This post is the tenth installment of “Laying Down the Law” – a series where our attorney friends at Troxel Fitch give legal advice for budding entrepreneurs. View the previous post about Venture Capital Financing – Term Sheets here.
Entrepreneurs start businesses for many different reasons, but something most entrepreneurs have in common is the hope that someday they will get a big payday for all of their hard work. There’s a variety of ways an entrepreneur can cash out on their business, but all of these events are generally described as an “exit.”
In this edition of Laying Down the Law, we will focus on one of the most common ways that companies exit, namely, through Mergers & Acquisition (M&A) transactions. Further, we will highlight common mistakes of business owners that can derail an exit and how to avoid them.
Mergers & Acquisitions
In its most basic sense, an M&A transaction is selling the company to another company. Typically, this happens either through an asset sale, a stock sale, or a merger.
An asset sale is exactly what it sounds like: a transaction where one company buys the assets of another company. This can be an advantageous structure for most buyers, as it allows them to cherry-pick the best assets of a company without taking on any liabilities or ongoing commitments of the seller (as well as taking advantage of the tax benefits of an asset sale). That being said, it is typically not the ideal structure for sellers for the same reason, as the obligations of the seller do not go away simply because their most valuable assets have been sold.
A stock sale is a transaction where one company purchases all of the stock of another company directly from the shareholders of said company. This can be an attractive option to sellers, because it is a complete sale of the company.
However, this is less advantageous to most buyers, because most of the time they would prefer to avoid taking on the debts and potentially unknown obligations of the company going forward. For companies with many shareholders, it can be incredibly difficult to round up all of the shareholders and get them to sell their shares. Therefore, in a stock sale, many companies are forced to pay a premium through a tender offer.
A merger is the third option that a buyer and seller can pursue when neither an asset sale nor a stock sale can offer the best outcome for the parties. A merger is a transaction whereby two companies agree to combine and go forward as one company instead of two. A merger is commonly used when a buyer would like to acquire the stock of a company, but does not want to deal with the headache of gaining 100 percent shareholder approval.
One big advantage of using a merger is that a merger typically does not require 100 percent shareholder approval from the company that is being acquired. There are many different structures for a merger, each with their own benefits and drawbacks, thereby allowing buyers and sellers to take advantage of different benefits depending on the goals of the parties involved. This flexibility can make using a merger structure a very attractive option for certain businesses.
Avoid De-railing Your Exit
Buying a business is a big decision, and an M&A transaction is typically a long process. It can sometimes take a year or longer to get through due diligence and determine if everything in the selling business is as it should be. Many times, deals fall apart when the due diligence period reveals that the seller has kept inadequate financial records, hasn’t kept up with corporate formalities, or doesn’t have fully executed contracts with their biggest customers.
Consider another example of how improper record-keeping can doom an exit. Large corporations often look to acquire smaller businesses that have expertise in emerging areas of technology, as opposed to spending a lot of time and money developing the new technology and expertise themselves. Many times, the main value that the corporation is trying to acquire is the intellectual property of the smaller company, such as a valuable patent for a new invention, or a trademarked brand that has built up a loyal customer base.
With so much value tied to the intellectual property of companies that hope to be acquired, it is imperative that the intellectual property of the company is protected and fully owned by the company. Often, the underlying intellectual property in a company has been developed by a team of different people over a number of years. If the company lacks certain essential documentation, such as an assignment of IP from tech developers to the company, or a patent application on innovative technology, the absence of such records can be completely ruinous to an M&A transaction.
With so much hinging on this review process, the frequency with which entrepreneurs overlook these important details is baffling. If you are hoping to sell your business in the next couple of years, it is best to begin talking to a CPA and a business attorney well in advance so that they can help you iron out any wrinkles before you leave millions of dollars on the table.
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