Chapter 8
Preparing for a Due Diligence Legal Assessment
Let’s begin this discussion by pointing out the not so obvious. You will need to conduct three distinct legal activities as you prepare to sell your business, and you will need (and want) to keep those activities on separate tracks, so now is a good time to start thinking of the activities in this way.
The first legal track that will need to be performed is the work required to complete the deal transaction. This track is necessary to complete the legal transfer of your business to the new owner. Once the deal is closed, you don’t want there to be any strings attached that will pull you back needlessly, unless you have negotiated them in advance. The new owner will want to be sure there are no legal encumbrances or constraints on the business at closing. You will be asked to guarantee this in writing.
This track includes the cleanup of legal issues such as ownership, outstanding litigation, etc. These tasks generally take time, so this track may become a driver in your desire to get to the beach. The transaction attorney should begin working with the attorney that is representing you in any outstanding litigation. To handle the transaction and transfer of your business you will need to hire a competent, qualified transaction attorney. No matter what type of sale you are executing (equity, asset, etc.), the attorney you hire for this track will be given the responsibility for making the transaction happen and executing a successful closing.
Warning: Nothing in this chapter is intended to reduce, replace, or discourage you from hiring a qualified attorney to advise you on the sale of your business.
The second track is for planning your post sale taxes. How you are paid, when you are paid, and how much your closing expenses are (particularly payouts to other individuals) can all have a significant impact on how much taxes you will have to pay on the sale. You cannot wait until you are on top of the sale to begin forming a tax strategy. The type of sale (asset or equity) will become a large determinant of the tax burden resulting from the sale, so you need to begin planning now. The sale’s type will impact your negotiations with a buyer, so you must know what the tax implications are well before you list your business.
If your personal attorney or your transition attorney are not tax attorneys or are not working with one, you will need to reach out to a tax attorney to develop a strategy before you list your business for sale. We will discuss this more in the last chapter, but don’t wait until you are about to close the sale. Meet with a tax attorney and develop a strategy sooner rather than later.
Look for an attorney with experience compatible with the size deal you are anticipating. This will be money well spent. Even though you aren’t anywhere near ready to close, don’t hesitate to move ahead and engage this help now. Now is a good time to locate a transaction attorney and start a dialog.
The type of sale (asset or equity) will become a large determinant of your tax burden resulting from the sale, so you need to begin planning now.
The third legal track you will need is the continuing support for your day-to-day operations as you begin your legal positioning. The legal positioning tasks are intended to prepare your business for legal due diligence, and most of that work will not require an attorney. The legal operations of your business will include document collection and organization, contract review and verification, a review of your professional and business licenses, and a review of all customer and vendor agreements. As you review these documents, you should anticipate finding areas where problems exist (e.g., finding out that one of the documents you collect needs to be replaced or revised), and in these cases, you may want to use an attorney to make the changes to the document. As you begin your positioning, the level of support you need from your attorney may increase temporarily. One of the primary reasons for doing legal positioning is to identify potential problems and issues before your buyer finds them. Finding problems during the transaction could delay the closing or completely kill your deal, so the tasks you’re going to take on now are intended to keep you from finding issues later in the process.
One of the primary reasons for doing legal positioning is to identify potential problems and issues before your buyer finds them.
When you do identify an issue, you may need to refer that issue to an attorney for resolution, but you may not want to pay your transaction attorney for this type of work. Check the hourly rates your attorneys are charging you. When your transaction attorney tells you what it would cost to handle the closing for your business, they probably have not included the resolution of operational problems you discover as you position your business. For operational issues, you may want to use the attorney that handles your day-to-day operations to handle this work. You will need an additional estimate!
“We thought we had cleaned up the ownership of the business, but we need to prepare a letter transferring shares we promised to our chief engineer. These shares will give him a payout after the closing.”
“The contract with a critical vendor requires we notify them whenever there is a management change, and now they want to write a new contract with the new owners.”
“I gave a personal guarantee to the landlord when the lease was written, and now it needs to be removed.”
When you discuss the activities connected with any of the three tracks with your attorneys, you will need to have a clear understanding of who will handle the transition and your post sale tax planning and who will handle the operational issues and how they will be resolved. Keeping the legal tracks separated can become tricky. Maybe you need a fourth attorney to negotiate with the other three attorneys! No, no, no—just kidding! Three attorneys are probably enough.
Legal Positioning Casts a Wide Net
In the normal thrashing that occurs with the day-to-day operation of a small business, there are many things that come across the owner’s desk that bind or constrain the operation of the business and commit the business contractually or financially. Think about the number of times you sign something or promise something to an employee, customer, or vendor. Anything that binds or constrains the way the business operates, or otherwise commits the business or costs the business money, is of real concern to potential buyers. The buyer knows it’s not possible to remove these constraints but they want to enter into the deal with their eyes wide open as to what constraints and commitments already exist. Here are some of the day-to-day items that constrain or otherwise commit the operation of any small business:
–any known pending, threatened, or anticipated legal actions of any kind
–all contractual agreements currently in place or the contractual “tails”7 related to any prior agreements that could constrain the ongoing operations of the business in any manner
–any known estoppel claims or waivers impacting the operation of the business
–all existing employment agreements (both written and verbal)
–all professional licenses and certifications currently in effect, expired, or pending, either to the business or to the employees on which the business depends
–all titles and deeds to real property
–all property and equipment leases
–all outstanding customer warrantees, guarantees, and service agreements
–all outstanding (active) purchase orders and invoices
–all operating agreements such as nondisclosure agreements (NDAs) and letters of intent (LOI)
To prepare your business for legal due diligence, you will need to identify and find all these documents (and potentially many others). Include any other documents of a similar nature not specifically listed here. Include any items that put a burden on the business after the sale. Sit back, pour yourself a cup of coffee, and start making a list of where every one of the documents on this list can be found. Find out who has the original signed copy and identify where it can be found (both the hard [printed] and soft [electronic] copies).
If putting your hands on the documents containing all the information you need will be as difficult for you as it is for many small businesses, you will want to put on a fresh pot of coffee! After locating these documents, they should be gathered and put in a document repository where they can be tracked and controlled.
Legal positioning proves that the proverb “the devil is in the details” is certainly the case in business deals. There is no room for any gray areas when preparing your business for legal due diligence. Where financial due diligence will focus on the past performance of the business, legal due diligence will focus on the current position of the business. Assume current position to mean “on the day the deal is closed.”
Where financial due diligence will focus on the past performance of the business, legal due diligence will focus on the current position of the business.
Create a Milestone Calendar
Finding all your documents and putting them in a due diligence file or in a virtual document repository is not enough. What commitments do these documents make? Are there critical dates where the business needs to do something? Financial payment schedules? You need to do more than collect the documents; you need to review the content of the documents to know what commitments they are making.
Legal commitments frequently result in critical milestone performance dates. One of the easiest ways to demonstrate to a buyer that you’re ready to transfer your business to them is to create a milestone calendar that identifies all the critical dates that will affect the business. Lease and license renewal dates, key contract commitment dates—any dates that could significantly impact the business’s operation should be tracked on a milestone calendar. If there are tasks associated with meeting a critical date, then the preparation start date should also be noted.
“The application is due on June 15 but collecting the data for the application will take a month. So identify the preparation start date on the milestone calendar as May 15.”
There should be a reasonableness to these tasks. If you have thousands of customers, then the sales department might want to maintain its own customer milestone calendar; but, if you have a client responsible for 20 percent of your revenue, you will need to be sure to include critical dates for this client on your milestone calendar.
Make your milestone calendar a rolling calendar (e.g., one that never ends). Of course, there is no excuse these days not to make it an online calendar. If your business conducts a monthly management review, then that is a good time to review closed items during the past month, look at near-term and long-term items, and assign appropriate action items to ensure you are prepared and not surprised by milestones.
Creating a milestone calendar will become a bit of a “thread-pulling” exercise. Once you review a document to identify commitment dates, you will also be able to identify other commitments, such as expense payments.
“There is a balloon payment of $500,000 due in three years.”
This may be something the buyer needs to know! That is a financial commitment you will want to make sure is noted on the calendar and in the budget as well.
“I think our chief engineer’s professional license runs out next March . . . or was it September? That’s not far away. I hope she has the time to complete the continuing education requirements according to the state mandates.”
“We advertised lifetime repairs on that product, but it was so successful we sold 55,000 instead of the 2,500 we originally planned. Then the problems started. Each repair costs $100, and that totals to $5,500,000 that will be negotiated out of your price if the buyer discovers it before you reveal it.”
“Our salesman ran an extension cord across the showroom floor and that old guy with the cane tripped on it and fell. We paid his doctors’ bills, but his son tells us he is still in pain.”
A buyer will expect any dependencies such as these to be disclosed—along with any overdue commitments to be resolved—prior to closing. Sometimes, rather than walking away from a deal, the buyer will mitigate their risk by requiring sufficient funds be set aside for a specified period to protect them against loss from any pending or outstanding issues.
Sometimes, the buyer will mitigate their risk by requiring sufficient funds be set aside for a specified period to protect them against loss from any pending or outstanding issues.
Government Regulatory Compliance
Every business faces a mountain of government rules and regulations from all levels of government. Financial reporting, employment, environmental, industrial, privacy protection—never, even in jest, ask if the government has run out of things to regulate. They may take that as a challenge!
The government, at all levels, creates regulation to constrain the way businesses operate. Over time, the regulations change in response to many things. As a small business owner, none of this is likely to be news to you. You may even be one of the business owners that have decided it’s time to move on rather than try to keep up with some recent change. This could be a costly decision, as a new buyer knows they will have to incur the expense for implementing the new change and will therefore devalue your business for not being up-to-date. Strategically, a better decision would be to bite the bullet, take the steps needed to become compliant, and then sell your business. There are process certifications that require the business to practice for a specified period. Buyers will try to qualify for the certification by buying a business that has reached some level of certification and use that business to umbrella their other businesses in.
“To qualify for that contract, you had to have worked as a certified shop for two years. They couldn’t qualify on their own, so they bought our shop because we met the certification requirement and they were able to bid under our certification.”
If your competitors have not yet reached compliance or they decide to buy a compliant business to umbrella the buyer’s other businesses, then the value of your business will go up—possibly significantly depending on your industry.
Some industries have certification and testing requirements controlling who can practice or operate a business in the industry. The certifications are often tied to individuals and sometimes tied to the business. You will want to help establish the credentials of your business by identifying all licenses and certificates held by the business and its employees. A list of these licenses and credentials will be requested by the buyer, so have copies available and make sure any pending renewals are taken care of. If your business relies on the personal license of an employee, be sure to have that employee under contract.
You will want to help establish the credentials of your business by identifying all licenses and certificates held by the business and its employees.
Along with reviewing all professional licenses, you need to make sure all of your registered business licenses and filings have been made and are up-to-date. Board minutes, information filings, and any state filings should be reviewed. Field sales offices that operate in a different state are a common place to find filing omissions and errors.
Intellectual Property
One sure way to increase the value of your business is to offer the buyer a competitive discriminator that no one else can legally offer them. This is done by capturing any intellectual property (IP) your business has created or is entitled to. A common mistake of small businesses is to avoid the cost of capturing their intellectual property. Unfortunately, this can turn out to be a penny-wise decision that will cost them when they are being sold. Intellectual property can be captured in the form of patents, trademarks, and copyrights.8
Patents
A patent is the public disclosure of a unique design or solution to a specific technical problem. In return for the disclosure, the government grants the inventor or their assignee the exclusive right to its use for some period of time. The patent creates value for a business because it allows the business to exclude others from using the solution and to license its use. Patents take the longest to capture and are the costliest. The international rules for obtaining a patent also vary greatly, but patents create real value for a small business because they tell buyers your business is unique and ahead of the competition.
Trademarks
Small businesses work hard to establish a brand and then fail to file a trademark to capture it as their own. A trademark is a word, group of words, or a symbol that uniquely identifies the source of a product. A trademark doesn’t preclude one business from creating products similar to those of another business. The trademark is used to identify the business that is the true source of a product. When you make a product that is distinguished from your competition, because yours has higher quality, you want to be able to apply your trademarked label on your product so customers won’t confuse them. Buyers will value your trademark and your brand because of the reputation that goes with it.
Copyrights
A copyright protects the author of an original intellectual work such as a literary, musical, or artistic creation or a creator of a computer program (among others). It gives the author or artist control of the publication and reproduction of the work. A copyright is the least expensive form of intellectual property to capture, and these days can be done quickly over the internet. The production cost for copyrighted material is comparatively low which makes it attractive for mass product sales (books, movies, music), and therefore also makes a business that owns the rights attractive for a buyer.
Intellectual Property (IP) Assignment
Patents are awarded to the designer who creates a new product design. The patent rights are then assigned to the business by the designer. Your chief engineer has been awarded three patents for work he did on your payroll and in your shop. You paid the patent attorney’s fees. Did he sign a form assigning the patent to your business? If not, you may have an issue to resolve (and a negotiation to hold with your chief engineer). Maybe your chief engineer hasn’t identified any patentable ideas. Have you asked her? Some small business owners fail to challenge their employees to identify intellectual property.
As you prepare to sell your business you will need to identify any patents, trademarks, or copyrights currently assigned to the business and ensure they are on your intangible asset list.
“We worked hard to release the product and moved on to start the design of the next one. We never had the time to file a patent, and besides, I knew the owners of this business weren’t going to pay for a patent filing.”
As you prepare to sell your business you will need to identify any patents, trademarks, or copyrights currently assigned to the business and ensure they are on your intangible asset list.
Capturing IP
While a lot has been done to improve the procedures and to lower the cost for capturing intellectual property, many small business owners still hesitate to seek these protections. The motivation that keeps small business owners from legally capturing their intellectual property may change or at least have different emphasis when they are trying to increase the value of the business they have decided to sell. Here are some of the common reasons:
–They forget to file. In the daily grind of running the business, everyone is so busy, and this is not an immediate task assigned to someone, so it is just lost in the hustle and bustle.
–They fear releasing their design solutions for public exposure in a patent where everyone else can see it, knowing that the technology life cycle is short, and the patent process is long. They choose instead to capture a market leader position over capturing the intellectual property.
–They do not want to pay an attorney to capture the intellectual property.
–They sell products in multiple country markets and the intellectual property laws and protections are different across jurisdictions.
–Many times, small businesses fail to train their employees about what constitutes intellectual property and fail to offer their employees an incentive for identifying it.
Many of these fears are based on fact; however, a lot has been done to resolve these issues and improve the process for capturing intellectual property. It may pay to look at the updated government processes before assuming how difficult or expensive it will be to capture your intellectual property. Patents remain the most difficult but also have the potential to significantly increase the value of your business. It takes time to file a patent, and yes, you should use an intellectual property attorney. The cost trade-off for the attorney might be worth it given the potential value increase. Even if you do not have the time to complete the patent process, being able to show a prospective buyer that a patent has been applied for may be a valuable discriminator for your sale. Trademarks and copyrights are much easier to apply for these days and much less expensive. Trademarks loose value if a buyer plans to merge your business into another or use their own brand.
It may pay to look at the updated government processes before assuming how difficult or expensive it will be to capture your intellectual property.
This might be a good time to hold an employee training session and to offer a bonus for anyone that identifies valid intellectual property currently existing within the business. You might be surprised what your employees produce. Aside from receiving a bonus, employees also like having their ideas acknowledged.
IP Violations Can Cost You
There are small businesses that have no value other than some old patent they still hold and may never have done anything with. Eventually others came up with a similar idea and developed a product based of their own without looking for existing patents. The business who owned the patent never challenged anyone for infringing on it. There are also buyers who look for just those businesses or just buy the patent outright.
In cases where a patent exists, even if it has been dormant, the value is not in the patent itself but in the money that can be made by going after other businesses who they find have violated the patent. Once a business has integrated the technology into their product, they are trapped. They can be sued for patent infringement and so are likely to pay to license the technology they are already selling to their customers. The term “patent pirates” has evolved because, while most businesses find the practice tantamount to blackmail, it has become a common practice. This doesn’t just happen with technology. It’s common for intellectual property (such as photographs and music) to be “pirated” off the internet as well. If there is any chance your business has infringed on someone else’s intellectual property, now is the time to resolve these issues. Make sure none of your employees has taken any shortcuts.
“We didn’t realize our web developer had illegally downloaded those pictures instead of buying them.”
Jim’s Bakery Example
Jim met with his transition team early in the process to determine their strategy for legal due diligence. He included the attorney who advises Jim’s Bakery and his transition attorney. Together the team came up with a list of documents they anticipated buyers might requested during their legal due diligence. The documents include the service agreements the commercial bakery used for their recurring bread-as-a-service (BaaS) customers.
The commercial bakery COO took the action to review each of these agreements to ensure he logged the date each agreement ended on. He planned to back each date up thirty days so sales could start working with the customer to ensure all of the automatic renewals went smoothly and to try to upsell additional products and services for the customer. To his surprise, he eventually found that several of them had expired and needed to be renewed, as the contracts were an older version that hadn’t included automatic renewals. They would have to resolve this by putting new agreements in place with those customers before they would be ready to be assessed during due diligence. If a buyer had found them, they might have tried to discount that income from the valuation. Jim contacted his attorney to review the agreement template and planned to have updated agreements sent to each customer thirty days before their renewal date.
The next action was a review of the intellectual property. To Jim’s surprise they had not actually captured much of it. After offering to pay a bonus to any employee who could identify an intellectual property asset, he was surprised when one of his staff asked why there was no trademark on the Jim’s Bakery logo. He knew that part of the value in his business was recognition of his brand name. His attorney was given the action to file the trademark as soon as possible.
Jim was actively driving his transition team. As a final action, Jim sat with a tax attorney who worked with the transaction attorney Jim had hired for the sale of his business. Working with his attorneys and his investment banker, they agreed that Jim’s Bakery would only be offered to buyers who were willing to buy the business as part of an equity deal. Jim’s banker pointed out that this approach might scare off some larger corporate buyers who would only consider an asset deal, but Jim insisted the tax advantages for him in an equity deal were too large to ignore.