In this final installment of our “55 Questions” series, we will look at key contractual and compliance issues that can often delay or even derail a transaction. Most of these issues can be addressed ahead of time, but if owners wait until after a valuation is agreed upon, these issues will only erode value and confidence in the transaction. In this Part VI of our series of “55 Questions to Ask Yourself Before You Sell Your Business,” we will address contractual, tax, regulatory, and processes and controls issues.
The goal of our series is to encourage owners to make their businesses more attractive to prospective buyers, thereby earning the right to command a strong valuation and a quicker closing in an eventual transaction.
Contract, Tax, Regulatory, and Processes and Controls Questions to Ask Yourself Before You Sell Your Business
- Do I have good processes and controls for contracting with customers, vendors, and other key partners in order to properly manage risk in my business?
Many smaller companies are lax in their contracting processes, often accepting with very little scrutiny customer and vendor contract forms. The results can be serious. On a long list of assumed potential liabilities can be unlimited liquidated or consequential damages for failure to perform by certain milestones or at certain standards proscribed in the contract. In any transaction, particularly deals structured to acquire the stock or membership interests of a company, assumption of these types of liabilities is often a deal killer, or at least will require escrow of proceeds until the potential risks have resolved satisfactorily.
When contracting with customers, we recommend working with legal counsel to develop a standard form contract. Doing so will establish key business and legal points that are appropriate for your business and industry. For those customers who sign the contract form as is, you will have assurance that the terms and conditions are acceptable. For those customers who want to negotiate certain points, at least the discussions will start with your form.
For all other contractual agreements with customers, vendors, and other key partners, we recommend designating a couple of key individuals who have been trained by your legal counsel and insurer on the key legal terms in a contract so that they can effectively identify problem issues. In most businesses, your insurance broker can advise you on limitations of liability, indemnities and other tricky aspects of managing contractual risks.
- Are all of my key contracts in force and current?
In some industries and business models, contracts are key assets of the company. Examples would include contracts to represent manufacturer products, authorized service provider agreements, and fulfillment agreements. Often as companies get comfortable working together, the process of formally renewing agreements and keeping key terms and conditions current, such as pricing and service levels, goes by the wayside. Pricing and other details may get changed through email, conversation, or course of performance. While all of these may be legally enforceable, they may not be acceptable to a buyer if the contract is a value driver of your company.
When a transaction is contemplated and due diligence commences, these key contracts will be scrutinized and buyers will most likely want the contracts to be in force and current. If the contract has lapsed and the buyer forces you to negotiate its renewal, you will be at a disadvantage in those negotiations because the vendor or manufacturer will know you are desperate to get the contact updated and renewed.
Keeping key contracts up to date and in force is a good business practice in general and could avoid a big headache in a transaction.
- Do I have good internal controls over foreign sales such that I know I’m not violating the Foreign Corrupt Practices Act?
The Foreign Corrupt Practices Act of 1977 (“FCPA”) makes it illegal to influence foreign officials with any personal payments or rewards. If your company does business internationally, either directly or through sales agency agreements, you should have a stated policy that your business will comply with the FCPA. Your policy should be backed up by frequent training and reminders to employees and sales agents that violations of the FCPA are not acceptable. We recommend requesting annual certifications of compliance from employees and agents involved in international business.
For experienced buyers, particularly public companies, lack of clear compliance with FCPA is a show-stopper. We were recently involved in a transaction in which the buyer, a public company, required extensive due diligence procedures around FCPA compliance before discussions could advance to valuation and structuring of the transaction. Without sound policies, strong tone at the top, and selection of reputable international sales agents, this transaction would not have proceeded to its eventual closing.
- Do I have a strong Sales Order management process that ensures effective execution of projects or fulfillments of orders?
We believe management of the sales order process is one of the most consequential activities in the effective operations of most businesses. Without clear understanding of the scope of services to be performed; the products to be purchased, fabricated, assembled, delivered, and installed; the entity to be billed; and the time-frame for completion of the work, businesses will suffer a whole host of problems such as poor customer satisfaction, profit erosion, and collections issues.
Many small companies fail to invest in the people and processes to effectively manage their orders. Instead, they rely on memories, familiarity, and hero effort to bring projects to completion and eventual collection of amounts due. Buyers know that these habits can be hard to break and will likely create integration headaches once the transaction is closed. While this may not derail the transaction, it may put any earn-out or escrowed funds at risk if payments of those funds is dependent on successful and rapid integration, profitability, or other operational factors.
- Do I have strong physical and digital controls around my IT resources?
IT systems are a valuable, strategic asset to most businesses. Because of the data that is maintained in these systems, there can also be significant business and reputational risks associated with these systems. Therefore it is important to take the necessary steps to protect your IT resources with strong physical and digital controls.
It is likely the prospective buyer of your business will engage specialists to review your IT infrastructure, controls, and processes. This review will help them understand the risks in your current environment and the costs, if any, to upgrade your hardware and other systems to their standards.
By having up-to-date safeguards, strong physical and digital controls in place, and an effective and active employee educational program to create awareness of phishing and other potential attacks, you will continue to build confidence that these risks are appropriately mitigated.
- Do I stay current on software licenses to run the business?
As part of the IT review mentioned in question five above, the prospective buyer will run programs on your network to identify all of the software being used in your business and to determine whether your software licenses are current. If the due diligence process indicates there is a severe deficit in licensing, the implications could delay a closing while you work out fees and penalties with software providers, reductions in purchase price to cover the cost of bringing licenses up to date, or escrow of purchase proceeds while the issues are resolved. Unfortunately, dealing with these issues during the due diligence process will give you very little leverage with software licensors in negotiating enterprise-wide or bulk licenses.
- Do I have good controls over company purchasing cards?
We are often engaged by companies after they have received an offer to be purchased. In one such instance, we were engaged to help a client through a transaction, and by noon of our first day on the job we had discovered a significant fraud related to poor controls over corporate purchasing cards. After a lot of hard work and conversation to rebuild trust, the buyer was willing to move forward to complete the transaction, so that our client enjoyed a happy result despite the embarrassment and economic loss related to the fraud.
Purchasing cards offer the opportunity to streamline and reduce costs of processing smaller transactions. However, they also offer the opportunity to bypass internal controls over purchasing and disbursements, and many small business owners fail to implement controls to ensure purchases made via credit card are authorized and are for valid business purposes. In addition to the potential loss of funds through fraud, owners are at risk of embarrassment and loss of credibility with prospective buyers if the fraud is found during the due diligence phase of a transaction.
- Do I maintain good maintenance records on all my key manufacturing equipment?
Prospective buyers will want to verify that all revenue-producing equipment has been properly maintained according to manufacturer guidelines. Smaller companies often fail to invest in this level of record-keeping, which unfortunately could come back to haunt them. It would be unlikely that failing to keep these records would derail a transaction, but it could result in additional cost and time delays to allow the buyer to conduct detailed inspections by either their technicians or third party authorized service providers.
- Am I complying with all applicable tax reporting requirements?
Most small businesses stay on top of their federal tax filing obligations as well as those of their home state. However, many fail to grasp the complexities and reach of other state and local jurisdictions. State and local tax laws (known as “SALT” in accounting circles) is a complex area of taxation and usually requires the assistance of experts to determine whether your business’s specific operating activities are creating tax liabilities in various jurisdictions. We strongly recommend that companies operating in multiple states seek advice on this issue whether or not they are contemplating a transaction.
- Do I have hidden or ignored environmental liabilities that should be addressed?
If real estate will be included in the sale of your company or if your business works with hazardous materials in any way, you should ensure that you are compliant with all applicable environmental laws as soon as possible and certainly prior to any transaction.
We once worked with a group of siblings who had inherited a business from their father. The company, which repaired automotive parts, had been in business at the same location for many decades. We believed it was likely that the real estate had some level of ground contamination as a result of careless disposal of oils and chemicals on the property. We strongly advised them to have an environmental study conducted on the property prior to listing the business for sale.
- If I operate multiple legal entities for tax and liability purposes, do I maintain well-documented legal separation between the entities in my contracting and business operations?
Most small businesses operate as limited liability companies or as corporations. Using one of these structures limits the exposure of the owners’ personal assets from liabilities incurred by the business. By setting up multiple legal entities, owners can shield the assets of each company from the liabilities and damages that might arise in another company.
However, for this strategy to be successful, owners must truly keep the business affairs of each company separated through proper contracting, accounting, and business operations. Also, the owners must not mingle personal and business checking accounts and expenses.
In a transaction, it is imperative that your financial records reflect the true operations of the business. If the legal and accounting records between entities and with the owners’ personal affairs are mingled as if they were all the same business, it will be very expensive and time-consuming to straighten it all out. You will run a great risk of the prospective buyer moving on to another opportunity or losing trust that he will ever receive accurate financial results about the business he is trying to buy.
- Do I have a list of all the leases that I’m a party to?
Leases on office, warehouse, and manufacturing space, as well as on equipment, often represent a significant future obligation of a small business. Lease obligations can represent future required cash outlays of hundreds of thousands or even millions of dollars. As a result, prospective buyers will want to fully understand the obligations they will be assuming, should they purchase your business. We recommend assembling and maintaining a list of all your lease obligations, including start and end date, monthly payment amount, escalator clauses, and any other key terms in the lease. Maintaining this schedule, along with an electronic file of the leases themselves, will greatly reduce the time to pull this vital information together during due diligence.
- Do I know if my major vendor relationship and manufacturing representation agreements are transferrable or have a “change in control” provision?
A key asset in many businesses is master service agreements with customer or representation agreements with manufacturers or software providers. Because there is usually an initial and often ongoing qualification process to maintain these relationships, manufacturers and customers often do not allow these contracts to be transferred to another party without their prior written approval or at all. We recommend creating a schedule of these important agreements, which includes documenting the terms and conditions of transferring ownership to another party, so that proper planning for obtaining consents and approvals can be coordinated with closing the transaction.
We have seen several instances in our practice where these provisions were not well vetted ahead of time, and closings were delayed and relationships with key customers and/or vendors were damaged due to lack of planning and rushed communications. It is better to plan ahead than to have these stressful issues arise in the final days of a transaction.
- Is my business nimble and resilient enough to withstand potential disruptions from new technologies or rapid market changes?
Often small businesses hit a home run with a single product or service, with a single customer, or in a single industry. When times are good, the owner has his hands full keeping up with orders and dealing with the inherent issues of running a business. But things inevitably change. Industries go through down cycles, new technologies come into the market, and customers’ needs change. When these changes happen, small businesses are often casualties.
Building resiliency into your business model is very challenging, but it is worth consideration, experimentation, and thoughtful investment. Businesses that have a demonstrated ability to generate revenues in down economic cycles or have successfully pivoted into different industries are more valuable than those that just ride the ups and downs of a single industry. Achieving this kind of diversification is not easy and not always possible, but owners should take some time (at least annually) to get away from the business and think about additional applications of their products and services, other potential products that could be manufactured using the same equipment, or other markets that could be served. Many successful companies set aside a percentage of their profits to invest in exploring these ideas further.
This concludes our series on “The 55 Questions to Ask Yourself Before You Sell Your Business.” All six installments of the series are available on our website, and if you would like assistance with your business to prepare it for future sale, HoganTaylor Advisory has the experience and talent to assist you.
We recently discussed our “55 Questions” with Gordon Deal on the “Your Money Now” podcast. You may listen to the podcast here.