506 – Are You Legal? Part 3 of 3: Legally Preparing Your Business To Sell

Podcast: Download (Duration: 33:38 — 31.0MB)

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Joanna Oakey

Podcast highlights:

02:12 – Why the legal side of a sale is important
04:42 – What are you actually selling?
05:55 – Shares or assets?
08:13 – Taking a look from afar
09:36 – The challenge of staff transfer
12:28 – Can it run without you?
13:33 – The question of confidentiality
16:31 – Who prepares the sale document?
20:02 – Getting the right advice
22:16 – Dealing with the emotions of a sale
22:49 – In cases of agreement changes
23:23 – Cover these bases
25:57 – The importance of a well-planned sale
28:51 – Communication is crucial
31:32 – Closing summary

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Part 1 of the series
Part 2 of the series

Transcription:

James: James Schramko here, welcome back to SuperFastBusiness.com, and this is the third part of a three-part series, for the Are You Legal? series. If you’ve just arrived at this episode and you haven’t heard episode one and two, please go back at SuperFastBusiness.com or in iTunes and have a look for Are You Legal?

Part one, we were talking about setting the foundations, having the right structure. We talked about intellectual property and what to do with staffing agreements, onshore and offshore.

In episode two, we talked about the key agreements that you need to have in your business, and we prepared a fantastic guide, and my co-host on this series, Joanna, gave us some resource as well, things that you need to look for in your business, and we also talked about how to get your cash flow ticking along nicely. So it’s a very important episode to listen to.

Today, we’re at part three, which is about building your business to sell. So we’re going to be talking specifically about the legal aspects involving a business sale, what you should be aware of, why this is important, and I’m going to introduce my co-host in the series, Joanna Oakey from aspectlegal.com.au. Welcome.

Joanna: Thanks James, thanks for having me back.

James: My pleasure. We’ve had some great comments in the previous episodes, some people have mentioned that they’ve gone and made some changes to their business as a result of some of the things we talked about in the earlier episodes.

Joanna: Right.

James: Business up for sale, we hear about that. A lot of my students are buying businesses, and some of them are selling businesses, so it’s something that’s always going on. And of course one of the greatest investments we might ever make is in building our own business, and one day we might sell it for a profit, or multiples of its annual profit. So there’s a lot of issues that come around, and I’ve been through this process a few times this year already.

Why look at the legal side?

So I would love to know, firstly, why do we have to consider the legal side of selling a business?

Joanna: Yeah, absolutely. When it comes to the point of sale, often what happens is businesses will find a potential buyer, will negotiate the commercial aspects of the sale, and then they’ll inspect to a legal adviser. But at that point, when the contracts are drawn up for the business and due diligence is done on the business, sometimes it’s only that time when businesses become aware of the risk that’s sitting in their business. And as soon as a buyer comes in and sees that risk, that can massively devalue the business, so reduce the amount that someone’s willing to pay, or it can place a potential sale on the rocks.

I’ve seen this happen time and time again when people have been really slow in thinking about the legal elements of the sale. Because the legal elements of the sale, essentially that key component of the sale that if it’s not done right, is done right at the end, but that can raise thorny issues that it’s too late to deal with. So if you deal with it right in the beginning, essentially you’re locking in the value of your business, and you’re reducing the likelihood that any thorns are going to appear during that due diligence phase or during that phase when the lawyers on both sides are involved.

James: Is that like when you’re selling some furniture or something and you take a picture of the scratch, and say, “Just letting you know, it has this scratch on it”, and like you’re putting it upfront.

Joanna: Yeah.

James: In copywriting terms, they call that a damaging admission. But it’s not like someone’s going to come and inspect it, or hand over the payment and then see the scratch, and then retract back and say, “Hang on a minute, this isn’t as described.”

Joanna: Yeah, absolutely. Well, in fact, I’d take one step back from that. I’d say, what you’re trying to do is you’re inspecting your furniture first to see where the scratches are, and you’re fixing the scratches, so that when you take your pictures, it’s in pristine condition. When the buyer sees the furniture that you have for sale, they see exactly what you’ve represented, and the transaction just flows through smoothly.

James: So what you’re saying is you should look at your business as if you were the potential buyer.

Joanna: Absolutely.

James: Because you have the benefit of a hundred percent vision on your business. Well, hopefully. You know your numbers and you have a good sense of what your business actually is.

What actually gets sold?

That sort of leads to a related question: when we are selling a business, what are we actually selling, and does that change?

Joanna: The answer to that question depends on what business structure you’re using. So in our first podcast in this series, we talked about business structure, and when you’re thinking about selling a business, that’s really the important time to go back and review the structure that you have in place, to make sure it’s the right structure to gear you up for a sale. And once you’ve worked out the structure that you’re using for a sale, there can be essentially two different ways of having a sale. You can either have a sale, if you have a company, you can sell the shares, or you can sell the assets or business out of the company.

And if you have a different structure, say for example you have a trust-based structure or you’re a sole trader, then you’ll be looking at selling the assets out, or the business out of that structure. And so the approach of selling shares versus selling assets or the business out of a structure, whatever the structure is, is a slightly different approach, and will have slightly different consequences in the sale agreement, and the sale process itself.

Sell the shares, or sell the assets?

James: Is there a preference between selling the business with its shares, or just selling the assets?

Joanna: Yeah, so if you have a company structure, and we’re talking at the moment about Australia, so in Australia, if you have a company structure, generally, it will be more advantageous to you from a taxation perspective to sell the shares. And it would generally be a simpler transaction to also sell the shares, because what you’re actually doing is you’re not having to change the ownership of each of the separate assets. So you don’t need to deal with each of the individual contracts because you’re just selling the company as a whole. You’re selling the shares out. But the company is a separate entity, so it keeps trading with the new people who’ve bought it, if you understand what I mean.

But if you’re operating as a sole trader, or out of a trust structure, you’re not selling the entity, you’re not selling yourself. You’re not selling the trust, usually you’re selling the assets out of it. So the way we deal with that from a legal perspective is that we effectively transfer every single contract, it doesn’t necessarily need to be every single contract, but we’re just moving each of those assets away from you and to the buyer.

James: Right, so in the case of one of the businesses that I sold, it was more or less an asset sale, because I kept my trust structure and sold the assets, which is more or less, in the sort of business we’re talking about, would generally be things like a domain name, a customer list, and then of course if there’s any suppliers and relationships, or where you’re getting your marketing from, you might have to transfer some of those things. And standard operating procedures.

Turned out that the list of standard operating procedures, or what I call the asset register, was probably one of the most valuable assets that the business had. Domain name, customer lists, and of course the team, was willing to go across and work for a new employer. So there’s a few moving parts to selling a business via transferring the assets. It’s like selling it almost by making up a bunch of components.

Taking a look from afar

Joanna: Bit by bit. Yes absolutely. And I think one of the elements that you’re talking about right at the moment also highlights another key thing in thinking about that sale of the business. You really need to step back and look at your business from afar and think about, what is it that is the real value in this business, and how have I locked in that value before I consider trying to find a purchaser for the business. So you’re thinking about all of those things for example, if intellectual property is a really important part of your business, how have you protected that intellectual property?

We spoke on one of the previous podcast episodes about trademarks and brand protection, but that’s not the only kind of intellectual property. Things like your standard operating procedures as you’re talking about now are also essentially intellectual property of the business. So when you’re thinking about what’s the value of the business and how do you lock that in, you need to really go through that process, how am I going to lock that in, how am I going to prove that that is a value, and how do I make sure no one else takes that and sells it off to someone else? So for example if my staff find out that I’m selling, how do I make sure that they’re not doing something with the client list or with the standard operating procedures that we have created? And indeed, how do we keep our key staff on as the business sells so that we can transfer them over as well?

James: There are some great challenges, and I think that’s why we put a lot of effort into one of our previous episodes. We talked about staff agreements and being very clear about who owns the intellectual property when you’re engaging a contractor or an employee, making sure that you’re clear on that. Yeah, there are a lot of factors. And certainly, in my case, it was helpful to signal to the team the change a long time in advance to give them a lot of time to process that, to make sure the stakeholders were all on board the idea of changing to a different owner. The stronger you can make the business its own entity, the easier it is for them to identify with that business unit.

In our case, it was more or less business units within our big business that transferred. There were two separate units went to two separate buyers. Basically wrapping them around a domain name was one of the central things that was able to segregate or silo that business unit from the rest of the business. And then it was identifying, if I were to sell off that silo, which things are they still dependent on from the mothership? And it came back to some basic stuff like accounting, payroll, bookkeeping, and customer relationship management. So we had to either make sure the buyer could take over those roles or we had to check that someone in the team could do those functions and make it fully independent. So those were some of the little subtle things that we had to consider when it was time.

Because as you said, if you don’t think about this stuff in advance, you might set up a great sale deal, and maybe your team doesn’t want to go and work for the new employer, or maybe they would like to buy the business as an employee buyout type deal. There’s so many creative ways you can structure deals these days. There’s no rule book on it, right?

Joanna: Yeah.

James: You could sell it upfront, you could sell it over time, you could have it on a performance basis or an earnout basis, you could have an employee buyout where they just buy the business from the original owner if they all chip in, and I’m sure there’s plenty of other ways.

Joanna: Yeah absolutely. And in fact, this concept of deferred payments, where someone pays part of the purchase price later on or earnouts where earnouts are essentially the name given to, your payment is based on the performance of the business over time, both of those link back really strongly to needing to make sure it works for the new buyer. I mean you want it to work well for the new buyer anyway, but structuring a deal in that way means that it’s imperative for you to make sure you’ve set this up well so that it keeps running smoothly as it transfers over.

Can it work without you?

James: That’s because a lot of the business value really comes down to the works-without-me factor, doesn’t it?

Joanna: Yeah absolutely.

James: This business is valuable to the extent that it can survive without you. Or at the minimum, you’d have to allow for a commercial salary to replace your role in the business. So if you can run your business a lot like the way that I teach, which is to remove yourself from being a job-like business to being an independently standalone run machine that works without you. Kind of like our content production machine that happens after I record this podcast. The machine takes over. Then it can increase your sale price because it’s definitely more attractive for a buyer, but you would have to demonstrate what the machine looks like and how it works.

And then we might move into some of the subtle things like preparing a book of sale or who do we reveal our sensitive data to. Are we going to get Microsoft, where they come and look at our books and then create their own version of it because now they know how it works?

Confidentiality agreement

Joanna: Yeah absolutely. So one of the key documents that you need right in the beginning before you speak to anyone is a strong confidentiality agreement. So you make sure that any information you disclose is protected. But these agreements can be often very difficult to enforce because it can be quite difficult to prove that someone has used information that you’ve provided. So it’s really important that you think about what are the other ways from a commercial perspective that we can protect how our confidential information is used. So that’s number one, considering who it is that we’re handing it over to before we hand over. So is there a way that we can screen buyers in the initial instance before we even consider handing over anything that might be confidential?

Secondly, in our confidentiality agreement, maybe we want to go one step further than simply including confidentiality. Often, I’ll suggest in certain transactions that it’s appropriate to have a restraint in the confidentiality agreement, which is a bit of a different approach to what many lawyers take. But my position is if you can get away with it, then you prefer to have the position where if you’re going to hand over the confidential information, the person who’s receiving it needs to give a promise that they won’t act in a way that could be detrimental to you. By that, I mean restrain them from acting in your market or from dealing with any of the customers that you’ve handed over details for. Those sorts of things. I’m really thinking commercially, how is it that we think cleverly about how we ensure that this information that we’re handing over isn’t misused.

James: Right. So putting some kind of filter or application process or showing enough of the essence of how it works without giving them the exact blueprint would be ideal I suppose if we have a fantastic process that really is unique. I think what you are talking about before, you kind of touched on it, I just want to highlight. With the confidentiality agreement, one of the main elements of that is that it really only protects you from things that the other person doesn’t know that you know that they learn through the agreement, but it doesn’t protect you from stuff they already know, does it?

Joanna: Yeah.

James: OK. So if you’re dealing with a very savvy buyer and they’re maybe from your industry and they’re just rolling up business…

Joanna: Absolutely. That’s absolutely right. Yes. That’s true.

James: They probably know a lot of the stuff and they might be just looking to increase their customer base or get access to a supplier that they’re locked out from or acquire a great domain name. It’s like, I remember, John Reese once talked about it, if you want to get to the top of Google, you can just go and buy the top ranked website today. Like you could get there today. It’s no mystery. It’s just a matter of money. So there’s always a creative way to get what you want. A lot of business sales happen for strategic reasons.

So a couple of basic questions Joanna, who prepares the sale document? Is it the buyer or the seller? Is there a convention here?

Preparing the sale document

Joanna: Well usually the seller. Although I must say in the transactions that we deal with, quite often, if we’re acting for the buyers, lawyer will prepare the sale document. So initially, convention, and particularly for smaller businesses, is that the seller will prepare the sale documentation. But if the purchaser of your business is a large business, they’ll want to control it. Or if the purchaser of the business has a particular concept in mind that may be different to your idea, once again, they may want to control it. So it depends on the size of the business and the size of the purchaser.

James: And I think we touched on this in an earlier episode, but what I found is generally, when the other person is preparing the document, that’s often a sign that it’s going to be looking to mitigate their risk and increase your risk in the deal. That seems to be a trend I’ve noticed. Is it, whoever prepares the document is probably going to start out a little on their side of the mid point?

Joanna: Absolutely. And that’s why it’s always, if possible, you want to control the preparation of the sale document because generally speaking, it ends up being easier, less risk for you, easier and probably cheaper because in a strange sense, it’s easier for lawyers to prepare documentation than it is for them to review someone else’s documentation to make changes that are needed. The reason for that is, some of these sale documents can be quite large and there can be traps hidden within them, and it requires a lot of attention to make sure those traps are identified. So that can almost, in some instances, be a more complicated process than simply preparing the document on your side because you’re dealing with documents that you understand right from the beginning.

James: Yeah. And I think I’ve seen cases where someone, they use a template for example, it might be the wrong type of template, like they might go for a business sale instead of an asset sale template, and it requires a lot of rework.

Joanna: Absolutely. And that’s when things get annoying, time consuming, and more expensive.

James: And often, the deal starts to break down when you have lawyers on each side won’t really budge or you get emotion involved. It must be said. Much like many other legal matters we talked about before that selling a business, someone might be feeling like they’re selling off their baby, they created this thing, they’re very attached to it. It sort of makes sense that the business that’s going to be worth more to sell is the business that you probably want to keep, so it’s a harder, emotional decision than to dump a business you hate, you’re sick off, you don’t want anymore, and you’ve run into the ground. That’s probably just like, take it off my hands, and you couldn’t be bothered. But the high value, highly emotional sales, it only needs a little bit of lawyer stoushing to start to just get to a loggerhead to the point where someone might throw in the towel and it might just turn the deal away.

Getting the right advice

Joanna: You’re so right. There’s two elements I think to what you’re talking about. One is the emotion, which I’ll come back to in a moment, but the second is the type of advisers that are involved. A business sale requires a different type of lawyer to other areas of law. It really requires a lawyer that understands the environment because business sale environments are all about taking the deal and finding out a way to get it across the line. Or if you’re acting for a buyer, it’s about finding a way to get it across the line assuming that the risk in the business is not massive that you’ve identified. So that’s always a bit of a caveat.

But you know, I think what often happens in this environment is you often have lawyers, who either number one, don’t quite understand the sale environment, so aren’t working really commercially to try and get through the process as commercially as possible. Secondly, you have lawyers that are too adversarial and want to fight. And often what happens is they want to fight on clauses that really don’t make sense in the situation.

In a business sale environment, there will always be risk, there will always be risk for the both parties, but it’s about looking at it and understanding the most appropriate commercial way to reduce your client’s risk as much as possible, but without doing it in a way that is ridiculous for the other party and that sometimes what causes real issues. In this environment, you have lawyers that just want to completely strip out any risk of their client at all, which really just isn’t possible. There will always be risk on both sides, it’s just about managing it in the best way, because if you’re trying to strip out all risk entirely, then you’re likely to be selling your business for a far lower value than you could otherwise sell it for.

James: Right. So it’s about people getting real and it’s knowing who’s in charge of your lawyer. Is it kind of like the lawyer is the thoroughbred horse and you’re the rider, and you do have the reins still, and some lawyers want to try and buck the client and just be wild broncos and other ones will be easily led by their client and there’ll be other ones where it’s a good relationship?

Dealing with emotions

Joanna: Yeah. I think it should always be a relationship where you’re working together with your lawyer because back to the point of emotion, it’s a really, highly, emotionally-charged environment. This is the time when people need strong relationships with their advisers both legal and accounting and brokers if they’re involving a broker as well. You need someone that you can work with together, strongly together with that’s on your page, but you need to be able to as the client feel like someone’s got your back but is working together with you to get you the outcome that you want. So it’s teamwork, it’s teamwork all the way.

Handling agreement changes

James: Right. So when there’s changes to the agreement, who’s paying for the changes? Is each party paying their own costs to the point where they think they’ve done enough and that’s it?

Joanna: Yeah generally, unless you can negotiate some other deal, but generally, each party pays for their own adviser’s costs for changes along the way. And that’s also why you want a document that’s good to start off with and ideally that you’ve controlled because you want as few changes as possible, because changes is where cost can start to really add up.

James: Right. So what other things do we need to look at when we’re selling our business from a legal perspective that we haven’t already covered?

Other things to look at

Joanna: OK. So we spoke about making sure you’ve got the right structure, we spoke about making sure you’ve locked in the value of your business, so you’ve protected your intellectual property and you’ve checked your key agreements, if the value in your business is connected to certain suppliers, or contractors, or clients, or staff, you need to think about making sure you’ve got each of those parties locked in and sometimes, it might be that it makes sense to be locked in for certain periods in a particular contractual relationship with each of those parties. Sometimes, there’s other ways you can achieve it, but basically, you just need to think about how is it that you can lock in the value of your business and can you use any of your contracts to do that?

Then the next thing is to make sure your house is in order. So we spoke briefly about this when we were talking about the chair, making sure there’s no chips on it, but you need to make sure that when the buyer inspects the business to check their level of risk in a sale that you’re not surprised by the risk that they suddenly find is sitting in your business. So it means looking at your business and making sure you’ve got your financials in order, that you’ve updated any contracts that need updating so they’re compliant with current legislation that changes quite regularly. You need to make sure you’ve ironed out any potential staff contract issues. So if you’ve got problem staff members, just deal with it early before the sale transaction starts. And if intellectual property is part of the value, just think about whether you need to do anything else to reduce risk.

So what you’re trying to do is ensure that you’re building the strength around the business. Dealing with any risk elements, covering them off with the right contracts or any other means that’s relevant so that when someone comes in and inspects the business, they see that your house is in order, they see this clean environment, something that is attractive for them to come in and take over, not something that they feel that they might be coming into and exposing themselves to risk in.

Different types of sales structures

And so then once you’ve done all of those things, then you need to get your head around the different types of sales structures. Do you want to sell the assets, or do you want to sell the shares, do you want all the money upfront, or can you think of some other ways that you might be able to drive a higher sale price by tacking on some sort of deferred payment or earnout at the end.

All of these things really need to be thought about well in advance of a sale because once you start down the sale process, you’ll find that you’re probably too busy. I’m sure you found, James, that when you start getting involved in a sale transaction, it becomes a really busy time. There’s a lot that you’re doing. You’re negotiating with the other side, you’re dealing with your lawyer, you’re dealing with accountants, you’re dealing with working out how this transaction will happen functionally. So it’s too late then to be thinking about all of these other issues that you should have put your mind to before.

James: Yeah, it’s like everything you’ve said in this series, if you can anticipate something that might happen in the future and head it off and remove ambiguity, then it streamlines everything. I guess it will be like if you’re going to bake a cake and you lay out all the ingredients and all the implements that you would use and the recipe all on the kitchen bench before you start and check that everything’s there, then it’ll be easier to get from start to finish with the finished product rather than to get halfway through and realize, “Oh my goodness, we don’t have eggs,” or “We don’t have a baking dish.”

Joanna: Absolutely.

James: Then it’s like, it costs more, you have unexpected emotion or energy expenditure.

Joanna: You can reduce your pool of buyers as well if you’re not planning this out properly from the beginning. So a well-organized business that has its value locked in, and that is plain-looking, and when a buyer comes in to do due diligence has a much bigger range with potential buyers than a business that looks a bit risky, that doesn’t have standard operating procedures, that can’t run without them or is dependent on the owner to do any of the components. So you’re not just talking about sale price, but you’re talking about the breadth of potential people you have to sell this business to.

James: Right. Yeah.

Joanna: So it just makes so much sense to get your head in gear and to work out what is the value in your business and how you lock this in from the beginning.

James: Yeah. And pound for pound, I think this is one of the best investments I’ve ever made in legal resource, was when I was selling my business units, I had help to ratify the contracts and to make sure that I had someone explain to me what risks were mine, what risks were the other party’s, what were we actually agreeing on, and if there was any gotchas or things that I should be aware of that had been sort of injected in there. Having that process of a little bit of back-and-forth and some fine tuning, we were able to get to a great situation for everybody, and it’s turned out to be super harmonious, absolutely no issues since.

Communication is key

And I will say this, that regardless of the legal side of it, the thing that’s been the most beneficial for my business sales is having a very clear and ongoing communication channel with my buyers to when things do pop up that you can’t anticipate at the time, it’s having an instant dialogue saying, “This just happened,” or “This has come up.” You know, like you might get a domain renewal that you forgot you owned, or you might get a customer niggle that happened after the sale date, but still hooked up to your system or something prior to the sale date that’s still probably your responsibility. It’s about being responsible and having very open dialogue to make sure there’s absolutely no emotion allowed to creep in because you’re being on top of it and having clear communication. I imagine a lot of breakdowns that flare up legally are when there’s been a communication breakdown.

Joanna: Yeah absolutely. Absolutely. Sometimes, that communication breakdown can be fed from different areas. As you said before, there’s a lot of emotion at this point.

James: Often, there’s family members or partners.

Joanna: Or staff. Sometimes.

James: Sometimes. Yeah. That’s right. Or you become aware of a situation that you weren’t aware of before that makes you look at something in a different way. You could be upset about something that you didn’t know was happening or what have you.

Joanna: Yup. And that’s one of the issues sometimes in due diligence, when the buyer is investigating the business. If they unearth some risk at that point, sometimes that can really break down trust because sometimes it looks like there was this issue that was being swept under the carpet and it was only because they actually found this issue that it was now clear. So that can really erode trust. And you may have never intended that, you may never have realized that there were those risks sitting in your business, but that can be a real issue in eroding trust.

And then the second component is how the advisers for the buyer and the seller interact together. Once again, if those interactions are aggressive rather than commercially focused, that can really erode the trust of both sides as well. So it’s really important that you really think about the people that you’re involving in the sale process. And as I said before, make sure you’re building it as a sales team. So a team that you’re working together with and you’re on the same page in terms of where you’re looking to get to out of this transaction.

In wrap-up

James: Well Joanna, is there anything else in summary? We’ve covered quite a lot here about due diligence, preparing agreements, what we’re actually selling, what are some of the components of perhaps an asset sale, we’ve looked at the value and risk profiles, what to do if things aren’t running smoothly, how to anticipate things, confidentially agreements, who we’re even letting look at the documents. So from a legal perspective, have we given it a good rounding?

Joanna: I think we’ve covered it.

James: Right. Well I just want to say thank you so much for this series. This is a three-part series, you’ve put a lot of time into sharing ideas with our listeners, absolutely for free I might add, and that’s wonderful. I’ve been speaking with Joanna Oakey from aspectlegal.com.au. If you need help with this stuff, especially if you’re in Australia, I would recommend Joanna. She’s been really helping me in the background with some of the things that I’ve been working on in my business and some of my new ventures. I’m setting up the foundations properly for those, and protecting my own business from potential pitfalls down the track.

What I like about Joanna, and it’s weird talking about you while you’re sitting there, is just how plain you make things sound so clear and very commonsense stuff and precise. All of our communications have been like that. So thank you so much for sharing this information. And also, thrilled to see your new podcast out at talkinglaw.com.au. If you want to listen to another podcast on legal stuff, go there and tune into Joanna’s podcast. It’s going really well.

Joanna: It is. Great. Thanks so much James! I’ve really enjoyed it.

James: Alright. If you loved this episode, or if you think it might help someone, please share it with them. Perhaps leave a review on iTunes. I always read them and appreciate them very much. Thank you so much.

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