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.

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.