What You Need to Know About Mergers and Acquisitions: 12 Key Considerations When Selling Your Company

By Richard D. Harroch, David A. Lipkin, and Richard V. Smith

Mergers and acquisitions involving privately held companies entail a number of key legal, business, human resources, intellectual property, and financial issues. To successfully navigate a sale of your company, it is helpful to understand the dynamics and issues that frequently arise.

In this article, we provide guidance on 12 key points to consider in mergers and acquisitions (M&A) involving sales of privately held companies from the viewpoint of the seller and its management.

1. M&A Valuation Is Negotiable

How do you know if a buyer’s offer price equals or exceeds the value of your company?

It is important to understand that offer price and valuation, like other terms in M&A deals, are negotiable. However, since your company’s shares are not publicly traded, the benchmarks may not be immediately clear, and the outcome of this negotiation depends on a number of key factors, including the following:

• Market comparables (are your competitors selling for 3x revenues or 12x EBITDA? Are you growing faster than the competitors?)
• Whether the buyer is a financial buyer (such as a private equity firm that may value your business based on a multiple of EBITDA) or a strategic buyer (that may pay a higher price because of synergies and strategic fit)
• The valuation used in your company’s last round of financing
• Prices paid in recent sales of shares by employees and early stage investors
• Your company’s most recent 409A valuation (appraisal of the fair market value of your company’s common stock)
• The trends in your company’s historical financial performance
• Your company’s projected financial growth
• The proprietary technology your company owns or licenses
• The business sector of your company
• Business, financial, and/or legal risks your company faces
• The experience and expertise of the management team
• Your company’s prospects and opportunities for additional financing rounds
• Whether there are multiple bidders for your company or a single interested party
• Whether your company is a meaningful IPO candidate

If you and the potential buyer are unable to agree on an acquisition price, consider an “earnout” as a way of bridging this difference of opinion. An earnout is a contractual provision in the M&A agreement that allows a seller to receive additional consideration in the future if the business sold achieves certain financials metrics, such as milestones in gross revenues or EBITDA. Although an earnout poses significant risks for a selling company and its stockholders, it also establishes a path for the selling stockholders to ultimately achieve the return they seek in the sale of the company, based on the continuing performance of the business following the closing of the transaction.

Finally, do not be afraid to negotiate. Even if a number proposed by a buyer “feels” right, consider making a counter offer. Buyers rarely make their best offers initially. As good negotiators, buyers hold something back, leaving room for final “concessions” to close the deal. Accordingly, a reasonable counter-offer on price ordinarily should not be poorly received. If you never ask, you will never know.

2. Mergers and Acquisitions Can Take a Long Time to Market, Negotiate, and Close

Most mergers and acquisitions can take a long period of time from inception through consummation; a period of 4 to 6 months is not uncommon. The time frame will depend on the urgency of the buyer to perform due diligence and complete the transaction, and whether the selling company is able to run a competitive process to sell the company, generating interest from multiple bidders. There are some things, however, that can be done to shorten the time frame:

• With the assistance of an investment banker or financial advisor, run a tightly controlled auction sale process so that potential buyers are forced to make decisions on a shorter time frame in a competitive environment.
• The seller should place all of its key contracts, corporate records, financial statements, patents, and other material information in an online data room early in the process.
• The seller should have a draft disclosure schedule (a key component of an M&A agreement) ready early in the process.
• Management presentations/PowerPoints should be prepared and vetted early.
• The company’s CEO should be prepared to explain the value-add that the selling company will provide to the buyer.
• The company’s CFO should be prepared to answer any financial questions and to defend the underlying assumptions of the financial projections.
• A lead negotiator for the seller, who is experienced in M&A deals and can make quick decisions on behalf of the company, should be appointed.
• M&A counsel should be asked to identify and advise on how to solve potential delays due to regulatory requirements (such as CFIUS, Hart-Scott-Rodino, or non-U.S. laws, such as competition laws) and contractual approval and other rights of third parties.

3. Sellers Need to Anticipate the Significant Due Diligence Investigation the Buyer Will Undertake

Mergers and acquisitions typically involve a substantial amount of due diligence by the buyer. Before committing to the transaction, the buyer will want to ensure it knows what it is buying and what obligations it is assuming, the nature and extent of the selling company’s contingent liabilities, problematic contracts, litigation risk and intellectual property issues, and much more. This is particularly true in private company acquisitions, where the selling company has not been subject to the scrutiny of the public markets, and where the buyer has little ability to obtain the information it requires from public sources.

Sophisticated strategic and private equity buyers usually follow strict due diligence procedures that will entail an intensive and thorough investigation of the selling company by multiple buyer employee and advisory teams.

To more efficiently deal with the due diligence process, selling companies should set up an online data room. An online data room is an electronic warehouse of key company documents. The online data room is populated with the selling company’s important documents, including corporate documents, contracts, intellectual property information, employee information, financial statements, a capitalization table, and much more. The online data room allows the selling company to provide valuable information in a controlled manner and in a way that helps preserve confidentiality. The online data room helps expedite an M&A process by avoiding the need to have a physical data room in which documents are placed and maintained.

Importantly, the online data room can be established to allow access to all documents or only to a subset of documents (which can vary over time), and only to pre-approved individuals. Most online data rooms include a feature that allows the seller or its investment bankers to review who has been in the data room, how often that party has been in the data room, and the dates of entry into the data room. This information can be very useful to sellers as an indication of the level of interest of each potential bidder for the selling company, and helps the selling company understand what is most important to each buyer.

Selling companies need to understand that populating an online data room will take a substantial amount of time and require devotion of significant company resources. Although many privately held companies also use online data rooms for financing rounds, much more information and documents will need to be added to the data room in connection with a possible M&A deal. Here, experienced M&A counsel can provide the selling company with a detailed list of the types of information and documents that potential buyers will expect to see in an M&A-focused online data room.

The selling company should not grant access to the data room until the site has been fully populated, unless it is clearly understood that the buyer is initially being granted access only to a subset of documents. If the selling company allows access before all material documents have been included, adding documents on a rolling basis, potential buyers may become skeptical about whether the selling company has fully disclosed all information and documents that potential buyers deem material. Such skepticism might hurt the selling company’s ability to obtain the best offer price from potential buyers.

Access to the online data room is made via the Internet, through a secured process involving a user ID and a protected password. Typically, two-factor authentication will be required to access the data room. As an additional security precaution, any documents printed from the online data room will include a watermark identifying the person or firm that ordered such printing.

See The Importance of Online Data Rooms in Mergers and Acquisitions

The selling company will need to ensure that its books, records, and contracts can stand up to a buyer’s robust due diligence investigation. Here are some issues that can arise:

• Contracts not signed by both parties
• Contracts that have been amended but without the amendment terms signed
• Missing or unsigned Board of Director minutes or resolutions
• Missing or unsigned stockholder minutes or resolutions
• Board or stockholder minutes/resolutions missing referenced exhibits
• Incomplete/unsigned employee-related documents, such as stock option agreements or confidentiality and invention assignment agreements

Deficiencies of this kind may be so important to a buyer that it will require them to be remedied as a condition to closing. That can sometimes be problematic, such as instances where a buyer insists that ex-employees be located and required to sign confidentiality and invention assignment agreements. Avoid these problems by “doing diligence” on your own company before the buyer does it for you.

See 20 Key Due Diligence Activities in an M&A Transaction

4. The Seller’s Financial Statements and Projections Will Be Thoroughly Vetted by the Buyer

If a buyer could only ask for one representation of a selling company in an acquisition agreement, it is likely the buyer would ask for a representation that the financial statements of the selling company be prepared in accordance with generally accepted accounting principles (GAAP), consistently applied, and that the selling company fairly present the results of operations, financial condition, and cash flows for the periods indicated.

Behind this representation, the buyer will be concerned with all of the selling company’s historical financial statements and related financial metrics, as well as the reasonableness of the company’s projections of its future performance. Topics of inquiry or concern will include the following:

• What do the selling company’s annual, quarterly, and monthly financial statements reveal about its financial performance and condition?
• Are the financial statements audited, and, if so, for how long?
• Do the financial statements and related notes reflect all liabilities of the selling company, both current and contingent?
• Are the profit margins for the business growing or deteriorating?
• Are the projections for the future and underlying assumptions reasonable and believable?
• How do the projections for the current year compare to the board-approved budget for the same period?
• What normalized working capital will be necessary to continue running the business?
• How is “working capital” determined for purposes of the acquisition agreement? (Definitional differences can result in a large variance on the ultimate price for the deal.)
• What capital expenditures and other investments will need to be made to continue growing the business?
• What are the selling company’s current capital commitments?
• What is the condition of the assets? What liens exist?
• What indebtedness is outstanding or guaranteed by the selling company, what are its terms, and when does it have to be repaid?
• Are there any unusual revenue recognition issues for the selling company or the industry in which it operates?
• Are there any accounts receivable issues?
• Should a “quality of earnings” report be commissioned?
• Are the capital and operating budgets appropriate, or have necessary capital expenditures been deferred?
• Have EBITDA and any adjustments to EBITDA been properly calculated? (This is particularly important if the buyer is obtaining debt financing.)
• What warranty liabilities does the selling company have?
• Does the selling company have sufficient financial resources to both continue operating in the ordinary course and cover its transaction expenses between the time of diligence and the anticipated closing date of the acquisition?

5. Multiple Bidders Will Help the Seller Get the Best Deal

The best deals for sellers usually occur when there are multiple potential bidders. By leveraging the competitive situation, sellers can often obtain a higher price, better deal terms, or both. Negotiating with only one bidder (particularly where the bidder knows it is the only potential buyer) frequently puts the selling company at a significant disadvantage, particularly if the selling company agrees to an exclusivity (“no shop”) agreement that limits its ability to speak with other potential buyers for a period of time. Sellers often try to set up an auction or competitive bidding process to avoid being boxed in by a demand for exclusivity by a bidder. By having multiple bidders, each bidder can be played off against the other to arrive at a favorable deal. Even if the reality is that there is only one serious potential bidder, the perception that there are multiple interested parties can help in the negotiations.

6. You Need a Great M&A Lawyer and a Great M&A Legal Team

It is critically important for a successful M&A process that the selling company hire outside counsel that specializes in mergers and acquisitions. The outside legal team should include not only seasoned M&A attorneys but also experts in appropriate specialty areas (such as tax, compensation and benefits, employee matters, real estate, intellectual property, cybersecurity, data privacy, antitrust, and international trade).

M&A transactions involve complex, multifaceted agreements and deal structures as well as challenging legal issues. They are typically fast-moving and can be contentious. To be effective, an M&A lawyer must be intimately familiar with both the business realities of M&A deals and the overall structure and inner workings of the acquisition agreement. He or she must have complete command of the applicable substantive law and must be a skilled advisor, negotiator, and draftsperson. A significant M&A deal demands an experienced, focused outside M&A lawyer who has “been there, done that” many times. It is very difficult to be effective as a “part-time” M&A lawyer.

The same holds true for the legal specialists required in M&A deals. Each specialist should be steeped in the M&A legal considerations relevant to your deal and practice their specialty full time. Although it is tempting to resist bringing on a “large” legal team out of concern that they will generate a large legal bill, experienced specialists will actually save you money by identifying significant risks early in a transaction and working to develop practical solutions. Moreover, a legal specialist M&A team that has worked together on many prior deals likely will be more efficient than a couple of attorneys who together claim to be expert in the many specialty areas that are critical to an M&A deal.

7. Consider Hiring an Investment Banker

In many situations, an investment banker experienced in M&A can bring significant value to the table by doing the following:

• Assisting the seller and its legal counsel in designing and executing an optimal sale process
• Helping to prepare an executive summary or confidential information memorandum for potential buyers
• Identifying and contacting prospective buyers
• Coordinating meetings with prospective buyers
• Preparing and coordinating the signing of confidentiality agreements
• Assisting the seller in properly populating the online data room
• Coordinating the seller’s responses to buyer due diligence requests
• Helping prepare management presentation materials for meetings with potential buyers and prepping the management team beforehand
• Assisting in the negotiations on price and other key deal terms
• Advising on market comparable valuations
• Rendering a fairness opinion (not common in sales of privately held companies, but occasionally desirable, especially in situations where directors have conflicting interests)
• Helping the management team in presentations to the company’s Board of Directors

Chris Gaertner, Global Head of Technology for the respected investment banking firm Rothschild Global Advisory, has stated: “To ensure the highest probability of a successful M&A exit, an investment banker should provide independent advice, drive a focused process, and act as a true partner to the company’s CEO, Board of Directors, and management team.”

8. Intellectual Property Issues Will Be Important

The status of the selling company’s intellectual property (IP) and its treatment in the hands of the buyer will often be of critical importance to a buyer. The key IP issues in an M&A transaction often include the following:

• The selling company needs to have prepared for the buyer’s review an extensive list of all IP (and related documentation) that is material to its business.
• A buyer will want to confirm that the value it places on the selling company, particularly if the seller is a technology company, is supported by the degree to which the seller owns (or has the right to use) all of the IP that is critical to its current and anticipated business. One area of particular importance is the degree to which all employees and consultants involved in developing the seller’s technology have signed invention assignment agreements in favor of the seller.
• Many software engineers and developers use open source software or incorporate such software into their work when developing products or technology. But the use or incorporation of such open source software by a selling company can lead to ownership, licensing, and compliance issues for a buyer. Accordingly, sellers need to identify and assess open source issues early in the deal process.
• The IP representations and warranties in a private company acquisition serve two important purposes: First, if the buyer learns that the IP representations and warranties were untrue when made (or would be untrue as of the proposed closing date) to a degree of materiality set forth in the acquisition agreement, the buyer may not be required to consummate the acquisition. Second, if the IP representations and warranties are untrue at either of such times, the buyer may be entitled to be indemnified post-closing for any damages arising from such misrepresentation by the seller. Accordingly, the seller will negotiate for limitations on the scope of the IP representations. The seller will also want to limit this exposure to as small a portion of the purchase price as possible (held in escrow by a third party) or require that the buyer pursue claims primarily against a policy of representations and warranties insurance. However, given the importance of IP to the buyer, it may seek the right to recover up to the entire purchase price if the IP representations and warranties turn out to be untrue.
• The buyer typically wants the selling company to represent and warrant that (i) the selling company’s operation of its business does not infringe, misappropriate, or violate any other parties’ IP rights; (ii) no other party is infringing, misappropriating, or violating the selling company’s IP rights; and (iii) there is no litigation and there are no claims covering any of these matters that is pending or threatened. These representations are extremely important to a buyer since a post-closing lawsuit alleging infringement not known prior to closing
  
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