Once owners decide to sell their business they must engage in an emotional, time consuming, and challenging sale process. At the same time they must operate the business without having the sales process negatively impact its value.
A business sale transaction can take several forms: (1) sale of assets, (2) sale of stock, (3) merger, ( 4) consolidation, or (5) share exchange.
The most common form of sale is the sale of assets. The primary reason for this is that purchasers do not like the idea of acquiring the seller’s liabilities, which may include unknown or undisclosed obligations.
If a stock sale is more practical, the sale of 100% of the stock for cash is the most desirable form of sale from the seller’s point of view. However, in most cases the purchaser determines the structure of the transaction and often this is not acceptable
The next most desirable form of sale is the sale of stock for a substantial cash down payment with the balance paid under the terms of a promissory note, with adequate security to insure payment.
Another stock sale structure is the sale of a minority interest in the stock of the company with the buyer having the right to purchase additional shares on agreed upon option terms.
The more complicated methods of sale, like reorganization, merger, consolidation or share exchange should only be used if there is a problem in getting approval for the sale from 100% of the shareholders.
The Pre Closing Process
1. First, the seller has to determine Enterprise Value – a fair price for the business. This price is what the market will pay, not what the seller thinks the enterprise is worth.
The Enterprise Value of a company is the market value of the business as a whole, determined by taking the market capitalization of the company (per share or membership interest multiplied by the share or interest value). The market capitalization amount is then adjusted for factors such as the company’s total debt, minority interests, non operational assets that can be sold without hurting company performance, and cash on hand. Once the Enterprise Value is determined, it is very useful in then calculating valuation, especially with valuation multiples like EBITDA (earnings before interest, taxes, depreciation and amortization). The going multiple can be identified by researching the company’s specific industry, the size of the company, and market share.
2. The seller must then identify a number of potential strategic buyers – that is, buyers from the same industry or business.
Alternatively a seller can put together a comprehensive presentation booklet and “shop” the deal to a broader list of candidates.
3. If a buyer indicates interest, the seller should negotiate a confidentiality agreement so that enough information can be disclosed to the potential buyer to enable it to decide if it wants to enter into serious negotiations with the seller for purchase of the business.
The terms of the confidentiality agreement should run both ways. In this way, the seller can obtain basic information from the buyer to determine if the transaction makes sense and whether or not the buyer has the financial capability to make the acquisition.
4. After disclosures are made by both parties and the disclosed materials have been evaluated, if the parties wish to proceed with the transaction, the potential buyer will issue to the seller a non binding letter of interest.
In some cases, the seller will request that a letter of intent (“LOI”) be signed before disclosing additional confidential information. However, professionals disagree regarding the use of letters of intent. The primary problem is that, in some jurisdictions in some circumstances, the presumed “non binding letter of intent” has been held binding by courts. Though this is very unlikely if the LOI is properly drafted, many conservative business people do not want to take the risk. Their position is that, rather than spend time working on a detailed letter of intent, time and energy should be used to work on an actual purchase agreement.
5. Due diligence is an intensive investigation of the business which may take place before the purchase agreement is signed, between signing and closing, or some combination of the two. The buyer and the seller will negotiate and agree upon a due diligence check list that they will follow.
The items to be investigated will depend on the structure of the transaction, the nature of the business to be acquired, and its assets and liabilities. For example, the due diligence checklist for an asset purchase in an industry where buyers have not been held accountable for the seller’s non acquired obligations, the checklist would be less extensive than the checklist for a stock purchase deal.
The buyer’s goal in due diligence is to find out about the business assets being purchased, assess the desirability of the purchase, and decide on the price, terms, and structure to offer.
The seller also needs to investigate the business or assets being sold to decide what warranties and representations it is willing to make in the purchase agreement. Depending on the way the transaction is financed, the seller will want to do some due diligence investigation of the buyer. In a cash sale, the seller wants to know that the buyer has, or will be capable of obtaining, the financing. However, if financing is part cash and part installment or other post closing payments, the seller will investigate the buyer more thoroughly to assess the likelihood of receiving full payment.
The timing of the due diligence process is something that is negotiated on a transaction by transaction basis. Sometimes the bulk of due diligence takes place before the purchase agreement is signed. In other cases, the parties sign a purchase agreement and designate a due diligence period of 60 to 90 days, with a provision that the buyer has to be satisfied with the results of the due diligence as a condition of closing.
The due diligence period should take place in a 60 to 90 day time frame so as not to disrupt the day to day operation of the business. Controls over the process are very important, especially if there is a desire for secrecy in the transaction. Due diligence will include examination of corporate books and records and evaluation of financial information, tax matters, title to assets, condition of assets, third party contracts (including labor), insurance contracts, intellectual property, and environmental matters.
6. A pre closing checklist will be negotiated at the end of the due diligence investigation. At that point, the buyer and the seller will be able to identify a list of tasks that must be accomplished before the closing. The checklist will include any required government and bank approvals and set forth the process to obtain them.
7. Typically, the purchase agreement, which sets forth the terms of the transaction, will require that seller agree not to enter into any transactions or take any actions prior to the closing which would negatively impact the value of the business or result in any of the representations and warranties of the seller not being true on the closing date.
The Closing Process
A closing date, time and location will be scheduled. That will be the “target date” for the business managers and professionals to complete all of the items in paragraph 6 above.
Normally, the parties will assemble at a mutually agreeable location for an official “closing” to sign documents and transfer funds. Because of the advancement of technology over the last decade, many closings now take place with authorized representatives of the seller and buyer convening, and other participants attending via telephone conference call or SKYPE.
In an asset sale the seller will deliver a bill of sale and lien discharges at the closing. In a stock sale, the seller will deliver the stock certificates, lien discharges, and letters of resignation from the company’s officers and directors.
Once the above documents are delivered, the buyer will wire transfer funds to the seller’s bank account pursuant to written instructions and authorization from the seller.
Post Closing Issues.
1. If the sale is cash for 100% of the stock or assets, the post closing issues will relate to warranties and representations. The buyer will insist that the seller make warranties and representations regarding the title to the stock being sold, title to the assets of the company, financial statements issued by the company, the existence of litigation or government investigations, and lack of environmental contamination and so on.
2. Many buyers propose purchase with a cash down payment with the balance paid in installments under the terms of a promissory note held by the seller. In a stock sale, the security for this note can be the stock held in escrow by a third party escrow agent. If the buyer defaults, 100% of the stock goes back to the seller and the buyer forfeits the deposit.
3. The buyer may purchase a minority interest in the company and receive an option or options to purchase additional stock. These options are exercised at the buyer’s sole discretion unless the seller requires “put” provisions that provide that, upon hitting certain benchmarks, the seller can force the buyer to purchase the stock.
4. If the transaction is structured as earn-out, the buyer agrees to purchase 100% of the stock for a cash price of $X based on the current business and projections of increases in business because of the transaction. The parties agree that, if the increased business is actually achieved, the buyer will pay the seller an additional amount of money $X + Y.
The buyer will propose a certain percent of the purchase price be set aside in a “basket” to reimburse the seller’s actual out of pocket losses if those warranties and representations prove to be untrue. The hold back period is negotiated between the parties (usually 1 to 3 years) and at the end of that period the money is released to the seller.
Statistics reveal that a high percentage of the monies held back for representations and warranties are ultimately paid over to the seller, provided of course, that the warranties and representations prove to be true.
Likewise, there is a significant percentage of earn-out dollars that never get paid to sellers. Buyers argue that, often, when sellers are projecting increased growth of businesses, they are overzealous and unrealistic, trying to get the highest price for both X and Y. On the other hand, sellers argue that once buyers take over control of companies, the sellers cannot control the operation and the buyers do not do what is necessary to meet the projections.
If you have questions concerning the sale, merger or acquisition of a Michigan business, contact Randy Wright at the firm’s Birmingham, Michigan law office 248-645-9680 for a confidential free consultation.