Questions & Answers Regarding Legal Matters Relating to Exit Strategies

By:  William Mutryn, Holland & Knight, LLP

1. From a legal perspective, how far in advance of an expected exit event should business owners begin to prepare for the possible transaction?  What are some of the items that should be done to prepare?

ANSWER:  In general a sales process for a company will take approximately six months or longer from the time an investment banker is engaged to the time of the closing.  Three to twelve months in advance of engaging an investment banker, an owner should commence preparations for the exit event.  The preparations should initially include estate planning on the part of the owners as transaction will present tax savings opportunities arising from a possible exit event.  Additionally, certain legal related preparations could be done including:

1. A review and update of corporate books and records for compliance with corporate laws as well as confirmation of ownership and stock options, if applicable;

1. An assessment of compliance with applicable laws and regulations including employment, fair labor standards, government contract, and export controls;

1. An intellectual property audit to make sure that the company’s intellectual property is properly protected and that the company has the necessary intellectual property conduct of business;

1. Employment audit with respect to employment practices, including consultants and independent contractors;

1. A tax review to assess compliance with applicable tax rules including S-Corp. regulations

1. A government contracts analysis to ascertain any restrictions in government contracts, subcontracts, or teaming agreements as well as set-aside work; and. 

1. A financial analysis to create a waterfall chart of revenues projected for the next two years as well as backlog and pipeline reports.

2. What qualities in a company do acquirers look for and how would these qualities affect the marketability of a firm?

ANSWER:  Some of the qualities in a company that acquirers value and which improve the market value of a company are as follows:

1. Quality, depth and experience of management;

1. Corporate culture including loyalty of customers and loyalty of employees;

1. A history of internal growth and an effective business development organization;

1. Profitability including market or above-market profit margins and EBITDA margins;

1. Strong and loyal customer relationships;

1. Capabilities including core competencies in areas that are expected to be in demand by customers in the future;

1. A strong backlog with few major contracts up for re-compete in the near future;

1. A strong a vibrant pipeline of future business opportunities to sustain growth;

1. Proprietary intellectual property; and

1. Limited small business or set-aside contracts and a proven ability to compete in a full and open environment.

3. In general, what are some of the major terms that sellers should expect to encounter in an exit event and what terms should sellers strive for?  These might include escrows/holdbacks, survival periods, indemnification caps and baskets, working capital requirements and non-competes.

ANSWER:  The terms and conditions of transaction documents have become much more complex in recent years and contain numerous terms, conditions, and provisions.  Some of the most important terms expected to be encountered by sellers and the prevailing range of how they are typically resolved are as follows:

1. Escrow/holdback.  In general a certain percentage of the purchase price is paid into an escrow account or held back by the purchaser as security to satisfy future indemnity claims.  The typical amount in these escrow/holdbacks are 10 to 20 percent of the purchase price.  Sometimes a promissory note is substituted for an escrow/holdback.

1. Survival Period.  The survival period for general representations and warranties is normally in the range of 12 to 24 months.  However, the survival period for certain “fundamental” representations and warranties, including title, authority, and capitalization and indebtedness, is typically unlimited and the survival period for certain “statutory” representations and warranties, including taxes, ERISA, and environmental is the end of the applicable statute of limitations periods.  Government contracts representations and warranties are treated separately and generally survive as long as the general representations, until the expiration of the statute to limitations or until a date in between these dates, whichever is negotiated.

1. Indemnification Provisions.  In nearly every transaction other than public company sale transactions, the sellers are required to indemnify the purchasers for breaches of representations, warranties, and covenants.  For general representations and warranties, there is usually a cap on the maximum indemnification amount and it can range anywhere from 10 to 30 percent of the purchase price.  The “fundamental” representations and statutory representations as well as willful misconduct and fraud, and specific known claims are normally outside of this cap and for these matters the cap is normally the purchase price.  There is typically a basket, which can be either a deductible or first dollar basket, and the amount of the basket is generally in the range of one-half to one percent of the purchase price.  Sometimes there are minimum claim sizes.

1. Working Capital.  In most transactions a target level of working capital or tangible net asset value is negotiated and this is the level that the selling company is obligated to have on its balance sheet at closing.  Typically there is a downward adjustment if the company falls short of the target level and often times there is an upward adjustment if the company exceeds such target level.  The level of working capital is negotiated based on the historic amount of working capital required to operate the business. 

1. Non-competes.  In most transactions the principal owners of the selling company are required by the buyer to enter into non-compete agreements that restrict their ability to compete with the company and solicit employees and customers for some period of time.  The ranges of terms for non-compete agreements are normally three to five years following the closing or one to two years following the employment of such person by the company or the purchaser.  The scope of the non-compete is negotiable. 
   

4. When should an owner disclose a possible exit to key employees and what incentives can be offered to motivate key employees to cooperate in a possible transaction?
 
ANSWER:  As a general practice, business owner would disclose his or her desire to execute an exit strategy to only a few key employees.  At the time a firm decision to sell is made and an investment banker or financial advisor is retained, a business owner would disclose the event to a small group of trusted employees who need to know for purposes of assisting in the transaction.  Normally this would include the Chief Financial Officer and one or two others.  Sometimes the company and the affected employee would sign a non-disclosure agreement emphasizing the employee's obligations not to disclose this sensitive information.  After a letter of intent is signed and a purchaser begins to conduct detailed due diligence, in most circumstances a larger group of key employees are brought into the circle of knowledge and they may enter into non-disclosure agreements.  At the time of signing a definitive agreement, closing or public announcement, then all employees would be informed of the transaction and normally meetings would be held with the new owners of the company.

There a number of incentives and techniques to more fully align the interests of key employees with the interests of owners in undertaking an exit strategy.  First, owners can enter into retention or transaction bonus agreements with key employees whereby the employee would receive an extraordinary bonus upon the closing of the sale which would be conditioned upon the closing and the employee entering into appropriate employment or retention agreements with the new owners.  Other economic incentives include stock options, phantom stock or Unit Appreciation Rights Plans.  Each has certain advantages and disadvantages, both financially and tax wise.

5. What impact do small business or set aside contracts have on the ability to complete a sale transaction and the valuation that a firm may realize?  What M&A structures have been used with respect to set aside contracts?
 
ANSWER:  Small business and set-aside contracts held by a company, ever since the SBA recertification rule in 2007, have a direct effect on the valuation and often the ability of a company to effectuate an exit strategy.  The SBA Rule requires a recertification within a certain number of days following a merger or sale.  Such recertification in and of itself does not trigger a termination of the set-aside contract.  However, the agency can no longer take small business or set-aside credit for such contract and there is an increased likelihood that if there are future option years, such options will not be exercised and instead the customer will re-bid the contract on a small business or set-aside basis.  This provides the buyer with a lower assurance regarding the sustainability of a company’s business and may result in the buyer paying a lower purchase price.

Contractual terms and structures have evolved to deal with small business or set-aside contracts.  If small business and set-aside contracts constitute a discrete segment of the business, it is possible for a company to divide itself and sell only the portion of the business that does not involve set-aside contracts whereby the business owner would retain the portion that has set-aside contracts.  Sometimes this is impracticable due to the overlap of employees and infrastructure.  Another approach is for the buyer to pay earn-out or contingent payments based on the exercise of future option years under small business or set-aside contracts or the migration of such work into a full and open contract vehicle.  These earn-outs can take a variety of forms and often involve comprehensive set of earn-out covenants to protect the seller’s ability to achieve the earn-out.  

6. What are alternatives to a sale of a company for an owner to achieve liquidity and compare the advantages and disadvantages of each?

ANSWER:  If the owner of a company desires to achieve liquidity and its sale transaction is impractical or non-economical, a number of alternatives are available.  First, the company can recapitalize itself with debt including senior debt and subordinated debt and use the debt to make stock repurchases or distributions to the owners.  Secondly, the company may be able to recapitalize with equity by selling a minority share of the company to equity holders and achieving some liquidity through the sale of minority interests.  Third, the company can consider an Employee Stock Ownership Plan (“ESOP”).  An ESOP can be formed to purchase either a minority interest, a majority interest, or all of a company and there are favorable tax benefits for sales of stock to ESOPs.  With ESOP transactions however, there are additional tax and legal issues which will involve significant costs as well as enhanced legal requirements.