What They Don’t Tell You When You Sell Your Company

January 12, 2021Article

Selling your company for a huge profit sounds enticing. What could be wrong with getting a huge up-front payment at capital gain rates in lieu of years of future sweat for an uncertain return and ordinary income treatment? That is certainly true, but there are some potholes in the road to be aware of before embarking on this journey. This article gives a realistic view of the ups and downs of this process in a typical sale.

Step 1: Speed Dating. In the initial stage, you will retain an investment banker and lawyer, and together they will usually solicit a number of potential buyers with a “teaser” PowerPoint. Most will pass, but some will express some interest, and the interested buyers will be required to enter into a non-disclosure agreement (“NDA”) and will be given some additional information on your company. After a bit of speed dating, you will settle on one potential buyer that seems serious and is willing to pay the most.

Step 2: Going Steady. Once you settle on one buyer, you will spend a lot of time negotiating a term sheet that spells out the general structure of the intended deal, but the only binding provision will be your grant of an exclusive negotiating period (usually ninety days) to the buyer, during which you can’t pitch your company to other potential buyers.

Step 3: The Prolonged Engagement. Once you sign the term sheet, the fun ends and reality slowly sinks in. Your expectation, based on the typical ninety-day exclusivity provision in the term sheet, is that the deal will be closed within three months and should be relatively painless given events so far. Oh, but were it so. Here is the reality of what will happen:

  • On most deals, the transaction will take at least six months.
  • You will be inundated with endless “due diligence” requests for information, and you will definitely need a full-time information tracker-downer. You will feel that your privacy is being invaded and as though someone is rifling through your underwear drawer and medicine cabinet.
  • In particular, you will be besieged with requests for accounting information and back-up, including questioning all your accounting practices. In addition to the information tracker-downer, you will need a full-time additional accountant to deal with all the requests and to translate your accounting methodology into Generally Accepted Accounting Principles (“GAAP,” and more on this below).
  • You will spend endless hours on long phone conferences listening to investment bankers and lawyers bickering over esoteric issues you won’t understand but are told you need to insist on.
  • You will have heart-stopping moments when either you almost give up due to significant business issues that seem insurmountable or the buyer almost gives up due to due diligence discovery of issues that you thought were inconsequential.

Step 4: The Prenup Documents. Here is a list of the key documents and the critical issues for each:

  • The Employment Agreement. You will almost always be asked to sign an exclusive Employment Agreement, typically with a five-year term. The key provisions in this document are (a) the ability of the company to fire you for “Cause” and (b) your right to quit for “Good Reason.” These issues are relevant in determining if you continue to be paid your salary upon termination, and they are often relevant in determining the amount you are paid upon a later sale of any retained interest you have in the company.
  • The Purchase Agreement. The Purchase Agreement is obviously the key document that determines how much you get paid, and a big part of that will depend on a lot of accounting jargon, including GAAP, working capital, liabilities, and EBITDA, so you are going to need to become well versed in this terminology. The details of these issues are beyond the scope of this article, but here are some pointers:
  1. Unless you have annual audited financials, it is unlikely that your financials are prepared in accordance with GAAP, in which case you will have significant heartburn revising your financials to conform to GAAP.
  2. There is more room for maneuver applying GAAP than most people realize, since (a) many calculations are left to management discretion within reason, (b) it is relatively easy to manipulate some calculations (such as increasing working capital by moving liabilities from short-term to long-term), and (c) the contract may expressly permit some “adjustments” to GAAP that are big enough to drive a truck through.
  3. In almost all cases, you won’t be paid the full purchase price on closing, as usually at least 10% of the purchase price is held back or placed in escrow for between one and two years to cover any potential claims based on your representations and warranties. You will hear a lot of lawyer fights over the scope of your liability for breach of these provisions, using arcane language such as “double scrape,” “mini-basket,” “cliff deductible,” and “tax benefit offset.”
  • The LLC Agreement. In rare cases, the buyer buys a minority interest in your company, in which case there will be a long list of things you can’t do without the buyer’s approval. In most cases, the buyer buys a majority interest, requiring you to retain a minority interest in the company, typically with a put or call over your retained interest after five years. In these cases, you will cede control to the buyer, so they will be running the show from now on, and you will be on a short leash.

Step 5: Marriage. There will be chaos as closing comes closer, and you will blindly sign stacks of documents without reading them in an effort to get to closing. After much angst, a much longer negotiation than you expected, and deal fatigue by all parties, you will finally close, get paid, and pop the champagne. And that brings us to the two secrets no one will tell you upfront:

  1. You should work off the assumption that you won’t see another dime from the put and call of your retained minority interest in the company, because even if the buyer does not run the company into the ground (a not infrequent occurrence), the buyer’s control of the company will give it the ability to divert income from the company or to manipulate the accounting formula for determining the put or call price in order to drive the price down.
  2. More importantly, money can’t buy you love (or happiness). From now on, you will be taking orders rather than giving them, and many a seller has seller’s remorse after they get kicked around a bit and lose the pride and satisfaction of being captain of the ship. So think about this carefully before setting sail.