What legal considerations should you be alert to when selling your company?
There are many legal considerations when negotiating an exit. You need to be aware of the potential risks and hurdles on your side, as well as what the perceived liabilities are for the buyer—plus, how to mitigate these risks and the adjustments a seasoned buyer and banker will demand in exchange.
Following are some of the most common legal questions and concerns when it comes to M&A.
Be keenly alert to any regulatory issues that could kill the deal. The issues may be big and obvious monopoly and antitrust issues or they could be industry-specific licensing issues. Real estate, insurance, health care, and communications companies can be particularly subject to governance. Be sure that ownership changes, especially across state borders, won't trigger legal issues that can cause the deal to blow up at the last moment.
Generally, the acquiring company is going to be assuming the legal risks and liabilities of the target company when they close on the deal.
This, among the other factors in this list, is the reason due diligence can be so cumbersome, time-consuming, and painful. Acquirers want to have clarity on what exposure they may have, how much that may cost, and the liabilities they may encounter in the future.
This can specifically include any noncompliance issues or pending litigation. This may even take into consideration questionable practices that could become legal or major business issues, such as data sharing.
Intellectual property (IP) can be one of the most desired and valuable assets in a merger or acquisition. Acquirers are going to want to know exactly what is registered and protected, and how. They are going to be looking for potential legal issues and claims around that, whether they may be justified or not.
You want to ensure your business has adequate working capital after the closing, especially if there are any earnouts or escrows requiring specific performance in the years ahead. Acquirers should want this, too, unless they plan to dissolve the business. Look for financial adjustments to cover these capital and cash flow needs
Your acquirer may request as much as 10 percent to 20 percent of the purchase price to be held in escrow. This is to cover them from unforeseen legal liabilities and costs or potential misrepresentations made by your company. This may stay in escrow for 12 to 24 months or longer.
Much of your business's value may be tied to contracts, such as sales contracts and subscriptions, or critical contracts with suppliers and vendors. Acquirers will need to review these contracts for longevity and any clauses that may devalue them and your assumed business value.
Your paperwork will not only commit you to fully tell the truth and represent accurate facts but also will spell out the extent to which you and the acquirer are indemnified from future lawsuits and claims.
Shareholder approval can be a legal issue. Know your stock's voting rights and power structure. Know your jurisdiction's laws on voting and what is considered a majority. Acquiring companies may also set even higher shareholder approval thresholds to minimize legal challenges later or to minimize risk after substantial cost and divulging of information. (The threshold can be as high as 90 percent or even 100 percent.) This is something you want to know as early as possible so that you can gauge how strong this deal is.
You and your team will likely be bound by noncompete and non-solicitation agreements post-closing. Buyers don't want you to dump this company on them and use the proceeds to create an even better solution to the same problem or poach their staff. It may be possible to negotiate these clauses out, though typically it is a matter of how tight they are and how long they run.
There are several ways to legally and financially structure the sale of your company.
It can be an all-cash deal. It can be in exchange for stock. There are a variety of ways that the company and its parts are legally transferred and paid for as well. How do they differ? What can the impact or side effects of these elections be? Which is best for you?
According to the Harvard Business Review,1 the number one difference between these two forms of payment for your company is risk. All cash deals mean you are out and paid. Whatever happens next doesn't really affect your personal finances. You received your money, though you no longer probably have any say about anything that happens in the business. This scenario is, of course, a far larger risk to acquirers. All the risk is put on them and their shareholders. This can clearly affect pricing. The lower the risk for them, the more they are willing to pay. In a stock deal, you share the risk. If the merger or acquisition drags down your buyer's stock price, then you'll definitely feel it in your wallet, with the reverse true also.
There are two ways that stock purchases can work. You may be given stock (equity) in the new acquiring company or in the merged company that has combined its assets.
An alternative to the typical stock or cash purchase is a structured asset purchase. They're technically not buying the whole company or its stock. They are purchasing select assets from the company. This can be a more simplified transaction and can potentially mean needing less due diligence, not requiring approval by minor shareholders, and a quicker closing. The acquirer may also benefit from far less liability.
When you're being offered stock for your company, it is vital to differentiate between receiving a fixed amount of value in shares versus a fixed number of shares. Stock values will fluctuate over time, potentially making a huge difference in the net proceeds. It could be a big windfall or a massive disappointment. It's also worth asking whether the stock price is likely to rise on the news of a merger or acquisition or if it may tumble. Look ahead. What direction is the stock market as a whole likely to take in the near future?
How soon you can sell your shares can make a big difference, too. How long will you be locked in? At what dates will you be able to liquidate portions of that stock in the market? How good are you at timing the stock market? The future value of stock isn't just tied to the performance of your old company or the acquiring one. Stocks can be hyper-volatile. They rise and fall more on emotion than fundamentals. Consider this carefully and think about how to price in the risk for yourself if you do accept stock as payment.
To balance risk and price for both sides, it is common to have a percentage of the sales price held to be earned or released over time—not just in escrow to cover unforeseen legal liabilities but also based on achieving and maintaining key performance metrics and milestones in the years after the closing. You may or may not be on board and in a leadership role to make sure that happens. Be sure the legal work clearly lays out what resources and control you will have to meet these criteria.
Whether you will be offered cash or stock, or how offers are likely to be structured, can depend a lot on changing trends over time. If interest rates are low and money is cheap, then it can make more sense for acquirers to raise money and finance cash purchases of target companies. The same is true when companies have a lot of cash on hand. In other phases of the economy, cash is far more precious, and stock offers will dominate the M&A scene. Watch these trends and their timing if you are really set on one type of arrangement over the other.
The top-line price can be meaningless if the terms and taxes eat you up. It's about what you get to keep. That's what is most important, at least when it comes to counting the cash, profits, and proceeds of an exit.
These different deal structures can make a substantial difference in how taxes are levied. Just like winning the lottery, cash typically triggers big bills from the IRS. You may easily be giving up 30 percent, 50 percent, or more of that lump sum almost right away, off the top. Stock and installment deals can spread out gains and how much cash you record in a given year over time. This can definitely help reduce tax exposure, especially in conjunction with other smart multiyear tax strategies.
Taxes can change over time, too. Elections and big shifts in political power can sometimes create dramatic changes in tax rates, what taxes apply, and what shelters may be available. Keep this in mind and evaluate what this could mean for your net by the time you close the deal.
Don't underestimate the value of a great CPA and tax expert. Be sure to get personalized advice for your unique situation before making any assumptions.
If continuing your startup's mission and seeing your company and team continue to flourish after the sale or merger is important to you, then how the deal offer is structured and how you are paid can be a significant signal of what's next.
Will acquirers be more motivated to put in the work and investment to make your venture thrive if they pay precious cash or they've borrowed heavily to purchase you? If they are just buying your assets or haven't committed resources for the longevity of the business in the paperwork, is it more likely they'll break it up?
If they fail or end up struggling financially themselves, what legal issues may arise? What liabilities may they try to throw on you and your cofounders?
Your personal connection to those on the other side of the table, synergy in work cultures, vision, and values, can all play a role in future performance and legal issues. But just like any partnership, it also pays to address these legal issues in advance, in writing. What jurisdiction will govern disputes? What resolutions are available?
There can be a variety of unforeseen glitches when selling a young startup. Many of them can center on the articles of incorporation and initial stock.
Some groups of cofounders take way too long to debate, file their company, and get off the ground as a result of worrying about small details. Other entrepreneurs, either in a rush or feeling overconfident, just steam ahead, either without incorporating the business or just registering online in a few seconds and never giving another thought to their articles of incorporation or that side of the business. That may not seem to have any negative impact on just getting to work and creating a thriving venture, but it is a fundamental part of a transaction when it comes to selling the business. If you don't have an actual business that is incorporated to be sold, then you may be limited to just selling the assets. That can still create a great outcome, but it may short-sell the true potential value of a strategic acquisition. It's always better to use an attorney and incorporate from the beginning, with the end in mind.
You'll find common threads among most of the companies that big acquirers buy, as well as in where they are incorporated themselves. Delaware is the most popular state in the US for its privacy and tax laws. Nevada and Wyoming are also top choices. Other states can be far more expensive.
Having failed to assign or issue founders' stock in the company at the beginning can bring a variety of issues when it comes to raising equity capital and selling the business. The value of the stock will change over time, and there can be less clarity from a legal standpoint on who owns intellectual property, as well as differences in the time before founders can sell their stock.
Other legal issues can arise from neglecting this side of the business if meetings and formalities are ignored and personal and business funds are commingled, leaving questions over the legal protections and validity of the corporation. Taxes can certainly be affected as well. Even typos in the registered company name or forgetting to renew the corporation can become expensive mistakes that can derail a business sale, even after having received an LOI and seeming just days away from the closing.
Although there are cheap DIY options, good attorneys will more than earn their fees for taking care of these details for you.
Startup businesses often take on a lot of different types of debt and encumbrances in the early days of the journey, typically without considering the real impact on a sale and the value of the company.
These encumbrances can include the following:
These are forms of liens on the business and future income. Some may also come with personal guarantees from the founders, which can lead to their personal assets being pursued in a default.
When cleaning up your business, paperwork, and finances to prepare your company for sale, you may want to eliminate a lot of debt. Don't leave yourself without any cash or financial runway. It may be more appealing with less debt and higher net profits. Your future acquirer may also have access to superior financing at much lower rates if they do want to finance anything.
If you can't or prefer not to settle these debts in advance, then make sure you learn what the consequences are in selling the company as is.
If there is a significant change in ownership, can the new buyer assume the debt according to the terms of these agreements? Will a sale accelerate the balance of any debt being due? What easements or encumbrances may there be on any real estate that could make a substantial value difference for the new owners?
It can be confusing to pick the best type of currency to accept for your startup. You also need to know how to structure all of the legal. And, of course, you have to decide to whom to sell your startup. This is a big part of the reason I went on to start Panthera Advisors after exiting my own startup.