December 2010 Archives

Mergers and Acquisitions - The Importance of Good Company Records, Part 2

December 30, 2010,

What should you do to get your company documentation ready for a potential merger or acquisition? Consult your lawyer. First, he or she will assist the company in getting its basic corporate minute book updated. Important transactions, such as those involving company stock or stock options, appointment or election of directors and officers, and substantial transactions should all be properly documented. The company's stock book and capitalization table should be reviewed for accuracy, particularly if there are multiple owners. If the company has gone through equity financings or debt financings, closing binders containing the material documents in each of these transactions will need to be made available.

Second, your lawyer should review existing documentation for legal traps. The minefield that poorly prepared documentation presents is extensive, but a few examples can help illustrate the problem. Companies early on may not be able to afford employees, so they will use independent contractors to help create their basic technology. If the company does not have a signed agreement from the non-employee inventor assigning all rights to the company, the inventor, not the company, owns the technology. If the same company has licensed its technology under a purchase order that provides for a transfer of title, then the company now may not own its own technology because it just transferred to the customer title to its technology. Of course, because it didn't get an assignment from the inventor in the first place, it may not have been legally able to transfer the technology to the customer, so the company may now be in breach. Situations like this do not typically advance closing dates.

Another legal trap exists in confidentiality terms, common to many contracts. These provisions prevent you from disclosing important information you receive from the other party. Often, this information includes the contract itself. As a result, you'll need to get permission from the other party to disclose the contract. When you ask the other party to disclose, they will want to know who the recipient will be. At that point, you'll need to disclose the name of the acquirer, and likely the fact that your company is being sold. The fact that you are being sold may not make the other party to your contract very happy. All of this requires you to make sure you know where you are under confidentiality, and to have a strategy where the disclosure requires delicate handling.

It is important to start early in making sure the documentation you provide to a buyer creates the best picture for the company. Otherwise, the once in a lifetime opportunity to sell your company may prove as fleeting as the paper in an oral contract.

Mergers and Acquisitions - The Importance of Good Company Records, Part 1

December 27, 2010,

Even in the San Francisco Bay Area, buying a business is like buying a house. You wouldn't do it without performing due diligence and a good inspection. Unlike a house, however, strengths and challenges in a business lie in its relationships, and not necessarily in its building. For this reason, buyers will spend a significant amount of time in reviewing a company's documentation before any merger or acquisition.

A buyer reviews documentation for a number of reasons. Many are business-oriented, such as whether the company has good title to its technology, has solid supply and strategic relationships, and has not overextended itself in promises made to customers or employees.

The fastest way for the sale of your company to implode is for you to be unable to deliver a complete record of your company to a buyer. It is typical for a company hoping to sell itself to make available online their corporate documentation promptly after a letter of intent is signed. The longer it takes to make this documentation available, the longer it will take to close the sale. A long sale process is almost never to the seller's advantage. Worse, not having information readily available creates a perception that the company is disorganized. This will increase the perceived risk to the buyer and will further lengthen the time to close.

Companies that wait until the last minute will often find their documentation is, at best cobbled together, inconsistent, and nonexistent. Poorly prepared contracts or agreements often contain traps that will result in the buyer shifting any risk arising out of the deficient documentation to the seller, thereby reducing the purchase price or making the seller liable for any damages incurred by the company after the sale.

Part 2 will provide some suggestions for getting your documentation in shape for a sale of your business.

Sale of a Business: Jump the GAAP

December 23, 2010,

Even in the reality-distorted vortex of Silicon Valley, a company's financial statements are a critical tool in any merger or acquisition. If you are a venture-backed company, or have substantial bank loans requiring annual audits, your company's financial statements may already be in relatively good shape. If you are an owner-operator, or have otherwise been relying on a tax-oriented approach to your financials, you'll need to convert your financial statements to the standards commonly used by accountants.

Generally accepted accounting principles, or GAAP, is the method used by the accounting profession to create financial statements. If you are trying to sell your company, you will need to have GAAP financial statements to be able to attract the best buyers, and to be sure you are getting the best value. Because GAAP is so widely used and, in many cases, mandatory, failing to provide a buyer with GAAP financials will increase the perceived risk with respect to buying your company, thereby lowering the price.

An acquirer will likely require that you submit GAAP financials. As part of your agreement with the acquirer, you will represent that your company's financials are compliant with GAAP. If you are wrong and the buyer is damaged as a result, the agreement will provide that you will have to compensate the buyer, usually through a reduction of the purchase price.

Because converting to GAAP financials is not an easy process, you need to get started as early as possible. In some businesses, such as those technology start-up companies, the conversion to GAAP could take years rather than months. Complications may arise, particularly in the revenue recognition area, and prior year financials may need to be restated. This could be disastrous if, in the middle of negotiations, adherence to GAAP eliminates the year-over-year profit increases you hoped to show.

Continue reading "Sale of a Business: Jump the GAAP " »

Mergers and Acquisitions: Start Now or Forever Hold Your Company

December 20, 2010,

Your company, like many companies in Silicon Valley, may suddenly find itself faced with a market window to sell and provide a liquid return for its owners. If you are an entrepreneur or other business owner, you are always on the lookout to reap the value of your business. Before you start planning the next phase of your life, however, you need to plan carefully how you will sell your company.

A company sale is typically a multi-year process, and the sooner you begin the better off you will be when a deal finally arrives. Although exceptions exist, particularly in the roulette world of high technology start-ups, a good rule of thumb is that it will take you between two to four years to sell an operating company. You should plan to begin the process no later than three years before you plan to close. Preferably you should start when you form the company.

Why so early? If you are an owner-operator, you will need to change your focus from maximizing the amount of cash and other compensation you generate from your company, to improving business valuation. A simple mathematical example drives home the point. Many companies are sold on a multiple based on earnings before interest, taxes, depreciation, and amortization (often referred to as "EBITDA"). If your business can be sold for five times EBITDA, that extra dollar in compensation will cost you five dollars in sale price.

Even if you are not an owner-operator, you need to start early to show a smooth history of revenue growth. Managing EBITDA to show constant year-over-year growth can go far in creating a perception of value, and of lower financial risk for the buyer.

Another reason to start early, regardless of whether you are a single owner or work with a number of investors, is that you will likely need to clean up a number of items. Of these, your financial statements are key. It is critical that your financial statements be expressed in generally accepted accounting principles, or GAAP, so that a buyer can compare your business with others and is comfortable that the financials have been prepared using standards acceptable to the accounting profession. Your legal documentation should also be tight. Your basic entity documentation, employment contracts, and materials agreements with key customers and vendors should be complete and fully executed. If you have a technology company, you will need a signed agreement from any person creating technology for your company assigning to the company any technology he or she has created.

Your ability to secure for yourself and your investors value for the company you have built may only occur once. Make sure you are prepared.

Doing It All Yourself - One of the Most Expensive Mistakes a Small Business Owner Can Make

December 16, 2010,

Recently, I have been doing a lot of work with a small business owner in San Jose. The more his business grew, the more stressed out he became. His fear of adding payroll to his company's expenses was hampering the growth of his start-up company.

When you first start your own business, you will probably handle all of the daily tasks yourself. For a start-up company, staff of any kind is a luxury you probably cannot afford. As the business grows, however, and in order for it to grow, you cannot keep trying to do everything. Eventually, you will have too much on your plate and your service will suffer. So, before you harm the reputation of this new business you have been working so hard for, you need to divide the tasks into those that you have mastered and can systematize and train someone else to do, and those that should be done by professionals.

Tasks for Staff: Examine your financial situation and figure out how much staff you can afford, then invest in hiring good people. Teach those people how to do the tasks your way and let them run with it and report back to you when appropriate. Stay in touch with them so that you always have your finger on the pulse of your business and never become too dependent on any one employee. Growing your business in this way will provide greater independence for you, greater value for your company, and larger profits. When my San Jose start-up client hired his first salesman and saw that the company could progress without being completely dependent on his efforts, he became a much happier person.

Tasks for Professionals: Sometimes doing it yourself is definitely not cheaper. Having the right professionals working for your business will save you a lot more in the long run - in time and money. Compliance and protection now can be much cheaper than fixing a problem later. When it comes to legal, accounting and tax needs, focus on creating value rather than saving money. For example, hiring a corporate or business attorney to help you choose the correct form of entity and then help you form your corporation, partnership or LLC correctly can protect you from legal and tax problems later. Using the right attorney to help draft contracts and agreements or review and revise contracts presented to you so that you get good contracts in place can save you from having to deal with onerous terms later. Hiring an accountant to help you set up your books correctly and report your income and deductions legally can save you from costly audit adjustments later.

You are the expert at what you do. Surround yourself with people who are experts at what they do. Once you have a good team of advisors, let them share information between them. It will save time, money and frustration for you and your business later.

Forming Your Own Corporation or LLC Online May Cost a Lot More Than Using a Lawyer, Part 2

December 13, 2010,

In Part 1 of this entry, I discussed problems that some of my Silicon Valley clients have had with improper choice of entity - either because the tax consequences weren't considered, or because restrictions in the California Corporations Code or Business and Professions Code were not taken into account. Here are two more expensive mistakes that business owners make when they try to form their own corporation or LLC online.

1. Not doing the required securities filings.
Online sites may not tell you that if you fail to file California and/or Federal securities filings you could be in violation of securities laws resulting in tremendous personal liability to return funds to your investors, despite the liability shield the entity is supposed to provide. Sometimes by the time I get involved it is too late to fix this, but sometimes we can do a late filing and get some, if not all, of the protection it provides. Corporations, as well as some LLCs and partnerships, are securities and must be treated accordingly.

2. Not completing the formation - with disastrous liability consequences.
By far the most common mistake when forming an entity yourself is not having the expertise to know what needs to be done after the initial filing with the Secretary of State, or not hiring the right advisor to counsel you. I have worked with many Silicon Valley business owners who thought they had a liability shield in place because they created their corporation or LLC with the Secretary of State, but in fact they were not in compliance with the Corporations Code and therefore did not have a valid entity to protect them in case they got sued. Filing Articles of Incorporation with the Secretary of State and getting an employer identification number with the IRS is not sufficient to create an entity. LLCs must have operating agreements. Corporations must have bylaws as well as minutes documenting required annual Board of Directors and shareholder meetings, electing directors, appointing officers, and approving corporation actions.

If you are not sure if your business is in the right type of entity, and is properly formed, don't wait until it is too late. Get advice now, before it negatively impacts your business later.

Forming Your Own Corporation or LLC Online May Cost a Lot More Than Using a Lawyer, Part 1

December 9, 2010,

I was in Los Gatos getting my hair cut this weekend and my hairdresser said something very interesting - he said that his best clients are the ones who try to do their hair themselves (especially their color) and then come to him to fix the mess they made. He said they are so grateful when he fixes the problem they created that they become clients for life. I am not the type of person to try to do my hair myself - too much risk for me. However, it struck a chord with me because it seems more and more I spend my time working with clients who have formed their own corporation or limited liability company through forms found on the internet, and then come to me to fix some problem they caused.

What is wrong with forming your own corporation or LLC online? Nothing, if you know what you are doing. However, most people who are starting a new business and need an entity do not specialize in forming companies. Here are two of the four most common (and costly) mistakes I have helped my Silicon Valley clients fix:

1. Picking the wrong type of entity -- with disastrous tax consequences.
In California, there are very different tax consequences for C corporations, S corporations, partnerships and limited liability companies. When I choose what type of entity to form for a client's new business, I consider franchise taxes amongst income and other taxes. For a real estate entity, I also consider property taxes and transfer taxes which can be quite different in Santa Clara county or another county. Fixing the type of entity can be as simple as making a tax election, or as complicated as converting to another form of entity - which can be done, but it is a lot more expensive than starting out with the right entity in the first place.

2. Forming an LLC for a business that is not allowed to be an LLC.
The California Corporations Code prohibits certain businesses from being a limited liability company. For instance, if your business is required to be licensed or certified under the Business and Professions Code, it is not eligible to be an LLC. I hate to see business owners spend their time and money on filing a limited liability company online, only to find out much later that it was not only worthless, it was giving them a false sense of security because they had no liability protection. The only fix here is starting over or converting to a corporation or partnership - both of which require new bank accounts, business cards, letterhead, etc. and are time consuming and expensive.

See Part 2 for two more expensive errors.