Canada: Sale Of A Business: Making A Controlled Auction Work For You

ONE EXTREMELY ATTRACTIVE WAY to sell a business is by means of a controlled auction, in which the seller of a business solicits bids through a process that it creates and controls. In a sense, such a seller gets to have its cake and eat it too. The risks and uncertainties of waiting for unsolicited takeover bids are largely avoided, while the higher number of bidders that generally participate in a controlled auction will tend to increase the potential of a satisfactory sale price.

Sound like a good deal? For many types of business, it can be. But a controlled auction is a major commitment, requiring careful planning and strong leadership. Broadly speaking, however, there are several strategic keys to success:

• Being prepared
• Being clear about objectives
• Maintaining control of the process
• Keeping key employees motivated
• Staying focused on closing

In what follows we discuss the process in greater detail, from setting objectives through to closing a successful deal.

In most cases, and especially if the business is a public company, the primary objective of a controlled auction will be to generate the best possible cash purchase price. But sellers will often have other objectives and concerns that can also influence the choice of a winning bidder. Sellers should accordingly ask themselves questions like these:

• Do we plan to retain some equity of the ongoing business?
• Are we willing to enter into restrictive agreements that will hinder our ability to compete in this line of business in the future?
• To what extent are we willing to stand behind the business in the form of ongoing indemnities?
• Is it important that the business continue as a going concern? Does it matter to us whether its core business values are maintained? (Such considerations usually arise in respect of smaller private companies.)

Some time ago, a large company wished to divest a steel operation that had become a non-core asset. The company decided to start a controlled auction. As is usually the case, this decision was not without its costs: it takes time and money to carry a controlled auction forward. After months of narrowing the list of potential bidders, the deal fell apart. Why? Because certain environmental liabilities had not been segregated from the target business. When potential purchasers found out about this, they lost interest. Not even an offer of a strong indemnity from the seller’s parent would help.

The moral of the story is simple: Plan Ahead. It’s important to identify any roadblocks to a sale before the auction starts. Improvising solutions on the fly can be costly and difficult. Each business is different, but the environmental issues faced by the steel company are a good example of a roadblock that many businesses face. For others, it will be the necessity of providing audited financials, of clearing up trademark and intellectual property ownership, of getting lawsuits off the books, or of isolating other types of potential liability. If sellers face these questions realistically before beginning the process, they might even conclude that a controlled auction is not the way to go, saving themselves and their business time, money and headaches.

The due diligence process will typically involve outside advisors who can advise on the best way of marketing the company’s assets. For example, while business owners tend to think of their business as a single entity (and therefore to assume that it must be sold as such), an advisor might see advantages to breaking it up into separate saleable divisions. For instance, if a parcel of land is the most valuable portion of the business, it may make sense to sell it separately from the physical assets of the business (perhaps with the help of an experienced commercial real estate agent). These considerations add further impetus to the "Plan Ahead" strategy: the last thing the seller wants is to think of a better way to market the business after the controlled auction is already underway.

Once a decision has been made to start a controlled auction, a company will typically choose a financial advisor to assist it. Choosing the right advisor is critical: companies should look for a firm with strong experience in their industry. Smaller companies may find it advisable to choose a quality boutique advisor whose fees and interests are geared to smaller transactions. Boutique advisors will often negotiate a lower work fee in hopes of making it back on the basis of a large success fee. For a small company, this kind of arrangement may be preferable.

The seller will also require a legal advisor. It is important that the counsel it deals with be experienced in advising on controlled auctions. This may make it advisable to look beyond traditional local counsel. Retaining a large and specialized firm whose practitioners are experienced in the process and its associated purchase agreements can enhance value and mitigate risk.

The next challenge is finding prospective buyers. Typically, the financial advisor will use its contacts to solicit interest. It will create an initial overview of the business that may take the form of a "teaser" or short letter setting forth the basics of the business for sale and the elements of the sale process. Once a preliminary list of interested parties has been identified, the seller will give appropriate consideration to the economic case of each potential bidder as well as to any other objectives that it may have established. Out of this will come a short-list of bidders to whom a Confidential Information Memorandum (CIM) (or some other form of descriptive memorandum regarding the business) will be distributed.

One of the challenges of an auction process is that a prospective purchaser who might otherwise offer the greatest purchase price may also be disinclined to participate in this form of competitive bidding process. Such a purchaser may subsequently make a more valuable offer outside the auction process. In this circumstance, a special committee of a board of directors or a board of directors generally may face a difficult decision regarding what constitutes the best offer for shareholders. In these circumstances, experienced financial and legal advisors are critical.

Once expressions of interest are identified and a shortlist of prospective purchasers is determined, the financial advisor will circulate a confidentiality agreement governing the rules of disclosure and the initial relationship between the parties.

Under the confidentiality agreement, potential purchasers will generally have to make a series of commitments similar to the following:

• That they will not use any evaluation material or material derived therefrom except to determine whether they wish to proceed with a transaction.
• That they will not disclose any such evaluation material except to employees and representatives involved in the evaluation (these employees and representatives should also agree to be bound by the terms of the confidentiality agreement).
• That they will not disclose the fact that the prospective purchaser has reviewed the evaluation material (this is meant to offer a measure of protection against prospective purchasers discussing the target business between themselves).

In some, but not all cases, prospective purchasers will also be asked to sign non-solicitation or other "no contact" provisions in respect of the target company. This provision allows the target company to determine those bidders who are serious about a purchase and those who are merely "kicking the tires".

In many circumstances, due diligence is split into phases. The first phase provides a general overview of the business as well as certain financial data. The second phase takes place only after there have been preliminary bidding rounds and the level of interest among prospective purchasers has been ascertained. Second phase due diligence would involve information of a much more sensitive and competitive nature, such as pricing agreements with customers and suppliers.

In a controlled auction, the second phase of due diligence generally begins once prospective purchasers have signed confidentiality agreements and been provided with a CIM. During this phase, the financial advisor will often arrange management presentations and site tours (depending on the nature of the business in question). At the same time, representatives of the prospective purchaser will conduct detailed due diligence. While traditionally due diligence has occurred at the office of the legal representative of the seller, on-line data rooms are becoming increasingly prevalent, offering greater confidentiality, less paper and reduced travel requirements. However, they can also slow the process down because of the lack of interaction between representatives of the prospective purchaser and the seller.

Commonly, the most challenging factor in this phase of the sale process is keeping senior management and key employees motivated. Their participation is crucial in trying to maximize the purchase price but key members of this team often know their future with any prospective purchaser may be limited.

Auctions can be drawn out affairs and place enormous strain on a company. Identifying a strong leader to spearhead the process is critical. The leader needs to be engaged and to have the authority to make decisions to keep the process moving forward. "Stay bonuses" are often used as a tool to retain and motivate senior management and key employees during this important portion of the due diligence process. Stay bonuses are typically paid at the end of a sale process and require the participation of the employees up to and including the closing of any sale transaction. Sellers will often tie the amount of the bonus to the success of the auction process. Often, severance arrangements are also negotiated in order to keep key employees involved through the process despite the fact their prospects with a prospective purchaser may be limited.

After conducting its due diligence, attending management presentations and participating in site tours, prospective purchasers will be required to submit final binding proposals. At this stage, the seller should keep in mind that maintaining the "illusion of the auction" is key to obtaining the highest possible bid. That is, in cases where few bids are submitted and especially in cases where only one bid is submitted, the seller will want to ensure that remaining bidder(s) continue to feel a sense of competition.

As part of the final bid process, prospective purchasers will be provided with a "seller friendly" purchase agreement and be asked to provide a letter of intent (LOI) or Memorandum of Understanding (MOU) which are meant to form the basis for the agreement between the parties. In some circumstances, a seller will not require an LOI or MOU and will simply have purchasers provide a marked-up copy of the purchase agreement with the purchase price identified.

While it is impossible for us to mention all of the factors to be considered in the context of a definitive purchase agreement, a seller should keep the following in mind:

• Minimize the number and extent of representations and warranties.
• Make copious use of "materiality" (with reference to the business and assets taken as a whole) and "knowledge" qualifications and, in the latter case, define "knowledge" to be the actual knowledge of particular individuals—usually senior officers of the company.
• Use objective or factual representations and warranties (e.g., "the company has not received written notification of any breach of any of its material contracts in the past two years") rather than subjective representations and warranties (e.g., "the company is not in breach, in any material respect, of any of its material contracts") or the dreaded "full disclosure" warranty.
• If selling shares, indemnify only the buyer and not the buyer and the company itself.
• Limit the survival period of representations and warranties (e.g., one year following closing for most representations and warranties, longer periods for matters such as environmental liability (say 3 to 5 years post-closing) and taxes (typically the relevant limitation period).
• Try to preclude a buyer from seeking damages or other remedy for breach if it can be shown that the buyer had knowledge of the breach prior to signing the agreement and/or prior to the closing of the transaction (in some jurisdictions, including Ontario, legislation already makes this the case).
• Exclude consequential, indirect and similar heads of damages and, even though loss of profits may not be consequential damages, try to lump all of these heads of damages together as exclusions.
• In the indemnity provisions, provide not only for the rules applicable to making any claim (e.g., written notice, particulars, etc.) but also consider limits of liability on the aggregate claims that can be made. The U.S. practice of limiting total claims to a percentage of the purchase price has been creeping into Canada and it is now common to see a ceiling as low as 20% of the purchase price as a limit on claims.
• Consider inserting thresholds for making claims (or better still, actual losses incurred) as a deductible (e.g. $100,000 or 1% of the purchase price) rather than a threshold or de minimis where claims go back to the first dollar.
• Always expressly include provisions requiring the purchaser to mitigate its damages and to offset any tax benefits, insurance or other amounts received by the purchaser.
• If the transaction is entirely domestic it probably is not advantageous to arbitrate any dispute (arbitrators tend to "split the baby"). But if considering a cross-border transaction, consider using arbitration provisions particularly to avoid the potential of costly jury awards.
• Try to provide that claims under the indemnity provisions (with appropriate qualifications and limitations) are the exclusive remedies of the buyer (i.e., no rescission or rectification of the agreement).

One final comment: in any transaction, the devil is in the detail. Therefore time spent on the definitive agreements will always be worthwhile.

A number of factors will influence the choice of the winning bidder. Generally speaking, no factor is as important as the purchase price submitted as part of the bid (again, especially in the context of a public company seller). As a result, a purchaser who is confident that it is submitting a favourable purchase price will often make significantly more changes to the purchase agreement than would ordinarily be tolerated by the seller.

However, notwithstanding a high purchase price, sellers may also be motivated by other factors, including:

• Timing of closing: in the context of a divestiture mandated by the Competition Bureau, timing of a divestiture can be more important than price.
• Conditions to closing: for instance, the ability to obtain or transfer certain sensitive permits or consents.
• Ongoing liabilities and the extent of indemnification: typically, a seller will not want to provide an ongoing indemnity for more than 25% of the purchase price, while purchasers will often seek 100% or more.

Once a purchaser is chosen, legal advisors undertake responsibility for closing the transaction. While this process is underway (typically there is a period of 30 to 90 days between signing of the purchase agreement and closing), it is critical, and often mandated by specific covenants under the purchase agreement, that the business continue to be run in the ordinary course. As at the start of the process, success in closing will depend on being prepared, knowing one’s objectives, controlling the process, keeping employees motivated and staying focused on closing.