Articles Posted in Mergers & Acquisitions

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In a recent acquisition that I handled for a company in Santa Cruz, the buyer decided to purchase, with cash, the stock of the company rather than its assets. Acquisitions through stock or equity purchases are a common method of buying a company. From an administrative standpoint, equity purchase acquisitions are one of the easiest deal structures to implement.

In an equity purchase acquisition, a company is bought by purchasing all of the ownership interests of that company. If the company is a corporation, a buyer purchases all of the company’s shares of stock from the company’s stockholders. If the company is a limited liability company or partnership, a buyer purchases all the ownership interests of the company from its members, in the case of a limited liability company, or its partners, in the case of a partnership. This discussion will focus on a stock purchase, although the basic issues outlined here are the same when dealing with a limited liability company or partnership.

The administrative benefit of a stock purchase transaction is that ownership changes simply by transferring all of the company’s shares. Contrast this with an asset purchase structure, where each desk, chair and personal computer must be accounted for and sold to the buyer.

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Because acquisition transactions in Silicon Valley move very quickly, it is a good idea to understand the basics of deal structure. Every approach contains trade-offs among a number of different factors, including ease of closing, tax impact, risk preferences, third party involvement, and regulatory issues. This post examines the asset purchase structure.

Asset purchase agreements are used when the buyer does not want to assume any liabilities of the seller, except for those specifically outlined in the agreement (and those from which applicable law does not permit the buyer to escape). This structure is typically used for small owner-operator businesses, such as restaurants, retail establishments, and small service or manufacturing businesses. It can also be used where actual, or a fear of, residual liabilities exist, such as with businesses performing hazardous operations.

In addition to their liability-limiting feature, asset purchase transactions can provide tax benefits to the buyer. For example, some of the assets purchased in the transaction can be depreciated over time.

The tax impact may of the transaction, however, require attention and negotiation. Assets which are not intended for resale may be subject to sales tax. Although the seller is liable for any sales tax in California, parties often negotiate and apportion this liability in sale documentation. Because different types of assets and obligations create different tax obligations, parties are required to agree to an allocation of the assets purchased to particular classes and report the allocations to the taxing authorities.

Special tasks face buyers purchasing a restaurant or a company which principally sells merchandise from stock. In these cases, a buyer, in cooperation with the seller, will make a “bulk sales” notice. If the buyer fails to do so, the buyer may be liable for claims of the purchased company, even if the buyer merely purchased the company’s assets.

Assets can be purchased with cash or stock. If stock is used, securities laws must be complied with, which can increase expense and time to close a sale. If a mixture of cash and stock is used, tax impacts might arise in corporate transactions depending on the relative proportion of each component.

Asset transactions create administrative burdens. All assets must be listed and accounted for. This often requires taking a physical inventory and making adjustments if the inventory predates the closing. If the business has valuable contracts, the contracts need to be reviewed to determine if they can be assigned to the buyer. If not, the other party to the contract may need to consent to the assignment, a potentially time consuming and frustrating process.

Because only assets are being purchased, employees of the purchased business may have to be terminated. Any employees with accrued vacation will have to be paid that vacation. The buyer will then have the option to hire those employees back, or bring in its own employees. For companies with a large number of employees which expect to close facilities after the acquisition, federal and California law may require advance notification to affected employees.

Asset deals provide the best liability limitation for buyers. However, their complexity may render them unwieldy for larger transactions and their use should be explored prior to committing to any sale.

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Finding a buyer for the sale of a business is a lot like dating. Your prospects and your ultimate happiness increases with the number of people you meet. Whether you cruise the bars in San Jose, or schmooze partners at a trade show in San Francisco, building interest in your company is a critical step in finding buyers.

One of the key tools used in building business acquisition interest is a set of documentation often referred to as a “book”. The book will describe the business, the industry, and the potential for growth. It may also include financial statements, projections, and risk factors.

The content of the book must be considered carefully. Financial projections should be accompanied by appropriate disclaimers, and competitive and other risks to the business post-sale should be outlined. If the sales transaction is in the high tens of millions of dollars, language stating that an acquisition could reduce competition or permit other forms of market dominance should be avoided.

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In Part 1 of this entry, I discussed the importance of a business owner choosing the right professional advisors to assist in the sale of the company, whether in San Jose or Palo Alto, and some of the different types of experts.

Although there is overlap, advisors that assist with businesses having a substantial sales price are investment bankers that specialize in mergers and acquisitions. These professionals often help in cleaning up a company’s operations, provide pre-acquisition strategic guidance, act as chief negotiators in the sales transaction, and provide advice and formal opinions concerning deal valuation.

Compensation is a key issue in any agreement with an advisor. Compensation can involve payment of an initial fee, such as where acquisition solicitation materials are prepared, to a commission, such as where the broker takes an active role in negotiations that are successfully closed. Brokers and investment bankers will typically request a non-refundable engagement fee and a success fee. The latter can take many forms. One form provides for a set amount, plus a percentage commission based on the transaction value. Another form provides for a commission percentage which changes with the transaction value, often providing higher percentage commissions for higher values to encourage the advisor to be more aggressive in its pricing negotiations. Exceptions or adjustments to the fee structure are often made for introductions or transactions then in process which were not sourced with the assistance of the professional. Most advisor contracts contain a “tail”, which allows the advisor to collect a success fee for transactions occurring within a certain period, typically 12 – 18 months after the advisory relationship ends. Sometimes the tail can be limited to transactions for which the introduction was made by the advisor.

Advisors can go a long way toward guiding a company and its stakeholders through a successful transaction. Management, however, can’t expect that the advisor will take care of everything involved, and must be prepared to contribute extensively toward the transaction’s success.

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Every business owner at one time or another wants to sell their Silicon Valley business and move from Los Altos, Mountain View or San Jose to Tahoe or Tahiti. Being bogged down in daily operations doesn’t leave a lot of time for an owner to make the necessary contacts to build interest in their company. Owners wish they could just have someone else sell their business.

There are a number of professional advisors that can assist in the sale of a company. Like fundraising, however, management cannot simply pass to someone else a function this important. One of the key reasons for management involvement is that a business buyer is typically found through the company’s own contacts.

As with any advisor, choosing the right professional to advise on potential acquirers and transaction terms is a combination of validation by your network, expertise, and your own personal comfort with the individual with whom you will be working.

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Any large business transaction, particularly a merger or acquisition, requires a well-coordinated team for success. Assembling your team early on makes a large difference between success and failure, whether you are in San Jose, California or Sydney, Australia.

The most critical advisors are your attorney and your accountant. If you are a business owner and you don’t have an attorney or an accountant advising your company, you need to get one now. Although either professional can “parachute in” to assist your company in the event of a sale, their advice to you will be much more efficient and effective if they have direct and long term experience with your company. Failing to have ongoing advice in legal, tax, and financial matters will likely result in the need for remedial work and higher expense in closing a business sale.

Finding a suitable attorney will likely be your first task in assembling your business team. As with any advisor, you should use your referral network to find a professional that is appropriate to your business. You should only choose someone who you believe can act as a trusted, strategic advisor in planning, growing, and selling your business, rather than someone who can merely produce documents. An attorney who you allow to attend your board and/or shareholder meetings and generally become familiar with your business will be able to advise you on building the proper foundation for an ultimate sale of your business. He or she will also be able to tailor their advice to the realities of your business and your own risk preferences.

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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.

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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.

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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.

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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.

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