2020 will go down in infamy with the spread of Covid-19 forcing businesses around the globe to lock down, shutter and deal with the new normal of operating in a worldwide pandemic. Now, with the political shift in the U.S. to a democratically controlled Congress and a democratic President, whose proposals include nearly doubling capital gains taxes and reducing estate and gift tax exclusion thresholds, business owners are considering whether or not to sell their businesses before the shifts occur in U.S. tax policies and regulations. If you are a business owner who has determined to sell your business, this article will help highlight for you what to expect generally in terms of the process, timeline and documentation for the closing of your sale. See illustrations in Figure 1.
Starting the Process
The process of selling your business begins with the seller assembling his or her deal team, which will typically be comprised of an accountant and attorney, each with experience in sale-side M&A, and a financial intermediary like an M&A advisor or broker.
To ensure complete confidentiality and protection of any non-public information related to the seller and his or her business, the seller will want to have any party who is involved in the transaction sign a confidentiality agreement or NDA. There could be issues involving intellectual property that is secret, competitive information and pricing, so the NDA is a mechanism to protect that information provided to others as part of the sales process.
The seller also will be thinking about what are the important documents that they will need to gather to show potential buyers. The next step is to prepare a data room. Nowadays, a data room is done virtually on-line with limitations to access for deal team members. A physical, in person data room where buyers and their representatives can go to review the seller’s documentation is still done but it is less common these days with the advent of secure online data rooms.
Another thing that the seller will be thinking about is what they can expect in terms of valuation for his or her business. The seller may want to get a private estimate from a business valuator to use as a benchmark for its sale and to set the minimum price. If the seller engages a financial intermediary, they will typically help the seller determine a valuation based on a variety of industry and business metrics and comparables.
And, the seller will want to start its trust and estate and tax planning so that the seller could achieve the most tax efficient outcome from the sale, taking into account capital gains and any gifting possibilities.
Finding a Buyer
There are different ways to find a buyer. Sometimes the seller will actually be approached directly by a potential buyer with an expression of interest or an unsolicited offer, especially if the potential buyer is a competitor or known party to the seller or a strategic buyer looking to get into the business or vertically integrate the business. In that case, the seller could engage in direct talks with the potential buyer. Other times, the seller may know potential buyers and approach them to purchase the business. This is dangerous as once the seller does that the market, including competitors, customers and suppliers will know the seller is on the sale block, which could hurt the seller and his or her business. More often than not, the seller will engage a financial intermediary, like an M&A advisor or broker, to help the seller locate and qualify a potential buyer on a confidential basis. The M&A intermediary will canvas their contacts in the market for potential purchasers and assist the seller in narrowing the scope of qualified buyers. The process of finding a buyer can take some time and for that the M&A intermediary will seek exclusivity and compensation upon the sale of the business, even during tail periods after such M&A intermediary’s engagement has lapsed.
To achieve the highest offer price, the M&A intermediary will recommend that the seller conduct an auction for the sale of its business. An auction is a process by which potential buyers can perform a detailed confidential, independent preliminary review of the seller’s business and bid to purchase it on a secretive and competitive basis. The potential buyers will have access to the data room, they will examine the information, they will have access to the seller and its management team to inquire as part of the due diligence process. Hence, the auction process gives the potential buyers the opportunity to kick the tires with the end game being getting a written offer from one or more of such potential buyers. As part of the auction process, the seller will prepare the bid procedures and a copy of the proposed purchase agreement. The end game is for the seller to receive one or more offers from potential buyers in the form of a letter of intent and a markup of the purchase agreement.
Evaluation of Offers
A letter of intent or LOI typically describes the most fundamental material terms and conditions or contingencies of the proposed purchase terms. The LOI typically is not a binding agreement, although some of the provisions in the LOI, like the provisions involving confidentiality and the exclusivity period, may be binding. The LOI is an understanding to negotiate in good faith towards execution of the final definitive agreements.
If the seller receives more than one offer, the seller and his or her deal team will evaluate the offers to determine the best one. Obviously, the seller will be looking for the highest priced offers but the seller will also consider other things such as the composition of purchase price – whether the purchase price is paid in the form of cash, stock, a combination of same, or a seller note, earnout or other form of consideration. The less the offers comprise of cash and contain notes or consideration tied to the future performance of the business the less attractive the offers will be. And, the more contingencies and conditions to closing that a buyer includes in the offer, the less attractive that offer will be. Similarly, if the markup to the purchase agreement from the bidder contains a lot of revisions and conditions to closing, the less attractive that offer will be. So, when the seller gets multiple bids, they narrow it down based on those factors.
Negotiation of the Definitive Agreements
Once the LOI is accepted by the seller, the buyer has an exclusivity period, usually for 60-90 days, to negotiate the final definitive agreements and to close on the purchase of the seller’s business. During the process of negotiating the final definitive agreements, the buyer will continue to conduct due diligence on the seller. It is at this time that, typically but not always, the buyer will find something negative about the seller’s business that causes the buyer to reprice the deal or to add to the purchase agreement additional contingencies or conditions to the closing.
The main definitive agreement is the purchase agreement and it will contain the material terms and conditions that were negotiated in the LOI. The purchase agreement will contain the specific detailed terms of the transaction, including all of the nuances of the transaction, what the purchase price is, how the purchase price is calculated, the form of the consideration to be paid by the buyer, how subsequent to the closing are any adjustments to the purchase price determined and how any disputes in calculating such adjustments are resolved, etc. The purchase agreement also includes the seller and buyer representations and warranties, the closing conditions, and even how to get out of the transaction if there is a problem discovered prior to closing that cannot be resolved by the seller and buyer. Quite often, in those cases, termination fees will apply either against the seller or buyer if they fail to close the transaction without a good reason.
Other agreements will be negotiated concurrently with the purchase agreement. See Figure 1 for list of common agreements. Things like the seller’s disclosure schedules, which often serve as exceptions to the seller’s representations and warranties, or the restrictive covenant agreement (otherwise commonly known as a non-compete and non-solicitation agreement), or the assignment agreements for any personal property used in the seller’s business such as intellectual property, or the employment agreements to secure the services of key employees, or a transition services agreement if there are any services that need to be provided by the seller on behalf of the buyer in connection with the business post-closing. If the transaction requires part of the purchase price to be reserved to cover any buyer indemnification claims, you will have an escrow agreement negotiated. If the form of the consideration is in the form of a seller note, then that’s also negotiated with the purchase agreement.
The timing of closings can vary depending on the deal and the type of business. Deals could take as little as 3-4 months to close from beginning to end for smaller, simple deals to 1+ years for larger, more complex transactions. See Figure 1 for typical timeline in each phase of the M&A process.
If the transaction is designed to have a simultaneous closing, the sale is closed at the time the purchase agreement and all of the other documents are signed and exchanged. On the other hand, if the transaction is designed to have a delayed closing, after the seller and buyer sign the purchase agreement and agree on the terms of the other ancillary documents, then the closing will occur at a future time, typically within 60-180 days, upon satisfaction of the closing conditions. Typical closing conditions include requiring the seller to obtain approval for the sale from regulatory bodies with oversight authority over the seller’s business, especially if the seller’s business is in a regulated industry like healthcare, banking or television. Also, in 2020, any deal with a purchase price in excess of $94,000,000 will have to secure advance antitrust approval from the Federal Trade Commission. Likewise, prior CFIUS approval may be required if the seller’s business is being purchased by foreign buyers. Besides regulatory approval, the seller may have to also obtain third party consents from contractual counterparties such as landlords of real property to be transferred in the sale or from customers, suppliers or lenders with approval rights in their respective contracts.
Buyers will have the right to exit a deal if the seller is unable to satisfy the closing conditions in the purchase agreement. However, much litigation has transpired as a result of buyers exiting a deal for unjustified reasons. One of those reasons is that the seller’s business has suffered a material adverse effect. The seller typically has the right to specifically enforce the purchase agreement and require the buyer to close if the seller has met all the closing conditions. Narrowing or eliminating the number of closing conditions, especially those that are ambiguous or difficult to prove, is an important negotiation strategy to increase the likelihood of a successful closing.
Once the deal closes and funds are paid and closing documents are signed and exchanged, sometimes the buyer and the seller will work on a press release to notify the world of the closing. In deals where a purchase price adjustment based on the performance of the seller’s business was negotiated, typically within 45 to 60 days after the closing, either the buyer will have to pay to the seller more money because the business performed better than expected or the seller will have to pay back some of the purchase price paid by the buyer at closing because the business performed worse than expected. Where an earnout payment is a post-closing component of the purchase price payable to the seller, after each year for typically 1-2 years after closing, the seller will receive an additional purchase price payment if the business sold performs better than expected.
Milton Vescovacci is a shareholder in Gunster’s Miami office, and a member of the firm’s Corporate practice. He remains dedicated to bringing a holistic approach to his practice and to getting deals negotiated and closed, experience that stemmed from his days as a banker for multinational money center banks on complex domestic and international transactions. Vescovacci has over twenty years of legal experience counseling lenders in a variety of sophisticated financings and companies and investors on the legal operations of their businesses, specifically in sales or acquisitions and other material events and day to day operations. He has negotiated and closed numerous secured and unsecured corporate finance and securities transactions, structured financings, venture capital investments, mergers and company acquisitions.
For any questions, please reach out directly to Milton Vescovacci.