Mass High Tech
November 2-8, 1998
Prepare Early and Often for Eventual Sale or Acquisition
BY WILLIAM F. SWIGGART
Selling your company or a share of your company, whether to a single buyer or to the public in an IPO, can be a way to reward your investors and fulfill a long held exit strategy. However, many entrepreneurs fail to realize that consistent adherence to good standards of corporate maintenance and adequate documentation of all business arrangements during the life of their business can be just as essential towards realizing good value through a sale as having good technology, effective employees, wide market acceptance, and healthy revenues.
If your corporate books, financial records, contracts, ownership of intellectual property, liability situation, or any combination thereof are in disarray, you may be forced to delay a sale or, worse, to sell off your company assets piecemeal rather than as a going concern, either of which may greatly reduce the amount of value that can be realized.
Even if it is still possible to clean up serious flaws in your company documents immediately prior to closing, asking your acquisition or IPO team to do so will greatly increase your accounting and legal fees, and correspondingly lower your sale proceeds, and could delay your closing, giving the buyer time to "rethink" its purchase decision.
The Due Diligence Process
Because all company assets and liabilities must be documented in order to be conveyed, the buyers (or, in the case of an IPO, the underwriters) closely examine all company documentation for flaws prior to its acquisition. This process is known by the standard of care to which the buyer's representatives are held during their examination of the acquisition target: due diligence.
Due diligence has been defined as "such a measure of prudence, activity, or assiduity, as is properly to be expected from, and ordinarily exercised by, a reasonable and prudent man under the particular circumstances; not measured by any absolute standard, but depending on the relative facts of the special case." BLACK'S LAW DICTIONARY, 544 (1968) (citing Perry v. Cedar Falls, 87 Iowa 315, 54 N.W. 225).
The due diligence process begins immediately following the exchange of a letter of intent for an acquisition between buyer and seller or, in the case of an IPO, the underwriting agreement, with the underwriters (i.e., the investment banking firm handling the deal) acting as buyer. The buyer, via its attorneys and accountants then conveys to the seller a lengthy "due diligence request" - a laundry list of categories intended to garner all documents that might normally prove the value or point to the flaws of the target company.
The seller must provide copies of or make available for inspection all requested documents. The buyer's acquisition team will then pore over the documents to find any gaps, indicia of liability to third parties, or loopholes in contractual arrangements that might allow employees, customers, suppliers or vendors to attack or abandon the target company following its purchase.
Areas of Scrutiny
Keep the following in mind at all times in order to avoid negative results from a "duly diligent" buyer's scrutiny:
A. Maintain Corporate Organization and Good Standing.
The buyer's analysis will start with the state of your company's corporate organization, consisting of its charter and by-laws, minute books, share or option issuances, stockholders' agreements, etc. If multiple classes of stock, option arrangements, or lengthy stockholders' agreements have been entered into in the past, these likely will have created multiple, and possibly conflicting, rights for certain classes of investors.
Whenever any such arrangements expire or lose their relevance, the better practice is therefore to undertake all actions necessary to terminate them immediately. Otherwise, multiple and possibly disgruntled parties may have to be tracked down prior to a closing, and contractual waivers or terminations obtained at great cost of effort and delay.
Similarly, the regular updating of your company's corporate and tax filings with state authorities can eliminate nerve-wracking, last minute scrambles to update filings and attendant late fees in order to obtain good standing certificates from the jurisdictions where the company does business prior to the closing.
B. Keep Branch and Subsidiary Filings Up to Date.
Whenever your company maintains unincorporated branch offices in other jurisdictions, it is obligated to keep formal qualifications to do business on file in those jurisdictions, and to renew them on an annual basis. If there are any separately incorporated subsidiaries, each will be held to the same standards by the buyers as if it were a separate business in terms of charter, minutes of meetings, by-laws, and stock issuances: all these documents must therefore be kept up to date and accurate, or corrective actions will have to be taken and filed by the seller's attorneys promptly in order not to hold up the closing.
C. Clean up Residues from Prior Financings.
If your company has ever financed a large piece of equipment or taken out a bank loan, it will have entered into a security agreement with each creditor, backed by UCC financing statements filed with state and local registries. Unless you have regularly obtained and filed UCC Termination statements from those lenders as the underlying debts have been paid off, you will find yourself asking your acquisition team to chase down and file, again at substantial cost, termination statements from multiple parties with whom you may have long ago terminated business relationships.
D. Document All Contracts.
The strength of the documentation for your customer, distributor, joint venture, development and vendor contracts probably will have the most direct impact on your company's salability. This is because the thoroughness and care with which these arrangements have been documented will directly impact the perceived reliability of your company's revenue sources, especially clauses affecting the ability of your customers to cancel or of your company to renew its supply relationships and the protection and ownership of your company's intellectual property.
One company was forced to delay its IPO because the officer that negotiated a key technology supply contract failed to insist on a renewal provision. By the time the supplier grudgingly agreed to add the provision (after months of further negotiations) the IPO market had cooled, causing the offering price for the stock to drop by more than 50% below the underwriters' original expectations, thereby costing the company and its original stockholders millions of dollars. Ironically enough, the supply relationship proved itself in the end to be inconsequential to the success of the company.
E. Use All Legal Protections to Secure Intellectual Property.
A company's long term ownership of its intellectual property, consisting of patents for its inventions, copyrights for its software, trademarks and trade secrets must be protected not only by contractual means, but also through periodic review and filings with the appropriate authorities by a qualified attorney. Trademarks, for example, can be lost to the public domain or blocked through unchallenged conflicting uses by other parties.
Similarly, most business people are unaware that an invention cannot be patent protected in the United States unless the patent application is filed within one year of its first disclosure to the public. Even a press release can start the one-year clock. It is self-evident that the sale value of a company with a patented key product will exceed that of a company whose key technology has entered the public domain through untimely disclosure or, worse, has been blocked by a patent obtained by a competitor. Other key means of protection include the copyright and trade secret laws, which can be used to protect key technology through the timely and consistent use of the right agreements with customers and personnel.
F. Other Concerns.
Other important concerns may include the strength or existence of employment and contractor agreements, the terms and duration of real estate leases for company facilities (especially the ability of a company tenant to renew a lease on favorable terms in a rising market), hazardous waste liability, the existence of lawsuits or claims (for or against company), insurance coverage for such claims, etc.
The vigilant upkeep of all documentation for your company assets is a never-ending task, but one that, ultimately, will be as rewarding as any of the other practices that make up a successful business, especially in the event of a sale of your business or a share of it.
William F. Swiggart is a founding Member of Swiggart & Agin, LLC, a Boston-based law firm. He concentrates his practice in the representation of technology companies. This article was based on a talk given by Mr. Swiggart before the Entrepreneurs' Financing Roundtable of the Technology Capital Network at MIT.
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