The global M&A market has remained strong from the end of 2017 into 2018, with the total deals announced in the first half of 2018 making it the best period for global M&A yet. With stockholders pressuring larger companies to grow their revenues and the strong liquidity position of many companies, it is a sellers’ market. For companies looking to sell and participate in the record-breaking 2018 global M&A market of $890.7 billion in Q11 and $889 billion closed with $1.3 billion announced in Q2,2 the toughest question is often how to start.
Before starting the process of soliciting potential buyers, how does a company prepare for a sale so it is best positioned for a positive outcome? A typical sale transaction can take six to eight months, or even longer, to complete from the time the decision to sell is made. This process can be significantly longer if unnecessary hurdles are encountered because the seller is unprepared. Consequently, it is important that any business owner seeking to sell his or her business in the near term take certain immediate steps. The following are some key questions every potential seller should ask to assess their readiness. In addition, we have provided below a checklist to assist with a potential seller’s preparation for a sale.
Are your corporate records up to date and accurate?
Buyers will typically require a seller to represent that its capitalization and corporate records are accurate and up to date from formation through the date of a sale. Despite the importance of these records, industry sources report mistakes in company capitalization and stock ledger records of up to a third of private companies.3 Mistakes discovered after a deal expose sellers to liability, and mistakes discovered during a transaction can cost companies valuable time and money and result in a sale not closing.
How many stockholders will need to approve a sale? Is any other party’s approval required? How likely is it that such approval can be obtained?
Many private venture-backed companies today have gone through multiple financing rounds. Some of these rounds may have added new investors or imposed conditions that must be met or stockholder approvals that must be obtained in the event of a sale. In addition, if a company has any outstanding debt or other securities, holders of those instruments may have separate and independent approval rights or even blocking rights. Before adding the time pressure of a close date, companies should start evaluating which groups of stockholders (or other parties) will need to approve a sale and how likely it is that such approval can be obtained. Waiting until the sale process has begun under a strict deadline can put a seller in a tough negotiating position. It may then face having to negotiate key deal terms with not only a potential buyer, but also with its own stockholders in order to obtain their approval. If the seller plans to rely upon a voting agreement compelling minority stockholders to approve a transaction, that agreement should be reviewed to confirm what type of transaction triggers that right to vote and how extensive that obligation is. Analyzing stockholder voting rights and understanding the approval requirements under any debt or other security instruments upfront can prevent the complexities of a three-way negotiation among the seller, the securities holders, and the prospective buyer and can save valuable time in getting the sale closed.
How will the “waterfall” flow in the event of a sale? What liquidation preferences need to be considered in soliciting offers?
Sellers may want to prepare one or more “waterfall” analyses to review and consider. A “waterfall” is an analysis of the liquidation proceeds in a sale including funds that would be distributed to debt holders, preferred stockholders and common stockholders. The “waterfall” helps a company understand which investors receive proceeds in a sale and how much each category of investors receives. This information can be very helpful in determining how likely it is that required approvals can be obtained.
How accessible and assignable are your company’s “material” contracts, and will the terms of the contracts, particularly employee contracts, be acceptable to a buyer?
Buyers will likely want to review a seller’s “material” contracts. Whether or not a contract is material depends on a company’s individual circumstances, but contracts with officers and other key personnel, important vendors and customers, financing agreements, contract templates, and government contracts (if any) will likely need to be provided to a buyer. Additionally, the material contracts provided to a buyer will need to be the signed and executed versions. If a seller is unable to quickly locate these documents it may give buyers the impression the selling company does not efficiently run its business operations. This not only costs time, but also affects a buyer’s overall impression of a company’s value.
Also, contracts may require approval or notice to permit the seller to transfer the contract to the buyer or to permit a change in control of the company caused by the sale. Again, in a time crunch, this can put a seller in the precarious position of having to negotiate with the buyer and its employees, customers, vendors, and/or financing sources. Employment contracts with officers and key personnel require additional scrutiny as the buyers will likely want to retain some or all of these individuals, and the terms of their employment, severance, and any change of control payments may need to be renegotiated during the sale process. Renegotiating compensatory agreements can take a significant amount of time and cause management to lose focus on the key terms of the sale itself. Sellers seeking to close a sale should have their contracts evaluated by legal counsel to determine materiality and transferability and should have the terms of employment and other compensatory arrangements reviewed as soon as possible to avoid unnecessary delays.
Are your company’s financial records in good order?
Providing a prospective buyer with accurate and complete financial statements is a prerequisite for any sale. While some buyers will accept unaudited financial statements, depending on the size of the transaction, most buyers will require audited financial statements for at least the last completed fiscal year prior to the closing of the sale. An audit, especially a first-time audit, of a company’s financial statements can take months to complete even if there are no surprises. Companies should carefully review their internal controls and procedures, financial policies, and any “off balance sheet” transactions now to avoid any surprises that could delay the delivery of an auditor’s opinion on the company’s financial statements.
How strong are your company’s compliance policies?
Almost all business activities are regulated in some way, but it is often difficult for companies to determine which regulations apply to their business and to further determine if they are in compliance with all applicable regulations. Buyers will, nonetheless, expect a company to comply with all applicable regulations whether a selling company is aware of these regulations or not, and to make representations to that effect in the purchase agreement. In light of this, companies should evaluate the state of their compliance with applicable governmental regulations before entering into a sales transaction.
Are the company’s data security and privacy policies and practices strong and compliant?
How well protected are your company’s intellectual property assets?
A company’s intellectual property is often its most valuable asset and, for most technology companies, may be the primary reason a buyer is interested in purchasing the company. Issues impacting intellectual property rights discovered during a transaction can delay or even kill a deal. Problems found in advance can often be remedied, but these actions may take time. Consequently, companies should review their intellectual property portfolio now to determine if there are any risks with respect to their intellectual property assets.
Are there any pending or threatened claims or litigation matters by or against the company? Does the company have records of past litigation matters?
A buyer will want to know of any pending or threatened litigation matters, and will likely want a history of the company’s past litigation. Like clear and complete contract, financial, and corporate records, clear and complete records of litigation matters affect a buyer’s overall impression of the company and its value. Buyers will typically require a seller to represent that all pending or threatened litigation have been properly disclosed to the buyer, and mistakes or omissions discovered after a deal may expose sellers to liability. Having a complete and accurate picture of the company’s current and past litigation will prevent issues later in the process.
Companies often ask what they need to do to prepare for a successful sale. Poor preparation for a sale can complicate, delay, or even kill a deal. The questions outlined above and the below checklist are the right place to start and help better prepare companies thinking about selling.
Key Steps in Preparing for an M&A Exit
- Review and update corporate and capitalization records and documents.
- Review approval requirements. How many shareholders need to approve an M&A transaction? Who else’s approval is necessary? Will you be able to obtain these approvals?
- Review liquidation preferences. Prepare a waterfall analysis. Check for acceleration and change in control provisions in warrants, stock option agreements, and other equity compensation plans and agreements.
- Review material contracts. Are the material contracts assignable? Do any contracts, including employment contracts, contain change in control provisions that might affect an M&A transaction?
- Get financial statements in order. Consider an audit if one has not recently, or ever, been performed. This may take months to complete.
- Review and evaluate company compliance with applicable governmental regulations.
- Review and evaluate company data security and privacy compliance, policies, and practices. Identify any risks or issues, and implement remedies and proactive improvements.
- Review and evaluate the company’s intellectual property portfolio. Identify and remedy any risks.
- Review and consider all pending and threatened litigation matters by and against the company. Review and summarize the company’s litigation history as well.
- Meet with or engage third parties to assist in preparing and executing an M&A transaction: legal counsel, an accountant, and an investment banker or broker may be necessary.
1 Mergermarket, Q1 2018 Global M&A Report, April 4, 2018.
2 Trefis Team, “Morgan Stanley Saw M&A Market Share Growth In Q2, But Goldman Still Made The Most Money,” Forbes.com, July 9, 2018. https://www.forbes.com/sites/greatspeculations/2018/07/09/morgan-stanley-saw-ma-market-share-growth-in-q2-but-goldman-still-made-the-most-money/#26d8f30d2901.
3 Paul Koenig & Mark Vogel, Tales from the Trenches, Third Edition, printed by R.R. Donnelly and Shareholder Representative Services, Jan. 2012. (“In SRS’s experience upwards of a third of the [stockholder ledger] spreadsheets received [from companies] have issues that require further clarification before distributions can be made.”)