In the last post of this series, I discussed the progress of implementing the first half of Title II of the JOBS Act, which instructs the SEC to amend Rule 506 to allow for general solicitation in Rule 506 offerings if certain additional conditions are met.   In this fourth post, I will look at the second part of Title II (namely Section 201(c)), which exempts some online angel investment platforms from the federal broker-dealer registration requirement.

First, I need to address the question: what exactly is an “online angel investment platform?”  When I use that term, I refer to an interactive website which matches startups with potential investors who are “accredited investors” under federal securities laws (i.e. they are wealthy).  Generally, federal securities law requires anyone in the business of “effecting” securities transactions on the account of others to register as a broker-dealer.  Registering as a broker-dealer is an arduous and difficult process and carries an extremely high compliance burden.  Thus, if online angel investment platforms were required to register, it would likely put most of them out of business.

These platforms existed prior to the passage of the JOBS Act in a legal gray area.[1]  Section 201(c) of the JOBS Act is an attempt to provide clarity on their status.  The provision exempts platforms that permit the offer, sale, purchase, or negotiation of securities transactions, including by general solicitation, as long certain conditions are met, namely: (a) neither the platform nor anyone associated with it takes any compensation in connection with the transactions on the platform, (b) the operator of the platform never takes custody of funds or securities, and (c) the platform and its associated persons have not been disqualified from the securities industry.  The provision does allow the platform to offer ancillary services, such as due diligence services (but not investment advice) and the supplying of standardized documents.

Unlike the rest of Title II, Section 201(c) does not require SEC implementing regulations to be effective, and therefore is already in effect.  In February 2013, the SEC issued some guidance on its interpretation of Section 201(c) in a set of online Frequently Asked Questions.  In its guidance, the SEC confirmed that it views Section 201(c) as fully operational, though it did state that it believes that an online platform can’t permit a general solicitation to occur on its service until the SEC finalizes the regulations permitting Rule 506 offerings with a general solicitation (I will get to more on that below).  Unfortunately, the SEC took two other positions that are, in my view, counter-productive.  First, the SEC stated that it viewed any compensation paid to the platform or persons associated with it as disqualifying the platform from the exemption, even if the compensation is not “transaction-based” (i.e. based on the success of the capital raise or in proportion to the size of the offering).  This extends even to compensation paid in the form of a flat fee.  It is unclear from the guidance whether an online platform may receive compensation for ancillary services.  The second interpretation is that, while Section 201(c) does exempt these platforms from broker-dealer registration, they are still broker-dealers and may have to comply with other regulations covering broker-dealers other than the registration requirement.  It is important to keep in mind that this kind of interpretive guidance can influence court decisions, but carries no official force of law.

So can the exemption for angel investment platforms be used now?  Yes, with one caveat.  It could certainly be argued that most uses of such a platform constitute an impermissible general solicitation, and thus we still need to wait for the SEC to finalize it’s regulations related to easing the restrictions on general solicitation.   Recently, in an August 30, 2012 letter (which was subsequently released publicly), the large international law firm K&L Gates LLP provided a legal opinion to AngelList LLC, the operator of an online angel investment platform, that it (a) is not required to register as a broker-dealer under federal securities laws and (b) companies posting information to accredited investors on the AngelList website are not engaged in a general solicitation in violation of Rule 506. K&L Gates took the view that AngelList need not register as a broker-dealer because of Section 201(c) of the JOBS Act, and that even absent this exemption, AngelList would not be required to register as a broker-dealer because it does not fall within the definition of a “broker” in the Securities Exchange Act of 1934 or perform any of the activities that the SEC and its staff have identified as causing an entity to be considered a broker. Most importantly, K&L Gates opined that companies posting information to accredited investors on the AngelList website are not engaged in a general solicitation in violation of Rule 506 because for 15 years SEC no-action letters have permitted similar websites that provided even more extensive services and information about offerings to accredited investors without raising general solicitation concerns.  Key to K&L Gates’ reasoning is the analysis found in the 1997 and 1998 Lamp Technologies, Inc. SEC no-action letters (available here and here). In the Lamp letters, the SEC Division of Corporation Finance staff concluded that posting information about private funds to a password-protected website accessible only by persons who (i) completed a questionnaire that allowed Lamp to reasonably determine that they were accredited investors, (ii) waited for a 30-day “cooling off” period, and (iii) paid a subscription fee would not involve a general solicitation or advertising in violation of Regulation D. The Division’s analysis hinged particularly on the fact that access to the website is limited exclusively to accredited investors. As AngelList’s website is so limited, and its activities are more limited than those described in the Lamp letters, its activities also should not be deemed to constitute a general solicitation or advertising.  Of course, K&L Gates’ opinion letter carries even less force of law than the SEC’s FAQ webpage, so no one can be 100% safe in relying on it.

Of further note, in two recent no-action letters issued by the SEC related to online angel investment platforms, the SEC’s Division of Trading and Markets issued no-action letters to FundersClub Inc. and AngelList LLC who were seeking confirmation that their online activities would not result in enforcement action by the SEC. The no-action letters did not address the issue of whether the solicitation of investors by an online platform would constitute general solicitation or advertising. The SEC did, however, permit the operators of such platforms the ability to take a “carried interest” (i.e. a portion of any gains from an investment) in exchange for monitoring the investments for the investors using the platform, on the basis that this was investment advisory activity rather than broker-dealer activity.  While this form of compensation is fairly standard in the VC and hedge fund industries, some attorneys have previously (and I believe incorrectly) taken the position that when a carried interest is taken on a deal-by-deal basis (rather than as part of a pooled investment fund), it constitutes “transaction-based compensation” and thus activity requiring broker-dealer registration.  Of course it does mean that while these platforms will not need to register as broker-dealers, they may have to register as investment advisers.[2]

Overall, there have been some fairly positive developments when it comes to online angel investment platforms.  Some of these have been the result of the JOBS Act and some the result of further development of existing law.  In either case, I think these are positive steps forward for the startup community and this area represents the most promising change brought about by the JOBS Act.

Next time, I’ll be discussing developments (or non-developments) in the area crowdfunding.

Footnotes

[1] No definitive determination has ever been made as to whether the activities of an online angel investment platform could be considered engaging in the business of effecting securities transactions on the account of others.  Some platforms already began doing business without registering prior to the passage of the JOBS Act, risking federal or state enforcement action or a private lawsuit. To date, no enforcement action has been taken.

[2] This is still preferable for the angel investment platforms, since the compliance burden for investment advisers is generally lower than for broker-dealers.

© 2013 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

The post The JOBS Act, a Year Later – Part 4: Online Angel Investment Platforms appeared first on Strictly Business.

This is part 10 of our series discussing the sale of a business from the seller’s perspective.  We’ve covered commencement of a potential deal through the closing and now turn back to the purchase agreement to discuss the indemnification provisions, which deal with post-closing events.  Indemnification provisions are among the most heavily negotiated portions of a purchase agreement, yet business owners may be tempted into thinking they are simply something lawyers like to argue over without realizing their importance.  In this post, we’ll try to give a simple explanation of the indemnification provisions, explain how these provisions may come up after the closing, and give a few generic tips for sellers in handling indemnification.  In the next post, we’ll provide some detail on specific provisions of the indemnity section and provide more seller tips related to those provisions.

A very basic seller indemnification provision reads something like this:

The seller and each shareholder, jointly and severally, will indemnify and hold harmless the buyer and its shareholders and subsidiaries (collectively, the “Buyer Indemnified Parties”), and will reimburse the Buyer Indemnified Parties for any loss, liability, claim, damage, or expense (including costs of investigation and defense and reasonable attorneys’ fees and expenses), whether or not involving a third-party claim, arising from or in connection with … [a list of matters].

So what does all of this legalese mean? In simple terms, the duty to indemnify and hold another harmless means to compensate the other for a loss suffered. In the context of a purchase agreement, the indemnity given by the seller and its shareholders is a contractual agreement by them to compensate the buyer for certain losses the buyer suffers after the closing and which are related in some to way to representations, warranties, covenants, or other obligations of the seller and/or its shareholders set forth in the purchase agreement. [1] (We discussed what “joint and several” means in this post.)

In short, if the buyer is harmed or damaged in specific ways after the closing, then the seller is contractually agreeing to compensate the buyer for that damage or harm.  From the seller’s perspective then, it’s critical to review and understand the seller’s indemnity obligations and to be sure they are as narrowly drawn as possible. [2]

Some of the matters typically made part of the seller’s indemnification provision are as follows:

• breaches of representations or warranties made by the seller or shareholders;
• breaches of covenants or other obligations of the seller or shareholders;
• any liabilities arising out of the ownership or operation of the company’s assets before the closing;
• any product manufactured by or shipped by the seller or any services provided by the seller before the closing;
• certain specific matters which may be disclosed in the disclosure schedules; and
• all liabilities specifically retained by the seller.

Here are two short examples of situations where post-closing indemnity might come up. One, suppose the buyer purchases the seller’s business based on a multiple of 5 times the seller’s EBITDA (based on seller’s financial statements).  The purchase agreement contains a representation and warranty from the seller that its financial statements are true, correct, accurate, in accordance with GAAP, etc.  After closing, the buyer discovers that the seller has not properly booked certain sales, and that revenues and earnings are overstated.  Here, the buyer may attempt make an indemnity claim based on the allegation that it overpaid for the business based on the seller’s misrepresentation of its financial statements.  And if the buyer purchased the business for a 5x EBITDA multiple, then the buyer might attempt to use the indemnity provision to reduce the purchase price based on this multiple.

Second, suppose that after closing, the IRS audits the business the seller has sold and finds an underpayment of taxes for one or more years ending before the closing. If the buyer is harmed by the under reporting of tax (either because the buyer overpaid for the business or perhaps because the deal was a stock sale and the purchased business is responsible for the tax), then the buyer will expect the seller to indemnify it for its losses.

With this background in mind, here’s a list of tips for sellers in negotiating the indemnification provisions of the purchase agreement:

Tip 1 – Don’t Leave It All to Your Lawyer.  Indemnification is a little more esoteric than the parts of the purchase agreement that deal with business issues, but it’s a critical part of the purchase agreement.  Make sure you read the indemnity section and ask your lawyer to review it with you (several times).

Tip 2 – Thoroughly Review the Representations, Warranties, and Disclosure Schedules.  One of the causes for indemnification by the seller is the seller’s breach of representations and warranties.  In fact, this is how the indemnity section and the representations and warranties are connected (the seller breaches a representation which causes the buyer loss or damage and the seller must indemnify).  Therefore, it’s vital that the seller thoroughly review and understand the representations and warranties and make adequate disclosures if there are potential issues related to the representations and warranties.  For more on this discussion, see this post.

Tip 3 – Thoroughly Review Retained Liabilities. – Another cause for indemnification is liabilities or obligations retained by the seller.  Therefore, it’s important to review and understand what the seller is retaining and, if applicable, to properly discharge those liabilities after the closing.

In the next post, we’ll get into some specifics of the indemnification provisions, such as damages subject to the indemnity, baskets (deductibles), caps, set-off rights, and others, and provide more practical tips for sellers with respect to these specific provisions.

Footnotes

[1] Note that indemnification is not strictly limited to post-closing matters but that’s the major concern and the focus of this post.  Also, it’s important to note that, even without indemnification provisions, if either party breaches the purchase agreement, the other can bring a claim for damages (lawsuit) for breach of contract. But the indemnification provisions broaden (or narrow) the scope of potential claims and add many important details, such as the procedure to be followed if a third-party brings a claim against either the buyer or the seller after the closing.

[2] There will likely be indemnity required of the buyer if the seller is harmed in some way but this tends to be much less important and is not the focus of this post.

© 2013 Casey W. Riggs and Jennifer Wilson — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

The post Selling Your Business — Practical Tips for Sellers — Part 10: Indemnification (Part One) appeared first on Strictly Business.

Tip 1 – Engage the Right Attorney – When engaging an attorney, be sure to get someone who has experience with your particular need.  Too many business owners engage “an attorney” without understanding that there are vast differences in skill sets and experiences of different lawyers.  Don’t use your brother-in-law, the criminal defense attorney, to help with your LLC or corporate work, for example.  You’ll save time and money and get better representation in the long run if you choose someone experienced in what you need.

To find the right attorney, ask for recommendations from other business owners or friends (with business experience) and then check websites for relevant experience.  When you meet with a potential attorney, ask lots of questions on the front end and make sure he or she has handled work similar to yours before you engage him or her.

Tip 2 – Communicate Clearly – Before talking to your attorney, get organized and make sure you can convey succinctly and clearly what it is you need help with and when you need it.  Too many clients dive into preliminary conversations or send cryptic e-mails leaving their attorney confused about what they need.  Remember, most attorneys bill by the hour; the better you can describe your problem, the faster your attorney can get to a solution and the less it will cost you.  And try to give reasonable turn-around times.  Many clients wait until the last-minute and then need immediate attention to their matter, which isn’t always possible.

Tip 3 – Consider Asking for a Flat Fee – Many attorneys will consider flat fees for well-defined projects.  If a client needs a document from me and production of that document is within my control, then I think a flat fee is reasonable to ask for.  If, on the other hand, I’m going to be involved in negotiations with some third-party that I’ve never met, it’s harder to quote a flat fee.  But it never hurts to explore this option.

Tip 4 – Be Responsive – I find that I am most efficient when I can sit down and knock out a project in a short amount of time.  However, I often start a project and then get stalled waiting on my client to get back to me with information or to answer questions.  That means when I pick back up, the project is not as fresh in my mind and it takes more time to finish it off.  We all know business owners work long hours, but the more responsive you can be the better in terms of getting a good service at an efficient price.

Tip 5 – Give Feedback – The best relationships between attorney and client are those where the parties frequently talk to each other.  From an attorney’s perspective, we can give better service when we know you and your business better and your feedback is important in this process.  If you like (or dislike) how your attorney has handled something, let him know.  The dialog will create a better relationship and service for you.

© 2013 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

The post Working Effectively with Your Lawyer: Five Tips to Effectively Engage and Use Legal Counsel appeared first on Strictly Business.

In the first post of this series, I discussed the disappointment experienced by many proponents of loosened securities regulations with the implementation of the Jumpstart Our Business Startups Act (or JOBS Act).  In this third post, we’ll look at the first part of Title II of the JOBS Act (namely Section 201(a) and (b)), which directs the SEC to permit general solicitation in some Rule 506 offerings.

Title II of the JOBS Act does not repeal the ban on general solicitation associated with all private placements; instead, it directs the SEC to amend Rule 506 and Rule 144A [1] to allow for general solicitation if certain additional conditions are met.  Those conditions are: (1) all purchasers must be accredited investors and (2) the issuer must take reasonable steps to verify that all purchasers are indeed accredited investors.  After much delay, the SEC finally issued a preliminary rule in August of 2012 (I previously discussed the delay here and the substance of the preliminary rule here). In the proposed rule, the SEC essentially parroted the wording of the JOBS Act and declined to provide for a safe harbor in the regulations to further define what “reasonable steps” actually means. Instead, the SEC stated that whether the verification steps taken are reasonable would depend “on the particular facts and circumstances of each transaction.” The SEC did give extensive suggestions and examples of what reasonable steps would be required in various situations in its commentary to the proposed rule.

A number of my fellow bloggers thought that the SEC’s proposal struck the right balance, including William Carleton and Joe Wallin, and I agree with most of their points.  However, when the preliminary rule was originally proposed, I was concerned that the lack of a safe harbor would inject too much uncertainty into the exemption and that the SEC would face considerable criticism from pro-business groups because of this.  Instead, it turned out that pro-business groups were mostly supportive, and asked only for various minor clarifications. For the most part, pro-business groups did not have a major issue with the lack of a safe harbor; in fact the National Small Business Association was concerned that any safe harbor would become the de facto rule, and thus if a proposed safe harbor’s requirements were too burdensome, the benefits of Title II would be lost.

Besides that lack of clarity, you might think that merely parroting the wording of the JOBS Act would not be particularly controversial, but you’d be wrong.  The preliminary rule unleashed a torrent of critical comments, particularly from investor protection advocates.  Here are some examples of their comments and suggested changes:

• The SEC’s Investor Advisory Committee commented that the proposed rule should go further to protect investors. It recommended that the SEC: (1) require the filing of either a new “Form GS” or a revised Form D; (2) require that all solicitation material be furnished to the SEC; (3) adopt a safe harbor for verification, rather than reasonable belief, of accredited investor status, including standards; (4) make the filing of Form D a condition for relying on the Regulation D exemption; (5) ensure that performance claims in solicitation materials are based on performance reporting standards; (6) amend the definition of “accredited investor” to require greater financial sophistication; and (7) fulfill the Dodd-Frank Act Section 926 mandate to implement rules disqualifying certain “bad actors” from relying on Rule 506.
• The North American Securities Administrators Association, Inc. (NASAA), composed of state securities regulators, professed itself “greatly disappointed” with the proposed rule because it fails to provide guidance to issuers or protections for investors. The NASAA’s recommendations were as follows  (1) the SEC must consider the impact on state-level enforcement; (2) the rule should require a more detailed Form D to be filed before any general advertising and after the offering, and failure to file the Form D must result in the loss of the exemption; (3) the SEC should establish non-exclusive safe harbors for the verification of accredited investors; (4) the rule should include disqualification provisions for bad actors as mandated by the Dodd-Frank Act two years ago; (5) the SEC should place reasonable restrictions on advertising by issuers and private funds; and (6) the SEC should clarify what ancillary services are permissible for new platforms that facilitate securities sales under Rule 506.
• The Consumer Federation of America (CFA) wrote to express strong opposition to the proposed rule, commenting that it fails to protect investors and maintain market integrity. Incensed that the SEC requested comment only on the issues of verification of accredited investor status and the addition of a checkbox to Form D and not on alternative regulatory approaches, the CFA stated that “it would not be possible to adopt a minimally acceptable rule based on this proposing release.”  The CFA also criticized the proposal because it covered private funds such as hedge funds and private equity funds.

While I certainly understand the concerns of investor protection groups, many of the changes requested are simply outside of the scope of what Congress intended when it passed the JOBS Act.   They represent a longstanding wish list for proponents of more stringent securities laws.  For instance, making the failure to file a Form D result in a loss of the federal and state Rule 506 exemption is something that many state securities regulators have wanted for some time but is a really bad idea and has nothing to do with the ban on general solicitation.  That said, the fact that we haven’t heard anything from the SEC since August indicates that the SEC is taking the investor-protection concerns raised very seriously, and so there is a good chance the eventual rule will be more restrictive than the proposed rule.  The timing of any final rule remains unknown.  In retrospect, it probably would have been more effective for Congress to have created a new statutory exemption in the Securities Act in lieu of asking the SEC to issue a rule.

Next time, I’ll cover the second half of Title II of the JOBS Act, which relates to online angel investing platforms.

Footnotes

[1] Rule 144A is another private placement exemption involving sales of securities to certain institutional investors.  Since it isn’t applicable to most issuers and investors (at least in the startup and private fund world), I won’t cover it here. You can read more about Rule 144A here.

© 2013 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

The post The JOBS Act, a Year Later – Part 3: Repealing the Ban on General Solicitation appeared first on Strictly Business.

Today, most closings are handled via email exchange of scanned signed documents, with original hardcopy of signed documents to follow by mail, and transfers of funds by bank wire.  While this is usually a convenient way to finalize the transaction (as opposed to the older way of having everyone around a table to sign and exchange documents), it requires more advance planning and can become a logistical nightmare if the process is not completely thought through, particularly when many parties or third parties not affiliated with the buyer or seller are involved.

Here are some tips for sellers in handling the closing:

Tip 1 — Have a Checklist.  Having a closing checklist is a must! The buyer’s counsel generally prepares a checklist and circulates it to all parties. If that doesn’t happen in your case, ask that your lawyer prepare one – and be sure to read it and ask questions if anything is unfamiliar. Most deals will include numerous documents and require signatures from a number of parties, including several third parties.  To keep organized, it’s almost a certainty that you’ll need a checklist to note each document to be signed, the status of the document until it’s in final form, and who needs to sign it.  The checklist should be constantly updated until right before the closing when it’s final.  If you have your own checklist prepared, be sure the buyer has a copy.  Most likely the buyer will have its own but just be sure you and the buyer are working off the same list and are in agreement as to where things stand as closing approaches. The closing checklist should include tasks to be completed after closing, too, so don’t discard it after the closing.

Tip 2 — Get Third Party Signatures in Advance.  As we’ve previously discussed, there will likely be a period between the signing of the purchase agreement and the closing when the parties will be required to get certain third-party consents and take care of other pre-closing conditions.  Be sure to have these in hand before closing if at all possible.  You don’t want to be trying to track down a third-party who is out-of-town on vacation on the day of closing.  If it’s necessary to hold signatures in escrow pending closing, that’s fine, but be sure the signing party is prepared to release the signatures upon the closing (usually an e-mail or call to you and your lawyer will suffice for this).

Tip 3 — Double Check Wire Transfer Instructions.  Get your wiring instructions from your bank in advance and double-check them.  Then double-check that the buyer has them correct on any document it’s using to get the wires out.  I saw one deal delayed because of a transcription error on wiring instructions delivered correctly by the seller but erroneously transcribed onto a bank document by a secretary for the buyer’s counsel.  The seller was not pleased to get his funds a day late. A better solution is to simply attach the wire transfer instructions received from the seller to the buyer’s bank’s internal document but do it far enough in advance so the bank can let you know if it has a problem with this setup.

Tip 4 — Coordinate Schedules and Availability.  It seems inevitable that someone will be traveling on the closing day, often in some foreign country.  So be sure to coordinate schedules of everyone who will be signing well in advance.  If any party or third-party will be out-of-town, be sure to get his or her signatures in advance to be held in escrow and set up clear instructions on how his or her signatures will be released. Don’t forget officers within your company whose signature might be required on one minor document. For example, the managing members or top officers know they will have to sign documents and be available throughout the day of the closing, but the company secretary, who might not otherwise be involved in the transaction or even around on a regular basis, may be required to sign just one certificate. Be sure to get that signature when you can.

A well thought through closing should be a simple event, but the importance of adequate preparation and planning cannot be underestimated. The buyer’s and your lawyers will be the ones in the drivers’ seats, but don’t settle in for a nap in the back — be on top of what you and others within your control will be required to review, provide, and sign throughout the process.

© 2013 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

The post Selling Your Business – Practical Tips for Sellers – Part 9: The Closing appeared first on Strictly Business.

I’m not saying I agree with his overall conclusion or every point, but he does make some good points, such as the fact that Title V of the JOBS Act, which allows private companies to delay going public, is causing a reduction in IPOs which may have surpassed any benefits of the IPO On-Ramp. Mr. Seward’s view largely stems from the fact that he believes the JOBS Act went too far in deregulating, rather than the view that the JOBS Act has been a disappointment because it hasn’t been implemented quickly enough.

As I discussed in my first post in this series, we’ll have a much clearer view of the effect of the JOBS Act years from now than we will now. But it doesn’t hurt to see what one year’s worth of hindsight can tell us.

© 2013 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

The post The JOBS Act, a Year Later – Part 2.5: The IPO On-Ramp (the Other Side of the Coin) appeared first on Strictly Business.

We’ve previously noted that most deals are of the “sign and close later” variety as opposed to a “simultaneous sign and close.”  The interim period between the signing of the purchase agreement and closing (which we’ll refer to as the “Pre-Closing Period”) is usually necessary to work through issues with parties who aren’t involved in the transaction.  Examples of such issues include getting consents from third parties to the seller’s contracts, obtaining governmental authorizations, getting the buyer’s financing in place, and working through issues with employees.  From the seller’s perspective, the Pre-Closing Period is critical.  You’ve got a deal “signed” but haven’t closed and you want to minimize any risk that the deal falls apart.

The buyer’s draft of the purchase agreement will probably include numerous covenants (both affirmative and negative) requiring the seller to take or not take certain actions and will contain many conditions that must be met for the closing to take place.  Once the seller executes the agreement, it is committed to the deal but wants as many “outs” as possible if something goes wrong between signing and closing, if it learns of information it might not like, or maybe even if it changes its mind.

Sample affirmative and negative covenants that a buyer might require from the seller include the following:

Affirmative Covenants.  The seller will (between signing and closing):

• Operate the business only in the ordinary course
• Keep its business relationships intact (those with employees, customers, vendors, etc.)
• Maintain its properties and insurance
• Comply with all laws
• Update the buyer on any changes or developments concerning the seller’s business
• Continue to keep the deal confidential
• Continue to assist the buyer with its due diligence

Negative Covenants.  The seller will not (between signing and closing):

• Increase pay of officers, employees, etc. or enter into termination or severance agreements
• Terminate customer or vendor agreements
• Make any capital expenditures
• Pledge or transfer any company assets outside the ordinary course
• Negotiate with any other party concerning the sale of the business

And sample conditions to closing might include:

• All of the seller’s representations and warranties remain true
• The seller shall have complied with all of the covenants
• The buyer shall have been satisfied with its due diligence investigation in its sole discretion
• The seller shall have obtained all necessary authorizations and consents
• There shall have been no adverse change in or development in the seller’s business
• The buyer shall have obtained financing to fund the purchase price

The buyer’s draft of the purchase agreement will typically contain language giving the buyer maximum opportunity to get out of the deal if any condition or covenant is not true.  The seller needs to do its best to minimize this risk.  Here are some tips for sellers in handling these portions of the purchase agreement:

Tip 1 — Keep the Pre-Closing Period Short.  To state the obvious, the longer the period between signing and closing the greater the risk that something will go wrong (e.g., a material adverse development with respect to seller’s business).  So keep the period as short as reasonably possible while allowing time to get third-party consents and handle other post-signing, pre-closing matters.

Tip 2 — Review Covenants Closely and Narrow Them Down.  Be sure the covenants are reasonable and necessary to protect the buyer from adverse events specific to seller’s business during the Pre-Closing Period and are not overly broad.  As an example, be sure the buyer’s “walk right” for a material adverse development excludes events such as a downturn in the economy or the industry in which the seller operates.  When the purchase agreement is signed, the buyer shouldn’t be able to get out of the deal merely because there is a negative development that affects all businesses in the seller’s industry.  That’s the buyer’s risk to take.

Tip 3 — Eliminate Closing Conditions that Are within the Buyer’s Sole Control.  Many buyers will include closing conditions that are within the buyer’s sole control, such as the example above that the buyer must be satisfied with its due diligence investigation in its sole discretion.  From the seller’s standpoint, this gives the buyer too easy of a walk right.  When the purchase agreement is signed, the seller wants to make sure it’s a firm deal and will close absent some extraordinary negative development between sign and close.  Delete contingencies such as this.

Tip 4 — Keep It Material.  The seller should attempt to introduce materiality or material adverse effect language in its closing conditions.  For example, there may be a closing condition that states no lawsuits are pending against the seller as of closing.  The seller should limit this to lawsuits that could reasonably be expected to have a material adverse effect of some sort on the seller’s business.  Another example is the condition that all of the seller’s representations and warranties remain true at closing. Again, the seller is best served by limiting this broad condition by using language such as “in all material respects.”

Tip 5 — Beware the Financing Contingency.  Many deals will be contingent on the buyer having obtained financing on terms acceptable to it in its sole discretion.  As a seller, you want to be comfortable that the buyer will in fact obtain the necessary financing before you spend your time and resources negotiating a deal, and certainly before the purchase agreement is signed.  Ask for and review the buyer’s bank commitment letter early on; and if the buyer is telling you that it will have the financing in place, then attempt to eliminate the financing contingency in the purchase agreement.  If you’re unable to eliminate it, then consider placing a covenant on the buyer that it will use its best efforts or reasonable best efforts to obtain the financing on terms set forth in the commitment letter.

The covenants and conditions to closing sections are very important parts of the purchase agreement and the transaction and should not be taken lightly.  Sellers should pay careful attention to these provisions to maximize the likelihood that the signed deal actually closes.

© 2013 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

The post Selling Your Business – Practical Tips for Sellers – Part 8: Pre-Closing Covenants and Conditions appeared first on Strictly Business.

In my previous post, I discussed the disappointment experienced by many proponents of loosened securities regulations with implementation of the Jumpstart Our Business Startups Act (or JOBS Act).  While some provisions of the JOBS Act went into effect immediately, implementation of many of the core provisions of the law has been excruciatingly slow while the SEC goes through the rulemaking process.  In this second post, we’ll look at the first set of provisions of the JOBS Act: “the IPO On-Ramp.”

Summary of the IPO On-Ramp Provisions

Unlike some of the other provisions of the JOBS Act, Title I went into effect immediately.  It adds the concept of an “emerging growth company” (referred to as an “EGC” in this post) to federal securities laws. An EGC is defined as an issuer of securities that had total annual gross revenues of less than $1 billion during its most recently completed fiscal year, if the first registered sale of the issuer’s common equity securities occurred or will occur after December 8, 2011. The designation continues until one of certain milestones of growth is met, such as when the issuer hits annual revenues of $1 billion or more.

One of the most important benefits to being an EGC is that before an initial public offering, EGCs may submit a draft registration statement, the lengthy and detailed content of which is prescribed by volumes of intricate regulations, for confidential nonpublic review by SEC staff before public filing, as long as the initial submission and all amendments are publicly filed not later than 21 days before the company begins pitch meetings with prospective investors (called “road shows”). Before the enactment of this provision, all companies were required to publicly file their registration statements prior to the commencement of the IPO, even if it turned out later that an IPO was not feasible. EGCs are also allowed to communicate with certain institutional investors to determine whether they might be interested in a contemplated securities offering before or after filing a registration statement (called “testing-the-waters communications”).

After the IPO, an EGC has scaled-down securities compliance obligations. For instance, EGCs are exempt from certain requirements governing the content of materials sent to shareholders relating to shareholders meetings, including disclosure of “golden parachute” agreements (compensation agreements with executives based on an acquisition, merger, consolidation, or asset sale) and the relationship between executive compensation actually paid and the company’s financial performance, as well as the requirement to disclose employee compensation, CEO compensation, and the ratio of those amounts in various filings. EGCs are only required to present two years of audited financial statements in an IPO registration statement and two years of accompanying financial data in any registration statement (in contrast to the three years and five years, respectively, that are required of non-EGCs).  In addition, the JOBS Act eases the SEC reporting rules that apply to EGCs on various topics including executive compensation and allows EGCs to delay complying with any new or revised financial accounting standard that applies to public companies until private companies must also comply.  EGCs are not required to have accounting firms attest to their management’s internal control assessment, and are not subject to rules requiring mandatory audit firm rotation or a supplement to the auditor’s report.

The JOBS Act also allows a brokers-dealer to publish research reports about an EGC that is proposing an offering without this being deemed an offer for sale or offer to sell a security (which would complicate or even prevent the IPO), even if the broker-dealer in question is participating in the offering.  Title I also prevents the SEC and FINRA from restricting certain securities analyst communications in connection with EGC IPOs.

Impact of the IPO On-Ramp

Unlike many of the other provisions of the JOBS Act, the IPO On-Ramp is generally favored by the venture capital community because they believe that it will help make the process of going through an IPO easier, less expensive, and less risky for the company, consequently making it easier for a VC to exit from its investment (which in the end, is the way VCs actually make money).  In contrast, many of the other provisions of the JOBS Act, like crowdfunding and Regulation D reform, are aimed at benefitting much smaller companies.[1] Thus, in a sense, the IPO On-Ramp should probably be viewed as a measure that deregulates big business, rather than a provision that attempts to strike a new balance between the competing public policy concerns of preventing fraud via securities laws and spurring the innovation of entrepreneurs by making it easier to raise money.  Nonetheless, there has already been at least one fraud investigation involving the IPO On-Ramp, though it is unclear if the passage of the JOBS Act actually facilitated the fraud in any way.

The large international law firm Skadden, Arps, Slate, Meagher & Flom LLP did a comprehensive study on the effects of the  IPO On-Ramp in January 2013.  The found that EGCs made considerable use of the confidential submissions process.  This makes sense since it allows the EGC to avoid publicly disclosing potentially sensitive strategic confidential information in the event of a failed IPO (and avoiding the adverse publicity of a failed IPO).  When combined with the provisions allowing “testing the waters” communications, EGCs have been able to mitigate some of the risks associated with the IPO process.  For instance, before the JOBS Act, if there was insufficient investor interest in the IPO, (i) the company would be out a lot of money, (ii) there would be negative publicity as a result of the failed IPO, and (iii) it would be difficult to immediately do a private placement after the IPO attempt because of the public nature of the IPO process (thus violating the general solicitation restrictions).

The Skadden study also found the provisions relaxing disclosure on executive compensation and compliance with some of the Sarbanes-Oxley provisions to also be very useful to EGCs and commonly used.  Conversely, the Skadden study found that the relaxed requirement to include only 2 years of financial statements was rarely used, since most companies by that point have enough financial statements to more than cover the normally required 3-year and 5-year periods.

Overall, I’d characterize the IPO On-Ramp as a modest success.  Some of the provisions, such as confidential submission of IPO registration statement to the SEC have been used by a number of companies going public.  It does not appear, at least as of yet, that these provisions have increased the likelihood of fraud in any substantial way.    Therefore, the IPO On-Ramp seems to provide for some level of deregulation (and thus reduced compliance costs) without harming the governmental policy interest of preventing fraud.

Footnotes

[1] Many in the VC community actually are opposed to crowdfunding for many of the reasons I described in part 1 of this series.  Cynics might argue that VCs oppose these provisions because they create additional competition for them when it comes to finding quality investments.

© 2013 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

The post The JOBS Act, a Year Later – Part 2: The IPO On-Ramp appeared first on Strictly Business.

The purchase agreement will typically contain a comprehensive list of representations that the seller is asked to give. Often, there will be 20 to 30 different sections covering various areas of the seller’s business, assets, etc. The following is just a sample:

• Due organization and good standing
• Capitalization
• Noncontravention (i.e., the purchase agreement will not contravene the seller’s organizational documents, any laws, any governmental orders, etc.)
• Financial statements
• Compliance with laws
• Tax matters
• Intellectual property
• Contracts
• Litigation
• Employees
• Environmental, health, and safety
• Related party transactions
• Customers

The representations serve three primary purposes from the buyer’s perspective. First, they further the due diligence process by (hopefully) ferreting out problems or issues with the seller’s business or assets so they can be addressed before an agreement is signed or taken into account in arriving at a purchase price; if they are sufficiently grave, the parties may abandon the deal.

Second, in the case of a deal in which the purchase agreement is signed and the closing is scheduled for a later date (as opposed to simultaneous signing and closing), the representations serve as a basis for allowing the buyer to walk away from the deal without closing (“walk rights”) if the buyer learns that the representations are not accurate at closing.

Third, they serve as a basis for allowing the buyer to recover some of its purchase price (through indemnification) after closing if the seller’s representations are inaccurate and the buyer incurs damages (this latter function is referred to as “risk shifting” in industry jargon because each party is attempting to negotiate the language of the representations to shift the risk of post-closing events to the other party).

Here’s sample language from a purchase agreement requiring the seller to represent that it is in compliance with legal requirements:

The Seller is, and has been since January 1, 2010, in compliance with all applicable laws (including rules, regulations, codes, plans, injunctions, judgments, orders, decrees, rulings, and charges thereunder) of federal, state, local, and foreign governments (and all agencies thereof), and no action, suit, proceeding, hearing, investigation, charge, complaint, claim, demand, or notice has been filed, commenced, or threatened against the Seller alleging any failure to so comply.

As is customary, the buyer has used very broad language in this representation and the seller needs to know how to handle the representation in its negotiations of the purchase agreement. With that in mind, here are some tips for sellers engaged in those negotiations:

Tip 1 — Consider Who Should Give the Representations.  The purchase agreement will typically include a lead-in statement that applies to the entire list of representations, such as the following:

The Seller and Shareholders, jointly and severally, represent and warrant to Purchaser that the statements contained in this Section 2 are true, correct and complete as of the date of signing and the Closing Date, as modified in the applicable section of the disclosure schedule accompanying this Agreement (the “Disclosure Schedule”).

This particular language is from an asset deal and requires the seller (the entity) and the shareholders of the seller to make the representations. So task one is to determine if this is appropriate or not. Ideally, in an asset deal, the seller’s shareholders will not have to give the representations, but often the buyer will insist that they do (at least perhaps majority owners). The smaller the company and the fewer the shareholders, the more likely it will be that individual shareholders will have to make the representations.

Also note that the representations are joint and several — meaning that the seller (the entity) and the shareholders are on the hook for the statements. At the end of the day, it may be the case that the entity and the shareholders have no choice but to give some or all of the representations, but think this through very carefully and limit shareholder responsibilities as much as possible.

Tip 2 — Review and Narrow.  The buyer’s initial draft of the purchase agreement will likely request overly broad representations from the seller as to its business and assets. The seller’s initial task is to review the statements very closely and determine those that it can give with certainty and those that are perhaps less certain. As an example, many sellers might react as follows when reviewing the sample representation on legal compliance above: “I think we’re in compliance with all laws but I am not totally sure.”

In that case, the seller’s goal is to make the statement completely true with as much certainty as possible by either narrowing the representation and/or making adequate disclosures (the latter is discussed below). When reviewing the representations, be sure to get input from others in the organization who might have knowledge of any issues covered by the statements (e.g., a human resources manager).

After you have a good understanding of your ability to make each representation with certainty (or not), consider narrowing the representations as much as possible, particularly those that result in significant risk to the seller and its shareholders. Common ways to narrow representations include adding “knowledge” and/or “materiality” qualifiers to the statements requested by the buyer. As an example, here’s the representation on legal compliance quoted above rewritten from the seller’s standpoint (with the seller’s additions in bold):

Except as set forth on disclosure schedule [cross-reference section number], and except with respect to any violations which would not have a Material Adverse Effect, the Seller is, and has been since January 1, 2012, in compliance with all applicable laws (including rules, regulations, codes, plans, injunctions, judgments, orders, decrees, rulings, and charges thereunder) of federal, state, local, and foreign governments (and all agencies thereof), and no action, suit, proceeding, hearing, investigation, charge, complaint, claim, demand, or notice has been filed, commenced, or, to the knowledge of the Seller, threatened against the Seller alleging any failure to so comply.

The seller’s modified language changes the representations in four ways. First, the seller has added a disclosure schedule in which the seller will note any violations of laws or pending or threatened suits, charges, etc.

Second, the seller’s version limits the entire representation to legal violations that would cause a Material Adverse Effect (a term that will be defined in the purchase agreement to indicate the negative effect of certain events on the seller’s business), but not that there are no violations, period.

Third, the seller has changed the applicable date from January 1, 2010 to January 1, 2012.

And fourth, the seller has added a knowledge qualifier with respect to issues that are simply threatened rather than actually in process. Taken as a whole, the representation as revised by the seller poses much less risk for the seller and hopefully the seller can now make this statement with a high degree of certainty.

Tip 3 — Disclose, Disclose, Disclose!  The seller must disclose any items required to make a representation true. So for example, if the legal requirement representation described above is true except that the seller believes it may have violated an employment law and has received an initial notice from the EEOC, then the disclosure schedule can be used to make the representation true. Here’s a sample disclosure:

The Seller received notice from the EEOC on [date] that it was reviewing a complaint filed by [ex-employee] alleging age discrimination.

The disclosure schedules are sometimes referred to as “insurance” in industry jargon, in the sense that they help insure the seller against future claims by the buyer.

Tip 4 — Update Disclosure Schedules. Most deals are of the “sign and close later” variety (as opposed to a “simultaneous sign and close”). When closing follows the signing at a later date, the seller must monitor the representations between the date of signing and the closing. It’s almost certain the buyer will require the seller to make the representations at the time of signing and at the time of closing. The seller needs to update its disclosure schedules such that they, as well as the representations they modify, remain true on the closing date.

The representations and warranties section of the purchase agreement is often the longest and most laborious section of the document. Knowledgeable sellers will pay significant attention to the statements included and limit their risk by narrowing the reach of the representations and by making adequate disclosures. Don’t simply leave these to your counsel and assume they are just verbiage for the lawyers to tinker with — know what the representations state about you and your company.

In the next post, we’ll discuss conditions to closing.

© 2013 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

The post Selling Your Business – Practical Tips for Sellers – Part 7: Representations, Warranties, and Disclosure Schedules appeared first on Strictly Business.

First, let’s start with an overview of the JOBS Act. The JOBS Act is divided into six main sections called “titles.”

• Title I of the JOBS Act — also known as the “IPO On-Ramp” — creates a new category of company called an “emerging growth company,” which is defined roughly as a company with less than $1 billion in revenue. An emerging growth company would enjoy more lax regulation by the SEC than other public companies for up to five years. For example, the act permits emerging growth companies to defer compliance with Section 404(b) of the Sarbanes-Oxley Act until the company is no longer considered an emerging growth company. Section 404(b) requires the company’s auditor to report on and attest to management’s assessment of the company’s internal controls, a requirement that necessitates high compliance costs. The IPO On-Ramp was effective upon passage of the JOBS Act. More details will be discussed in a future post.
• Title II makes two distinct changes in the law related to private placements. First, it contains a provision instructing the SEC to revise its rules to remove the general solicitation prohibition applicable to offerings made under Rule 506 of Regulation D, as long as all purchasers are accredited investors. Second, it exempts from broker-dealer registration certain online platforms that pair investors with companies seeking capital and potential co-investors and those that provide ancillary services (such as due diligence or provision of standard documents). The provision related to online platforms became effective upon passage of the JOBS Act. The provision repealing the ban on general solicitation in Rule 506 offerings has not gone into effect because of delays in the SEC’s rule-making process, generating considerable friction between some members of Congress and the SEC.
• Title III is the so-called “crowdfunding” law. Probably the most well-known of all the provisions in the JOBS Act, it creates a new exemption from securities laws for certain offerings conducted online. It has not yet gone into effect because of delays in the SEC’s rule-making process. At the time it passed, I was very critical of it, mainly because I thought that the heavy compliance burdens it imposed would make it unworkable for small companies looking for investors. In a future post, I’ll reexamine and possibly reassess my views in light of the events of the last year and discuss recent developments associated with this portion of the act.
• Title IV essentially instructs the SEC to revise a little-known securities registration exemption known as Regulation A, increasing the amount that can be raised under that exemption from $5 million to $50 million. Like the Regulation D reform and crowdfunding provisions, title IV has not yet gone into effect because of delays in the SEC’s rule-making process. More details will be discussed in a future post.
• Titles V and VI make it easier for companies to remain private (i.e., avoid having to become a public reporting company). Prior to the passage of the JOBS Act, if a company had over $10 million in assets and any class of its equity securities was held by 500 or more shareholders of record, it was required to become a public reporting company, which essentially forced the company into conducting an initial public offering. It was widely speculated in the media that Facebook became public only because of this rule and would have preferred to remain private had it not been required to register. The JOBS Act increased the number of shareholders a company may have before the registration requirement is triggered in two ways. First, it increased the threshold so that it is triggered if the company has either (1) 2,000 or more persons or (2) 500 or more persons who are not accredited investors (except for a bank holding company, for which the threshold is a straight 2,000). Second, it provided that shareholders who received their shares through an employee compensation plan are not to be counted towards these limits. Shareholders who acquire their shares through a crowdfunding offering also do not count towards these limits. These provisions took effect upon passage of the JOBS Act, though some rule-making still needs to be done by the SEC.

What is most striking about the JOBS Act is how little effect it’s actually had thus far. This is because the SEC has failed to issue many of the implementing regulations that actually make many of the most important provisions of the act effective. Many of the act’s provisions are not self-effecting; that is, until the SEC issues regulations, they have no force or effect in law. Disappointment has abounded. I have previously written about how Rep. Patrick McHenry (R – NC), chairman of the subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs, wrote a letter in August 2012 to Mary Shapiro, the chairman of the SEC at the time, accusing her of ignoring the law by failing to issue the revisions to Regulation D allowing for general solicitation. More recently, Reps. Darrell Issa (R – CA), Jim Jordan (R – OH), Jeb Hensarling (R – TX), and McHenry sent a letter to SEC Chairman Elisse Walter, expressing that they are “surprised and troubled” to see the SEC expending resources on a project to force political spending disclosures by corporations while so much of the JOBS Act remains unimplemented (namely Titles II, III, and IV). More recently, McHenry and others introduced legislation in Congress to impose on the SEC a deadline of October 31, 2013 to implement Title IV (related to reforming Regulation A). Since the SEC has missed every other deadline in implementing the JOBS Act, I’m not sure what will come of this.

What’s causing the regulatory paralysis? The central issue is that there are two completely different mindsets at work when it comes to the world of capital formation. On one side, there is the view that we need to deregulate the issuance of securities for startups, small companies, and high-growth companies because our current securities laws are too complex and difficult for small companies to comply with. Compliance would require companies to hire legal counsel that is highly specialized (and thus expensive) at the precise point in time when they are least able to afford to do so. According to this viewpoint, making securities laws less onerous would make it more likely that good ideas will be able to obtain needed investment, creating economic growth. This was the central premise behind the JOBS Act.

But there’s a second viewpoint, held by many just as strongly as the first, which is that securities regulations are in place to prevent fraud and loosening them is only likely to increase fraudulent behavior. In addition, advocates for stringent securities laws argue that, while some offerings may not be fraudulent, most potential investors are not in a position to evaluate whether startup investments are a good allocation of capital or whether they are too risky for them to bear. In this view, the potential for fraud plus most people’s inability to evaluate investments has three negative effects: (1) investors will suffer from losses that they cannot bear economically (think of the widow who loses her life savings in a risky venture); (2) because of the widespread losses that people will incur due to fraud and bad business ventures, over time people will become less willing to invest because of fear of such losses (i.e., a loss in confidence in the markets — think the Great Depression, which is when the federal Securities Act of 1933 was passed); and (3) because there will be large numbers of amateur investors investing in things that they have no way of evaluating, capital will actually get mis-allocated, which will hurt economic growth.

The problem is that both of these perspectives are right. Securities laws ARE complex. They are often difficult to comply with, and the severe consequences for failure to comply with them (criminal and civil money penalties, rescission rights for investors, and inability to raise future capital among them) deter entrepreneurs from seeking investors for their ventures. The high cost of legal services and significant amount of compliance is often way out of proportion to the budgets of many startups. It is also true that fraud presents a serious problem and is quite common. In addition, investments in startups often become just another form of gambling rather than a carefully considered investment decision.[1]

The public policy concerns underlying both of these viewpoints are good ones. Some might accuse me of being wishy-washy and trying to have it both ways. Actually, I am (with regards to having it both ways), because the facts motivating both viewpoints are not mutually exclusive. It is possible for it to be true that (a) securities regulations make obtaining capital complex enough to deter entrepreneurs from embarking upon promising ventures AND (b) people often get defrauded or make poor investment decisions or evaluations of risk.

My view is that too many people talk about increasing regulation or decreasing regulation as if one or the other is inherently a good thing or a bad or that one public policy concern should always trump another. What we need is smart regulation that specifically targets the things we are trying to prevent (like fraud) and doesn’t prevent things that we aren’t trying to prevent (like useful allocations of capital).

With this background in mind, are the provisions of the JOBS Act “smart” regulation? Often with these kinds of things, the consequences will only be evident years after implementation. The difficulty of balancing the two viewpoints I described above is what is significantly slowing down the implementation of the JOBS Act by the SEC. To make things worse, just a few years before the JOBS Act, Congress imposed significant regulatory responsibilities on the SEC in the Dodd-Frank Act and the SEC is behind in its implementation of that as well. All of this creates quite a mess.

In the next post, I will explore how the implementation of the IPO On-Ramp has transpired.

Footnotes

[1] Indeed, prolific economic commentator Steve Rattner recently wrote an opinion piece in the New York Times expressing this precise view.

© 2013 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

The post The JOBS Act, a Year Later – Part 1: Introduction appeared first on Strictly Business.

The first draft of the purchase agreement will generally be prepared by buyer’s counsel and will be divided into several separate sections, such as the following:

• Description of the Transaction
• Representations and Warranties of the Seller
• Representations and Warranties of the Buyer
• Pre-closing Covenants
• Conditions to Closing
• Post-closing Covenants
• Termination
• Survival and Indemnification
• Miscellaneous or General Provisions

The actual sections included will depend, in part, on whether the deal is structured with a signing date followed by a later closing or, alternatively, as a “sign and close” transaction where both events happen simultaneously. In the latter case, the purchase agreement is generally simpler and won’t include the Pre-closing Covenants or Conditions to Closing sections.

The first section, which we’re discussing in this post, will often contain the major business terms.  Here’s a brief list of the major terms and tips for reviewing this section of the purchase agreement.

Assets/Interests to Be Sold.  The buyer’s draft of the purchase agreement should accurately describe what is actually being purchased by the buyer (the specific assets in an asset deal or the stock or other ownership interests in a stock deal) and those assets or liabilities being retained by the seller, if any.  Hopefully, there is agreement on such big picture terms prior to receipt of the purchase agreement so that there won’t be lots of negotiation on these points.

As a seller, you’ll want to be sure all of the descriptions are correct.  In particular, in an asset deal, be sure all assets you intend to remain with you (“excluded assets”) are specifically listed.  Typical excluded assets are cash, marketable securities, assets associated with retained liabilities (e.g., 401(k) assets if the plan is being retained), and often certain personal assets (e.g., the seller’s vehicle).  Generally, the buyer will draft very broad language when describing the transferred assets, such as “all assets used in the business, including…”  Therefore, it’s up to you, as the seller, to carve out assets that should not be transferred.

On the liability side, be sure all liabilities that the buyer will take are listed (here, the buyer’s purchase agreement will usually use very restrictive language such as “seller retains all liabilities and obligations except for the following: [list of specific liabilities]”).  Typical liabilities that the buyer will assume include obligations under assigned contracts and accounts payable.  Again, this is only relevant in an asset deal.

A stock deal is typically simpler to describe but be sure the description of stock or other interests being purchased and sold is correct.

Purchase Price.  Often, the purchase price terms will be one of the first subsections of this section.  It should include (i) the portion of the purchase price to be paid at the closing and how it will be paid (e.g., $5,000,000 million by wire transfer to a bank account of the seller), (ii) any portion of the purchase price to be paid via delivery by the buyer of a promissory note to the seller (e.g., $2,000,000 by delivery of the buyer’s promissory note to seller), and (iii) any portion to be paid via an earn-out.  Many times there are potential adjustments to the purchase price too (e.g., working capital adjustments), some of which may be made at the closing and others which are made post-closing.  Such adjustments should also be very clearly described.

Closing.  The “Closing” should be defined and described in the purchase agreement.  Most deals now close by exchange of documents by electronic transmission with originals to follow by overnight mail.  A specific date for the closing should be set, especially in a deal that will provide for signing of the purchase agreement before the closing.  Also, it’s common to set the effective time for the closing (e.g., 11:59 p.m. on the date of closing), to eliminate any confusion about events that occur or conditions that apply on the “Closing Date” but before or after the “Closing” itself.

This first section of the purchase agreement should be fairly straight forward and should not require significant negotiation but it is one of the most important sections because it contains the major business terms.  So be sure to think it through and review it very carefully with your lawyer and probably your CPA.

In the next post, we’ll discuss representations and warranties in the purchase agreement.

© 2013 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

The post Selling Your Business – Practical Tips for Sellers – Part 6: The Purchase Agreement appeared first on Strictly Business.

This is the fifth in a series of posts discussing the sale of a business from the seller’s perspective. In the first four posts, we provided an introduction to this series and discussed asset versus stock sales, seller financing, earn-outs, and letters of intent. In this fifth post, we’ll discuss the beginning of the deal process (after signing of the LOI), which typically begins with a comprehensive review of the seller’s business by the buyer (generally referred to by those in the M&A industry as simply “due diligence”).[1]

The due diligence process can often overwhelm sellers who need to be focusing on more important aspects of the transaction. It’s incredibly stressful to be working on key aspects of the deal (and simultaneously running your business) while being bombarded with e-mail requests for more and more information, some of which may seem irrelevant or immaterial. To keep your sale progressing smoothly so you can focus on what’s important, you need to know what to expect and how to respond before you start the process. Here’s a description of the purposes of due diligence and a general outline of the process followed by some tips for handling it efficiently

The Purposes of Due Diligence

Due diligence is performed by the buyer to determine if it wants to go through with the purchase of the business. As the seller, you are privy to all sorts of information that the buyer doesn’t have and due diligence is the primary way the buyer has of getting at this information. While you may know with certainty that there are no potential environmental issues with your real properties, the buyer doesn’t know this but wants to find out in the due diligence process. So keep this in mind when the buyer is asking for all kinds of information, some of which may not be relevant. Due diligence is also used to put together the schedule of disclosures required in connection with the purchase agreement. We’ll begin discussing the purchase agreement in the next post.

The Due Diligence Process

Due diligence will likely begin with one or more diligence request lists. You may get one comprehensive list submitted by the buyer’s law firm which requests accounting, financial, and legal information. Or you may get separate lists (one from legal, one from financial/accounting). If you get a brief list, you can be pretty sure that a longer list is coming later. (If you want to see a sample diligence request list, send us a quick e-mail and we’ll be happy to provide one.)

When you get the request list, you will be expected to provide complete and accurate responses to all items requested, and most likely, this will be done by means of a virtual data room. Popular electronic data room providers range from those like Merrill, which offers a full-featured service with extensive security options (for example, documents can be made available on the site for printing only and users cannot download them to a local drive), to cheaper or free options, such as an in-house extranet service or cloud services such as Google Drive or Dropbox. Electronic diligence entails a lot of scanning and organization for you and means, generally, that the parties involved expect instant responses to requests and a constant awareness of what is provided.

The due diligence process, on the buyer’s side, will likely be run by mostly associate attorneys, many of whom may seem to exercise little or no common sense at times. You’ll know what I mean when you get repeated requests for a signature page to a postage meter lease. However, to be fair, the associates are charged by their senior partners with running down every contract, document, etc., and aren’t charged with making judgment calls about what is or is not important at the due diligence stage.

The due diligence process may at times seem grueling. It often continues right up to the point of closing with continuing requests for missing or additional information, all while you’re running a business, trying to negotiate a transaction, and attempting to maintain some sanity.

With this backdrop of the purposes and process of due diligence, here are some practical tips to make life easier in this phase of the deal:

Point 1 – Consider a Pre-Transaction Review — Consider having your law firm review your books, records, contracts, etc. before the deal process even starts. Your lawyer will have a good idea as to what information the buyer will be looking for and it can help tremendously to have your information organized and collect missing information before the deal starts. You’ll be glad you did this when you’re in the heat of the deal.

Point 2 – Provide Complete Responses — Many buyers will want to review everything (every contract, financial statement, customer list, accounting record, and on and on), and will expect it to be complete. When you hunt down the documents requested, before scanning them, check them over to be sure that they are the most current version and include all party signatures and all attachments, exhibits, annexes, schedules, and so on. You can be sure that the purchaser’s lawyers are going to come back and hassle you for anything that is missing.

Point 3 – Allocate Responsibilities — Decide on an allocation of responsibility within your company and between you and your lawyer. Some business owners take charge of going through their files and scanning and uploading all the documents to be provided. Others send boxes of disorganized papers and files to their law firms for junior associates to go through and organize. Yet others work out an arrangement somewhere between these extremes. Whatever you choose, make sure that everyone knows who is responsible for uploading new documents and informing the group that new documents are available.

Point 4 – Use Reference Numbers and Descriptive File Names — When organizing and delivering documents, consider using reference numbers and writing them right on the documents before you scan them. Also be sure to use file names that start with those reference numbers and that include a helpful descriptor. As in other areas of life, the file name “Scan00001” is completely worthless to anyone looking for a document and will lead to inefficiency and confusion. Instead, use a name such as “2A Tennessee real property lease”.

Point 5 – Always Load It in the Data Room — Don’t assume that just because you e-mailed a document directly to purchaser, or to your accountant, that anyone else involved in the transaction has seen it. Put all documents in the data room, even if any party asks that you e-mail a particular document directly. Above all else, remember to make sure your lawyer sees every single document you provide to anyone else.

Point 6 – Be Aware of Confidentiality — Be aware of where you are in the process and adjust disclosure accordingly. If you are at an early stage and wish to keep customer names confidential, for example, provide customer contracts with the customer names redacted. Number them so that you can provide a number-customer name key once you are ready to reveal the names. If you’ve allocated the responsibility of uploading documents to your lawyers, be sure to keep them in the loop as to documents that should remain confidential or that should be redacted before being uploaded.

Point 7 – Use “N/A” — If your company doesn’t have any of a certain type of document requested — for example, deeds to real property (because all of your offices are leased) — be sure to indicate that there is nothing to provide on the request list. If you have provided some documents in a given category, but others are coming, indicate that as well. It is easiest to do that right on the request list.

Point 8 – Keep the Due Diligence Information — Whether a deal closes successfully or fails to close, be sure to keep records of all documents you provided during the due diligence process. It is easy enough to burn a CD-ROM of the entire electronic data room. If the deal closes, you may need to refer to these documents from time to time, especially if any dispute or indemnification claim arises under the purchase agreement. If the deal doesn’t close, you can also use this to make the process go that much more quickly in your next attempt. Don’t lose sight of this important step in the aftermath of a deal that fails to close.

If you can keep these tips in mind while going through the due diligence process, you’ll be in a much better position to guide the transaction from a high level.

In the next post, we’ll begin discussing the purchase agreement.

The post Selling Your Business – Practical Tips for Sellers – Part 5: Due Diligence appeared first on Strictly Business.

We’ve previously written about LOIs from the point of view a buyer of a business and recommended that a lawyer be engaged at the LOI stage. However, in this post we want to discuss some of the important points from the perspective of a seller of a business. Here are four tips for sellers in negotiating the LOI followed by a list of items sellers might consider including in the LOI.

Point 1 – Get the Maximum Benefit of Your LOI – From the seller’s perspective, negotiating power is often highest at the LOI stage. However, many sellers fail to take advantage of their relative negotiating strength at this point in the deal process, instead viewing the LOI as non-binding and thus not as important as it really is. From a practical standpoint, after a seller has signed the LOI and started the deal process, the seller has often formed a mental and emotional commitment to the sale (and the cash) and it can be very difficult to negotiate with an experienced buyer concerning items that haven’t been previously “agreed on.” Often, a sophisticated buyer simply says “no” to what may be important and reasonable requests because they weren’t included in the LOI, leaving you, as the seller, with the nearly impossible position of risking the deal or giving in. So, point one is to maximize your leverage at the LOI/term sheet stage by broadening the scope of your LOI to include not only business points but significant legal points too.

Point 2 – Be Clear as To What’s Binding and What’s Not – As I’ve previously discussed, it’s imperative to be clear as to which portions of the LOI/term sheet are binding and which are not.

Point 3 – Be Aware of Expectation Setting – Often, the LOI will be the first negotiations between buyer and seller and, thus, the first chance for the parties and their counsel to “size each other up.” If you treat the LOI lightly and try to sign too quickly without giving it your full consideration, you might be giving the buyer the impression that you’re too anxious or want the deal “too much,” thereby giving the buyer more confidence in its negotiating power. I’ve seen many sellers rush to sign something, thinking it’s non-binding and can be changed which, in my view, only leads to problems down the road. Instead, treat the LOI stage as a critical step in the deal process and be tough, yet reasonable in negotiations.

Point 4 – Strike a Balance – Despite what I’ve just said, don’t overdo it. The LOI is, after all, an expression of intent for the most part, so don’t try to negotiate the entire deal at this stage. There’s a reasonable balance that needs to be maintained – negotiate towards a clean, crisp LOI that covers the salient deal points (business and legal) but don’t get into the minutia at this stage.

Potential Items to Consider – With this backdrop in mind, here’s a list of items sellers should consider including in the LOI, some obvious and some you might not think of:

• In an asset deal, include a generic list of assets being sold and list any significant excluded assets; on the flip side, do the same with liabilities to be assumed by the buyer or excluded.
• Clearly state the purchase price and payment terms; include basic terms of any seller financing or earn-outs, if applicable.
• Clearly describe any working capital adjustments and associated assumptions.
• Provide a general framework for how the diligence process will proceed and note any items you will retain pending execution of a definitive deal document (e.g., sensitive customer information).
• Consider stating who will be required to give representations and warranties from the seller’s side (will it be the selling entity only, or the individual owners as well?).
• Note any significant closing conditions – e.g., whether the deal is contingent on the buyer obtaining its own financing.
• List the basic indemnification terms (who will provide the indemnities; what will the baskets, caps, and survival periods be) and consider noting any special terms that might apply in your deal.
• Consider listing the basic terms of any employment or consulting agreements for the principals of the sellers post-closing (how long you will work post-closing and what your title and compensation will be after closing).
• List the basic non-competition terms that will be applied to the sellers post-closing (e.g., sellers won’t compete for three years after closing).
• List the buyer’s intent with respect to seller’s employees (will they all continue with the buyer post-closing?) and note whether buyer will be able to discuss the deal with employees prior to a definitive deal document being signed.
• Note the anticipated closing date and any special terms that might apply (e.g., the deal must close on or before X).
• Be sure confidentiality and non-disclosure provisions protect your information – often, there’s a separate confidentiality/nondisclosure agreement. If there’s not, be sure to include these provisions in the LOI and make sure they are binding. If there is a separate agreement, make sure the LOI does not supersede the confidentiality/nondisclosure agreement.
• Be sure your LOI disclaims reliance by the buyer on information it may review during the due diligence process. If you don’t get to a definitive deal document, you don’t want to be on the hook for claims by the would-be buyer if it claims reliance on preliminary discussions or diligence information.
• Consider an exclusivity clause. You most often see these clauses in the buyer’s favor, which is usually reasonable, but you might consider whether it’s reasonable to restrict the buyer from talking to your competitors while you’re negotiating with the buyer. You don’t want the buyer pulling out because it finds a better deal in your industry while you’re negotiating in good faith and providing the buyer with sensitive information.
• Be clear on who pays deal expenses in the event the deal doesn’t close. You’ll generally want to make sure the buyer is paying its own costs.
• Include normal contract “boilerplate” provisions, such as those dealing with governing law, jurisdiction for disputes, etc. Again, if the deal doesn’t close, you’ll want to be sure these items are covered.
• Clearly list the binding provisions.
• Add anything that’s unique and material to your deal. At a minimum, you want to make sure you and the buyer are on the same page to avoid surprises.

In the next post, we’ll discuss the due diligence process.

© 2013 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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The New Asset Management Unit

As discussed previously, Karpati is part of the Asset Management Unit of the SEC’s Division of Enforcement, which specializes in investment advisers and investment companies, including private equity fund managers. He noted that the unit has been cultivating expertise in the following areas: industry structure, customs and practices, manager incentives, and trends and risks that enable the unit to detect and investigate fraud. The unit has garnered this expertise by hiring industry professionals with significant experience in private equity, hedge funds, mutual funds, and due diligence, having each unit staff member develop a detailed plan covering either a type of investment vehicle or an investment practice, and retaining attorneys with practical investigative experience. The increase in expertise has enabled the unit to detect fraud at an earlier stage by uncovering data anomalies, allocate resources more effectively, and tackle more complex and technical cases.

Karpati described how the unit collaborates across the SEC by, for example, training National Exam Program examiners and accompanying them to exams of private equity managers — giving the unit direct exposure to industry professionals and keeping it on the “leading edge” of industry trends and issues. The unit also collaborates with the SEC’s Division of Investment Management when an investigation involves complex legal issues and when the Division of Investment Management is crafting rules that affect the private equity industry.

Anticipating an Increase in Private Equity Enforcement Actions

When asked, Karpati revealed that “it’s not unreasonable to think that the number of cases involving private equity will increase.” This is due to the rapid growth and maturation in the private equity industry before the financial crisis, resulting in a level of assets under management similar to or greater than that of the hedge fund industry, as well as more private equity managers registering as investment advisers. He pointed out two ways in which private equity is particularly prone to fraud: portfolio companies can be controlled in a way not visible to investors, and investors often become less involved in monitoring the fund over time.

Karpati outlined a number of recent cases involving private equity funds or issues often seen in the private equity industry, yielding the following examples of misconduct:

• Usurping an investment opportunity
• Misallocating fund expenses
• Misstating portfolio company performance to investors
• Misappropriating investor funds to repay previous investors
• Taking amounts from fund as “advance management fees”
• Insider trading using stolen confidential information
• Inflating values of illiquid assets
• Overstating the value of debt securities and CLOs in an investment portfolio

Practices of Concern to the Unit

Karpati discussed some of the practices that the unit is scrutinizing in particular. First, he addressed fundraising and capital overhang. The combination of less capital available to new funds and significant amounts of uninvested capital means that many managers face failure, tempting them to engage in aggressive and potentially fraudulent behavior. Second, he addressed lack of product transparency, which matters particularly in terms of the valuation of illiquid assets and portfolio company operations and during the marketing period, when managers may be tempted to write-up assets, writing them down after that period ends. Third, he discussed conflicts of interest, which include the following:

• Profitability vs. the best interests of investors, especially at publicly listed firms
• Charging expenses to the management company vs. charging them to the funds
• Charging additional fees
• Conflicting interests of different clients, investors, and products
• Fund business vs. manager’s other, competitive business

Risk Analytic Initiatives for the Private Equity Industry

Karpati explained that the unit’s expertise is devoted in part to developing and implementing “risk analytic initiatives,” or RAIs, that proactively detect fraud and other suspicious activities  via data and quantitative analysis. RAIs are designed to analyze data to ferret out factors that indicate high risk, such as lack of transparency and lack of monitoring by investors. Of currently active RAIs, one focuses on private equity. It attempts to detect “zombie” private equity managers, which Karpati described as “managers who have assets under management but are unable to raise follow on vehicles.” The unit’s concern is that such managers have an incentive to maximize revenue using the existing assets, rather than act in the best interest of the fund’s investors, and that this incentive can give rise to fraudulent activities. The specific factors the unit attempts to detect in this analysis include the following:

• Misappropriation from portfolio companies
• Fraudulent valuations
• Lies about the portfolio to cause investors to grant extensions
• Unusual fees
• Principal transactions

How to Reduce the Risk of Inquiry

Karpati reminded his audience that under the Investment Advisers Act of 1940, investment advisers have a fiduciary duty to act in the client’s best interest. According to case-law cited by Karpati, this duty comprises the following obligations: “an affirmative duty of ‘utmost good faith, and full and fair disclosure of all material facts,’ as well as an affirmative obligation ‘to employ reasonable care to avoid misleading’ … clients.” He stated that investment advisers may be found at fault even when they do not intend to injure a client or even if a client does not suffer a monetary loss.

Karpati put the responsibility for ensuring that clients’ interests supersede those of the management company and its principals on the COO and CFO, as they are tasked with overseeing the investment manager’s business. He offered the following specific tips:

• Integrate compliance risk into the overall risk management process
• Implement a set of compliance procedures appropriate for the business model
• Assign a deal professional with experience in compliance issues to review and implement these procedures
• Involve COOs, CFOs, and CCOs in the firm’s significant decision-making processes and have them act as investor advocates (for example, in disclosing results to investors)
• Utilize the Limited Partnership Advisory Committee to address conflicts of interest
• Give COOs and CFOs authority in the organization to proactively identify and resolve issues
• Immediately consult with the internal compliance department and counsel to resolve potential breaches of fiduciary duty to investors
• Be ready for exam inquiries, cooperate with exam staff, and implement necessary corrective steps

Private equity firms should be aware of the enhanced scrutiny that the SEC will be bringing to bear and, in addition to avoiding activities that obviously constitute misconduct, keep their fiduciary duty to investors in mind at all times and avoid allowing economic and organizational pressures lead them into aggressive tactics or overlooking conflicts of interest.

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An “earn-out” is a deal structure whereby a portion of the purchase price is contingent on the purchased business achieving some pre-determined goal after closing. Common earn-out terms are attainment of certain revenues or EBITDA by the purchased business in the year or two after closing. Earn-outs are common when a buyer and seller aren’t quite in agreement on valuation. For example, the seller wants $5 million and is confident post-closing financial performance will support such a price but the buyer is skeptical and thus only willing to pay $4 million at closing. An earn-out might bridge the gap in this example with the buyer paying $4 million at closing and agreeing to pay another $1 million (or more) if post-closing performance proves to be as the seller claims it will be. Earn-outs add significant risk and complexity to deals from the seller’s standpoint and need to be thoroughly evaluated. Here are a few issues to consider:

Term — from the seller’s point of view, earn-outs should generally be structured with relatively short terms, often no more than two to three years, and many times much shorter periods.

Top Line or Bottom Line — earn-outs can be tied to any financial (or non-financial) measure, but common alternatives are revenues or adjusted EBITDA. Revenues are generally less prone to producing disputes because they are much easier to measure. Adjusted EBITDA, on the other hand, can be very tricky and needs to be very carefully considered. As a seller, with an EBITDA measure, you need to focus on what expenses the buyer might incur that could be detrimental to attainment of the EBITDA target. It could certainly be the case that the buyer may want to take actions or incur expenses that it believes are in the best long-term interests of the purchased business even if it hurts EBITDA in the short run. Be aware of this potential and consider requiring covenants from the buyer that will it use reasonable efforts to help the business hit the earn-out targets. Discuss the buyer’s plans for the business after the transaction and try to determine if there are planned activities that might result in needed adjustments to EBITDA after the closing.

Control — as a seller, your ability to control or influence the business and its results will be substantially reduced (if not eliminated) at the closing and any post-closing control or influence you have will likely diminish quickly. However, if you will be staying on with the business with the buyer (perhaps as an officer or consultant) for some period of time, then you may have some ability to influence the business’s results. Think carefully about how much influence you may have on the earn-out hurdle (as an officer and consultant) and how important this is to you as the seller. Many sellers will only be comfortable with an earn-out if they are running the show during the period in which the earn-out is to be measured.

Stand Alone Business or Division — will the purchased business be a stand-alone business post-closing or will it be incorporated into a larger business? If it’s going to be part of another business, then there are more questions and the earn-out process will likely be more complicated. Will it be tied to the overall business or just the purchased business? How will financial results of the earn-out business be separated from the larger business? How will corporate overhead be allocated to the earn-out business? Will there be audited financial statements for the earn-out business or not?

Dispute Process — make sure your deal documents include a dispute resolution process. As a seller, you want to make sure you have the right to review and inspect the buyer’s financial records post-closing to evaluate whether or not the earn-out hurdle was achieved. And there should be some sort of dispute process, such as giving the seller the right to have an independent CPA firm review the financial results of the earn-out business.

Payment Terms — if the earn-out amount (when determined) is not paid in a lump sum, then the seller will bear the same risks with respect to the earn-out payments as with a seller financing.

Other Terms — what if the buyer sells the earn-out business before the earn-out amount is attained? Should this result in some portion of the earn-out being automatically earned and payable? What if there is a change in management (e.g., as seller, you’re comfortable with the current CEO but he’s replaced with a new CEO during the earn-out period)?

As with seller financing, earn-outs add significant risk and complexity to a sale of business transaction. A prepared seller will give significant thought to any earn-out terms very early in the deal process and consider ways to maximize earn-out success in the context of the specific business.

In the next post, we’ll discuss letters of intent and then move into the due diligence process.

© 2013 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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