V O L . 5 , I S S U E 2

CONNECTING AND INSPIRING YPO’S GLOBAL LEADERS

LET’S MAKE A DEAL

B E T T E R L E A D E R S T H R O U G H L I F E L O N G L E A R N I N G A N D I D E A E X C H A N G E TM N O V E M B E R 2016

THE 8 ESSENTIALS OF INNOVATION

THE UNBRIDLED UNICORN

WHEN ART AND BUSINESS

CONVERGE

N O V E M B E R 2 0 1 6 53

g C O V E R S E C T I O N

SELLING ONE’S BUSINESS IS ONE OF THE MOST IMPORTANT TRANSACTIONS

in the life of an entrepreneur. Yet many owners end up leaving money

on the table or exposing themselves to unnecessary risks post-close.

In short, the devil is in the details. And the details are many. What

provisions should you always include in the letter of intent? How do you

maximize your chances of actually receiving an earnout? What should

you diligence before agreeing to be paid in the form of stock of the

acquiror? And what about the post-closing working capital adjustment?

Deal Anatomy: Avoid Pain Upon ExitBY BRETTE SIMON

52 I G N I T E © YPO

54 I G N I T E N O V E M B E R 2 0 1 6 55

Letter of intent Sellers beware — once a letter of intent (LOI)

is signed, your leverage is lost. The LOI grants an exclusive option on your business — in short, the buyer has a specified number of days (usually 90) to decide whether to buy your company, during which time, the seller cannot talk to any other potential suitors. Given this dynamic, a seller should include as many important details in the LOI as possible, as it will serve as a critical guidepost for subsequent negotiations of the definitive deal documents.

For example, is the working capital target spec-ified? Escrow amount? Indemnification cap? Negotiate these at the LOI stage when the buyer still is trying to win the deal away from other bidders versus after the buyer has locked up the deal. Does the buyer have any required approvals (for exam-ple, from a foreign parent company)? Will the buyer need third-party financing? The further in advance you have these spelled out, the better — certainty of close is key for a seller. Will the acquiror be buying stock or assets? Finally, what are the tax implications of the deal structure?

Also, many sellers neglect to include a right to terminate the LOI. If the buyer attempts to renegoti-ate the price after the LOI is signed, the seller should have the right to walk away. Or if the buyer fails to complete due diligence by an agreed-upon date, the seller should have the option of terminating the LOI and the buyer’s exclusivity. This keeps the buyer honest and also keeps the deal moving forward in a timely fashion.

Working capital adjustment Most merger and acquisition transactions require

the seller to leave a certain amount of working capi-tal in the business, which the parties reconcile after closing. This can significantly affect the amount of cash that ends up in the seller’s pocket. Once the target working capital amount is negotiated (ideally at the LOI stage), the parties need to agree on how it is calculated and by whom.

If the buyer will control the preparation of the final working capital statement (which makes sense if you’ve sold and no longer will have an internal

accounting function), the seller typically has the right to review and dispute any items in the state-ment. It is imperative that you secure access rights to the books and records of the buyer (i.e., your former books) which you will need to verify the statement.

If the seller’s financials are not prepared in accor-dance with generally accepted accounting principles (GAAP), the seller should negotiate an agreed-upon set of accounting policies for how the final work-ing capital statement will be prepared by the buyer to account for any non-GAAP items. Otherwise, the seller runs the risk that the buyer will prepare it in accordance with GAAP, which creates an “apples-to-oranges” situation.

Finally, it should be a two-way adjustment. Just as the seller should be obligated to pay the buyer if the business was left with insufficient working capital, so should the buyer return any excess working capi-tal to the seller.

Structure of purchase price Receiving cash at close? Great. How about seller

paper? If the seller will be taking back a promis-sory note, the buyer’s ability to repay the note now comes into play. Representations about the buyer’s solvency should be included in the purchase agree-ment, and the seller should conduct financial due diligence on the buyer. For example, the seller needs to understand where they sit in the capital stack, as the note most likely will be subordinated. How much debt is senior to you and could possibly block your right to repayment? A detailed review of the buyer’s existing loan agreements is essential (espe-cially as a seller note typically is unsecured).

If the buyer is a private equity fund, the fund will want the seller to retain some equity in the company (aka rollover equity), which ties a portion of the purchase price payment to the success of the business post-close. Sellers should ensure that the definitive documents address the following issues: What rights (if any) will you as the seller have as a minority shareholder of the business? Where do you sit in the “liquidation waterfall” if the company is sold in five years?

Private equity buyers often prefer to offer com-mon stock to sellers, as the common stock does not receive any payments until all of the preferred stock is paid (which often includes not just return of cap-ital but also a preferred return). However, sellers should negotiate to receive preferred stock, which means they own the same class of stock as the fund and have the same rights, preferences and privileges as the buyer.

If the buyer is a strategic acquiror/operating company and the seller is taking back stock in the buyer itself (as opposed to stock in the business that was just sold, as discussed above), it behooves the seller to conduct just as much diligence on the buyer as the buyer is conducting on the seller and the target. The representations and warranties about the buyer’s business should be nearly as robust as the seller’s representations and warranties, and provi-sions enabling the seller to liquidate the stock if the company is not publicly-traded (such as registration rights or a put right) should be included.

EarnoutsWhile earnouts (additional purchase price based

on how the company performs post-close) could be the subject of an entire article by themselves, there are a handful of key items that always should be addressed in any earnout provision:

u On what is the earnout based — revenues (sales), gross margin, or earnings before interest, taxes, depreciation and amortization (EBITDA)? The higher up the income statement you are, the better off you are as a seller.

u Is it a “cliff” or a sliding scale? Try to avoid an all-or-nothing earnout where if the earnout target is one dollar short, the seller gets nothing. Collars are preferable, where if the business falls within a certain range, the seller at least receives a percentage of the earnout amount.

u Is it cumulative? In other words, if the earnout target is missed in year one but exceeded in year two, should the seller be able to apply the overage to the shortfall in year one in order to receive both earnout payments?

u What sort of operational control does the buyer

have post-close? The more the seller can restrict the buyer’s ability to allocate overhead and/or personnel to the target’s business and limit the buyer’s right to integrate the company with the buyer’s existing business (or divert opportunities to buyer’s other business units), the higher the likelihood that the earnout target will be met.

u What happens if the buyer terminates the seller

during the earnout period? Should the earnout accel-erate? (But beware the risk of making the earnout look too much like compensation and thus convert-ing its tax treatment from capital gain into ordinary income.)

Receiving an offer to sell your company is an exciting time for any business owner. By following these suggestions, sellers hopefully can avoid vari-ous potential pitfalls and achieve the best possible deal for their company. s

Brette Simon advises her clients on capital raising,

strategic alliances and exit transactions in various

industries, including media, health care, software,

and branded consumer products (including food and

beverage). Simon has been practicing in the field

of corporate law since 1994, and was previously

a corporate partner at Bryan Cave, Jones Day and

Sheppard Mullin. She also practiced at Gibson, Dunn

& Crutcher and O’Melveny & Myers. Simon ranked

first in her graduating class and graduated Order of

the Coif from UCLA School of Law, where she was

editor of the “UCLA Law Review.” She has spoken at

numerous industry conferences and to YPO. Simon

has garnered numerous accolades throughout her

career, including recognition as one of the top 13

dealmakers in the United States for the middle

market by “The Deal,” and being selected as a winner

of the inaugural “40 Under 40” award by The M&A

Advisor.

SIM

ON

A seller should include as many important details in the letter of intent as possible, as it wil l serve as a critical guidepost for subsequent negotiations of the definitive deal documents.

© YPO