Preparing a Small to Mid-Cap Company for Sale
Lawyers who frequently find themselves on the sell-side of small to mid-market M&A transactions quickly learn that while these transactions usually represent the most significant financial event in their clients’ lives, the sellers are oftentimes alarmingly unprepared to proceed with a sale transaction. The obvious reason for this unpreparedness is that most small to mid-sized business owners are focused on running their businesses (as they should be) rather than concerning themselves with taking the measures necessary to prepare for a potential sale transaction. This article is intended to be a basic primer for small to mid-sized business owners (and their financial advisors) who may be considering undertaking a sale transaction, starting with the concerns that may prompt the consideration of a sale and addressing several of the major issues that must be confronted once the decision to sell has been made.
First, what typically prompts a business owner to explore a sale of his or her company? Oftentimes the company’s owner recently has discovered that he or she has health problems that may mandate a lifestyle change. Competition is another frequent factor—the company may be suffering increased competition from larger businesses (e.g., the “big box” retailer comes to town). In many cases, the lack of a competent successor to manage the business after the current owner’s retirement or death (e.g., the owner has no children, or the owner’s children are uninterested in or incapable of running the business) prompts the exploration of sale opportunities. In other cases, the company’s owner has much of his or her net worth tied up in the company and would like to “cash out,” either partially or wholly. In others, the company may need additional capital that the owners are unwilling or unable to invest or obtain from other sources. Finally, the owner may recognize that the current market environment makes a sale transaction attractive (e.g., the company is in an industry currently favored by buy-out funds, market factors make the company’s future look highly profitable, etc.).
A related issue that any selling business owner must consider at the outset is what he or she expects to obtain from a sale of the company. The most obvious answer is liquidity—the sale proceeds may generate many times the owner’s current salary and other distributions from the company. Liquidity, however, is far from the only reason for considering a sale transaction. For example, in a partial sale of the company, the buyer may provide the company with capital to expand the business (potentially making the existing owners’ retained ownership position more valuable in the future). Diversification of investments is another potential benefit of a sale transaction. By selling the company, the owner will be able to use the proceeds to diversify his or her investment portfolio and eliminate (or, if the owner retains some ownership or part of the consideration is seller financing or buyer stock, lessen) the owner’s risk of the company’s value declining in a future market downturn. Another potential benefit is that a voluntary and orderly sale transaction consummated during the owner’s life will usually generate a higher purchase price and better terms than a forced and rushed sale that may be necessary after the owner’s death.
Once the decision to sell has been made, the next major issue is identifying potential buyers and marketing the proposed transaction. There are two main ways of identifying potential buyers and getting them interested in a sale: (1) raising the company’s profile; and (2) engaging a business broker or investment banker. Each is discussed in turn below.
If the company is relatively small, it is unlikely that its business, however profitable, is going to be sufficient to garner much attention from potential buyers. Rather, the company (and its owners) will need to be proactive in raising its profile through various marketing efforts, such as participating in local business associations and community organizations. Additionally, the company may want to consider hiring a public relations consultant to work on its behalf.
As noted above, good business brokers and investment bankers can be very helpful in identifying potential buyers and maximizing the purchase price; however, it is important that the company treat the engagement of a broker or investment banker as a key hire. The company should carefully examine the background, experience and reputation of any proposed broker or investment banker and should ask for and question references provided by the broker or investment banker. Legal counsel should be involved in reviewing and negotiating the broker’s or investment banker’s engagement letter, which will set forth the terms of the engagement, including the broker’s fee structure (including when the fee is earned), and the company’s indemnification obligations. Additionally, the company should consider how the proposed transaction fits within the broker’s or investment banker’s business model. For example, if the proposed transaction is small in comparison to most of the broker’s deals, this may signal that the company will not get the broker’s full attention. Conversely, if the proposed transaction is relatively large for the broker’s business model, the broker may lack the resources to adequately support the deal. Specific issues to consider include the following: (a) finding a broker that specializes in selling privately held businesses; (b) make sure that the broker has expertise in reconstructing the earnings of a privately held business to communicate its true worth; (c) ensuring that the broker is knowledgeable in revaluing depreciated assets to show their true value; (d) confirming that the broker is capable of organizing and conducting a thorough research effort to compare the company to others in the marketplace; and (e) establishing a fee structure that aligns the interests of the broker and the company’s owners. Finally, the owner should consider whether the company’s legal counsel, accountants or other financial advisors can provide similar services at a more efficient cost than a broker.
Throughout the buyer identification process, the owner should keep in mind that an auction is often the ideal scenario. If the owner is able to create a multi-bidder auction among several qualified buyers, it will naturally result in seller leverage, and it also tends to keep the winning bidder—who will be aware that there may be other willing buyers if the deal falls through—motivated to close the transaction. If the proposed deal size and buyer interest warrants it, experienced M&A counsel will oftentimes structure a formal, multi-round auction process.
Another key issue during the buyer identification process is confidentiality. It is important that the company act as discreetly as possible, and it is vital that each potential buyer sign a thorough confidentiality agreement covering the fact that negotiations are taking place, the substance of any negotiations or deal, and the contents of any due diligence materials reviewed. These precautions are necessary for the obvious reason that dissemination of the company’s trade secrets and other confidential information would be harmful to the company and for the less obvious reason that a proposed transaction can become increasingly unattractive if it becomes common knowledge that negotiations with several potential buyers have occurred without a successful closing. Additionally, a well-drafted confidentiality agreement can help protect the company’s customer and supplier relationships. The following are some key points to consider: (a) limiting disclosure to the employees and advisors of buyer who have a need to know the information; (b) ensuring the buyer is liable for any breach of the confidentiality agreement by the buyer’s consultants or advisors and not permitting any disclosure outside the covered group without notice and the opportunity to contest; and (c) confirming that the confidentiality agreement expressly addresses the return of the company’s confidential materials.
After identifying a buyer, the next step for the seller is getting its key players on board with the proposed transaction. If the company has multiple owners, the deal leader should attempt to build consensus around the decision to sell. This is also the time to consult with the other owners to determine a purchase price range, consideration form (e.g., cash, buyer stock, promissory notes, earn outs, etc.) and payment terms all parties would be willing to accept. At an early stage, the company’s legal counsel should determine the requisite approvals that will be needed to approve a sale, including the requisite Board, owner, regulatory and third party approvals.
At this point, it is also important to organize the deal team. In a very small business, the deal team may consist of the principal owner alone; however, it is more typical to include the members of the company’s senior management, each of whom will be responsible for his or her area of expertise (with the CEO acting as team leader). The key issue here is to keep the deal team’s size sufficiently small (promoting efficiency and confidentiality) while also ensuring that it is broad enough to include individuals whose areas of expertise will inevitably play a role in the transaction (e.g., human resources, finance, sales). Of course, it is also typical to engage outside advisors to the deal team. Advisors typically engaged to assist with a sale transaction include legal counsel, the company’s accountant(s) and, at times, a business broker or investment banker. Careful thought should go into the selection of these advisors. Legal counsel should have significant experience in M&A transactions, while a business broker/investment banker should have a demonstrated record of successfully closing transactions of similar size to the proposed transaction, particularly within the company’s industry or in the company’s geographic area. Most importantly, all advisors should be selected and assembled as early as possible in the sale process and be aware of the necessity of moving quickly and efficiently during all phases of the transaction. Finally, it is essential that one of the deal team members—be it the attorneys, accountants or some other person—have sufficient tax expertise to take the lead in analyzing and negotiating the tax aspects of the transaction.
As noted above, it is important that the owners come to some consensus regarding the valuation of the business. The business’ value may be determined by formal valuation methods, such as book value, multiples of earnings, discounted cash flows, and the like. These methods are oftentimes supplemented by looking to valuations used in comparable transactions, which would provide guidance as to the current market value of the company. Typically, only public company deals are available for this purpose but oftentimes a business broker or investment banker can give some advice based on recent private company transactions in which it has been involved. A related question is whether the valuation should be performed in-house or by an independent third party. The use of an independent appraiser may enhance the objectivity of the business valuation, as well as providing additional credibility. It also should be noted that an independent appraisal may establish the value of the company’s assets at a higher figure than that found on the company’s balance sheet.
Another major issue to address at this point in the transaction is seller due diligence, or, to put it less glamorously, dealing with internal housekeeping matters. By being organized, the company can make the buyer’s due diligence review quicker and easier, which will keep the deal moving towards a successful conclusion rather than getting sidetracked by missing items or issues that could have been easily remedied beforehand. This also has the side benefit of helping to avoid the prolonged disruption of the owner’s business. Additionally, a disorganized seller can give the buyer (or its attorneys) the impression that the company is poorly managed, which may prompt them to start digging for additional problems. This, in turn, can result in downward pressure on the purchase price. Conversely, a highly organized seller can make potential buyers more comfortable with the business. While getting organized and taking care of corporate housekeeping can be time-consuming and expensive, it also provides the seller with an opportunity to simultaneously conduct an internal due diligence review before the sale process commences. This internal review will give the company a chance to assess its strengths and weaknesses, correct problems, and predict issues likely to be raised by potential buyers, which will also allow the company to develop negotiation strategies for dealing with them. For example, the company can use its findings to identify synergies with certain potential buyers, which may aid in purchase price negotiations.
That said, perhaps the most important reason for keeping up with housekeeping and conducting a pre-sale internal due diligence review is to generate a list of disclosures that will be used to attempt to shift risk from the seller to the buyer. In the typical purchase agreement, the seller will be asked to make extensive representations and warranties regarding the company (e.g., that all contracts are freely assignable), but the seller may also be permitted to avoid liability for breaches of such representations and warranties to the extent the seller qualifies the representations and warranties with specific exceptions that the seller discloses on an ancillary document called the “disclosure schedule.” Thus, keeping up with housekeeping issues will alert the company to items that will need to be included on the disclosure schedule, which may ultimately allow the seller to allocate some of the risk back to the buyer (and keep more of the sale proceeds).
Common housekeeping issues that sellers should be aware of include the following:
Ultimately, the company will need to be able to provide potential buyers with evidence of its relationships with customers, vendors, landlords and other third parties. Some of the issues the company should be addressing include the following:
a. Are there binding contractual arrangements in place with key lenders, customers and vendors? If not, the company should consider formalizing these relationships in written agreements.
b. Are there any important contracts that are set to expire in the near future? If so, they may need to be renewed, particularly if the company has a renewal option that would add significant value.
c. Does the company have fully executed copies of all material agreements and instruments, including (i) all agreements relating to the company’s indebtedness and lines of credit; (ii) all leases, mortgages and deeds; (iii) all material agreements with customers and suppliers; (iv) insurance policies; and (v) joint venture agreements and the like? If not, fully executed copies should be obtained if possible and practical.
d. Does the company have a system in place for collecting, organizing and storing all material documents? If not, part of the housekeeping effort should be devoted to creating such a system.
e. May material contracts be assigned without the third-party’s consent?
Potential buyers will want to know the company’s claims history, particularly in a transaction structured as a sale of stock or merger where liabilities will be transferred (absent any liability allocation provisions in the purchase agreement to the contrary) to the buyer or surviving entity. The company will want to become familiar with the sources of potential claims and address the following questions:
a. Are there adequate records of all claims made against the company, even if they did not result in formal litigation?
b. Is the company’s business likely to have resulted in environmental damage? Does the company use toxic chemicals or generate toxic waste? Are (or were) there any underground storage tanks located on any real property owned or occupied by the company?
c. Are there any pending or threatened claims against the company and/or by the company against third parties?
Not surprisingly, potential buyers will view assets subject to liens and security interests as being less valuable than assets held free and clear. Accordingly, the company should address the following issues during the housekeeping process:
a. Is there a system in place for terminating liens and security interests as and when debts are satisfied? All such security interests and liens should be terminated promptly after the underlying debt is satisfied.
b. Is there a system in place to collect and maintain records of all outstanding liens and security interests?
A full understanding of the company’s historical accounting and tax issues is critical. For example, oftentimes a sale transaction includes a purchase price adjustment based on the company’s closing date working capital. If the company’s business is cyclical, a target based on the average trailing twelve-month working capital amount (or an adjustment for 100% of all closing date working capital) will make much more sense than a number derived from a recent balance sheet.
Potential buyers will derive comfort from organized and up-to-date books and records. They will want to see confirmation that the company has been conducted in compliance with applicable law (i.e., corporate, limited liability company or partnership law, as applicable) and that, if possible, there are no ambiguities in ownership or doubts about the entity’s legal validity. The following are some of the items that should be addressed:
a. Is the company in good standing with its state of organization and any other states in which it is authorized (or is required to be authorized) to do business? Have annual reports been filed in the applicable jurisdictions?
b. Are the company’s corporate books and records (e.g., Articles of Incorporation, Bylaws, board and shareholder minutes, stock ledgers, old cancelled stock certificates, annual reports, etc.) up-to-date and indicate compliance with applicable law?
c. Has the company’s Shareholders’ Agreement (or Operating Agreement if the company is an LLC) been executed by all shareholders (or members) and, where applicable or appropriate, spouses?
d. Does the company have copies of all stock (or LLC membership interest) purchase agreements?
e. Does the company have copies of all agreements to issue stock (or LLC membership interests), such as options or warrants, and are all compliant with applicable law?
f. Does the company have a schedule of outstanding equity options showing date of grant, vesting schedule, exercise price and expiration date for each such option?
If the company’s business is licensed or regulated, potential buyers will want assurances that any and all necessary licenses or permits have been obtained and will be freely transferable (or at least transferable without undue delay and expense). Therefore, the company should review the status of its permits and licenses, as well as making a determination regarding their transferability. Likewise, the company should determine if it has all required environmental permits and required compliance programs. Obviously, any issues of noncompliance should, if possible, be remedied before the potential buyer commences its due diligence review.
Safeguarding the company’s intellectual property is a particularly important housekeeping issue. In certain industries, intellectual property rights can form a very large percentage, if not all, of the company’s value. If the company’s business is reliant on intellectual property (including trade secrets and proprietary information), then it is very important to make sure that adequate steps are taken to protect and maintain the company’s rights. Such steps include the following:
a. Filing and maintaining copyrights, trademarks and patents.
b. Ensuring that all relevant employees have entered into agreements covering the company’s confidential and/or proprietary information and inventions.
The company should confirm that it is current on all taxes, including income, franchise, business license, property and payroll taxes. The company should also work with its accountants to evaluate whether there exist any risky or overly aggressive tax positions taken by the company.
Potential buyers will want to learn about the company’s operations (e.g., production capacity, production methods, principal suppliers, distribution methods, lead times) and sales (e.g., sales history, pricing policies, product line changes, competitive advantages/disadvantages, advertising programs, customers), and the company’s management team should be prepared to convey such information, whether orally or in written form, such as business plans, price lists, sales forecasts and the like. Care should be taken that a buyer not be permitted to contact vendors, customers or other third-parties without the seller’s consent. The company and its deal team should have a full understanding of the good and the bad of the company’s business and should be ready to “explain away” as best as possible any issues. For example, if the company has a high concentration of customers (i.e., a handful of customers represent a significant percent of sales) this can represent a risk to the business. If, however, the facts are developed and it can be shown that these customers have been long-term, growing customers and/or that there are barriers to any such customers seeking competitive products or services elsewhere, the deal team should know those facts and try to frame this potential business risk as a positive (e.g., “the company has a long, growing and successful relationship with a core-group of financially strong customers”)
Potential buyers will be interested in reviewing the company’s employment agreements, consulting agreements, collective bargaining agreements, employee benefits plans and employment policies and procedures. The company should begin to collect these documents and should consider having ERISA counsel review all such items for legal compliance.
It is important that the owners root out any issues that could potentially have a significantly negative impact on the sale transaction. Discerning these “deal killers” (or “price killers”) and dealing with them, or negotiating through them, in a timely fashion may help avoid a loss of the seller’s credibility. Matters such as environmental problems, threatened litigation, aggressive tax positions, or customer dissatisfaction need to be addressed in the most positive fashion possible.
In connection with the operation of the business, the owners may have been required to sign personal guaranties of the company’s debt. These items should be considered in connection with efforts to eliminate all post-closing personal liability.
After the company has conducted its internal housekeeping review, the next major issue is managing the disclosure of problems unearthed during the review. As a general rule, it advantageous to be up-front in disclosing negative items to potential buyers. Failing to disclose a negative issue will almost inevitably result in more harm than a prompt and full disclosure to the buyer. At best, the buyer will discover the problem during its due diligence review and then will use it as leverage to decrease the purchase price. Even worse, however, is the scenario in which the buyer does not discover the problem until after the closing and then seeks indemnification from (or simply sues) the seller. While disclosing problems to the potential buyer may be quite unappealing, it does have the advantage of giving the company the first shot at framing the issue and suggesting a creative solution. Furthermore, the company’s up-front attitude may give the potential buyer greater confidence in the company, making it less likely to see phantom issues lurking throughout the transaction.
While the internal due diligence review tends to focus on the legal and financial aspects of the proposed transaction, the owner should be aware that there is almost always a significant psychological component to a sale transaction—i.e., motivating the management team and protecting the morale of the rank-and-file. It is crucially important that the deal team understand the management team’s perspective on the transaction. When the proposed transaction is first disclosed to the management team, many members, understandably, may react with fear and anxiety if they are not given a stake in the deal. Given the importance of management’s participation in the sale process, it is a good idea to provide them with some peace of mind and/or financial participation in the transaction. The following are several techniques for doing so: (a) seller bonuses—i.e., cash bonuses to be paid by the seller at the closing of the transaction; (b) severance packages—i.e., the company and certain key members of management may enter into employment agreements (or revise existing agreements) to provide for generous severance benefits if they are terminated as a result of the sale transaction; (c) stay bonuses—i.e., cash bonuses to be paid by the seller at (or after some period of time after) closing; and (d) buyer stock options—i.e., stock options in the buyer, which will motivate the recipient employee to continue working for the buyer after the closing.
Oftentimes the company’s CFO will end up bearing a great deal of the workload during a sale transaction. A motivated CFO can be especially important during the potential buyer’s diligence review, as he or she will typically have first-hand, practical knowledge of the company’s finances, contracts, customers and suppliers. Thus, the CFO’s responsiveness and dedication to the transaction will typically dictate the pace and momentum of the deal. Therefore, the company should take extra care in ensuring that the CFO remains properly motivated. Some experts suggest paying the CFO a special monthly bonus for the duration of the transaction as compensation for all of the extra effort that a successful transaction will require. This will be particularly important if the buyer does not intend to retain the CFO after closing, which is a relatively common scenario.
It is important to note that the company’s workforce, particularly its management team, can be a significant source of value to the buyer. In fact, many financial buyers, such as private equity firms, are highly interested in retaining key personnel after closing. After all, they are in the business of generating investment returns from their portfolio companies by identifying and acquiring well-run businesses, not in actually running their day-to-day operations. Strategic buyers, such as industry competitors, may have less interest in retaining the company’s management after closing as they will often seek to consolidate the company’s operations into pre-existing management structures.
Unlike the management team, rank-and-file employees will play a small role, if any, in the sale transaction; however, continued high employee morale and productivity are vitally important elements to a successful closing. Not surprisingly, rumors of an impending sale of the company can also be quite unsettling to rank-and-file employees. Thus, serious thought should be given to the question of when and how the company’s employees should be informed of the proposed transaction. Generally, one of the following two approaches is taken, with the first being more typical than the second:
Under this approach, the company would not disclose the transaction to its employees and also would take measures to prevent its employees from discovering it indirectly. Such measures would likely include (i) limiting the potential buyer’s (and its representatives’) access to the company’s offices or facilities, particularly during regular business hours; (ii) instructing management not to disclose the transaction’s existence to employees; and (iii) using a code name when referring to or corresponding about the transaction.
Under this approach, the company would advise its employees that the company’s ultimate goal is to build and sell the business and that potential buyers may be making frequent visits to the company during the course of their employment. Additionally, the company would try to allay the employees’ fears of an acquisition transaction by being as open and honest as possible about any deals that may be on the horizon. It should be noted, however, that potential buyers may not find this to be a particularly attractive policy.
Deal structure is among the first points of negotiation for a proposed sale transaction. Involving tax experts at the beginning of discussions can be enormously beneficial to both parties in identifying the most tax-efficient structure for the proposed transaction. For example, a buyer may be willing to pay a higher purchase price in order to structure the transaction as an asset sale so that it can obtain a stepped-up basis in the acquired assets. In fact, under the right circumstances, such as an acquisition of an S corporation or the acquisition of an entity out of a consolidated group of entities, the parties may be able to structure the deal as a stock sale for corporate law purposes while electing to treat it as an asset sale for tax purposes (i.e., by making a 338(h)(10) election). If the selling entity has sufficient NOLs to eliminate or greatly reduce the corporate level income tax from the deemed asset sale, such an approach may be beneficial to both parties. In addition, in the right circumstances, a tax-deferred structure (i.e., a non-taxable or partially taxable reorganization) may also be attractive to the participants.
In addition to advising on structural issues, tax experts can provide valuable counsel regarding the most tax-advantaged means of receiving and/or distributing sale proceeds. Additionally, tax experts can also play an important role in identifying, avoiding and rectifying, if necessary, any potential tax problems that may arise under Internal Revenue Code Sections 409A (with respect to certain types of deferred compensation) and 280G (regarding so-called excess “golden parachute” payments resulting from the sale of the company), including ensuring that any management team incentive package that the company may want to put together in anticipation of the transaction is properly structured to avoid these issues.
At the outset and throughout the sale process, the company’s financial statements will be the central focus of the buyer’s due diligence review. If the numbers fail to add up or to otherwise inspire confidence, it is unlikely that the sale transaction will proceed much farther. Therefore, the company should consider addressing the following issues during the preparation phase:
While generating audited financial statements may be prohibitively expensive for a very small business, if the company is truly a mid-cap business that would generate a purchase price of significant size, it may be a good idea to have audited financial statements prepared for each of the company’s two most recently completed fiscal years. This is particularly true if the company anticipates generating interest from any public company or private equity buyers (or that the potential buyers may need to obtain bank financing for the transaction). Obtaining audited statements before starting a sale process may also uncover accounting issues that can be addressed before they are discovered by a potential buyer.
Closely held businesses are often run from a “tax-minimizing” perspective rather than an “earnings-maximizing” one. For example, the shareholders of a closely held business may have had the business pay for (i.e., expense) various personal benefits to the owners, such as personal travel and entertainment. The owners also may receive compensation well in excess of what the company would incur if it were to hire a non-owner employee. These actions, of course, reduce the company’s reported earnings. While it is probably overkill to advise the company to eliminate these practices entirely, the company should be prepared to identify these items to the buyer and explain how the company’s earnings would improve if these expenses were eliminated. In many cases, an accountant can help the company identify and prepare a list of the appropriate adjustments to determine the company’s real “as adjusted” earnings to present to potential buyers which will likely help the company achieve a higher sales price.
The company’s accountant should review the company’s books and propose remedies for any serious accounting problems that are discovered in the course of such review. If accounting problems are raised or discovered for the first time during the buyer’s due diligence review, the chance of a successful closing will be significantly reduced.
Once the sale transaction has progressed beyond the preliminary stages, the seller will then need to focus on setting and maintaining the correct pace for the deal. In this area (and perhaps others), the deal team’s mantra should be John Wooden’s aphorism: “Be quick but don’t hurry.” Momentum is a key issue in keeping a deal on track to close, and the deal team should endeavor to be nimble and responsive to the buyer’s requests, bearing in mind that in many cases (even if regulatory filings or approvals are not required) a deal will take up to six months to complete. On the other hand, the company should remain firmly in control of the process and refuse to be unduly rushed or pressured by the buyer. Experienced M&A counsel will be able to assist the deal team in setting and maintaining the appropriate pace for the transaction.
Finally, as the sale transaction progresses, it is important for the deal team to remember that the company’s business is not selling the company—in short, do not neglect the business. While it is often necessary that the senior management team play a significant role in preparing the company for a sale, it is vitally important that the company continue to operate on a day-to-day basis. When the time comes for the buyer’s due diligence review and negotiation of the purchase agreement, the buyer will expect to see a healthy, functioning business. Therefore, it is crucial that members of senior management not allow themselves to be so consumed with preparing for (and negotiating) the sale transaction that the company’s actual operations suffer from neglect. Failure to keep this in mind can negatively affect the buyer’s perception of the company’s value and, accordingly, the purchase price. Also, a deal is never a sure thing until “the ink is dry” on the purchase agreement. Accordingly, if the deal falls through, the sellers will continue to own the business and will suffer any negative consequences that may result from the company’s failure to focus on its business during the sale process.
The author wishes to acknowledge the assistance and input of Dave Krosner and Kim Bayless of Poyner Spruill LLP, many of whose suggestions and revisions were included in this article.
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