful liquidity event.

· Education. Companies that embrace open source are well versed in the tenets of the open source movement and understand the importance of compliance with the terms of the applicable licenses. It is the software company that has not directly addressed the use of open source that will harbour developers who act inappropriately. The first step is to convince everyone involved in development of software that all software is distributed pursuant to license terms that govern its use and that these terms must be reviewed to ensure compliance with open source obligations. Commercial software that requires payment typically goes through a formal procurement process. Open source software, when downloaded without charge, can potentially evade the business controls that are a normal part of procurement unless the developers take the initiative to seek review of the open source license terms.

· Choose your expert. There is no substitute in a transaction for a person who has firsthand knowledge of the steps that have been taken to manage the software development process. Scurrying around to re-create or gather information necessary to respond to due diligence inquiries does not produce convincing evidence of compliance and could erode the acquiror’s confidence in the management team. An individual who has earned the trust of the developers, is technically competent to choose between development alternatives, has participated in the decisions about open source usage and has the authority to ensure follow-through will be invaluable in the due diligence process.

· Systematically preserve archival records. If any issues arise, the acquirer will want to know that it is possible to identify work that occurred prior to a particular date. Promises that records exist, followed by an inability to produce those records, is an error from which the target may not recover.

· Review the company’s code base. Acquirers will often search a target’s code for indications of open source software usage. Some programs search all text strings for words associated with free and open source software, such as GNU, GPL and Linux. Other programs attempt to identify object code that is identical to code found in these programs. It is much better to identify and resolve open source issues in a private and privileged dialogue with company counsel in advance, than to try to address these issues for the first time in the midst of a transaction.

Open source is fast becoming a part of the landscape. Executives will soon see management of open source license compliance as just one more business process to manage risk. Through knowledge of open source and its implications, both private equity investors and portfolio company management will be able to get ahead of the curve, and position their software companies for successful liquidity opportunities.

This article is reproduced with permission of Testa, Hurwitz & Thibeault, LLP. For more information about Testa, Hurwitz & Thibeault, LLP, please contact www.tht.com

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