By: Karl Ahlm, Gould & Ratner LLP

For owners of companies that may now or in the future have interest in pursuing a sale of their business or other "liquidity event" transaction, there remains a substantial amount of capital earmarked for investment in these types of transactions. Corporate and other "strategic" acquirers have record levels of cash on their balance sheets and a 2010 report by research firm Pitchbook estimated that $477 billion was available for investment by private equity funds, including funds targeting investments in middle market and lower middle market businesses. 

Although recent macroeconomic developments, including slower economic growth in the United States economy and the possibility of a recession, and the European sovereign debt crisis, could have a chilling effect on merger and acquisition activity, various reports indicate that both the total number of M&A deals year to date in 2011 and overall deal size compare favorably with 2010 levels (and, in the case of deal size, there has been a noteworthy uptick in 2011). In short, there are very attractive liquidity opportunities available for sellers of healthy businesses.

We have found repeatedly in representing both buyers and sellers of middle market and lower middle market businesses that advance planning by sellers that might have some "loose ends" or deficiencies in certain areas can help to facilitate a smoother and more efficient due diligence and sale process, and avoid unnecessary distractions that in some cases can delay or even derail a sale process. These actions, many of which are good practices for any business to follow, even if a sale is not anticipated, are for the most part not difficult to implement and should help mitigate unnecessary legal risk.

Corporate Records: Minute books and other corporate records should be kept current and brought up to date, if necessary. Minutes of board meetings demonstrating that a board has met regularly and properly discharged its fiduciary duties and oversight functions should help to ensure that the separate existence of an entity is respected, and therefore help to protect shareholders from personal liability in the case of a claim or other action by a creditor against the company. Generally speaking, minutes should not be "transcripts" of board discussions, but they should be sufficient to show that the board engaged in a thoughtful and deliberative dialog on matters it considered.

If some arrangements that are important to a business have traditionally been done on a "handshake" basis or through an oral understanding (without a written agreement), consider putting these understandings in writing so that they can be better understood by and assigned to a buyer. Documenting these arrangements prior to a sale process can also identify any misunderstandings regarding terms prior to involvement from a buyer and can avoid problems after a deal closes.

Also, make sure that any key corporate documents, such as stock ledger records and shareholder agreements, are up to date and signed by all relevant parties, including minority shareholders. Principal shareholders should understand how any "drag-along" or other shareholder agreements work (or if there are no such agreements in place, consider whether to adopt them) well in advance of embarking on a sale process, particularly where there might be different goals and objectives within the shareholder group in structuring a sale.

Protect IP Rights: While this issue is more important in some industries than others, review and confirm that employees, consultants, and/or other developers who might have or in the future claim rights in proprietary IP and software of the target business have assigned these rights to the company.  Consider having all new hires and existing employees who have not done so sign non-disclosure and assignment of invention agreements in forms that are sufficient to provide enforceable rights in favor of the company and a buyer. A seasoned buyer will, at a minimum, want to be indemnified by the sellers for any post-closing problems that might arise regarding its ownership of IP rights.

Change of Control/Assignment Provisions: Although they cannot be avoided in many circumstances, where a future sale or liquidity transaction is anticipated, when possible, try to resist including "change of control" provisions (i.e., provisions in an agreement which give the other party the right to terminate the agreement upon a change in ownership--and which therefore require the consent of the counterparty to do a deal) in contracts and agreements. If a consent provision cannot be avoided, it may be possible to draft the language so that it is more flexible. While there are differences driven by the transaction structure (i.e., sale of the stock of the company vs. sale of its assets) that will impact how these provisions are interpreted, any change of control or assignment provision that requires a third party's consent can complicate a sale process and open the door for a counterparty to ask for a payment of a fee or changes to deal terms in exchange for its consent. Similarly, be aware of how change of control language in loan or other financing documents can impact a sale if debt will not be paid out at closing.

Financial Information: A target company's financial information will of course be a critical part of any sale and due diligence process. If a company that does not have bank financing or other shareholder reporting obligations requiring audited financial statements has not previously obtained an audit, it might be appropriate to at least consider obtaining one and/or review any need for improvements or enhancements in financial reporting. Public company buyers and buyers who rely on debt financing to finance the purchase price may require that a seller have audited financial statements. Also, to the extent that family or other personal arrangements with shareholders or other affiliates run through the financial statements of the target company (as is the case with many family-owned businesses), pro forma adjustments will need to be made to remove these items from the historical numbers in order to normalize earnings for purposes of arriving at a purchase price that accurately reflects the anticipated post-closing operation of the business under the buyer's ownership. While in many cases there are tax or other reasons for having these affiliate arrangements run through the company financial statements, to the extent that arrangements which are not essential to a target business can be eliminated in advance of a sale, it will help to simplify the financial diligence process when prospective buyers look at a business from the perspective of how it would be operated under their ownership. Also, if a company has unprofitable contracts or above-market expenses, they may be best dealt with well in advance of a sale process so as not to be a drag on earnings.

Incentives for Management that Align Interests: Recognizing that different types of buyers will desire differing levels of post-closing involvement from existing management of a target business, it is worthwhile to consider whether adopting any particular management incentive arrangements (or making any adjustments to existing incentives or arrangements) could help to better align the interests of management with those of the selling shareholders, both in the period leading up to a sale and also during a post-closing transition period. For example, providing for a change of control bonus arrangement that vests and becomes payable at some point following the closing of a sale transaction (e.g., six months after a closing, rather than full payment of the bonus at the closing), assuming continued employment by an executive or employee through the post-closing payment date, should help to ensure a smoother transition of ownership because management will have been incentivized to remain with the business for some transition period after a closing. Other incentives can be designed to fit the particular circumstances of the relationship with management and the potential buyer(s).

Director Indemnification Agreements: Consider entering into director indemnification agreements between the company and directors with survival periods that extend for the applicable statute of limitations for potential claims against directors. If a sale transaction is structured as a stock sale or a merger, indemnification agreements will give directors additional comfort that the surviving company will have a contractual obligation to indemnify them for any claims that might be brought against a former director after a deal closes. Many outside directors will request these agreements as a condition to agreeing to serve as a director.

Be Careful about Shareholders who are not "Accredited": In U.S. companies with larger shareholder groups, shareholders who are not "accredited" (as defined by the U.S. securities laws) can complicate a sale process under circumstances where some or all of the purchase price is paid by the buyer in the form of its stock or other equity, rather than cash. The U.S. securities laws generally provide that a natural person must have individual net worth, or joint net worth with his or her spouse, in excess of $1 million (excluding the value of his or her primary residence), or income exceeding $200,000 in each of the two most recent years (or joint income with a spouse exceeding $300,000 for those years) and a reasonable expectation of the same income level in the current year in order to qualify as an "accredited investor." Many companies have shareholders who are not "accredited" or they may have allowed "accredited" shareholders to transfer their shares to family members, trusts, or other entities who are not "accredited." If some portion of the consideration in a stock or merger deal is paid in the form of stock of the buyer, the presence of shareholders who are not "accredited" can at a minimum trigger the need for additional legal and accounting work in order to make disclosures required by the federal securities laws and therefore complicate and delay getting a deal done. Careful planning and understanding of the securities laws is always important, particularly with private companies that have a diverse shareholder group.

Estate Planning: For many shareholders of privately held and family owned businesses, effective estate and tax planning can reduce or defer, in some cases dramatically, the amount of tax to be paid by the selling shareholders. Typically, these actions must be completed well in advance of a sale process in order to achieve the desired effect. An experienced estate planning attorney or other advisor with expertise in this area can provide guidance. The benefits of this planning will in all likelihood far outweigh the cost.

Karl Ahlm, a Partner in the Business Counseling and Transactional Group at Gould & Ratner LLP, focuses his practice in the areas of mergers and acquisitions, private equity and venture capital, and general corporate matters.  He can be reached at kahlm@gouldratner.com. The information provided in this article is only a general summary and is being distributed with the understanding that the author is not rendering legal, tax, accounting, or other professional advice, position, or opinions on specific facts or matters and, accordingly, assumes no liability whatsoever in connection with its use.

© 2011 by Karl M. Ahlm. All rights reserved.