Preparing for a Financing or Sale
Updated: Sep 7, 2020
Privately held companies vary considerably in their readiness to get through a financing or sale. Those that have been through a few financings, mergers, or other strategic deals set the bar at the “more ready” end of the spectrum. The “less ready” end is dominated by companies with less deal experience, less cash and sometimes less interest in administrative details.
Transaction readiness isn’t just about having a slick pitch deck, offering circular or business plan. It also requires policies, processes, systems and documentation necessary to substantiate important details about a company’s products, operations, physical and intangible assets, markets, customers, suppliers, employees, risks and opportunities.
Transaction readiness positions a company to seize financial or strategic opportunities quickly and confidently. It can also directly improve deal terms. In a financing, this can mean a higher valuation, less haggling over preferences and anti-dilution provisions, and a faster close. In a sale, it can mean greater up-front compensation versus delayed earnouts, as well as less onerous escrow requirements to cover future claims and liabilities.
This is an area of opportunity for business counsel. Almost any privately held company, struggling or not, can take fairly simple steps to improve its transaction readiness – steps counsel can introduce, discuss and help implement. Leading a successful readiness effort is an ideal way to forge a stronger and deeper attorney-client relationship, as it involves helping the client identify and correct a wide range of important operational and administrative weaknesses.
Road Map to Readiness
This post describes three steps to transaction readiness: (i) creating a virtual data room; (ii) checking it against a sophisticated due diligence list; and (iii) drafting a mock “schedule of exceptions” or “disclosure schedule.”
For many smaller companies, building a data room is a huge accomplishment in and of itself. If resources are tight, steps (ii) and (iii) can wait. Companies that already have a data room can check their readiness by taking either or both of steps (ii) and (iii).
This is not a one size fits all program. Some clients will have both the means and motivation to move quickly. Others may be so far behind and short on resources that some or most of this process is simply unaffordable. Some companies in between these extremes may need a gradual implementation that spreads out the cost and administrative commitment.
The Data Room
A key first step for any company wanting to improve its transaction readiness is to create a virtual data room – one capable of supporting a sale or significant financing. Creating a comprehensive data room is like piecing together a big, complicated puzzle – one that creates a detailed picture of a company for a potential investor or buyer.
The real challenge isn’t usually the puzzle itself, but rather the scavenger hunt that’s inevitably required to find, fix or create missing pieces – i.e., missing or deficient company records. These, in turn, often point to the need for new or improved processes or procedures.
Data Room Selection
Many companies already have some kind of virtual data rooms and there may be pressure to stick with it. That’s fine, as long as it meets the following minimum criteria:
Sate of the art security, availability, stability and redundancy.
Capacity to quickly upload and download large documents.
An easy user-interface.
Flexibility to create and organize folders and sub-folders.
Flexible administrator controls to add and remove users and to assign varying degrees of user privileges across the data room and as to specific folders.
Tools to see who is using the data room and what they are looking at and downloading.
Auditing tools to track and retrieve usage.
Familiarize yourself with at least two or three top virtual data room platforms to compare their strengths and weaknesses. Pay attention to how fees will be calculated.
Organizing a Data Room
The above is a simplified data room org chart with only two tiers of folders. It’s a starting point for thinking about how to organize a data room. Additional top line folders might be required, and any well-organized data room will also have third and fourth tiers of folders under the two shown. There only firm rule for organizing a data room is that users should be able to find what they are looking for.
Due Diligence Request Lists.
Counsel who have never closed a financing or M&A deal should first study a quality “due diligence request list” to appreciate the wide range of documents needing a home in the data room. Templates can be found online or, better yet, obtained from M&A counsel.
Note, a due diligence “check-list” is not the same – they are generally less specific.
Caveat: no due diligence request list is perfect. Most are overbroad and include requests for documents not relevant to every company. Companies respond to irrelevant requests with a simple “N/A.” Similarly, a company’s data room should not contain irrelevant folders.
Populating a Data Room
Once you have the top level folders and sub-folders roughed out and you have a reasonably good idea of what is supposed to go in them, it’s time to begin uploading documents. As with any puzzle, start with the things you are most confident about. And keep in mind that future data room users will certainly appreciate the use of clear and consistent document naming conventions.
Once the easily located documents have been uploaded, the process might become more like a scavenger hunt – tracking down missing documents. Many can be tracked down with the help of company insiders. Others can usually be created or re-created with a little legal elbow grease.
Finding and Fixing More Serious Problems
But with most smaller or medium sized companies, ultimately you may arrive at more serious challenges: gaps reflecting weaknesses in basic areas of governance, business processes and controls. Every company has its issues and this process unfortunately often uncovers several at once. Counsel should help the client prioritize fixes without being alarmist. Specific problems might include the following:
Missing and Incomplete Contracts. Companies with weak processes around contract negotiation and management often have trouble producing fully executed copies of important contracts – sometimes the best available version is missing the other party’s signature, other times key exhibits are missing. Sometimes key relationships have been established, ill-advisedly, on a handshake.
Cleaning up contract loose ends can require significant effort, but clients rarely argue against the wisdom of it.
Corporate Governance. Governance is an area where counsel should look for the unexpected – lapsed entities, missing entity formation or “qualification to do business” records, officers who have never been appointed, improperly elected board members, boards that do not meet or keep minutes, and actions by officers lacking required board approvals, such as option grants or other securities issuances. Governance lapses can be challenging to solve even for experienced counsel, but again, most clients are quick to recognize the need to fix such things.
Policies and Procedures. In recent years, regulatory requirements and evolving best-practices have imposed ever-increasing expectations on businesses of all sizes and across most industries. As a result, many companies are required or expected to have privacy policies, security and data handling policies, quality management and change control policies, and other regulation-specific policies and procedures documents.
Designing, drafting and implementing these policies and programs at the last minute during a transaction can be an unwelcome distraction and embarrassment.
Stock and Option Issuance Problems. Stock issuances and option grants require specific and very precise processes and documentation. Companies that handle such matters without professional help often fall short, raising equity ownership issues that potentially impact the all-important cap table.
Specific gaps can include missing board approvals for stock issuances or option grants, missing option grant documentation, outstanding promises of equity grants and missing documentation from early financings. These fixes can be the equivalent of corporate open-heart surgery. Sometimes less-than-perfect solutions are the only options available. It usually helps to bring in fresh eyes and expertise to deal with these kinds of challenges.
Intellectual Property Assignments. Intellectual Property (IP) assignment issues come in several forms.
First, regarding newer companies, it’s always worth asking whether the founders who contributed IP to the enterprise actually signed formal IP assignments. If not, they need to, and they should usually be retroactive to business formation.
Secondly, companies commonly fail to obtain advance invention assignments from new employees, independent contractors and consultants. Any individual writing code, designing products, producing marketing or branding materials or doing almost anything else creative is making intellectual property.
In many cases, IP is owned by its original creators. So companies should consider getting IP assignments from virtually everyone they deal with, whether as part of a larger confidentiality and non-compete agreement or a standalone IP agreement.
Requesting an assignment after an employee’s date of hire usually requires new consideration. And it’s always easier to track down individual inventors while they are still with the company.
Lastly, all patents claimed by a company should be backed by assignments to the company, whether the inventors are still company employees or whether the patents were acquired in an acquisition. Assignments are often missing or incomplete. Patent documentation is complex. Setting up proper data room folders requires at least a quick conversation with an expert. Any gaps identified should also be closed up with the help of patent counsel.
A final IP issue that might be uncovered is the absence of key trademark registrations. Counsel should ask the client to list all names, marks, and slogans currently in use and independently check them against the company’s website, advertising and packaging. These names, marks and slogans should then be run through state and federal trademark registries to see what’s registered, what isn’t, and what might be in conflict with other marks.
This process will often reveal the need for additional trademark registrations. In some cases it may also identify potential conflicts that need to be addressed in a “coexistence agreement” with a third party or worked around in some other way before too much more is invested in a potentially vulnerable trademark.
Depending on a company’s line of business, a similar exercise may be required to determine any missing copyright registrations for website content or other protectable works or content.
Final Steps to Transaction Readiness
So once you’ve helped identify and fix the big and small gaps daylighted by this process, the client should have a reasonably complete data room – and a much better handle on some key governance, administrative and operational processes. This is a big accomplishment.
Now let’s look at a couple more steps to check the completeness of the data room and to uncover any remaining issues a company might encounter if it tries to close a financing or sell itself.
Back to the Due Diligence Request List. Hopefully the data room was organized with the help of a due diligence request list. Either way, once it’s done, checking it against a good due diligence request list is likely to turn up a few more issues.
At this stage, missing documents are likely to be more exotic than during the scavenger hunt phase – things like missing ISO audit reports, wage and hour compliance analyses and open source software schedules.
Reps and Warranties. Every stock or asset purchase and sale agreement (PSA) or asset purchase agreement (APA) contains representations and warranties, or “reps and warranties.” In medium and larger deals they often go on for many pages. Here are a few examples of the types of statements you find in them:
"Each Material Contract is valid and binding on Seller in accordance with its terms and is in full force and effect."
"Section 6.02(b) of the Disclosure Schedules lists all Intellectual Property Registrations and Intellectual Property Assets, including software, that are material to the operation of the Business."
"Section 6.09(a) of the Disclosure Schedules lists all current Permits issued to Seller which are related to the conduct of the Business as currently conducted or the ownership and use of the Purchased Assets."
Find a good PSA or APA and read through its reps and warranties carefully.
Many relate directly or indirectly to documents in the data room – or that are missing from the data room. As you read, highlight any statement you can’t say for sure is supported by documents in the data room. What other documents are missing? Some documents can be found, others can be created. Those that don’t exist but should are listed on the Schedule of Exceptions, along with any other “skeletons” in the company closet.
Schedule of Exceptions. The “schedule of exceptions” or “disclosure schedule” to a PSA or APA is where all of a company’s warts are acknowledged – every active litigation matter, loan covenant violation, regulatory blemish, property lien, delinquent large customer account and so on. They often also include definitive lists of leased or owned properties, assets to be transferred or withheld, lists of patents, trademarks and copyrights, and other key items.
Schedules of exception and disclosure schedules arise out of and are dictated by references like this in standard reps and warranties.
"No event has occurred that, with or without notice or lapse of time or both, would reasonably be expected to result in the revocation, suspension, lapse or limitation of any Permit set forth in Section 4.13(b) of the Disclosure Schedules."
A schedule of exception or disclosure schedule always follows the numbering of the given PSA’s reps and warranties clauses and sub-clauses.
As another example, if section 5.5(a) in a PSA reads “… and the company is aware of no pending or threatened litigation except as set forth in the Schedule of Exceptions," the schedule of exceptions should have a corresponding section 5.5(a) listing the company’s pending or threatened litigation matters, likely with references to where related documents can be found in the data room.
Using a good PSA or APA, help your client create a draft schedule of exceptions. This is the final test of how ready the company is to close a deal.
Every company will be forced to acknowledge negative items in preparing a schedule of exceptions. The idea is to identify the client’s warts and manage them down to where they won’t interfere with closing an important deal.
Companies raising money or selling themselves have much to prove about IP ownership, customer and supplier relationships, regulatory compliance, governance history, litigation risks, and a wide range of other matters concerning assets, operations and risks. For the uninitiated, it is generally much more challenging than expected. Gaps identified late in a deal process can delay closing and cause unfavorable changes to deal terms.
If a deal isn’t imminent, a full-blown transaction readiness process can be a tough sell. A reluctant client might be more receptive to a piece-meal approach - building a data room one top level folder at a time and prioritizing areas of greatest risk and greatest opportunity. Logical starting points are often governance, IP, contracts or regulatory.
However approached, improved transaction readiness is a worthy goal for many clients and the process offers counsel a framework for systematically identifying important weaknesses and helping the client to prioritize corrective actions.
Paul Swegle has served as general counsel to numerous tech companies and advises a dozen others as outside counsel. He has completed $12+ billion of financings and M&A deals, including growing and selling startups to public companies ING, Capital One, Nortek, and Abbott.
Paul has authored two authoritative and practical business law books, available for preview and purchase here: