Karen: Good afternoon everyone. It 's now 1:00 o'clock so we're going to get started. So welcome and thank you for attending the second installment of Gowling WLG's M&A webinar series; M&A in Uncertain Times. Today our panel will discuss how you can use the economic slowdown, caused by COVID-19, to get your house in order if you're contemplating selling your business in the future, or as a matter of good practice, generally. Our first installment aired last week on how the disruptive effect of COVID-19 is impacting M&A transactions in Canada at different points in the deal life cycle. If you missed the first webinar series, an on demand version has been posted to our website. Before we get started, just a few housekeeping points. To view the presentation, all speakers please click on the speaker view in the upper right hand corner of your screen. For questions throughout the session please use the Q&A button at the bottom of your screen. We'll try our best to answer questions at the end of the session and you should feel free to reach out to our team afterwards as well. This presentation is also being recorded and will be posted on our website in a few days. It also counts for 1 hour of Continuing Professional Development. For example, in the case of Ontario, it counts for 1 hour of substantive credits towards the mandatory annual CPD requirements of the Law Society of Ontario. And it wouldn't be a law firm webinar without a legal disclaimer. As you expect, today's session is a high level overview. For any specific advice please contact your legal counsel. As you know this situation is extremely fluid and changing daily. So now to our panel.
Participating in today's session are, one of our tax partners, Ted Thiessen and three of our M&A lawyers, Melanie Condic, Marcus Hinkley and Lorraine Mastersmith. I am Karen Hennessey, also an M&A lawyer and I'll be moderating the discussion today.
Turning to our agenda, our plan today is to discuss a number of actions that a seller, or a target business, can take to make the deal process run smoothly. We know that in many big market M&A deals the sellers of the business may not have been through a transaction before and may be overwhelmed by the amount of diligence requests, calls and documents to correct and review. Typically, it's the founders and key employees of a business that are charged with coordinating the diligence requests and managing the sale. But these are the same people who are trying to run the business and are working full time doing so. This often results in a different financial performance at a time when a target company is being financially evaluated and the purchase price is being negotiated. Our suggestion is for business owners to use this slowdown in operations to organize the company's affairs and ensure a smoother and more efficient diligence period. We also provide some practical examples of what can happen if the target is not prepared and then provide practical and easy tips on how to prepare your business for sale. We will discuss steps that can be taken to ensure a tax efficient sale from the seller's perspective, including how to minimize tax payable on the sale proceeds, and also how to anticipate and be proactive on the items that a buyer would be most interested in during the due diligence phase. This is a moderated discussion so we're now going to take down the slides so that the panel is more prominent in your screen. My first question is for each of the panelists and I'll ask you to set the stage and provide some context. Tell a story, or even a horror story, of a deal that you've worked on that may not have gone as the seller planned and how the seller could have mitigated that issue. So, Melanie, can I start with you?
Melanie: Hi Karen. I think we can all speak about transactions that have been derailed by items that have come up during the due diligence process. Something all sellers need to be conscious of is that this the buyer's look at their company. There view of these records will impact the buyer's view of how the business is being run. A seller using its resources on the front end can be really beneficial, especially if it's doing it while they're not under a time crunch. For example, I had one file last year that died at the due diligence phase, mostly because the records of the seller were a mess. The data room was basically a data dump that we had to try to make sense of. In this transaction the seller from a pharmaceutical business and the buyer was interested in some of its key patents. We were given access to the data room, the records were really unorganized, there was a ton of material, most of it was haphazardly placed in different folders in the data room. There were several duplicates of the documents. We had also discovered pieces of a historical reorganization that we weren't told about so we had to try and puzzle all these pieces together to understand the chain of title to these IP assets. But because everything wasn't there, and the seller themselves couldn't give us a roadmap to the company's history, along with all these missing links between all the documentation, the state of these records made it too risky for a client to proceed at their original price point. The seller, themselves, wasn't wiling to come down. Had the seller, in that instance, taken the time up front to organize those records so that they could address those missing links by either filling them or explaining what had happened, the transaction might not have fallen apart.
Marcus: Hi everyone. Marcus here. Thanks for joining us today. In my experience I found that whenever regulatory licence or permits involved, it can potential delay a transaction, and this can sometimes be quite significant if the seller's not organized. One particular example that comes to mind is a deal that involved product that were defense related and they were therefore registered under the Canadian Controlled Goods Program. During the diligence process we were acting for the buyer, who was a large US client of ours, and we had asked the target do you have the products registered under the Controlled Goods Program here in Canada, or is there anything registered under the International Traffic in Arms Regulations in the US, so ITAR, some of you may know. The target wasn't really sure if they had any of these registrations, and it wasn't until signing the deal that they realized that they had, and produced the relevant documents. This required us to delay the transaction to provide a 45 day window to allow for a pre-transaction notification under the Invest in Canada Act. Then we had to add a closing condition for the approval of the investment review division. Something else to bear in mind there is had a national security review been ordered, by the government, then this would have delayed closing by up to a further 200 days. It just highlights that knowing whether there are any regulatory hurdles, at the outcome of a transaction, can really help the parties allocate the risk and plan the transaction accordingly.
Ted: Hi everybody. I'm Ted. I'll talk a little bit about tax stuff today. I can give an example, certainly, of something that I see fairly often. Although a lot of business owners are generally aware of the existence of the lifetime capital gains exemption, it's a much smaller subset of those people that might be more familiar with what the actual conditions that need to be met in order to take advantage of that exemption. There are several conditions. I won't be able to discuss all of them today because there are so many and they are so detailed that subject could have it's own webinar. Two conditions that often comes as surprise to business owners are one, they need to own the shares directly in order for the capital gain to qualify for the exemption, and second, they need to have held the shares for at least 2 years prior to sale. For business owners that utilize a structure where they hold shares in a holding company, that in turn holds shares in an operating company, those two conditions that I just mentioned, can cause some last minute scrambling particularly if the holding structure was put in place less than 2 years prior to the sale. For example, a buyer for reasons that we'll touch on later when we talk about due diligence, is rarely going to be interested in acquiring a holding company with an operating company underneath it. They almost always want to acquire the operating company only. For business owners who holds their operating company indirectly through a holdco, a sale of the operating company by the holding company wouldn't be sheltered, typically, by the capital gains exemption. Even if the business owner can convince the buyer to purchase the holdco shares, that sale can only benefit from the exemption if the business owner has held the shares of the holdco for more than 2 years, which can be a problem for buyers that put a holding structure in place, and then before the 2 year period is up they decide to sell. How could those issues have been mitigated? It's important to remember that you need to have the end goal in mind. Depending on the nature of your business, if the most likely exit event is a sale, then ideally you should periodically be talking to your tax advisor to get a sense of what that might look like given your current structure. It's easy to get caught up in the day to day running of your business, but periodically checking in with your advisor to discuss options well in advance of an exit event when you actually have the luxury of time to think about them, is always going to be the best mitigation strategy.
Lorraine: That's great. Thanks, Ted. Hi, this is Lorraine. Hi everyone. Building on what Ted has just described, I've been involved in numerous transactions where, pre-transaction, reorganization of the seller has resulted in delays. From a corporate perspective, these reorganizations can involve layers of holding companies and trusts, and when they're done late in a transaction, which is often the case, they result in additional late stage due diligence requirements. Substantive revisions will need to be made to the purchase agreement. The parties will have changed from what was initially contemplated and therefore, you're going to have to make some changes to the purchase agreement, and the parties are going to have to contemplate what part of their due diligence would need to be done of those other entities that have been interposed into the transaction. I've seen these types of circumstances prolong closing by several months. As Ted said, if you put these tax efficient structures in place prior to negotiating the terms of a sale, those types of delays can be easily avoided. Also, following on to what Marcus had to say, particularly in respect of businesses that are contractors or sub-contractors to companies with government contracts, I've been involved in several transactions where closing's been delayed due to matters that could have been dealt with by the seller in advance. One in particular that comes to mind involved compliance by the seller with provisions in its material contracts relating to government procurement policies. Concerns in this regard only came to light during the due diligence process, and the buyer ended up modifying the reps and warranties that they had included in the purchase agreement, as a result of it's diligence findings. The seller then had to go back and conduct an internal analysis to determine whether or not it was complying with the terms of its material contracts. Then it had to take steps to modify its business practices to ensure that it could provide the representation required by the purchaser in the agreement. Had an internal review of the seller's compliance, that these contractual requirements been undertaken prior to the transaction negotiations, this would have prevented the delay that was caused by the seller's need to conduct that material analysis, and they would have been in a position to propose acceptable qualifications to the reps that were required by the purchaser.
Karen: Great. Thanks everyone. Ted, you mentioned a client not being able to take advantage of the capital gains exemption and how with advanced planning that client could have fared much better from a tax perspective. Lorraine also mentioned tax issues relating to a corporate company's corporate structure. Can you give us any other tips on how a seller, or a company, can prepare now to minimize tax payable on the proceeds of a sale?
Ted: Yeah. Sure. Thanks, Karen. A few things. In terms of reducing tax liability on a sale, it would make sense to incorporate, if you haven't already. Because quite apart from the liability consents that often drive the incorporation decision, incorporation can have tax benefits if a sale is going to be the likely exit event. That's because a sale share is generally going to be taxed as a capital gain, and when you compare that to the sale of assets of an unincorporated business, particularly one that's been operating for a long time, that type of sale would typically give rise to recapture. Recaptures taxed at a higher rate than capital gains are taxed. You can usually move the assets of an unincorporated business into a corporation under tax deferred basis. It can typically be done without incurring an upfront tax cost or cash cost. Assuming you're already incorporated, you might want to think about issuing shares to your spouse or other family members, to the extent you haven't already. These transactions can be implemented to allow that to happen without requiring significant capital injections. The benefit, obviously, is that spreading the sale proceeds over more shareholders will generally reduce the overall tax rate payable on the sale. To go back to the capital gains exemption for a minute, one of the other conditions that you have to meet for that exemption to be available, is that during the 2 years you hold the shares of the assets of the company you're selling have to fit certain criteria. Generally speaking, 50% or more of those assets have to be used in an active business in Canada. So, bad assets for purposes of that test might include, for example, things like passive investments, or excess cash. On a periodic basis you're going to want to examine your company's assets and make sure that you're not offside the value requirements of the capital gains exemption. Because once you're offside, you have to get back onside before 2 year clock can start running again, you effectively restart the 2 year period. Purification transactions have been devised by tax advisors to help you make sure you meet the test but you have to stay on top of it so that you're aware of when you might need to take remedial action.
Karen: Great. Thanks, Ted. That's happened to one of my clients, for sure, where the company thought it was a good idea to put their investment portfolio in there. It was a big surprise when they realized that put them offside the test. There was a lot of scrambling going on. I think that it goes without saying that tax advice is critical to any business owner thinking about a sale. I want to move on now to issues that the seller may be concerned about. We know that one of the first substantive steps that a buyer will undertake before committing to a purchase is due diligence. I think it's fair to say that most business owners, in particular owners of small to medium sized businesses, greatly underestimate the work involved in the diligence process. Lorraine, can you please describe the purpose of diligence and why a seller needs to be organized?
Lorraine: Sure, Karen. The purpose of due diligence is to provide the purchaser with information that's required for them to make a proper assessment of the business that they're buying. The purchaser's going to want to know about the quality of the assets and the nature of the liabilities that it's going to assume when it takes ownership of the business. The information that's disclosed to the purchaser in the diligence process is then measured against the seller's reps and warranties in the purchase agreement. From the seller's perspective, going through this process informs whether or not they can make the requested representations. For example, compliance with its material contracts, which I mentioned earlier. To ensure that appropriate qualifications are made to those representations where that's necessary. By taking the steps early in the process of readying the company for a sale, to gather the information that's typically requested by a purchaser, and reviewing the material contracts for compliance, the seller will find itself very much prepared to determine what representations it can provide and what qualifications might be needed. Which will result in avoiding late stage surprises that could delay a closing or even become a deal breaker. The more organized a seller is in this regard, the greater the confidence this is going to instill in the purchaser, that the management of the company is on top of the business. This in turn could lead to the ability of the seller to negotiate lower earnout amounts or holdback amounts. That means more cash in the seller's jeans on closing. All good reasons.
Karen: Yeah. That's the ultimate goal. Cash in jeans. So we discussed how selling shares of a business can have significant tax advantages for a seller. But before a buyer's going to commit to purchasing shares, one of the first things they're going to want to see, of course, is the company minute book. Melanie, can you talk about the importance of having the minute book in order?
Melanie: For sure. As Lorraine had mentioned, being organized is key to any due diligence review, and having an organized and up to date minute book is one of the ways that the seller can show the buyer that they're on top their business. The most critical part of these records for the buyer will be ensuring that there is a clean chain of title to the shares that they're potentially going to acquire. So if there's any deficiencies relating to the issuance of shares, or the transfer of any shares, they may be putting the deal in jeopardy. Even if you don't want to necessarily engage lawyers to fix issues right now, taking the time to identify any gaps, draft up a list of missing information, such as missing share transfers, unrecorded share issuances, any contracts that the company's entered into or changes in management, by having that list your life will be a lot easier when you do eventually work with your legal team to rectify the records. The less of a time cruncher on when you're doing this, the easier it is to be efficient. There are certain items that you may not even be aware that should be in your minute book. If you're uncomfortable and uncertain about this, one of the items of value that you might consider, is reaching out to your law firm and having a member of their corporate services team, one of the law clerks, complete a minute book review. This is a cost efficient way to identify these issues and it's easier to work from a deficiency list to start rectifying items. These clerks are day and day out in minute books so they know what should be in them. They can point out then what common items are missing, such as your annual director and shareholder resolutions. If you had a multitude of unsigned resolutions or minutes that you need to go track down, whether there's original share certificates in the minute book, or if there's just copies of their records of where those originals are, and finally, if there are shareholder agreements, because if there's a shareholder agreement potentially that could impact the approvals and timing for your transaction. We're talking about this in context of a share deal. In an asset deal the seller will still want to look at the minute book because they'll want to see what approvals are necessary but it might be on a lower priority than in the instance of a share deal. But, as Ted mentioned, a share deal is usually more optimal for the seller so you're going to want to make sure that those records are in order.
Karen: Great. Thanks. Another key consideration in a deal is that a buyer's not only assuming the physical assets and contracts of the business, but also acquiring the businesses workforce. Lorraine, what types of information is a seller typically interested in about a business with employees?
Lorraine: Thanks, Karen. A buyer's going to be keen to understand the makeup of your workforce in order to assess any potential liabilities, and they'll also want to begin the workforce planning, for post transaction. You're going to need to be in a position to provide detailed information on all of the employees. Particularly relating to things like salary, age and the length of service of each employee. A purchaser is going to want to review all of the employment contracts you have in place and all employee handbooks and policies. Particularly if you're a technology company, buyers are going to want to ensure that you actually own all of your intellectual property. In this regard, they'll want to ensure that all employees have signed contracts that assign to your company all of their rights in any intellectual property that they developed during the course of their employment. Buyer's counsel is going to be looking for specific language in these contracts that requires employees to waive all of their moral rights in any IP that they develop. Further, in the event that any past employees have been disgruntled on leaving the company, you should collect any facts and correspondence in relation to this, as the buyer is going to want to assess any risk of litigation and potential liability that might result from a departing employee.
Ted: Yeah. That's good, Lorraine. Just staying with the employee topic for a minute. On the tax side the classification of workers as contractors versus employees can often a thorny due diligence issue. That's because of what we've been talking about here is the fundamental difference between asset sale and a share sale is that in a share sale the buyer's going to be quote/unquote "inheriting" all the liabilities of the company. A tax liability is going to be foremost in their minds. It's not uncommon for small and medium sized businesses to retain the services of a number of workers, that they choose to categorize as contractors rather than employees, and because the employer categorizes them in that way the employer doesn't withhold source deductions for income tax, doesn't withhold CPP or EI and doesn't make CPP or EI contributions. In some cases the categorization that might have been agreed upon between the employer and particular worker doesn't necessarily hold up under close scrutiny. For example, regardless of the name that the employer and the worker decide to give to the relationship, if the worker doesn't work for anyone else, uses tools and space that are exclusively provided by the employer, and has no real control over what he or she can accept or turn down, that worker might well be an employee and not a contractor, for tax purposes. Which would mean that the corporation should have been withholding income tax and CPP and EI, in respect to that worker, for who knows how long. Failure to withhold and remit source deductions can result in significant historic liability for taxes, premiums, interest and penalties for the company, and a purchaser's going to want to make sure that workers have been properly characterized, and that the appropriate source deductions have been withheld, and the appropriate employer contributions have been made and remitted in respect of all the target companies workers. Compiling supporting information regarding every worker that you're categorizing as a contractor is going to give the purchaser some comfort that you've been on top of it, and there is no hidden tax liability that they might become responsible for, post-closing.
Karen: Great. Thanks, Lorraine and Ted. From my experience, the time consuming part of the diligence process for seller's is the collection and organization of contracts. Melanie, can you talk about how a seller might go about organizing their material agreements and contracts?
Melanie: Yeah, sure, Karen. So I would say that one of the more onerous tasks of the seller undertaking in due diligence is the organization of their material contracts. Essentially, the seller's going to need to sort through all it's current agreements, take stock of them, figure out if there's any missing items or gaps in these agreements, such as an amendment that's missing or an unexecuted copy of a renewal. The buyer is going to want know what contracts they are inheriting. So if you, as a seller, have a sense of what commitments you have to and from third parties, this knowledge can assist you at the negotiation phase in marketing the sale of your business, because you'll be able to speak to those issues off-hand. Having an organized database of these material agreements can also make it easier to answer potential questions from a buyer. When it comes to the actual due diligence process it makes it easier for the buyer to verify the information you've given them. Then as a seller, one of the first steps you want to do is when you're going through these, identifying and sorting the types of contracts you have. This might be supplier agreements, customer agreements, services agreements, real property leases, equipment leases, other industry specific contracts. Then you're going to want to organize them accordingly. If you organize them by type of contract it's going to be easier for you at the DD phase to parse through them to provide the buyer with what they'll want to see.
Karen: Thanks, Mel. So once all the contracts are organized are there any particular clauses or provisions in the contracts that the seller should be reviewing or looking out for?
Melanie: Yeah. There's definitely some key provisions you're going to wanting to be looking for, particularly whether the transaction has the potential to trigger any obligations under these agreements. For example, a consent requirement from a third party. In the context of a share deal, this will typically be found under a change of control provision, and then if you're in an asset transaction you're going to be more looking at the assignment provisions to see if that gets triggered. Assuming that you're compiling this information without actually knowing your deal structure, we'd recommend that when you are taking note of these clauses, it might be helpful to index some of the details about how you go about obtaining the consent, whether it be a change of control or an assignment. Noting items such as like who is the person that you contact, is there any cost associated, are they entitled to information about the buyer such as the buyer's financial statements. Then what, if any, is any timing for consent because if you need to give 30 days notice, it's really important to know that ahead of time so that you can plan for that. I think what you need to remember as a seller is that these third parties don't have a vested interest in your transaction, usually, so they're not under the pressure to deliver the consents in a timely manner. You're often at their mercy. Because this is your deliverable under the transaction, if you do some of the leg work ahead of time, you'll have a sense of what kind of time and effort you might need to be putting into chasing these consents. I think the whole group can probably speak to instances where a third party consent either held up a transaction by a couple of days or a week or two, just because you couldn't get a hold of that landlord or it was just in their queue of emails and they get to it when they get to it. There's a couple of other obligations that maybe within some of these agreements. So something like a right of first refusal or a right to terminate a contract upon a change of control. For example, if a material supplier to your business can terminate the contract within so many days of a change of control, or someone else under a contract has a right to buy one of your material assets before you're actually able to offer it for sale, it might be proactive to have some of the discussions with those third parties before you go ahead and negotiate a sale that has the potential of being derailed, because this third party isn't going to consent to the transaction. And then, finally, one item I think that sometimes gets overlooked by sellers, is a confidentiality agreement obligation under these agreements. You'll want to go through these and determine what you can and cannot disclose. It may be that you're able to disclose the material contents as long as the other party's under similar confidentiality obligations. Which means you're probably going to have to sign a non-disclosure agreement before you show any of these contracts to a third party. Sometimes they'll be more rigid confidentiality obligations where you're not, let's say, be able to disclose any identifiable information about the third party. In that instance you may consider whether or not redacting some of that information, then puts you in a position where you can disclose it. One thing we just want to caution with redactions is make sure that the you actually use proper redaction software so they can't reverse engineer the redaction. Then there are other circumstances where you may not be able to disclose very much information about that agreement at all. You just need to be very in tune with those items.
Marcus: I think those are all great points, Mel. Just something that I'd like to add in here is when you're reviewing these material contracts it kind of builds a little bit about on what Lorraine was saying earlier on. You should be paying attention to whether these third parties are in the defense cyber security industry. Even the healthcare industry in the current climate. Look at whether any of these customers are government bodies in municipal, Provincial or Federal level, which is going to be particularly important if any potential buyer of your business is non-Canadian, as it may increase the risk of a national security review under the Investment Canada Act, and consequently could result in a delay to the closing and/or pre-transactional filings to the government.
Lorraine: Those are great points, Marcus, and one further comment I'm thinking that is also important to keep in mind, is just building on both comments from Mel and Marcus, is that assuming your due diligence process is successful and your transaction is proceeding, one of the more onerous obligations you're going to face is preparing disclosure schedules. That's used to qualify the representations and warranties that you're giving in the purchase and sale agreement. One of those tasks will include preparing a list of material contracts of the company and likely a list of all the required consents. If you've done the leg work that we've discussed, the process of populating these schedules is going to be far more cost efficient and you'll avoid numerous hours of doing, or paying your counsel, to do a deep dive into all the company's agreements when you're under other transactional pressures. It's a really good idea to do these things when you have the time, ...
Karen: That's great. So Marcus, I'm going to turn back to you as whenever text savvy lawyers, any other thoughts on how to organize the contracts that are actually available and ready for a buyer to review as part of due diligence?
Marcus: First of all, I think our head of IT would disagree with your text savvy comment, but I'm happy to talk to this. Something to bear in mind when collecting all of this information is that it's important that the documentation is in an electronic form and it's clearly labeled and organized in a coherent manner. This includes organizing the documents and folders and choosing a file name that makes it obvious what the document is. I'm a senior associate, and I can tell you from having spent the first 5 plus years of my career in diligence data rooms, that a well organized data room is not only going to help reduce the legal fees but it's going to make your legal team feel warm and fuzzy inside. We've taken the approach with some of our clients to set up a data room for them based on our standard due diligence request list and then we build in folders to reflect the questions we would typically ask for a seller. For instance, folders relating to employment agreements, material contracts, minute books and other things. This allows the target company to organize its documents ahead of time using the numbering and folder structure already in place in our diligence request list. It means that when a sale transaction occurs, the target company's able to provide the data in details to the buyer, complete with a breakdown of what is included and where. An organized and complete data room allows for the buyer to feel comfortable that complete and accurate disclosures has been provided and this can save time and money on both sides in negotiating the transaction. By eliminating as many questions on the buyer's diligence list as possible, and providing the buyer with the detailed disclosure on the operations of the business, the risk of the representations and warranties in the purchase agreement being incorrect is lowered and therefore, as a seller, you may be able to negotiate lower liability caps and reduce indemnification periods, or even receive more of the purchase price on closing by negotiating a lower earnout or holdback amounts.
Lorraine: Marcus, we have lots of clients in Ottawa that are using artificial intelligence in their diligence process. Are you seeing the same thing in Toronto?
Marcus: Yeah, we have Lorraine. We see clients on both sides of it really, buy and sell side, utilize AI, especially in analyzing large batches of contracts. We use a system called CARA which allows clients to drop in a large number of contracts and then it will run a report to identify how many agreements have a change of control provision, for example, or assignment restrictions. Building on what Mel was saying earlier on, it's kind of handy ahead of time figure out what you're working with. They can also turn your contract into searchable PDF's which makes the diligence process a little easier too. We had a client, in particular, that dumped 500 plus contracts into the system and asked it to produce a report outlining how many change of control, assignment, most favoured nation, an exclusivity clause, existed in those agreements. This allowed the client to quickly, and pretty cheaply, lay up what consents were required, if it was going to sell the particular division of the business and then which it later did. I think the use of AI and technology is extremely important and I'd encourage anyone on the call today to talk to their legal counsel or, if you don't have legal counsel, ask about setting up a data room and how you can use artificial intelligence to prepare your business sale.
Karen: Thanks, Marcus. Those are great points, including one of the first ones you made, which seems very simple but name your documents so you know what it is. I recently worked on a deal where there were close to 1,000 agreements to review but the data room, they scanned their agreement and the name of it was just numeric numbers the scanner attributed to the agreement. It was extremely frustrating and clearly increased legal costs cause you didn't know who should review it until you opened it see what the document was. So, Lorraine, earlier you mentioned that potential purchasers are going to want to confirm that the seller owns it's IP in the context of employees. But are there any other IP related matters that prospective sellers should address when ready to sell for a sale?
Lorraine: Yeah, for sure there are Karen. The rights that a target company has in its intellectual property is a really important aspect of many, many transactions. In addition to taking the usual steps to protect the company's IP through it's employment contracts, as I've mentioned and the registration of trademarks and patents of course, the company should also ascertain and document the additional steps it has taken to secure things like property rights and how it is managing it's source code. The seller should review it's licencing agreements with the suppliers of technology that has been used in developing the seller's products. This is really important where software forms part of a company's product portfolio. The seller should really take steps to determine whether any of its products contain any open source software. Often seller's management may not even be aware that open source has been used in the development of its products. Open source is a free easy way for engineers on development teams to access and to incorporate into their development method. It may often make things a lot easier for them. Time to market is always important in product development. Often these things may go overlooked until the time of the transaction. But this can come at significant costs to the company in a sale transaction. Any use of open source software in the development of products should be noted. The open source licence should be reviewed and, particularly, if open source is used in key products, the company should consider running scans on those products to identify vulnerabilities and quality risks. So that those can be addressed in advance of commencing a diligence process. I've seen situations where the purchaser has requested a scan, identified open source in the seller's products and the vulnerabilities and quality risks were identified and that diligence process resulted in the negotiation of reduced purchase price. It's really a key thing for companies to consider.
Karen: Yeah, absolutely. That's great. Thank you. Marcus, earlier you talked about a deal didn't go as planned. You talked about how regulatory issues can potentially delay or even derail a transaction. Why did this typically happen and what can a seller do to mitigate the risk of that occurring?
Marcus: Good question. As I mentioned at the example at the beginning of the webinar, understanding the regulatory landscape that applies to a target company can be the difference between an official closing, or potentially lengthy closing period, or even a cancelled transaction if a closing condition isn't satisfied for the production of the regulatory permission from a government regulator. Pulling together submissions to regulatory bodies to note the time of a transaction, update information on public record or to request consent to the transaction, can often add significant time and effort to the closing process and, in particular, where a consent is required to allow the transaction to occur, the buyer will want a receipt of consent that their conditions are closing. Another factor to consider is that the Canadian government has the power to review any foreign investment regardless of whether the transaction is always under the value threshold, so automatic review under the National Security Review powers contained in the Investment Canada Act, these powers allow the Canadian government to request additional information in relation to the transaction, the parties and any shareholders of the parties, and conduct a full review of the transaction which can delay by it up to 45 or even 200 days. So if the government finds that the transaction is injurious to national security, they can either block the transaction or allow it with certain strict conditions. It's been rare that these national security reviews have been triggered but recently there's been an increase in the last few years and, in particular, if the target company operates in the space, telecom, cyber security, Canaccord, infrastructure or utilities industries, there may be heightened chance of national security review being ordered. If your business operates any of these industries then it's important that you understand your regulatory obligations early on in a transaction so the parties can plan around any foreign investment considerations. Some of you may have seen over the weekend that the Canadian government actually announced that they're reviewing foreign investment transactions with even more scrutiny until the economy recovers from the effect of the COVID-19. This really drives home the importance of using this economic slow down to get to grips with your regulatory landscape, and understand what your obligations, are especially if you anticipate selling your business to a foreign buyer.
Lorraine: Thanks, Marcus. I agree that these regulatory issues can impact a deal significantly and, as I mentioned before, we're always concerned with having to rely on third parties for any type of consent or response. What do you see are practical things that a seller can do now to address these regulatory risks?
Marcus: Good question again. I think there's a few things that I'd probably recommend. The first thing, identify who the applicable regulatory body is. If you operate in banking, telecom, money services, cannabis, pharmaceuticals, or defense, to name a few then you'll likely going to be subject to regulatory oversight. Typical bodies, OFSI, the CRPC, DIN Health Canada or Public Services in Procurement Canada. You should really nail down who the applicable regulator is. This also applies if you import and export goods, which is something that is commonly overlooked too. We find out that, a number of deals I've worked on that clients have been importing and exporting stuff, and then figure out they need a permit to do it. Second, locate the permits, certificates or registrations that you have with those regulators and save an electronic copy. You should also be noting whether the permit is in good standing, has expired or is about to expire, because from experience finding out last minute that you need to renew a licence, or that it's about to expire, can potentially delay or even derail a transaction if it takes a long time to get them up and running. These are fundamental items in the operation of the business. Any consent from a regulator you know is going to be required, likely, to complete the transaction. Third, some regulatory bodies, including Health Canada and Public Services in Procurement Canada when you're dealing with controlled goods and defense related issues, require that a company has certain individuals, or an individual, which is typically an officer or a director have stringent security assessments conducted so they're security cleared. It's important to identify these people at the outset and understand how long they've had these permissions because the buyer, as is typical, may anticipate, when they buy the business, replacing the whole board of the target entity post-closing. If they do that then they inadvertently invalidate the regulatory permit the business needs to operate. By identifying the issue early both the parties can plan accordingly, whether it be deciding to keep the individual in place, or replace them with someone else of the buyer's choosing. Of course, the buyer may not have someone that can step in and that's been security cleared. If that's going to take too long to get someone security cleared, and they don't have anybody, often they have turn around to the individual in question and negotiate with them to stay on post-closing, which obviously changes the deal dynamics. Again, it's all about being prepared. I think the fourth thing I'd recommend is once you've identified the first three things, what regulatory licences you need to operate, you found the copies of the licences, you've confirmed who the regulator is and you've identified any individuals with specific permissions, it's then a good time to pick up the phone to legal counsel and then speak with the regulator on a normalist basis and find out what the steps are, if its a change of control event, finding out what you need to do ahead of time, it really can help you start preparing the necessary documentation which, again, is a common theme in this webinar, these things take time and effort and the more you've done on your own leg work before you involve legal counsel, and the buyer's involved, it can save a lot of time and money. Ultimately, unless it's your birthday, no one really likes a surprise so the aim of any regulatory considerations is to try and identify, one, what the regulatory permissions the target has, and two, what needs to happen in relation to those permissions as a result of the sale transaction. As mentioned, these things add a lot of planning complexity and they could trigger Investment Canada issues which is whole other ballgame. The earlier that you know these things, the earlier the buyers and the sellers can begin dealing with them. This can help reduce the interim period between signing and closing, and ultimately, increase deal certainty.
Lorraine: I agree, Marcus, particularly on the not really liking surprises. Particularly in the deal context. I do think that one bigger picture consideration for sellers to have is that in a regulatory context not every buyer is going to have the familiarity that you do with your regulator in your industry. So if you do have a sense of what kind of information the regulator is going to need from the buyer to process any approvals, whether at the company level or the individual level, then you can take this opportunity to be prepared to educate the buyer, if they are unfamiliar with the industry, and then the two of you can work together in order to get the relevant information in front of the regulator.
Karen: Thank you all. That was great. Lorraine, in many cases the target business may have outstanding loans to a financial institution or other lender, and just like all the other third parties that we talked about, dealing with lenders can add complexity and delays to a transaction. What are your thoughts on things that a seller can do in advance to minimize such delays?
Lorraine: There's a number of things that a seller can do. If the business has existing debt then a buyer's going to want to understand the impact any sale might have on your financing arrangements. Most loan documentation is going to require the lender's consent to have any change control of the company or an assignment of its material assets. There may also be pre-payment penalties involved if the intention is to pay out all of existing indebtedness on closing. You'll want to know that ahead of time. To minimize potential delays a seller can have searches run against both the company and its shareholders. It's important to run those searches against shareholders, as well as the company, because you may not be aware that some of your shareholders might have a lien against their shares that they hold, that may be prohibited under your shareholders agreement but you never know until you've done the search what the facts are. Good to know that ahead of time. You want to run those searches. Make sure that you're aware of all the rules. Review your contracts with your lenders and determine what consent requirements are required, how much notification is required. Ideally, if you can notify your lenders in advance that you are making plans, you may not have a deal on the table yet, maybe you are backing with foresight and trying to get ready, you're lenders are going to appreciate that you're being upfront and trying to being organized in this regard. If you take the step to potentially notify them in advance that you have plans and then you can work with their lenders to ensure that you understand what the requirements are. They're on the radar screen in terms of the timing perspective of when you might need that consent. You have all that done well in advance of closing. Then you've got a plan that's put in place to deal with these things and they'll be deal with in a more expedited fashion.
Melanie: I totally agree, Lorraine, and to add to your point I think another benefit to running these lien searches ahead of time, as a seller, is you can also identify if there's any old registrations against the business, or the seller that, should have been discharged long ago because the loan has been paid off. We've run into this so many times and in that instance it can take a long time to discharge because you're no longer in contact with that lien holder, or they've changed, they've moved, they don't exist anymore. That can be a timely process.
Lorraine: That's a really good point. I've definitely faced that. I'm sure Karen has too.
Karen: Yup. Absolutely. So, I want to say thank you to everyone. Before we turn it over to our audience questions, just a few last things. So far we've heard great tips about getting the business ready for sale. I did want to make a comment though, to suggest that these are items that every business should be considering doing now, even if there's not a sale on the immediate horizon. Before we get to our audience questions I'd like to turn it over to each of our panelists to provide any other recommendations or tips for businesses, whether they're contemplating a sale, or you just want to use this time to tackle projects that will assist in running a business more efficiently or effectively once the pandemic is over. Lorraine, maybe I'll start with you.
Lorraine: Yeah, sure. One thing a business can do is use this time to update its forms of customer and supplier agreements. For example, there may be provisions that are constantly being renegotiated by the other parties. If you can go through and identify what those are, and maybe create some sort of handbook for your contracts that have typical clauses that are subject to negotiation, then you can establish what your fallback position is for those types of negotiations. So that the people who are out in the field negotiating these agreements on a day to day basis may be able to have a little bit of guidance as to where they can agree, and where they can fall back, and that way you've got a nice little inventory of what those contract provisions are.
Ted: Karen, from a tax perspective I'd say to the extent you've got any outstanding tax returns, just get those filed. Even if they're nil returns. It's not super, and the reason I raise that is, it's not super uncommon for someone who runs, for instance, a holding company on top of several operating companies, and one of their operating companies may have been inactive for a number of years, for whatever reason they haven't dissolved it, but because it's been inactive and has gotten no income or entitled to a refund, they simply haven't filed returns in respect of it. Any entities in your structure that have outstanding return requirements are going to raise red flags for a purchaser. Because if we back up for a second and remember that purchaser's generally want to buy assets, and sellers generally want to sell shares, we're already asking for a gift. We want the purchaser to buy our shares. They might be willing to accept that provided that they can keep risk to a minimum. So things like outstanding returns are not something you want standing in the way of closing a sale and having a purchaser being able to kind of throw that back at you, and either grind the price or delay closing. Right? That's a pretty simple thing that you can do. Once you've got all that stuff filed, the other thing I would say is, it goes back to what Marcus has been talking about with respect to populating data rooms. Get all your stuff, all your returns, all your assessment, all your correspondence with the CRA. Get it scanned. Get it into electronic format. Give it a name that makes it easily identifiable and keep all that stuff in a folder in one place so that when your lawyer comes to you and says, "Okay. It's time to go. We need a folder from the data room." You have it and you're not stuck spending hours into the wee hours of the night trying to gather all your stuff and get it scanned at the last minute.
Melanie: I think it's also a great time right now to provide any training to your employees. Use this time to refresh them of your policies and procedures, particularly if there's been any updates since they've been hired. They may not have, outside of getting an email, then in tune to some of those updates to policies and procedures. If your company has inhouse legal department, or has other professionals that are subject to continual education obligations, they should be using this time to get on top of that and bank those hours.
Marcus: On the employment theme I think a number of clients have to let people go and other clients are going to be looking to hire a bunch of people when this is all done. People are looking forward at their workforce and doing some planning there so, not only is it important to identify the types of people you want to employ, but look at your employment agreements and your human resources policies and your manuals. Are they fit for purpose? Do they do what they need to do? To Lorraine's point, do those agreements relinquish any IP rights, especially if you're a tech company. It's important to kind of look at that stuff and speak to the appropriate advisor there. Then in relation to what I was saying earlier on, just putting together a list of any regulatory permits in a Excel sheet or something that lists when they expire, who the regulator is, if you've got any designated individuals, stuff like that, that would be really helpful.
Lorraine: Just building on that, just one last point, Marcus. Another thing that you could do is create a compliance manual that would identify any renewal dates for your business registrations or permits and any security registrations affecting the company. Taking inventory of your IP and determining whether you haven't actually renewed registrations or if anything should be mended. You should use down times to look at these things because there have been significant changes to the legislation relating to trademarks, in particular, over the last year.
Karen: Great. Thanks everyone. It's all been fabulous advice. I think a common theme throughout is the more organized you can be at the outset it really shows that the business owner's been a good steward of the business. That would give a seller a lot of comfort that they can rely on your reps and warranties. I think, as you said at first, everyone's repeated it, the goal is keep as much money in your jeans as possible. Showing that stewardship gives people great comfort. Before we turn to questions I do just want to highlight our upcoming webinars in this series, M&A Uncertain Times, so same time next week on April 28th at 1:00pm, Eastern is our next webinar, M&A Deal Dynamics Post-Pandemic. We also have a number of other webinars in the works so keep an eye out for those announcements soon. As I mentioned at the outset last week we had our first one on The Destructive Effect of COVID-19 on M&A Transactions in Canada. That webinar is now available on our website. I do want to turn to some questions from our audience. I see that a few of them had come in. There is time now if there are any others.
The first question that we have is about material contracts. So maybe I'll put this on to you, Melanie, as you spoke earlier to material contracts before. One of our audience members is asking if you can explain what you mean by a material contract. How does a business owner know what's material?
Melanie: For sure. Material contracts are going to be a contract that hits a certain threshold that either monetary value, unexpired term, the ability to renew or can it be terminated within a certain period of time. It will also be any contract that's so critical to your business that if it was terminated your businesses would be substantially and adversely affected. In a deal context the exact materiality threshold of time or money is using paid by the buyer and it's tied, usually, to the value of the business. If the business is worth a certain amount of money what's material to that business. Often for contracts that can't be terminated on less than 30 to 60 days that's often what we see captured within this definition. Then any contract that's essential to your business will be always be caught by that term.
Karen: Thank you. Marcus, I have a question I think is geared towards you. You mentioned earlier that the Canadian government has increased it's scrutiny of foreign investments during this pandemic. Can you talk a little bit more about that?
Marcus: Yeah, as I said earlier on, over the weekend the government announced that it's going to be paying particular attention and additional scrutiny to any foreign investments, regardless of value, that relate to public health or involve the supply of critical goods and services for Canadians or the government. They're going to much deeper diver into a foreign investment by state owned investors or even private investors that are closely tied to governments in foreign jurisdictions. The government noted that the some of these investments might not necessarily be commercial in nature so they could be harming Canada's economic and national security interests. Interests, the National Security Review panel is notoriously ambiguous and they can be quite broad, so to see that it's kind of been extended to take into account the current pandemic, and they're looking at public health and supply chain, it just means that buyers and sellers both need to be mindful of the fact that there's going to be additional information requested. Maybe extension of timelines for review, which are all powered under the Act, and that this is kind of apply until the economy recovers. After this COVID pandemic, which, you know how long's a piece of string? We don't know when that's going to be. It kind of just drives home what we said earlier on, the more you know about your current situation and what regulatory permissions you have, if the government steps in and says, "Hey, we want to take a closer look at this.", you've got the information to hand. As we mentioned earlier on too, some of you may know that if there's a notification required under the Investment Canada Act you can file it up to 30 days after the closing of the transaction, but if we deem it's in an industry, or their a fact patent that mean that the chance of a national security review are a little bit more likely, for a defense product for example, that the target company manufactures, then often they'll do a pre-closing filing, 45 days prior to closing, because that 45 day window is the period of time the government typically has to put its hand up and say, "Hey we have a problem." So if you file 45 days prior to closing, the idea being that on closing you've heard nothing, you're good to go. The government kind of reinforced this and said that they recommend filing in advance. So it's just something that we need to be aware of. That the National Security review powers have been kind of extended a touch and that's it more important than ever to be prepared and anticipate a 45 day closing period.
Karen: Great. Thanks, Marcus. Another question that has come in relates to board of directors meetings. The question is, is there is any reason to keep the minutes of an annual board of directors meeting in the minute book? They say they only have one shareholder, being the US parent. Lorraine or Melanie, do either of you want to pick that one up?
Lorraine: I was just thinking if there's only one shareholder you probably are doing your annual meeting of that entity by way of resolution. Normally, yes, that resolution would be included in your minute book. It's proper to do that just from a perspective of compliance. Just showing that you actually are doing your annual filings and appointing the auditor, or the accountant or waiving that requirement on an annual basis, and electing the directors of the company on an annual basis. Those things should be reflected in your minute book. Any buyer would be looking for them.
Karen: Great. Thank you. I see it's now 2:00. I do have another one or two questions so we'll stay on to answer those, but for those who have to drop off because of other time commitments, we did want to say thank you very much. We have appreciated the opportunity to discuss this topic with you. Until next time, please stay positive, stay healthy and our very best to everyone. Thank you.
To our panelists, the next question I have talks about the buyer's financer, the buyer's lender. The comment relates to typically the buyer's lender also wants access to diligence. The question, is there anything in particular that a seller should be aware of ahead of time or should you, for example, permitting the buyer's lender access to the data room, access to the seller's landlord's subordination agreements, should a seller expect a buyer's lender to take a big role in the purchase process and what can they do in advance? Anybody want to take a first stab at that one?
Melanie: I can address it, I think. I think that a lot of the same issues apply even if it's the buyer's financer. Most importantly, I think, in this situation is going to be the confidentiality obligations that we talked about in the material contracts. The buyer's bank may or may not be covered by the NDA that you have drafted. If it's not or if there's any sort of uncertainty and you've got really stringent confidentiality obligations, you're probably going to want the bank to also enter into a NDA, to make sure that you're not inadvertently disclosing information that you're not allowed to and then going offside your own confidentiality obligations. I think, generally, they're probably going to look at the same information that the seller is, and all the other aspects apply in making sure that your records are all in order, so that the buyer's bank also has the same confidence in your business.
Karen: Great. Thank you.
Marcus: I know that isn't exactly what we're discussing on the webinar today but it's a good segue, from a buyer's perspective we talk about the buyer's financer, I had something that popped up in a deal where the buyer's lending agreement actually prevented them from having an earnout structure in a transaction and we didn't find that out until we were about to sign the deal. So then we had to completely change the consideration and the earnout mechanism to comply with their lending agreement. I know we're talking mainly about sellers today but a lot of points you've raised kind of go to the buyer as well. In particular, take a look at your own financing agreement to make sure the LOI that you're dreaming up with the potential target, are you allowed to do the financing or the consideration structure that you're putting forward, is that prohibited under your agreement. It's just something that I think that sometimes buyer's overlook.
Karen: Great. Thank you. So I think that's all we have time for now. Thank you very much everyone. Hopefully we'll see everyone next Tuesday, same time.
Melanie: Thank you.
Marcus: Take care everyone. Thank you.
Lorraine: Thank you.