Planning to Sell Your Company
As with most things, it pays to plan early. All too often companies fail to take simple steps that may help to ease the process through an exit.
The benefits of looking at these issues at an early stage are varied. For one, it is possible to identify those issues that are likely to create stumbling blocks in negotiations. If such issues are identified at an early stage, before the sale process begins, you can take steps to address them. Even if the problems cannot be solved completely, the purchaser is likely to be more comfortable and the issues are less likely to become a significant hurdle in negotiations.
Whilst it clearly may not be possible to solve every problem, there are often things that can be done to mitigate any difficulty that they may cause. We will look shortly at some of the areas where problems often arise and one or two ways in which they can be dealt with.
In the longer term, planning ahead means that there is less likely to be a warranty claim once the company has been sold. A purchaser is likely to seek significant warranties in relation to the trading and tax history of the company, its assets and its liabilities.
These warranties seek to provide the purchaser with comfort that there are no hidden problems within the business. Any warranty claims that do arise provide a retrospective price adjustment to the transaction. It is therefore clearly in the your interest to minimise the risk of this happening.
What is being sold?
It may sound obvious, but the first thing that ought to be done is to identify what exactly it is that you are looking to sell. We have assumed here that you are running an incorporated business. It is likely that you will effect a share sale, transferring the share capital of the company involved. However, your company may have within it other assets and benefits that are not to be sold.
For instance, the company may hold a property. Often a trading company will own and occupy a freehold property. Thought needs to be given at an early stage as to whether best value for the property is obtained from a sale of the company owning the property, or whether better value could be obtained by transferring the property as a separate asset and giving the trading company a right to occupy the property under a lease.
Similarly, a company may hold investment assets or significant cash balances which are not needed in the operation of its business on an ongoing basis. In these circumstances, steps should be taken to extract the value of these items before the sale process begins. A purchaser dealing with a company such as this, where there may be non-trading assets to be extracted prior to completion, will expect you to have thought about the steps to be taken and the assets that are to be transferred out of the company before getting into detailed negotiations. A prime example of this relates to property.
Another area to plan ahead is in relation to pensions. Often, private companies will have pension schemes within their company for the sole benefit of the owners of the business. In these circumstances they will, understandably, be reluctant to transfer ownership of the company and, potentially, control of their pension scheme to a third party.
The pensions industry often works at a much slower pace than that taken by corporate transactions, and, it is therefore important in such cases to approach the pensions administrator at an early stage and take steps to ring fence the pension scheme - possibly removing any discretionary powers which the company has, to give the vendors control over their own pension fund.
Identifying the likely purchaser
Part of planning ahead for an exit is to identify the likely exit strategy. This may involve a flotation or, more often, a sale process. Either way, you will be likely to be required to provide comfort in relation to the company to the potential purchasers of the business.
Identifying the likely purchaser of a business may help to focus the your mind on the planning steps to be taken. One of the interesting developments over the past few years has been the rise in the number of vendor-initiated management buy-outs, often transferring the company to next-generation family or professional managers. This is particularly the case in smaller companies where the shortage of venture capital finance for transactions below £4-5 million in value has led to a need for greater innovation in the funding of transactions.
In these cases, many of the issues in relation to warranties and indemnities will not apply, because the managers may have as much involvement in the business as the vendors. However, if the situation is that the most likely purchaser for the business will be the incumbent management, it may be appropriate to restructure the share capital of the company to provide a suitable environment for this to happen. In such transactions, ownership of the company is often transferred from the vendors to the management purchasers over a period of time.
Otherwise, if their decision is to proceed by way of sale to a financial purchaser or a trade sale, it is helpful to identify the likely process to be used. Again, an increasing trend is to sell by way of a formal auction process. In these circumstances it may be that the vendor is negotiating contracts with two or more potential purchasers at the same time.
This means that the vendor is obliged to provide disclosure information at an earlier stage than would often be the case. Again, from the point of view of ensuring an easier process and maintaining the confidence of purchasers, it is important that the relevant comprehensive information is available at the outset.
Whilst most purchasers will understand that information may change if circumstances develop, there is always a suspicion bred if, late in the process, new information is made available which could have been provided at an earlier stage.
Whether or not management and employees are the likely purchasers of the business, one of the items to consider at an early stage is the incentivisation of management and senior employees in the business.
Depending upon the size and nature of the business, it may be that the your best price may be achieved by properly incentivising senior employees. This can be done by way of share options and the Enterprise Management Initiative Scheme, which was introduced a couple of years ago and provides an ideal framework in which to provide benefits in a tax efficient manner.
Alternatively, if you are reluctant to provide real share ownership to its management, a shadow share scheme can be set up. This provides remuneration benefits linked to the value or notional value attached to the company's shares. This is paid in cash and treated as part of the payroll, but provides a direct link between remuneration and the value of the company.
Consideration should also be given to any existing employee shareholders. The EMI benefits reflect a growing tendency to try to incentivise senior managers by means of share ownership. This means that increasingly in the future we may find owner managers who are looking to sell businesses in which they have minority shareholders.
Hopefully, in these situations, the owner managers will have ensured that, before issuing shares to employees, there are appropriate provisions to prevent employees being able to veto a sale.
For example, any purchaser is likely to want to buy all of the company, but at the very least will want to be able to guarantee that it is able to buy 90% of the company to enable it to trigger the compulsory purchase mechanism under the Companies Act.
If, however, employee shareholders have significant minority stakes, they could, collectively, be able to scupper a transaction by refusing to sell. In these circumstances it would be possible to extract a degree of "ransom value" from their shareholding.
This can be avoided by incorporating into the Articles of Association or any Shareholders Agreement governing relations between the owner managers and employee shareholders, appropriate "drag along" provisions. These would enable the owner-managers to require minority shareholders to sell their shares on the same terms if an appropriate offer is made. These are often found in venture capital articles and should be considered in any situation where an owner manager is considering opening up the share capital of the company to employees generally.
Service contracts for senior management should also be reviewed. This is particularly the case with any senior managers or employees who could be considered to be "key" by an incoming purchaser. Care should be taken to ensure that the service contracts in these circumstances have appropriate provisions, such as restrictive covenants and notice period.
Clearly, a purchaser coming into the company will look at the terms of employment of those key employees who are to remain. They will want assurance that those employees cannot leave too easily and set up in competition. Accordingly, restrictive covenants become very important, as too does the length of the notice period.
Clearly, you need to review your taxation affairs at an early stage if you are looking at an exit.
One of the big improvements in the taxation regime over recent years has been the introduction of Capital Gains Tax taper relief, and the possibility of an effective 10% tax rate on sales of business assets. However, there are traps for the unwary. The definition of a business asset is linked to companies carrying on a trade.
We have seen a number of instances where companies that are "trading" in a normal sense have significant non-trading assets, such as properties, investments in equities and large cash balances. There are dangers here. If the level of "non-trading" assets in a company is excessive then it is possible that the shares would cease to be business assets and as a result fail to qualify for the enhanced taper relief.
Each case has to be considered on its merits, but this is something that needs to be reviewed at an early stage.
Similarly, you ought to be considering inheritance tax planning. This may involve the creation of wills, settlements or transfers of shares to other members of their family to take advantage of lifetime gift exemptions.
Keeping your company shipshape
It is surprising how often the "little things" can be those that create the most disturbances on a sale process. For this reason, it will inevitably pay for you to give thought to reviewing various administrative issues within the business.
An example here is the company's statutory books. These are the "log book" for a company and show ownership, directors and record transactions that have taken place. It is always surprising how often the statutory books of the company are not properly kept up to date. Although this is often easily rectified, there are issues that can arise from statutory books that can create significant problems.
Another area where it may be appropriate to review the company's provision is that of insurances. This is particularly the case where a company may have a significant risk of employee liability, product liability or other risk areas, such as trading in the United States. Having a formal insurance review, with a report to the board on the appropriate levels of comfort, may be helpful in providing the purchaser with comfort that these matters have been properly addressed.
Intellectual property may also be an area to be reviewed. This covers a whole range of issues, from ownership of copyright on websites to the licensing of technology.
Although we no longer have to deal with "Year 2000" issues, there are still common areas of dispute. One of these relates to the availability of software licences. Vendors ought, before getting too deeply into a sale purchase, effect an audit of their computer systems to ensure that they have sufficient licences for the software operated on their system. Again, this is a matter this is easily resolved if there are "pirate" software programs running on their systems, but, it is better to deal with these issues before getting into the sale process.
A review should also be undertaken as to whether or not a company has properly protected any intellectual property that it uses in its business. This can range from patents or trademarks through to domain names. Potentially, significant value in a business can be lost if it has not taken steps to properly protect its intellectual property.
Environmental issues are becoming a larger concern as environmental legislation becomes more aggressive in its enforcement of appropriate standards. Environmental issues therefore become quite significant areas for negotiation on business disposals. This is particularly the case where the purchaser comes from an American background, or has experience in America, where there is much more extensive and well-developed environmental legislation.
Often, purchasers will come from a point of view in these transactions where they expect the vendors to enter into a full environmental indemnity. This is common practice in the United States. In this country, this is a practice which is often resisted, but resisting an environmental indemnity, or even more extensive environmental warranties, is easier to do if there is available information to demonstrate the narrowness of any environmental exposure within the business.
To do this, it is sensible to carry out an audit of the environmental status of the company or business to be sold. The first step here is to look at what discharge consents, if any may be required. This may relate to the discharge of pollutants into the atmosphere, through to the drainage of surface water into the local sewers. All these are issues that ought to be reviewed at an early stage.
On a more general level, few vendors are likely to thank you for suggesting that they dig up their factory to discover what, if any, pollutants lie underneath the surface. In any event, sometimes the best advice to a business in these circumstances is to let sleeping dogs lie.
A purchaser however may have an eye on the approach that is likely to be taken on a subsequent sale. To a degree, he may even be anticipating changes in environmental law that impose greater obligations on land- owners. It is possible to undertake a desktop review relatively cheaply to ascertain from historic ordinance survey maps and other available documentation what the property has been used for in the past.
This may be helpful in demonstrating a period of "safe" usage and satisfying a purchaser's concerns. At the very least, it is helpful in determining whether a more invasive environmental investigation should be undertaken.
Finally, vendors ought to be encouraged to review what, if any, grants they have received in the business in the period prior to a sale, and the terms applicable to each of them. Often grants, such as regional development assistance, are provided on terms that require repayment if there is a change in control of the business within a period of time after the grant is provided.
The government agencies responsible for issuing grants are reluctant to provide finance to companies that have the effect of inflating the sale value, particularly where that sale is realised in a short space of time. In practice, often the government agency involved will not seek to enforce repayment of the grant, but it may be appropriate to approach the government agency concerned and investigate what their attitude might be. This may enable the vendors to present information to the purchaser, which is sufficient to satisfy any concerns they may have that there is a contingent repayment obligation within the company that is likely to be crystallised.
Within the extensive warranties that are often found in the sale and purchase agreement, there are areas which commonly give rise to problems which are capable of being dealt with in advance. Doing this can save much time and expense in the negotiations relating to a warranty schedule.
Many of these issues relate to the contracts entered into by the company. A purchaser will be seeking comfort that the company has entered into contracts to protect its business, and has not left itself unreasonably exposed to risks of product liability and other similar claims.
For this reason, it is often beneficial to a company to carry out an audit of its contract documentation and the way in which it is implemented. Terms and conditions of trading- whilst not the sexiest of topics- often form the core contractual documentation, on which a company conducts its business. As a matter of good practice, these ought to be reviewed on a regular basis, certainly at no more than two or three year intervals in any event.
In circumstances where there is an exit, particularly in contract-based businesses, this review should be carried out at an early stage. Failure to do this may result in the purchaser seeking additional warranties, or even indemnities from the vendors, against perceived weaknesses in the company's contractual position.
Often, when we come to review contracts entered into by companies, whether as part of a disclosure process or in due diligence, we find that there are a number of contracts which contain termination provisions linked to a change in ownership of the company. In many instances vendors are surprised to find that these provisions exist.
Equally, it is often the case that these provisions are contained in the contract merely because they are "standard" and had they been addressed when the contracts were first entered into it may have been possible to negotiate them away. It is all too easy to sign off on "standard" form documentation, such as hire purchase and leasing contracts, without reviewing them in detail.
However, a little bit of time spent on these housekeeping issues can remove potential issues in a sale further on. Similarly, any particular onerous provisions, such as liquidated damages clauses, need to be reviewed in the context of the possible effect on the value of the company should it be sold.
Whilst standard form documentation should be reviewed, perhaps more important still is a review of the company's contractual provision with regard to its most material contracts. These may be contracts for the supply of goods or services to the company (for instance where the company is reliant upon one or two major suppliers for the bulk of its needs or for critical components) or contracts for the supply of goods and services to customers.
A review should be undertaken to ascertain whether or not these give the company the necessary level of security of trading. Is the supplier or customer able to change the level of dealings with the company without notice, or even to terminate the agreement? These issues will have an impact upon the business to be sold, and potentially its value.
If there are outstanding disputes or litigation, thought should be given as to whether or not these can be resolved. Clearly no-one is likely to thank you for suggesting that they settle litigation at a disadvantage merely to smooth the process of a sale, but disproportionate time can be spent addressing these issues in a sale process. A cost benefit analysis needs to be undertaken on any litigation or dispute to see whether or not they are capable of being resolved satisfactorily - whether a little bit of time invested now might benefit later.
For instance, a claim for damages may be discounted entirely when a purchaser looks at the value of the company. If the vendor believes that the claim has value, it may be better for him to settle the claim and realise that value prior to the sale.
Alternatively it may be appropriate to seek to transfer the benefit of any claims which the company may have which are contingent, and not reflected in the value being paid by a purchaser, to the vendors or another vehicle owned by the vendors. This will have taxation implications which will need to be reviewed, but may give the vendors the opportunity to fight their corner for their own benefit, although inevitably, at their own cost.
These are just a few of the areas that ought to be addressed when looking at companies or businesses that are being marketed for sale. There are many others, and every business is different.
However hopefully we have demonstrated that a little bit of thought and time spent reviewing the situation of a company early in the process can help to smooth the path to a sale and, even, add value on completion of that sale.
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