Exit Planning Exchange

By David Hoffer

As a CEO in a competitive industry, you know who’s likely to buy your business. You’ve been watching these companies since the day you opened. You’ve tracked their every move. You’ve followed their successes and failures. You may even know their senior managers personally. And why not? There are only a few of these companies — the leaders in the very same industry you’ve staked out. If anyone’s going to buy your business, it’s one of these companies.

If you’ve been thinking along these lines, you’re not alone. Nearly every CEO who considers selling his or her company starts by assuming that potential acquirers will come from inside the industry. In reality, buyers from outside your immediate line of business may offer a better deal. In this month’s Viewpoint, we’ll talk about why strategic buyers from outside your industry may, in fact, significantly outbid your competitors, present some case studies of successful cross-industry transactions and show you how to increase the rewards of selling your business by widening the pool of potential buyers.

Bulls-eye! An expanded approach to targeting buyers

At Mirus, we think of potential buyers as a series of concentric circles — like a bullseye target. However, unlike in archery, it’s often the periphery, not the center, that’s the most interesting part of our target.

That’s because the center of the target contains the most obvious acquirers, companies that are in the same industry as yours, serving the same kinds of clients with the same sorts of products and services. You already know these companies. You can probably draw up a short list of these firms off the top of your head. Yet even though these candidates are easy to identify, you do your company a disservice if you do not consider other kinds of companies.

So to expand the circle, we ask a series of questions. We look at our clients’ customers and think about what other sorts of companies might like to get access to that customer base, even if they don’t have the same sort of product or service offerings. We think about the products or services our client provides and try to identify companies that might want to offer those products and services to their customers. We also think about geography. A company with a strong presence in, say, Boston, might be attractive to an acquirer looking to raise its profile in New England. In these cases, the businesses should be complementary, but do not necessarily have to be the same.

You might wonder why we spend so much time looking for a wider pool of buyers. Essentially there are two reasons. First, and most obviously, more buyers mean more competition for any given target and, in general, higher prices. Yet there is another even more important difference. Buyers within a target’s industry generally expect to pay a multiple on earnings or multiple on revenues that is consistent with industry standards. Buyers from outside the industry, however, are not merely buying more of what they have. They are making a strategic inroad into another area of business, whether it is an entrée into a new market or access to a valuable customer base. As a result, these buyers may not be constrained by an industry consensus on appropriate multiples as they value a target. They are making an acquisition that they hope will transform their business, and that may be worth more to them than the going price within the industry.

Creating demand for core products

Now let’s look at how this kind of exercise might work with regard to a specific company. We’ll start with Daticon, a well-established provider of electronic discovery and document conversion services based in Norwich, CT, that was recently acquired by Xiotech.

As you’ll see, litigation services companies sit at the center of this diagram. These are the “obvious” acquirers, companies in essentially the same business as Daticon. A bit further out, Mirus identified companies in related businesses, such as electronic evidence management, litigation consulting and facilities management. It is only in the third concentric ring that we get to companies in the electronic compliance management, archiving and storage industries. Further out, we have possible matches in compliance infrastructure, enterprise search and information services.

Daticon is an interesting case because it was sold in a public auction process, which allows Mirus to disclose bids from various companies. It attracted a bid from Xerox Corporation, a document management company which would fall quite near the center of our diagram. However, the winning bid came from Xiotech, a storage equipment company that Mirus identified as a potential buyer even though it had not previously been actively involved in electronic discovery or litigation support.

The critical point was that Daticon’s electronic discovery services required a great deal of disk storage, to archive vast quantities of emails, memos, documents and other data sources. It also demanded a good way to manage and selectively retrieve documents out of this enormous pool of information. Xiotech saw Daticon’s core business as an opportunity to enter a higher value added business than disk manufacture — and, as a side benefit, to generate additional demand for its data storage products. As a result, it was willing to pay more than companies directly involved in Daticon’s business, outbidding all competitors with a $30 million offer. Its bid exceeded Xerox’s final offer by $3 million.

Enhancing offerings to existing customers

Now let’s look at another company that was recently acquired by a firm outside its industry, DxCG, a health care software company. DxCG’s main business was developing software that helps healthcare providers, payers and employers to forecast healthcare costs. By understanding these costs, companies can more effectively negotiate insurance premiums, set rates for treatments and budget for care. DxCG had grown rapidly. When it came up for sale in 2004, it had more than 175 clients, including Blue Cross Blue Shield of Michigan, Highmark Blue Cross Blue Shield, Kaiser Permanente, and Pacific Business Group on Health.

About a year before it was sold, Mirus had advised DxCG on an offer from another health care software company, but the deal had not been consummated. Interest in DXCG’s software remained strong, however, and we continued to evaluate and communicate with a wide swath of potential acquirers — health care companies, software companies, and other more tangentially-related businesses.

Eventually, through these efforts, DxCG received an offer from Insurance Services Office (ISO), a company started to serve a consortium of insurance companies. ISO had emerged as a leader in providing risk management tools to a broad spectrum of clients not just in the insurance industry, but in finance, real estate, government and human resources. Even though the company had not, up to that point, operated in the health care space, DxCG’s health care cost models seemed like a natural fit into its suite of data analytics offerings.  Buying DxCG would give ISO a foothold in risk management in an area that had become increasingly important to its clients: health care cost management.  Because of the deal’s strategic importance, ISO was willing to pay a premium over the original same-industry bid, allowing DxCG shareholders to maximize the value of their holdings.

Different companies, complementary technology

Sometimes companies acquire targets outside their industry not to gain access to products, customers or markets, but to obtain complementary technology. That was the case when PixelVision, a leading developer of LCD technology, began to look for a strategic buyer.

PixelVision’s main business was serving financial traders with high-end flat panel displays; however, in developing this business, the company had generated 26 discrete, differentiating technologies. These technologies were protected by six patents, including a patent for analog-to-digital image conversion that allowed digital display devices such as projectors and LCDs to be connected directly to the analog CRT jack on a PC. After identifying all of these technologies, many having numerous applications, Mirus brainstormed with the engineering team to identify additional applications–outside the financial vertical–for the technology. Mirus then presented these technologies in the offering memorandum.

Ultimately, the buyer for PixelVision was not a display company, but a switch company. Cybex, now Avocent (AVCT), was the leading manufacturer of analog KVM switches that allowed a single keyboard, display and mouse to operate multiple computers in a server room or network operations center (NOC). PixelVision had already developed a digital KVM for its financial application that Cybex could use in the NOC market (a multi-billion-dollar market opportunity). It was this application, teased out in the Mirus brainstorming session, that resulted in Cybex coming to the table with a strong offer.

Similarly, when Tellabs, a maker of data, voice and video transport, switching/routing and network access systems, bought DSP Software Engineering, technology was the main draw. At Mirus, we identified DSPse proprietary digital signal processing software as an important tool in Tellabs’ strategy to develop voice-over-IP communications capabilities, a dynamic and fast-growing segment of its core business. We highlighted this technology in our presentations to Tellabs and elicited an attractive winning offer for DSPse.

Looking outside the box for buyers

All these examples point towards one core principle: when looking to sell a company, the best offer may very well come from outside your immediate industry. These buyers often have compelling strategic reasons for purchasing companies peripheral to their core business — whether to access new customers, sell additional products and services to existing customers, fill gaps in proprietary technology or expand into new distribution channels and markets.  Because they are making strategic acquisitions aimed at transforming their companies, these buyers may be willing to pay more for your business than your closest competitors.

The key to identifying potential buyers is to think expansively about your company’s products, its clients, its technology and its marketplace strengths. Then you can look both within and outside your core business for companies that might benefit from what you have to offer.

At Mirus, we’ve helped dozens of companies widen their universe of potential buyers and seek out attractive offers from acquirers inrelated, complementary or even completely different businesses. If you’d like to find out more about our bulls-eye approach and how it might work in your specific situation, please contact us.

David Hoffer is a partner at Mirus Capital Advisors, Inc. Founded in 1987, Mirus Capital Advisors is a middle-market investment bank that specializes in merger advisory, capital-raising services, fairness opinions and valuations to entrepreneurs, corporations and professionalinvestors. By combining a proven process, industry and transactional expertise, and personalized service, Mirus has completed hundreds oftransactions for both public and private companies. Our affiliate Mirus Securities, Inc. is a registered broker-dealer and FINRA/SIPC member. Additional information about the firm is available on our website www.merger.com.

By Laura Kevghas and Donald Richards

Top Five Buyer Blunders and How to Avoid Them

Many of the past Viewpoints we’ve published have advised sellers on how to secure a great deal in the M&A market. In this issue, we take a seat on the other side of the conferencetable to highlight five common and sometimes critical buyer mistakes that can be fatal to a transaction.

Some of these mistakes or misunderstandings can cause a seller to mistrust a prospective buyer. Others lead a buyer to present an offer that doesn’t meet the seller’s needs or interests.  In any case, they can result in a deal that’s in serious jeopardy.

Why This Matters:

Most buyer mistakes are avoidable. Being aware of how things can go wrong will help you improve your chances of sealing the deal.

1. KNOW the Real Decision-Maker(s)

Things can get off track right from the start if you don’t take the time up front to clarify key and hidden Decision-Makers in the seller’s world. John Kenny, Executive Vice President of Corporate Development for Iron Mountain, states that one of the most important factors that needs to be uncovered early on is whether the people that you’re dealing with on the seller side are the people who can actually approve a transaction. “I’ve seen a lot of cycles wasted and deals just never get done,” he said, “because you’re talking to someone who isn’t authorized to make a decision, or the board isn’t aligned with the sale.”

Although unfortunate, it is not unheard of for someone on the seller side to overstate how much authority they have to get a deal done. Mirus once had a principal of a seller represent himself as the sole decision-maker, only to have the partner committee turn down the letter of intent the principal had negotiated because his partners did not want to sell the company at any price!

Exaggeration of authority may be difficult to ascertain, and supports the idea of asking probing questions up front . Confirming as many deal-related details as possible early in the relationship helps streamline the deal process and keep it from derailing.

2. DON’T Focus on Price Alone

Some buyers assume getting the best price possible is the only thing that matters to a seller. In reality, many sellers have other goals that are important to them. Not taking time to uncover these objectives can be a big mistake.  John Kenny also advises learning as much as possible about the complete dynamics of a seller’s situation in advance. “One of the first questions to ask is why the asset is for sale,” he adds,“…and also understand whether it’s a distress situation and whether it’s been shopped for a while. Are they shooting for the whole market, or targeting you specifically?”

Mirus represented a client recently who wanted to ensure that his staff, many of whom had helped him grow the business for more than twenty years, had bright futures with the company post-acquisition. One finalist in the auction process,who didn’t believe this was a real objective of the seller, was dropped from the process despite a high proposed purchase price, when they indicated that they planned to cut employees and close facilities after the close of the sale.

Similarly, many entrepreneurs want to know that the company brand and culture they’ve spent years building–and which they believe support their company’s success–are going tobe maintained. Factors like these are often especially important when a family owned business goes on the market.

“Seller motivations are important, because if the seller cares about their brand, or their people, or their staff’s ongoing employment; and these factors don’t match up with integration into the new company, then you might as well stop–because you won’t be the preferred buyer,” adds Kenny.

3. Romance the Seller

Sellers want to believe a prospective buyer is really pursuing them and truly cares about the business the seller has built.  This is especially true if the seller is planning to stay involved with the business, but it can also be true even if the seller is planning to exit.

“You need to distinguish the different situations,” said attorney Les Fagen, a partner in the Venture Capital practice group at Cooley Godward Kronish’s Boston office. “If it’s a family-owned or founder-owned business, not spending time ‘romancing’ the seller can definitely be a problem.”

Taking time to get to know the seller, and letting the seller get to know you, are essential to building the type of personal bond that will help move a deal forward. Making sure that there are enough face-to-face meetings, spending time getting to know sellers and their key players, listening closely and asking good questions, and helping the seller learn about you are examples of the types of things a buyer can do to help a seller feel “wooed” and special.  At the end of the day, relationships buy companies.

4. BUILDING A Win-Win DEAL

Some buyers focus on winning during every negotiation with the seller, whether it’s related to the purchase and sale agreement, employment agreements or post-closing integration. Every purchase and sale agreement has numerous points that involve a give and take between buyers and sellers. Sellers can get fed up and walk away, simply due to the perception that a buyer is trying to shift all possible risks to the seller’s side.

“Being too aggressive in negotiating the indemnities in the purchase agreement is one of the more common problems,” Les Fagen elaborate(s) . “The seller wants certain limitations on liability, and the buyer wants all these protections in the document. Not wanting to intelligently assume risk on a buyer’s part is probably one of the most common reasons that deals fall apart.”

5. Organization

A seller can quickly lose confidence when a buyer doesn’t appear competent or knowledgeable in terms of how they approach the sales process. “One of the key success factors for an acquisition is earning the seller’s trust, that you will indeed be able to close the transaction,” pointed out Fagen. “The seller wants to know that the buyer has the ability, the wherewithal, and the determination to close and close promptly. I’ve seen a number of deals fall apart because the buyer took too long and didn’t keep the process moving forward.”

The due diligence process is seen by many sellers as a proxy for how they will work with the buyer post-closing.  A smooth due diligence process comforts the seller and his/her management team that the buyer’s company is also well run, and that integration and post-closing activities will be smooth and well-managed.

Planning for Success

Buying and selling a business can be challenging for those on both sides of the table. If you’re on the buyer’s side, understanding as much as you can about your seller in advance will help you anticipate and avoid the common mistakes discussed here. Through good planning, excellent listening and communication skills, understanding your seller’s motivations, and knowing your seller’s key influencers; you can become a successful buyer, and complete profitable transactions.

Laura Kevghas is a principal and Donald Richards is a partner at Mirus Capital Advisors, Inc., with a collective history of more than 150 buy-side transactions. Mirus is a middle-market investment bank that specializes in advising companies on strategic mergers and acquisitions. By combining a proven process, industry and  transactional expertise, creative thought, and personalized service, Mirus has completed hundreds of transactions for both public and private companies. Mirus is a registered broker-dealer and FINRA/SIPC Member. For more information, visit www.merger.com.

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By Laura Kevghas

The phone rings unexpectedly one day, and on the other end is a CEO wondering if you would be willing to sit down and talk about selling your business. You may or may not discuss a purchase price. You may or may not commit to even a meeting, let alone an exchange of information. But nonetheless, that single unexpected phone call can touch off one of the most significant, emotional and time-consuming events in your life as a business owner: deciding whether to sell your company. The way you respond, both initially and in the weeks that follow, can have an impact on your company, your employees, and the value you can realize from the sale of your business.

For this article we asked experts in accounting, law and business consulting for advice on what to do when you receive this kind of phone call. Their suggestions – on everything from evaluating pricing, to managing proprietary information, to establishing a team of advisors, to performing due diligence on the buyer – can help you navigate the complexities of your unsolicited offer, and make the most of your opportunities, whether you decide to sell or not.

Why This Matters:

• Planning ahead can make the unexpected offer manageable
• Contemplating selling your business is the most significant and emotional decision you’ll ever make
• Even considering an offer can affect your company, your employees and your family

Top ten rules for evaluating unsolicited offers

Though every company – and every deal – is different, we have found that there are a number of simple principles that can simplify the process of responding to an unsolicited offer and help you make the right decisions. Here are ten things to keep in mind when someone offers to buy your business:

Rule #1: Don’t wait until the offer comes to plan your response

“Unsolicited offers can come at any time,” says Tom Sherwin, founder of the consulting firm CEO Resources,Inc. “Ideally, CEOs should have a strategic plan in place before they get an offer.” That plan doesn’t have to be complicated, he adds. CEOs simply have to know whether they plan to continue to manage the business over the next three to five years, or whether they would be open to the possibility of a sale.

Linda Swerling, founder of Level II Solutions, adds that business owners should consider their personal, as well as financial, goals. “How long were they planning to work? What was their exit strategy for the business? All these things need to be written down,” she says.

Sherwin says that he regularly meets with CEO’s who maintain that they have no interest in selling theircompanies; yet it’s often merely a question of price. “We play a game of ‘what if’ scenarios, usually over lunch,” he says. “What if someone offered you 20% more than you think your company is worth? What about 50%? You end up constructing a game plan. Say, for instance, that you would consider offers above 25% of some benchmark. At 50% you would actively pursue a deal. And at 100% above the benchmark, you schedule a closing. Then you put that game plan away until the time comes.”

Rule #2: Know what your company is worth

Of course, you can’t evaluate an offer without having a very good idea what your company is worth. Public companies learn their value every day when the market closes, but for private, closely held companies, it may be worth spending the money  required to get a good valuation at least every three to five years, Sherwin suggests.

Amy Mastrobattista, an attorney with the Boston law firm Ruberto, Israel & Weiner, says that the first stop should be your CPA, who can walk you through the most appropriate valuation techniques for your company and industry. “It’s also not a bad idea to develop a relationship with an investment banker far in advance of any planned exit,” she adds. “They can incorporate their knowledge of market conditions, recent transactions and prevailing multiples in your industry to give you a more accurate view of your company’s value.”

“To truly understand your company’s worth, though, you need accurate and timely financial information,” asserts Swerling. “Your current performance relative to last month,the year-earlier period and budget all influence the value of your company.”

The integrity of your financial data is important, not just in understanding the value of your business, but in presenting it to outsiders, comments Margery Piercey, a CPA with the accounting firm Wolf & Company. “First impressions are important when you put numbers in front of a potential buyer.  And it can have an immediate impact onvalue if your financial statements aren’t in order. You reallyneed to make sure that your numbers are presented in sucha way that you’re going to be maximizing value, by ensuring that your financial statements are in compliance with GAAP and industry-specific reporting norms, and that you’ve identified any owner-related or other expenses that won’t continue post-closing.”

Rule #3: Protect your company’s proprietar y informat ion

Very early on, potential buyers will often request extensive proprietary information about your company.  It’s important to provide information in stages – very little early in the process, and further information in pieces, only as you become comfortable that a transaction with this potential buyer is desired and likely.

However, Mastrobattista points out that “Before you share any information at all with a prospective purchaser, you need to have a good confidentiality agreement inplace. This is the case even if the potential acquirer is not a competitor. You don’t want your confidential business information to be used for any improper purpose, even if youthink it’s innocuous.”

Piercey concurs. “Usually in the early stages of getting to know your potential buyer, you are going to be disclosing a good deal of information,” she says. “It’s important that your attorney has put a strong confidentiality agreement in place to make sure you’re properly protecting trade secrets, customer lists, and other things that contribute to the value of your company. That way, if the deal doesn’t go through, you haven’t given away some of these things of value.”

Rule #4: Keep it quiet

These negotiations should, in most cases, be kept confidentialfor as long as possible. “The impact on the employees of even considering a sale of a business can be very unsettling and actually can reduce the value of the business,” says Piercey.

“Control of information is critical,” adds Mastrobattista. “Rumors about your deal can affect not just employees, but customers, vendors and lenders. If the transaction falls through, it can even have a negative impact on your company’s reputation, since people may assume there was something wrong with your business.”

Mastrobattista advises CEOs to think carefully about who within the company needs to know the details of a transaction and to limit the access to this information to a small group of top managers for as long as possible.

Rule #5: Put together a team of expert s

“Acquisitions take up a good deal of time – incremental time over what the CEO is already spending on the business,”says Piercey. “Moreover, they require experience and insight that most CEOs don’t have. As a result, it is critical that the CEO bring in people who are experienced in transactions: investment bankers, accountants, lawyers and tax advisors.”

“You’re only going to sell your business once, and it’s a steep learning curve,” cautions Sherwin. “Why would you try to do that yourself?” He advises seeking out experienced transaction professionals, people who specialize in M&A and work on multiple transactions every year. He recommend stalking to other CEOs who have sold their businesses for referrals to investment bankers in your market.

Mastrobattista adds that you can often find these people by asking your current team of advisors. Your regular accountant, for instance, canusually recommend a taxspecialist experienced in M&Atransactions to augment his or her expertise. Your general counsel may know an M&A lawyer. “The best place to find good people is from good people,” Mastrobattista says.“Talk to your trusted sources for business referrals and evaluate independently.”

Rule #6: Scrutinize deal structure and provisions carefully

Price is one key factor in a deal, but it’s not the only one.“You and your team should look closely at the structure of the transaction,” says Mastrobattista. “Is it cash? Is it notes? Is it stock? Are there hold-backs? Are there earn-outs?” There are tax implications to all of these different purchase price methods that a good tax advisor will help you evaluate. Each structure has different risk implications as well, with payment in seller notes or earn-outs increasing the risk that you won’t receive the value you expected from the transaction.

Rule #7: Think about other possible acquirers

“Just because one person is interested in buying your business doesn’t mean you have to sell it to them,” says Sherwin, adding that there may be multiple offers out there, in addition to the unsolicited one.  For CEOs who are interestedin pursuing a sale, he recommends widening the circle of potential buyers, not just approaching known competitors, but a larger circle of complementary, often larger potential buyers.

Unearthing these buyers may require an investment banker’s help, Sherwin adds, and Mastrobattista concurs that their insight can be invaluable. “You need to look at the state of your company and of the market as a whole when you think about soliciting other offers,” she says.

Deciding to widen the circle of potential buyers carries with it the risk that the buyer who gave you the unsolicited offer may not wait for you to test the market. This is when an investment banker can be particularly helpful to determine if the offer on the table is pre-emptive enough to be worth accepting to the exclusion of other potential buyers.

Mastrobattista adds that bankers can tell you more about the market’s appetite for deals like yours, but that ultimately, the transaction should be done on your timetable. “There’s nothing worse than rushing a deal through, not understanding all the implications of price and market conditions, and then getting bitten in the end.”

Rule #8: Check out the buyer carefully

CEO’s should also scrutinize their potential buyers carefully.  Sherwin says he is always astonished when a company owner agrees to a transaction without first verifying that the buyer can pay. “There are a lot of people out there who can’t close,” says Sherwin. Particularly in today’s tight credit climate, you want to know that the buyer has the financial capacity to close the transaction.

Rule #9: Plan your post-transaction role car efully

You sell your company, and what then? Every one of our experts maintains that you should think carefully about what, if any, role you play in the acquired company.

If the transaction is structured to include an earn-out, you may wish to continue to run the business through the earn-out period to ensure that the maximum incentive payment is earned.

However, Swerling suggests that CEO’s consider the implications of their shift from owners to employees, if they continue in the business. “You’ve been managing this business for years or decades. You’ve been doing everything your way, maybe with the support of some hand-picked managers. Now it’s not yours anymore, and the company you built will change,” she says.

Rule #10: Don’t be afraid to walk awa y

Given the intense and emotional nature of negotiating a sale, our final rule is perhaps the hardest to follow. If a transaction turns out not to be in the best interest of you or your company, you need to be willing to pull the plug.  Not every deal is a good one.  Sometimes even attractive transactions can turn sour over the course of negotiations, or as market conditions change. Even if you’ve spent months working on a transaction, it may still be better, at a certain point, to simply walk away.

Unsolicited doesn’t have to mean unanticipated

Unsolicited offers happen more often than you think – and they can be a welcome wake-up call to business owners caught in the day-to-day details of running a company. Yet they shouldn’t take you completely by surprise. Sound preparation for an unsolicited offer is good strategic planning.

By developing a strategy that says whether, when and for how much you would consider selling, by obtaining accurate valuations of your business on a regular basis, and by developing relationships with seasoned M&A advisors now, you can make sure that you maximize whatever opportunities come your way in the future.

Laura Kevghas is a principal at Mirus Capital Advisors, Inc. Founded in 1987, Mirus Capital Advisors is a middlemarketinvestment bank that specializes in merger advisory, capital-raising services, fairness opinions andvaluations to entrepreneurs, corporations and professional investors. By combining a proven process, industry andtransactional expertise, and personalized service, Mirus has completed hundreds of transactions for both publicand private companies. Our affiliate Mirus Securities, Inc. is a registered broker-dealer and FINRA/SIPC member.Additional information about the firm is available on our website www.merger.com.

By Sarah C. Richmond

The day you dreamed of has arrived: SuperCo has just offered big bucks to purchase your company. Before buying the Porsche, keep in mind that the purchase price is only one factor that determines how much money you will get out of the deal. The founder who is aware of the pitfalls will best be able to maximize her value in the sale.

I. Be Careful Along the Way.

A company that has reached the point of sale after one or more venture rounds will have negotiated preferred stock terms with its venture capitalists along the way. A founder who does not pay careful attention to the VC’s liquidation preference may be in for a rude awakening when the VC walks away from the sale with a lot more than the founder expected.

The liquidation preference is the amount the VC gets upon a liquidation, merger or sale of the company before any payments are made to common stockholders. The most typical liquidation preference (and most appealing to founders) is one where the VC receives his original investment back if it is more than he would get by sharing in the sale proceeds on a percentage basis. This way the VC gets his money out first if the company is sold in a fire sale.

A more aggressive VC may try to impose what’s called a “participating preferred” liquidation preference, which is much worse for the founders. With this stock, the VC gets his original investment back in a sale of the company (or even a multiple of his original investment), and then also shares in the remaining sale proceeds on a percentage basis. If you hit a home run, the participating preferred benefit will be lost in the rounding error. If you only hit a single or a double, it can dramatically shift the benefits of the sale from the founders to the investors. Since you can never be sure about where you will end up, try to avoid giving a participating preferred liquidation preference if you can.

II. Talk to a Tax Lawyer.

A common mistake founders make when selling their business is talking to “the tax guy” too late. There are lots of ways to structure a deal (asset sale, stock sale, merger), multiple company structures (S Corp., C corp., LLC), and various combinations of stock and cash that can be given as payment. Each structure has its own tax consequences for both the buyer and seller, and there are ways to minimize and defer the taxes if you get the structure right from the start. It’s not too early to think about these concerns when you first set up your company.

Will officers be subject to ongoing employment, consulting or non-compete agreements with the buyer? If so, it might save tax dollars to allocate some of the purchase price to these agreements. A good tax attorney can help you work through this, so talk to one before signing a letter of intent.

III. What are you Getting?

You can be paid in stock, cash or a note (which is less common). Cash is always taxable, and stock may be taxable, depending on the deal. If you are getting stock, don’t assume that you can go out and sell the stock the day after the deal closes just because it is public company stock. Why not? In order to be able to sell the stock, the stock must either be registered as of the closing, come with registration rights, or become eligible for sale under securities laws within a short period of time.

IV. When are you Getting it?

Timing of the purchase price is also key, and buyers can tinker with the timing by using an “earn-out.” This is where the seller receives part (or even all) of the purchase price after the closing, depending on the performance of the seller’s business. An earn-out is useful when the expected profitability of the acquired company is hard to assess at the time of closing. From a seller’s perspective, an earn-out has several problems: it is difficult to come up with an exact formula to measure performance, the seller is dependent on the buyer to provide the necessary resources to make the earn-out happen, and many acquisitions fail, resulting in little or no earn-out payment.

What should you do in an earn-out situation to maximize your eventual payout? Accept an earn-out only when one or more of the selling shareholders will stay on with the buyer and exercise control over development and marketing of the acquired assets. Make sure the earn-out formula directly tracks the performance of the assets acquired in the sale, rather than the seller’s overall business. Evaluate the timing of the earn-out, as well as the milestones and the likelihood of achieving them. Make sure the buyer commits to a large enough marketing and hiring budget for the entire earn-out period. Maintain as much control as possible over whether the earn-out is reached: paying attention to these details before the sale is finalized is the best way to do that.

IV. Beware of “Hidden” Liabilities.

A buyer can put mechanisms in place which can lower the value of the sale after the closing. In an asset sale context, the buyer can exclude specified liabilities of the seller, and those liabilities can reduce the purchase price post-closing when the seller is stuck with the bill. Also, many purchase agreements are drafted with such strong representations, warranties and indemnities that the selling shareholders remain exposed long after the deal is done. Review the deal documents carefully: watching your purchase price disappear after the closing can be a very painful experience.

V. Be Smart.

Evaluate your buyer. Most deals these days are paid for with at least some stock, and the selling shareholders will thus become partial owners of the acquiring company for at least some period of time. Also, many (if not all) of the seller’s employees will typically continue on with the acquiring company. Do your homework and carefully evaluate the strength of your buyer. Make sure you are joining forces with a company you believe in.

Bring a knowledgeable lawyer into the process early on. The farther along in the process you get, the less room there is for the lawyer to help.

Last but not least, don’t forget to run your business while negotiating the sale. Deals crash for all sorts of reasons, and you don’t want to be left holding less than what you started with.

Sarah C. Richmond is a partner at Gesmer Updegrove LLP, a Boston law firm focused on entrepreneurial companies and their investors.  She can be reached at sarah.richmond@ gesmer.com

By William S. Andronico

By Andrew Crain

The purchase agreement documents the legal sale of the company’s assets or the shareholders’ company stock to the buyer, and the terms of the purchase agreement are just as important as the purchase price in determining the seller’s economic benefit from a transaction.  To help you better understand the purpose and contents of the purchase agreement, this paper describes the major provisions including (1) what is being sold, (2) payment amount and payment terms, (3) assurances from the seller regarding the stock or assets being sold and assurances from the buyer regarding the purchase, (4) remedies of each party if the other breaches the agreement, (5) if the agreement is to be signed in advance of the actual sale (rather than simultaneously) a list of conditions that must be met in order for the sale to occur, and, (6) if appropriate, a provision that the seller will consult for the buyer, and/or a promise that the seller will not compete with the buyer, for a period of time after the sale.

(1)        The list of what is being sold will specifically identify the shares of stock or the assets (and liabilities) to be included in the transaction.  In an asset sale, this list typically includes customer lists, business records, bills of material or formulas, goodwill, equipment, intellectual property, and working capital.  Working capital includes inventory, accounts receivable and accounts payable.  The amount of working capital is negotiated, but typically is set as the 12-month average of inventory plus receivables, minus payables.  For seasonal businesses, the seller may be required to include enough working capital for the buyer to operate the business at its seasonal peak.

(2)        The payment amount and terms will list the purchase price to be paid at the closing of the transaction, the method of payment, and the details of any seller financing and any royalty or earn-out provisions.

(3)        The assurances made by the seller in the purchase agreement are called representations and warranties.  These typically include statements that: The company exists and is in good standing in the states where it does business

• The transaction has been authorized by and will be legally binding on the seller
• The transaction will not breach any law or any other agreement
• The seller owns the stock or assets free and clear of any creditors’ liens (or will pay off its debts and clear those liens at the closing of the transaction)
• The company’s financial statements fairly present its financial condition
• The seller has filed all tax returns and paid all taxes owed on the stock or assets
• There is no litigation, either pending or threatened, regarding the stock or assets
• The company has all permits, licenses and approvals needed to operate its business
• There has been no recent material adverse change in the company’s business
• If the company owns trademarks, copyrights or patents, a variety of representations and warranties regarding this intellectual property
• If the sale includes real estate, a variety of representations and warranties concerning the description of the property, proper title to the property, and compliance with environmental laws

Most of these representations cover facts and circumstances that the seller knows to be true.  Often, however, the seller is also required to give representations and warranties regarding problems that already exist but are unknown at the time of the transaction and become known later, only after the transaction has occurred.  Sellers sometimes ask, how can I represent and warrant a fact that is not yet known to me?  The answer is that representations and warranties are a method of allocating risk between the buyer and seller:  if existing but unknown circumstances come to light after the closing and reduce the value of the company, buyers typically require that the sellers bear those costs.  In order to limit exposure, the seller can often limit certain representations and warranties “to the best of seller’s knowledge” or to a “material” level.

As the representations and warranties are negotiated and discussed, the seller should alert its investment banker and attorney to any facts or circumstances that are inconsistent or contrary to a requested representation.  Those facts and circumstances are then listed in exhibits to the purchase agreement as exceptions to the representations and warranties, and because the buyer is thus made aware of those exceptions, the seller has no liability to the buyer for those facts and circumstances.

(4)        The buyer bases its purchase decision in part on its due diligence review of the company, and in part on the seller’s representations and warranties.  If a representation turns out to be untrue, the buyer has not received what it bargained for, and will want a remedy from the seller.  The purchase agreement typically provides that the seller will indemnify the buyer for any losses resulting from a misrepresentation, breach of warranty or fraud.

The seller, of course, wants to limit its exposure and to know that the proceeds of the sale are safe.  To balance the interests of the buyer and the seller, most purchase agreements provide for both a time limit (the “survival period”) and a dollar limit (the “cap”) on the seller’s indemnification obligations.

The survival provision typically provides that most representations and warranties will expire after 12 or 18 months following the closing; beyond that date, the buyer cannot seek indemnification for the representations and warranties.  Certain fundamental representations and warranties (such as organization, authority, title, taxes and environmental matters) typically do not expire.

The cap provision typically provides that the seller’s maximum liability to the buyer is limited to a percentage of the purchase price.  Depending on the circumstances of the transaction, that percentage may be as little as 10% or as much as 100% of the purchase price.  Fundamental representations and warranties and fraud by the seller may be subject to a higher cap or may even be uncapped.

In some transactions, the purchase agreement provides that a portion of the purchase price – often equal to the indemnification cap – will be paid by the buyer into an escrow account rather than directly to the seller.  The escrowed money is held by an escrow agent for an agreed-upon period during which the money is available to the buyer to cover any indemnified losses, and then at the end of the escrow period the balance is released to the seller.  Escrows are typically used when the buyer cannot easily enforce the indemnification provision – for example, when an entire company is sold and the proceeds are immediately distributed to multiple stockholders.

In other transactions where a portion of the purchase price is to be paid over time as a contingent “earnout” measured as a percentage of future sales, gross profits or net income, the purchase agreement sometimes provides that, in lieu of an escrow, the buyer may set off future earnout payments to cover any indemnified losses

(5)        If the purchase agreement is signed in advance of the closing, the agreement will contain a list of closing conditions that must be met in order for the closing to occur.  These conditions will be specific to each transaction.  Sellers should seek to limit this list, as any unmet condition will provide the buyer with the opportunity to terminate the planned transaction.

(6)        In some transactions the seller’s industry expertise will be valuable to the buyer and may also be valuable to competitors.  In these cases, the buyer may request that the seller enter into a consulting agreement so that the buyer will benefit from this expertise.  Conversely, the buyer may insist that the seller enter into a non-competition agreement so that competitors may not benefit from this expertise with resulting harm to the buyer.  In deals that include a consulting agreement or a non-competition agreement, and depending on the corporate organization of the company, in order to minimize tax obligations the seller may prefer to allocate a greater portion of the total transaction price to the consulting fee and/or the non-competition payment and to reduce the purchase price of the stock or assets accordingly.

The terms of the purchase agreement are just as important as the purchase price in determining the seller’s economic benefit from a transaction.  The form and timing of payment, the scope of the seller’s representations and warranties (and thus the allocation of risk between buyer and seller), the indemnification provisions, and the tax implications of the transaction structure all affect the transaction value for the seller.  For example, consider Deal 1, an all-cash transaction with limited representations and warranties and minimal indemnification obligations, versus Deal 2, a transaction involving cash plus seller financing with numerous representations and warranties and indemnification obligations that include a lengthy survival period, a large cap and an escrow.  Because of the terms of the purchase agreement, the seller may choose the beneficial terms and relative certainty of Deal 1 over the less-favorable terms of Deal 2, even if Deal 2 is priced at $100 and Deal 1 is priced at $90, $80 or even $70.  Just as the purchase price is negotiated between the buyer and seller, the terms of the purchase agreement are also negotiated between the parties with the assistance of their investment bankers and attorneys.  We are well-informed regarding current market norms for both price and terms and very experienced at negotiating favorable transactions for our clients, and we look forward to assisting you in successfully negotiating and closing your transaction at advantageous price and terms.

Andrew Crain is a Managing Director at Briggs Capital, LLC, 858 Washington Street, Suite 100,Dedham, MA 02026, tel. 781.493.6581 ext 207 andy@ briggscapital.com; www.BriggsCapital.com

by Sarah Richmond

The media is filled with reports of the red hot merger-and-acquisition market. In the technology sector in particular, the volume and transaction value of 2007 M&A deals are both forecast to approach levels not seen since 2000. And despite improvements in the IPO market in recent years, M&A remains the liquidity event of choice for venture-backed companies.

These trends bode well for entrepreneurs hoping for a sale to a strategic buyer. However, for many of these aspiring sellers, a deal will never be concluded even though their business’s fundamentals are solid and buyer interest is strong. These “M&A casualties” occur because too often entrepreneurs do not exercise sufficient planning, realism and creativity.

An early mistake that sellers make is not having a realistic picture of how much their business is really worth. Much as many parents overestimate the intelligence and beauty of their own children, many founders overestimate the value of their own company, causing them to expect an unrealistic price. If you are a seller thinking about your exit, finding comparables in the marketplace will help you arrive at a realistic valuation. Much of this type of data is available online, and there are also outside advisers who can assist you.

Even realists sometimes find that their expectations are out of sync with a buyer’s willingness to pay, so thinking of creative solutions that can bridge the gap is important. One solution that is frequently employed is an earnout, which defers some of the sale price to future payments, which are contingent on sales targets, product developments or other milestones. An earnout satisfies the seller’s desire to be compensated for the expected future value of its assets, while also satisfying the buyer’s desire not to overpay for value that has not yet been realized at the time of the sale. However, sellers should be mindful that earnouts are only successful for the seller when very careful attention is paid to the structuring of the earnout when negotiating the deal.

The due diligence process is another contributor to deal failure. Major problems result when a seller fails to disclose important information about the company, and this information is later ferreted out by the buyer or its attorneys in their due diligence review. This can result in a purchase price reduction midstream, or even the suspension of negotiations. At the very least, because the “trust factor” has been impaired, the buyer will now feel the need to dig deeper and spend more time on due diligence than they otherwise would have.

Entrepreneurs can help smooth the way by doing their own due diligence on their company before the negotiations even begin. This will provide an opportunity to fix problems in advance, and even if this is not possible, at least it allows the seller to frame the issue for the buyer with the appropriate context, while retaining the buyer’s trust.

Many things outside the entrepreneur’s control can kill a deal midstream, and reducing the time-span of the due diligence period minimizes the likelihood of these events occurring. Priorities at the acquiring company may change during the process, making the acquisition seem less compelling. In addition, market conditions can change at any time, and a drawn-out process is the seller’s enemy.

Lastly, the acquisition period is an intense and distracting time for the entrepreneur and the company’s senior management team. Since a significant amount of time and effort is typically required to negotiate the deal documents and coordinate the due diligence review, many of the seller’s key people may not be able to focus as tightly on their day-to-day responsibilities. If this impairs the business’s performance leading up to the closing, the buyer will get nervous and the acquisition itself may be jeopardized. Management should be sure to keep its eye on the ball and continue to focus on running the company despite the distractions of the deal.

Deals fall through for a number of reasons. Anticipating the types of things that can go wrong, and working to address them with creative solutions, will contribute to ultimate deal success.

Sarah C. Richmond is a partner at Gesmer Updegrove LLP, a Boston law firm focused on entrepreneurial companies and their investors. She can be reached at sarah.richmond@gesmer.com.