Thanks for your interest in our series on Preparing for an Exit. In addition to the recap of our suggestions below, we are also providing some market research on IT Services stock performance, valuation metrics and M&A activity.

Chapter 3: Preparing for an Exit – Corporate and Capital Structure

This is the third segment in a series DecisionPoint has put together to help prospective M&A candidates think about some of the fundamental issues that may materially impact a transaction.

Corporate form refers to the type of legal entity through which the business is owned. The most common entities are corporations (subchapter C or subchapter S), LLCs (limited liability companies) or partnerships. Capital structure refers to the way a company finances its assets, typically through a combination of ownership (equity) and debt. Both the corporate form and capital structure could have a material effect on a sale transaction.

Assets versus Shares:

Your corporate form may have a significant impact on your after tax proceeds if a sale transaction is effected through the sale of your company’s assets. If you are organized as a C corporation and you sell all of your assets, typically your company will have to pay corporate tax on the sale of the assets and then when the proceeds are distributed to the shareholders, the shareholders will pay tax on the distribution at dividend rates. This double taxation could materially reduce your after tax proceeds. There are some strategies to reduce the impact of the double tax but those are beyond the scope of this segment. Generally, if the selling entity is an S corporation, LLC or partnership, those entities are considered “pass through” entities and there is only one level of tax.

In a sale of shares or equity interests, there is only one level of taxation and the proceeds are taxed at the capital gains rate, currently 15%. However, many buyers have a strong preference to purchase assets as they get a better tax treatment and can avoid assuming liabilities that would flow with a purchase of equity. Because the form of the transaction has a different impact on the buyer than the seller, the structure of a deal impacts valuation.

Capital Structure:

Generally, a transaction is more complex if you have a complicated capital structure, including having many equity-holders and/or multiple classes of equity. A comprehensive and unanimous stockholders’ agreement is advisable whereby the smaller shareholders provide the larger shareholders with certain rights to act on behalf of all shareholders (such as drag-along rights). In general, every party that owns equity directly or indirectly has the potential to impact or even block a transaction. There are strategies to manage these kinds of risks but they should be considered and implemented well in advance of a transaction.

Similarly, complex debt structures that provide lenders with security and rights to benefit from equity appreciation (such as warrants or conversion rights) may also complicate a transaction and impact the value that the equity holders may receive in a deal.

Key employees who are likely to be viewed as such by a buyer may also need to be incented through stock options or some other bonus arrangement to actively participate in a sale process.

As the owner/CEO of a company, these are some of the considerations that should be taken into account prior to a sale of your company.

Chapter 2: Preparing for an Exit – Contracts

This is the second segment in a series DecisionPoint has put together to help prospective M&A candidates think about some of the operational areas of their business that may have a material impact on a transaction. Our perspective comes from decades of C-level operational experience, more than 150 transactions on both the sell and buy-side, and numerous board roles, including one of our partners who sits on the board of a billion dollar NASDAQ software company.

A buyer will expect the target to have contracts that are current and readily available in a due diligence process. This goes for all contracts such as agreements with customers, employees, partners, suppliers, etc. We have seen cases where the due diligence process was slowed down when the target could not locate certain customer and employee contracts and other cases where contracts with active employees and customers had expired. This can also lead to loss of target credibility and trigger stricter due diligence in other areas by the buyer. Our advice is to locate and establish contracts where possible for long-term customers/partners where current contracts have expired but customers/partners are still doing recurring business. It’s also beneficial to renegotiate and extend terms on contracts that are expiring in the next 12 months. Buyers generally view longer term customer contracts to be more valuable than shorter term agreements. For IT services companies, having an accurate representation of gross margin, utilization and average bill rates is expected.

Another important consideration is whether contracts (specifically customer contracts) prohibit assignment without customer consent. Such language could restrict your ability to transfer your company’s contract rights or obligations in a sale, change of control or merger. A buyer bases its purchase price, in large part, on assumed future business results and achieving those results may depend on a contract continuing after an acquisition. Not surprisingly, acquisition agreements typically require that existing contracts remain enforceable after acquisition, except as otherwise agreed. The absence of an anti-assignment clause in a contract generally permits both parties to assign the contract freely, without the consent of the other party. So, be aware of restrictive clauses in your agreements and assess their impact. This should be done early in the process to make sure there are no last minute negative surprises. As always, there is no room for error in the exit preparation. Better to prepare in advance and ensure a stress free process.

Chapter 1: Preparing for an Exit – Getting Your Financial Statements in Order

This is the first segment in a series DecisionPoint has put together to help prospective M&A candidates think about some of the operational areas of their business that may have a material impact on a transaction. Our perspective comes from more than 150 transactions as well as decades of C-level operational experience.

When preparing for a strategic acquisition process, your financial statements have to be in order and should be well understood by the CEO as well as the CFO. A strategic acquirer will expect up to date financial statements (P&L, balance sheet and cash flow) for the current year and historical statements that have been reviewed (ideally audited) by a credible outside accounting firm. While cash based statements may be the norm for some closely held businesses, your financials should be prepared using the accrual method in accordance with GAAP. Care should be taken to ensure expenses are properly categorized to provide a true picture of operating metrics, including gross margin, SG&A and profit (EBITDA). Mischaracterized expenses or items not properly booked will skew these metrics causing a loss of credibility and hurt the M&A process. For IT services companies, having an accurate representation of gross margin, utilization and average bill rates is expected.

Financial projections are another important element to focus on. Obviously it’s difficult to project P&L statements beyond a couple of years but acquirers want to evaluate your assumptions and thought processes for growth. Acquirers are quite skeptical of growth that does not mirror your history unless you can point to new events, new products or other tangible reasons to justify faster growth and more profits. Remember, an acquisition process can take up to twelve months so potential acquirers will have time to observe your ability to project near term performance. It’s essential to hit your budgeted numbers that are 3-9 months out.

Simply put, there is no room for error in financial preparation. Better to measure twice and cut once.

Chapter 4: Preparing for an Exit – Operational (coming soon)