ABA Section of Business Law
ABA Section of Business Law
Business Law Today
July/August 2000
And the factory goes to . . . How to succeed in selling your business without really trying (too hard)
By FREDRIC D. TANNENBAUM
An entrepreneur who has worked a lifetime (whether an actual lifetime or an "Internet lifetime," which may be considerably less) may have one or more reasons for selling the business.
No heir apparent or pool of talented management may be at hand to lead the company after the entrepreneur’s retirement. The capital required for the business to expand or be competitive may be excessive. The market timing for sale may be ripe. The industry in which the business competes may be consolidating. No public offering may be possible or desired.
Whatever the businessperson’s reasons for sale, he or she typically has only one real chance to do it right. A sale process that is not conducted thoughtfully and efficiently may diminish the ultimate ability to maximize the sale price, not to mention disrupt employee morale, customer and supplier relations, as well as the owner’s and the owner’s family’s peace of mind.
The right business, sold in the right way, should be able to take advantage of the current feeding frenzy for merger and acquisition activity. The demand for businesses spurred by a consolidation in virtually every industry, the creation of new industries due to the explosion of e-commerce and Internet-related activities and services, and an abundance of capital should create opportunities to enhance a seller’s leverage in a sale negotiation.
The National Venture Capital Association estimates that more than $50 billion in venture capital was raised in 1999, an increase from $20 billion in 1998! Mergers and Acquisitions magazine reports that nearly 6,000 transactions worth almost $500 billion took place in 1997 alone and approximately $2 trillion in 1998. Most likely, these figures do not account for the additional thousands of smaller transactions that remain unreported each year. While the pace of initial public offering activity has been frenetic as well, a merger or sale is the likely exit strategy for most businesses.
This article will discuss the legal and strategic issues that an entrepreneur should address in preparing for the sale of his or her company. We will provide a special emphasis on pre-sale team formation, preparation for due diligence, retaining employees, corporate risk assessment and housekeeping, and avoiding common mistakes. We will also discuss tips for avoiding post-closing litigation.
Although the article offers a seller’s perspective in preparing for the sale of his or her company, a buyer who is considering purchasing a growing business will find these materials helpful in providing insight into the seller’s strategies and areas of concern.
To paraphrase Henry Ford, selling a business is 5 percent inspiration and 95 percent perspiration. The main preparatory steps are:
• forming a team of trained and experienced advisers expert in selling businesses,
• preparing for prospective buyers’ due diligence,
• formulating a package of materials to assist potential buyers in evaluating the business,
• considering employee retention programs,
• recasting the seller’s previous financial results in a normalized way and
• avoiding common but avoidable mistakes.
The need to form a team of expert advisers should be obvious. Very few businessmen, however, form a team of professional advisers in a systematic and organized way early in the sale process. Often-cited reasons are the entrepreneur’s own self-confidence in his or her ability to sell the business, lack of awareness of the benefits of doing so and minimization of expenses. A team of three indispensable types of advisers, however, can facilitate the process and maximize potential value by assisting the entrepreneur in minimizing typical mistakes and in preparing the business for sale in a professional way. The three types of advisers that should be a part of any team for all but the smallest transactions are:
Investment banker/adviser — Depending on the size of the transaction, this professional will perform several functions for the seller. First, the investment professional will give the seller a reasonable range of likely values for the business. These values and ranges will be based on the investment professional’s access to and experience in comparable transactions in the same industry. While the entrepreneur may have a visceral sense of what he or she would like for the business, the investment professional may be able to educate the entrepreneur regarding valuation methods for different industries (such as, appropriate multiples of revenues for Internet companies, operating cash flow for wireless telephone companies) and give the executive a reasonable expectation of value.
Second, the investment professional can prepare a confidential information memorandum (CIM). This process will be described in more detail below.
Third, the investment professional will formulate a list of potential buyers and advise on a strategy and timetable for contacting those buyers in a way to maximize value. For example, given the nature of the business and the industry, the sale process may be a controlled auction, a direct contact of one or more likely buyers with exclusive or partial exclusive opportunities to negotiate, or a pre-emptive right granted to one buyer to short circuit the more formal auction process. Part of this formulation of a list of buyers is to "pre-qualify" the financial wherewithal of a prospective purchaser.
Finally, the investment adviser, working in tandem with the other members of the team, may assist in developing the legal and tax structure of the transaction to address the unique structure of the seller.
Fee structures for investment advisers vary with the size of the transaction. While they are negotiable, there is often a stated norm based on the range of the deal.
Accountant — A certified public accountant will assist the seller in preparing the tax returns, financial statements and related reports that the potential buyers will need to review. The CPA will be able to explain whether the seller’s accounting practices conformed with or deviated from generally accepted accounting principles and what deviations, if any, were made. The CPA, as with the lawyer, will also advise the seller on the tax implications of the proposed transaction. Finally, the CPA may assist in estate planning and structuring a compensation package for the seller in order to maximize the benefits associated with the proposed transaction.
Lawyer — The business lawyer is crucial in performing several functions to assist the seller in maximizing value for the business. First, the lawyer will assist the seller in pre-sale corporate "housekeeping," which involves the "clean-up" of corporate records, developing strategies for dealing with dissident shareholders and shoring-up third party contracts.
Second, the lawyer will review the confidential information memorandum to avoid misrepresentations and minimize any other legal exposure and assure compliance with the securities laws.
Third, the lawyer will advise the seller on how to evaluate competing offers. Two identical proposed purchase prices may have radically different implications from a tax standpoint, or from the standpoint of certainty of closing, or minimization of post-closing potential liability to the seller. For example, a proposed $10 million purchase price for assets may or may not be different than the same price for stock.
Conditions to closing such as satisfaction with due diligence or obtaining financing or a renegotiation of key contracts with customers or suppliers certainly reduces the chance of a successful and prompt closing. Broad representations, warranties and indemnities also increase post-closing liability to the seller. These are all areas where trained counsel should give expert advice.
A related matter is counsel’s services in drafting and negotiating confidentiality agreements, risk assessment, letter of intent and purchase agreements, as well as organizing the data room and other due-diligence functions.
Further, a lawyer can advise the entrepreneur regarding employee-retention programs that will be described below.
Finally, experienced lawyers should assist in structuring the transaction within the seller’s existing organizational framework to minimize income and estate tax liability. Hopefully, the entrepreneur has worked with counsel from the inception of the business to structure it in a way that will provide flexibility for, and minimize the impact of, an ultimate sale. Moreover, a well-attuned executive will discuss estate planning opportunities with counsel at an early stage of the company’s existence to try to shift future appreciation to junior generations (which may be done at minimal tax cost and at the same time retain control in the entrepreneur).
In preparing for due diligence, the lawyer plays at least three vital roles:
Data room preparation — As trivial and mundane as this may sound, a well organized and neat data room redounds very favorably to the benefit of the seller. Having all relevant contracts, leases, financial statements, employment agreements, human resources materials, litigation summaries in a tidy, easy to read, easy to catalogue and orderly area gives a buyer several favorable impressions of the seller. The seller appears accommodating, well organized and prone to full and complete disclosure.
The lawyer should prepare an index of all relevant materials that will be copied, bound and placed in a data room for prospective buyers to see. Some sellers will even go the "extra mile" and suggest that the lawyer summarize each contract and lease and place the summary in the data room as well.
Confidentiality agreements — The confidentiality agreement prohibits the prospective buyer and its agents from disclosing or using any nonpublic information concerning the seller discovered during the due-diligence process. While these agreements are fairly straightforward, the seller’s team should evaluate certain complexities and nuances. For example, is the prospective buyer merely using the due-diligence process as a "fishing expedition" to extract competitive information to be used against the seller? If this sort of voyeurism is a concern, the seller has several options.
First, the seller could "stage" the release of data until it became absolutely certain that the potential buyer was seriously interested in making a responsible bid for the business. The seller could provide certain redacts of financial information and other data, but not disclose sensitive data such as pricing, gross margins or customer and supplier lists. Second, the confidentiality agreement could also contain a clause prohibiting the prospective buyer from soliciting seller’s employees for a certain period of time. Buyers will resist such a provision and argue that the restriction is too burdensome.
In managing the due-diligence process, the seller should maintain careful records concerning what information was given to whom and at what time. These records will help rebut a buyer’s claim that it obtained the confidential information from an unrelated source. While confidentiality agreements often also relate to oral information, a seller should consider following up oral communication with written confirmation of such disclosure, especially in sensitive cases with buyers who are competitors.
Finally, the seller should be aware that the practicality of enforcing the confidentiality agreement is limited by the integrity and ingenuity of the unscrupulous buyer. Clever buyers can find many ways around all but the best-crafted agreements. Even if an agreement were clearly breached, and proof of the breach could be clearly demonstrated, the practicalities of the proof may outweigh the associated costs. For example, a seller may be understandably hesitant to call a customer or supplier as a witness, or potentially expose well-guarded trade secrets in open court.
Related to the dissemination of information to third parties is the disclosure of the potential sale to employees. The uncertainty involved in any sale, and the impact that uncertainty has on job security, tends to have an impact on the morale of the seller’s employees.
Legal evaluations and clean-up — The lawyer should begin considering possible legal obstacles to a smooth sale. These impediments may include: obtaining consents from landlords or government agencies, assessing the likely cost of resolving litigation or other claims, environmental clean-up responsibility, the existence of unfavorable material contracts as well as anti-trust or other regulatory concerns. The team should also evaluate whether obtaining any critical consents may be problematic.
For example, in the broadcasting industry, the consent of the network to the transfer of its affiliate is key to any transaction involving the affiliate. In the recent purchase of LIN Television by Hicks Muse, LIN was able to thwart an unwanted bid from Raycom when LIN’s network, NBC, announced that it would not consent to Raycom as a successor to LIN.
Smoking out these problems early on will save everyone time and aggravation, and also avoid diluting the seller’s negotiating position.
Proper record keeping is extremely helpful to enhance the appearance of the seller for a possible sale. While prospective buyers may not be impressed with meticulous minute books, company documentation and other records, they will undoubtedly be unimpressed by sloppy and haphazard record keeping. Additionally, counsel should try to assure that all other "housekeeping" items are in good order. These items include removing liens if the underlying debt has been discharged, having proper noncompete and confidentiality agreements in place with key employees, and perfecting registration and assignments of patents and trademarks.
The investment adviser, together with the other members of the team, should prepare some form of confidential information memorandum. The CIM is like a business plan, serving as an informational tool and road map to the prospective buyer. The CIM provides an executive summary of the seller’s business, its history, its management, competitors, marketplace, financial history and business plan, and financial prospects. The CIM will serve as a marketing tool for the business and answer many obvious questions about the seller.
What about employee morale and retention? To employees of a seller, a sale can be both the best and worst of times. If the buyer is a large company with generous benefits and better opportunities for growth, the prospects can be exciting and fulfilling. However, the unknown is always frightening. Moreover, if employees are diverted from their regular activities to thinking about the sale, normal operations can be hurt. Therefore, the seller needs to devise ways both to limit the number of employees with knowledge of the impending sale and to motivate and retain employees through the closing.
Devising programs to limit the disclosure of the impending sale to only those employees of the seller who "need to know" will minimize the anxieties of the seller’s employees as well as keep them focused on conducting business. Key executive and supervisory personnel should be briefed first, and all of their questions should be answered so that they can inform their subordinates.
Immediately prior to the closing, top management of the acquiring company needs to assure the employees of the seller that the beneficial policies of the seller will be continued (if true) and that such employee will be welcome into a larger and better organization if that is their intent. Employees who do not feel they are part of a team will have poor morale and poorer productivity. Alternatively, if employees are not to be retained, stay bonuses and other retention programs will at least keep them motivated through the closing. It is essential that lines of communication be kept open at the time of the acquisition.
In addition, the entrepreneur and his or her team should consider means to retain employees between signing and closing, to assure that the seller’s financial performance does not deteriorate and that the seller can deliver to the buyer an intact organization without mass defections. Common retention programs include stay bonuses, rolling over of stock options, revisions to employment agreements, revised equity participation plans and acceleration of vesting if the employee remains through the closing (or stays for a finite period after closing at the request of the buyer).
Stay bonuses may vary based on the size of the transaction, the generosity of the seller, the seller’s fear of losing key people, and the age of the work force. Bonuses may be determined based on a percentage of the person’s salary, a percentage of the price, or a figure dependent on the employee’s longevity with the company.
Since privately owned companies often tend to keep reported profits and thus taxes as low as possible, financial recasting is a crucial element in understanding the real earnings history and future profit potential of the entrepreneur’s business. Buyers are interested in real earnings and recasting shows how the business would look if its financial management practices were normalized or matched that of a public corporation in which earnings and profits are maximized.
In presenting the complete earnings history of an entrepreneur’s company, financial statements should be recast for the preceding three years. There is nothing wrong or untoward about this process. This is merely an attempt to enable a prospective buyer to compare apples to apples in assessing the raw earnings potential of a business. Recasted items to consider include:
• Many successful entrepreneurs are fortunate enough to have been rewarded with salary and bonuses far in excess of their comparable worth. Additionally and conversely, many family members who may not be making as great a contribution may have been excessively compensated. Perversely, some owners of pass-through businesses may take a low salary (to minimize payments to Social Security and Medicare) and pay the rest in dividends. Therefore, actual salaries of family business participants should be adjusted to prevailing market levels.
• Examine the expenses of key personnel. Country club dues, fancy dinners, car leases, first class travel and other "perks" may be items that could be reduced or eliminated.
• Lower ending inventory levels increase costs of goods sold, which, in turn, reduces net income. More accurately counting inventory will also increase profits to more actual levels and, at the same time, increase the book value of the business.
• Affiliated transactions. Leasing or licensing real estate, equipment or patents from the entrepreneur or his or her family to the business (or vice versa) is a typical way to inflate or deflate earnings. These rentals should be reviewed for their fairness and recast if appropriate.
• If a division or line of business or facility had been sold, or there was an extraordinary write off of an item such as a large bad debt from a bankrupt customer, consider removing these items since they are not normal or recurring.
• Some capital items may be expensed, instead of depreciated, by private businesses, further deflating profits. For example, in some cases customer acquisition costs should be amortized (such as in the case of an Internet service provider attempting to gain a customer) instead of deducted in the year in which the expense is incurred.
• The entrepreneur may have depreciated capital items on an accelerated depreciation method. If the seller had used a straight-line method of depreciation, which may be more appropriate for a public company buyer, net income would have been increased.
• Removal of corporate overhead expenses. If a seller is likely to be purchased by a consolidator, then the seller’s home office and top management team are likely to be redundant. The seller may therefore suggest that it is appropriate to recast its earnings to reflect the elimination of this overhead. The buyer may respond that it should not have to pay a higher price because it is incurring these overhead expenses.
The sellers should avoid common preparation mistakes. Even if the entrepreneur has meticulously followed the steps suggested above, he or she needs to try to avoid stepping in any of several minefields of common human mistakes.
• Impatience and indecision. Timing is everything. If the seller seems too anxious to sell, buyers recognize desperation and take advantage of impatience. If the seller ponders on the sidelines too long, the window or market cycle to obtain a top selling price may pass by.
• Telling others too early or too late. Again, timing is critical. If you tell key employees, vendors or customers that you are considering a sale too early in the process, then they may abandon your relationship in anticipation of potentially losing their jobs or fear of the unknown. Key employees, fearful of their jobs, may not want to take the chance of relying on the unknown buyer to honor their salary or benefits. Yet these key employees and strategic relationships may be items of value that the buyer is counting on being around after closing.
If you wait too long and disclose at the last minute, then employees may feel resentment for being kept out of the loop or key customers or vendors may not have the time to react and evaluate the impact of the transaction on their businesses or, where applicable, provide their approvals. That is another reason why consideration of retention-bonus programs is critical.
• Eliminate third-party transactions with relatives. This especially applies when these relationships will be of no strategic interest to the buyer. Shed ghost employees and family members on the payroll who will follow you out the door.
• Purchase minority shareholder interests. Why? So the new owner won’t have to contend with their demands after the sale or be concerned that they will delay the sale process. However, be careful not to underpay since a selling minority shareholder could claim that you did not disclose a material fact about the impending sale.
• Positioning the proforma. The price that a buyer may be willing to pay depends on the quality and reasonableness of your overall presentation of the future potential of the business, including profit projections that you are able to demonstrate and substantiate.
• Pre-qualify your buyer. It is critical to pre-qualify your buyers, especially if the transaction will contemplate a continuing business relationship after closing. Needless to say, you do not want to be left alone at the altar by a bridegroom who cannot afford the tuxedo for the wedding! The buyer must demonstrate its ability to meet one or more of a series of pre-closing conditions, such as availability of financing. The seller should take the time to understand the buyer’s post-closing business plan, especially in a roll-up or consolidation where the seller’s "upside" will depend on the ability of the buyer to meet its business and growth plans.
The worst nightmare for a seller is to receive a phone call from the buyer after closing that something is wrong. After countless hours in agonizing over the sale, selecting the team, organizing the due diligence, retaining the employees and hammering out complex agreements, the only list of buyers on which seller wants to be included is the Christmas card list. As a result, here are some basic suggestions to assist the seller to minimize the risk of post-closing confrontation with the buyer:
• Disclose everything. Many post-closing disputes involve arguments over undisclosed liabilities or inaccurate representations. When in doubt, disclose. It is better to tell too much than too little.
• Make sure the buyer is clear as to its post-closing obligations and liabilities. All liabilities to be assumed by the buyer should be expressly disclosed and all contractual obligations to be assumed or assigned should be included in the schedule. Avoid surprises.
• Try to promptly obtain all required third-party consents. Post-closing litigation will occur if a third party "comes out of the woodwork" after closing and makes claims against the buyer (as successor). For example, make sure that all applicable Uniform Commercial Code "bulk sales" notice requirements are met.
• Make sure you are clear as to your post-closing obligations in areas such as consulting services you will be required to provide to buyer, noncompete covenants, and other important post-closing conditions.
• Have a system in place for monitoring your "earn-out" compensation. Try to have the earn-out based on financial parameters that are not that easily subject to manipulation by a clever buyer. For example, try to have the earn-out based on revenues or gross profit. Avoid tying the earn-out to net profit or cash flow since these figures can be easily deflated by increasing expenses.
• Carefully review all representations and warranties you have made in the definitive documents. If unclear, then prepare a disclosure accordingly or negotiate for a diluted standard.
• Try to limit the post-closing exposure with appropriate cushions, caps and survival periods.
Tannenbaum is a partner at Gould & Ratner in Chicago and is president of LawExchange International with offices in Europe, North America and Australia.
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