How To Prepare Your Company For Sale
(With Due Diligence Checklist)
Stuart M. Horwitz and Jason S. Damicone
Planning ahead will pay off in the long run.
Stuart M. Horwitz,
the founding member of the Horwitz Group, LLC,
has over 28 years of corporate, tax, estate, probate
and succession planning experience. He is one of
only five attorneys in the state of Ohio, and the only
attorney in northeast Ohio, to be a Board Certified
Specialist in Federal Taxation and Estate Planning,
Trust and Probate. Mr. Horwitz uses the latest techniques in his practice including many techniques
developed in-house. He can be reached at stu@
thglawfirm.com.
Jason S. Damicone
an Associate with the Horwitz Group, has 10 years
of tax and estate planning experience. During his
career, he has gained experience in the areas of
corporate/business transactions, corporate/business planning, taxation, estate planning, probate
and trust administration. His extensive educational
background in taxation has been instrumental in allowing him to meet the challenging business and
personal planning demands of his clients. He can
be reached at [email protected].
IT IS NEVER TOO EARLY to start planning for the
eventual sale of your company. While this article will not
explain every step that should be taken, the purpose is to
give the reader a general framework for moving forward.
Step One: Identify The Price
You should obtain a valuation. From a strategic bargaining standpoint, your detailed valuation can serve as
a negotiating chip with a buyer. It’s one thing to say, “I
think my company is worth ‘x’.” It’s another thing to have
backup that can ultimately be shared with a prospective
purchaser.
Step Two: Identify The Type Of Buyer
There are two types of buyer: the strategic buyer and
the financial buyer. A strategic buyer is buying your business because you have something that will enhance its
business. For example, a competitor of yours would be a
strategic buyer as it would be buying your customer lists
and/or methodologies. A strategic buyer would not keep
your administrative staff, since this would amount to redundant personnel; this buyer would also keep fewer employees generally.
A financial buyer is purchasing your business because
of your annual profit. Why is it important to differentiThe Practical Lawyer | 31
32 | The Practical Lawyer ate? A financial buyer will pay one multiple of your
EBIT or EBITDA; whereas a strategic buyer will
pay a much higher multiple and may even base its
upper-end offer on its (i.e., buyer’s) ultimate profit
using your key information/goods.
In most cases, the price will be set early in the
process. If you try and negotiate a higher price later, there will be significant pushback from the buyer
and you may end up losing the deal. Most sellers
only get one chance to cash out; so it is important
to have all your ducks in a row at the beginning of
the negotiations.
Step Three: Make Sure Your Business Is
Structured Properly
Depending on the type of entity you have, you
may want to tweak the structure. For example, if
you are a Subchapter C corporation you may want
to convert to a Subchapter S corporation. This
could result in a significant reduction in income
taxes upon sale. Most counselors will tell you a
conversion will be ineffectual if you end up selling
within 10 years (the general rule is that any conversion within 10 years of the sale date will be ignored
and there will be two levels of tax); however there
is an exception to this rule. Any appreciation after
the date of the conversion will only be subject to
one level of tax. For example, if your business was
worth $5 million in 2013 (and you elect S Corp status) and you end up selling your company in 2015
for $8 million, the difference ($3 million) is only
subject to a single level of tax. In order to buttress
your argument we advise that you obtain a valuation at the time of the conversion.
There are other steps that can be taken; creativity is your only limiter. For example, we sometimes
recommend that a C Corporation contribute its assets to a limited liability company and convert the C
Corporation to an S Corporation. This more complex restructuring can provide many benefits. First,
if you want to bring in outside investors, this special
structure can provide for a single level of tax on op-
February 2014
erating income going forward and give you the latitude to bring in a diverse group of investors (LLCs
taxed as partnerships are much more flexible than
S Corporations). Second, if you want to incent key
employees, you can have the LLC issue a special
type of equity ownership known as a “profits interest.” This is a very versatile planning technique that
is often overlooked. Third, if you decide to retain
your company, this structure can maximize your
flexibility in operating your business. There are numerous issues in setting up this type of structure so
you should consult with a tax attorney.
Even if you are an LLC taxed as a partnership
or an S Corporation, there could still be structuring
issues. For example, if you are an LLC taxed as a
partnership now, you may want to consider switching to an S Corporation if you would be operating the company for a number of years. You could
save significant dollars relating to the social security
tax from such a conversion. If you are an S Corporation, you may still want to adopt the LLC subsidiary structure discussed above. This would give
you more latitude in bringing in investors and/or
rewarding key employees.
Step Four: Perform Due Diligence — Now!
Deals tend to fail when the buyer is surprised.
The best way to avoid surprises is to anticipate a
buyer’s questions/requests. Fortunately, this is a
relatively straightforward process. Attached to the
end of this article is a due diligence checklist. We
recommend that you review all of the issues and
address/fix the issues before engaging in any discussions with a prospective buyer.
There are certain major issues in any due diligence review. First, make sure your key employees are locked up with employment/non-compete
agreements. If the purchaser is a financial buyer
it may be concerned about the company’s continued viability should certain key employees leave.
Second, if there are any outstanding or threatened
claims, this could cause a buyer to withdraw or at
Preparing Your Company for Sale | 33
least require a substantial escrow until the claim is
resolved. Third, if you have taken any aggressive
positions on your returns or financial statements
you should address them now. Fourth, whether you
are a corporation, partnership or LLC, you should
get your company’s internal documents updated.
For example, a corporation should have a current
minute-book with all necessary actions approved
by the shareholders and directors. A partnership
or LLC should have current a current partnership
agreement or operating agreement, as the case
may be. Fifth, you should check on all licenses and
compliances. If you are in any way non-compliant,
the deal can be held up, so it is a good idea to fix
it now. Rest assured, in a stock deal there will be
a representation and warranty to this. This would
also include any “license to do business” in other
states. Sales and use tax issues may be a particular
concern. Sixth, it is important to address any nonqualified or qualified plan issues well before a sale
as these problems generally take a while to remedy.
Seventh, you should review all material contracts
as well as your relationships with your suppliers,
distributors and customers. Problems with any of
these topics can delay a closing; or worse.
Step Five: Crunch The Numbers And
Determine Your After-Tax Takeaway From
A Stock Or Asset Deal
An acquiring company will generally either
purchase your shares of stock (or LLC/partnership
interest) or all of your assets. While most sellers
want to sell their stock, most buyers want to purchase all the assets of the seller. Sellers like to sell
shares as this gives the seller capital gain and the
seller does not have to worry about any wrap-up
of the company as the buyer continues on with the
company. The buyer generally wants to purchase
all of the seller’s assets as this gives the buyer a “step
up” in the basis of all the items purchased; thereby
allowing for maximum depreciation. Further, by
purchasing assets, a buyer can generally obtain a
fresh start, from a liability perspective. It is imperative that you know what your tax rates will be, as
this will dictate what your target purchase price
needs to be.
Step Six: Protect Your Company
This can be the critical step in any sale. You
should have a confidentiality agreement ready for
the prospective purchasers. In addition to addressing outside parties, you need to address inside parties — the employees. It is advisable to minimize
any contacts between buyers and employees. If the
buyer(s) is a strategic buyer, you may have a mass
exodus of employees if they discover you are “shopping the company.” Finally, even if the buyer signs
a confidentiality agreement, you should try and
maintain/protect your trade secrets regardless.
While a confidentiality agreement is called for, it is
not perfect. Remember — other than litigation attorneys, who would be happy about engaging in a
protracted lawsuit against a buyer who violated the
confidentiality agreement?
Step Seven: Protect Yourself And Your
Profits
There are numerous ways you can lose your
money:
• Indemnity. If you are a manufacturing concern,
buyers will generally require that you indemnify
them for any claims arising prior to the acquisition date. To circumvent this problem, you
should see if you can be named as a co-insured
on any products liability insurance that the buyer will carry. If this is not an option, then you
should look at tail policies to cover the indemnification period (usually five years);
• Escrow. Another critical deal point is the escrow/holdback. Get as much money up front
as the escrow may never be paid;
• Carve off non-business and certain other assets.
If you want to retain anything held in the company, you can distribute them now (i.e. insur-