How Not To Screw Up Your M&A Exit
The acquisition process can unearth dozens of issues that a startup may not have previously thought about. As a result there are many ways mergers and acquisitions can fall apart, says Ron Fleming, partner in Pillsbury Winthrop Shaw Pittman’s corporate & securities practice based in New York.
Fleming says his work on mergers and acquisitions for startups focuses on two main things: helping you get your financial considerations and helping you keep it. Right now, deal flow is high. “We’re seeing a lot of activity. M&A is as hot as it’s been in the past 5 to 6 years,” he says.
These days, companies are moving faster than ever to make acquisitions. Transactions that used to take months often now happen in a couple weeks, partly as a result of new technology. And the acquisition process is typically not a full-blown investment banking process, Fleming notes.
In general, both buyers and sellers want to get a deal done before some larger macro issues cause problems. “There’s a lot of pressure to make it happen. Just in general, there’s a sense that the world feels like it’s about to fall off a cliff. You want a liquidity event to get done before something changes–a government shut-down, a fiscal cliff, a stock market crash. Nothing good happens by waiting.”
Here are some basic (by no means comprehensive) tips from Fleming to prepare for an M&A process:
Get Your House In Order
In other words, think ahead and get all your filings and paperwork together. Fleming once represented a buyer with a great business. But he found out part way through the sale process that the company was set up with an Alabama LLC. “That can slow down the transaction tremendously.”
When incorporating your company, think of preparing documents–this can be useful in a variety of situations: raising a venture capital round, getting acquired, or even going public. But keep in mind that in general 99% of exits are mergers and acquisitions, Fleming says. “In the big picture, our goal in life is to not spook the buyer.”
Anticipate and facilitate the due diligence process by keeping an updated “data room” of all your important documents including:
1. Audited Financial Statements – The last thing you want to be doing during an acquisition process is scrambling to look for documents. Documents could include the mundane or the very important such as board minutes, stockholder actions, ordinary course contracts and more. “I was shocked that great companies in New York and beyond don’t even have audited financials,” Fleming says.
2. Capitalization – Who are the investors on your cap table? Make sure everything and everyone is accounted for. Are there any problems with past employees, investors, or other shareholders? You don’t want surprises during the acquisition process. This can be a problem if, for example, you promised equity to a contractor long ago who comes back later demanding it.
3. Clean Corporate Governance – Similar to capitalization, the last thing a buyer wants is to be trying to buy a company and find out the decision-making structure or ownership structure is unclear.
4. Internal Revenue Code 409A – Observe the necessary formalities in equity grants. An outside third party group can do an analysis for you.
6. Intellectual Property ownership, assignment or contribution – Who owns the patents and other IP your company is using?
7. S Corp foot faults – If you’re an S corporation that can scare people off. There are very technical rules on S corporations. If you have a bad S Corp, you can have certain corporate tax liabilities that buyers may not expect. This can take an enormous amount of time to sort out, Fleming says.
8. Sales Tax Compliance – This can affect ecommerce companies, subscription businesses or any company that sends sales people on the road. States are getting more aggressive on this issue. Don’t ignore it. “Companies have spent hundreds of thousands on diligence reconstructing where sales people were at certain times,” Fleming says.
9. Employee/Independent contractor classification, compliance, and overtime rules – Don’t play fast and loose with this. There can be big issues for taxes related to employees. A company may have a junior programmer and that person might be eligible for overtime pay but the company may not have realized this. These are real life details. “We had clients who were sued in NYC on these issues. A startup who may not know about these issues says to us, ‘We are liable for this?'”
Contracts, Contracts, Contracts
– Change of Control/Anti-assignment Provisions in key customer or supplier agreements – Some customers or suppliers have change of control provisions in their contracts. What this means is if a company is sold they can renegotiate the contract. Often a partner will ask for new (better) economics. If the acquiree relies heavily on this customer or partner that can be a problem. “I’ve seen lots of times companies rely intensely on a customer that makes up 30 to 40% of revenue.”
– Non-Compete Provisions for buyer and affiliates – These can be very broad. For example if a startup A has a non-compete with another startup, and Facebook buys startup A, that noncompete could then apply to Facebook. “We see people enter into agreements that all of a sudden come back to haunt them. For example, if there are broad non-compete clauses, when the bigger company comes to buy you, they often won’t be able to live with that.”
– Long-term contracts that could disrupt buyer integration – Fleming has seen long term contracts that have hurt deals. “I’ve seen some examples of long-term telecommunication contracts and bandwidth. They turned out to be two to three year contracts. The buyers hated them. I’ve always seen someone who thought they got a great offer with a 12 year lease on real estate. That might be something that could come back to haunt you.”
Keep the Band Together
Most deals are conditioned on keeping the team of the acquired company in place. The people involved in a company are often one of if not the most valuable asset in the transaction, Fleming says. “People buying a business generally want a subset or all of the people resources. The buyers don’t just want the special equipment, they want the people who know how to drive it and the people who built it. and who can build the next version.”
Economic incentives in cash or stock vested over time are often key parts of a deal to keep a team in place, he says. So design equity incentive plans to promote retention after the acquisition. In other words you want to keep people at the acquiring company as long as possible, Fleming says. In one case, Fleming saw a buyer require the founders to keep 10% of their company during an acquisition to keep “skin in the game” for the next three years.
Also: watch out for the impact of single or double-trigger change-of-control provisions, including severance acceleration, Fleming says. These provisions, sometimes given to certain employees, can scare off buyers.
Proactively Address “Nastygrams”
Deal with “nastygrams” from competitors or trolls related to intellectual property as soon as possible, Fleming says. Don’t wait to address these issues. Every company with any degree of visibility will at some point get a threatening letter, Fleming says. Often it will claim to have the technology that the company built and that it should be licensed. Take care of these issues well before you get into the due diligence phase of an acquisition.
“Many people think ignorance is bliss, and everyone’s got their head down,” he says. “The startup world is 24/7, and you’re constantly raising capital, hiring people and finding customers. It’s easiest not to deal with it. You don’t want to deal with litigation. You think, ‘What are they going to do come after me?'”
But it’s always best to handle those issues when you’re not the hottest company, but when you’re just a small startup. You can make things go away cheaply if you deal with them head on, he says.
When you go to raise the next round or sell to a buyer, they can be very concerned with a patent or other related issue. You could end up spending much more in due diligence than if you’d dealt with it earlier, Fleming says.
“Sometimes buyers say they want ‘non-infringement’ from counsel, meaning they want to research all the relevant patents in the field. Meanwhile you could’ve paid $10,000 for a perpetual license long ago, instead of paying ten times as much (in diligence fees). Be aggressive on these things, not passive.”
On a related issue, companies should address allegations that they poached confidential information or wrongfully solicited employees, Fleming says. (On a related note, try to obtain signed releases from terminated employees, he says.) People often move on to the next gig and keep in contact with coworkers. They then hear from a friend that a new company is great and are recruited. Often a company didn’t solicit the employees. They just applied, he says. Regardless, always respond to an issue, don’t ignore it. You want to have an evidentiary record that you dealt with the issue.