This post is the first of a three-part series exploring the Mount Everest of being a Founder–selling your company.
Companies come in all shapes and sizes–and are frequently changing. Even a week ago, who’d have thought about selling an AI company that helps parents create personalized storybooks for and with their kids?
In this series, we will focus on internet-based companies like SaaS companies, but, as you will see, much of what we will talk about equally applies to other types of tech companies.
Not Losing Sight of the Endgame
When you watch the evolution of a founder, you’ll see some notable stages.
- The “conquer the world” phase is when the founder cannot wait to share their vision.
- In the “work boots” phase, the founder focuses on grinding to build the business and getting it in front of as many customers as possible.
- In the “get off my lawn” phase, the founder focuses on keeping competitors off and dealing with slowing growth.
However, throughout these phases, founders are always thinking about the exit. And that is what we are focused on in this series.
Throughout the series, we will discuss, from a selling founder’s perspective: (1) pre-sale considerations and terms, (2) the nuts and bolts of the purchase and sale agreement, and (3) the closing process.
Putting the Pieces Together
Even if you’ve spent the last three years thinking about selling your company, unless you’ve done it before, you’ll likely have unrealistic expectations and, at times, feel completely overwhelmed. After all–it's just a simple software program; how hard could it be to sell?
If you've sold or purchased a non-SaaS business before, you might expect this to be a walk in the park. However, mergers and acquisitions (M&A) deals for brick-and-mortar businesses differ drastically from those for SaaS companies, many operating exclusively or virtually exclusively on the Internet. The technical, tax, legal, and practical considerations vary greatly.
Typically, these businesses consist of “Components”:
- Intellectual property (e.g., one or more domain names, websites, email accounts, social media accounts, trademarks, source code)
- Commercial contractual relationships (e.g., customer and vendor relationships, such as payment accounts like Paypal and Stripe)
- Administrative relationships (e.g., insurance, payroll systems, financials, employee benefit plans)
- Stakeholder relationships (e.g., lenders, investors, and employees).
Each Component is crucial for the operation and success of the business and must be transferred to the buyer or retained or terminated by the seller.
Selling a company is like solving a Rubik's cube comprising the above Components. Many pieces must be put together correctly for the sale to be successful. Third parties play a vital role in this process. You need to know where all the pieces are, how they are organized and where they fit, and (hopefully not) whether you have any missing pieces.
In preparing to sell your business, you must be or quickly become an expert in these Components. We’ll call this the “getting prepped for diligence” phase because any potential buyer worth its salt will want to scrutinize these Components for discrepancies, errors, or gaps.
In addition to buying your contracts—we’ll get to that next—the buyer primarily buys intellectual property or “IP”.
IP is an umbrella term for a set of intangible assets or assets that are not physical. IP gives the party holding such rights the (exclusive) right to use, duplicate, license (rent out to third parties) or otherwise dispose of such IP while being able to assert legal rights to protect the same from improper use by third parties.
Traditionally, these fall under buckets like:
- Trade secrets (are a company’s process or practice that is not public and which provides a competitive advantage (e.g., the recipe for Coke))
- Trademarks (rights to certain names or symbols you use to identify your specific business, goods, or services from others)
- Copyrights (rights to use, copy or duplicate certain original material, such as songs or movies)
- Patents (specific exclusive rights granted to new inventions, designs, processes, or improvements.
You must make sure that the Company owns the IP created by its individual employees, contractors, consultants, and other partners. This is usually handled by confidentiality and invention assignment agreements (CIIAAs) signed by all employees and contractors that work for the company.
It is good practice to get these in place as a part of the hiring process rather than after the fact – asking your lawyer to draft a simple form CIIAA for use in all early and later hires can save you a lot of headaches down the road.
Most importantly, in such documents, the present assignment language is crucial.
Otherwise, a buyer might demand certain indemnities in the PSA or a reduction in the purchase price out of fear that a former employee will claim that the IP the buyer is buying belongs to the employee and not your company. /callout
Similarly, if you have any registered IP, such as trademarks, patents or copyrights, they must be legally transferred to the buyer.
You should also know how the ownership of other digital assets (e.g., email, social media accounts, domains) is recorded and how to transfer such ownership to a buyer. The transfer of these digital assets is usually dictated by the contract with the host (e.g., domains with GoDaddy).
Funny I mentioned contracts . . .
Think about how you document your relationships with customers and vendors (e.g., payment processors like Stripe, e-mail hosts like Gmail, etc.). In a perfect world, they should be covered by some written contractual relationship. This may be a contract between the company and the relevant party (physical documents or PDF versions). Or it may be a website “click-wrap” Terms of Service/Use/Sale that all your customers read in-depth and click “agree” at the end.
Vendors for tech companies often include domain registrars, website hosts, advertisers, content providers, other SaaS vendors providing services for other companies (e.g., Calendly for calendar scheduling), and e-commerce platforms like Amazon. You may also have some minor brick-and-mortar presence, such as office space, meaning real estate leases or license agreements and a landlord are involved.
It is not uncommon for there to be no traditional written contracts with larger SaaS vendors. More frequently, you will have agreed to clickwrap agreements - the lengthy documents people often skip when signing up for online services. In some cases, counsel may have to create them as part of the representation to ensure that most (if not all) third-party agreements transfer over at or after closing.
If any of your contractual relationships aren’t formally on papered or click-wrapped, that doesn’t mean there isn’t a “contract,” just not a “written” contract. In those situations, at the very least, you will still want to describe the relationship.
We often see informal relationships or contracts, especially when related or affiliate parties are involved. These are major red flags to buyers during due diligence. Getting written contracts before the buyer can access your data room will save you time, headache, and money.
Having fairly tidy contracts is crucial for another reason: consent and notice requirements. Most founders never think about “anti-assignment” or anti-transfer clauses. But you should.
The latter is more common in terms of service with prominent vendors, such as Google’s Gmail suite, while the former are more often found in traditional commercial contracts, like master services agreements.
The third parties on the other side of these contracts are not directly involved in the sale but can still significantly impact the process. During a sale, the buyer and seller are intrinsically motivated to cooperate. However, third parties can pose a challenge because you have no control over them and may struggle to incentivize them. Since these third parties lack incentives, they often cause problems, delay providing relevant approvals, and otherwise interfere with the deal.
If your contracts are organized well, it will be that much easier for your team to identify necessary consents and notice requirements and make relevant requests for consent far in advance so as not to hold up closing. The parties must identify and transfer all crucial components, even if it is impossible to transfer 100% of the business legally or practically.
Next up are administrative relationships, including insurance, payroll systems, employee benefit plans, and financials. Many of these items also include contracts with third parties, which your helpful lawyer will review for the same issues noted above (notice and consent).
For insurance, the items you’ll need to have in order are the policies for your commercial general liability insurance and any supplementary (e.g., umbrella) or industry-specific policies (e.g., cyber and data privacy). These documents will include necessary consent and notice requirements. While insurance will often be terminated at closing, buyers often require a seller to provide a list of all potential required consents and notices.
You should also identify (or obtain if you do not have them) certificates of insurance or copies of the same. These will succinctly state your existing insurance policies’ details without deep diving into the policies themselves.
Payroll systems are those processes by which your business pays its employees and contractors. A third-party vendor (like Rippling) may handle them internally or externally.
You should have a good handle on these systems when the buyer requests items during due diligence. These may include how many full-time and part-time employees you have, whether they are exempt (i.e., not eligible for overtime), citizenship or residency, primary place of work, and bonus structures and payouts.
Often buyers will ask a seller to state affirmatively that the closing will not result in any bonus or other incentive being given to employees. Or they may ask to state affirmatively that the closing will not negatively impact existing benefit plans.
If these statements are untrue and cost the buyer substantial money to fix post-close, you could be on the hook for post-closing indemnities (basically reimbursements).
Relatedly, your company likely offers or is required to offer employee benefits, such as retirement contributions (like 401Ks) or health, dental, and/or vision insurance.
You should be able to access related policies for health-involved insurance offered as buyers frequently ask about these policies, plus notices and consents will likely be involved. Having such policies and related retirement contribution documents will be crucial if the buyer requests details about existing policies and the impact that the closing might have on them.
Lastly, your financials are hugely important, consisting of the primary documents such as the income statement, balance sheet, statement of cash flows, and all underlying documents, including tax returns.
Provide these documents to your team early in the diligence process. This will enable your team to identify areas of spending or other discrepancies that require looking further into. It may flag a certain vendor or customer, especially regarding notices or consents. Alternatively, these documents will provide your team knowledge about which areas to tactically ignore (like low-dollar vendor or customer relationships, the cost of not obtaining consent or notice will be much lower for post-closing penalties owed to a buyer).
Lastly, stakeholder relationships are the glue that holds your company together. Consisting of employees, investors, and lenders, you must have a concise understanding of these parties and the relevant documents underlying each.
First, employees are the lifeblood of your company. You should know critical details about your employees, which a buyer will likely request. Further, as noted above, you should have (or quickly put into place) CIIAAs with your employees.
Relatedly, written contracts are crucial for employee equity.
Equity granted to employees should be reflected in written contracts, such as restricted stock purchase agreements (RSPAs) and option award agreements. All of these items should be tied under a company stock plan laying out the rights and obligations of the party related to equity. A cap table reflecting this layout is vital to a buyer to see exactly how the company's existing equity is divvied up.
Before entering the sale process, these items should be handled; otherwise, you could face post-closing issues with current or past employees claiming they own the company when they do not.
You may also employ independent contractors, under which many of the same items above are largely applicable (especially as relates to IP).
Investors play a crucial role in your company, providing both capital and, often, business advice and consulting.
Similarly, prior stakeholder relationships with the company should be properly put down on paper (or at least .pdf). You should have written award and/or investment vehicle agreements for each, such as convertible promissory notes and SAFEs (Simple Agreements for Future Equity).
Lastly, your company may have lender relationships if you financed any aspect of your business operations. Lenders often consist of banks (such as the recently collapsed Silicon Valley Bank) or similar entities which have lent money for business operations or equipment. Lender relationships may also exist if your company has any traditional brick-and-mortar presence, such as mortgagees on a piece of land your company bought to operate its business on or from.
Thankfully, lenders will not let you borrow money without putting it down on paper. And, they’ll likely require you to collateralize your loan with your company’s or maybe even your assets or even a related (or even unrelated) affiliate or subsidiary’s assets (meaning if you default, they can force you to sell those assets to pay back the loan).
For these reasons, it is crucial to maintain your loan documents, promissory notes, and related documentation and give it to your legal team early in the process. Loan documents almost always require lender consent for any large changes to your business (such as selling it!) or any underlying property. Lenders can and will accelerate your loans if you fail to get the required consent. And if this happens post-close, the buyer will likely be able to shift this entirely back on you as a post-closing indemnity.
As you can see, there are many presale considerations that you must take into account and steps you must begin to take before ever entering into an LOI. Take care of these presale issues, and your deal will move forward as smoothly as Tennessee Whiskey.
That wraps up our first series of the blog. Join us next time as we’ll tackle specific purchase agreement deal terms, how to calculate purchase price, and letters of intent.
Disclaimer: While I am a lawyer who enjoys operating outside the traditional lawyer and law firm “box,” I am not your lawyer. Nothing in this post should be construed as legal or tax advice, nor does it create an attorney-client relationship. The material published above is only intended for informational, educational, and entertainment purposes. Please seek the advice of counsel, and do not apply any of the generalized material above to your facts or circumstances without speaking to an attorney.