Selling a Privately-Held Business Part 2 – Legal Audit of Seller

Posted by Thomas E. Sowers on

At some point very early in the process after the seller has made the decision to put the business on the market, the seller should have its legal team perform a legal audit on the seller.  The purpose of the legal audit is to review the state of the company in order to identify and anticipate issues that likely will be raised during the purchaser’s due diligence investigation of the company.  Basically, these are issues that could be a hindrance to the transaction, or issues that could negatively affect the negotiating position of the seller or negatively affect the terms of the business deal the seller ultimately receives.  I will discuss the due diligence process in a later post.

It is important that the legal audit occur as soon as possible in the process.  Many sellers often fail to consider the legal issues relating to the sale of the business until faced with the issues when they arise during the course of the transaction.  This will likely lead to a loss of negotiating leverage that is difficult for the seller to recover from.

So, what does the legal audit involve? Below is a list of issues that will often be handled during a pre-transaction legal audit.

Make sure that the corporate record books for your company are complete and in order. If your company is a corporation, you should be sure that all of your annual meetings have occurred and been properly recorded, and that your corporate record books properly document the ownership of the corporation. A sophisticated prospective purchaser will want to look at your corporate record books, and it will send a positive message to the purchaser (in terms of your record-keeping for the company as a whole) if you provide a purchaser with corporate record books showing that you have followed the proper corporate formalities in the operation of your company. Providing a purchaser with incomplete or sloppy corporate record books could cause the purchaser to worry that there are questions regarding the underlying validity of prior corporate actions by your company, or to call into question the accuracy all of the other business records that you provide to the purchaser for review.

If you have created a service mark or trademark for your company that you intend to transfer as part of the sale, consider registering the mark with the proper governmental authorities if you have not already done so. If you have registered the mark, check to see that all renewals for the mark have been filed (in Georgia the registration of a mark is good for ten years). If a service mark or trademark is being transferred to a prospective purchaser, having the mark properly registered will obviously be appealing to the purchaser and again speak well of your record-keeping as a whole for the company. If a significant amount of goodwill has been generated by your company through the use of a mark, a purchaser will have an expectation that the mark is registered.

For any key employees of the company not currently subject to an agreement with the company that prohibits the employees from competing with the company or soliciting clients of the company after the termination of their employment, consider requiring these employees to sign such an agreement. A prospective purchaser will want some assurance that after the acquisition of your company, current employees of the company will be prevented from competing with the purchaser or taking the clients of the company with them to a competitor for some period of time.

In Georgia, the continued employment of an employee is adequate consideration for restrictive covenants granted to a company by a current employee (as opposed to a new hire) so you would not necessarily need to make any additional payment to the employee to make the covenants enforceable. If you have key employees who are not currently bound by a restrictive covenant agreement, you should speak to an attorney about what may or may not be appropriate with respect to restrictive covenants for these employees (particularly those employees whom you would not expect to be employed by the purchaser of your company).

You should review any contracts that the prospective purchaser will likely assume in an asset purchase transaction, such as any real property leases, to see whether they can be assigned without the consent of the other party to the agreement (in a stock purchase transaction your agreements would need to be reviewed to make sure that the transfer of the stock does not require the consent of the other party, or trigger any obligations on your part). If the consent of the other party is required, then it may make sense to contact the other party as soon as possible to determine whether the other party is willing to consent. For any contracts that a prospective purchaser may not want to assume, review the termination provisions of those contracts to see whether you are able to terminate the contract at will, and if you can, what is required in order to terminate. Many agreements will require a party to pay a fee to be able to terminate the agreement. Other agreements may require a specified notice period that must be adhered to before you are able to terminate the contract. Deals can be delayed or fall apart over a seller’s failure to receive an important third party consent. Therefore, it is important that you understand the assignment, change of control, and termination provisions of all of your contracts so that you can plan ahead and be prepared to take action (e.g., terminate an agreement) at the appropriate time.

Just as with the leases and other agreements to which your company is a party, you should review any employee benefit plans that the company has so that you are prepared to be able to assign or terminate those plans.

If you and any business partners are parties to an agreement relating to the operation of your company (for example, a shareholders’ agreement or an operating agreement), you should review the agreement to be certain that you understand whether the sale implicates any of the provisions of the agreement. You may want to consult with an attorney to deal with those issues and to help you properly terminate the agreement and dissolve your entity, if this is your intention. A prospective purchaser will be extremely wary of proceeding with a transaction where there are any lingering issues among the sellers. Make sure that you have a handle on all of these issues prior to engaging in discussions with a potential purchaser.

If intellectual property is a significant asset of your business, you should be certain that you can document your company’s title to the intellectual property prior to marketing the business for sale. A prospective purchaser could very well be dissuaded from proceeding with the transaction if you are unable to document the company’s ownership of the intellectual property. Though you may believe that your company owns all of its intellectual property, if the intellectual property being sold involves inventions or works of authorship created by an employee or independent contractor not subject to a well-drafted agreement that addresses ownership of these creations, you could have an issue. If intellectual property is an important asset of your business, you should be sure to have an attorney analyze any potential issues as to the ownership of the intellectual property prior to marketing the business so that you have time to address any issues.