DON’T WAIT! GET YOUR LEGAL HOUSE IN ORDER NOW
This week on “In Process: Conversations about Business in the 21st Century,” Trusted Counsel continues with the next podcast in the series dedicated to the topic of preparing your business for sale. This series leads up to the physical event the firm is hosting at 5:30 p.m., on Thursday, Apr. 19, 2018, in Atlanta titled, “Prepping the Princess for the Party: Is Your Business Ready to Sell?”
Many business owners who have sold a company generally agree that it’s a fairly stressful experience for anyone who’s not been through the process before. Sellers typically don’t really understand all the complexities, how long it can take, and what actually is involved. While they’re thankful when it gets closed, most sellers don’t relish the overall experience. However, sellers who can get their legal house in order now with the help of good professional support will find the sale process much easier to navigate.
In the second installment of the six-part podcast series, show hosts Evelyn Ashley and John Monahon go inside the firm to speak with two of Trusted Counsel’s law partners, Allen Bradley and Tom Wardell, about the legal side of selling a business―from before a buyer knocks on your door until the final distribution from the sale is made.
“A large issue for a seller is recognizing capital income rather than ordinary income,” said Allen. “Often, when the purchasing price is tied to an earn-out, there can be ordinary income issues. Today there’s a 20-point spread in the two tax regimes, so capital gain is very important.”
Unfortunately, sellers often wait to bring in legal counsel once they’ve already gotten a Letter of Intent. That’s a big mistake. Sellers, especially first timers, can benefit greatly from having sound advice not only from the tax perspective but also from the legal side that can help determine the value of a business and identify strengths as well as weaknesses―because those are the things buyers usually focus on.
“There are some fundamental terms within a Letter of Intent,” said Tom. “Price is obviously one of them. Another is the nature of the transaction, for example, is it going to be structured as an asset sale or a stock sale? Will there be a continuation of management. If there are to be down-stream terms, then what are those terms? Sometimes you get further into things like expectations with respect to employment agreements. Usually a Letter of Intent will run two-three pages more or less.”
During the course of the podcast, entrepreneurs, business owners and C-level executives will learn about:
- Often overlooked legal elements in the preparation process
- What to expect during the actual negotiations
- How contracts can be structured
- The importance of network security and privacy to the sale
- How and when to communicate customer information
- Impact of employee incentive packages
- The concept of escrow
Learn about the steps you can take to prepare your business for a sale now or for the future by streaming the conversation in its entirety in the player below, or download it to your mobile device via iTunes. Don’t miss a single episode, subscribe to our show “In Process Podcast” on iTunes to receive this episode as well as future episodes to your smartphone.
“Prepping the Princess” is an invitation-only event for C-level executives and business owners. The event will provide substantive information on the key elements, which most every business should possess, to make it an attractive participant at the sale dance. For more information on the event and to request an invitation, please go to preppingtheprincess.com.
Is Your Business Ready to Sell? Part Two:
Don’t Wait! Get Your Legal House in Order Now
(c) Trusted Counsel (Ashley) LLC. All Rights Reserved.
John Monahon: Hello and welcome to In Process, conversations about business in the 21st century. Presented by Trusted Counsel, a corporate, intellectual property law firm. I’m John Monahon.
Evelyn Ashley: I’m Evelyn Ashley.
John Monahon: We are partners in Trusted Counsel.
Today’s episode is getting your legal house in order. This is the second episode of a series of six shows that we’re doing for a series called Prepping The Princess: Is your business ready to sell. This series is for businesses and their chief executives and what they should be thinking about to get themselves to a point where they’re ready to sell their business.
Evelyn Ashley: We’re really looking forward to the event and I think that our chat today, which we don’t do a lot of legal focused podcasts. Hopefully that will be extremely helpful for a lot of our listeners.
John Monahon: Right. I actually just got an email today from a CEO of a business who was saying, “I’m going up to another city to discuss a potential sale. Let’s have a pre-talk about what I can expect and what some things maybe I need to think about before I even enter into that meeting, before we even get to the letter of intent stage.” So I think this is exactly what we’re going to cover.
Evelyn Ashley: Absolutely. Those are the questions that so many people actually ask.
John Monahon: So let me introduce our law partners who are joining us for today’s discussion. Today we have Allen Bradley to discuss legal side of a business. Allen focuses on corporate and technology law, corporate finance and private securities, corporate and partnership tax, executive and other non-qualified compensation, corporate and individual real estate, and wills, trusts and estate law. He’s involved with renewable energy and sustainable initiatives and has assisted clients with obtaining federal and state grants and other subsidiaries with a regard to renewable energy projects. Prior to joining Trusted Counsel, Mr. Bradley was a partner at Stites and Harbison as well as Foltz Martin LLC and Schnader, Harrison, Segal and Lewis. Before that, he was vice president and general counsel for Shephard Systems Inc. practicing in the areas of general, corporate and tax law, executive and other non-qualified compensation, intellectual property licensing, and portfolio management.
We also have with us Tom Wardell who joined Trusted Counsel in 2018 as senior counsel. He is a respected legal industry veteran with more than 40 years of corporate counseling. His focus at Trusted Counsel will be adding his transactional expertise as well as providing clients with unparalleled knowledge in public securities and corporate operations and governance. Additionally, he will be involved in the training and mentoring of new attorneys, sharing his experience of having been both on the operating side of a law firm as well as a CEO of a $250 million computer systems company, which he exited in the early ’90s. Allen and Tom, welcome to the show.
Allen Bradley: Thanks.
Tom Wardell: Thank you.
Evelyn Ashley: Thanks for being here.
So let’s just move right to it. We do want to talk a little bit about the process itself. It’s generally a fairly stressful experience for anyone who’s not been through a sale of their business. It can also be stressful getting it ready to be sold. I think a lot of what we’ve experienced is that sellers are not really … They don’t really understand how long it can take and what actually is involved. A lot of times it’s 20/20 hindsight. They go through the experience and they’re like, “Oh, I can’t believe how complex, how horrendous that actually was.” It’s good when you get closed but not necessarily the experience itself. So what do all of you think about is there a way for us to actually help clients to get through this a little bit easier? Education is everything, but what have you seen?
Allen Bradley: I think it’s important to recognize that they’re always at least three 40s. The buyer, the seller, and the federal government. So it’s important to do the tax due diligence before the process begins. Such as making sure that this corporation election has been made and all the paperwork is in place. Those types things are very important from a tax standpoint to confirm.
Evelyn Ashley: Right. In order to get through the transaction and to be able to rely on the position that you’ve taken.
Allen Bradley: Right.
Evelyn Ashley: So I guess add to that, what else? I mean, a lot of times unfortunately we get brought into this after a client has already had a buyer knock on the door and say they get all excited. They have no necessary prospective on what the value of their business is or anything else. Sometimes they’ve already got a letter of intent in their hands. I think it’s important that they understand that they should probably bring us in a lot earlier. Not just from the tax perspective but also from what is the value of your business, what are your strengths, what are your weaknesses because those are the things the buyer usually goes for.
John Monahon: Yeah. I think that sometimes when we come in and after the letter of intent, expectations have been set, which actually makes it much more difficult to change the deal if it’s not properly structured. Letter of intents can range from being way too detailed to not even closely detailed enough. But although they’re mostly nonbinding except for the confidentiality provisions, I do think they set a pretty solid expectation for the deal, which is hard to undue if your legal counsel hasn’t looked at it yet.
Allen Bradley: Certainly one expectation is private transactions for there to be a sale of assets as opposed to the sale of stock. With the new tax act and the emphasis on C corporations is important to realize that a sale of assets from a C corporation involved two levels of tax. So that’s one of the expectations that needs to be looked at at the time of letter intent is signed.
Evelyn Ashley: Exactly. I think it’s important for C corporation owners for whatever reason that they are that status, that they understand that they do have an opportunity to actually elect that flow through, but they need to do it early enough.
Allen Bradley: Right.
Evelyn Ashley: That’s five years, is that …
Allen Bradley: I think it’s been shortened to five years. Yes.
Evelyn Ashley: Yeah.
Allen Bradley: The burn off period.
Evelyn Ashley: So they can elect and then over that time period they probably want to wait for the full five years in order to get the tax benefit of the flow through.
Allen Bradley: Correct.
Evelyn Ashley: I think the other thing we see clients get stressed out about is the whole negotiation dance, if you will, because negotiation is a key part of essentially everything that we get involved with. But we tend to be almost immune to the fact that it’s there because we know it’s going to happen. I think that the thing that surprising clients a lot of times that haven’t been through this is that it’s all negotiation. From the moment you start talking to a buyer. You have to have focus on how do you support your financials and understand them? What are your expectations because you know that it’s a balance of risk. A buyer’s going to come in and basically say, “I’m going to hold you responsible, seller, for basically everything that’s gone on with this business going forward.” How we actually help them to support that balance going forward.
John Monahon: I think that’s a good point and I think that’s one of the most important things to think about when you want to sell your business. A lot of people day to day, they’re stuck in the just selling their business, I have a certain number in my head, which is a very limited scoop of selling your business. As we know, there’s a lot of other elements there, like you said. Limiting your risk on the back end. Maybe how long you’ll have to work there. Even that number is subject to a large about of negotiation. Is it going to be an earn out? Is some portion going to be contingent? Have we figured out the target networking capital that could adjust the purchase price? There’s a lot of other considerations, which can change the deal that you expect to get into something else.
Evelyn Ashley: Right.
Tom Wardell: I guess I just add just framing people’s thoughts around two items. One is what is it you think provides the value for the buyer? In my own case, it turned out to be a huge customer base. Although once in, they realized they were also buying a bunch of very valuable software. But the more important thing actually is to treat it like any other project. Put a team together because it is going to be resource intensive. If you don’t organize the team up front, you’ll find your people going crazy.
Evelyn Ashley: Right.
Tom Wardell: You will go crazy.
Evelyn Ashley: I think that’s a really … It’s also an important point to understand that your team needs to be committed to actually stay on the other side of the deal because they are one of the assets in the transaction that the buy, most likely, will expect. It would be a very small percentage of transactions where a buyer’s going to come in and basically just say, “I’m taking the product and I don’t care about anything else.”
Tom Wardell: That’s correct.
John Monahon: What’s important to getting your legal house in order to be attractive to an acquire?
Allen Bradley: Certainly one issue for technology companies is to review the state sales tax and where sellers should be collecting sales tax. With the recent tax act and the removal of many state deductions, large states are often trying to increase their revenue collection so this is a big issue.
Evelyn Ashley: Yeah. I think that’s really important. We have seen situations where that can break down a transaction because the buyer actually sits there saying, “We’ve identified that you’ve got some major sales tax liability and we’re not going to be responsible for any of that.” You might still be able to do the deal, but your seller is the one whose going to absorb that impact.
Allen Bradley: Yeah. The sellers going to discount the price to reflect that liability.
Evelyn Ashley: Yes. Exactly. They will have to. I mean, it’s also important, we saw this very recently with some transactions that we did, how important tight contracts, particularly when you’re representing the seller, our own clients, having really tight long term contracts where you actually have a term of years revenue that you can rely on and how that can actually build immense value inside your business. Many times we see these transactions where you got a seller who will just randomly take the customer’s paper and sometimes you’re forced to. I understand. But a situation where a company can actually put themselves in a position where they control what that contract looks like can really enhance the value of that company going forward. We’ve clearly seen that. That and limitations on their warranties, their liability, what kind of indemnity do they have in there, what are their potential exposures going forward.
John Monahon: I think one of the most critical things in any acquisition is an acquirer whose buying a business is looking for continued value, which takes place in the form of that contract. So what some people don’t realize when selling their business is a lot of times we have to get consent to transfer those contracts to the acquirer. You can’t get consent then the value doesn’t transfer to the acquirer. That usually is in a change of control provision in the contract so we have to review that. Unfortunately, the bigger the client and the more revenue that you have from that customer, usually the more likely it is to have an anti-assignment clause in it. So that’s something that if you’re going to sell your business, you probably should be thinking about in advance. I’ve even argued that some relationships are getting even trickier as well because the seller also has vendors of let’s say data that they rely upon to continue their services to their customers. Those vendor relationships are coming from very large corporations that may not want to continue that relationship with the acquirer because they might be competitors. So that’s something to think about as well. Not only can your customer contracts transfer but can your vendor relationship transfer as well.
Evelyn Ashley: Right. Your key relationships. The other thing that we certainly seen and everyone knows this because it’s in the newspaper all the time, security. Privacy and security. Buyers are very, very sensitive to what does your network look like. Particularly because most buyers when you’re a technology business, they are not going to just shut down your security system, your network system. They’re going to be using it at least for some time period going forward. So we have clients that are like, “Well, we’ve never done a friendly hack. We have no idea. We’re so tiny. Who cares.” Or “We’re so middle market that who cares. No one cares about us.” The reality is we’ve actually seen clients that because of other situations that have arisen in their business, they have actually found out that they have been backed. So these are provisions that are showing up in the agreements, and clients have to be ready to stand with complete knowledge of what that network looks like.
John Monahon: Absolutely.
Tom Wardell: I guess I’d say you also want to make sure, especially with intellectual property, that either inbound or outbound licenses are solid and that you really don’t have to negotiate with the licensees or the licencors in order to transfer the value because that will be an integral part of what’s being paid for.
Evelyn Ashley: Absolutely.
Tom Wardell: Consistent with that is also you know how solid your customers, your own customer base is if what your selling includes an annuity stream and it often does. It’s in the form of a support contract in particular. It’s one thing to have those support contracts, of course, but support contracts are easily walked away from if customers are not happy. So I would advise any senior manager who’s in charge of the sale to do a little sampling to make sure the customer base is where you want it to be and where you want to be able to represent that it is because you will be selling that. Cheapest cost of sale is for a buyer to buy a customer base.
Evelyn Ashley: Absolutely. Then even on a more basic level, we’ve even seen sellers of technology, software, intellectual property that they have built that haven’t actually gotten their proper assignments from contractors. Where they’ve brought a contractor in at some stage who has provided something that relates to their ultimate product, and they’re unaware that if they don’t have a written assignment of the copyright and the ownership there, that they don’t actually own it. You never want to be in a situation where you have to go back when you’re selling to explain, “I need that assignment now.”
Tom Wardell: You need to look too at just the basic books, minute books, stockholder records just to make sure they’re there.
Evelyn Ashley: Everything is clear.
Tom Wardell: In fact, everybody that has an option, returned an option agreement. Simple stuff like that.
John Monahon: Mm-hmm (affirmative). I guess one thought about all of this risk that shows up is if I’m the seller, I think to myself, “These are not big issues because they’re something I’m very familiar with. I feel like I’ve addressed them. They don’t really concern me.” I would probably think, “Oh, well that …” I would have somewhat of an explanation for everything as why it’s a non-issue. But to an acquirer whose not in your business who sees these and then talks to an attorney about, “Oh, well you could be on the hook for millions of dollars of damages.” They don’t have that same level of comfortableness with these I guess liabilities that you might see in the tax or the intellectual property or the security. So I’d say that, Allen, you were talking about it takes off of the purchase price. I would tend to agree. It probably does so at a great magnitude than the actual risk usually just to compensate as insurance.
Evelyn Ashley: Yeah. Because no one really … You know that the risk is there but you don’t really know what that means. You can put some sort of a dollar number to it, but you’re never actually going to say, “Oh yeah, we think that the liabilities $50,000. We’ll just knock $50,000 off.” It’s going to be, “Well, I don’t know what the penalties are or anything else.” So it’s going to be a lot bigger.
So Allen, what have you seen with regard to employee incentives as part of an exit? Change of control agreements, options, phantom stock. What typically happens for the employees in that situation?
Allen Bradley: Oftentimes, the large component of options, for example, is a vesting feature. That vesting feature typically is three to four years. From an employee standpoint to provide the incentive, the idea of acceleration of that vesting upon a change of control, upon a sale, incents employees quite a bit. So that’s something that we often see in contracts.
Evelyn Ashley: I know one of the things that we have really recently seen is employees or contractors that actually hold phantom stock inside of a business. They don’t necessarily understand that that is not something they can get capital gains treatment on. So I think there’s always that shock. It’s always kind of better that they know at the time it’s issued what that impact is going to be because we’ve been in a situation where they’ve actually earned in the seven digits. Then they have a massive tax problem on their hands on the other side of that.
Allen Bradley: Yes.
John Monahon: Allen, when we left off, we were talking a little bit about employee incentives in anticipation of a sale. Can you take us through the considerations of ordinary income tax versus capital gains on those?
Allen Bradley: Sure. A large issue for a seller is recognizing capital income rather than ordinary income. Oftentimes when the selling prices, purchasing price is tied to an earn out, there can be ordinary income issues. Today there’s a 20 point spread in the two tax regimes, so capital gain is very important. Another issue that arises is that if part of the purchase price is allocated to a non-compete, which is very typical sale of a small or medium size business, that can turn the purchase price into ordinary income as well, so that’s always a big issue for us.
Evelyn Ashley: Plus I know that that also comes up in transactions where perhaps the full value of the business has not actually been experienced yet, and the buyer is willing to say, “Fine. We’ll do an earn out.” Where in the future you might actually earn some cut. What have you seen there, Allen?
Allen Bradley: If that earn out is tied to continued employment, for example, the individual not being terminated from employment, you can turn the earn out from capital gain to ordinary income treatment. That makes a big value difference to the seller.
Evelyn Ashley: Very negative. Yeah.
John Monahon: Oh the break, Tom brought up an excellent point, which was a lot of times equity is promised to people at one point early on in the company but not actually delivered. You all want to discuss about some of the … That’s a recurring problem. I mean, what issues does it cause for the seller?
Allen Bradley: Certainly from a tax standpoint, the idea of satisfying that one year holding period for capital gain if equity is awarded right before the transaction, the sale event, then it can be ordinary income versus capital gain. So that’s always a large tax issue.
Tom Wardell: Then you have the problem of people expecting that they’re going to wind up with an inexpensive opportunity. The conversation occurred when the stock was worth 10 cents and now the stock is going to be sold for three bucks. You hand that stock off to people and you’ve just given them a two dollar and 90 cent tax problem. That happens an awful lot. With all the best intentions.
Evelyn Ashley: Absolutely.
Tom Wardell: But once you’ve nailed a price, given that participation in whatever form, precipitates a tax piece for the individuals that is very expensive.
Allen Bradley: Tom, you raised a good point there. That many people think that taxes do only if one receives tax. Of course, the IRS takes the positions that stock generates tax liability as well.
Tom Wardell: Especially if you’ve just sold with a designated price.
Evelyn Ashley: That’s right. Well, and absolutely regardless of whether you’re a private or public business, it has that impact on you.
John Monahon: I think a lot of times when we see this it’s because there is a CEO in charge, perhaps, whose also the founder. He or she does not want to give up ownership because thinks, “Well, I don’t want anybody to be an owner unless there’s a sale.” But that just completely delays it. But we have other things that we can do to accomplish that goal such as granting it currently at a lower value prior to sale and then having to accelerate, of course, upon the sale of it, which achieves both goals, right?
Tom Wardell: Also, making it clear that it’s entirely possible to separate the economic benefits of ownership from the management rights of ownership. You can do it with an agreement, you can do it with a non-voting stock, you can do it with any number of vehicles, which lawyers use all the time.
Evelyn Ashley: That’s right. There’s all kinds of ways to actually achieve that. So let’s talk a little bit and actually before we leave that, I think it’s very important that businesses actually understand that as part of that kind of getting your legal house in order, that’s when these discussions need to occur too. Is there anyone that you have promised maybe in writing, by email or something els or even just a verbal conversation over time that you have promised them ownership in the business because that is definitely coming out as part as this transaction. It will put an end to your sale very quickly.
So let’s talk a little bit about structures. What kind of an asset versus a stock sale and let’s talk a little bit about what is the difference between an asset and a stock transaction from a legal perspective.
Allen Bradley: Certainly from a tax standpoint, a large issue is to what degree is the seller receiving equity in the purchaser. If tax is technically owed on that equity unless the transaction is structured as a tax free reorganization, then often we’re able to treat the, for example, stock that is received by the seller as tax free and tax would be paid only on a sale of that stock, maybe three or four years down the road, so that’s always a large issue. We’ve seen many clients, they organize as limited liability companies, LLCs, there’s a potential to do what’s called a rollover and again, achieve that tax free treatment.
Evelyn Ashley: I think that’s actually a really good point because you’ve got these LLCs that are taxed as partnerships, the flow through that haven’t actually looked again at perhaps an S corporation tax election would have been more appropriate to help them kind of through the exit. Again, these are all things tax plays just a major role in what you find out when you finally get to that exit transaction.
John Monahon: Tom, can you tell us a little bit why an acquirer would want an asset purchase rather than a stock purchase or vice versa?
Tom Wardell: Well, probably first and foremost, the reason a buyer wants to or favors an asset purchase is if they buy the stock, they buy whatever contingent, hidden, unrecognized liabilities go with it. But generally, it will be a function of price frankly. What you’re going to pay. What you’re going to do if you’re going to take on a tax transaction versus an asset transaction. There’s a tendency to prefer asset sales because if you’re the buyer because you really know what you’re getting. If you’re a seller, there’s a kind of on gross, and Allen, you can correct me or jump in here, but there’s kind of on gross preference for the stock sale because it’s complete. You can identify what you’re down stream exposure is through the indemnification provisions or something. Furthermore, you can lay claim immediately to the concept of capital gains treatment.
Allen Bradley: I think the stock sale, certainly from a simplicity standpoint, is sometimes preferred. But buyers forfeit the ability to deduct the goodwill, which is typically in a private business is the major asset. So the goodwill is an asset that’s amortized over 15 years, but again, that has to be considered in view of the purchasers entire tax situation, particularly in view of the limitations under the new tax legislation.
Evelyn Ashley: So we mentioned earn outs a little bit earlier. So how does everyone feel about earn outs? I mean …
Tom Wardell: I hate them.
Allen Bradley: Basically, an earn out is typically a way for the buyer not to have the pay the seller.
Tom Wardell: Problem with earn outs, there’s several but Allen certainly touched on one. The other is who’s going to keep the books. More than one sides managed to negotiate a difference in the method of payment as in right now as opposed to later by simply saying, representing the seller. Well, of course we’d love to do that, but there’s got to be a separate set of books otherwise we have no way of protecting our earn out.
Evelyn Ashley: Eventually controlling it, and I think that’s really important.
Tom Wardell: If you’re a buyer, you don’t want to do that.
Evelyn Ashley: Yeah. Exactly. But if you’re a buyer who’s very incented really wants the seller, you can actually leverage and narrow down those controls.
Tom Wardell: The value of an earn out is that it allows you to push out in time an opportunity to capture more value than you might get at the time of closing the first time around.
Evelyn Ashley: Absolutely. I agree. They’re extremely complex and they’re a pain in the neck, but there are situations where they actually can work. I have actually seen sellers get paid out.
Tom Wardell: As have I. I still don’t like them.
Evelyn Ashley: Yeah. I don’t think any of us …
John Monahon: I have to ask, Tom, did you have any sort of earn out in your deal when sold your company?
Tom Wardell: We had an escrow because we had a tax review going on at the time. So there was about a three year escrow period for those of us who were the principle owners, we paid out everybody else so that they didn’t have to worry about that. Fortunately, the problem went away. So there’s a pay out, but we did not use an earn out.
Evelyn Ashley: I think that does raise a good point though. The concept of the escrow because that’s another thing that sellers who haven’t been through a transaction before are completely thrown by the whole idea of, “What? I don’t get all my money at closing? That doesn’t sound right.” That escrow can come in a couple different forms. The form of an escrow agents going to hold the money for x amount of time, pending the buyer filling comfortable that they can release because there’s no liabilities. But also there’s the concept of a promissory note that might be payable over time, which in and of itself can actually be a form of escrow because there’s usually a set off where if there are challenges or problems that arise after the transaction, those amounts can be deducted from the promissory note.
John Monahon: Tom, I want to ask you about the letter of intent. We talked earlier about the importance of getting your legal team involved at that point, but what are the various elements of a letter of intent?
Tom Wardell: Well, there are some fundamental terms of course. Price is obviously one of them. The nature of the transaction, I.e. is it going to be structured as an asset sales, is it going to be structured as a stock sale, will there be a continuation of management. If there are to be down stream terms, then what are those terms? Sometimes you get further into things like expectations with respect to employment agreements. Usually a letter of intent will run two, three pages more or less. It depends on where people are in the diligence process as to whether or not you’ll also wind up putting in place provisions like if anybody talks about this transaction, the deals off. I use that one fairly frequently just to try and make sure that people don’t talk about what’s going on. Access to diligence is an important part of any letter of intent.
Evelyn Ashley: Certainly the non-compete of the sellers.
Tom Wardell: Non-solicitations. I mean, sometimes all of that’s been put into a nondisclosure agreement ahead of a letter of intent so that it isn’t embedded in the letter of intent. But all of those terms need to be covered as up front terms before you get too far ahead. The final thing will be this is nonbinding.
Evelyn Ashley: Yeah. Absolutely.
Tom Wardell: Except for certain provisions like the confidentiality provision and the non-solicitation provision.
Allen Bradley: Certainly we’ve seen many times when the transaction is a strategic buyer, someone that’s in the same industry as the seller versus an investor who is not necessarily in the same industry. That confidentiality protection is very important when the buyer is actually your competitor.
Evelyn Ashley: Yes. Absolutely. Protecting your customers and when do you actually want to release their names, which we are generally of a school of you don’t. Assign numbers to them and then when we get closer, we know we’re going to close when we’ve gone through that definitive agreement. Then we allow the buyer to actually do a test by releasing certain names and they can actually have conversations with the seller and those customers about the relationships.
I think the other thing that is really important and we have seen this pretty regularly that if you’re dealing with a fairly sophisticated buy, certainly a private equity buyer, they are going to be looking for gap financial statements. So your financial statements have to be in accordance with generally accepted accounting principles. I know that we talked about this is Aprio in one of our prior podcasts, but we actually had a situation where even the investment banker that was involved was not aware that the client was not fully gap compliant. The letter of intent actually had that in there. It wasn’t until we were brought in that we said, “Are you?” The client said, “No.” That had a lot … That had a major impact on the price in the deal.
Tom Wardell: That’s hugely important, and the reason is because, like it or not, the accounting standards are driven by the FCC. If you’re a strategic investor, you absolutely contemplate that at some point you’re going to exit with the value added that goes with the public market. Furthermore, buyer or seller, if there’s going to be a credit line of any kind, the banks are going to expect financial statements that looked exactly like the financial statements that they’re used to. So what’s happened and it’s in the regs now is that sellers, even small sellers, are driven to addressing that question. Now sometimes it can be tucked in as being not a ding on purchase price but otherwise it will impact purchase price.
Evelyn Ashley: Right. We’ve seen the wording of normalized to gap, which, again, if you’re not in accordance with gap, you need to understand what the impact is on …
Allen Bradley: The other thing is I think that’s very important because so many private businesses are cash based reporting, both tax and accounting purposes. So it’s a big transition to go to a coral basis and then to gap.
Evelyn Ashley: Yes. Exactly. Once again, they need to understand what that impact is early on.
Tom Wardell: Then an international setting, that can also be a real … The thing you mentioned, Allen, can also be a real component because the common view is more in line with what we think of as bookkeeping, as opposed to accounting.
Allen Bradley: Right.
Evelyn Ashley: So since we’re going to run out of time here, let’s just move on to … So we’ve talked about the letter of intent, we’ve talked about diligence, which again is truly a open the book on this business so the buyer can thoroughly understand exactly how it’s operated, what it’s documentation looks like, it’s looking for formalities, it’s trying to identify the potential risk, the contingencies that are in this business, so that can be reflected in the contract. Of course, part of the definitive agreement is going to be based very much on representations and warranties of the seller, and I think sellers are always shocked at the broadness of these statements so what have all of you seen kind of in regard to going through this experience for the client?
John Monahon: And can you explain quickly what a representation and warranty signifies?
Evelyn Ashley: Yeah.
Tom Wardell: You’re telling the buyer that accept as you have scheduled particular exceptions that each of these elements of your company has been fully and truthfully disclosed, and those elements will be everything from the financial statements that we’ve referenced to the intellectual property that we’ve talked about to the fact that your building lease is in good order and fully enforceable. Essentially what you’re saying is, “I’m handing you this business. I’m basically handing you this business as a handful of photographs of all the elements of this business, and I have told you everything you need to know in order to run this business on these photographs. To the extent that this photograph needs to be caveated. I’ve put the caveats in something we all the disclosure schedules.”
Allen Bradley: Tom, I think on the tax side, a large component is recognizing that the focus on federal income tax is not the whole story. There’s also state tax and particular sales tax with technology companies.
Evelyn Ashley: Mm-hmm (affirmative). Absolutely. It gets down to … I mean, it’s very … Those provisions are extremely specific. They are intended to drive out questions and knowledge. I think sometimes sellers, after they get over their shock, are then completely overwhelmed by how can I remember all of this, if their documentation does not support being able to answer those questions.
Tom Wardell: Then there’s the representation on the representation.
Evelyn Ashley: Yes.
Tom Wardell: Which is long since … I hate it. The one that says basically everything I’ve just told you was true is in fact true. I have done my best to scrub and determine that it is true.
John Monahon: Right. Can you tell us a little bit about the importance of them? What happens if they’re not true? what is that trigger for the seller?
Allen Bradley: Oftentimes it triggers a reduction in purchase price. Is the amount of the purchase price held in escrow that maybe reduced.
Tom Wardell: It’s a failure of the reps. It’ll produce a claim. The claim will at bottom be based on what would be called a breech of contract. You try and address that through things like indemnification provisions, what we call baskets embedded in indemnification provisions, but essentially the seller is saying to the buyer, “I’ll stand behind these reps and if they fail, I will indemnify you against that loss.” Now indemnification provisions are as creative as the people drafting them. I mean, there could be thresholds. There can be less than dollar for dollar. There can be recaptures. It’s whatever people negotiate, but it’s real.
Evelyn Ashley: It’s really not. I think overall what we’ve stressed is this is a pretty complex undertaking that really does require good professional support to get a seller through the process completely. So we have basically ran out of time. We have a lot more to say, but I want to thank Tom and Allen for joining us today. This has been excellent and I think we probably need to reconvene and maybe do a follow up on something like this because this is really key information.
John Monahon: We hope you enjoyed In Process today. If you have any questions on the topic, please reach out to info@Trusted-Counsel.com. If you’re interested in learning more about us, please visit our website at Trusted-Counsel.com. For more information on our upcoming Prepping The Princess event, visit PreppingThePrincess.com.
Evelyn Ashley: We’ll see you next time.