0 comments on “DO NON-VOTING SHARES IN CALIFORNIA CORPORATIONS HAVE VOTING RIGHTS?”

DO NON-VOTING SHARES IN CALIFORNIA CORPORATIONS HAVE VOTING RIGHTS?

By Rajnish Puri

Small business owners – new and established – often inquire about the pros and cons of creating voting and non-voting forms of equity. Naturally, the primary motivation behind the inquiry is to limit the number of persons who can influence business decisions.  This article examines the relevant issues to consider when issuing non-voting shares in the context of California corporations.

New businesses, when deciding on the form of legal entity for their existence – a corporation, limited liability company, partnership or other – consider a variety of factors. The analysis typically includes an examination of issues pertaining to tax implications, the ability to attract investors, simplicity of corporate documents, effective governance models, and the flexibility of establishing employee incentive plans.  Management and control of business affairs is a theme that connects most issues and, therefore, gets a strong consideration in the decision making process.  Interestingly, having the ability to control a business is not just confined to new enterprises; it comes up regularly throughout the life cycle of any organization and most certainly at moments of transition such as recapitalization (raising new capital or rearranging the deck of existing investors), succession planning (transferring ownership to the next generation that would include actively and passively involved family members), and the sale of a business (who decides whether or not to sell), to name a few. This issue, when examined in the context of a corporation, often raises the idea of establishing voting and non-voting shares.  Having the two categories of shares, in many instances, makes sense – the premise being that the ability to vote on company affairs be restricted to a select few who have primary responsibility for growing the business compared to those who remain passive investors or hold a minority position. But, just because a category of shares is labeled non-voting, does it take away all of the voting rights of a shareholder owning such shares? Not in the case of shareholders of corporations organized in California. Therefore, if one is not aware of the rules dealing with this subject, granting non-voting shares might inadvertently create the very rights that were intended to be prevented.

The Rule. California law, specifically Section 400(a) of California General Corporations Code (CGCL), allows corporations to issue one or more classes or series of shares that can have “full, limited or no voting rights.”  However, as a condition to issuing shares with limited or no voting rights, corporations must ensure that there exists a class or series of shares that has full voting rights.  Based on existing law, holders of non-voting shares are precluded from voting on routine corporate matters like the election of directors or other material transactions requiring shareholder approval, thereby eliminating their voice from management and control.

The Traps. Despite the obvious non-voting label, CGCL creates two exceptions, which, if overlooked and left unaddressed, could potentially give the non-voting shareholders a veto right in certain critical situations. Section 903(a), which describes the procedures of amending a corporation’s articles of incorporation, requires that certain amendments must be approved by holders of outstanding shares of a class, “whether or not such class is entitled to vote” as per the articles.  This exception could pose a problem when a corporation seeks to raise new capital and create new classes of shares that often trigger the need to amend the articles, and the terms are not favorable to the holders of non-voting shares.

A similar situation arises in the context of corporate reorganizations – a term defined under Section 181 to include a variety of merger transactions – which call for shareholder approvals. Section 1201(a) states that the principal terms of a reorganization must be approved by holders of “each class” of shares.  While the rules provide some comfort by noting that different series within the same class do not constitute different classes for purposes of the required approval – thereby allowing the (majority) voting stock to control the approval process notwithstanding the (minority) non-voting position – there could be situations, particularly in closely held businesses, where the voting and non-voting shares represent equal ownership of the business.  Effectively, under certain circumstances, the holders of non-voting shares might have the ability to block an amendment to the articles or a reorganization.

The Solution. What is otherwise expressly prohibited under CGCL can be mitigated by having contractual commitments between shareholders.   As a condition to granting non-voting shares to shareholders, the holders of voting shares can require the holders of non-voting shares to agree in advance to vote along with the holders of voting shares in reorganization transactions and other specified situations involving the corporation.  The agreement among shareholders could also provide for serious consequences of a breach by a party of its obligations under the agreement, which, if structured carefully, would serve as a  strong deterrent.  Such agreements can be set forth in voting agreements among shareholders, which are permitted under CGCL Section 706.

In conclusion, it is important to consider the limitations of non-voting shares and address them to ensure there are no surprises at critical moments of an organization’s life cycle.

Hope you found the above discussion helpful. In my upcoming posts, I plan to share with the readers practical knowledge and trends on a variety of corporate finance topics applicable to early stage and established businesses.  Stay tuned for another conversation on ClarkTalk!!

Thank you for joining us on ClarkTalk!  We look forward to seeing you again on this forum.  Please note that the views expressed in the above blog post do not constitute legal advice and are not intended to substitute the need for an attorney to represent your interests relating to the subject matter covered by the blog.   If you wish to consult with the author of this post or another attorney at Clark & Trevithick, please contact Raj Puri by email at rpuri@clarktrev.com or telephonically by calling the author at (213) 341-1322.

 

 

0 comments on “DON’T WANT DISPUTES WITH YOUR BUSINESS PARTNER? FOLLOW THE MONEY!”

DON’T WANT DISPUTES WITH YOUR BUSINESS PARTNER? FOLLOW THE MONEY!

By Rajnish Puri

Generally, it is friends or family members who jointly create a new business and in doing so, become business partners. So, why is it that, only in a matter of time, the once-friendly relationships turn sour and, as business partners, the same friends and family have disputes and, in many cases, litigate against each other?  Primarily, money matters . . . I believe.  How can such disputes be prevented?  The famous motion picture in the late 1970s – All the President’s Men – offers a clue.  Remember Deep Throat’s advice to Bob Woodward –  “Follow the Money”? Agreed that those three words led Woodward to reach only the source of the problem in the famous thriller about the Watergate scandal.  However, the advice, if followed when creating agreements among business owners, can bring clarity to expectations in the relationships, avoid fallouts and, most importantly, retain the original friendships –  the primary idea being about keeping an eye on the money from the time of investing in, to the moment of exiting, the business.  In that context, this article offers key ideas to consider for agreements among shareholders of corporations, members of LLCs, and partners in partnerships. For convenience, in the discussion below, the term “owner(s)” includes shareholders, members and partners and, similarly, “company(ies)” means privately-owned corporations, LLCs and partnerships.

Capital Contributions.  Businesses need capital, certainly at the launch and frequently at later stages.  An agreement among the owners should specify the initial capital contributions they are expected to make to the company in exchange for their ownership interest.  That’s the easy part.  But, what happens when the company needs more money? The owners must identify the decision making process to make calls for additional capital and establish the timing and other limitations.  It is just as important to agree on the consequences when one or more owner fails to satisfy the request for new capital.  These may include automatic dilution of ownership percentages in the company or, if other owners step in to make up for the shortfall, whether to treat the shortfall as a temporary loan.  Just like the inflow of money, its outflow, too, requires attention.  In addressing the distribution provisions, owners must describe the criteria for making the distributions and other considerations, like mandatory tax-related payments and repayment of the invested capital before the sharing of profits.

Management and Control. Although the concepts of managing and controlling the business do not directly involve money issues, they indirectly impact such issues. Owners should clearly define the role each would play in the operations of the company and set the voting thresholds required for approving major decisions.  Often, the responsibility to operate the business rests with a few.  A sensitive item is whether or not the operating owners should be entitled to any compensation, which is an expense that reduces the profits.  Without clarity on the issue there’s the risk of some owners feeling they are receiving less benefits than the others.  Similarly, when dealing with the important subjects – typically involving significant money matters such as borrowing, adding new owners, disposition of major assets, real property agreements, and material business agreements – the stakes are high and so is the need for an understanding among the owners as to who among them is/are best suited to authorize decisions on such crucial matters.  Arguably, everyone would like to have a say, but the unanimous voting requirement would give everyone a veto, which might lead to more problems than solutions.

Transferring Ownership.  Unlike publicly-held companies, investments by owners of private businesses are generally not liquid.  There may arise situations in the future when one or more owners wish to cash out from the business for different reasons.  Once again, money plays a role.  Equally compelling is the need to ensure that the entire ownership of the company remains among friendly parties.  The two objectives, sometimes inherently conflicting, are addressed through provisions that require the selling owners to offer their equity interests first to the company or the other owners before selling them to third parties – referred to as the right of first refusal.  A similar situation exists when a significant number of owners wish to sell their interests but others do not.  The majority achieves its goal by providing in the agreement a right to compel the minority to join the sale – referred to as the drag along right.  Both scenarios require the owners to deal with the selling price.  Incidentally, under both situations, third parties play a role in influencing the sale price.

Exits – Forced and Unforced.  Finally there are circumstances – some forced and others unforced – that compel an owner’s exit from the company.  Death, disability, retirement, termination of employment (where owners also are employees), marital dissolution and personal bankruptcy are some such situations.  To address these exigencies, owners should ask themselves the following three questions: first, who has the right or obligation to acquire the interests of the affected owner; second, how is the affected owner’s interest valued; and third, what are the terms of payment?  Absent answers to these questions in the agreements, owners may find themselves in undesired and costly disputes among each other.

Hope you found the above discussion helpful. In my upcoming posts, I plan to share with the readers practical knowledge and trends on a variety of corporate finance topics applicable to early stage and established businesses.  Stay tuned for another conversation on ClarkTalk!! If you have questions, feel free to contact the author by email at rpuri@clarktrev.com, or telephonically at 213-629-5700.

 

 

 

0 comments on “START-UP CAPITAL: WHEN CONVERTIBLE DEBT MAKES SENSE!”

START-UP CAPITAL: WHEN CONVERTIBLE DEBT MAKES SENSE!

By Rajnish Puri

Often, entrepreneurs are too eager to seek funds from relatives, friends and other investors in the hope of converting their business ideas into operating businesses in exchange for equity – an ownership interest – in the enterprise, without considering the consequences presented by this form of capital raise.  Start-ups rarely expand their business without selling equity in the company, but should this be the primary method of raising capital when attempting to get out of the gate?  Does borrowing, with certain limitations, make more sense?  This article examines some disadvantages of raising capital in exchange for equity during the early stages of a start-up and discusses the benefits of pursuing convertible debt as an alternative.

Valuation and Control of Business.  When considering sale of equity in a start-up, the primary question is one of valuation because, without having a firm idea of what the business is worth, founders might risk giving up too much for very little in return.  (Investors, too, especially those with little or no familiarity with assigning a value on businesses, face the risk of overpaying for the percentage and type of equity they would receive in exchange for their investment.)  Naturally, given the limited resources available to entrepreneurs at the early stages, obtaining an independent appraisal for the business is impractical and, therefore, not common. Such inequities are avoidable in a borrowing (see later) and diminish with time, as the business grows and brings a greater degree of certainty to the value and, thus, a fairness to the parties involved.  Another concept frequently overlooked by entrepreneurs is the loss of control associated with selling equity, which comes in the form of granting board seats and other contractual commitments to investors.  Under certain situations, the lack of control or a violation of such commitments may lead to the removal of the founders from the business – an outcome neither anticipated nor desired by an entrepreneur.

Debt versus Equity.  At the risk of oversimplifying, debt needs to be returned to a lender whereas equity typically stays with the business.  Actually, there’s a lot more to the distinction between the two forms of financing.  Debt does not appreciate in value (apart from the earnings through interest); equity increases with business growth and offers the potential of lucrative returns to the investor.  On the other hand, debt, like equity, may not be recoverable when a business fails.  For a business, the costs of borrowing money include the payment of interest, the limitation of time within which the loan is to be paid off or risk bankruptcy or foreclosure and the inability to borrow again – consequences generally not experienced when raising money through the sale of an ownership interest in the business.

Features of Convertible Debt; Things to Avoid.  Broadly speaking, a convertible debt is a promissory note accompanied with a special feature that allows conversion of the amount outstanding under the note into equity of the borrowing entity upon the occurrence of certain events. Similar to a promissory note, a convertible debt instrument describes the amount borrowed, term of the loan, interest rate and consequences of non-payment.  The convertibility aspect describes (1) the timing for conversion, which is typically a time in the foreseeable future when the business raises new capital, (2) the valuation to be used when computing the conversion of debt into equity, which is linked to the valuation deployed for the new capital raise, and (3) the conditions of conversion, which generally require a mutual agreement between borrower and lender and, occasionally, include a discount feature favoring the lender.  (Note that the discount feature, which allows the lender to convert debt into equity using a price lower than the price at which the business sells equity in the new financing round, raises tax issues that are not within the scope of this article.)  Borrowers should be careful and avoid giving assurances of repayment of debt (by issuing individual guarantees) or agreeing to controls imposed in the form of negative covenants that require lender’s permission for certain business activities.  Obviously, the size of the borrowing will impact the final terms, but, for capital raised through debt at early stages by start-ups, guarantees and the use of negative covenants are uncommon.  Using a convertible note to raise capital at an early stage avoids the perils associated with an unknown valuation of the start-up’s business (for both parties) and prevents giving up control (by founders) until the later stages of the business when the extent to which control might be conceded can be carefully measured.  In times when investors are looking to invest in businesses with promise and entrepreneurs are routinely conceiving promising ideas, raising capital through convertible debt provides a balanced alternative.

Hope you found the above discussion helpful.  In my upcoming posts, I plan to share with the readers practical knowledge and trends on a variety of corporate finance topics applicable to early stage and established businesses.  Stay tuned for another conversation on ClarkTalk!!

Thank you for joining us on ClarkTalk!  We look forward to seeing you again on this forum.  Please note that the views expressed in the above blog post do not constitute legal advice and are not intended to substitute the need for an attorney to represent your interests relating to the subject matter covered by the blog.   If you wish to consult with the author of this post or another attorney at Clark & Trevithick, please contact Raj Puri by email at rpuri@clarktrev.com or telephonically by calling the author at (213) 341-1322.

 

 

 

 

 

 

 

0 comments on “Crowdfunding: Is it for Everyone?”

Crowdfunding: Is it for Everyone?

By Rajnish Puri |

Regulation Crowdfunding issued under the Securities Act of 1933 (Securities Act), became effective on May 16, 2016, six months after the Securities and Exchange Commission (SEC) published the final rules relating to Section 4(a)(6) of the Securities Act.  The regulation provides guidance to startups and small businesses on how to raise money from smaller investors via the Internet.  But, is raising capital through a crowdfunding mechanism for everyone?  This article briefly examines the background for the regulation, provides an overview of the key rules, and makes certain practical observations about the effectiveness of the crowdfunding process.

The term “crowdfunding” is designed to allow (and encourage) “crowds” to “fund” businesses with relatively low dollar investments.  Broadly speaking, federal and state securities laws, make it unlawful for persons to sell securities unless sold pursuant to a registration statement effective under the Securities Act or under one of the several exemptions authorized under the Securities Act.  To facilitate raising capital for startups and small businesses using the Internet and social media platforms, and to provide individual (including non-accredited) investors an opportunity to invest in those entities, Congress established a regulatory framework for crowdfunding by enacting the Jumpstart Our Business Act (JOBS Act) on April 5, 2012.  The legislation was codified in Section 4(a)(6) of the Securities Act, with Regulation Crowdfunding providing guidance on the finer aspects.  When sold in compliance with Section 4(a)(6) and Regulation Crowdfunding, the securities qualify as an exempt transaction (Crowdfunding Exemption) obviating the need for a registration statement.

Who Is Eligible?  Only companies organized under the laws of a state or territory of United States are permitted to raise capital using the Crowdfunding Exemption, so long as they are not subject to the reporting requirements of the Securities Exchange Act of 1934.  Foreign companies, investment companies, companies with no specific business plans and companies that have failed to comply with the reporting requirements of Regulation Crowdfunding during the two-year period immediately prior to the crowdfunding offering, are not authorized to avail themselves of the Crowdfunding Exemption.

Rules for the Issuer. The Crowdfunding Exemption caps the amount an issuer may raise in a 12-month period to $1 million using crowdfunding offerings.  (Note: Crowdfunding offerings are not integrated with other types of offerings – for example, a Regulation D offering – and an issuer is free to raise capital independent of the Crowdfunding Exemption so long as it complies with the requirements of the other exemption.)  The offering must be transacted using only one intermediary online-platform that must be registered with the SEC.  For each offering, issuers must file Form C with the SEC using EDGAR, the SEC’s electronic filing system.  The disclosures accompanying Form C include, among other things, the filing of the company’s reviewed or audited financial statements (depending on the size of the offering), a description and discussion of the business, information about officers, directors and owners of 20% or more of the company, and related party transactions.  If there are any material changes or updates to the information included in the original Form C, issuers are required to file amendments using appropriate forms prescribed for such purposes.  The rules also require that, after a crowdfunding offering has been completed, issuers file financial statements with the SEC and post the statements and other disclosures on the issuer’s website on an annual basis.

Limitations for Investors. Individual investors are subject to certain limitations with respect to their investments in a crowdfunding offering.  Securities acquired may not be resold for a one year period.  The amount an individual may invest during a 12-month period in all crowdfunding offerings is limited by the individual’s annual income and net worth (without taking into account the value of the individual’s primary residence).  If either the annual income or the net worth of an individual is less than $100,000, the maximum amount that can be invested is the greater of (a) $2,000, or (b) the lesser of 5% of the individual’s annual income or net worth.  If the annual income and the net worth are equal to or greater that $100,000, the maximum amount that can be invested is 10% of the lesser of the individual’s annual income or net worth, subject to an annual limit of $100,000 for all crowdfunding offerings.

Costs versus Benefits.  Because Regulation Crowdfunding went into effect only about a week ago, there isn’t enough data out there, as yet, to accurately determine its impact on the business community or perform a thorough cost-benefit analysis of the legislation.  As a preliminary observation, however, it appears that the costs and administrative burdens of compliance associated with the regulation seem to outweigh the benefits.  For starters, the SEC estimates the preparation and filing of Form C to take about 100 hours, with about 25% of that time being attributed to outside professionals.  Adding to the preparation and filing costs is the compensation an issuer would pay an intermediary for the listing as well as the accountants’ fee for the preparation of reviewed and audited financials – a practice not prevalent among early stage companies.  Apart from the costs, by posting the  financial statements and other material disclosures about the business on its website, a startup or a small business might be at a disadvantage by making the information available to the competition.  Of course there are protections that can be built to secure the data, but, those, too, carry a cost.  With the ability to invest as little as $2,000,  arguably, the number of shareholders in a crowdfunded business might exceed a manageable figure which could add to the administrative burdens of management dealing with shareholder matters – be it information dissemination or simply seeking shareholder approvals for governance issues.  Depending on the size of the proposed offering, alternative exemptions available under the securities laws might be more attractive to the issuers.  By contrast, businesses less willing to work with, or facing difficulty in successfully raising capital through, traditional channels of funding, utilizing the Crowdfunding Exemption could be desirable, so long as they are willing to comply.

Hope you found the above discussion helpful.  In my upcoming posts, I plan to share with the readers practical knowledge and trends on a variety of corporate finance topics applicable to early stage and established businesses.  Stay tuned for another conversation on ClarkTalk!!

Thank you for joining us on ClarkTalk!  We look forward to seeing you again on this forum.  Please note that the views expressed in the above blog post do not constitute legal advice and are not intended to substitute the need for an attorney to represent your interests relating to the subject matter covered by the blog.   If you wish to consult with the author of this post or another attorney at Clark & Trevithick, please contact Raj Puri by email at rpuri@clarktrev.com or telephonically by calling the author at (213) 341-1322.

 

0 comments on “Considering Selling Your Business and Wondering Where to Begin? The Anatomy of a Definitive Agreement”

Considering Selling Your Business and Wondering Where to Begin? The Anatomy of a Definitive Agreement

By Rajnish Puri |

Part four of a four-part series.

In this four-part series on the subject of selling your business, I have shared with you, based on my experiences, the various stages an owner of a privately-owned business can expect to go through when considering an exit strategy.

As discussed earlier in this series, in the context of a simultaneous sign and close transaction, buyer and seller do not have a legally binding agreement between them until the execution of a definitive agreement, a moment that also coincides with the closing.  It is therefore important to solve, beforehand, the mystery of a definitive document. What does it contain? What do the provisions mean?  How does everything fit together? Before answering these questions, it is helpful to note that a business can be purchased and sold adopting different structures for the transaction – the primary three being a sale of shares, a sale of assets and a merger of entities.  Hence, the respective names for the definitive documents – a Stock Purchase Agreement, an Asset Purchase Agreement and an Agreement and Plan of Merger.  The focus of this conversation is on the first two, they being more common than the third.  Although a given document may have several provisions depending on the terms and structure, broadly speaking, both types of agreements can be categorized into four principal segments as follows.

Specifying What is Being Sold and Purchased.  The initial segment of an agreement typically describes, with adequate specificity, the items being sold and purchased at closing – shares, in a Stock Purchase Agreement and, assets, in an Asset Purchase Agreement.  While the description of the shares that are the subject of transfer is relatively straightforward, reaching an agreement on the assets being sold (or retained) often requires more extensive drafting.  Unlike a share transfer where title to the entity’s assets and liabilities remains unchanged, the agreement for the sale and purchase of assets is not just limited to the notion of a transfer – it also requires the parties to address the concepts of which assets and liabilities are retained by the selling entity as well as identifying the liabilities being assumed by buyer.  The actual instruments of transferring title are generally included as exhibits to the agreement.

Purchase Price and Related Nuances.  A substantial segment of an agreement is devoted to describing the amount and timing of the purchase price being paid for the shares or assets, and the contingencies that may lead to adjustments, both upward or downward, in the price.  Other than the amount – something that parties generally establish “firmly” in a Letter of Intent, despite its non-binding nature – almost every element of this section warrants careful consideration by both seller and buyer.  Of the aggregate purchase price, what portion is to be delivered at closing or how much buyer or a jointly appointed escrow agent may holdback for potential post-closing obligations of seller, are subjects typically addressed here.  In certain transactions, particularly those dealing with seasonality in the target business or involving historical swings in revenue streams, it is in this segment where one finds provisions on purchase price adjustments linked to agreed-upon working capital targets and additional payments, or “earn-outs,” contingent upon the target business attaining certain milestones under buyer’s watch.

Statements About the Business.     Labeled as “Representations and Warranties of Seller,” with the exception of “as-is” transactions, this segment ends up being, by far, the most negotiated portion of an agreement.  The section includes several statements from Seller about various aspects of the business, some qualified with materiality, knowledge or both, and many without such qualifiers. (There also is a separate section covering the representations and warranties of a buyer, which is limited to certain fundamental matters and rarely draws intense scrutiny.)  In explaining the primary purpose behind this section, a friend once quipped that, whereas the section dealing with the purchase price provisions describes what a seller would receive at closing, by contrast, this section essentially lays the groundwork for what a seller would have to return to buyer should seller’s statements later turn out to be untrue, subject, of course, to other terms and conditions found in an agreement. In other words, the provisions of this segment are important with potential for serious implications.  It is principally for this reason that counsel for both parties spend significant time negotiating the provisions of this section, with seller’s counsel motivated by limiting the scope of seller’s representations to ultimately limit buyer’s recovery post-closing (as discussed below). Naturally, buyer’s motivation is quite the opposite and counsel’s strategy is dictated accordingly.  An ancillary document associated with this section is the disclosure schedule, which contains information required pursuant to seller’s statements about the business and exceptions to the representations.

Post Closing Matters.   The last major segment of an agreement deals with matters relating to indemnification and restrictive covenants, although each appears in a separate dedicated section of its own.  The indemnification obligations are mutual between seller and buyer, but it is the seller’s that merit more attention.  The provisions deal with survival periods for the parties’ representations and warranties, scope of protections, limitations on liability and a description of procedures to be followed by the parties if problems were to arise.  With respect to the restrictive covenants, the document imposes on seller obligations to not compete in the target business industry and refrain from soliciting the employees or customers of the business being sold.  Finally, an agreement contains general provisions about methods of communication between parties, dispute resolution procedures, and the law governing the interpretation of the agreement, among other matters.

In Part One, Part Two and Part Three of this series, I shared thoughts on First Steps, Purpose of a Letter of Intent, and What Transpires after Signing the Letter of Intent, respectively.  Hope you found the discussion in this series helpful.  In my upcoming posts, I plan to share with the readers practical knowledge and trends on a variety of corporate finance topics applicable to early stage and established businesses. 

Thank you for joining us on ClarkTalk!  We look forward to seeing you again on this forum.  Please note that the views expressed in the above blog post do not constitute legal advice and are not intended to substitute the need for an attorney to represent your interests relating to the subject matter covered by the blog.  You should certainly consult legal counsel of your choice when considering the sale or purchase of a business.  If you wish to consult with the author of this post or another attorney at Clark & Trevithick, please contact Raj Puri by email at rpuri@clarktrev.com or telephonically by calling the author at (213) 341-1322.

 

0 comments on “Considering Selling Your Business and Wondering Where to Begin? What Transpires After Signing the Letter of Intent!”

Considering Selling Your Business and Wondering Where to Begin? What Transpires After Signing the Letter of Intent!

By Rajnish Puri |

Part three of a four-part series.

In this four-part series on the subject of selling your business, I plan to share with you, based on my experiences, the various stages an owner of a privately-owned business can expect to go through when considering an exit strategy.

 After a willing seller of a business and an interested buyer have executed the Letter of Intent (LOI) (please see: part two of series here), the real work to complete the purchase and sale of the target business gets underway. Teams of advisors, for both sides, go to work simultaneously, on their way to accomplishing their respective goals tied to a common end-result.  In theory, transactions of this type can be signed first and closed at a later date after the completion or, in some cases, the waiver, of the requisite closing conditions.  Practically speaking, however, a significant number of transactions involving privately-owned businesses are completed adopting the simultaneous sign and close mechanism.  In other words, the parties sign the definitive agreement and close the transaction at the same time.  For purposes of this conversation, we assume a simultaneous sign and close scenario.  The time period between executing the LOI and closing a transaction involves the following primary activities, all taking place concurrently.                  

Preparing and Negotiating the Definitive Agreement.  With some of buyer’s investigation of the target business conducted prior to the LOI stage and the principal terms of the deal enumerated in the LOI, generally, soon after the signing of the LOI, buyer’s counsel commences preparation of the definitive asset purchase agreement or stock purchase agreement based on the agreed-upon structure of the transaction.  This is also the stage when representatives of buyer and seller are introduced to each other and establish the framework of communications, timing and expectations for completing the deal.  When working on preparing the initial draft, buyer’s counsel is in regular communication with its client and team of advisors to build the essential provisions of the definitive document.  Depending on the size and complexity of the transaction, this exercise usually takes a few weeks before buyer’s counsel presents the first draft of the definitive agreement to seller’s counsel. The negotiations begin soon thereafter, with seller’s counsel leading the effort on behalf of seller’s team.  Simultaneously, seller’s counsel actively engages seller personnel most familiar with the target business to begin preparing the disclosures and other schedules to the definitive agreement, a process that continues through the finalization of the transaction documents.  Although most of the attention is devoted to negotiating the definitive agreement, preparation of the ancillary documents also gets underway once both parties have reached a consensus on the primary structure of the former.

Due Diligence and Coordination with Third Parties.  Due diligence investigation of the target business is an exercise that rarely stops until the closing.  In fact, this aspect of the transaction only gains momentum with time, and justifiably so.  If not done during the pre-LOI phase, secure virtual data rooms are established at this stage where seller continues to add pertinent information about the business giving access to both buyer and seller teams of advisors.  While non-legal advisors pore over the analytics of the business data, counsel, specifically buyer’s, typically examines the information to formulate provisions in the definitive agreement.  Seller’s counsel utilizes the data room information and communications with seller principals to prepare the disclosure schedules and determine the third party approvals required as a condition to closing. As the parties are targeting a simultaneous sign and close, the task of communicating with third parties – most notably landlords (where real property leases are part of the business being sold) and parties to significant contracts in the business – becomes both critical and sensitive, requiring the parties to strike a delicate balance.  The transaction might not close – therefore, the need for obtaining contingent and confidential approvals from third parties.  The transaction needs to close  – therefore, the need for a timely approval.  Some of the other principal communications involve tracking down the selling shareholders (especially where the ownership is broadly held), arranging calls between buyer and key relationships of target business, and addressing human resource issues to ensure a smooth transition for employees (if applicable).

Continuity of Business Operations.  While all the activity surrounding the sale and purchase is ongoing, someone from seller’s team must continue to mind the store.  Readers may recall from an earlier discussion in this series that, but for a select few provisions, LOIs are mostly non-binding in nature.  As a result, there is no legally binding agreement between a buyer and seller to do the deal unless the parties execute a definitive agreement. Accordingly, the parties could spend an enormous amount of time and resources negotiating the transaction and yet end up walking away from the deal.  (Note: Discussing the consequences of walking away is outside the scope of this conversation.) Some of the reasons for terminating negotiations could be outside the control of the parties, such as a sudden shift in market conditions, failure to obtain adequate financing or the inability to overcome regulatory hurdles.  Many of the circumstances, however, can be managed, and ensuring that the target business remains strong or consistent with its past performance is a priority.  A typical transaction cycle may last three to six months from start to finish, which could be an eternity from seller’s vantage point given the distractions caused by the negotiation process.  Despite all precautionary measures, the word somehow gets out that the target business is in play leading to conversations among employees and others concerning their future, which, in turn, could impact performance.  Buyer bids for the target business based on certain assumptions that include attaining baseline financial metrics. If those assumptions fail to reach the expected levels or new conditions suggest their imminent decline, buyer might renegotiate the price or decide to take a pass.  Naturally, not a desirable outcome by either party and certainly not for seller who may watch its goal of selling the business drifting away – at least for some time.  Hence, the point person appointed by seller at the early stages of the process should ensure the preservation and consistent performance of the business.

Closing and Transition. Somewhere along the line in the negotiation process, and typically after the two sides believe they have a well developed draft of the definitive agreement (even if not final), a closing date is penciled in.  Even though it is a date that is only tentative at this point, in my experience, both seller and buyer take it very seriously and both teams work diligently toward meeting the target date.  It is not uncommon, especially in document-intensive transactions, for parties to stage a pre-closing, a day or two prior to the actual closing date, to ensure everyone is on the same page and that all pre-closing conditions have been, or will be by the closing date, completed.  Finally, following months of laboring through the process of conducting due diligence, negotiating deal documents, communications among seller, buyer and the employee contingent that remains with the target business, among other activities, the closing date arrives and the purchase and sale of the business is completed.  Interestingly, in contrast to the flurry of activity taking place leading up to the closing date, the actual closing process is relatively short and less intense (other than the typical anxiety associated with accomplishing a significant task).  The parties exchange signed pages of the transaction documents, buyer remits the purchase price and, occasionally, there is a press release or a limited announcement often conducted jointly by the parties.  At that moment, buyer officially takes over the ownership and operations of the target business and, sometimes by express agreement and occasionally without one, certain designated personnel from seller management assist buyer with the transition to ensure the transfer goes through with minimal interruption.

In Part One and Part Two of this series, I shared thoughts on First Steps and the Purpose of a Letter of Intent, respectively.  In Part Four of this series, I plan to give to our readers an overview of the primary components of a definitive agreement.  Stay tuned for another conversation on ClarkTalk!!

Thank you for joining us on ClarkTalk!  We look forward to seeing you again on this forum.  Please note that the views expressed in the above blog post do not constitute legal advice and are not intended to substitute the need for an attorney to represent your interests relating to the subject matter covered by the blog.  You should certainly consult legal counsel of your choice when considering the sale or purchase of a business.  If you wish to consult with the author of this post or another attorney at Clark & Trevithick, please contact Raj Puri by email at rpuri@clarktrev.com or telephonically by calling the author at (213) 341-1322.

1 comment on “Considering Selling Your Business and Wondering Where to Begin? The Role of a Letter of Intent”

Considering Selling Your Business and Wondering Where to Begin? The Role of a Letter of Intent

By Rajnish Puri |

Part two of a four-part series.

In this four-part series on the subject of selling your business, I plan to share with you, based on my experiences, the various stages an owner of a privately-owned business can expect to go through when considering an exit strategy.

Once a seller has completed the initial steps in deciding to sell its business (please see last week’s article) and also has identified the most suitable buyer, generally speaking, the first formal expression of interest between the two parties to carry out the sale and purchase transaction is memorialized in a Letter of Intent.  Traditionally, the buyer prepares and submits the signed letter to seller who, after consultation with its team of experts, elects to either accept the proposal as presented or provide modifications for buyer’s consideration.  In certain situations, prior to executing the Letter of Intent, the parties may enter into a confidentiality agreement to facilitate exchange of information about seller’s business for buyer’s preliminary evaluation.  As is implicit in its title, the Letter of Intent is a medium through which a willing seller and a willing buyer communicate to each other their respective “intent,” and not a definitive promise, to enter into a transaction under certain terms and conditions.  Nonetheless, with the exception of certain provisions (discussed below), the commitment, though primarily non-binding at this stage, is sophisticated enough to convey that each party is serious about pursuing the deal.  Letters of Intent may vary in style, length and the extent of details included, but often address the following primary matters.

Establishing the Principal Framework.  Depending on the nature and size of the target business, its history and ownership structure, parties make an early decision to agree on the structure of the proposed transaction, with the primary choices being an asset or a stock purchase transaction.  When uncertain, parties defer the decision on the structure pending further evaluation of the business by buyer.  The purchase price buyer is willing to pay to seller is the next key component of a Letter of Intent, as are the associated conditions, such as expectations about the level of debt to be assumed by buyer and adjustments to the purchase price based on the working capital available at closing. The timing of payment of the purchase price – what portion is to be paid at closing and how much is subject to a holdback or linked to the post-closing performance of the business – is another aspect the parties tend to describe at this stage.  Finally, if buyer has engaged in prior, even if limited, due diligence about the business, buyer sets forth the conditions it expects to be completed prior to closing the proposed transaction.

Non-Binding v. Binding.  Because buyer has plenty to investigate about the target business before legally committing itself to go through with the proposed transaction, with the exception of select provisions, a Letter of Intent is predominantly non-binding.  A binding commitment between the parties is expressed in a definitive agreement, typically entered into between the parties following buyer’s due diligence investigation.  From buyer’s perspective, some of the prerequisite investigations imposing demands on its time are understanding the financial statements, contracts and ongoing obligations of the business, evaluating third party relationships, and understanding employee matters and related aspects – all of which could impact buyer’s decision on the structure and financing of the transaction or, in some cases, whether or not it is even prepared to move forward.  The provisions that are typically binding in a Letter of Intent are the obligations of the parties to bear their respective expenses, ensuring confidentiality of information shared by seller (although it could be addressed through an independent non-disclosure agreement), granting buyer and its team of advisors extended access to information about the target business, and buyer having exclusive rights to evaluate the business for a limited period of time.

Due Diligence and Confidentiality.  Unless previously addressed in the context of a non-disclosure agreement executed between the parties, a Letter of Intent, when signed, permits buyer and its designated team of advisors (attorneys, accountants, and members of buyer’s management) to begin their due diligence investigation of the target business.  To ensure that the information seller shares about the business remains protected and is limited to use by buyer solely to evaluate if buyer should acquire the business, a confidentiality provision is an important element. Occasionally, the confidentiality provision also includes names of select individuals from seller’s team who are the only ones authorized to receive and respond to buyer’s inquiries to ensure a coordinated and efficient due diligence process.

Exclusivity and Termination.  The last thing a potential buyer wants to do is to engage in the investigation of seller and the target business, incur costs and fees, and make the related time commitments – only to later learn there are other potential buyers invited to the party, triggering the need for an exclusivity provision seeking seller’s assurance that buyer is the only party engaged in negotiations.  What frequently gets negotiated is the duration of the exclusivity period, which, depending on the size of proposed transaction, varies between 30 to 90 days.  Naturally, seller prefers the shorter end of the spectrum to allow itself other options should the buyer have a change of heart, and buyer likes to maximize the duration.  And, finally, there is seller’s need for certainty about the process, which is addressed through listing the conditions – satisfied or failed – that trigger the termination of the Letter of Intent, again with a select surviving the termination.

In Part One of this series, I shared thoughts on First Steps.  In Part Three of this series, I plan to focus on What to Expect between Signing a Letter of Intent and Closing.  Stay tuned for another conversation on ClarkTalk!!

Thank you for joining us on ClarkTalk!  We look forward to seeing you again on this forum.  Please note that the views expressed in the above blog post do not constitute legal advice and are not intended to substitute the need for an attorney to represent your interests relating to the subject matter covered by the blog.  You should certainly consult legal counsel of your choice when considering the sale or purchase of a business.  If you wish to consult with the author of this post or another attorney at Clark & Trevithick, please contact Raj Puri by email at rpuri@clarktrev.com or telephonically by calling the author at (213) 341-1322.

1 comment on “Considering Selling Your Business and Wondering Where to Begin? Here are Some First Steps!”

Considering Selling Your Business and Wondering Where to Begin? Here are Some First Steps!

By Rajnish Puri

Part one of a four-part series.

In this four-part series on the subject of selling your business, I plan to share with you, based on my experiences, the various stages an owner of a privately-owned business can expect to go through when considering an exit strategy.

You have labored hard to build a profitable business and are now contemplating an exit.  So, where to begin? In today’s economy, where mergers and acquisitions of large businesses frequently dominate the front pages of major newspapers, what goes largely unnoticed, and, therefore, little discussed, is the corresponding activity in the world of small- to medium-sized, privately-owned businesses and the tough decisions that confront their owners.  Whether it is identifying the right buyer, determining the correct value of the enterprise, selecting the most tax efficient structure, or optimizing the timing – these are only some of the many complex decisions you must make. If you are one of those potential sellers, here are initial steps in the planning.

Identify Your Goal.  Sellers are motivated by different reasons to sell their businesses.  What is yours?  Is it retirement, tying up with a strategic partner for further growth, a new-found opportunity, or something else? The answer to this question sets the stage for the remainder of the process.  If retiring, the primary goal often becomes maximizing the value of the business being sold; a strategic alliance would focus one’s attention on seeking the right partners; and a new interest might influence the timing of the deal if capital is required to fund the new venture. Your ultimate goal may also affect what you intend to leave behind –financial security for the family, a legacy for those who helped grow your business or both.  It’s important for your advisors to understand what your goal(s) are early in the process to effectively implement tax planning tools for the benefit of the sellers and others impacted by the transaction.

Build a Team.  Just like you are undoubtedly the architect of your business, the art of selling businesses, too, has its specialists.  Similarly, as you trusted your talent to grow your business, trust the experts to help you with the sale process.  The four key advisors on your team should be – a tax advisor capable of addressing both income tax and estate planning needs, an attorney experienced in mergers and acquisitions, a valuation professional with experience in similar-sized businesses, and a point person within the business to ensure normal operations of the business during the sale negotiations and to be the liaison between seller and buyer.

Get Your House in Order.  Has curiosity ever tempted you to walk into an open-house in your neighborhood (even if you were not in the market to purchase real property)?  And, if so, did you notice the curb appeal, the landscaping, the fresh paint or the artwork on the walls, the kitchen with utensils neatly tucked away in the cabinets, or the clean bathrooms?  Doesn’t the appearance make the property more attractive, which also justifies, and, in some markets, even drives up, the price?  Or, at least, lays the groundwork for a buyer to be prepared to pay a good price?  Optics play a role.  Selling a business isn’t much different in terms of preparing it well to ensure the seller can demand a fair price. In the context of selling a business, getting your house in order means addressing multiple fronts, prior to putting up the “for sale” sign.  Some of the simple, but often overlooked, tasks are: ensuring the accuracy of corporate records; evaluating and managing the risks stemming from pending litigation, expiring contracts, aging receivables, and cyber security; knowing your financial statements; examining the application of regulatory framework; and confirming the condition of the operating assets.  Careful planning in managing these areas plays a role in attracting good value for the business and a faster closing schedule.

Timing the Deal.  Finding the perfect timing to complete a transaction is by far one of the most unpredictable elements of deal making, though there is no single factor that is controlling.  There may exist a willing seller, but is there an interested buyer? Does the economy favor a strong valuation for the seller’s business and also allow buyer to tap into credit markets for financing?  Are there tax issues, prevailing or looming, affecting the timing of a closing? Does the seller wish to reward key employees upon closing and, if so, are the desired plans in place?  And, so on and so forth.  All of the stars need to be aligned for a transaction to succeed.  Your preparation must weigh all the elements prior to beginning the sale process to ensure the best outcome.

In the next part of this series, I plan to focus on Letters of Intent – often the first formal step that commences the negotiations between a seller and buyer.  Stay tuned for another conversation on ClarkTalk!!

Thank you for joining us on ClarkTalk!  We look forward to seeing you again on this forum.  Please note that the views expressed in the above blog post do not constitute legal advice and are not intended to substitute the need for an attorney to represent your interests relating to the subject matter covered by the blog.  You should certainly consult legal counsel of your choice when considering the sale or purchase of a business.  If you wish to consult with the author of this post or another attorney at Clark & Trevithick, please contact Raj Puri by email at rpuri@clarktrev.com or telephonically by calling the author at (213) 341-1322.