Exit Strategy Planning and Legal Due Diligence

Exit Strategy Planning and Legal Due Diligence - Article written by a leading Exit Planner and Corporate Lawyer
By Stephen Cummings and Vanessa Grant

Stephen Cummings is the CEO of Rizolve Partners, a leading Exit Planning firm.

Vanessa Grant is a leading corporate lawyer with Norton Rose Fulbright Canada who is skilled in preparing for and executing business transactions for entrepreneur-led private and public companies.

PLANNING YOUR BUSINESS EXIT

There are many areas in your Business Exit where agreements and representations are made to a third-party buyer that he/she will rely on in agreeing to the transaction. Having legal advice to ensure that reasonable bargains are made such that options for recourse are limited by reasonability is important to mitigate risk.

Seeking early strategic advice, followed up by disciplined pre-due diligence planning is key to negotiating a successful transaction and ensuring that momentum in the deal is preserved.

Finally, having a skilled M&A lawyer to negotiate your side of the bargain who understands the current market for appropriate legal terms, conveys to the bidding team that you are serious about concluding a satisfactory deal.

Legal Advice on Planning Your Business Exit

The legal advisor is one of the key advisors to a business owner in planning for and executing an exit. This advisor should be part of your core transition team. Their role has the key objective of ensuring that all of the existing company legal agreements and corporate governance structures are drafted and allow for a transaction to proceed with minimum friction from any stakeholder, including the buyer.

There are two core roles that the legal advisor fulfills in this regard:

  • Ensuring that a company is ready from a legal perspective to navigate the transaction process. This includes ensuring that the existing (and subsequent) legal agreements and corporate governance structures (controls, policies, and guidelines) are drafted in contemplation of a future purchase and sale agreement such that documented acceptance of a transition into third party ownership has been reached, so far as possible, well in advance of a transaction; and
  • The legal advisor has well developed experience in drafting and negotiating a purchase and sale agreements at current market terms. Not all advisors have equal experience and a legal representative who is active in the M&A market is important.

 

Legal Advice for Planning to Sell / Exit your Business

STRATEGICALLY PLANNING A TRANSACTION

In strategically planning a transaction, a legal advisor should be included to offer advice in the review in such matters as:

  • Tax efficiency of the ownership or corporate structure;
  • Capital structure and the approval process for a transaction;
  • The nature and extent of the liabilities contained in the financial instruments held;
  • The corporate governance in any shareholder agreements, the articles and the laws of the company that will impact the ability of the entrepreneur to affect a transaction;
  • Understanding the nature of the outcomes of different exit options.

After making a decision to transition the ownership of the company into different hands, the legal advisor should then be engaged to review, from a tactical perspective, all of the elements of the corporate group structure, agreements governing the rights of shareholders, equity compensation plans and other financial instruments, the articles of the company, the laws and existing legal agreements to ensure that there are no blockers or issues of significance that would cause a problem for the transaction. Examples of the legal counsel review would include the following:

Buy-Sell Agreements
  • Are there any?
  • If so, do these agreements contain documented purchase options?
  • If so, are there any provisions related to the departure of the entrepreneur?
Participation Agreements
  • Are there bonuses or distributions on exit?
  • Are there allocation of profits, distributions or carried interest that activate on sale?
Intellectual Property
  • Does the company have an inventory of its registered and unregistered intellectual property? For example:
    • Patents
    • Trademarks
    • Trade secrets
    • Copyrights
    • Domain names
    • Data
  • If the company develops or has developed its own software, is the software subject to an open-source license?
  • Is it clear who owns the intellectual property?
    • Distinguish between employer, employee, contractor or prior employer
  • Are protections in place to further guard the intellectual property such as:
    • Assignment of intellectual property agreements
    • Confidentiality agreements
    • Prior restrictions
    • Internal policies and procedures
    • Licenses
Financial Agreements
  • What are the financial covenants?
  • Are there personal guarantees that will need to be released on closing?
  • What are the change of control provisions?
Contracts
  • For all agreements:
    • Is there a change of control provision that requires the consent of the counterparty on a change of control (sale) of the company?
    • Are there limitations of liability or unlimited liability?
    • Are there indemnification clauses?
    • Do you have insurance to cover the indemnification provisions in the agreement?
  • Customer and vendor agreements
    • Is it clear which form of agreement takes precedence (look for terms and conditions that are incorporated by reference into purchase orders – do they conflict with the master agreement)?
    • Are the performance terms of the contract clear?
    • What are the termination provisions? Is the contract a long-term contract, or a short-term contract? Is the duration of the contract consistent with industry norms?
  • Leases
    • Leases almost always have a change of control provision – consider the relationship with the landlord and whether there will be any issues obtaining consent for a change of control.
  • Licenses
    • Review intellectual property clauses: who owns any intellectual property?
Human Resources
  • If there are any written employment agreements or offers of employment, do they reflect the current state of employment law?
  • What are the liabilities for vacation pay, potential severance pay, and benefits? Are these clearly documented?
  • Non-compete, non-solicit, confidentiality, and assignment of intellectual property provisions – what are they and what do they affect?
  • Retention – do you intend to provide retention incentives for any employees – all or key only?
Business Litigation and Risk Management
  • Litigation
    • Is there any litigation?
    • If so, is it likely to settle or be resolved prior to any sale of the company?
    • If it is not likely to be resolved prior to a sale, discuss with your legal advisor how best to manage it with a prospective buyer.
  • Reducing likelihood of litigation
    • Do you regularly perform credit and background checks?
    • Are there onerous contract terms that should be flagged for prospective buyers?
  • Insurance
    • What insurance policies are in place?
    • What is the scope of the insurance? Does it cover the operations of the business?
    • Do you need directors’ and officers’ insurance?
    • Does the company have CGL and named insureds?
    • Are professional liabilities covered such as errors and omissions?
    • Is workers’ compensation and employer liability covered, either statutorily or with policies?
    • Do you have cyber security insurance?
    • Do you have employee dishonesty coverage?
Corporate and Regulatory Filings
  • Have all the annual returns been made and are they in good standing?
  • Have all extra-provincial registrations been made?
  • Are all required regulatory and tax filings up to date in each jurisdiction in which the company does business?
  • Does the company have all permits in all jurisdictions to carry on its business?
Minute Books
  • Do you have them completed?
  • Are they up to date?
  • Is the list of shareholders up to date and accurate?

 

PLANNING YOUR BUSINESS EXIT - Legal Advice from Experts

DRAFTING THE TRANSACTION AGREEMENTS

The second major area where you will need skilled legal expertise to help you mitigate transaction risk is in drafting the transaction agreements. Key documents and components of the agreement of transaction terms are:

  • Letter of intent (“LOI”).
    An LOI is a non-binding letter of intent usually drafted by a prospective buyer as an indication in writing of a buyer’s willingness to purchase the company. While the document is of a legal nature, however, it is not intended to be fully binding. The only binding obligations tend to be with respect to confidentiality and exclusivity. The LOI sets out the terms of the acquisition process and provides insight into what the final offer and its terms might look like.
  • Purchase and sale agreement.
    A buyer may elect to purchase the shares of a company or all or some of the assets of a company. The form of transaction (share or asset sale) depends on a number of factors, including tax and business risk. Regardless of the form of acquisition, a business purchase and sale agreement is a legally binding contract that outlines the terms and conditions of buying or selling the business. It specifies the purchase price, assets, liabilities, warranties, any purchase price adjustments, and other important details to protect the interests of both the buyer and the seller. Much of the negotiation of a purchase and sale agreement is around what is the limit to how much a seller has to pay where there is a breach of the representations, warranties, and covenants made. The limit might be an amount equal to the purchase price (not as common as it once was) or a percentage of the purchase price and any holdback or escrows of the purchase price.
  • Documenting and negotiating representations and warranties.
    Representations and warranties in a business purchase and sale agreement are statements made by the seller about the condition and status of the business being sold. These statements cover various aspects such as financial information, legal compliance, contracts, intellectual property, and other relevant details. If any representation or warranty is found to be untrue, the buyer may have legal remedies or options for recourse.

FINAL TAKEAWAYS

In summary, having a legal advisor with the appropriate M&A skills involved in the early consideration of the transaction strategy can save a lot of time and money. As part of the aligned core transition team, this advisor creates the potential for the transaction to proceed with minimum friction from any stakeholder, including the buyer. You can see from the above analysis that there are many areas to consider and having a trusted, knowledgeable legal advisor who knows you and your goals is critical to achieving a satisfactory outcome.

 

For more information about Exit Planning, check out our process expertise tips sheets here.

What is Transferable Value and How Do I Build It?

Transferable value refers to the value that a business holds for someone else, without the original owner’s involvement. It is important to understand that transferable value is not the same as profit. Although a business may generate substantial profits, it may not necessarily have transferable value. The transferable value of a business is determined by its ability to function effectively in the absence of its owner, rather than how efficiently the owner manages it.

Peter Christman, the co-founder of the Exit Planning Institute, in his book, “The Master Plan”, identifies the three legs to the stool of a successful exit strategy:

  1. Maximizing Transferable business value;
  2. Ensuring that the Owner is financially prepared; and
  3. Ensuring there is a plan for “What next?”

Each of these key elements of a successful exit strategy need to be understood as they are critical. In this blog we will focus on Transferable Value.

The acquirer of a business whether it be a family member, employees, or third parties, are really looking to take possession of a business that produces cash into the future on a sustained basis with predictable results.

To build transferable value in your business, it’s essential to assess your value drivers. By implementing and improving value drivers, you can develop a business that can be transferred to someone else without any significant disruption to its cash flow.

So what are prime examples of transferable value and issues surrounding it that an incoming owner would prize highly and pay fully for?

Leadership and Human Resources

A strong team of human resource assets that work towards a common vision and set of goals within a defined culture that establish the boundaries for strong working relationships. Within that team would be competent management that can help ensure the smooth running of your business, maximize profits, and make informed decisions that drive growth towards the Company Vision.

Supporting management should be a balanced team with multidisciplinary skills that facilitate the execution of the Plans to individually and collectively defined goals and who motivate each other. The key quality is a team that can execute a plan consistently to increasingly valuable ends.

Examples of issues found in due diligence that would raise value in the mind of the buyer:

  • Strong, skilled, balanced and competent management teams;
  • Retention agreements with key staff to ensure that they stay with the company to facilitate transition;
  • A succession plan for leadership positions as the Owner transitions out of the business, and no gaps in skills in the human resource matrix.

Maintenance of Good Financial Records

Maintaining good financial records is another crucial step in building transferable value in your business. This includes having a clear record of your revenue, expenses, and cash flow. By keeping accurate and up-to-date financial records, you can track your business’s financial performance, identify areas for improvement, and demonstrate to potential buyers or investors that your business is financially stable and well-managed.

Here are some reasons why maintaining good financial records is important:

  • Financial transparency – creates trust and confidence;
  • Better decision-making – to make informed decisions on cost cutting or new initiatives;
  • Tax compliance – to stay compliant with regulations and make appropriate deductions;
  • Improved cash flow management – to track cash flow and manage finances; and
  • Valuation – to show a clear picture of prospects to help the evaluation of future value.

Being able to deliver future projections and estimate the net cash flow that the business will generate, informs decision making and enables nimble management as economic conditions change. Evidence of the repeating cycle of success: Strategic plan; Budgeting process; Performance review; and Rolling forecasting, demonstrates that the business possesses up-to-date information on goal attainment as the central focus of its tactical decision-making process. It also highlights the business’s capacity to adapt and modify plans to embrace emerging opportunities and address potential risks on a timely basis.

During due diligence, a buyer will be assessing:

  • What the quality of the reported numbers are – audited financial information is presumed to be the highest quality;
  • The value of future plans with projections that are predictable and sustainable. This will help the buyer assess future returns so an offer can be made based on both reported and anticipated cash flows;
  • The current status of compliance reporting; and
  • The appropriateness of accounting policies with GAAP and consistency with their presentations.

Issues that could create transferability issues are: Loss making businesses; qualified audit opinions; or contingent liabilities such as the outcome of current lawsuits.

Legal Protection

A company contract is a legally binding agreement between two or more parties that outlines the terms and conditions of their business relationship. Contracts play an important role in protecting business interests, reducing risk, and increasing transferable value.

Having clear legal contracts in place that document agreements with Customers, Suppliers, Employees, Partners, Shareholders and other key stakeholders to the business is important for a third party, particularly when the buyer is purchasing shares of the company.

It is commonly the case that Companies have short-cut creating legal documentation as they grow and have avoided incurring legal fees by “copying” other company document formats. While this serves a purpose at the time (keeping costs down), it is important for a lawyer to review the existing documents to confirm that they are appropriate for the current business conditions especially in contemplation of a change of control.

Given the focus of the buyer on the future and sustainability and growth of current business, the existence of patents to protect intellectual property into the future is of heightened importance – even if the patent protection is in place but “pending”.

Finally, having no disputes outstanding and a clean record is valuable. Conversely, the existence of lawsuits is often a blocker to transferability. It is therefore highly recommended that legal disputes are settled well in advance of any transaction.

Recurring Revenue and Efficient Sales Processes & Systems

The process and systems that exist in a company to identify, prospect, engage, excite, sell to and convert prospects and customers in the Sales process is a key leverageable asset. A buyer will want to ensure these are in place to facilitate their plans to operate and grow the business into the future. The absence of good quality, repeatable systems is likely a significant issue for a buyer that can negatively impact transferability and business value.

In particular, the existence of a sales pipeline and a sales back log will be the subject of detailed due diligence, and the probability of conversion of the pipeline into future cash will determine how transferable the business is.

During due diligence, the quality of the processes and systems will be assessed.The existing pipeline, as often captured in a CRM, will be scrutinized and is often key to the value placed on a business.

Transferability will be impacted where:

  • Systems and processes are undocumented, impacting scaleability; and
  • Sales pipeline and evidence over the probability of converting a lead is poor, leading to low visibility behind sale projections.

The repeatability of sales to customers should be emphasized during due diligence both historically and in showcasing the ability to convert prospects.

Marketing and Customer Service to Support a Strong Brand

Developing a strong brand is a critical step in building transferable value in your business. A strong brand creates a lasting impression on your customers, making your business more memorable and recognizable. It can differentiate your business from competitors, increase brand recognition, build customer loyalty, support premium pricing, and provide a competitive advantage. By doing so, you can create a more attractive business for potential buyers or investors.

The transferable value is often documented in:

  • The development of a marketing brand book – that documents characteristics of brand identity;
  • Documentation outlining the company’s Unique Selling Proposition;
  • A history of strong and improving customer satisfaction scores using widely accepted scoring benchmarks such as Net Promotor Score; and
  • Marketing conversion metrics giving a clear track record of understanding the ideal customer and their needs and wants.

Operational Capacity and Ability to Fulfil the Sales Promises

Operational capacity is the business’s ability to fulfil orders in a timely manner such that the customer is satisfied that the brand promise has been fulfilled time and again.

The buyer of a business is interested in whether the Operations of the systems of fulfilment and Customer service are repeatable and set up such that the promises made by Sales are satisfied no matter what time of year and in spite of different influences on the business.

They also focused on whether such practices are scaleable and therefore sustainable. In this regard they would want to know if Standard Operating Procedures (“SoP’s”) are in evidence and are teachable to facilitate higher volumes.

Transferable value is contained in:

  • Documented SoP’s;
  • Documented training in Systems and Procedures;
  • Products that are standardized as opposed to being customized; and
  • Human resources that are onboarded and trained in procedures with defined job descriptions so that they can become a productive member of the team in the minimum time possible.

 

In summary, this presents several key value drivers and indications for you on what represents transferable value. This is by no means an exhaustive list, and you should seek professional help in identifying transferable value in your business. Your company’s transferable value needs to be showcased and emphasized during due diligence with prospective acquirers.

As a final thought, the “three legs to a stool” is a powerful symbol in this context when you consider what happens to the three-legged stool that is short one leg. Note that 75-80% of businesses fail to sell when they are brought to market *. Beware ignoring the components of a successful exit strategy and in particular the drivers of transferable value.

By focusing on the key value drivers, you can build transferable value in your business and make it more attractive to potential buyers or investors. It is important to remember that building transferable value takes time and effort, but the long-term benefits can be significant.

 


 

* Tom West, Business Reference Guide

 

Rizolve Partners understands what needs to be done to achieve sustainable, high-quality growth.
To learn more, check out our process expertise tips sheets here.

Four Steps to Finding Your Sell-By Date

Most business owners think selling their business is a sprint, but the reality is it takes a long time to sell a company.

The sound of the gun sends blood flowing as you leap forward out of the blocks. Within five seconds you’re at top speed and within a dozen your eye is searching for the next hand. Then you feel the baton become weightless in your grasp and your brain tells you the pain is over. You start an easy jog and you smile, knowing that you did your best and that now the heavy lifting is on someone else’s shoulders.

That’s probably how most people think of starting and selling a business: as something akin to a 4 x 100-meter relay race. You start from scratch, build something valuable, measuring time in months instead of years, and sprint into the waiting arms of Google (or Apple or Facebook) as they obligingly acquire your business for millions. They hand over the check and you ride off into the sunset. After all, that’s how it worked for the guys who started Nest and WhatsApp – right?

But unfortunately, the process of selling your business looks more like an exhausting 100-mile ultra-marathon than a 100-meter sprint. It takes years and a lot of planning to make a clean break from your company – which means it pays to start planning sooner rather than later.

Here’s how to backdate your exit:

Step 1: Pick your eject date

The first step is to figure out when you want to be completely out of your business. This is the day you walk out of the building and never come back. Maybe you have a dream to sail around the world with your kids while they’re young. Perhaps you want to start an orphanage in Bolivia or a vineyard in Tuscany.

Whatever your goal, the first step is writing down when you want out and jotting some notes as to why that date is important to you, what you will do after you sell, with whom, and why.

Step 2: Estimate the length of your earn-out

When you sell your business, chances are good that you will get paid in two or more stages. You’ll get the first check when the deal closes and the second at some point in the future — if you hit certain goals set by the buyer. The length of your so-called earn out will depend on the kind of business you’re in.

The average earn out these days is three years. If you’re in a professional services business, your earn-out could be as long as five years. If you’re in a manufacturing or technology business, you might get away with a one-year transition period. (Estimate: + 1-5 years)

Step 3: Calculate the length of the sale process

The next step is to figure out how long it will take you to negotiate the sale of your company. This process involves hiring an intermediary (a mergers and acquisitions professional, investment banker or business broker), putting together a marketing package for your business, shopping it to potential acquirers, hosting management meetings, negotiating letters of intent, and then going through a 60 to 90-day due diligence period. From the day you hire an intermediary to the day the wire transfer hits your account the entire process usually takes six (at best) to 12 months. To be safe, budget one year. (Estimate: + 1 year)

Step 4: Create your strategy-stable operating window

Next you need to budget some time to operate your business without making any major strategic changes. An acquirer is going to want to see how your business has been performing under its current strategy so they can accurately predict how it will perform under their ownership. Ideally, you can give them three years of operating results during which you didn’t make any major changes to your business model.
If you have been running your business over the last three years without making any strategic shifts, you won’t need to budget any time here. On the other hand, if you plan on making some major strategic changes to prepare your business for sale, add three years from the time you make the changes. (Estimate: + 3 years)

Figuring out when to sell

The final step to finding your sell-by date is to figure out when you need to start the process. Let’s say you want to be in Tuscany by age 50. You budget for a three-year earn out, which means you need to close the deal by age 47. Subtract one year from that date to account for the length of time it takes to negotiate a deal, so now you need to hire your intermediary by age 46. Then let’s say you’re still tweaking your business model – experimenting with different target markets, channels and models. In this case, you need to lock in on one strategy by age 43 so that an acquirer can look at three years of operating results. (Estimate: 4-7 years)

It certainly would be nice to make a clean, crisp break from your business after an all-out sprint, but for the vast majority of businesses, the process of selling a company is a squishy, multi-year slog. So the sooner you start, the better.

Rizolve Partners is a trusted strategic advisory firm dedicated to helping business owners achieve peak value. If you’d like to learn more, let’s have a conversation. You can reach us in any number of ways here.