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The founders of a small but growing tech company met with us to discuss positioning the company for acquisition, expecting a fairly painless process. After all, the company had a hot product and potential buyers had been abuzz for months. Unfortunately, when we sat down to review the basics, we discovered that their IP rights were not clear and their legal house was a mess. Cleaning up the issues and getting in a position for due diligence would likely delay an acquisition for months! The lesson? The time to start planning for an exit isn’t when your hand is on the doorknob!The past few years of economic turmoil demonstrate that we cannot predict the financial markets. Nor can you always predict the future of your business, except for the fact that you will someday exit your ownership position. Given that this change is inevitable, you can take the steps to make sure you are ready for it. Whether your exit strategy is an initial public offering (IPO), being acquired by other insiders or unrelated parties, or leaving the business to family members, proper planning will help you enhance your business’ value and pave the road to a clean getaway. To avoid speed bumps, business owners should keep the four following guidelines in mind from the get-go.
1. You can’t sell what you don’t own.
While this may sound obvious, ownership problems arise often. A frequent problem is ownership of intellectual property that is not properly protected. The value of intellectual property such as trademarks and internet domain names can be dramatically impaired by failure to register with the appropriate authority, or registering ownership in an individual’s name instead of the company’s. Employees who helped develop software code or other IP assets must transfer ownership rights to their employer in writing or else they retain rights that cloud the company’s clear title. If trade secrets are important to a business’ value, since legal remedies for trade secret infringement are only available if the business takes reasonable efforts to maintain secrecy, an acquirer will want to confirm appropriate practices are in place.
Liens on business assets are frequently discovered when an acquisition is in the works. M&A due diligence often unearths UCC filings against a company’s assets, many of which are for previously-paid debts, such as old bank lines of credit or equipment financing. As years pass by, lenders go through acquisitions and restructurings, making it difficult to track down an authorised person to sign a release.
2. Keep clean corporate and financial records.
Poor corporate records regularly create problems for a closely held company being acquired. Buyers typically request copies of minutes and stock records as part of due diligence. However, most closely held businesses neglect their minute books, and end up wasting valuable time trying to clean up their records for the acquisition. The passage of time (and events such as a necessary signer’s death or departure) often frustrates efforts to complete clean-up. Sometimes, stock records have been maintained so poorly that the company cannot prove that its cap table is correct. These problems can be extremely detrimental to an M&A deal, as the buyer wants assurance that it is getting what it is paying for. In some cases, poor corporate records can jeopardize an acquisition or result in the buyer demanding it be structured in a form less beneficial to the seller, such as an asset transaction instead of a stock deal or merger.
3. Address key contract and risk management issues.
Important contracts, such as with strategic partners and key vendors, need to be enforceable and allocate risk appropriately, and not contain terms that could scuttle a business exit. In an acquisition, particularly if structured as an asset sale, key contracts will need to be assigned to the buyer. Contracts containing anti-assignment clauses will require obtaining the consent of the third party. Difficulties in obtaining such consent are a frequent source of delay in M&A transactions. Obtaining a third party’s consent might require offering significant concessions, which could jeopardize the entire deal. If the acquisition is structured as a stock deal, a similar problem is presented by “change in control” provisions, which require the other party’s consent if there is a change in the ownership or control of the business entity.
Workforce issues also figure prominently in acquisitions. Good employment contracts and policies are critical; for example, the employer’s right to terminate at-will and ownership of employee-created IP should be firmly established.
4. Establish buy-sell arrangements.
For many closely held businesses, an owner’s most likely exit opportunities are a buy-out by other owners, or a management buy-out, which may be orchestrated through an Employee Stock Ownership Plan (ESOP). So, it is a must to adopt a buy-sell arrangement, and we encourage clients, even newly formed startups, to do so early, while owner relations are harmonious. This requires the owners to consider which future events should trigger or permit a buyout, select an appropriate valuation mechanism, and possibly fund a buyout upon death through life insurance.
In short, even if an ownership exit is not foreseen in the near future, it is inevitable, so entrepreneurs should heed these 4 reminders, and plan and act now.