What You Need to Know About Mergers and Acquisitions: 12 Key Considerations When Selling Your Company

By Richard D. Harroch, David A. Lipkin, and Richard V. Smith

Mergers and acquisitions involving privately held companies entail a number of key legal, business, human resources, intellectual property, and financial issues. To successfully navigate a sale of your company, it is helpful to understand the dynamics and issues that frequently arise.

In this article, we provide guidance on 12 key points to consider in mergers and acquisitions (M&A) involving sales of privately held companies from the viewpoint of the seller and its management.

1. M&A Valuation Is Negotiable

How do you know if a buyer’s offer price equals or exceeds the value of your company?

It is important to understand that offer price and valuation, like other terms in M&A deals, are negotiable. However, since your company’s shares are not publicly traded, the benchmarks may not be immediately clear, and the outcome of this negotiation depends on a number of key factors, including the following:

Market comparables (are your competitors selling for 3x revenues or 12x EBITDA? Are you growing faster than the competitors?)
Whether the buyer is a financial buyer (such as a private equity firm that may value your business based on a multiple of EBITDA) or a strategic buyer (that may pay a higher price because of synergies and strategic fit)
The valuation used in your company’s last round of financing
Prices paid in recent sales of shares by employees and early stage investors
Your company’s most recent 409A valuation (appraisal of the fair market value of your company’s common stock)
The trends in your company’s historical financial performance
Your company’s projected financial growth
The proprietary technology your company owns or licenses
The business sector of your company
Business, financial, and/or legal risks your company faces
The experience and expertise of the management team
Your company’s prospects and opportunities for additional financing rounds
Whether there are multiple bidders for your company or a single interested party
Whether your company is a meaningful IPO candidate

If you and the potential buyer are unable to agree on an acquisition price, consider an “earnout” as a way of bridging this difference of opinion. An earnout is a contractual provision in the M&A agreement that allows a seller to receive additional consideration in the future if the business sold achieves certain financials metrics, such as milestones in gross revenues or EBITDA. Although an earnout poses significant risks for a selling company and its stockholders, it also establishes a path for the selling stockholders to ultimately achieve the return they seek in the sale of the company, based on the continuing performance of the business following the closing of the transaction.

Finally, do not be afraid to negotiate. Even if a number proposed by a buyer “feels” right, consider making a counter offer. Buyers rarely make their best offers initially. As good negotiators, buyers hold something back, leaving room for final “concessions” to close the deal. Accordingly, a reasonable counter-offer on price ordinarily should not be poorly received. If you never ask, you will never know.

2. Mergers and Acquisitions Can Take a Long Time to Market, Negotiate, and Close

Most mergers and acquisitions can take a long period of time from inception through consummation; a period of 4 to 6 months is not uncommon. The time frame will depend on the urgency of the buyer to perform due diligence and complete the transaction, and whether the selling company is able to run a competitive process to sell the company, generating interest from multiple bidders. There are some things, however, that can be done to shorten the time frame:

With the assistance of an investment banker or financial advisor, run a tightly controlled auction sale process so that potential buyers are forced to make decisions on a shorter time frame in a competitive environment.
The seller should place all of its key contracts, corporate records, financial statements, patents, and other material information in an online data room early in the process.
The seller should have a draft disclosure schedule (a key component of an M&A agreement) ready early in the process.
Management presentations/PowerPoints should be prepared and vetted early.
The company’s CEO should be prepared to explain the value-add that the selling company will provide to the buyer.
The company’s CFO should be prepared to answer any financial questions and to defend the underlying assumptions of the financial projections.
A lead negotiator for the seller, who is experienced in M&A deals and can make quick decisions on behalf of the company, should be appointed.
M&A counsel should be asked to identify and advise on how to solve potential delays due to regulatory requirements (such as CFIUS, Hart-Scott-Rodino, or non-U.S. laws, such as competition laws) and contractual approval and other rights of third parties.

3. Sellers Need to Anticipate the Significant Due Diligence Investigation the Buyer Will Undertake

Mergers and acquisitions typically involve a substantial amount of due diligence by the buyer. Before committing to the transaction, the buyer will want to ensure it knows what it is buying and what obligations it is assuming, the nature and extent of the selling company’s contingent liabilities, problematic contracts, litigation risk and intellectual property issues, and much more. This is particularly true in private company acquisitions, where the selling company has not been subject to the scrutiny of the public markets, and where the buyer has little ability to obtain the information it requires from public sources.

Sophisticated strategic and private equity buyers usually follow strict due diligence procedures that will entail an intensive and thorough investigation of the selling company by multiple buyer employee and advisory teams.

To more efficiently deal with the due diligence process, selling companies should set up an online data room. An online data room is an electronic warehouse of key company documents. The online data room is populated with the selling company’s important documents, including corporate documents, contracts, intellectual property information, employee information, financial statements, a capitalization table, and much more. The online data room allows the selling company to provide valuable information in a controlled manner and in a way that helps preserve confidentiality. The online data room helps expedite an M&A process by avoiding the need to have a physical data room in which documents are placed and maintained.

Importantly, the online data room can be established to allow access to all documents or only to a subset of documents (which can vary over time), and only to pre-approved individuals. Most online data rooms include a feature that allows the seller or its investment bankers to review who has been in the data room, how often that party has been in the data room, and the dates of entry into the data room. This information can be very useful to sellers as an indication of the level of interest of each potential bidder for the selling company, and helps the selling company understand what is most important to each buyer.

Selling companies need to understand that populating an online data room will take a substantial amount of time and require devotion of significant company resources. Although many privately held companies also use online data rooms for financing rounds, much more information and documents will need to be added to the data room in connection with a possible M&A deal. Here, experienced M&A counsel can provide the selling company with a detailed list of the types of information and documents that potential buyers will expect to see in an M&A-focused online data room.

The selling company should not grant access to the data room until the site has been fully populated, unless it is clearly understood that the buyer is initially being granted access only to a subset of documents. If the selling company allows access before all material documents have been included, adding documents on a rolling basis, potential buyers may become skeptical about whether the selling company has fully disclosed all information and documents that potential buyers deem material. Such skepticism might hurt the selling company’s ability to obtain the best offer price from potential buyers.

Access to the online data room is made via the Internet, through a secured process involving a user ID and a protected password. Typically, two-factor authentication will be required to access the data room. As an additional security precaution, any documents printed from the online data room will include a watermark identifying the person or firm that ordered such printing.

See The Importance of Online Data Rooms in Mergers and Acquisitions

The selling company will need to ensure that its books, records, and contracts can stand up to a buyer’s robust due diligence investigation. Here are some issues that can arise:

Contracts not signed by both parties
Contracts that have been amended but without the amendment terms signed
Missing or unsigned Board of Director minutes or resolutions
Missing or unsigned stockholder minutes or resolutions
Board or stockholder minutes/resolutions missing referenced exhibits
Incomplete/unsigned employee-related documents, such as stock option agreements or confidentiality and invention assignment agreements

Deficiencies of this kind may be so important to a buyer that it will require them to be remedied as a condition to closing. That can sometimes be problematic, such as instances where a buyer insists that ex-employees be located and required to sign confidentiality and invention assignment agreements. Avoid these problems by “doing diligence” on your own company before the buyer does it for you.

See 20 Key Due Diligence Activities in an M&A Transaction

4. The Seller’s Financial Statements and Projections Will Be Thoroughly Vetted by the Buyer

If a buyer could only ask for one representation of a selling company in an acquisition agreement, it is likely the buyer would ask for a representation that the financial statements of the selling company be prepared in accordance with generally accepted accounting principles (GAAP), consistently applied, and that the selling company fairly present the results of operations, financial condition, and cash flows for the periods indicated.

Behind this representation, the buyer will be concerned with all of the selling company’s historical financial statements and related financial metrics, as well as the reasonableness of the company’s projections of its future performance. Topics of inquiry or concern will include the following:

What do the selling company’s annual, quarterly, and monthly financial statements reveal about its financial performance and condition?
Are the financial statements audited, and, if so, for how long?
Do the financial statements and related notes reflect all liabilities of the selling company, both current and contingent?
Are the profit margins for the business growing or deteriorating?
Are the projections for the future and underlying assumptions reasonable and believable?
How do the projections for the current year compare to the board-approved budget for the same period?
What normalized working capital will be necessary to continue running the business?
How is “working capital” determined for purposes of the acquisition agreement? (Definitional differences can result in a large variance on the ultimate price for the deal.)
What capital expenditures and other investments will need to be made to continue growing the business?
What are the selling company’s current capital commitments?
What is the condition of the assets? What liens exist?
What indebtedness is outstanding or guaranteed by the selling company, what are its terms, and when does it have to be repaid?
Are there any unusual revenue recognition issues for the selling company or the industry in which it operates?
Are there any accounts receivable issues?
Should a “quality of earnings” report be commissioned?
Are the capital and operating budgets appropriate, or have necessary capital expenditures been deferred?
Have EBITDA and any adjustments to EBITDA been properly calculated? (This is particularly important if the buyer is obtaining debt financing.)
What warranty liabilities does the selling company have?
Does the selling company have sufficient financial resources to both continue operating in the ordinary course and cover its transaction expenses between the time of diligence and the anticipated closing date of the acquisition?

5. Multiple Bidders Will Help the Seller Get the Best Deal

The best deals for sellers usually occur when there are multiple potential bidders. By leveraging the competitive situation, sellers can often obtain a higher price, better deal terms, or both. Negotiating with only one bidder (particularly where the bidder knows it is the only potential buyer) frequently puts the selling company at a significant disadvantage, particularly if the selling company agrees to an exclusivity (“no shop”) agreement that limits its ability to speak with other potential buyers for a period of time. Sellers often try to set up an auction or competitive bidding process to avoid being boxed in by a demand for exclusivity by a bidder. By having multiple bidders, each bidder can be played off against the other to arrive at a favorable deal. Even if the reality is that there is only one serious potential bidder, the perception that there are multiple interested parties can help in the negotiations.

6. You Need a Great M&A Lawyer and a Great M&A Legal Team

It is critically important for a successful M&A process that the selling company hire outside counsel that specializes in mergers and acquisitions. The outside legal team should include not only seasoned M&A attorneys but also experts in appropriate specialty areas (such as tax, compensation and benefits, employee matters, real estate, intellectual property, cybersecurity, data privacy, antitrust, and international trade).

M&A transactions involve complex, multifaceted agreements and deal structures as well as challenging legal issues. They are typically fast-moving and can be contentious. To be effective, an M&A lawyer must be intimately familiar with both the business realities of M&A deals and the overall structure and inner workings of the acquisition agreement. He or she must have complete command of the applicable substantive law and must be a skilled advisor, negotiator, and draftsperson. A significant M&A deal demands an experienced, focused outside M&A lawyer who has “been there, done that” many times. It is very difficult to be effective as a “part-time” M&A lawyer.

The same holds true for the legal specialists required in M&A deals. Each specialist should be steeped in the M&A legal considerations relevant to your deal and practice their specialty full time. Although it is tempting to resist bringing on a “large” legal team out of concern that they will generate a large legal bill, experienced specialists will actually save you money by identifying significant risks early in a transaction and working to develop practical solutions. Moreover, a legal specialist M&A team that has worked together on many prior deals likely will be more efficient than a couple of attorneys who together claim to be expert in the many specialty areas that are critical to an M&A deal.

7. Consider Hiring an Investment Banker

In many situations, an investment banker experienced in M&A can bring significant value to the table by doing the following:

Assisting the seller and its legal counsel in designing and executing an optimal sale process
Helping to prepare an executive summary or confidential information memorandum for potential buyers
Identifying and contacting prospective buyers
Coordinating meetings with prospective buyers
Preparing and coordinating the signing of confidentiality agreements
Assisting the seller in properly populating the online data room
Coordinating the seller’s responses to buyer due diligence requests
Helping prepare management presentation materials for meetings with potential buyers and prepping the management team beforehand
Assisting in the negotiations on price and other key deal terms
Advising on market comparable valuations
Rendering a fairness opinion (not common in sales of privately held companies, but occasionally desirable, especially in situations where directors have conflicting interests)
Helping the management team in presentations to the company’s Board of Directors

Chris Gaertner, Global Head of Technology for the respected investment banking firm Rothschild Global Advisory, has stated: “To ensure the highest probability of a successful M&A exit, an investment banker should provide independent advice, drive a focused process, and act as a true partner to the company’s CEO, Board of Directors, and management team.”

8. Intellectual Property Issues Will Be Important

The status of the selling company’s intellectual property (IP) and its treatment in the hands of the buyer will often be of critical importance to a buyer. The key IP issues in an M&A transaction often include the following:

The selling company needs to have prepared for the buyer’s review an extensive list of all IP (and related documentation) that is material to its business.
A buyer will want to confirm that the value it places on the selling company, particularly if the seller is a technology company, is supported by the degree to which the seller owns (or has the right to use) all of the IP that is critical to its current and anticipated business. One area of particular importance is the degree to which all employees and consultants involved in developing the seller’s technology have signed invention assignment agreements in favor of the seller.
Many software engineers and developers use open source software or incorporate such software into their work when developing products or technology. But the use or incorporation of such open source software by a selling company can lead to ownership, licensing, and compliance issues for a buyer. Accordingly, sellers need to identify and assess open source issues early in the deal process.
The IP representations and warranties in a private company acquisition serve two important purposes: First, if the buyer learns that the IP representations and warranties were untrue when made (or would be untrue as of the proposed closing date) to a degree of materiality set forth in the acquisition agreement, the buyer may not be required to consummate the acquisition. Second, if the IP representations and warranties are untrue at either of such times, the buyer may be entitled to be indemnified post-closing for any damages arising from such misrepresentation by the seller. Accordingly, the seller will negotiate for limitations on the scope of the IP representations. The seller will also want to limit this exposure to as small a portion of the purchase price as possible (held in escrow by a third party) or require that the buyer pursue claims primarily against a policy of representations and warranties insurance. However, given the importance of IP to the buyer, it may seek the right to recover up to the entire purchase price if the IP representations and warranties turn out to be untrue.
The buyer typically wants the selling company to represent and warrant that (i) the selling company’s operation of its business does not infringe, misappropriate, or violate any other parties’ IP rights; (ii) no other party is infringing, misappropriating, or violating the selling company’s IP rights; and (iii) there is no litigation and there are no claims covering any of these matters that is pending or threatened. These representations are extremely important to a buyer since a post-closing lawsuit alleging infringement not known prior to closing can expose the selling company or the buyer to substantial damages or, worse, loss of the right to use the intellectual property it purchased. Of course, a seller does not want to, and should not, shoulder the entire infringement risk. Given these competing considerations, the scope and limitations of these representations and warranties are often heavily negotiated and the outcome of the negotiation is largely dependent upon the bargaining power of the parties.
The buyer will be concerned about overly broad licenses and change in control provisions in the selling company’s IP-related agreements. For example, if a key license terminates upon a change of control, the buyer may seek a substantial purchase price reduction or walk away from the deal altogether. A prudent seller will review its IP documents early in the deal process in order to identify these provisions and work with its advisors to develop a strategy for addressing any identified risks.
The buyer will undertake a careful review of the selling company’s involvement in any current or past IP litigation or other disputes.
The buyer will want to confirm that the selling company has implemented and maintains appropriate policies, practices, and security concerning data protection and privacy issues. With recent highly publicized data breaches and significant changes in applicable laws (such as the recently effective EU General Data Protection Regulation and recently enacted California Consumer Privacy Act), buyers are especially sensitive to cybersecurity and data privacy matters in the M&A setting. And, sellers need to anticipate these concerns and conduct a thorough review of their policies, practices, and security, as well as possible exposures and non-compliance with legal requirements, in order to effectively negotiate cybersecurity- and data privacy-related provisions of the acquisition agreement.

A comprehensive discussion of these issues in contained in 13 Key Intellectual Property Issues in Mergers and Acquisitions.

9. Don’t Get Trapped at the Letter of Intent Stage

One of the biggest mistakes made by sellers is not properly negotiating the letter of intent or term sheet.

Frequently, a buyer will present the selling company with a non-binding letter of intent or term sheet that lacks detail about key deal terms. Large serial buyers usually leave the impression that these preliminary documents are more a formality internal to their process, and therefore should be quickly signed so that the buyer can move without delay to the next “more important” stages of the M&A process (such as due diligence and negotiating definitive acquisitions documents, including continuing employment arrangements).

However, a selling company’s bargaining power is greatest prior to signing a letter of intent or term sheet. These documents, although non-binding with respect to business terms, are extremely important for ensuring the likelihood of a favorable deal for a seller. Once the letter of intent or term sheet is signed or otherwise finalized, the leverage typically swings to the buyer. This is particularly the case where the buyer requires an exclusivity or “no shop” provision prohibiting the seller from talking to other bidders during negotiation of a definitive acquisition agreement. To avoid this trap, the selling company needs to negotiate the terms of the letter of intent or term sheet, with the assistance of its legal and financial advisors, as if it were a binding document.

The key terms to negotiate in the letter of intent or term sheet include the following:

The price, and whether it will be paid in cash up front, or all or partly in stock (including the type of stock), and whether any of the purchase price will be deferred and evidenced by promissory notes.
Any adjustments to the price and how these adjustments will be calculated (such as for working capital adjustments at the closing).
The scope and length of any exclusivity/no-shop provision (it is always in the best interests of the seller to keep this as short as possible, such as 15 to 30 days).
The non-binding nature of the terms (except with respect to confidentiality and exclusivity).
Indemnification terms and whether buyer will purchase a policy of representations and warranties insurance to insure against damages resulting from breaches of the seller’s representations and warranties.
The amount and length of any indemnity escrow and a provision stating that the indemnity escrow will be the exclusive remedy for breaches of the agreement (and any exceptions from this exclusive remedy, including for breaches of “fundamental representations” such as capitalization and organization of the company).
Other key terms to be included in the acquisition agreement (discussed in the next section below).

See Negotiating an Acquisition Letter of Intent

10. The Definitive Acquisition Agreement Is Extremely Important

One key to a successful sale of a company is having a well-drafted acquisition agreement protecting the seller as much as possible. To the extent feasible and depending on the leverage the seller has, your counsel (and not the buyer’s counsel) should prepare the first draft of the acquisition agreement. Here are some of the key provisions covered in the acquisition agreement:

Transaction structure (for example, share purchase, asset purchase, or merger)
Purchase price and related financial terms
Possible adjustments to the price (a seller ideally wants to avoid the risk of downward price adjustments based on working capital calculations, employee issues, etc.)
The milestones or other triggers for earnouts or contingent purchase price payments
Where stock is to be issued to the selling stockholders, and the extent of rights and restrictions on that stock (such as registration rights, co-sale rights, rights of first refusal, Board of Director representation, etc.)
Amount of the indemnity escrow or holdback for indemnification claims by the buyer and the period of the escrow/holdback (an attractive scenario for a seller is no more than 5-10% of the purchase price with an escrow period of 9 to 12 months). In some deals it may be possible to negotiate for no post-closing indemnification by the buyer and no escrow/holdback. This may be achieved through the use of M&A representations and warranties insurance.
The exclusive nature of the escrow/holdback for breaches of the acquisition agreement (except perhaps for breaches of certain fundamental representations)
The conditions to closing (a seller will ideally want to limit these to ensure that it can close the transaction quickly and without risk of failure of such conditions)
The nature and extent of the representations and warranties (a seller wants these qualified to the greatest extent possible with materiality and knowledge qualifiers). Intellectual property, financial and liability representations, and warranties merit particular focus.
If the closing of the transaction does not occur immediately following signing, the nature of the business covenants applicable between signing and closing (a seller wants these to be limited and reasonable, with the ability of the company to get consents if changes are needed, with the consent not to be unreasonably withheld, delayed, or conditioned).
The scope of and exclusions to the indemnity (including baskets, caps, and carveouts from the indemnity)
The treatment of employee stock options
The terms of any management team/employee hiring by the buyer
Provisions for termination of the acquisition agreement
The responsibility and cost for obtaining any consents and governmental approvals
Responsibilities of the parties for obtaining antitrust and competition law clearances and approvals
Whether the transaction will be subject to U.S. CFIUS review if there is a foreign buyer or other national security interests involved, and allocation between buyer and seller of the risk that the deal will not close due to government objections
The allocation of risk, especially concerning unknown liabilities

See 18 Key Issues in Negotiating Merger and Acquisition Agreements for Technology Companies

11. Employee and Benefits Issues Will Be Sensitive and Important

M&A transactions, particularly in the case of technology companies, will typically involve a number of important employee and benefits issues that will need to be addressed. The employee questions that frequently arise in M&A transactions include the following:

How will the outstanding stock options and restricted equity issued by the seller be dealt with in allocating the M&A consideration?
Do any unvested options or equity accelerate vesting as a result of the deal? If not, should the seller negotiate for acceleration? Some options held by management may be subject to a “single trigger” (vesting acceleration solely by reason of the deal closing), and others held by management or key employees may be subject to a “double trigger” (vesting acceleration following the closing only if employment is terminated without cause or for “good reason” within a defined period following closing). The equity plan and related option or equity grant agreements must be carefully reviewed to anticipate any problems.
Will the buyer require key employees to agree to “re-vest” some of their vested options or rollover/invest some of their equity in the continuing entity?
Does the seller need to establish a “carveout plan” or provide retention agreements to retain management or key employees through the closing (typically where the deal value is unlikely to fairly compensate them through their stock options)? Is there a need for a change in control bonus payment plan to motivate management to assist in the Board’s effort to sell the company while staying focused on continuing to run the company’s business despite the distractions of the sale process?
Will the acceleration of payouts to management or certain key employees from the deal trigger the excise tax provisions of Internal Revenue Code Section 280G (the so-called “golden parachute” tax)? If so, the seller may need to obtain a special 75% stockholder vote to avoid application of this tax liability (and the related loss of tax deductions available to the buyer).
What are the terms of any new employment agreements with or offer letters to key management of the seller?
If there will be termination of employment of some of seller’s employees at or shortly following the closing, which party bears the severance costs?
If the buyer is not a U.S. company and does not desire to grant stock options or equity incentives, what types of cash compensation plans will the buyer use to retain key employees of the seller?
Have all current and past employees signed confidentiality and invention assignment agreements? Will employees be required to sign a new form with the buyer?
Are there any employment agreements of the seller that are problematic for the buyer?
Will the buyer insist on certain agreements—such as non-compete agreements (to the extent lawful)—with key employees as a condition to closing the deal?

12. Understand the Negotiation Dynamics

All M&A negotiations require a number of compromises. It is critical to understand which party has the greater leverage in the negotiations. Who wants the deal more—the buyer or the seller? Are there multiple bidders that can be played against each other? Can you negotiate key non-financial terms in exchange for an increase in price? Is the deal price sufficiently attractive that the seller is willing to live with post-closing indemnity risks that are greater than it would otherwise prefer? Do you have an experienced M&A negotiator on your side who knows what issues are not worth fighting about?

It is important that your M&A team establish a rapport with the lead negotiators on the other side, and it is never helpful to let negotiations get heated or antagonistic. All negotiations should be conducted with courtesy and professionalism.

For a comprehensive overview of this topic, see the authors’ new book on M&A published by Bloomberg: Mergers & Acquisitions of Privately Held Companies: Analysis, Forms & Agreements.