Originally published in October 2017
Copyright © 2017 Knox McLaughlin Gornall & Sennett, P.C.
Valuation of Business
Comparable sales of businesses: Research what similar businesses in the industry and geographic region have sold for in the past few years. While such information provides an “accurate” look at the marketplace for a business, this is not a perfect valuation method since all transactions have their own nuances and issues. It is sometimes difficult to get full details on all aspects and conditions involved in a completed sale (i.e., seller-financing, equity, etc.). Trade associations are good sources of general information on comparable sales in certain industries.
Professional independent valuation can be performed: Can be expensive to have done but gives the “best current evidence” of value of business and operations. Most valuations will at least look at some comparable sales of similar businesses (see above) and thereby provide a sense of the recent market.
Note: If a formal valuation is done, it will typically be requested as part of due diligence process (see below). In negotiation process, existence of a formal valuation can get tricky.
“Back of the Napkin”: Value of hard assets + value of established “goodwill.” Very general and generic method for business valuation. Typically done as rough estimate in very early discussions between buyer and seller.
Clean-Up of Corporate Records/Assets
The buyer will want access to any and all information. “Every stone will be overturned” – good and bad. No company is “perfect.” Ideally, preparation for any sale occurs two or three years in advance.
Company records should be well organized and formally document previous transactions. Director/shareholder or Manager/Member meetings should be organized and complete. If multiple owners exist, ensure records and ownership are well documented. Buyer will be sensitive to potential issues with minority or disgruntled owners. Be wary of “confidential” or awkward discussions in corporate minutes and records.
Make sure key contracts, suppliers and customers are in order and formalized. Review material leases and agreements with customers, vendors and suppliers. Are they written, and if so, are they signed by all parties? Can the contracts be assigned/transferred easily? Terminate unprofitable or unattractive arrangements and make sure vital contracts renew and/or do not expire. Convert verbal arrangements to writing if critical to the business. Prevent long-standing relationships from being terminated inadvertently. Also, key employees may need a written employment contract.
Review financial statements and assets with a critical eye. Clean up the balance sheet and analyze reviewed/audited financial statements. Prepare and review projections and budgets to illustrate growth potential to buyers. Clean up receivables, remove or sell obsolete equipment or inventory, eliminate unprofitable assets. Clean up asset list and explore overall condition of tangible assets.
Planning with Advisors and Investigating the Market
Make sure buyers and sellers get advisors involved early in the process.
For buyers, evaluate the overall market for the business: investigate competitors and strategic partners in the business, and evaluate history of customers and suppliers of the business.
For sellers, marketing of the business opportunity is tricky. A seller can market the business on its own, or it can hire a broker for a commission/fee. Seller must balance the competing interests of preserving confidentiality of a potential sale and the seller’s desire to reach all potential buyers.
Obtain Initial Financing Approval
Buyers should begin discussions with bankers and financial advisors on financing methods and terms. Financing pre-approval helps narrow a buyer’s focus during purchase price negotiations. If competitive bidding process is used, loan pre-approval is desired.
Sellers should check loan covenants and current debt instruments. Check for any loan prepayment penalties or premiums. If it is a stock deal, can a buyer assume certain debts and liabilities without consent
The advantages/disadvantages to sellers are as follows:
For the seller, an asset sale is generally a more cumbersome process than the sale of corporate stock/equity. An asset sale requires the seller to organize, track and transfer title of all assets to the buyer and requires more documentation to be produced by the selling party. An asset acquisition generally requires the drafting of the following: deeds, bill of sale, contract assignments, assumption agreements and other documents required to transfer assets. Additionally, there may be problems related to obtaining third-party consents when transferring contracts.
The seller will be required to recognize gain on sales and distributions of assets. One exception is the liquidation of an eighty percent (80%) owned subsidiary in a complete liquidation where Section 332 of the Internal Revenue Code (“IRC”) applies. However, an asset sale is a more favorable structure for a seller if it is selling one division of the seller and retaining another.
Comparatively, an asset sale may leave the seller with unwanted assets which may be difficult to dispose of when the seller is no longer in operation (i.e., obsolete inventory or equipment, aged accounts receivable, environmentally-risky property, etc.).
The advantages/disadvantages to buyers are as follows:
A buyer typically prefers to acquire the assets of a company. In an asset acquisition, the buyer does not acquire the seller’s liabilities unless they are specifically assumed by the buyer.
Exceptions to this general rule include the following:
A buyer will take a basis in assets acquired equal to cash paid, fair market value (“FMV”) of non-cash property and the amount of any liabilities assumed. The purchase price will be allocated among the assets acquired and will determine the buyer’s ability to depreciate such assets and recover basis. The allocation of purchase price and offsetting ability to depreciate such assets will have a significant effect on the buyer’s future tax liability.
The one disadvantage to buyers in an asset deal is the complexity of the transaction, especially with respect to transfers and assignments of third-party contracts and permits/licenses.
The advantages/disadvantages to sellers are as follows:
The seller generally prefers the sale of corporate stock/equity because of the relative simplicity of the transaction. Advantages include the ability to transfer some contracts without obtaining consent of a third-party, and the seller avoids future liability for any occurrence prior to the sale. Gain is taxed to the seller at capital gains rates.
One disadvantage is that a seller may have difficulty convincing all shareholders of a corporation to sell their stock. A buyer may require the sale of 100 percent of the stock in a company to avoid dealing with future minority shareholders.
The advantages/disadvantages to buyers are as follows:
A buyer generally assumes the seller’s liabilities in a stock/equity sale which include events that are both foreseen and unforeseen.
A buyer typically assumes the seller’s transferred tax basis of any assets in a stock/equity sale and does not benefit from any previous depreciation.
A buyer may be able to utilize carry-forward net operating losses (NOLs) acquired by the seller in a stock/equity sale. The use of NOLs is limited to the restrictions set forth in IRC Section 382.
In a 338(h)(10) transaction, the buyer and seller make an election under IRC Section 338 and treat a stock sale as a hypothetical asset acquisition for tax purposes. This allows the seller the benefit and ease of a stock transaction, while preserving the buyer’s ability to secure a step-up basis in assets acquired for tax purposes.
The parties to a transaction should enter into a properly structured confidentiality/non-disclosure agreement (“NDA”) before the exchange of any proprietary information, since a potential buyer and potential seller may be business competitors. As such, the potential seller must be cognizant of the fact that a transaction may not be executed and of the fallout related to exposure of confidential information to an existing competitor. A strong NDA is crucial to outline the terms of exchanging confidential information, and the seller must determine any limits on the exchange of proprietary information.
An NDA should protect the parties in the exchange of confidential information, set parameters for the use of the information and outline recourse available to an injured party if necessary.
Initial Disclosure of Limited Information
Financial information: A potential buyer will typically require the seller to produce financial statements and federal and state income tax returns for the last three (3) to five (5) years. A buyer will typically request documentation concerning any loan, credit and security agreements as well as any information on significant equipment or personal property leases. At this stage of the discussions (before any term sheet or letter of intent), the exchange of information is very limited, but it is just enough for the potential buyer to assess the company and make an offer.
Projections: A potential buyer will typically request any financial projects prepared by the seller internally or with the assistance of the seller’s CPA. For most buyers, these are critical since a buyer is also looking at purchasing the potential growth and future profits of the seller.
Letter of Intent/Term Sheets
Binding: A binding letter of intent creates a legally binding obligation and may prevent future renegotiation by a party, including requiring a party to accept a term in the document it later determines to be disadvantageous upon due diligence. Litigation may result if the parties leave a transaction and break a binding letter of intent.
A binding letter of intent is very unusual, unless the parties have a long history together.
Non-Binding: A non-binding letter of intent includes a clause allowing a party to leave a transaction and does not create a binding legal obligation. The non-binding letter of intent sets forth an agreement in principal and gives the parties the ability to leave a deal in the event unforeseen facts or circumstances occur.
Cash is still “king” and preferred by sellers as the most liquid and simplest form of consideration and payment. If a competitive bid process is in place, then cash payments will preempt rival non-cash bidders.
From seller’s perspective, it is the least risky method of payment.
From buyer’s perspective, it may decrease the buyer’s debt rating or impact its capital structure.
This is a very common method when the buyer does not have the funds (or inclination) to pay the entire purchase price at closing. The negotiating positions of the parties are key, especially if the seller is in economic and financial turmoil. Seller will typically subordinate its financing to the buyer’s primary lender(s). Caution should be used when taking security interest and collateral behind primary lender(s). Buyer and seller must be sensitive to the requirements of primary lender (i.e., interest rate, payment schedule, default terms, etc.).
It is a risky prospect to the seller (i.e., potential default by buyer):
This method may enable the seller to utilize an installment sales method for tax purposes and defer overall gain at the time of the closing.
The seller should have some real concerns over default and remedies against buyer, namely:
Escrows provide recourse for a buyer in the event of a breach of representations and warranties or potential outstanding liabilities of the seller. Seller will often try to limit the purposes and use of escrow funds. The escrow is tied to indemnity obligations and limitations of seller in the definitive agreement.
Escrow amounts range based on overall purchase price of the transaction, typically a range of 5% to 20% of the overall purchase price. The typical term of escrow ranges from 6 to 24 months from closing.
Most often used to bridge a “valuation gap” with respect to the purchase of a seller. Seller believes its company is worth more and thus accepts a lower upfront payment with the potential for future additional payments if seller’s anticipated “increased value” is realized. Future milestones and events must be as objective as possible.
The parties agree that additional payments will be made to seller if certain events occur or certain milestones are reached by the business after the closing. Typical events are future revenues, future sales to a specific customer or other financial metrics. EBITDA (earnings before interest, taxes, depreciation and amortization) is also a common element and financial metric in an earn-out. Milestones may or may not be realized and thus payments are considered contingent.
This is a risky arrangement for sellers:
If an earn-out is proposed, then a seller should seek to keep the existing seller management in place with buyer to run the business and increase the performance of the company. There is a motivation of seller to make sure the business performs well. The buyer needs to be mindful of the difficulty of a seller to change its “mindset” as no longer an owner of the business.
Very typical provision in M&A deals and factored in as part of overall purchase price and payment, as the seller wants to insure the buyer has adequate working capital to meet business requirements post-closing.
Comparatively, seller wants to receive payment for asset infrastructure that enabled the company to operate and generate profits. Working capital adjustments are meant to protect buyer against seller performing or refraining from certain actions such as:
A typical working capital adjustment calculation includes a measurement of the change between the sum of cash, inventory, accounts receivable and prepaids minus accounts payable and accrued expenses. Adjustment mechanism compares the actual working capital at the closing against a target working capital level, where the target working capital is the “normal level” for the operation of the company based on an historical review of performance. Other adjustments are included, and parties should ensure financial advisors and accountants review the calculations and methodology.
An adjustment and “true-up” usually occurs within a few months (i.e., 90 days) after the closing. The purchase agreement will address and handle any disputes between the parties on the working capital adjustments.
Corporate Minute Book and Records Review
The buyer should determine if any restrictions on the transfer exist and also review the seller’s stock register and stock certificate book for the current ownership status. The buyer should review copies of outstanding share certificates for additional restrictions. Also, the buyer should review corporate minute books and records to determine if existing officers and directors are properly elected.
Title Search and Lien Search
The buyer should determine whether the seller has good title to property to be acquired in the transaction. A corporate lien search should be performed to determine if any liens are outstanding against the seller. Be aware that, if the seller does business in other jurisdictions or owns property in multiple jurisdictions, then a lien search should be done in each such jurisdiction.
Site Visits and Inspections
Buyer should visit the site of the seller’s operations. Any specialized equipment held by the seller should be inspected to determine condition, reliability, etc.
Environmental Review and Assessment
Buyer should conduct a study to determine if any environmental concerns exist on property acquired as part of the transaction. If appropriate, the buyer should have an independent assessment done of the property prior to sale, and include specific representations and warranties related to condition of any real property acquired in the agreement.
Buyer in a stock acquisition should review financial statements and all federal, state and local tax returns for the past three (3) to five (5) years and determine if it will acquire any material tax liabilities (tax obligations) or tax assets (NOLs).
Buyer should review existing contracts with key suppliers, vendors and other third parties. A buyer should determine whether such contracts are assignable in the case of an asset acquisition, or subject to some limitation related to the sale of the seller’s stock.
Buyer should perform a review of existing management, officers and directors to determine whether to retain existing personnel following the transaction.
Intellectual Property (“IP”) and Technology Review
Buyer should review all IP owned by the seller including all patents, pending patent applications, trademarks, tradenames and copyright registration papers. Additionally, the buyer should review and determine whether the seller’s existing technology platform (i.e., computer systems) may be utilized or incorporated by the buyer after the transaction.
Employees and HR Review
Buyer should review all existing employment contracts entered into by the seller and existing employees of the seller. Significant HR policies should be reviewed, and an audit of any outstanding or potential litigation by employees against the seller should be performed. A buyer may incorporate appropriate representations and warranties into the agreement to mitigate any potential exposure related to an outstanding HR liability.
Buyer should determine whether the seller must comply with any state or federal regulatory requirements. The buyer should be confident the seller has complied with all necessary regulations in the past, and that it will be able to comply with such regulations after the transaction. A buyer may incorporate appropriate representations and warranties into the agreement when appropriate.
Representations and Warranties
Buyer should require the seller to give specific representations and warranties regarding the acquired business, which protect the buyer of a business and outline the terms whereby a buyer can walk away from a transaction.
Seller should require the buyer to make certain representations concerning the buyer’s valid existence and authority to enter into a transaction.
Closing Conditions and Requirements
Buyer and seller should include certain conditions and requirements in the agreement that must take place in order for each party to be obligated to perform.
Buyer and seller should indemnify each other from future liability caused by the other. Representations and warranties should be included in the definitive agreement to protect each respective party from any future claims made against the company or breach of a condition of sale.
In an asset acquisition, a buyer and seller should agree on an allocation of the purchase price between the seller’s assets and intangibles (i.e., goodwill and going concern value). The tax consequences following the sale of different classes of assets are not the same for a buyer and seller.
Generally, a buyer will benefit from a majority of the purchase price being allocated to assets of the seller. A buyer is able to depreciate assets over a shorter period of time than the period required to amortize intangibles.
Generally, a seller will benefit from a majority of the purchase price being allocated to intangibles. Gain from the sale of an intangible capital asset will result in capital gain treatment for the seller.
Buyer should require certain key employees of the seller to enter into non-competition agreements. To be enforceable, a non-competition agreement must be reasonable as to geography and time period. A buyer should also require a seller to enter into a corresponding agreement to not solicit existing customers or key suppliers of the business after the transaction.
Employees and Consulting Arrangements
Buyer should determine whether it intends to employ existing employees of the seller, or, if appropriate, enter into a consulting arrangement with certain employees after the transaction.
Bulk Sales and Regulatory Matters
In Pennsylvania, a buyer is required to secure from a seller a bulk sale clearance certificate if the seller is selling 51 percent or more of its assets. Without such clearance certificate, a buyer may be liable for a seller’s Pennsylvania state tax liabilities.
Buyer and seller should consider entering into an indemnification and escrow agreement if the parties are unable to secure a bulk sale clearance certificate from the state prior to execution of the transaction.
Buyer and seller should consider incorporating in a purchase agreement certain alternative dispute resolution platforms in lieu of future litigation. The cost of a future dispute may be decreased by forcing the parties to first require mediation and/or a venue other than state or federal courts.
The complexity of the deal and desires of the parties will dictate the overall timeframe for negotiations and eventual closing of transaction.
Simultaneous Signing and Closing vs. Deferred Closing
While closing can occur at the same time as the execution of the purchase agreement, the majority of closings occur at a later date after signature (“deferred closings”).
Deferred Closings are preferred, to deal with things like:
Risks of Deferred Closings: Often requires a more complex acquisition agreement and must factor in changes in business between signing and closing.
Benefits of Deferred Closings: It reduces risk of prematurely “going public” and may increase likelihood of closing. It also may give additional time for integration of the seller.
Issues with Changes in Business Between Signing and Closing
Risk of loss: Buyer usually assumes more of the risk (as a practical matter), and parties should allocate the risk in the purchase agreement.
Risk Allocation Provisions commonly used are:
Material Adverse Effect (“MAE”) clauses. MAE clauses are used as a condition to the closing and qualifier of the representations and warranties. The definition of a MAE clause is often subject to heavy negotiation. Many parties scrap MAE clauses for broad and general indemnification provisions.
Representations and Warranties. Updates to the disclosure schedules may be needed.
Purchase Price Adjustments. Working capital adjustments (see above). Cash or debt adjustments to seller’s financial condition. Collection of A/R (increased collection or slow-down?).
Satisfaction of closing conditions and closing deliverables:
Closing the Deal
Expedite the period between signing and closing. Avoid post-signing letdown and keep momentum/sense of urgency.
Use closing agenda and checklist: The who, when, what and how of getting the deal done.
Typically occurs at the office of buyer’s legal counsel or title company (as settlement agent); however, in light of the need for seller to transition operations, it is not uncommon for closing to be conducted at seller’s office/business.
Buyer and seller dictate where and when closing should be held. In light of email and wire transfers, location is not as essential anymore, and many closings are conducted “remotely” with PDF exchange of signed documents and wire of funds when approved.
Closing date and effective date do not need to be the same. Year-end and quarter-end are the best “clean” cut-off dates; Month-end or beginning is generally used.
Depending on buyer’s intentions for the business, the buyer may lease seller-owned property for a period of time.
Long-term lease vs. Short-term lease. Buyer will prefer short-term lease with “easy” termination provisions. Seller will want longer arrangement and greater certainty on rental payment stream of income. Typical compromise is a locked-in period at fixed rent and increased rental rate thereafter with eventual renewal option at buyer’s discretion.
Option to Purchase. Buyer may request/seek ability to acquire the real estate at some point in the future. If negotiated as a Right of First Refusal, the seller must be wary of other triggers such as:
Seller will also want some certainty on terms of Option to Purchase and/or limited time periods for exercise of Right of First Refusal.
Assignment of lease and rent payments. Seller should ensure lease can be easily assigned if property is sold. Also, seller may wish to assign the eventual rental payments to shareholders/owners if seller is dissolved/liquidated.
These are becoming more and more common in transactions, especially for handling integration of employees and technology. They can take several forms but usually require seller’s services and assistance in transition of business operations and customers. Relatively short-term arrangements that are especially useful in circumstances with key customers and unique technology requirements (computer systems, database conversion, etc.). Usually for no or nominal consideration/payment. Possible reverse transition services arrangement – i.e., seller needs assistance from the buyer for post-closing matters, etc.
Depending on the deal structure, buyer may take on all, some or none of the seller’s current employees. Integration of employees can be difficult, especially if new management is brought in and/or demotions occur. There may be an adjustment to new policies and requirements.
Note: If structured as an asset deal, seller should give written notice of termination to its employees and prepare final payroll (even if employees will be hired by buyer immediately upon closing).
Retirement plans and programs: Unless a stock deal or a buyer assumes the retirement plan, seller will need to finalize and administer the plan for employees. Check the plan documents to determine what kind of services or assistance the plan provides for education of employees. Integration of employees into buyer’s plan can be tricky, especially for those employees with many years of service with the seller.
Health and welfare benefits
Holiday/vacation/paid time off (PTO): Can be a sticky issue for employees, especially those with many long years of service with seller. Payment for and handling of PTO and holiday/vacation time is often picked up in working capital adjustments.
Look to lock up key personnel if current agreements do not exist. Typically made part of the purchase agreement and sometimes a condition of closing. Non-compete and non-solicitation provisions.
In asset deal, buyer may acquire use of corporate name or corporate designation (i.e., fictitious name, etc.). Documents are required to be filed with Department of State to amend and change the name and registered address of the seller.
Seller will coordinate with accountants for tax returns and financial statements. If a stock deal or merger, buyer and seller will need to coordinate and cooperate in subsequent tax return after closing. Typically, closing date financial statements will be required for working capital adjustments.
In asset sale, seller may eventually desire to dissolve and liquidate the business entity. Dissolution starts the clock for running of the applicable statute of limitations period for any unknown claims or creditors (i.e., two years).
Caution: Some thought must be given to the impact of dissolution on seller-financing, deferred payments, escrow payments, lease payments, etc.
Originally published in October 2017
Copyright © 2017 Knox McLaughlin Gornall & Sennett, P.C.