Put it in writing Featured

8:00pm EDT August 26, 2007

Sales agreements start with a conversation and end with a contract. Each line of the sales document can have huge ramifications on the value of the deal for the buyer and the seller. But before a company even begins sales negotiations, it should prepare and review all of its existing documentation that supports its business operations and can impact its selling price.

“Companies should periodically review their contracts and documentation to be certain that they accurately reflect their relationships with suppliers, vendors and customers, and current methods of doing business,” says Howard Berrington, partner at Levenfeld Pearlstein, LLC. “This is particularly important when preparing for a sale.”

Smart Business spoke with Berrington about how to use documentation to position your business for a successful sale.

Why is it beneficial to review contracts and documentation before putting a company up for sale?

Contracts are typically considered assets, such as agreements that lock in suppliers of goods and services for extended periods of time at favorable pricing. However, contracts can also be liabilities, like a long-term agreement to supply a substantial customer with goods and services at less than a company’s standard profit margin.

Existing contracts could also be obstacles to completing a sale. Many written contracts provide that neither party may assign the contract without the prior written consent of the other party. If the supplier, vendor or customer will not consent to the assignment or requests additional financial concessions or accommodations, the buyer may reduce the purchase price or make the sale contingent upon receiving the consent. If the seller proceeds with the transaction without assigning the contract and after the sale has no ability to perform the contract, the seller may be liable for damages for breach of contract.

If a business decides to structure the transaction as a sale of stock, it doesn’t need to receive an assignment of the contract. However, many contracts have termination rights and other consequences upon a ‘change in control.’ Also in a stock sale, the buyer assumes all of the seller’s known and unknown liabilities. The risk associated with unknown liabilities may result in a reduced purchase price, deferral of a portion of the purchase price and/or contingencies to the payment of a substantial portion of the purchase price to the seller.

How can companies’ contracts enhance their value before they go to market?

When companies do business on a handshake, the buyer may want to defer a significant portion of the purchase price contingent upon the customers and business retained after closing. Many times, the transaction will be structured as an ‘earn-out,’ where the deferred portion of the purchase price is based upon the business, sales, customers or profits retained by the buyer. This form of contingent purchase price is not advantageous to a seller.

This issue should not arise if the customers are contractually committed to the company for a period of years. When written contracts exist, it is very easy for the seller to demonstrate the cash flow and the profits, which the buyer should realize as a result of the sale.

How should companies structure their contracts with suppliers in preparation for a sale?

It’s always preferable to enter into contracts that are freely assignable without the consent of the other party. But if this provision is reciprocal, this type of agreement may or may not be advantageous. Another alternative is to make the contract assignable upon a sale of substantially all of the company’s assets out of the ordinary course of the company’s business.

What else should companies consider before they look to sell?

Before a sale, a company should consider what assets it may wish to exclude from the sale. For example, a buyer may not pay very much for the potential revenue or profits from a new line of business. If this line of business is not competitive with the buyer, it may be preferable to spin it out to the seller for continued post-closing operations.

Similarly, when the purchase price for a business is based on a multiple of revenue or profits, capital assets may not be valued at their highest level. We recently worked with a company with real estate that was far more valuable as a stand-alone asset than as a portion of business’s assets. Before the sales discussions, the real estate was spun out into a separate entity and leased back to the company. Eventually, the company was sold to a competitor who wanted to consolidate a significant portion of the business operations into its existing facilities. The real estate was subsequently sold to a developer for purchase price far above what the competitor would have paid.

HOWARD BERRINGTON is a partner at Levenfeld Pearlstein, LLC. Reach him at (312) 476-7504 or hberrington@lplegal.com.