Often you know that your plan is not to run the company in the long term, but to build it to the point where it can run itself as a self-sustaining profitable business. After this point, you may want to be acquired and ‘cash out’. The startup entrepreneurs and the venture capitalists refer to this as exit plan. If this is the case, there are a few things you will need to keep in mind, as a founder or someone responsible to preserve and maximize the valuation of the startup business.
By taking certain steps in the beginning, one can ensure a smooth sale, and no compromise with the valuation of the business. One of the major risks involved here is that you may not receive the complete economic value of the business, as the price may be lower than expected due to perceived liabilities existing with the company, or the acquirers may get turned off by the legal difficulties, even though the business may be economically sound. So, here is a list of things you can do to ensure a perfect acquisition of your startup.
Basic Premise
When an acquirer buys a profitable business, he/she wants it to run as it is running at the time of acquisition. There may be an interest to make it more efficient, but the acquisition should not result in any change in the fundamental business position of the company. The key employees/functionaries must continue, the suppliers must not lose interest, the contacts in the government or elsewhere must not slack, the existing contracts and loan agreements should remain enforceable, dispute resolution agreements should remain enforceable, and the main business should remain as attractive as it was when the pitch to sell the company was made to the acquirer. So, the objective of your planning should be – to hand over a smoothly running company, the main functions of which are not affected by the transition of ownership. If one of these things goes haywire, your company may still get acquired, but one thing is assured – each potential acquirer will shove the issue on your face and ask for ridiculous discounts on the real value of the company.
Ensure a corporate limited liability structure
It is really good to run a startup as a proprietary business or other simplified structures like association of persons, unregistered partnership and so on when you are not taking investments. That leads to a hell lot of tax savings and savings, on account of legal paperwork, accountancy and other formalities required by a corporate entity; which can help a lot when you are just starting up. However, if you are planning on getting acquired, or even selling a part of the company to an investor, you must have a limited liability corporate structure. You can incorporate these things just in time before the acquisition, but no acquirer/investor will even consider your company if they are not incorporated. Most common structure for this is private limited company, but another viable but not so popular option is limited liability partnerships. LLPs have been introduced in India rather recently, and most investors have no idea about it so it may be a little more difficult to sell them an LLP, but the significant tax savings and avoidance of hassles of corporate compliance may be worth the trouble for many.
In case of a Private limited company, the shareholder’s liability and in case of LLP, the liability of the partner is limited to the amount the person contributes by way of share capital.
Trademark and strategically name products and services
The startup must be selling either products or services. In any case, the same should ideally have a name which is distinguished from the name of the company in general. Everyone wants to have the option of selling a vertical open. Let’s say you are Superstrength Pvt. Ltd. selling Superstrength Nutrient Jam and 10 other products (maybe you are not selling yet but just planning them). Tomorrow if I like only the Jam making vertical, can I buy it from you and run it without changing the name of the product? I cannot, because the customers identify your product by your company name. So, I have 3 options:
a) Buy the entire company or I must change the name ( It is also possible to assign brand rights on limited products; no change of name will be required then but it may be difficult to find someone willing to buy on those terms)
b) I can ask your company to change its name such that I can use the brand name while selling the jam
c) I can ask your company not to use the same name for selling jam and related products. That means you can still sell Superstrength Nailpolish Remover but not Superstrength Jelly.
Most importantly, you may not want the brand name which is used by you for the other products of your company be jeopardized by my actions in relation to the jam vertical that I buy from you. This is why acquirers will usually refuse to buy a vertical along with assigned brand rights – owners want total control over the brand image. That is why it pays to differentiate the name of various unrelated products, and also the name of the holding company.
Also, it is important to have these names, apart from logos and trade dresses (think packaging), if any, trademarked. This ensures that you are the only one having the intellectual property rights to use those names, and no random person can enter the market and start selling Superstrength Toothpaste if they want. Trademark is also a kind of intellectual property, having widely accepted valuation methods, which will help when valuation of the company is performed to determine the acquisition price. Each of the trademark and product verticals can then be valued separately, adding up the sum total to a higher price.
Have a well defined agreement on the exit strategy
This is not the most intuitive step, but nonetheless one of the most important steps. Even if you are not sure whether you want to exit, you must define an exit strategy right after incorporation, before incorporation, or at the time of investment, as you enter into share-subscription (SSA)/ shareholder (SHA)/ partnership agreements.
Remember that there are many stakeholders in the startup – founders, investors and debtors being some of them. Your co-founder may lose his house in a fire and may therefore want to sell his part of the business. One of the investors may decide to become a monk and want to sell everything he holds. Exit strategy provides for these contingencies.
Exit strategy should be agreed upon by the key shareholders and then crafted into the relevant agreements. A few aspects to be dealt with:
a) What happens to the CEO/CFO and other key personnel on exit? Do they also get to go?
b) Is there going to be any tag along/drag along/right of first refusal etc? (for the uninitiated, tag along is where minority shareholder gets to sell his shares to the buyer of majority shares, usually, at the same price and terms as the majority shareholder without having to negotiate or find a buyer. Drag along is the right to force another shareholder to sell at the same price and terms to the same buyer.)
Drafting contracts and agreements in a transfer neutral way
One important factor to be ensured is that all the contracts with counterparties that one is currently doing business with should be correctly drafted so that the contracts will be neutral to a transfer of business or change in ownership; this is very important to ensure that no problem arises between future buyers and your present counterparties. It’s very important for the prospective buyer to know the modalities of the deal with present client, its legal validity, the future of the contractual relationship etc. In many cases, there are contractual provisions that could prevent a change in control without the consent of third parties like key customers, suppliers, venture capitalists, etc. These must be paid attention to.
Also, a major issue can be dispute resolution clauses including arbitration and negotiation clauses. Will the existing clauses cover the new owner? The clauses giving you right to participate in these dispute resolutions must be drafted to ensure that such right is transferable to acquirer.
Employment and supply contracts
Usually, no acquirer will appreciate a situation where they have to find replacement for a lot of employees and suppliers/service providers in a profit-making company they are buying. Employees constitute a major factor driving profitability, and the acquirer will probably want this winning team when he buys the company. The same applies to suppliers and service providers. Therefore, it is in your interest to ensure that employees agree to the acquisition and that suppliers and service providers are kept in the loop about acquisition. It is best if they are neutral to the transfer. Most startup employees, however, know that acquisitions are normal in the lifecycle of a startup and there is nothing particularly alarming about it. It is a good idea to stipulate this in the contracts with employees and start-ups itself – that may go some way in assuring the acquirer.
Contributed by Ramanuj Mukherjee and Esha Shekhar
Ramanuj Mukherjee is the co-founder of iPleaders, that offers Legal Risk Management Services for businesses, and Esha Shekhar is part of the iPleaders research and implementation team. Read iPleaders.in to find out about various legal risks that may affect your business.
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