Unlocking value and managing risk in an exit of a privately held business

Before embarking on a sale of a privately held business, a business owner should understand the strategic and legal considerations involved in the process. Understanding the process can increase the owner’s control and leverage, manage transaction risk and unlock value.

Some of the strategic considerations in the pre-contract stages of the sale process include:

  • Undertaking due diligence and getting affairs in order
  • Maintaining control over the disclosure of information
  • Controlling the auction process

Undertaking due diligence and getting affairs in order

Preparation for a sale should include a due diligence by the owner on its business. Potential buyers will conduct their own due diligence, and at the very least, the owner should know the issues that are likely to be raised by the buyer. This will allow the owner and management to prepare responses to key questions that a buyer might ask and reduce the risk of being surprised by unanticipated issues.

The owner’s due diligence process may also reveal certain areas which could decrease the value of the business and result in adjustments to the purchase price. If such areas are identified early in the owner’s due diligence process, this will provide the owner time to take any corrective actions to address these issues such as:

  • tidying up existing company records;
  • ensuring that all necessary forms have been lodged with the relevant authorities;
  • resolving any outstanding claims or risks of litigation; or
  • putting in place appropriate intellectual property protections like registering a trade mark.

A number of these steps can be easily undertaken, but a poorly organised business could be perceived by potential buyers as a business with operational or other weaknesses and risks which could, in turn, result in a reduction in value.

The owner’s due diligence process can also identify legal risks in its arrangements with key suppliers and customers that go directly to value. Being aware of the issue will enable the owner to formulate strategies to address it. This may involve identifying the right time to negotiate a change to the arrangements with the customer, for instance, an extension of the term of the contract.

Identifying execution risk

Due diligence by the owner is also key to ensuring that there are no major stumbling blocks to the execution of the sale, such as whether there are any confidentiality obligations applying to the disclosure of key information about the business and whether consent from third parties are required to make such disclosure.

If the sale is to be structured as a sale of the entity that operates the business, the owner’s due diligence process should identify whether there are any “change of control” provisions in key contracts. These provisions could be in the form of requiring the consent of the counterparty to any change of control of the entity proposed to be sold, or triggering a termination or other right exercisable by the counterparty on such change of control.

If the entity being sold is only one of a group of entities, the owner’s due diligence should also consider whether any action is required to disengage that entity from the group. For instance, this could involve obtaining a release of the entity from the group’s financing facilities, or if the group is consolidated for tax purposes, the steps required to exit the entity from the tax consolidated group.

Maintaining control over the disclosure of information

Managing the disclosure of information in the due diligence and bid phase of the sale process is a way in which the owner can maintain control of the process. The timing and way in which key information about the business is disclosed can be vital to maximising value and managing risk for the owner.

Requiring potential buyers and their advisers to enter into a confidentiality agreement before being provided information about the owner’s business is the primary means of managing unauthorised use or disclosure of the confidential information of the business.

Data room

Another strategic consideration for the owner is the extent and detail of the information that should be disclosed, typically in a data room, to the potential buyer during the buyer’s due diligence process. As mentioned above, in some cases, confidentiality obligations owed to third parties may prevent the disclosure of certain information. Depending on the stage of the transaction and how many potential buyers there are at that time, the commercial implications of disclosing certain types of information will also need to be considered. For instance, if a potential buyer is a competitor, certain commercially sensitive information may need to be excluded from the due diligence data room.

The use of a “black box” in the data room to separate such sensitive information, where such information is not disclosed until the final stages to the ultimate buyer, can be a way of managing this risk. The existence of black box information, and therefore, information considered to be important to the owner may also be perceived by a potential buyer as a signal of value.

Access to the data room will generally be regulated by a set of data room rules which specify the procedures and protocols to be followed by a user when accessing the data room. These rules will also typically contain confidentiality provisions and a disclaimer by the owner of any responsibility or liability with respect to the information in the data room. However, as it is not possible to contract out of prohibitions on misleading or deceptive conduct under legislation, the owner must take care during the sale process not to engage in misleading or deceptive conduct and should not assume that wide disclaimers will allow the owner to avoid liability for such conduct.

From the perspective of value to the transaction, a well thought out and logically presented data room will add to the owner’s credibility and demonstrate to potential buyers that the business has the systems and tools to manage and track the key business information.

Vendor due diligence report

In a sale process where there are several potential buyers who are granted due diligence, the owner may find it useful to have commissioned a vendor due diligence report that can be shared with the potential buyers. A vendor due diligence report is one which the owner/seller commissions an expert, such as a financial or tax expert, to prepare on a relevant aspect of the business. The expert is usually independent, so as to give a level of comfort to the potential buyers.

The key aims of the vendor due diligence report are to provide, as far as possible, a level playing field for potential buyers in relation to information about the business, which may enhance competitive tension, and to reduce the burden on the owner of having to respond to multiple requests for the same or similar information from several potential buyers.

It may also shorten the due diligence period required by potential buyers, ensuring that the momentum of the transaction and interest of the potential buyers are maintained.

Controlling the auction process

If the owner decides to undertake an auction process for the sale, it is important that the owner maintains careful management over the process.

Bid instruction letter

As a starting point, it would be useful for the owner to have a clearly prepared bid instruction letter which should set out the parameters and assumptions that bidders should apply in making their bid. This allows the owner to compare the bids on the same basis. For instance, it would be much easier for the owner to compare the bids if the bid prices were all determined using the same assumptions and adjustments.

The bid instruction letter should also require the bidders to specify any major conditions precedent to completion. A bid that is subject to a condition that may be difficult to satisfy (for instance, subject to the decision or action of a third party) may not be as desirable as a bid which is subject only to conditions within the control of the parties to satisfy, even if the former bid was for a higher price.

Term sheet

Following the bid process, the owner may choose to enter into a term sheet with the preferred bidder. A term sheet, also known as a heads of agreement, memorandum of understanding or letter of intent, is a document which is commonly used to set out the main terms of the transaction. The intention is often that the term sheet will not be legally binding (subject to certain provisions such as confidentiality or exclusivity being binding), with the intention that the term sheet will set out the framework within which the legally binding agreements are to be prepared.

If the buyer needs to obtain external funding for the purchase price, the entry into the term sheet could also be the trigger required for the buyer to start the process with the financiers.

Even if the term sheet is not intended to be legally binding, there are advantages in spending some time and care in negotiating it. This allows the parties to focus their minds on the key substantive issues of the transaction, such as price and price adjustment, transaction structure, the potential scope of the warranty and indemnity regime, and conditions to completion. In this way, the term sheet identifies the way forward to a level of detail that enables the parties to progress the transaction from a position of mutual understanding, thereby hopefully simplifying the negotiations on the binding agreements.

For example, one area in the term sheet which could have the potential to lead to an erosion of the purchase price when the binding documents are negotiated is the level of detail that the term sheet provides on any purchase price adjustments. For instance, it is not unusual for the purchase price to be stated to be on a “cash-free/debt-free” basis and often this term is used in the term sheet without further specifics of what that term is actually intended to mean. In simple terms, “cash-free/debt-free” means that the seller keeps all cash and pays off all debts of the business at completion of the sale. However, what can become contentious is what constitutes “cash” and/or “debt” of the business. For instance, does cash mean just the amount in the bank account or does it take into account deposits in transit and cheques drawn? Do the debts include trading debts arising in the ordinary course of business and hire purchase or finance lease agreements? As there are no standardised definitions for this term, if the term sheet is vague on these concepts, there is a potential for the final definitions in the binding agreements to be more unfavourable to the owner than originally anticipated, thereby eroding the purchase price.

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