Preparing to sell your business when you first start may seem counterintuitive but doing so will greatly reduce the cost and stress later and will likely help you realize a higher valuation if you do decide to sell.
Starting a business is exciting. It’s also expensive. You’ve worked hard to save money to launch the business, maybe have raised some money from friends and family or other investors, and you are trying to be cautious in how and where you spend your money. It can be tempting to cut costs and assume you can “clean it up later”. The problem is that “later” never comes. You are busy doing what you do best, managing and building your business. Administrative issues, tracking down individuals to sign documents they should have signed at the outset, getting your accounting on the right track are all far down on the “to do” list.
As a result, many founders, while having done an amazing job growing their business, find themselves behind when an opportunity arises (sometimes very quickly) to sell their company. A potential buyer will initially conduct a detailed analysis of your business through a process called due diligence. They will ask to see a wide variety of documents, such as employment and corporate records, customer and vendor contracts, as well as your books and records and tax returns (among other things). All of this helps them understand your business to see what valuation is justified (or to confirm that the offer they made in a term sheet is accurate) based on the current financials and growth opportunities and what liabilities exist or might arise down the road.
A seller who is behind in having these documents and records in place already may unexpectedly find themselves spending a lot of time and money trying to retroactively get documents signed, obligations paid, and issues cleaned up. It also may give a possible buyer pause that the Company is not well organized and therefore potentially riskier. At best this delays the sale and at worst results in the deal collapsing or the buyer reducing the offered purchase price. It also will make the due diligence period extremely stressful. Much of this could have been avoided by handling the business from an administrative and financial side correctly from the outset.
Here are some common issues we see when helping our clients in due diligence:
- Doing a quick formation of their company on-line and not completing the organization process to make sure the legal entity is properly organized. On-line formations can be economical, but it is not uncommon for us to see clients trying to clean up organizational issues after the fact if they don’t follow through and complete the process.
- Forgetting to have employees and independent contractors sign offer letters, intellectual property assignment agreements, and commission agreements.
- Misclassifying employees as independent contractors.
- Forgetting to maintain accurate corporate records on an ongoing basis (annual shareholder actions/meetings, making annual state filings etc.).
- Using the cash basis of accounting rather than the accrual method when there was not a strong reason to use the cash method. The result is that it makes it more difficult for a potential buyer to obtain accurate historical records and predict cash flow in the future. Sometimes the seller then needs to change over their accounting method.
- Not obtaining a 409A valuation when pricing stock options if possible or failing to document and approve options in a timely manner, which can result in a higher exercise price for employees or unforeseen tax issues.
- Not paying sales tax in all of jurisdictions where products or software are being sold, which can create huge future liabilities for a potential buyer or force you to pay for audits and back taxes prior to a sale.
- Not using a payroll service to handle payroll to make sure all employees are paid accurately and timely, which can result in potential future liability for the buyer.
- Failing to keep accurate time records for all employees, which creates potential future liabilities for unpaid wages, meal breaks, overtime etc.
- Not having a system in place for tracking and keeping all customer and vendor agreements, which will need to be turned over during due diligence.
- Failing to document and obtain releases from departing shareholders.
The above is only an illustrative list of issues that we have seen. Forming the business correctly at the outset and staying on top of documentation and financial issues will go a long way towards reducing your stress and expense in the future and hopefully result in a higher sale price for your business.
If you have questions about the above or the due diligence process please reach out to Brandon Smith at bds@sfcounsel.com or Heather Sapp at hgs@sfcounsel.com.
Written by Brandon Smith