I have been involved in numerous lower middle market M&A transactions as an attorney and as an investment banker. I have also consulted with companies as they prepare for a sale process. As a result of this experience, I have a good sense as to what the owners and senior executives of lower middle market companies should do to prepare the company for sale. Below are some of my thoughts on how you can prepare your lower middle market company for a successful sale process.
Plan Ahead, Way Ahead
Selling your company can be – and probably will be – a long, complex process that will likely take six months to a year (or longer) from when the sale process starts until the sale closes. Selling a company is almost always a major distraction to management, as the process will take up the bulk of management’s time, which can interfere with operating the business. The best thing management can do is plan way ahead – a year or longer from when the sale process is expected to start. Why so long you ask? It’s because you will want to work with your legal, accounting and tax team to prepare the company for a sale.
Get Your Core Team Together and Start Planning
It is crucial that you have your advisory team (attorneys, accountants, tax advisors, etc.), and select members of your management team, identified and in the loop well before you start the sale process. Only a few trustworthy people in your company should know the company is preparing for a sale, because you don’t want your employees, customers, competitors and vendors to know that you are considering a sale. Once your core team is identified, you should meet with this team to discuss the process and the steps needed to prepare your company for sale. You should also meet with this team on a periodic ongoing basis to make sure the pre-process is moving forward smoothly. If at all possible, the core team should meet off the premises of the company. The company’s accounting firm or law firm will usually gladly offer meeting space for core team meetings.
Some of the actions your company and core team should take well before the formal sale process begins should include the following:
- Financials. Many buyers prefer target companies to have at least a few years of audited financials available to analyze before a sale. Some buyers will accept unaudited financials so long as they are prepared in accordance with generally accepted accounting principles (GAAP) by a reputable accounting/audit firm. If the company’s financials are not audited and/or aren’t GAAP, then it will take time for the company’s accounting/audit firm to prepare GAAP and/or audited financials. A company with strong financials can often command a better valuation than a company with weak financials. In addition, discuss contingent liabilities with your accountant, as you want to make sure any contingent liabilities are adequately disclosed in the financials.
- Taxes. In addition to getting your financials in order, you also need to have your taxes in order. Your tax returns will be scrutinized by the buyer and in the deal documents you will represent that all tax returns are complete, accurate and timely filed, and that all taxes are paid.
- Legal Matters. A key component of the sale process is legal due diligence. Buyers and their legal team will spend a significant amount of time very thoroughly reviewing the company’s corporate legal documents, cap table, major contracts, intellectual property, employment matters, environmental matters, litigation, and more. If the company’s legal matters aren’t in good order, the sale process can be delayed while the company updates its legal matters to a current date.
- Employment Matters. A key area of scrutiny in the sale of a company is employment matters. The buyer will want to review the employment and consulting agreements, confidentiality agreements, benefit plans and equity incentive grants (such as stock options) as well as any employee disputes. Buyers will also want to identify key personnel that they will need to continue with the company after the sale.
- Intellectual Property. Intellectual property (IP) includes patents, trademarks, copyrights, trade secrets, domain names, websites, social media, customer information and more. A buyer will conduct due diligence to confirm that the selling company actually owns and has adequately protected its IP. You should work with your IP counsel to make sure that all IP is in good order before launching the sale process.
- Litigation. Legal disputes are inevitable in business. If your company is a party to any litigation, or is involved in any legal dispute, or is aware that a legal dispute is likely, discuss with your attorneys on how to deal with these. If it is possible to resolve some of the disputes prior to the sale process, it can help to smooth any concerns the buyers have about litigation.
- Address Financial and Operational Issues. A company may have financial and/or operational issues that should be addressed prior to launching the sale process. Financial issues can include AR aging, high debt levels, volatile cash flows, and more. Operational issues can include customer concentration, customer churn and employee turnover. A company that has lots of financial and operational issues will have a harder time commanding a premium purchase price from a buyer.
- Maximize EBITDA and Other Key Metrics. EBITDA and EBITDA growth rate are probably the most common “high level” financial metrics that buyers use to value a lower middle market business, with revenue and revenue growth close behind. Buyers will also analyze working capital, capital expenditures (capex) and “free cash flow”. As you develop relationships with investment bankers, you can ask them about the metrics (Key Performance Indicators) that buyers will consider most when analyzing the business, and then you can determine how to maximize these metrics.
It is really important to address the foregoing points well before starting the formal process to market and sell the company. If the foregoing issues aren’t addressed, the company may look disorganized to a buyer. In the worst case, a potential buyer may think the company has something to hide.
Prepare Robust Financial Projections
As part of the sale process, the company will typically present three-to-five year financial projections in its marketing materials. These projections help support the valuation the company hopes to obtain in the sale process. Detailed financial projections take time to prepare and must be prepared on a “bottoms-up” basis, starting with operating metrics to build up to revenue and expenses, as opposed to “top-down” projections where revenue is based on industry metrics and market share. Your CFO should prepare these financial projections. If your CFO isn’t versed in financial modeling, consider hiring a consultant to prepare these projections. When you hire an investment bank, they will review through these projections and work with the company to refine them.
Develop Relationships with Investment Bankers
In most cases, the sale of a lower-middle market company will involve investment bankers. Start to develop relationships with investment bankers early in the pre-sale process. Investment bankers can be tremendously helpful to a company as it prepares for a sale by providing industry information and key financial and operating metrics. In addition, investment bankers will be able to provide informal valuation ranges for the sale of the company. You will want to develop relationships with several investment bankers with expertise in the industry and meet with them several times during the pre-sale process. Then, when you’re ready to start the process, you will likely know which investment bank you will want to retain.
Prepare Company Presentations
Some companies get a head start on preparing the marketing materials for the sale of the business. The marketing materials include an executive summary, a presentation and sometimes a Confidential Information Memorandum, or “CIM”. Some companies I have worked with will work with a consultant to develop these materials before engaging an investment bank, as a means to articulate the Company’s vision, strengths, competitive advantages and financial results and projections. This exercise could speed up the actual sale process.
Prepare a Data Room
Buyers will provide the target with a due diligence request list, which asks the company to provide, usually in an online data room, extensive financial, operational and legal information about the company. Responding to due diligence request lists is a very time-intensive and laborious process. You might consider asking your attorney for an example of a buyer-oriented due diligence request list. With this due diligence request list in hand, you can create an online data room (Dropbox, Box, SharePoint, etc.) and start pulling together the information and documents identified in the due diligence request list. While the actual buyer due diligence request list will likely be different than what you have used to prepare the internal due diligence room, most of the hard work will have been done and it will be a matter of moving documents from the company’s internal data room to the buyer’s data room.
Understand Deal Terms
When a letter of intent or term sheet is presented to the company, it will include the purchase price, the structure of the transaction (stock purchase, asset purchase or merger), and a variety of deal terms, including but not limited to:
- Consideration type (cash, cash and management rollover, stock, or cash and stock);
- Earnouts and milestone payments;
- Treatment of options;
- Post-closing purchase price adjustments;
- Indemnification baskets and caps;
- Representations and warranties insurance; and
- No shop provisions.
There are M&A deal terms studies that your attorney can provide to you and you should devote time learning and understanding the deal terms, their variations and the impact on the deal.
Establish and Use a Separate, Non-Company Email For All Communications Relating to the Sale
After a sale of the company closes, the buyer will typically own all existing emails, domains, social media accounts and more. Because of this, the seller should not use their work email for matters relating to the sale of the business. If a seller uses a company email account to discuss sensitive matters (such as customer problems, litigation, etc.) then the buyer could possibly use these emails against the seller after the closing, by saying the seller didn’t disclose the problems and therefore committed fraud. Attorneys will include provisions in the sale documentation that attempt to address these concerns, but you should discuss with your attorneys whether you should set up separate, non-company email accounts for the core team and to use those non-company email accounts for the sale of the business. Sellers should also use a separate email for personal matters.
Interview and Hire Your Investment Banker
If you’ve developed relationships with several investment banks during the pre-sale process, you may know which investment bank you want to hire. If not, you will undertake a formal process of interviewing bankers, called a “bake-off” or a “beauty contest.” In this process you will interview several investment banks (usually somewhere from three to seven banks, sometimes more), and they will pitch you to show you that they have deep industry knowledge and relevant experience, and how they can obtain the best price for the company on the best terms. Once you’ve identified the investment bank you want to retain, work with your attorney to negotiate the terms of the engagement letter.
Start the Sale Process
Once the investment bank is on board, the sale process begins. These sale processes take on a life of their own and can be time consuming, frustrating and exhilarating all at the same time. If you have prepared yourself and your company for the sale process, it can be a smoother process with fewer bumps along the way.
The best thing a company can do is to be prepared well before the actual M&A sale process begins. Starting early, getting the company’s house in order, and preparing for the M&A process can make the actual sale process go more smoothly, with fewer surprises, and may result in a better outcome for the sellers.
Hat tip: A big Thank You to Ron Foy for his valuable contributions to this article.