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6 Ways Sellers Unwittingly Kill Mergers & Acquisitions Deals

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For many business owners, the sale of their company is a once-in-a-lifetime undertaking. A common scenario involves negotiation between a first-time seller who has spent years devoted to building a company and a seasoned buyer with many acquisitions under their belt (especially private equity and public company buyers).

The merger and acquisition (M&A) process has a steep learning curve and, as with any complex undertaking, prior experience and a strong understanding of the process are invaluable. We’ve written in the past about potential land mines awaiting unsuspecting sellers, and the following are some additional common mistakes we routinely see from first-time sellers.

This article is the second of a 2-part series. Read part 1 of the series: “3 Ways Buyers Can Kill A Perfectly Good M&A Deal.”

1. Sellers Who Preclude A Competitive Process

All too often, sellers believe they already know their buyer and push to close a transaction with that buyer. In fact, frequently the sale process has been instigated by an inquiry or even a tentative offer from that very buyer. However, it can’t be overemphasized: a key to closing a successful transaction – one including optimal price structure, terms, and time to close – is to foster competition among multiple potential buyers. A little professional rivalry keeps buyers motivated, focused, and on track. It encourages buyers to put forward their strongest offer with a winning combination of price and deal terms. It swings the negotiating pendulum the seller’s way since buyers believe the seller may be selected from multiple offers and only one can win. And ultimately, should the process with one buyer stall, the seller will have one or more viable backups.

2. Sellers Who Aren’t Prepared For Due Diligence

Once buyer and seller have signed a letter of intent, due diligence will begin in earnest. The seller will be asked to populate a data room with current financial statements, financial projections and underlying assumptions, strategic plans, market analyses, operating documents, customer and vendor contracts, employee details, employee manuals, management incentive programs, real estate contracts, regulatory and compliance reports, and on and on. A potential buyer will turn the business inside out during the due diligence phase, meaning that a seller needs to be prepared to help the buyer come to terms with the skeletons in the closet. Every business has weaknesses or flaws, major or minor, which the seller should discuss early on with its deal professionals. These potential issues need to be presented to the buyer and should never be late-game surprises that damage the relationship built between buyer and seller.

3. Sellers Who Can’t Articulate An Industry Overview

Potential buyers will be extremely interested in the seller’s competitive differentiation, the structure of the competitive landscape, and industry trends, as well as critical technological and regulatory impacts. Sellers who can’t hold their own during intense questioning and lengthy discussions in this area risk losing the confidence of buyers. Buyers will be planning to take the business to the next level by bringing new capital, talent, and other resources to bear, and will rely on a seller’s insights into the industry as the buyer begins to formulate its road map. To set their own expectations, sellers need to educate themselves on comparable transactions and valuations in their industries. Sellers should expect any offers for their business to be in line with those comps, barring any persuasive reasons that their valuation should be an outlier.

4. Sellers Who Neglect Their Business During The Deal Process

Buyers are interested in acquiring a company that is a healthy performer – very likely factors that originally brought them to the negotiating table. An M&A transaction typically takes several months to a year to close, and is an exhilarating, exhausting and extremely challenging time for most selling business owners. Sellers who get overly caught up in trying to oversee the transaction process, or do not have a solid management team in place to keep the business firing on all cylinders during the deal process, may cause the business to lose some of its sheen in the buyer’s eyes. If the company under performs for a quarter or two, the purchase price may be reduced, and the seller’s negotiating position will be weakened. Sellers must allow their real professionals to keep the transaction process moving ahead while walking a tightrope between running the business and responding timely to proposals, due diligence requests, and other deal negotiation matters.

5. Sellers Who Lack A Sense Of Urgency

Conversely, the common refrain among deal professionals, “time kills all deals,” reflects the damage incurred when closing the transaction does not take center stage for the seller, buyer, and their deal teams. Transactions have momentum and allowing them to ebb can be damaging and even fatal to closing. A buyer may assume that a seller who misses deadlines is unmotivated, incapable, or disorganized. Do those qualities reflect the business behind the scenes, they wonder? If delays become so extreme that the buyer focuses their attention elsewhere, all may be lost. Sellers should make every effort to avoid revising deal timelines.

Contact Us

At Linden Law Partners, we specialize in quarterbacking all aspects of M&A deals, and we’ve represented buyers and sellers in hundreds of M&A deals. While there are many common threads among the most successful transactions, we recognize the uniqueness and personal attention required for each deal. Contact us to discuss how we can help.

3 Ways A Buyer Can Kill A Perfectly Good M&A Deal  

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Part 1 of a 2 Part Series

You’re an experienced buyer with a handful or more of M&A deals under your belt. You’ve identified a willing target company, a performer in an industry you know well, one that ties into your acquisition strategy – no small feat! You have financing ready to go and know how to put in the work necessary to do a deal. What could possibly go wrong? Plenty, as it turns out.

How do motivated buyers and sellers, both with excellent intentions, frequently allow deals to lose momentum or, worse, become so contentious that one or both parties decide the only course of action is to walk away? In this first of a two-part article series, we’ll explore some reasons good deals go bad based on buyer behavior. In our next article, we’ll look at common ways a misguided seller can derail an M&A transaction.

We repeatedly see three buyer behaviors that, left unchecked, have killed deals.

1. The Heavy-Handed Buyers.

“Muscling” the deal. Buyers sometimes assume that they hold all the cards and any motivated seller they approach will be eager to strike a deal. This isn’t always the case. A buyer can’t force a deal through, can’t scream, kick or will a transaction into being without a shared philosophy, a shared reason for doing a deal, a cultural parallel, a meeting of the minds of buyer and seller.

A well thought out strategic rationale forms the solid foundation upon which deals get done despite lengthy negotiations, distractions, contention, and deal fatigue along the way. When both buyer and seller are crystal clear on their motivations for the deal and there exists sufficient overlap of a shared vision, both parties are likely to push through to a closing.

Buyers also frequently communicate poorly. M&A transactions are all-consuming – difficult, distracting, and sometimes emotional. A busy buyer can fail to communicate, unintentionally act forcefully or in a clumsy, insensitive manner in a fast-paced, complex deal with countless nuanced decisions to be made. Parties are pulled in many directions.

A buyer, having been through several transactions and doggedly pursuing a closing, might neglect regular communications with the seller; the seller, often with no M&A experience, may (will) require regular communication on deal specifics. A confused, neglected seller is not a happy seller, and a systematic, organized communication process will go a long way towards keeping all parties on track and moving towards their shared goal.

2. The Buyer That “Always Does It This Way.”

Overly rigid adherence to a one-sided plan. Going into a transaction with a plan to get it closed is critical; equally important is expecting that plan to fail. No two deals are alike, even with industry, size and geographic commonalities.

Every combination of ownership structure, culture, company history, strategic rationale, financials, market position, and vendor relationships is different. These and many other variables form the background for negotiations and the definitive agreement.

Often, large corporations and private equity buyers with countless acquisitions under their belts (and always on the lookout to score the best deal for themselves) tend to follow “their own” formal M&A process with a deal team of specialized members responsible for specific tasks.

The seller of a smaller business, on the other hand, is often seeking a relationship with the “right” buyer. In these cases, when process and often ‘unilateral’ Buyer desires trump the human side of the deal, there’s a real possibility the seller will pull out. A successful buyer doesn’t wear blinders and insist on a set, stilted transaction process.

Cookie cutter doesn’t cut it. A successful buyer develops confidence in their ability to be flexible, instead of putting their confidence in the perceived clarity of a rigid process. Buyers that are beholden to “their way” and that like to tout “we always do our deals this way” (which often translates to meaning they got one over on less attentive or savvy sellers and their advisors). This type of myopic buyer philosophy isn’t a productive way to get the deal done – it’s primarily just arrogance.

3. The Buyer That Over-Lawyers.

This defines almost all corporate and private equity buyers to the point that we joke here that they “simply can’t help themselves.”  The generic definitive agreement that’s 100 pages long and screams of overreaching with absolutely no thought or sensitivity to reasonable seller considerations.

Voluminous purchase agreements that inadequately address key points already negotiated are a big red flag. Yet with all their experience, corporate and private equity buyers (and their lawyers) engage in this behavior all the time.

The seller will wonder if the buyer has even been listening for the past few months! And a purchase agreement that includes irrelevant information “just to cover all the bases” is pointless, infuriating and a colossal time waste. A buyer who waves it off with, “oh, that’s just our legal department” only makes the situation worse.

Both parties need to bring the right talent to the deal, and a buyer needs the right attorney on the job – one who is heavily involved in the process, dedicated to its successful outcome and willing to tailor negotiations and the definitive agreement to the unique transaction in a manner that is fair to both parties, and who possesses a degree of emotional intelligence.

Parting Advice To M&A Buyers.

Keep your eyes on the prize (and make sure your advisors keep their eye on the prize) and don’t lose sight of the strategic rationale by getting bogged down in negotiations. Communicate, even over-communicate, key deal points.

Remain flexible, favoring a tailored approach over adherence to a process that worked in another situation in the past. Hire the right M&A professionals and trust their instincts. Deals are hard work – but getting out of your own way can often get you most of the way there.

At Linden Law Partners, we specialize in quarterbacking all aspects of M&A deals, and we’ve represented buyers and sellers in hundreds of M&A transactions. While there are many common threads among the most successful transactions, we recognize the uniqueness and personal attention required for each deal. Contact us to discuss how we can help.

4 Lessons From Shark Tank: Be a Founder, Not a Flounder

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The massively popular ABC reality show Shark Tank puts entrepreneurs in one of the most high-pressure situations you can imagine – pitching their business ideas to venerable titans of industry on national television. I enjoy watching the show, and through my work with countless founders and investors, I’ve also found that the common mistakes made by hopeful contestants on the show provide good reminders for founders to keep in mind while plotting a course of growth for their business.

These seemingly minor mistakes often demonstrate flawed thinking or incomplete planning that will raise red flags with investors, and can ultimately torpedo potential capital-raising opportunities for any early-stage business. Below, I highlight some key takeaways based on mistakes repeatedly made by entrepreneurs on Shark Tank.

1.   Prove the Market Need for Your Business Idea Before Seeking Investors

This is the practice of “customer development” advocated as part of the “Lean Startup” methodology developed by Eric Ries,1 and contributed to by Steve Blank2 and other thought leaders. On Shark Tank, shark Robert Herjavec3 has often criticized an entrepreneur’s failure to undertake this important step in their business development.

The idea is straightforward. Before focusing on seeking money from investors, you should first have demonstrated the need for your product or service in the market based on actual customer input and data. Talk with potential customers early in your company’s lifecycle to determine whether there is interest in your concept and then rework and refine it as needed.

It’s easy to see how, after sinking countless hours and resources into a new business idea, entrepreneurs can adopt tunnel vision and forget about the larger picture of ensuring their idea solves a legitimate problem for real customers in a cost-efficient way.

But without demonstrating that you have customers or the ability to get them, it’s probably too early to start soliciting money from outside sources, and as seen in Shark Tank, successful founders will have completed this research upfront while the failure to do so will deter investors from investing in your company.

2.   Avoid Overemphasizing Market Size

According to Mark Cuban: “. . . one of the things we repeat over and over again is that one of the worst ways to sell in Shark Tank is to come in and talk about how big the market is.”4 Market size is often emphasized as a critical statistic for any entrepreneur, and it’s true that learning your market and understanding the opportunities within it are important for analyzing the feasibility of your business concept.

However, overselling or hyping market size as proof of the potential future performance of your business isn’t helpful to investors. Why? Because market size is just a number. Savvy investors will instead want to see each individual business owner’s concrete plans for penetrating that market, regardless of its size.

1  Ries, Eric. The Lean Startup. Crown Business,2011.
2  Blank, Steve. “Why the Lean Start-Up Changes Everything”. Harvard Business Review, May 2013,  (June 16, 2020).
3  Wise, Sean. “’Shark Tank’ Investor Robert Herjavec’s Best Advice for First-Time Founders”. Inc., Aug. 24, 2019, https://www.inc.com/sean-wise/shark-tank-investor-robert-herjavecs-best-advice-for-first-time-founders.html.
4  Canal, Emily. “Mark Cuban Called This Entrepreneur a Liar on ‘Shark Tank’ Here’s Why she Still Left With a Deal.” Inc., Mar. 25, 2019, https://www.inc.com/emily-canal/shark-tank-season-10-episode-17-dare-you-go.html.

3.   Don’t Overly Focus on Maintaining Vast Amounts of Equity for Yourself

A common refrain among founders on Shark Tank and many of the founders I work with is to balk at deals they fear will give up too much control of the company. For instance, a founder may seek $500,000 from investors based on the working capital needed to get the business to the next stage, but want to only give up 5% of the equity in their company for that investment.

This can result in a vastly over-inflated valuation of their company ($10,000,000 in my example), at a time when the business is perhaps only at the proof-of-concept stage with no operations or profitability. In reality, the amount of equity you give an investor is just one piece of a much larger puzzle.

I’ve seen eager founders give investors overly generous board rights, or even board control, for a relatively small investment amount at an early round, because they think it’s a less material term or even justified since they got the “right” valuation. And, if you set such a high valuation at the outset in order to keep your equity, how feasibly can you increase the valuation of your business in later rounds?

An accurate valuation of your company is critical when bringing on investors, but it can often be too easy to become so consumed by the valuation and the amount of equity on the table that founders will overlook bad deal terms, such as potentially severe conditions attached to the investor’s money, and the impediments that those terms can later present for the founder and the business.

4.   Do Your Due Diligence When Deciding on an Investor

For the majority of entrepreneurs on Shark Tank that draw interest from more than one shark, they’ll accept the offer from the shark willing to invest at the highest valuation. However, you’ll notice every so often that an entrepreneur on the show clearly favors a specific shark based on the individual expertise or experience of that shark given his or her background/experience as an entrepreneur or investor.

These select entrepreneurs recognize and appreciate the value that shark can bring beyond just money. This is smart! You want investors that can add more to your business than just money – such as contacts, advice, experience in your industry, and strategic direction. Plus, once an investor is an owner in your company, the relationship is essentially permanent until there is an exit event.

That’s why it’s critical for founders to do their due diligence on potential investors before pitching them, and before that, to have seriously considered whether investor capital is even needed at the particular stage of the business. Always check several references for each investor, no matter their reputation or track record. Talk with other founders to find out how it has been to work with the investor and whether they held up their end of the bargain.

Ask the investor the right questions that will help you determine whether your interests and those of the investor are aligned, in both the near-term and the long-term. Taking the time to do this work upfront will save you many headaches down the road. And don’t be like the majority of Shark Tank entrepreneurs that focus more on a shark’s valuation only rather than applying a holistic approach that balances valuation against investor fit and background.

Conclusion

Unlike so many other reality shows on TV, Shark Tank actually provides some practical, actionable lessons that both new and experienced business owners can use in the real world. As seen time and again both on and off the show, a founder’s upfront preparation will demonstrate, in concrete terms, how their business idea (and even more critically, the founder) is worth the risk to an investor, while a lack of preparation will result in just the opposite.

About Linden Law Partners

Linden Law Partners is a boutique transactional law firm founded by professionals with decades of experience. We’ve advised companies, entrepreneurs, and investors in hundreds of early-stage and venture capital financings, and have been lead counsel for M&A transactions ranging from hundreds of thousands of dollars to $700 million. Contact us to discuss how we can help.

The Amazing Tale of Theranos: What it Means for Founders, CEOs, and Investors

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Theranos, a spectacular American business crash-and-burn, is the start-up that keeps on giving – in the form of lessons for founders, CEOs, and investors. Once a technology and media darling embraced by investors, Theranos’ inevitable demise came when it failed for 15 years to produce promised results. What’s more, its downfall came with a huge price tag, costing investors more than $900 million.

If you’ve read Bad Blood, the 2018 book by Wall Street Journal reporter John Carreyrou, you’re likely astonished by two facets when it comes to Theranos. On the one hand, there’s the audacity and powers of persuasion (or lies) by Theranos, rewarded by the blind faith (greed) of investors, on the other.

To catch you up, Theranos was founded in 2003 by then 19-year-old charismatic and persuasive Stanford dropout, Elizabeth Holmes. Holmes had an enthralling vision – to blanket the world with a supposedly astounding technology invented by Theranos which she called “the Edison.”

The Edison was a small portable machine touted by Holmes as a breakthrough health technology she claimed could perform more than 200 blood tests very rapidly using only a few drops of blood. According to Holmes, cost and misery for patients would be alleviated, and the productivity of healthcare workers everywhere would skyrocket.

Based on her claims about Edison, Holmes was able to raise more than $900 million from investors in her quest to transform the blood-testing industry. At its 2013/2014 peak, Theranos was valued – on paper anyway – at $10 billion. As reported by Forbes magazine in 2015, Holmes herself was supposedly worth a cool $4.5 billion.

However, despite its idealistic vision, Theranos had a fatal flaw – its lauded technology was never fully developed, and it never actually worked. Many product demonstrations were allegedly faked.

Theranos ceased operations in 2018. Holmes and her COO – who was also secretly her boyfriend – were charged with criminal fraud. Holmes is currently on trial. She now has a net worth of nothing, although she resides on the grounds of a $135 million Silicon Valley estate with her new hotel-heir husband. The trial start date was also extended to August 31, 2021, as the original start date coincided with the birth of Holmes’ first child.

The Theranos story provides dramatic illustrations of 4 critical lessons for entrepreneurs, CEOs, and investors.

The Right People are Essential to a Business 

Holmes herself possessed no business or manufacturing experience, and she had no formal medical or scientific education or experience. She should’ve surrounded Theranos with a management team and board members with strengths and expertise in these areas.

Instead, she filled her board with more famous names than a White House cocktail party – high-profile politicians, media moguls and other personalities with no actual backgrounds in healthcare or technology.

As a founder and CEO, seek people who know more than you do, challenge you, disagree with you occasionally, and are experts in various disciplines. When filling out your management team and board, add professionals with experience relevant to your line of business and those with unrelated but essential skill sets.

Expect your team to challenge your thinking, ask hard questions of you, and constantly set a higher standard. While high-profile names can attract attention, your company will benefit from an inner circle of experts possessing proven industry backgrounds and sophisticated financial experience. Always rely on these types of first-class professionals once you’ve found them.

Investors need to thoroughly evaluate the people side of any target company, searching for the right personalities and skill sets. Are the backgrounds of the senior management team and the board members relevant to their roles? Do they have successful track records? Who is there, and who is missing?

Culture Counts 

Theranos was a toxic mix of fear, mistrust, and locked rooms. Holmes’ COO and romantic partner was described as a domineering tyrant and even a “psychopath.” Holmes and her COO ruled with an iron fist, and there was a shocking lack of corporate governance.

Departments were siloed and communication between them emphatically discouraged. Whistleblowers were fired and later threatened by the company’s lawyers. The culture of secrecy enabled Holmes to perpetuate ‘her’ narrative since few people at Theranos were ever shown the whole picture.

As a founder or CEO, stay in tune with your company’s culture. Openly share information about products, services, business lines and strategies across the company. This will ensure that all teams are helping move the business in the same direction and prevent the type of secrecy that was a hallmark of Theranos’ culture.

Dissent needs to be allowed, even encouraged. Transparency is always paramount. And, while proper legal advice is critical in today’s business world, don’t over-lawyer. Theranos spent ridiculously excessive amounts of time and money trying to intimidate instead of focusing on what mattered – developing a reliable product and building a sustainable company.

Investors should interview partners, advisors, and employees to explore the culture. Is there a legitimate corporate governance structure to help prevent fraud or unauthorized decisions? Employees will rarely be universally happy with their employer, but their feedback should generally be positive. This type of employee review, an example Carreyou found on Glassdoor during his research of Theranos, is a major red flag:

“How to make money at Theranos:

  1. Lie to venture capitalists
  2. Lie to doctors, patients, FDA, CDC, government. While also committing highly unethical and immoral (and possibly illegal) acts.”
Don’t Disregard Due Diligence 

Too many Theranos investors failed to conduct meaningful due diligence, instead preferring to piggyback on the abysmal diligence efforts of others with the mentality of: “Investor A is a successful person/entity/investor and if they’re in, I’m in.” Theranos didn’t disclose its financials and allegedly lied to regulators. Product demonstrations in some cases were supposedly faked using their competitors’ equipment!

Touted “partners” of Theranos, when later interviewed by journalists, asserted they never had any involvement with the company. Numerous outside medical experts claimed there were many fundamental flaws with the Edison that even the most basic industry review would have uncovered from the beginning.

As founder or CEO, expect potential investors to conduct in-depth due diligence of your company when evaluating a possible investment. They’ll require you to populate a data room and to disclose all your contracts, financial statements, business plans, regulatory filings, and on and on. It took an incredible amount of time and investment before the true story of Theranos was uncovered … but it was.

Investors need to understand the importance of due diligence and spend the necessary resources to delve into the inner workings of a target company. Do you fully understand the company’s business model and products? If not, your ability to recognize mistakes and lies is compromised.

More established companies should provide audited – or at a minimum for smaller companies, externally reviewed – financial statements from a reputable accounting firm. In many cases, it’s prudent for an unbiased third party to conduct a quality of earnings analysis. Investors should insist on complete and open product demos, access to reliable financial information, and proof of regulatory filings.

Besides reviewing the materials in the data room provided by the target company, investors should interview customers, employees, other investors, vendors, business partners, industry experts and competitors. They need to look for third-party validations of products, performance, and achievements. Are there red flags?

With few exceptions, piggyback due diligence is not a winning strategy.

Don’t Lie to Others … or Yourself 

Holmes’ legal defense team is claiming Theranos merely failed, like countless other companies, and failure is not a crime. Her defense team has also implied that while Holmes possessed typical Silicon Valley startup moxy and hubris – she didn’t commit fraud.

But did Holmes and Theranos cross that eventual line in the sand where hubris in fact becomes fraud? Overall public sentiment on Theranos currently sways much more toward “yes.” In a few months, we’ll learn whether the Holmes jury shares the same sentiment.

As a founder or CEO, you must be ruthlessly honest with your management team, employees, investors and, most importantly, yourself. Be optimistic, but don’t over-promise. Have confidence your idea will be developed and evolve over time, but don’t oversell it as perfected before it really is. Know that investors will examine what you claim to have achieved, even while they evaluate what you say you’ll do next.

Investors need to reassure themselves through rigid financial analysis, industry validation and proven regulatory approvals that a target company’s claims are supported. Even if desired results aren’t yet 100%, investors should expect progress towards stated goals.

Investing based on fear of missing out is never a winning strategy.

Conclusion 

It’s easy for founders, CEOs, and investors to become carried away by the momentum of an exciting vision. But narrative is never a guarantee of success, and substance is always far more important than style. There are reasons for the typical investment process, with steps including pre-investment planning, term sheets, and deep-dive due diligence.

And the reason Theranos happened on such a high profile and massive scale is because these fundamental pre-investment steps were skipped! While Holmes’ actions were by any stretch over the top, the abject failure of supposedly sophisticated investors to insist on basic, check-the-box diligence validation, contributed equally to their own financial misfortunes.

Founders, CEOs and investors must always be willing to put in the hard work necessary for any proposed investment without taking shortcuts.

About Linden Law Partners 

Linden Law Partners is a boutique transactional law firm founded by professionals with decades of experience. We’ve advised companies, entrepreneurs, and investors in hundreds of early-stage and venture capital financings, and have been lead counsel for M&A transactions ranging from hundreds of thousands of dollars to $700 million. Contact us to discuss how we can help.

M&A Disclosure Schedules: What They Are and Why They Matter

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What are Disclosure Schedules?

Disclosure schedules are formal legal attachments that accompany the definitive purchase or merger agreement in an M&A transaction. Think of disclosure schedules as a series of exhibits to the definitive agreement. The content of the disclosure schedules is either “incorporated into” the definitive agreement, or it qualifies and supplements the terms and provisions of the definitive agreement.

Among other things, disclosure schedules also serve as formal legal informational documents in an M&A deal where virtually every element of the acquired business is disclosed by the seller to the buyer in writing.

Why do Disclosure Schedules Matter? 

One key function of disclosure schedules is the identification and description of the inner workings of the acquired business. For example, a buyer wants to have an organized location and list of the key contracts of the target business, the seller’s financial statements, a list of personnel of the business (and their terms of employment or engagement), the meaningful intellectual property, the seller liabilities not intended to be assumed by the buyer (think lawsuits or unpaid taxes, for example), and much more.

While you might ask why buyers don’t obtain this information during due diligence, the answer is they do, but the information is only as good as what the seller provides.

So, the disclosure schedules not only formalize and aggregate due diligence information on the target business in a central and organized document, but the formality of disclose schedules (and the information included or not included in them) has legal consequences for the seller. From this perspective, properly prepared disclosure schedules provide buyers with a level of risk insulation.

Disclosure schedules are equally (or more) important for sellers and their own risk insulation in M&A deals. First, most M&A sellers provide representations and warranties on virtually every – if not every – aspect of their business.

The disclosure schedules provide sellers with the opportunity to address and manage liability concerns in instances where “unqualified” representations and warranties cannot be given without the seller breaching the rep.

  • Simple example 1: “The business has always paid its taxes except for immaterial local taxes where we believe they are not legally owed as described in Section ABC of the disclosure schedules.”
  • Simple example 2: “The business has always prepared its financial statements in accordance with GAAP, except as described in Section XYZ of the disclosure schedules.”

In both examples, the seller has avoided breaching a representation and warranty that it would otherwise have breached absent the disclosure (“we’ve always paid our taxes” – which isn’t true in example 1, and “we’ve always prepared our financials in accordance with GAAP” – which isn’t true in example 2).

In each case, and assuming the disclosure was adequate (particularly in the case of example 2), the seller would avoid liability for any resulting liabilities to the buyer from the local tax issue in example 1 or deviations from GAAP accounting in example 2.

Proper disclosure alerts the buyer to the possible issue and permits it to make a decision about whether it will willingly accept the liability, or request some other protections from the seller, such as an escrow holdback of some amount to address any resulting issue, a written affirmation from the seller providing for indemnification on the issue, and/or some other mutually acceptable outcome agreed by the parties in the definitive agreement (i.e., subsequent lawsuit avoided).

What Happens if Disclosure Schedules Don’t Include Required Information or are Incorrect? 

At a baseline minimum, a seller breaches the underlying representation and warranty if it: (a) does not disclose information required by the rep/warranty, or (b) discloses the information incorrectly. In either case, if the buyer incurs any liability associated with the underlying matter, the seller will be contractually obligated to indemnify the buyer.

If the seller’s failure to disclose the information is intentional or reckless (or if the disclosure made is intentionally or recklessly incorrect or misleading), then arguably the seller has committed fraud. This is especially problematic for a seller because the seller’s indemnification liability in such instances will rightfully be outside of customary contractually negotiated limits on the amount of indemnification which buyers may claim for breaches of representations/warranties.

What’s more is that “civil fraud” can and does occur in M&A deals where sellers are perfectly genuine and ethical individuals with no desire to ‘defraud’ anyone in the typical sense. Civil fraud or its equivalent (like securities fraud) can occur simply as a result a seller’s failure (even if no sinister motive exists) to disclose information that a reasonable buyer would be expected to consider in the ‘mix of available information’ in making the decision to purchase the business or not.

In short, plenty of fair-hearted M&A sellers have been sued for fraud around issues of disclosure and non-disclosure in M&A.

Types of Information Included in Disclosure Schedules

While the nature and extent of declaration information depend on the deal, the items below outline some of the more common types of information M&A sellers must include in disclosure schedules:

  • Material contracts
  • Employees and employee benefit plans
  • Financial statements and accounting matters
  • Key customers and suppliers
  • Title to assets and indebtedness
  • Pending litigation
  • Tax information
  • Insurance policies
  • Compliance with laws
  • Intellectual property
  • Licenses and permits

Conclusion

Preparing proper disclosure schedules is a tedious and time-consuming, but important aspect of M&A, especially for sellers. Even the most seasoned business owner can run into significant legal issues when preparing disclosed schedules.

Like most of M&A, it’s highly advisable that you have a seasoned M&A attorney on your side to assist with the preparation and review of disclosure schedules, as well as to advise you regarding the impact they will have on the representations and warranties made in the definitive agreement. At Linden Law Partners, we’ve advised hundreds of business owners on all aspects of M&A. Contact us to discuss how we can help.

Selling Your Company: The Why of the LOI

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First-time sellers often feel pressure to rush into signing a letter of intent, or LOI, submitted by a potential buyer, but the LOI is much more than a box to be checked on the journey to selling your company.

At the LOI stage in a deal, you and your buyer have limited information about each other. You are still getting to know one another, due diligence is just commencing, and the optimal deal structure for both sides has yet to be determined.

How then can the buyer be expected to present you with a detailed letter of intent? On the other hand, can you as a seller commit to a deal based on the purchase price, with little additional information? In general, a buyer will prefer a short, high-level LOI, while sellers should push for a more in-depth, negotiated LOI.

Although the LOI or term sheet, as it is also referred to, is not legally binding, it documents both parties’ intent to close a deal based on specified terms. It reflects both the buyer’s and seller’s crucial requirements for the deal and provides a blueprint for the definitive agreements.

Many deal professionals believe that a deal is either won or lost during the LOI stage of the process and that it’s essential to outline all the key points in the deal. We’ve written in the past about what belongs in a thoughtfully negotiated and comprehensive LOI. In this article, we’ll expand on three reasons why you should think about your LOI as an important, or perhaps the most important, step in the deal process – the “why” behind your LOI.

Negotiating Leverage
As a seller, your leverage peaks during the LOI negotiations when buyers are competing to acquire your company and begin to diminish after one is signed. An LOI typically calls for an exclusivity period during which the seller is prohibited from discussing the sale of the company with other potential buyers, while the buyer will conduct due diligence and write the definitive agreements.

A sophisticated buyer won’t proceed into costly, time-consuming due diligence without an exclusivity period and the assurance that the seller is committed to pursuing a deal with them; however, a seller should grant it very judiciously.

As a seller, you lose not only the leverage provided by the threat of another buyer offering a higher price or better terms. Due diligence means that buyers will have access to sensitive information, vendors, customers and key employees, and word of an impending sale can dissuade them from making commitments to your company.

And should the buyer – for whatever reason – not proceed, the implication to the market is that they discovered a fatal flaw during their due diligence. In short, your negotiating position is weakened, making you more likely to agree to unfavorable terms to close the deal.

Takeaway: negotiate the key deal points while your leverage is at its highest point.

Deal Costs
Deal expenses can be significant and start to ratchet up during the due diligence phase. For the buyer, there is travel to meet the management team or conduct plant tours. A buyer will commit significant time and, often, an outlay of cash; for example, accounting, regulatory, or industry specialists may be hired to provide analyses. And the buyer’s attorney will produce a lengthy, detailed first draft of the definitive agreements.

For the seller, much of the cost comes in the form of upheaval within your company. Your management team will populate a data room and respond to due diligence requests. Countless meetings – both internal and with your team of deal professionals – will require significant time commitments.

There may also be requests for your company to engage outside specialists to produce environmental, quality of earnings or other reports. And, of course, you and your deal professionals will be heavily involved in reading, re-writing and negotiating the definitive agreements.

Takeaway: before these costly, time-consuming steps are taken, work through the difficult conversations and document key deal points in the LOI.

Likelihood of a Close
Deal negotiations can be drawn out, costly and even adversarial. However, when buyer and seller have these often difficult discussions about key deal points early on, critical deal terms and structure are agreed upon at a high level and outlined in the LOI.

Once both parties have aired their must-haves and deal-breakers, surprises during the lengthier, more detailed negotiation of the definitive agreements should be few and of lesser importance. Conversely, in the absence of such discussions, it can be an uphill battle for the seller to gain ground on requests not previously outlined in the LOI.

Takeaway: a thorough, negotiated LOI both decreases the time required to produce the definitive agreements and increases the likelihood of a closing.

The Ideal Scenario
When considering an LOI from a potential buyer, the ideal process involves in-depth discussions so that both buyer and seller agree from the outset that a deal can be reached. Potential deal breakers are brought to light and resolved.

Having negotiated and documented the terms of the transaction that are important to both parties, the process of writing, negotiating, and finalizing the lengthy, detailed definitive agreements moves quickly and smoothly. An understanding has already been reached, and the process is collaborative as both parties work actively towards that deal.

As a seller, you are putting your deal at risk by neglecting critical deal points in a brief, high-level LOI. It is advisable to rely heavily on your team of deal professionals to help you walk the fence between a thorough, thoughtful LOI and the needless breakdown of negotiations in the early stage of a deal. Work towards a deal with a good likelihood of closing by agreeing on a thorough, thoughtful LOI while you have a strong negotiating position.

At Linden Law Partners, we specialize in quarterbacking all aspects of M&A deals, and we have represented buyers and sellers in hundreds of M&A transactions. While there are many common threads among the most successful transactions, we recognize the uniqueness and personal attention required for each deal. Contact us to discuss how we can help.

© 2021 Linden Law Partners, LLC. All rights reserved.

Selling Your Company: Walk Away for the Best Deal

Posted on by lindenlawpart1

When you begin negotiations with a potential buyer who is interested in acquiring your company, theoretically the goal is a deal that is fair for both parties. Nonetheless, as we’ve said before, M&A deals can be competitive, messy and even contentious, with each party trying to get a deal outcome that serves their own best interest.

Even if you’ve built an exceptional company and are a talented business owner with the ability to turn anything you touch into gold, buyers will often start with lowball offers and you will need to negotiate to get the outcome you want and deserve.

The process isn’t always positive for both sides and it’s critical – for a number of reasons – that you’re prepared to walk away from the negotiating table if you feel what’s being proposed to you isn’t fair.

Unleash the Power of Selling Your Company

Negotiating or Begging?
In the words of legendary sports agent Leigh Steinberg, who has negotiated more than $3 billion in sports contracts and inspired the movie, Jerry Maguire, “The first key step is introspection. You need the clearest possible view of your goals.” Prepare in advance your list of non-negotiable must-haves; your deal-breakers. While cashing in some chips and getting a fair purchase price is always a critical component of a deal, sellers also have additional motivations; for instance, preserving the culture of the firm they have built, rewarding an unfailingly loyal executive team, leasing their owned real estate to the buyer, etc.

Discuss your goals at length with your deal professionals. Revisit your goals often. When negotiations begin and offers, counteroffers and compromises start flying, take a moment to reevaluate whether you are approaching your goals or getting perilously close to your walk away limits. You also need enough context to understand what constitutes a fair outcome based on the marketplace. Your deal professionals will both advise you on what is “market” and advocate to help you obtain it.

It can be a tricky mindset, but you need to go into the negotiations willing to walk away. A sophisticated buyer will know whether you are willing to walk and, if not, they will get the best deal for themselves while you come up short. If you aren’t negotiating with the full faith and power of a walk away in your pocket, you’re not actually negotiating, you’re just begging.

Foster Competition
If you’re approached by a buyer who is interested in making an offer for your company, you will likely be flattered, intrigued and maybe even ready to begin the sale process. But know this: a lack of competition makes it easier for a buyer to play by their own rules and set the terms of the deal.

Just like the products or services you sell, the law of supply and demand applies to the sale of your business: when demand exceeds supply, the value increases. Not only does competition help keep all buyers “honest”, but it also provides you with a safety net so that you are unafraid of walking away from an unfavorable deal. You know you have alternatives.

To attract multiple offers and create a competitive environment, your investment banker should run an auction process that covers the following aspects:

  • Scouring the market for a wide variety of buyers and buyer types – strategic and financial, geographically dispersed, international and domestic
  • Get an early read on the level of interest in the market and potential valuation for your company
  • Vet potential buyers for their appetite and ability to close a deal, and requalify them as the process moves along and the stakes get higher
  • Allow all qualified buyers to play in a defined deal process with well-communicated timelines
  • Pit the buyers against each other by requesting favorable deal terms

If you have foregone the services of an investment banker, you should make every effort to attract other suitors to maximize your outcome. You should consider approaching prospective buyers you have a relationship with. Regardless, quality competition provides a litmus test of the purchase price and deal terms, improves the timeline, and decreases closing risk as buyers are qualified, requalified, and forced to pay market price and provide other market terms.

Keep It Professional
You’ve worked hard to build a stellar reputation over the years and it’s very possible that you will encounter the parties to your negotiation again, either in later negotiations or in business. Keep emotions in check – respect the other side and don’t let your desire to close a deal overcome the quality of that deal. Resist wasting their time and yours in negotiations that are not going your way. Don’t allow yourself to feel that walking away is a losing strategy – winning means staying true to your own goals.

At Linden Law Partners, we specialize in quarterbacking all aspects of M&A deals, and we have represented buyers and sellers in hundreds of M&A transactions. While there are many common threads among the most successful transactions, we recognize the uniqueness and personal attention required for each deal. Contact us to discuss how we can help.

© 2021 Linden Law Partners, LLC. All rights reserved.

3 Key Deal Structure Elements When Selling to Private Equity Buyers

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Private Equity Buyers

Private equity (PE) firms have many ways of structuring a merger or acquisition deal to entice sellers to get to “yes” in the sale of their business. Each of these structural elements will have a real and significant impact on the actual purchase price a seller will walk away with as well as their rights and obligations post-closing.

It’s therefore critical for sellers to closely analyze and understand how structure affects deal outcome from the get-go with any prospective PE acquirer. In this article, we dive into three key structural elements that every selling owner should know in the context of the overall deal calculus so that they can make the best decisions with respect to whether they are truly getting the deal they want in a company sale to PE.

For purposes of this article, we assume that the seller has already established an enterprise valuation for their business. It’s advisable that sellers engage an experienced and knowledgeable investment banker or M&A valuation specialist to assist in the development and negotiation of an accurate valuation on which a purchase price for the business can be based. 

1.   Payment Structure.

In today’s M&A environment, the payment structure for an M&A sale to PE will almost always consist of some portion of cash and some portion of a deferred and/or contingent payment whether by earnout, rollover equity, or promissory note (or some combination thereof).

Too often, sellers bullish on the future prospects for their business and the buyer’s financial wherewithal post-closing view deferred or contingent consideration as almost guaranteed, but the reality is that payment of most deferred or contingent consideration is rarely, if ever, guaranteed and is in fact at risk.

The degree to which a deferred or contingent payment is at risk varies depending on the specific structure and requirements agreed to by the parties, and so sellers should look very closely at the terms and conditions placed by the PE buyer around payment of these amounts.

Earnouts

In an earnout arrangement, the buyer agrees to pay the seller a portion of the purchase price upon achievement of specific post-M&A financial milestones or objectives. Our previous article provides a deeper discussion of M&A earnouts, where we touch on common risks to sellers with respect to earnouts, such as prolonged attachment to the acquired company, inability to control achievement of the milestones or financial targets, and the inherent difficulty of calculating the earnout amount.

One component of the earnout that many sellers and their advisors may overlook at the letter of intent stage and in the purchase agreement is the subordination of the earnout to the payment of the acquired company’s senior debt.

PE buyers will often require that the acquired company incur substantial debt in the form of a line of credit and other loans in order to finance the PE acquirer’s purchase of the business, as well as for the acquired company’s working capital post-closing.

The PE buyer and its lender may then require that the earnout payment be subordinated to the senior debt, meaning that the PE buyer will be prohibited from paying the seller the earnout if the buyer / acquired company is in default to its senior lenders, which can create significant problems for sellers who have earned the payment but are then told they can’t be paid because of the acquired entity’s noncompliance with a financial covenant under their senior loan agreements (and the seller will have no control over these senior loan covenants).

In addition, if there will be an earnout, aside from the subordination issue, it is important to obtain a guarantee either directly from the PE fund or another affiliated entity of the PE that has the financial money to ensure there is an independent source of the backstop to pay the earnout if is achieved. Without this, if the PE buyer defaults on paying the earnout, sellers may find they are seeking recovery from an entity with no assets, making it impossible to recover on those amounts.

Seller Rollover Equity Consideration

More and more PE buyers are requiring that sellers “rollover” a portion of the purchase price into equity of the acquired company (or an affiliate of the buyer, such as one of its PE funds). We covered rollover structures in M&A deals in a previous article.

As much as 20% (and usually at least 10%) of the purchase price can be required to be rolled over. Some of the more important components of rollover equity structures for sellers to consider include:

  • Ensuring the rollover equity is the same class as the equity acquired by the PE buyer.
  • Limiting the triggers for a premature buyout or forfeiture of the seller’s rollover equity, such as upon the selling owner’s separation of service without cause. The goal is to allow the seller to hold the rollover equity until the exit event on the same terms as the PE investor given that the rollover equity is in effect just like a cash investment by the selling owner (in contrast to it being a cash-free grant in exchange for services to the company such as one would expect to see with key employees who receive equity but didn’t roll potentially millions of dollars of their sale proceeds as selling founders often do as part of sales to PE buyers).
  • Limiting the percentage or amount of payments, such as excessive management fees, to the PE firm that may unduly reduce the amount realizable to the founders as it pertains to their rollover equity.
  • Implementing come-along (sometimes called “tag-along”) rights in the event of both full and partial exits to provide the selling owner with the same rights to sell their equity in the event the PE buyer decides to sell some or all of its equity to a third-party.
  • Using preemptive rights, which allow the selling owners to maintain their pro rata share of their equity should the acquired company issue new equity (such as to the PE investors or their affiliates) or anti-dilution measures to address the potential for dilution of the selling owners’ rollover without their consent.

2.   Employment Agreements for Sellers.

Selling owners typically continue in management employee capacities after the closing. Therefore, employment terms (often detailed employment agreements) will be expected and important for PE buyers and sellers.

Any employment agreement should address the salary, term, authority, benefits, bonus potential, and severance (if triggered upon a termination without cause) of the selling owners. For more information on post-closing considerations for sellers, see our prior article covering these items.

Sellers need to negotiate appropriate terms like severance upon termination of their employment “without cause” or for “good reason” (not forgetting to also negotiate the meanings of these terms, which can differ dramatically from deal to deal).

PE buyers routinely endeavor to negotiate repurchase rights on the rollover equity of sellers in the event of their termination for any reason—typically on less-than-optimal terms. For instance, there could be a payout at a price determined by the management board of the PE buyer which is payable over a period of several years with no collateral.

Sellers should push back on this to ensure they maintain their rollover equity until there is a subsequent exit event by the target. At a minimum, sellers should insist any such repurchase rights would exist only on a “cause” termination (illuminating the importance of having an appropriate “cause” definition that is not open-ended or vague and is attached to an event unlikely to occur, such as fraud on the part of the seller).

See one of our previous articles here that utilized a prominent public figure to analyze the importance and impact of “cause” and “no cause” separations and the financial ramifications associated with those distinctions (and which also includes important tips when it comes to negotiating the terms of executive employment agreements).

3.   Equity Incentive Plans for Key Employees.

In PE deals, both the buyer and seller will want to incentivize key personnel of the acquired company to stay on post-sale. Profits interests are common incentives that help align the interests of a private equity buyer and employees of the target company. Other equity incentive plans include stock options, restricted stock, or bonus pools. These incentive plans are not just for key employees other than founders. In most cases, the selling founders are also eligible to participate in them.

Conclusion.

Payment structure, employment agreements, and equity incentive plans for key personnel are critical elements in any M&A sale to a PE acquirer. At Linden Law Partners, we have represented numerous sellers in all aspects of once-in-a-lifetime sale events to PE firms, including for the development and negotiation of the key elements outlined in this article. Contact us today to discuss how we can help.

Selling Your Company: 3 Key Deal Advocacies You Need

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You’ve heard it before: when you’re ready to sell your company, your very first step should be to hire a team of seasoned deal professionals. But why? What, exactly, should you expect from your deal team? In a word: advocacy. A professional boxer would not step into the ring without a team to coach and keep him on his feet from start to finish, and neither should you. From taking your company to market through reviewing offers, due diligence, negotiations, definitive agreements and closing, your deal team will champion your cause by providing valuation, contract, and strategic advocacy.

3 Key Deal Advocacies You Need for Selling Your Company:

Getting your deal team on board from the beginning is critical to help you avoid building a deal on a shaky foundation, such as a weak valuation or contract terms that are not favorable to you. It’s very difficult (if not impossible) to walk back something you neglected to deal with in your conversations with prospective buyers early in the process.

1. Valuation Advocacy.

Sophisticated deal advisors will begin by taking a cold, hard look at your business to assess its readiness for market. This is not the time to have advisors tell you what you want to hear. Are the right systems and management team in place? Are sales moving in the right direction, and supported by a strong marketing plan? Are the numbers favorable and defendable?

AdvocacyEarly on, your deal team will work to position your company to garner the highest possible valuation. The level of interest in the market will determine the value of your company, typically based on a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization). Your investment banker will advise you on multiples typical in your industry and will present prospective buyers with an adjusted EBITDA portraying the most profitable picture.

Expect to answer endless questions while your financial and accounting representatives scrub your financials. They need to know, before a potential buyer moves into the picture and commences due diligence, where any skeletons are hidden. They may add back one-time or owner’s expenditures. An above-market owner compensation package? Addback. That all-expense-paid company retreat in Jackson Hole? Health and country club memberships? Addbacks.

The resulting “base case” presents buyers with a reasonable run-rate for the company post-acquisition, and your deal team will backstop the position with an “upside case” to demonstrate the enhanced profitability the buyer may expect with growth and synergies. 

Buyers frequently request a Q of E (quality of earnings) assessment performed by an unbiased third party. Having gone through the adjusted EBITDA “dress rehearsal”, you and your accounting team will be prepared to deal with the rigor of this analysis of income and earnings.

The last thing you want to do is weaken your negotiating position by damaging your credibility with a potential buyer. Nothing scares off potential buyers faster than sloppy financials or questionable accounting practices.

You should also understand that valuation is not just simple math, and that the highest-priced offer is not necessarily the best one! In a competitive sale process, an interested buyer may be forced to offer a market-rate multiple but do so in such a way as to preserve their cash at closing and protect their potential downside (should the company not perform as expected).

This means you can often expect prospective buyers to include earnouts, rollover equity, and other financing options as part of their valuation and offer. Buyers want to buy low, you want to sell high, and these financing options are commonly used to bridge the gap. Through the offer and negotiation stages, your deal team will work to maximize cash to you at closing by negotiating to minimize the impact of these delayed and conditional payments. After all, as we say in the deal business, “Cash is King.”

2. Contract Advocacy.

Expect your deal attorneys to continually interface and negotiate with scores of sophisticated M&A attorneys that leave no stone unturned looking not after your interests, but rather the buyers’ desire to make more money for themselves in the deal. There will be numerous interrelated variables to consider, negotiate, and manage.

Look to your deal professionals to translate the numbers, help you to understand every nuance, and draft your desires into the letter of intent and definitive agreements. This process takes extraordinary attention to detail and significant expertise with complex contracts. 

Most deals have a contingent piece in the equation when it comes to a portion of the purchase price. Even all-cash deals invariably have an escrow holdback, where a portion of the price is held in an escrow account as insurance for the buyer.

Wouldn’t a $50 million cash at closing offer be more attractive to you than a $50 million all-cash offer that requires a 20% ($10 million) holdback to protect against working capital adjustments or undisclosed liabilities for an extended post-closing period? Although it’s likely in just about any sale deal that some portion of the closing proceeds will be escrowed, an M&A expert will know if you’re being asked for too much to be held back and/or for a time period that is too long.

An experienced M&A attorney will also have access to market studies and experience to advocate for market (or better than market) terms for you on these elements. Similarly, the representations, warranties and indemnities included in your definitive agreements can lead to price erosion and should be in line with what’s market for similarly situated deals. (You may not be familiar with what’s market for these items, but a specialized M&A attorney will be). 

Additional layers of complexity come into play with the interrelations between the purchase or merger agreement and the numerous other complex agreements required to fully memorialize a deal. For instance, implications of each of the following (among many other key contractual provisions) must be seamlessly woven into the definitive agreements: 

You need contract experts to run interference, identify what’s critical and what’s not, translate it for you, and then negotiate it, get it, write it, and ensure it stays in the contract through signing and closing. The cold, hard truth is that all the terms of your deal will be included in the contract and your deal gets done exactly according to the contract. All those tantalizing valuation figures discussed between principals are ultimately meaningless if they’re not properly reflected in the contract. Reality.

3. Strategic Advocacy.

Valuation and contract advocacy require consistent, coordinated strategic planning as well as negotiations involving you, your deal team, the buyer and the buyer’s representatives. Your team needs to always be aligned and repeatedly realigned. Each of you must know who is talking to whom on the other side, and you must continuously coordinate your messaging and negotiation strategy.

It’s essential that your buyer constantly hears the same message from each of you, with no chinks in the armor. The many variables, negotiations, and staying in tune with your team inevitably takes a toll, and you will need allies in your corner. Expect them to recommend where to push back, where to concede, and remind you, when the going gets tough, that hard conversations are part of making deals.

Your deal team should keep you strong, focused and on task when the deal gets muddied – as it will. A key strength of a seasoned deal-professional is their ability to keep their eyes on the prize when the deal bogs down (as most do) in the innumerable details.

Expect your deal team to help you see beyond all the noise and disarray and keep your sights on stepping off the playing field victorious (which in practical terms for owners selling to sophisticated buyers can mean you got to the 50-yard line, i.e., you ended up with a deal that was fair).

We Can Be Your M&A Deal Advocates.

We are strong proponents of hiring deal experts to guide you through the complicated, lengthy, and all-important process of selling your business. At Linden Law Partners, we specialize in quarterbacking all aspects of M&A deals, and we have represented buyers and sellers in hundreds of M&A transactions.

While there are many common threads among the most successful transactions, we recognize the uniqueness and personal attention required for each deal. Contact us to discuss how we can help.

Protective Provisions in LLC Operating Agreements: Why They Matter

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Introduction: Protective Provisions In LLC Operating Agreements

You came up with the right business idea, formally organized your LLC, are about to raise some seed money from friends and family, and you are ready to prepare the operating agreement for your company.  Or maybe you are a prospective investor, and you believe in the idea and team behind a business operated as an LLC that pitched you for a capital investment.

Whether you are a founder or investor, the protective provisions (sometimes referred to as “major decision” provisions) of an operating agreement are critical to consider, understand, and have appropriately drafted in the LLC operating agreement.

What Are Protective Provisions?

Generally, a designated manager (or board of managers, such as if there are multiple founders) is granted with the power and authority to decide, approve, and conduct the day-to-day decisions of an LLC. However, the “protective provisions” give rights to investors, whether through their representation as a manager on the board or through their voting rights as members in the LLC, to approve certain decisions of the company.

These approval rights are often critically important to the long-term success of the company and its investors. The protective provisions are often heavily negotiated by investors and founders. 

While the protective provisions for anyone operating agreement may be deal-specific, a list of typical ones that both founders and investors should evaluate includes:

  • An increase or decrease to the authorized amount of membership interests (or designation of differing classes of membership interests, particularly classes which are senior to or on parity with the class of interest held by investors); 
  • The redemption of previously issued membership interests (other than under equity incentive plans or employment agreements giving the company a repurchase right on discontinuation of services);
  • The company’s making of distributions (other than tax distributions); 
  • The company’s borrowing of money above a designated threshold amount;
  • The sale of the company or another other change of control transaction; 
  • An increase or decrease in the number of the company’s managers;
  • Changes to the annual budget above certain threshold amounts; 
  • The hiring of executive employees (and/or compensation levels above a designated threshold amount); and
  • The amendment of certain fundamental provisions of the operating agreement (such as distributions, allocations, and other similar provisions that were likely a fundamental basis for a member’s willingness to make an investment in the company). 

Why Do Protective Provisions Matter?

It is self-evident why protective provisions matter to investors in an LLC. Without them, the founders have unfettered ability to spend company money, and to otherwise make unilateral decisions for the company or themselves, that may have no relation to the overall interests of the investors and/or the protection or increase of the value of their investment.

What is sometimes less obvious is the impact of protective provisions on the interests of founders and their ability to operate the company in the manner they may feel most prudent to all constituents involved. For example, it is probably not a wise idea to give extensive protective provision rights to investors for a relatively small overall investment amount. Consider an instance where the total investment is $50,000.

In these cases, for an early-stage startup to need to obtain approval from investors on each major company decision can be impractical and overly time consuming, particularly where the investor is not involved day-to-day and is not truly in the same position as the founders to best assess the company’s needs and objectives.  

For more significant investments in LLCs, such as tried and true venture capital type investments (which do occur in LLCs more routinely than years past where companies were more frequently structured as C-Corporations), the likelihood is high that investors will demand board of manager representation rights and an extensive list of protective provisions.

In these cases, it puts emphasis on the need for founders and investors to be more intricately aligned on the company’s plans and objectives from the outset of the investment (such as a shared philosophy pre-investment on matters of strategy, budget, hiring, raising subsequent capital, and the eventual exit desires for the company).

Conclusion.

The protective provisions in LLC operating agreements can significantly impact the rights of both the founding members and investors. The appropriateness for various protective provisions often depends on the stage of the company and the overall size of the investment.

Regardless, founders and investors alike need to assess, understand, and appropriately draft protective provisions, which are often some of the most heavily negotiated and impactful elements of LLC operating agreements. The attorneys at Linden Law Partners have prepared and negotiated hundreds of LLC operating agreements for business owners and investors at all stages of the company’s business life cycle. Contact us today to discuss how we can help. 

© 2021 Linden Law Partners, LLC. All rights reserved.

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