M&A: How to Prepare Your Company for Sale

By Stuart M. Horwitz and Jason S. Damicone of Horwitz & Damicone

Published in the Advisory with permission of the author

As with most planning, preparation is key to a successful sale of a company.  You can eliminate or minimize possible issues in a future sale by addressing them now.  You can also maximize the selling price by implementing certain steps.  Even if you never end up selling the company, this exercise could provide insights into operations and possibly increase annual cash flow.

How Much Can You Reasonably Ask?

In order to determine this number, you should engage a reputable valuation expert.  Even if you “know” how much the company is worth, having a third-party report can provide significant help in negotiations.

Who Could Purchase Your Business?

You may think there are a wide variety of possible purchasers out there; however possible buyers can be grouped into two categories:  strategic and financial.  Strategic buyers generally do not want the employees; they do not want the building/offices/plant; what they want are the trade secrets and other intangibles.  They are buying the company because you have a really good “mousetrap” and they want that technology.  Strategic buyers (who are usually larger than you) believe they can take your technology and much more effectively exploit your product/know-how.  In the abstract, the “Sharks” on Shark Tank are generally doing this.  They want to know about your sales; but it is more of a weeding-out process.  The goal in negotiating with a strategic buyer is to get him/her off of your financials.  The price based on the financials is a low point.  Strategic buyers will generally pay much more than financial buyers because they believe they can much more effectively utilize your know-how and at a much lower cost point, due to lower labor costs (because they already have administrative people and possibly skilled labor that they are currently paying—and they likely will just load them up with more work). 

A financial buyer is buying the company based (mainly) on its financial statements.  He/she anticipates taking over the company and running it similarly to the way it has been operating in the past.  A financial buyer wants to lock in key employees and will be more likely than a strategic buyer to retain employees.  While you can rake in more funds with a strategic buyer, choosing financial buyers can protect the workforce a bit.  If you want to sell to a strategic buyer but still want to protect the workforce, at least to some extent, you could allocate a portion of the sale price to severance payments for employees.  You could also offer “stay pay” arrangements to give key employees extra funds to help during the transition.

Review Your Business Structure

Life evolves and so should every company.  Fifty years ago, most companies were C Corporations.  Now most companies are S Corporations, and there is a trend toward limited liability companies (LLC).  S Corporations and LLCs have become the “go-to” structures, as they are pass-through entities, with a single level of tax on income; whereas C Corporations have a double level of tax.  Using a pass-through entity may be the economic linchpin in ensuring the sale of the company goes through.

Do the Due Now, Due Diligence That Is

Many issues can “spook” a prospective buyer.  Expired licenses, EPA issues and late-filed tax returns are just some of the problems that can arise when a buyer begins the due diligence phase of the purchase.  For example, if one or more licenses are expired; you can go through the process of renewing them now.  If it takes a year, that may be okay.  If the buyer discovers the expired license during its due diligence period, he/she may not want to wait a year to make sure the license can be reissued.  If there are any possible EPA issues, you may want to obtain at least a Phase I audit, if not a Phase II.  Conducting these audits takes a while and can hold up the deal, or possibly crush it.  Having copies of Phase I and II audits also shows that you are on top of things; it can greatly expedite the sale process.  Finally, if you are not timely filing your tax returns, the prospective buyer may be concerned about possible IRS liens, not to mention be concerned about how you are running the company. (Is there anything else out there?).  We have attached a sample due diligence checklist to aid you in the process.

Sale of Assets or Sale of Interest in Entity (stock or membership interest)

Generally a purchaser will want to buy the company’s assets; not your stock or membership interest in the company.  The purchaser can avoid past liabilities and re-depreciate the assets (tax benefit).  If you have a pass-through entity (S Corporation or LLC), you may be okay with a sale of assets from an income tax perspective.  It is always advisable to sit down with counsel and/or your accountant to crunch the numbers and determine the “take home” money before proceeding too far into a deal.

Trust But Verify

Fear of losing the competitive edge is a major reason that a business owner delays shopping the business.  Is it possible to protect trade secrets and still move forward in selling your business?  Yes and no.  Before having any discussions with a prospective purchaser, the buyer should sign a nondisclosure/nonuse agreement.  This will contractually prevent the buyer from either: a. Telling anyone about the company; but also b. Using the company’s techniques for the buyer’s benefit.  In addition, you should not let the buyer speak with any employee until the sale is all but imminent, especially if it is a strategic buyer.  Finally, my brother gave me the best piece of legal advice, “Contracts are only as good as the people who enter into them.”  Do not just rely on a contract to save a business.  You should vet the prospective purchaser.  Find out if he/she has purchased other businesses and contact those people.  A little investigation up front can save a lot of problems down the road.

Make Sure the Sale Agreement Protects You, Post Deal

You can protect your profit by taking several steps.

Hold Harmless/Indemnification—The sale agreement should contain a hold harmless and indemnification agreement.  Selling the business does not prevent someone from suing the former owner.  The hold harmless/indemnification provision typically states that the purchaser will hold the seller harmless from any lawsuits relating to actions taken after the sale.  Usually that means the buyer’s attorney will defend you from any lawsuit.  Also, if someone obtains a judgment against you, the buyer agrees to make you whole.  Finally, it is advisable to obtain a “tail policy,” which will provide additional protection against lawsuits post deal.

Beware the Holdback—The buyer may try to “hold back” a significant portion of the purchase price to address any surprises, such as a breach of contract that is discovered after the sale.  While this may sound like a reasonable position, try and get as much of the proceeds at the closing as possible.  It is not uncommon for a buyer to “discover” breaches after the sale.

Maybe a Tax-Deferred Transaction Would be Helpful

A number of techniques can defer taxation—tax-free reorganizations, like kind exchanges, involuntary conversions, etc.  If you are more interested in obtaining a cash flow versus a large amount of up-front cash, counsel should explore these options.

What about My Commercial Real Estate?

A strategic buyer probably will not want the building.  The trade off is a higher purchase price.  Even a financial buyer may not be interested in the real estate.  If the buyer is not interested in your building, do not assume you will be able to sell the real estate immediately to someone else.  One solution is to ask the buyer to enter into a short-term lease, perhaps 3 – 5 years, with an option to terminate the lease, with notice, if you find a buyer for the building.  Another solution is to enter into a like-kind exchange in lieu of a sale of the real property.

APTs and EPs

Asset protection trusts (APTs) and proper estate planning can be critical both before and after the sale.  Before the sale, you should have a proper succession plan for the business.  Your spouse and heirs should be aware of your choices if you pass unexpectedly.  An APT can be a good vehicle to hold some or all of your interests in the company.  After the sale, an APT can be utilized to hold a portion of the sale proceeds.  Your estate plan should also be revisited post sale to make sure that the funds are protected for your heirs. 

Summary

It’s never too early to start planning for a sale.  Invest a little time with advisors now and it will reap significant dividends in your future.

Disclaimer: The views and opinions expressed in this article are those of the individual sources referenced and do not reflect the views, opinions or policies of the organizations the sources represent.

Due Diligence Checklist

A. Are the Books and Records Up To Date?

• Review both internal and external documents (i.e., filings with the state and bylaws, minutes, etc.)
• Your org. chart
• List of owners with percentages owned
• List of all states where you do business

B. Tax and Financial Information

• Tax returns and audited financial statements for three years
• List of all debt
• List of inventory
• List of all assets
• List of A/R and A/P
• Depreciation schedules

C. Real Estate

• List of all real property

D. Employees and Benefit Plans

• List of employees
• Copy of Employee Handbook
• Copies of all qualified plans and summary plan descriptions (both collectively and non-collectively bargained)
• Labor disputes
• Worker’s compensation history
• Unemployment insurance claims history

E. Licenses and Permits

• List of all governmental licenses, permits or consents
• Any correspondence or documents relating to any proceedings of any regulatory agency

F. Environmental Issues.

• Copies of any Phase I or II audits
• Copies of any past remedial action
• Copies of any EPA or other orders

G. Key Products

• A list of all key products

H. Key Relationships and Contracts

• List of key customers
• List of supply or service agreements
• List of other key contracts

I. Litigation

• List of all pending and contingent litigation

J. Insurance Coverage

• List of all liability, key man, fire, etc., insurance policies
• List of all covered and uncovered claims for past three years