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Seller Alert: What’s in Your Closet?

By Scott LeRoy
Vice President, Operations & Business Analysis

Who can forget the running gag in television comedy of the exploding closet? Lurking behind the unassuming closet door lies utter chaos. The character’s challenge is to open the door quickly, retrieve what’s needed and slam the door shut in one rapid movement.

This situation is, of course, a setup for the unassuming character that is sure to be buried in an avalanche of odds and ends in the next scene. This is the perfect metaphor for what we buy-side M&A folks sometimes find when starting due diligence on a selling company.

I certainly don’t want to imply that the business you are considering selling is in utter chaos “behind the door.” However, based on our firm’s IT services merger and acquisition experience, I’d be surprised if every process and procedure you planned to explain is documented as you intended.

Always be preparing to sell tomorrow

I believe you should always be building your company as if you were selling tomorrow. You will certainly run the business more efficiently and you can count on achieving better margins as well. When the day comes that you choose to sell, your deal may be better because of the preparation you have done along the way.

When you enter into a Letter of Intent (LOI) with a buyer, expect to provide a mountain of materials during due diligence. Remember that this time-consuming and vital task comes at a time when you are still running your business. Keep in mind that every loose end will require extra time to track down and close out. Additionally, those loose ends have been known to trigger more questions to answer. That’s why Cogent recommends that you audit your operations, financials and customer contracts now rather than be surprised later when time is short.

The following list details the most common areas where we see discrepancies. Often, issues in these business-critical areas can undermine a transaction. While issues such as these might not stop a deal completely, buyer concerns can slow the due diligence process significantly. The good news is that each of these areas of concern offers relatively easy opportunities to correct. In the end, you’ll be in better shape for any future sale. After all, you want to be able to open your selling closet without ducking.

Review the following list and see how many items you can check as thoroughly documented and complete. Next, focus your efforts on the areas that need your attention. Here’s the list:

Customer Contracts

Randomly sample 10 customer contracts. Are they in digital form with standardized naming conventions? Signed and countersigned? Stored where intended? Able to tie-out to the current relationship?

If any of the contracts in this sample group contradict your contract policy and process, you should audit and update all your contracts. Identify any contracts that may require customer authorization to be transferred or assigned as that may cause a buyer pause. If you have multiple versions of agreements, cull those duplicate documents down to a single version. Ensure that all active agreements contain the same language and terms. Lastly, it is best to present customers with new agreements when their term expires versus letting them sit in auto-renewal status. The Statements of Work (SOW) associated with these agreements can age poorly over time. It is recommended that you follow best practices and keep updated agreements, featuring similar language and terms, for each customer.

Vendor Contracts

When you are reviewing your list of current vendors and associated agreements (if any), be aware of any clause that may require prior authorization to transfer the relationship. Language that can slow or derail transference of the relationship is particularly troublesome in contracts with data centers and service providers. Most vendors require prior written consent before assignment or change of control can take place. As you review these agreements for termination clauses and associated fees, keep in mind that the buyer will want to know about the timing and financial cost that will come into play if the decision to terminate the relationship is made.

Corporate Documentation

Be sure you can locate corporate bylaws, meeting minutes, logs for equity issuances and other relevant documents. Also, contact your Secretary of State to find out if your entity is in good standing. This is easy because most states have a portal where you can determine the company’s standing in a minute or two. If your business is not in good standing, take the steps to return your entity to good standing. Often, this process involves paying a fee to bring your status current. Also, set an annual reminder to keep your good standing up to date.

HR Matters

Ensure that offer letters, contracts, and federal and state documents are on file for each employee and verify that they are signed. We highly recommend that you have non-disclosure and non-solicitation agreements in place for all employees. If you discover any special compensation, bonus or commission arrangements, take the time to document these agreements. Also, check your Employee Handbook, policies and organization charts, updating them as needed.

Deferred Revenue

If your business invoices for revenue before services are provided, funnel those funds through your balance sheet in a deferred revenue account. Consult your CPA to establish a process. If you already do so, excellent! But, ensure that your month-end balance ties out properly.

Asset Lists

How easily can you pull this together? Many small- to medium-sized companies rely on their accountant to track assets for depreciation. We recommend having living work papers that can tie out all active physical assets with serial numbers and location. This detailed record keeping will be especially useful to selling organizations with equipment on client premises.

I’d recommend working with your team to test and improve the state of these listed items. Make it a learning experience for everyone and an opportunity to correct procedures to ensure that you’re achieving the outcomes you expect. You just never know when a strong potential buyer will be interested in acquiring your growing enterprise!