Private, high-growth companies driven by or selling technology, often start up, proceed through several financing rounds and are ready for exit via a merger or stock or asset sale within a matter of a few years from inception. Others take longer and a few companies are appropriate for and able to execute an initial public offering. In any event, the vast majority of companies deciding to exit choose to seek stockholder liquidity through some sort of merger or acquisition transaction (“Sale Transaction”). These transactions routinely take three-to-nine+ months to go through preparation, initial auction, letter of intent, due diligence, documentation and closing processes. Preparation should occur months before commencing active solicitation of a buyer.
This post will outline the most basic steps to preparing a company (“Company”) for a Sale Transaction that will withstand buyer’s due diligence. These steps, however, will vary depending on the Company’s industry and the business model. Software and IT will differ from health care, medical devices and business services. Social media will differ from advanced manufacturing, and so forth. Importantly, business-to-consumer models will differ from business-to-business models. Having said this, please take note of the following general suggestions:
1. Review and, if necessary, clean up corporate recordkeeping.
It is important to have all records of ownership in order and to resolve any ambiguities or issues that might exist so that the capitalization table is accurate, and the right to proceeds from the Sale Transaction is clear. The impact of any options or warrants outstanding should be considered, and a plan for giving notices to stockholders or parties with options should be anticipated, which takes into account the requirements of any existing stockholder agreement or other contractual undertakings, which could affect the rights of those who have a claim on proceeds. In some companies, these recordkeeping issues are well taken care of on an ongoing basis and there is no need to address problems. In others, because of the complexity of the capital structure and/or the speed with which the company has grown, such recordkeeping matters have been less of a priority. A comprehensive review of issues can solve potential problems ahead of time.
2. Analyze how to obtain approvals, if and when required, from stockholders and key contract parties.
High-growth companies often raise money from venture capital investors who have rights to approve any form of liquidity event, whether it be a mere loan, raising money, or a Sale Transaction. Well before a potential Sale Transaction is within view, management and board members of the Company should understand very specifically what approval requirements exist, how they are going to go about obtaining those approvals, and stockholder sensitivities which may come into play.
Likewise, Company management should identify approvals required of noteholders and commercial lenders who are senior in liquidation to stockholders.
Moreover, customer and vendor contracts, leases and other material agreements often have clauses that explicitly require pre-approval of a proposed Sale Transaction, or at a minimum, prior notice.
Company management should budget enough time prior to engagement with a potential buyer to analyze and provide for these approval rights, so as to enhance readiness and organization, to not waste a buyer’s time, and to minimize the prospect of an unsuccessful transaction.
3. Be prepared to understand how the Company’s material contracts will be transferable to and affect a potential buyer’s business.
In due diligence, buyers look at customer and other material contracts that sometimes contain provisions that will dramatically affect the way a buyer looks at a Sale Transaction, and the way in which due diligence is conducted. For example:
- Some customer contracts that are assignable in a Sale Transaction may be terminable at will or have onerous indemnification provisions.
- Some commercial contracts may have confidentiality provisions preventing disclosure to anyone, including potential buyers, without written consent.
- Some customer contracts may have non-compete provisions that affect the way a potential buyer being asked to take assignment of such an obligation looks at a Sale Transaction.
- Some customer or vendor contracts may have non-assignment or “change of control” provisions that don’t allow assignment or change of control without consent of the seller’s customer or vendor.
- Some customer or vendor contracts may have exclusivity provisions, which may cause a potential buyer to object to receiving an assignment of such a contract in a Sale Transaction because it would bind the buyer to the obligation to maintain such exclusivity.
- Some customer contracts may have “most favored nation” clauses that require that the price offered by the selling Company be the lowest price offered to any customer, and a potential buyer may have a problem taking assignment of such an obligation.
- Some commercial contracts may have “exclusive dealing” provisions that should be examined carefully before sharing with a potential buyer in a Sale Transaction.
- Some employment contracts contain sensitive compensation and other information that may cause issues for a buyer.
- Some documents memorializing debt, equity or joint venture transactions with third parties impose requirements on the selling Company, which may affect the buyer’s ability to close the Sale Transaction.
- Strategic investors may have negotiated rights of first refusal to invest in or buy or make a first offer to the Company, which may dramatically affect the way another potential buyer would look at a potential deal.
These are examples of thorny contract issues that may cause a particular potential buyer to back away or take pause. These types of potential problems should be anticipated well before entering into a sale process.
4. Put financial records in order.
A good advertisement for the Company is a set of strong financial records that are organized and updated in accordance with generally acceptable accounting principles. Most potential buyers will insist on audited financials for at least one full fiscal year, and often more. The precondition for a smooth audit is a good set of internal controls and procedures and financial policies, which may need to be updated periodically and which should be reviewed by a respected accounting firm, either local, regional or national in scope, depending upon the nature of the selling Company’s business, and the requirements of the community of potential buyers.
5. Identify material contingent liabilities, whether financial, technological, operational or legal.
Contingent financial liabilities are off-balance-sheet liabilities that may not appear on the surface, but are contingent upon the happening of an event in the future and should be identified. Likewise, examine the legal landscape to look for any potential litigation or disputes that may either disrupt the Sale Transaction or develop after the transaction closing, for which the sellers may have indemnification obligations under the purchase documentation.
6. Analyze employment issues.
Examine the selling Company’s employee base to assess who logically can appeal to a buyer and who will not, and who will have the desire and ability to perform under new ownership. Depending upon the strength or weakness of key employees, and the contractual benefits and restrictions applying to them, management can assess how to position these employees in the sale process, and potentially thereafter.
7. Test regulatory compliance.
Whatever local, state, federal and/or international laws and regulations apply to your business, all smart potential buyers will expect the selling Company to be in compliance, and will always expect the seller to represent and warrant to this effect in the operative purchase agreement. A highly regulated Company considering a Sale Transaction should undergo an internal regulatory audit prior to disclosing anything, and should consider utilizing third-party advisers if appropriate to assist in preparing for the transaction. See cybersecurity risks noted below.
8. Test the integrity and strength of the Company’s intellectual property.
A Company that derives its primary value from the intellectual property (“IP”) needs to protect that intellectual property at least within common industry norms, and sometimes at an even higher standard. Whether the primary technology is licensed or owned and protected by patents or trademarks, or is simply maintained as a trade secret, certain things can help assure that IP has value and stays proprietary, such as: understanding the term and scope of the operative license or licenses of IP; checking on the status of patent filings; ensuring that all employees have signed assignment of invention agreements; or considering whether obtaining certain IP opinions will be helpful, such as those pertaining to patentability or freedom to operate. Hire a good IP lawyer to review IP compliance issues and to test for strong IP ownership and title.
9. Test the soundness of the IT/cybersecurity strategy and plan.
Whether the target is a traditional product company using technology or a company selling technology, buying a company amounts to buying data that needs to be protected and, depending upon the industry and the nature of the regulatory regime, kept private to a degree that comports with relevant regulations, and sometimes at an even higher standard. In most companies, data is maintained through the use of software applications with respect to which a buyer will often want to do an IT/cybersecurity audit of some sort. If the selling Company is regulated as to cybersecurity and privacy issues, such as in the cases of energy, health care, and retail businesses (e.g., storing credit card information), seller’s adherence to regulations will be a key due diligence concern of the buyer. If there is any doubt of compliance, an internal audit to uncover latent risks is desirable. Therefore, to varying degrees depending upon the circumstances, the selling Company needs to understand any cybersecurity and breach of privacy risks that may exist, long before a sale process is initiated.
10. Hire competent transaction professionals (before doing anything else).
The quality of service providers can make the difference between success and failure.
Start by engaging a lawyer focusing on relevant transactional work with a firm behind him or her, with the required specialties, including relevant understanding of the business of the Company.
With respect to accountants, the decision often has to be made of whether to stick with a smaller accounting firm or hire a bigger, more well-known firm. We suggest that you hire an accounting firm that is familiar with the business of the Company and can impress potential buyers.
Also, except for small transactions (usually less than $5 million – $10 million in purchase price), strongly consider hiring an investment banker, or a local intermediary for smaller deals, to create a sale process, particularly if there is not an obvious strategic buyer, and the selling Company does not have an experienced financial professional in-house.
Finally, every Company should evaluate whether it needs valuation help, or to do internal audits of financials, operations, technology, security, environmental issues or some other subject matter area that is central to the business, by hiring experts (if they do not exist internally) well before the sales process is commenced.
Different businesses with different risk characteristics demand different preparations for exit. Having said this, the fundamentals above are applicable to almost all businesses today across the board.