BY DAVID L. OBERG ESQ. and MADISON OBERG, ESQ.
Three things you should consider before selling your business.
Selling a business is a process, and it can be stressful. But there are certain things that a prospective seller can do to make the sale process more manageable. Before listing the business, a seller should: (1) make sure that the financial books and records are in order; (2) make sure that the legal books and records are in order; and (3) understand what consents and approvals from third parties are necessary to sell the business or its assets.
Some Background
Generally, the sale of a business will fit into one of two forms—a stock sale or an asset sale.
Stock Sale
In the case of a stock sale, the buyer acquires the ownership, i.e., capital stock of a corporation or membership interests in a limited liability company (LLC). In essence, the buyer steps into the shoes of the old seller. From the perspective of those on the outside, the company looks exactly the same the day after the sale is consummated. The difference is on the inside, as the company now has a new owner. But all other aspects of the company should remain the same. For example, the Federal Tax Identification Number (EIN) remains the same, the State registration numbers remain the same, and generally the licenses and permits that were issued to the company should remain in place. Here is a caveat that is discussed more fully below—the seller needs to be aware of which licenses or permits can be transferred and what, if any, prior consents and/or approvals from third parties will be required.
Asset Sale
In the case of an asset sale, the selling company (corporation or LLC) remains with the seller. The buyer acquires the desired assets (and perhaps some of the corresponding liabilities). The acquired assets are held by a company that is different than the original selling company. So, third parties (customers and suppliers) are now dealing with an entirely different company than they were the day before the sale transaction was consummated. This is very different from the above example of a stock sale, where third parties would be dealing with the exact same company, and merely the ownership changed.
There are several very good reasons why a transaction would go down one path or the other, but those are beyond the scope of this discussion. However, the seller should anticipate that, regardless of the type of sale, a large component of that process is the diligence phase. It is during the diligence phase that the buyer will ask for information to verify the status and condition of the company, the overall capabilities of the company, and the assets and liabilities of the company. Understanding what will be expected, will not only help to reduce the anxiety associated with a sale, but proper planning will help the seller achieve a more realistic price. Below are three things that the seller should consider before starting the sale process, and why each of these items could impact the selling process and the price.
Pre-Sale Diligence
Clean up the financial books and records. One of the key components of price is the company’s “profitability.” The seller wants to maximize the price, and the buyer wants to get the lowest price. Most companies will sell at a multiple of its earnings, meaning the profitability of the company. So, generally speaking, the higher the profit, the higher the price for the business.
The seller should anticipate that the buyer will require the seller to produce not only the current financial records for the company, but the historical (usually the prior three years) records. These records will likely include tax returns, balance sheets, profit and loss statements, and the backup to support each.
To understand the true profitability of the company, the seller should make sure that the financial records are current, accurate, and that they have been carefully reviewed by an accountant. The buyer will be looking to verify earnings and expenses of the company, and all irregularities need to be explained. By example, if the seller is running personal expenses through the company, or if the company is paying for outside services that only benefit the owner, these need to be backed out. Similarly, if the owner has contributed personal assets that are not on the balance sheet, these too need to be accounted for and explained. Finally, if there are any other unusual practices that the owner has taken, these practices will need to be explained.
The key take away is that the seller must anticipate that the buyer will be scrutinizing the financial records. So, take the time before the sale process starts to carefully have those records brought current and make sure that there is ample backup to support what was done in the past. By carefully working through the financial records at the front end, the seller and the seller’s advisors should be able to determine what a realistic sale price will be.
Cleanup the legal books and records. The seller should anticipate that the buyer will also require an inspection of the corporate records of the company. At its most basic level, if the buyer is attempting to acquire “all” of the ownership, the buyer will want to see the records that demonstrate and account for all of the past and current owners. It is not uncommon for owners of a startup to offer and/or give equity (ownership) to key individuals that helped the owner start the business or run the business. But, at the stage where the owner is now attempting to sell all of the ownership in the company, the owner must be able to account for all of those prior gifts. The seller needs to anticipate that buyer is not looking for any “undisclosed” partners, and so the seller had better be able to account for all 100% of the ownership interests.
But there is more to corporate records than just the stock/ownership. Corporations and LLCs should have minutes to reflect corporate actions. Here are four very good reasons why companies should prepare minutes:
It’s the law. California Corporations Code Section 1500 mandates that, “each corporation shall keep adequate and correct books and records of account and shall keep minutes of the proceedings of its shareholders, board and committees of the board . . .” Certain actions require approval by either the board or shareholders, such as the appointment of officers and the election of directors. These actions are supposed to be documented in writing. Although other business entities, such as LLCs, are not required to hold annual meetings, it is not an excuse from maintaining accurate minutes or otherwise disregarding “corporate” formalities.
Respect the entity or risk veil piercing. The need to respect the separateness of the entity is the same for both LLCs and corporations. Without deeply diving into the law of alter ego, the short answer is that one of the first factors that a court will consider in assessing if it is going pierce the corporate veil is whether the entity maintains corporate records. Associated Vendors, Inc. v. Oakland Meat Co., 210 Cal. App. 2d 828 (1962). The policy is simple: if the owners of the entity fail to maintain corporate formalities and disrespect the separateness of the entity from themselves, then the court will also not respect the separateness. That means that the court will allow the corporate veil to be pierced, thereby exposing the personal assets of the owners (shareholders and members) to liability.
It keeps owners informed. For many business entities there is a separation between the owners who are actively involved in the day-to-day operations of the enterprise, and those who are more passive (the silent investors). Maintaining and distributing the minutes to those “less active” owners is important for keeping them informed about significant events and transactions that have been undertaken by the entity. It also lowers the risk of a lawsuit from a passive investor who might otherwise try to claim, “I didn’t know . . .” or “I wasn’t told . . .”
It looks good to the buyer. Maintaining good minutes provides a historical record of significant events in the lifecycle of the entity, such as loans, leases, approval of major acquisitions, and any other significant events that are outside of the entity’s ordinary course of business. The seller should anticipate that the buyer will scrutinize these records. So, maintaining accurate records provides one example of how the owners have treated their business, i.e., is everything neat an orderly or is it unkept and disorganized. Think of an example of the person who is trying to sell a used car. In one case, the seller has detailed records of each time he took the car in for service, and each service was performed by the dealership or a properly licensed and authorized third party mechanic. In the other case, the seller “represents” that the car has been properly maintained but has no records to back up the statement. In which example would you anticipate that the seller would achieve a higher price for the sale of his used car.
Understand consents and approvals that will be required. The seller needs to understand what consents and approvals will be required to consummate the sale. In most commercial agreements such as loans, licenses, leases, purchase orders, and supplier contracts, there are prohibitions and/or restriction in what is referred to as a “change in control.” Change in control can be defined differently in each agreement, but generally the agreement will prohibit a change in more than 25% of the ownership of the company without the prior written consent of the other party to the contract.
Some parties may be easy to deal with, such as a commercial landlord. In fact, some commercial leases contain a detailed provision of what the landlord will require from the prospective buyer to effectuate an assignment. On the other hand, certain parties may be very difficult, such as contracts with the U.S. government or other state agencies.
The important point is that the prospective seller should work with experienced legal and financial advisors to understand the full landscape of which commercial agreements will require consents and what will be required to achieve the consents, before starting the process to sell. Not only will timing likely be an integral component of the sale transaction, but if the buyer will not meet the requirements of the “other party” the seller and buyer should understand those issues before they even start the buy/sell dance.
Final thoughts
All businesses have their imperfections. By taking time to make sure your business’s finances and records are in order prior to listing it for sale, it’ll set you up for a smoother, uneventful transaction.
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