Selling a business: preparing for diligence

Attention to corporate organization and diligence preparation could pay dividends in enhancing the value of a business.

This third installment of the basics of selling a business addresses the importance of corporate formalities and recordkeeping and preparing for a buyer's or investor's diligence.

GETTING YOUR “HOUSE IN ORDER”

Legal structure and governance.

Background.? Businesses generally are organized as corporate entities or as limited liability companies (LLCs). Corporations are owned by stockholders, who hold equity in the form of shares and are governed by a board of directors pursuant to the entity’s bylaws and state law.

LLCs issue membership units or interests, and are governed by a managing member or a managing board that is analogous to a corporate board of directors, pursuant to an operating agreement and state law. LLC operating agreements generally are flexible instruments, allowing founders to dictate governance in a contractual manner (analogous to the governance of partnerships in a partnership agreement).

Corporations and LLCs both provide liability protection to the individuals that own, govern, manage and operate the business. If applicable formalities are observed, those that own, govern, manage and operate the business will not be personally responsible for debts, obligations or liabilities incurred by the entity (whether a corporation or LLC).

The most prevalent form of corporation (a “C corporation,” referring to the applicable Internal Revenue Code provisions) is taxed at the corporate level on corporate earnings. In addition, stockholders must pay personal income taxes on any corporate earnings distributed to stockholders in the form of dividends. C corporation earnings thus are subject to two levels of taxes.

Some corporations, “S corporations,” elect special tax status so that corporate income, losses, deductions and credits “pass through” to their stockholders for federal tax purposes. This allows S corporations to avoid double taxation on corporate income. Stockholders of S corporations report the flow-through of income and losses on their personal tax returns. Although S corporations benefit from “pass through” tax treatment, S corporations are subject to strict requirements that may make maintenance of S corporation status difficult. Among others, IRS requirements limit the classes of equity and the nature and number of stockholders permitted to S corporations.

Like S corporations, LLCs are pass-through entities for federal tax purposes, avoiding the double tax structure of C corporations.

Because S corporations are subject to equity and stockholder-related restrictions, businesses that anticipate raising capital from investors typically are organized as C corporations. If investor funding is not expected, an S corporation often is deemed to be the best structure. An LLC has tax and legal characteristics similar to an S corporation, and may be advantageous for businesses having a limited number of owners. With an LLC, however, granting equity to employees is more challenging than with a corporation, where the tax and legal treatment of stock options and other types of stock compensation is well established.

Review organizational actions and related records.? Whichever legal structure has been utilized, a review of the legal formalities is advisable. Were all of the appropriate organizational actions taken? Have all necessary state and other filings been made? For instance, is the business entity in “good standing” in each state where it engages in business? Are the applicable records in order? To the extent that there are any deficiencies (which is not uncommon!), corrective actions can be taken.

If a corporation, are the articles of incorporation up to date? Are bylaws in place and have they been observed? If the entity is an S corporation, have all of the associated tax requirements been satisfied and documented appropriately? If an LLC, is an operating agreement in place? If the business uses a “doing business” name, have applicable filings been made? Again, should gaps exist, issues generally can be resolved.

Governance. An entity’s organizational documents and applicable state law address how the entity is to be governed. Most state corporate laws, for instance, contemplate periodic board meetings and an annual meeting of stockholders, all of which should be documented and for which minutes and accompanying materials should be retained in the entity’s corporate files. Similarly, an LLC’s operating agreement may prescribe a minimum number of meetings of members. You should review the applicable governance requirements and should confirm that the necessary actions, meetings and procedures have been undertaken, and that appropriate documentation exists and is organized.

Many businesses benefit from a board of directors comprised of individuals with skills, experiences and attributes that can assist management in growing a successful company. Where the business is highly technical or specialized, the board of directors may be supplemented by an advisory board having relevant expertise.

Beyond founders and executives who also may serve as directors, the involvement of independent board members or advisors reflects “best practice” governance and will be viewed by prospective buyers (or investors) as a “plus” factor. Implementation or refinement of these good governance practices might be considered, depending on the nature of the business.

Liability protection. To ensure that the legal structure provides liability protection, observing the formalities prescribed by the entity’s governing documents and preserving the separate nature and existence of the entity is critical. Failing to adhere to simple precautions could result in “piercing the corporate veil” to impose liability on individuals involved in the business.

Business should be done in the name of the legal entity (or its “doing business” name), and the entity rather than an individual should be “held out” as the business. For instance, any business-related website, invoices and marketing materials of the business should be in the name of the entity (although individuals obviously also can be mentioned as involved in, managing or conducting the business of the entity). Contracts and other business and legal documents should be signed in the name of the entity.

Assets of the entity should be kept separate from personal assets; “commingling of assets” is a common basis for “piercing the veil.” The entity should have its own bank accounts, which should be used only for business purposes.

These all are points to which a knowledgeable purchaser (or investor) will be attuned.

Recordkeeping.

Prospective buyers and investors appreciate companies that have complete and well organized records. Incomplete or unavailable documents and records are red flags and literally could cause an otherwise promising business offer to disappear.

In addition to the “corporate” documents and records previously mentioned, sellers should review the due diligence list that will follow in the next segment of this series; the list itemizes the records that prospective buyers and investors will want to review. Having these documents at hand in an organized fashion will evidence careful attention to the business, underscore the attributes of the company and support the claims made in the marketing materials.

PREPARING FOR DUE DILIGENCE

Sophisticated buyers and investors will conduct “due diligence,” a review and analysis of important company and business documents and records, coupled with interviews of key management and stakeholders. What might be viewed by a business owner as an unduly intrusive process, diligence can be managed and if prepared for effectively, can increase a prospective buyer’s or investor’s confidence in the business, thus enhancing value.?

Document repository.? To facilitate the diligence process, an electronic document repository of key documents – an electronic "diligence room" – typically is established. Depending on the nature of the business, the diligence repository can be as simple as a Dropbox or Google Docs folder. Prospective buyers (and investors) generally look for the following categories of materials as part of their diligence investigation. Sellers who anticipate these diligence requests and have the materials organized and readily available set themselves up for success.

Key diligence documents are listed below. (Do not be dismayed by the length of this list – which does in fact reflect common diligence requests from buyers and investors. Many of the materials are likely to be easily retrievable and other categories simply may not be applicable).

Corporate organization – documents and history

• Organizational documents, bylaws, organizational resolutions
• Corporate structure diagram (showing subsidiaries and affiliates), if applicable
• Minutes of board meetings and unanimous consents
• Minutes of shareholder (or member) meetings
• Stock transfer ledger/records
• Shareholder agreements
• Agreements that include registration rights, preemptive rights, rights of first refusal
• Warrants, warrant agreements, stock option agreements and plans
• Offering documents/private placement memoranda/subscription agreements
• State qualifications to do business

Financial information

• Financial statements of the company for three most recent fiscal years, preferably audited (if not audited, then “reviewed”), and interim quarterly financial information
• Any management letters to the company and responses
• Critical accounting policies, such as those relating to revenue recognition and write-offs
• Budgets and projections for current year (including budget to actual information)
• Current business plans
• Federal and state tax returns
• Aging analysis of receivables
• Schedule of distributions to equity holders

Material contracts

• Agreements and instruments evidencing debt or lines of credit
• Financing documents (sale/leaseback arrangement, capitalized lease, installment purchases)
• Guarantees by the company
• Documents evidencing loans to, or other transactions with, related parties (founders, directors, officers, employees, etc.)
• Agreements, arrangements and understandings between the company and any affiliates or related parties
• Agreements relating to material acquisitions or dispositions of assets, mergers or similar transactions
• Royalty, licensing, marketing, sales, broker, distributor, participation and similar agreements
• Joint venture, co-branding, R&D agreements
• Forms of agreements used in the sale, distribution, provision of products and services by the company
• Contracts entered into outside the ordinary course of business

Customers and suppliers

• Schedule of major customers/clients and suppliers (if any)

Property

• Leases of real property, and documents relating to ownership of real property
• Material equipment purchase and financing agreements
• Schedule of fixed assets

Intellectual property

• Schedule of all trademarks, patents, copyrights and other material intellectual property owned by Company, and related registrations and applications
• Intellectual property-related agreements to which Company is a party, including license and sublicense agreements and assignments of intellectual property
• Documents relating to material intellectual property licensed by the Company

Operations

• Company policies, handbooks and procedures, such as delegations of authority, risk management policies, cyber security procedures, privacy-related policies, internal controls and segregation of duties

Employee and related party matters

• Schedule of officers and key employees and current annual compensation, bonuses, special awards and benefits
• Schedule of directors and annual compensation
• Agreements with directors
• Employment, consulting, management, indemnification, severance agreements
• Confidentiality and non-compete agreements
• All documents relating to receivables from, or payables to, officers, employees, directors or 5% shareholders
• Employee manuals and handbooks
• Schedule of employee benefit plans and compensation programs, arrangements, agreements, practices that cover present or former employees, executives and directors
• Materials for employee benefit plans, stock option, stock purchase and stock bonus plans

Insurance

• Insurance policies, including covering real or personal property, general liability, product liability, cyber, life and disability, indemnification, casualty, workers’ compensation and business interruption
• Schedule of pending claims, if any
• Schedule of denied claims, if any

Litigation and legal matters

• Schedule of all pending or threatened litigation or other proceedings
• Consent decrees, judgments, injunctions, rulings, settlement agreements and other agreements presently applicable to the Company
• Demand letters and other correspondence regarding demands that have not been resolved
• Documents relating to contingent liabilities

Regulatory matters

• Business and other government licenses, permits, permissions, approvals
• Filings, reports, correspondence, orders, etc. from or relating to federal, state and local regulatory agencies and related legal and regulatory requirements
• Procedures, manuals and material documents relating to regulatory compliance

The next – and final – installment of this primer on selling a company will outline the main components of a typical acquisition/purchase/investment agreement. Stay tuned!

#DueDiligence #CompanySale #acquisitions

(c) 2024 Pebble Beach Associates, LLC

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