Angel Insights Blog

After many early mornings and late nights, it is natural for a founder of an emerging company, and its investors, to look to the future and ask, now what? For many emerging companies, the next step is an exit through a private acquisition or merger.  If the company is not properly prepared, this exit may be difficult or even less likely to occur.  Angel investors, as frequent board members, board observers and informal advisors, may be able to encourage their portfolio companies to take steps to encourage a successful exit.

Selling an emerging company through a private M&A transaction, also known as an “exit”, has unique benefits compared to other exit options such as an initial public offering. Sales come in many forms and include different kinds of buyers. However, before a letter of intent can be signed, the founders and executive officers should look closely at the company’s operations and other key areas to prepare it for the exit transaction.

1. Deal Team and Internal Diligence

Founders and executive officers should first form a deal team of the company’s professional advisers, including accountants, financial advisers and attorneys. They should also consider retaining an investment bank or business broker to help determine the overall salability of the company and its valuation – a common topic in negotiations. Additionally, a company’s angel investors often serve as informal advisors during this process to provide insight from working through a number of exits with other companies. The team’s collective experience will be vital to the founders and executive officers as they set expectations for the deal. For example, they may recognize the need to adjust the legal structure of the company if the company exits through an asset sale or confirm all needed invention assignments have been executed with the relevant parties to protect the value of the company’s intellectual property. These experts will work with the company’s department heads and other essential employees during the deal process to prepare the company for exit.

Once the deal team is formed, the next task should be to address as many of the company’s outstanding issues as possible. While any buyer will conduct their own due diligence, an internal due diligence process can help company founders and executive officers identify and clean up any issues in the company’s operations before buyers start to kick the tires. Common areas for review include financial statements and taxes, legal documents such as its material contracts and intellectual property registrations, and internal organizational records.

2. Financial Records

Potential buyers typically have standard expectations regarding an emerging company’s financial records. These expectations are:

• Audited, GAAP Financial Statements. Audited, GAAP financial statements enable a potential buyer to efficiently analyze the company’s financial outlook both during the due diligence process and for any post-closing purchase price adjustments.
• Accountant-Prepared Financial Projections. Financial projections of the company’s future income and related expenses provide a basis for expected returns, which makes the accountant’s role in preparing the projections especially important.
• Complete Tax Returns and Filings. Since outstanding tax returns or filings and unpaid tax liabilities can lead to frustration during the deal process, a potential buyer prefers to see a clean record of all tax returns and filings.
• If a company is unable to prepare audited GAAP financial statements or financial projections, then its team should ensure, at a minimum, that all of the company’s current financial statements are in order without any outstanding accounting issues and all tax returns and filings have been made. Otherwise, the company should work with an accounting firm to have its financial statements be in line with industry expectations.

3. Contracts and Legal Concerns

There are a number of areas of legal concern in an emerging company’s operations a potential buyer will review during its due diligence. Some such issues include:

• Material Contracts. Material contracts, such as leases or vendor supply contracts, could have provisions that require a third-party’s consent prior to the acquisition (i.e., change-of-control or anti-assignment provisions), and certain contracts with noncompetition restrictions or at-will termination provisions are typically a concern for potential buyers.
• Intellectual Property. While intellectual property concerns vary, any emerging company should ensure all IP rights are protected and being validly used by itself or any third-party with which the company works. The emerging company should evaluate its own protections, such as whether its employees have executed invention assignment agreements.  
• Specific Legal Issues. In addition to intellectual property, a number of other legal areas of concern will require the input of attorneys who specialize on issues such as environmental assessments of personal and real property, whether real property has clear title and other related real estate issues, and the transferability or terminability of employee benefits plans and insurance policies.

Generally, a company seeking a potential exit should review all of these areas before going to closing. It is important for the company’s attorneys to address these issues as soon as possible, such as having invention assignments executed by all relevant employees, before they can be raised by a buyer.

4. Company Records

Books and records are another area of concern for emerging companies seeking exit, including:

• Company Minutes and State Filings. The company should bring the minutes and resolutions from the board of directors and equity holders up to date, confirm all required state filings for domestic and foreign registration have been made, and collect a comprehensive set of all correct and complete organizational documents.
• Options and Warrants. Investors in emerging companies commonly have open options and warrants for the purchase of future equity. These should be resolved through internal negotiations prior to a potential buyer’s involvement.
• Equity Holders’ Rights. Another common aspect of emerging companies’ equity are equity holders’ rights (e.g., right of first refusal), which should be reviewed and addressed by confirming the consent of such equity holders to the potential transaction.

Cleaning up a company’s books and records is an effective way to avoid potentially deal-disrupting questions during a buyer’s due diligence process – whether related to recordkeeping or equity issues.

5. Next Steps

Once a company’s internal due diligence is sufficiently completed, the deal team should identify preferred deal terms and potential buyers. Important deal term considerations include whether the buyer will be strategic or financial, if the founders wish for a rollover, or post-closing investment into the buyer or a buyer affiliate, and whether a portion of the deal’s consideration will be subject to certain future financial metrics (i.e., an earnout). As with diligence, the deal team’s knowledge of past deals and their terms will be an invaluable resource for the founders and executive officers. 

Overall, the more preparation that can be done in advance of an exit by private M&A transaction, the better. The above touches briefly on some of the key areas to address in advance of seeking an exit transaction, that collectively create a solid foundation for a deal.

Author:

Joseph N. Petrone, Associate, Fox Rothschild, Joe represents and advises clients in a broad range of corporate and real estate matters including general transactions such as mergers and acquisitions and private offerings, corporate governance matters, and commercial contract preparation and review.