With the passage of summer and another Labor Day in our rear view mirrors, we are entering a seasonal spurt of enhanced M&A activity. We anticipate that this activity will continue until the first week or so in November. At that time, new activity typically slows down prior to the year-end holidays and the focus shifts to closing transactions in process, either right before or right after December 31st, as tax planning dictates. With most businesses performing better in the revived economy and the availability of relatively low cost capital, we expect to see an active market this fall.
With that in mind, this month's article, Preventing Legal Deal Killers, is timely. It is authored by Julian Izbiky, an experienced business acquisition attorney in Denver. We have closed a number of transactions with Julian and his firm and I asked him to share some thoughts on some of the issues that he has seen that might derail a transaction. Several of these pitfalls can, and should, be addressed before the business goes to market.
Ronald V. Chernak
A legal deal killer is a legal issue that causes a purchaser to walk away from a deal. A business owner can take steps in advance of a transaction to prevent a legal deal killer from occurring.
Employee Issues
Having key employees is a critical value driver for a business. But what happens when the key employee says that he won't work for the prospective purchaser and that, if the business is sold to the prospective purchaser, he will quit and start a competing business? I once saw this exact situation derail a $1,500,000 transaction. So, what could the seller have done to prevent this from occurring?
Business owners should consider having their key employees enter into non-competition and non-solicitation agreements. Many business owners think that such agreements are unenforceable, but in Colorado a company may enter into enforceable non-compete agreements with key employees. In order to be enforceable, a non-compete agreement must be reasonable as to geographical area and time period. Also, a non-compete agreement should be provided to a key employee either when the employee is initially hired or, if a non-compete agreement is provided to an existing employee, should be provided in conjunction with the company providing the employee with additional compensation or some other benefit. Further, the non-compete agreement should state that the business owner may assign it to a purchaser of the business.
If a key employee quits prior to a closing, it could negatively affect the value of the business and decrease the likelihood of the business owner being able to sell the business. Business owners should consider providing their key employees with a financial incentive to remain employees of the business through the closing date. One way to do this is to enter into a phantom stock agreement with an employee. Phantom stock is not actually stock, but a contractual agreement between the company and the employee that provides the employee with certain financial benefits that are similar to the financial benefits the employee would have received if he were an owner of the company.
Trade Secrets and Intellectual Property
A business's trade secrets and intellectual property can be significant value drivers for the business. It's important that business owners take steps to protect these assets and make sure that they can be transferred to a purchaser. A business owner should have his employees sign confidentiality agreements and take other steps to protect the confidentiality of the company's important information.
A business owner should also take steps to protect his business's intellectual property. Business owners should determine if they have any patent rights or trademark rights worth protecting and, if so, they should consider filing patent or trademark applications (trademark applications are not expensive and are within the budget of most business owners). If a business has had a software developer develop proprietary software on behalf of the business, or if other intellectual property has been developed on behalf of the business, such as trademarks, taglines, or designs, the business owner should confirm that these intellectual property rights have been assigned by the company that developed such intellectual property to the business. If not, the creator may be considered to be the owner of these intellectual property rights, notwithstanding that the business owner fully paid the creator for the development of such intellectual property.
Lease Issues
A business's lease may be an important asset. When negotiating a lease or a lease extension, a business owner should make sure that the lease provides the business with the right to exercise renewal options, and that a purchaser of the business will be able to exercise these renewal options. Many leases state that the assignee of a lease (such as a purchaser of the business) may not take advantage of any renewal options, and that if a business owner requests that the lease be assigned, then the landlord has the option to terminate the lease. Also, a business owner should make sure that his lease guaranty does not continue in effect during a renewal period if the purchaser of the business exercises the renewal option after the business is sold.
Corporate Issues
A business owner should assure that his corporate records are up to date and that there are no open issues in regard to who the owners, directors, and officers of the business are. If there are any options to acquire the stock of the business, these options should be in writing.
By taking these steps, a business owner can greatly increase his odds of avoiding deal killers and enabling his business to be sold.
Julian is a member of the American Bar Association, the Colorado Bar Association, the Arapahoe County Bar Association, and the Colorado Association of Business Intermediaries (past member of the board of directors). His firm specializes in purchases and sales of businesses, establishing and maintaining corporations and limited liability companies, and drafting and reviewing contracts, real estate, and trademarks.
