This article written by attorney Emily Penaskovic, was originally published by both the NHBR and seacoastoline.com and can be found here.
In October, Sheehan Phinney lawyers based in Portsmouth joined together with Peloton Advisory, an M&A advisory firm, to lead an interactive panel regarding trends in the current M&A market and what privately held companies can do to increase the enterprise value of their business when preparing for a future sale. A few key takeaways from that discussion are that the M&A market is still active, albeit lethargic when compared with recent years, and for companies facing a longer runway before launching into a transaction, this can present an opportunity to do some legal housekeeping, which can help increase enterprise value when an exit opportunity arises.
M&A trends
For those who have not yet been through a business transaction, the term “M&A,” often tossed around by business advisors, may be perplexing. Mergers and acquisitions, usually abbreviated as “M&A,” relates to the buying and selling of businesses. These types of deals are commonly structured as either an asset deal, where the company sells all or substantially all of its assets, or a stock sale, in which case the company’s owners sell their ownership interests.
Despite the economic shifts that have taken place over the past year, including rising inflation, fears of a recession and increased interest rates, M&A deal activity has not come to a halt, particularly for mid-market deals. Smaller transactions have been less affected by market volatility than larger mega-deals, which are rare in New Hampshire. That said, there have been shifts in certain aspects of the deals as compared with the height of transaction activity in 2021.
When it comes to the buyers in these transactions, there has been less activity from private equity buyers as opposed to strategic buyers. Private equity deals involve funds that raise money from investors, acquire and grow businesses, then sell the businesses as an investment strategy. As interest rates rise and the economy becomes more volatile, the private equity model becomes less stable. Additionally, private equity firms that were very active recently may have cooled on acquisitions to focus on growing the portfolios acquired over the last few years. While private equity deals are still happening, they are progressing more lethargically and cautiously, with increased due diligence. On the other hand, strategic buyers are companies that are already operating in a similar area of business as the target company, and these buyers have a calculated reason and high motivation to acquire the specific target. The motivation for entering these deals is not purely financial, and these types of deals have been less affected by shifts in the economy.
Generally speaking, transaction values have been lower compared to the post-pandemic record-breaking years, but this largely depends on the industry. For example, valuations have dropped in technology but have remained steady in other industries. Where the parties have difficulty in agreeing on a valuation, purchase price adjustments and earnouts can be utilized to ensure that a fair price is paid, and the inclusion of these terms in M&A transactions is on the rise.
Increasing enterprise value
Inevitably, active deal making will resume and will favor the best-prepared sellers, and a lull in activity presents an opportunity for companies to address basic legal housekeeping that can ultimately increase enterprise value and ensure a smoother transaction down the line. “Enterprise value” refers to the gross market value of a business and oftentimes is synonymous with the transaction value when the business is sold.
From a corporate governance standpoint, solid organizational documents, including a shareholder agreement where relevant, should be adopted and a chain of title for any stock that is issued, transferred, or redeemed should be maintained. Corporate formalities, such as documenting annual director and officer elections, should be followed. While it may sound obvious, companies should also ensure that they maintain good standing in each state where they transact business.
Intellectual property should be protected from the outset by having founders assign all early developments over to the company and by having all employees and contractors confirm that the company owns all developments that they work on relating to the company’s business. To further protect intellectual property, employees and contractors should sign confidentiality agreements, and certain employees should be bound by non-solicitation restrictions to prohibit them from taking customers or employees if they leave the company.
In the employment context, having a solid management team is critical to increasing enterprise value. Founders should be strategic in incentivizing the management team and other key employees, including by providing equity and equity-based compensation. Engaging a solid human resources team and employment attorney can help to avoid costly wage claims and issues regarding the misclassification of employees, which could hinder a future transaction.
Issues with real estate, whether leased or owned, can easily hold up a transaction and should be addressed early on. Leases should be reviewed well in advance of a transaction to determine whether assignment of the lease is allowed and whether landlord consent is required (especially in the context of a potential asset deal). If real estate is owned, the company should ensure that old encumbrances resulting from loans are properly terminated and that such termination is recorded.
Finally, engaging business advisors, including lawyers and M&A advisors, early on, ideally before entering into negotiations for the sale of a business, can ensure a smoother, faster, and more efficient transaction. Rather than jumping on the first letter of intent that comes across the table, the terms of which inevitably will be too good to be true, companies should rely on their trusted team of advisors to help shop the market, negotiate the terms of a potential deal, and ultimately enhance enterprise value.