COVID-19 has devastated the global economy, caused many companies to freeze or significantly curtail operations, and impacted many M&A transactions. However, for those Canadian small and medium enterprises (SMEs) who are still contemplating a sale of your business in the future, this lockdown period is the perfect time to prepare your company for a successful sale. In this article we provide some practical tips on how best to use a slowdown in operations to prepare your business for a future M&A transaction.
Gowling WLG Focus
Although the economic slowdown has created an unprecedented number of challenges for businesses around the world, it also offers an opportunity to get your house in order if you are contemplating selling your business in the future (or as a matter of good practice, generally).
In mid-market M&A the sellers of a business may not have any transactional experience and may be overwhelmed by the amount of diligence requests, calls and documents to collect and review. Typically it is the founders, management and key employees of a business that are charged with coordinating the diligence requests and managing the sale while continuing to run the business. This can result in a dip in financial performance at a time when the target company is being financially evaluated and the purchase price is being negotiated.
If you are contemplating selling your business in the near future (or were in the process of doing so before it was postponed) and operations have slowed down during the COVID pandemic, now is a great time to start preparing the business for a sale in an effort to both significantly speed up the legal due diligence process (and consequently, the sale), and reduce the burden on the founders/key employees of the business during the transaction.
Tax-Efficient Structuring of the Transaction
From a seller's perspective, any proposed sale of the business will ideally be completed on the most tax-efficient basis for the seller, and it is common in M&A transactions for there to be an analysis of whether a share or asset sale is best (generally, a share sale will be preferred by the seller while an asset purchase will be preferred by the buyer). Some measure of tax-deferral can usually be achieved if the buyer and seller are willing to include shares of a corporate buyer as part of the consideration received by the seller, but this can be difficult to structure where the buyer is not a Canadian company.
Depending on the circumstances, a pre-transaction reorganization might be necessary to achieve a more tax-efficient result from the seller's perspective. Such a reorganization could involve, for example, a restructuring of the seller's shareholdings (perhaps transferring shares held individually by a shareholder into a holding company or trust structure). If the seller intends to keep some of the target company's assets (or the buyer is unwilling to purchase certain assets), a pre-transaction reorganization might involve spinning out those assets to the seller, or to a new corporation owned by the seller, prior to closing the transaction (for example, spinning out any owned real estate into a separate company and leasing it back to the target company, or spinning out retail assets when the buyer is only interested in manufacturing assets).
Ensuring an individual seller's ability to access the lifetime capital gains exemption can also be an important consideration in circumstances where the seller has available exemption room, but might require a pre-sale reorganization transaction to purify the target company of certain assets that could preclude access to the exemption (e.g. excess cash or passive investments). In addition, one of the requirements for the exemption's application to a share sale is that the seller have held the shares for at least two years, so if a seller's likely exit event involves a share sale they would be well advised to consider the implications of that requirement well in advance.
As might be expected, the complexity of implementing a pre-transaction reorganization can range from simple and straightforward to complicated and time consuming, depending on the measures to be implemented. Practically speaking, structuring any pre-closing reorganization will necessarily involve balancing a seller's desire for optimal tax efficiency versus a purchaser's desire for simplicity and low risk. Since closing documents cannot be finalized until the final structure of the deal is understood by all parties, and typically the completion of the reorganization is a condition to closing under the purchase agreement, a complex or last minute reorganization could result in increased professional fees and potentially delay closing a transaction.
Preparing for Legal Due Diligence and Disclosure Schedules
One of the first steps in any M&A deal is for the buyer's counsel to submit a legal due diligence request list to the seller's counsel. This diligence list contains questions and information requests on every aspect of the business, and will form the basis of the information disclosed against the seller's representations and warranties in the purchase agreement (commonly known as the "Disclosure Schedules"). Providing complete and accurate responses to diligence requests and accurately populating the Disclosure Schedules gives the buyer more information with which to assess the deal, and protects the seller by increasing the likelihood that the representations and warranties are indeed correct or appropriately qualified. Providing the buyer with detailed disclosure on the operations of the business can also help the seller negotiate lower earnout or holdback amounts (to receive more of the purchase price on closing), as well as lower liability caps and reduced indemnification periods, as the risk of the representations and warranties being incorrect is reduced.
Although there is no substitute for working closely with your legal and financial advisors through an M&A transaction, below we have provided some practical advice on tasks you can do now during the economic slowdown to help prepare your business for a smoother sale, and potentially, on better negotiated terms.
- Minute Books: Generally speaking, it is more advantageous for a seller to sell the company by way of a share sale. Therefore, it is essential that the company minute books are historically accurate and up-to-date. This includes (i) accurate records of all share issuances, transfers and cancellations, along with up-to-date shareholder registers and ledgers; (ii) historically accurate and up-to-date directors and officers registers; (iii) shareholder resolutions authorizing the appointment of directors and other matters reserved for the shareholders (which typically includes amending the constating documents of the company); (iv) director resolutions authorizing the appointment of officers and other matters reserved for the directors (which typically includes share/option issuances, dividends and entry into certain contracts); (v) copies of any shareholder agreements (including any amendments); and (vi) original (or copies of) share certificates for any shares issued and outstanding.
Action items: Review the minute book now to see if it contains all of the above information and if not, work with your legal and financial advisors to fill in the gaps.
- Employees and Contractors: A buyer will be keen to understand the makeup of your workforce in order to assess any potential liabilities and begin workforce planning post-closing. As part of their diligence a buyer will likely ask for (i) a record of all employees, listing information such as their name, job title, age, salary/wage, status (full-time employee, part-time employee, contractor), start and end date, benefits (vacation, car allowance, dental, etc.) and any other notable terms of their employment/contractor agreement; (ii) fully executed copies of all employment/contractor agreements; and (iii) copies of any policies, handbooks, pension plans and benefits plans.
Action items: If you haven't already done so, create a record of all employees specifying the information outlined above, collect fully executed copies of all employment/contractor agreements, and collect copies of any and all policies, handbooks, pension plans and benefit plans. If needed, create a list of employees/contractors for whom you don't have a signed copy of an agreement or any agreement. Once you've completed the above you should discuss your approach with legal counsel before asking employees/contractors to sign anything or taking any further action. Further, in the event that past employees have been disgruntled on leaving the company, you should collect any facts and correspondence in relation to same as this may need to be disclosed during the diligence process.
- Material Contracts: Understanding the contractual commitments of a target company, including whether there are any contractual issues in relation to assignment, change of control, non-competition, exclusivity and/or most-favoured-nation clauses, makes up a key component of the legal (and financial) diligence process. Typically the buyer will request fully executed copies (including any amendments, side letters or assignments) of all real property and equipment leases, customer contracts, supplier contracts, financing/banking documents and any other material contracts of the target company.
Action items: Collect fully executed and dated copies of all of the contracts listed above (including any amendments and any assignments). Create a list of any missing, unsigned or undated contracts, and include any notes in the list that may be helpful to add context (for instance: "lease assigned from "X" to "Y" on [date] but waiting for signed copy back from landlord"). Consider creating an electronic database for these contracts so that they are easily located, sorted and shared with your advisors, and ultimately your buyer. If you have had any material disagreements with customers or suppliers, make a note of such instances and record all correspondence as this may need to be disclosed.
- Intellectual Property: The rights of a target company in any intellectual property is an important aspect of many transactions. It should be clear what intellectual property the target company owns, including any trademarks, patents, copyright and source code, and whether such intellectual property is registered, and if so, where (jurisdiction) and when. For intellectual property that is not owned, the buyer will want to understand the terms and conditions of any intellectual property licences. Further, a buyer may ask the seller to show that employees have relinquished, waived or assigned any rights to company intellectual property in the form of a written agreement. The nature of the target company will dictate how much time and attention is paid to this aspect of legal due diligence (for instance, the ownership of intellectual property is likely much more important in a tech or manufacturing deal as opposed to the purchase of real estate assets).
Action items: Create a list of all owned and licensed trademarks, patents, copyrights and source code. As part of your review of the company's employment records, check to see if employees and contractors have agreed to assign their rights to any intellectual property or waived their moral rights in any copyrighted work. Make a list of any third parties that have claimed that the company has breached their intellectual property rights, and vice versa.
- Existing Indebtedness and Encumbrances: In any transaction, a buyer will want to acquire the company 'free and clear' of any encumbrances, so it will be important to identify any encumbrances against the assets of the business and the shareholders (their shares in the company may be secured). If your business has existing debt then a buyer will want to understand the impact any sale will have on your financing arrangements. Most loan documentation requires the lender's consent to any change of control of the company or assignment of material assets, and there may also be prepayment penalties if the intention is to pay out all existing indebtedness on closing. Dealing with lenders can add complexity and delays to a transaction, so understanding the impacts of a sale at an early stage can help mitigate these risks.
Action items: Consider running lien or judgment searches against the company and its shareholders to ensure you are aware of any outstanding personal property registrations, liens or judgments against the company's assets or shares. Your legal counsel can perform this efficiently if you do not have the resources to do this. You should review any agreements with your lenders to determine the impact any sale will have on your financing arrangements.
- Regulatory Considerations: If the target company operates in a regulated industry (for instance, telecommunications, money services, cannabis, pharmaceuticals, defence, etc.) then a buyer will want to see copies of all regulatory and/or import/export permissions, as well as any material correspondence with the applicable regulators (for instance, OSFI, FINTRAC, Health Canada or Public Services and Procurement Canada). In addition, if individual permissions are required by the applicable regulator to operate the business (for example, security clearances or assessments with Health Canada or under the Controlled Goods Program), then you should identify who these individuals are, what permissions they hold and how long they have held them. These items are often fundamental to the operation of the business, and consent from the applicable regulator may be required to complete a sale transaction. Understanding the regulatory landscape for a target business can also be important from a foreign investment perspective if a foreign buyer seeks to acquire the company. Obtaining consents from regulatory and government bodies can be a time consuming process. Having a good handle on these requirements at the outset of your transaction should mitigate the risk of delays in your closing.
Action items: If the target company is regulated then all permits, certificates and material correspondence received from the regulatory body should be sourced, along with any information pertaining to individuals with specialized permissions. You may also want to begin taking steps to prepare any change of control notifications or consents that may be required in light of a sale transaction if you have the internal expertise/capacity to do so. Being prepared from a regulatory perspective can help reduce lag time to file any required documentation, which can help reduce the interim period between signing and closing and increase deal certainty.
Organization of Diligence Materials
Of course, when collecting the documentation mentioned in this article it is strongly recommended that all documentation be in electronic form and labelled and stored in an organized fashion. It may be advisable to ask legal counsel for a copy of a typical diligence request list so that you can organize your documents in accordance with the heading and numbering contained therein. Alternatively, you can create your own index and filing system of your records. Conducting legal due diligence is time consuming and expensive, so if the diligence materials are clearly organized and correctly labelled it can help to reduce time and cost for all parties. As first mentioned above, by providing the buyer with complete, organized and accurate information in the diligence stage, the sellers can build goodwill and trust with the buyer and may be able to negotiate more favourable terms in the sale transaction.
The above suggestions are aimed at helping sellers use any down time during the economic slowdown to facilitate complete, accurate and timely disclosure to a prospective buyer. Being organized on the run up to a sale transaction can not only assist in speeding up the transaction and negotiating more favourable deal terms, it can also help save on professional fees. Ultimately, you should put yourself in the buyer's shoes: think about what is important to your business' success and focus your review on those items.
Even if you are not contemplating the sale of your business in the near future, utilizing the time created by any slowdown in your company's activities caused by the COVID-19 pandemic to properly organize your company and identify any potential issues will enable you to hit the ground running when normality is restored, and also promote a culture of good corporate governance within your organization.