United States: Founders: Get The Most Out Of A Sale Of Your Company

The day you dreamed of has arrived: SuperCo has just offered big bucks to purchase your company. Before buying the Porsche, keep in mind that the purchase price is only one factor that determines how much money you will get out of the deal. The founder who is aware of the pitfalls will best be able to maximize her value in the sale.

A company that has reached the point of sale after one or more venture rounds will have negotiated preferred stock terms with its venture capitalists along the way. A founder who does not pay careful attention to the VC's liquidation preference may be in for a rude awakening when the VC walks away from the sale with a lot more than the founder expected.

The liquidation preference is the amount the VC gets upon a liquidation, merger or sale of the company before any payments are made to common stockholders. The most typical liquidation preference (and most appealing to founders) is one where the VC receives his original investment back if it is more than he would get by sharing in the sale proceeds on a percentage basis. This way the VC gets his money out first if the company is sold in a fire sale.

A more aggressive VC may try to impose what's called a "participating preferred" liquidation preference, which is much worse for the founders. With this stock, the VC gets his original investment back in a sale of the company (or even a multiple of his original investment), and then also shares in the remaining sale proceeds on a percentage basis. If you hit a home run, the participating preferred benefit will be lost in the rounding error. If you only hit a single or a double, it can dramatically shift the benefits of the sale from the founders to the investors. Since you can never be sure about where you will end up, try to avoid giving a participating preferred liquidation preference if you can.

A common mistake founders make when selling their business is talking to "the tax guy" too late. There are lots of ways to structure a deal (asset sale, stock sale, merger), multiple company structures (S Corp., C corp., LLC), and various combinations of stock and cash that can be given as payment. Each structure has its own tax consequences for both the buyer and seller, and there are ways to minimize and defer the taxes if you get the structure right from the start. It's not too early to think about these concerns when you first set up your company.

Will officers be subject to ongoing employment, consulting or non-compete agreements with the buyer? If so, it might save tax dollars to allocate some of the purchase price to these agreements. A good tax attorney can help you work through this, so talk to one before signing a letter of intent.

You can be paid in stock, cash or a note (which is less common). Cash is always taxable, and stock may be taxable, depending on the deal. If you are getting stock, don't assume that you can go out and sell the stock the day after the deal closes just because it is public company stock. Why not? In order to be able to sell the stock, the stock must either be registered as of the closing, come with registration rights, or become eligible for sale under securities laws within a short period of time.

Timing of the purchase price is also key, and buyers can tinker with the timing by using an "earn-out." This is where the seller receives part (or even all) of the purchase price after the closing, depending on the performance of the seller's business. An earn-out is useful when the expected profitability of the acquired company is hard to assess at the time of closing. From a seller's perspective, an earn-out has several problems: it is difficult to come up with an exact formula to measure performance, the seller is dependent on the buyer to provide the necessary resources to make the earn-out happen, and many acquisitions fail, resulting in little or no earn-out payment.

What should you do in an earn-out situation to maximize your eventual payout? Accept an earn-out only when one or more of the selling shareholders will stay on with the buyer and exercise control over development and marketing of the acquired assets. Make sure the earn-out formula directly tracks the performance of the assets acquired in the sale, rather than the seller's overall business. Evaluate the timing of the earn-out, as well as the milestones and the likelihood of achieving them. Make sure the buyer commits to a large enough marketing and hiring budget for the entire earn-out period. Maintain as much control as possible over whether the earn-out is reached: paying attention to these details before the sale is finalized is the best way to do that.

A buyer can put mechanisms in place which can lower the value of the sale after the closing. In an asset sale context, the buyer can exclude specified liabilities of the seller, and those liabilities can reduce the purchase price post-closing when the seller is stuck with the bill. Also, many purchase agreements are drafted with such strong representations, warranties and indemnities that the selling shareholders remain exposed long after the deal is done. Review the deal documents carefully: watching your purchase price disappear after the closing can be a very painful experience.

Evaluate your buyer. Most deals these days are paid for with at least some stock, and the selling shareholders will thus become partial owners of the acquiring company for at least some period of time. Also, many (if not all) of the seller's employees will typically continue on with the acquiring company. Do your homework and carefully evaluate the strength of your buyer. Make sure you are joining forces with a company you believe in.

Bring a knowledgeable lawyer into the process early on. The farther along in the process you get, the less room there is for the lawyer to help.

Last but not least, don't forget to run your business while negotiating the sale. Deals crash for all sorts of reasons, and you don't want to be left holding less than what you started with.

Copyright 2001 Lucash, Gesmer & Updegrove, LLP