This document discusses key considerations for business owners selling their companies. It outlines several important details that should be addressed in a letter of intent, including working capital targets, escrow amounts, indemnification caps, and any required approvals. The document also discusses structuring the purchase price, earnouts, working capital adjustments, and diligencing the buyer if receiving stock as part of the sale. Business owners are advised to negotiate important terms upfront and retain rights to terminate the letter of intent under certain conditions.

1. VOL. 5, ISSUE 2
CONNECTING AND INSPIRING YPO’S GLOBAL LEADERS
LET’S
MAKE A
DEAL
BETTER LEADERS THROUGH LIFELONG LEARNING AND IDEA EXCHANGETM
NOVEMBER 2016
THE 8 ESSENTIALS
OF INNOVATION
THE UNBRIDLED
UNICORN
WHEN ART
AND BUSINESS
CONVERGE

2. N O V E M B E R 2 0 1 6 53
g C O V E R S E C T I O N
SELLING ONE’S BUSINESS IS ONE OF THE MOST IMPORTANT TRANSACTIONS
in the life of an entrepreneur. Yet many owners end up leaving money
on the table or exposing themselves to unnecessary risks post-close.
In short, the devil is in the details. And the details are many. What
provisions should you always include in the letter of intent? How do you
maximize your chances of actually receiving an earnout? What should
you diligence before agreeing to be paid in the form of stock of the
acquiror? And what about the post-closing working capital adjustment?
Deal Anatomy:
Avoid Pain
Upon Exit
BY BRETTE SIMON
52 I G N I T E © YPO

3. 54 I G N I T E N O V E M B E R 2 0 1 6 55
Letter of intent
Sellers beware — once a letter of intent (LOI)
is signed, your leverage is lost. The LOI grants an
exclusive option on your business — in short, the
buyer has a specified number of days (usually 90) to
decide whether to buy your company, during which
time, the seller cannot talk to any other potential
suitors. Given this dynamic, a seller should include
as many important details in the LOI as possible, as
it will serve as a critical guidepost for subsequent
negotiations of the definitive deal documents.
For example, is the working capital target spec-
ified? Escrow amount? Indemnification cap?
Negotiate these at the LOI stage when the buyer still
is trying to win the deal away from other bidders
versus after the buyer has locked up the deal. Does
the buyer have any required approvals (for exam-
ple, from a foreign parent company)? Will the buyer
need third-party financing? The further in advance
you have these spelled out, the better — certainty of
close is key for a seller. Will the acquiror be buying
stock or assets? Finally, what are the tax implications
of the deal structure?
Also, many sellers neglect to include a right to
terminate the LOI. If the buyer attempts to renegoti-
ate the price after the LOI is signed, the seller should
have the right to walk away. Or if the buyer fails to
complete due diligence by an agreed-upon date, the
seller should have the option of terminating the LOI
and the buyer’s exclusivity. This keeps the buyer
honest and also keeps the deal moving forward in
a timely fashion.
Working capital adjustment
Most merger and acquisition transactions require
the seller to leave a certain amount of working capi-
tal in the business, which the parties reconcile after
closing. This can significantly affect the amount of
cash that ends up in the seller’s pocket. Once the
target working capital amount is negotiated (ideally
at the LOI stage), the parties need to agree on how it
is calculated and by whom.
If the buyer will control the preparation of the
final working capital statement (which makes sense
if you’ve sold and no longer will have an internal
accounting function), the seller typically has the
right to review and dispute any items in the state-
ment. It is imperative that you secure access rights
to the books and records of the buyer (i.e., your
former books) which you will need to verify the
statement.
If the seller’s financials are not prepared in accor-
dance with generally accepted accounting principles
(GAAP), the seller should negotiate an agreed-upon
set of accounting policies for how the final work-
ing capital statement will be prepared by the buyer
to account for any non-GAAP items. Otherwise, the
seller runs the risk that the buyer will prepare it in
accordance with GAAP, which creates an “apples-to-
oranges” situation.
Finally, it should be a two-way adjustment. Just as
the seller should be obligated to pay the buyer if the
business was left with insufficient working capital,
so should the buyer return any excess working capi-
tal to the seller.
Structure of purchase price
Receiving cash at close? Great. How about seller
paper? If the seller will be taking back a promis-
sory note, the buyer’s ability to repay the note now
comes into play. Representations about the buyer’s
solvency should be included in the purchase agree-
ment, and the seller should conduct financial due
diligence on the buyer. For example, the seller needs
to understand where they sit in the capital stack,
as the note most likely will be subordinated. How
much debt is senior to you and could possibly block
your right to repayment? A detailed review of the
buyer’s existing loan agreements is essential (espe-
cially as a seller note typically is unsecured).
If the buyer is a private equity fund, the fund
will want the seller to retain some equity in the
company (aka rollover equity), which ties a portion
of the purchase price payment to the success of the
business post-close. Sellers should ensure that the
definitive documents address the following issues:
What rights (if any) will you as the seller have as a
minority shareholder of the business? Where do you
sit in the “liquidation waterfall” if the company is
sold in five years?
Private equity buyers often prefer to offer com-
mon stock to sellers, as the common stock does not
receive any payments until all of the preferred stock
is paid (which often includes not just return of cap-
ital but also a preferred return). However, sellers
should negotiate to receive preferred stock, which
means they own the same class of stock as the fund
and have the same rights, preferences and privileges
as the buyer.
If the buyer is a strategic acquiror/operating
company and the seller is taking back stock in the
buyer itself (as opposed to stock in the business
that was just sold, as discussed above), it behooves
the seller to conduct just as much diligence on the
buyer as the buyer is conducting on the seller and
the target. The representations and warranties about
the buyer’s business should be nearly as robust as the
seller’s representations and warranties, and provi-
sions enabling the seller to liquidate the stock if the
company is not publicly-traded (such as registration
rights or a put right) should be included.
Earnouts
While earnouts (additional purchase price based
on how the company performs post-close) could be
the subject of an entire article by themselves, there
are a handful of key items that always should be
addressed in any earnout provision:
u On what is the earnout based — revenues (sales),
gross margin, or earnings before interest, taxes,
depreciation and amortization (EBITDA)? The
higher up the income statement you are, the better
off you are as a seller.
u Is it a “cliff” or a sliding scale? Try to avoid an
all-or-nothing earnout where if the earnout target
is one dollar short, the seller gets nothing. Collars
are preferable, where if the business falls within a
certain range, the seller at least receives a percentage
of the earnout amount.
u Is it cumulative? In other words, if the earnout
target is missed in year one but exceeded in year
two, should the seller be able to apply the overage
to the shortfall in year one in order to receive both
earnout payments?
u What sort of operational control does the buyer
have post-close? The more the seller can restrict the
buyer’s ability to allocate overhead and/or personnel
to the target’s business and limit the buyer’s right
to integrate the company with the buyer’s existing
business (or divert opportunities to buyer’s other
business units), the higher the likelihood that the
earnout target will be met.
u What happens if the buyer terminates the seller
during the earnout period? Should the earnout accel-
erate? (But beware the risk of making the earnout
look too much like compensation and thus convert-
ing its tax treatment from capital gain into ordinary
income.)
Receiving an offer to sell your company is an
exciting time for any business owner. By following
these suggestions, sellers hopefully can avoid vari-
ous potential pitfalls and achieve the best possible
deal for their company. s
Brette Simon advises her clients on capital raising,
strategic alliances and exit transactions in various
industries, including media, health care, software,
and branded consumer products (including food and
beverage). Simon has been practicing in the field
of corporate law since 1994, and was previously
a corporate partner at Bryan Cave, Jones Day and
Sheppard Mullin. She also practiced at Gibson, Dunn
& Crutcher and O’Melveny & Myers. Simon ranked
first in her graduating class and graduated Order of
the Coif from UCLA School of Law, where she was
editor of the “UCLA Law Review.” She has spoken at
numerous industry conferences and to YPO. Simon
has garnered numerous accolades throughout her
career, including recognition as one of the top 13
dealmakers in the United States for the middle
market by “The Deal,” and being selected as a winner
of the inaugural “40 Under 40” award by The M&A
Advisor.
SIMON
A seller should include as many important details in the letter
of intent as possible, as it will serve as a critical guidepost
for subsequent negotiations of the definitive deal documents.
© YPO