Mergers and Acquisitions
Increasing Business Value
We live in an era of rapidly increasing business value for information, know-how, and intangible property. This increase in value has nothing to do with the internet. All entrepreneurs, regardless of their business, should be alert for the opportunity to create intangible property – in the form of contracts evidencing key business relationships – to help enhance the value of their business.
• Basic Philosophy. Even if you have no present intention to sell your business, you should always run your business as if you do. Properly positioning a business for sale increases – sometimes dramatically — the exit value you realize. We’ve seen many instances where an entrepreneur received an attractive unsolicited offer. Many times, the entrepreneur is then faced with explaining why the “true profits” are higher, or why the buyer will continue to benefit from key business relationships after the transaction closes and the entrepreneur leaves.
• Example. Many times, a business’ key relationships – relationships that are very valuable – are informal. They might be based upon the personal relationships of the entrepreneur or the entrepreneur’s key employees with critical customers or suppliers.
For example, suppose a key vendor has been supplying goods for very favorable prices and terms in recognition of the volume of business given to the vendor and the vendor’s relationship with the entrepreneur. If the entrepreneur remains involved in the business, the advantages and added value provided by this relationship may continue indefinitely. However, if the entrepreneur wishes to sell the business, the buyer will be concerned about the evaporation of that relationship. From the buyer’s standpoint, due to this risk, there is less value to the business.
The solution is to look for opportunities to document valuable business relationships in a simple contract. Even a letter agreement will do. The important point is to have the agreement document a definite term during which the agreement will be in effect. The entrepreneur can point to the agreement to show that, for example, the vendor is committed to providing goods on the same favorable terms for at least several years following the sale.
• Other Examples. Another example involves key employees. Many businesses operate with loyal, long-standing key employees who work without a formal employment contract. However, if those key employees are needed to maintain the company’s profits, most sophisticated buyers will require employment agreements with them as a prerequisite to a purchase.
We have been involved in many situations where an absentee owner who sells a business has great relationships with key employees, but as the business sale approaches, the key employees recognize that it’s a “new game.” They may ask for salaries, benefits, etc. from the new buyer that they would never dream of asking from the old owner. Even worse, the ownership change may cause them to seek other opportunities.
Most lawyers advise their clients to avoid legal liability by using written employment contracts, including “at will” provisions in appropriate cases. However, a significant benefit of written employment contracts – giving permanence to valuable relationships – is often overlooked. If the entrepreneur wants to take advantage of a sale opportunity that materializes, the employees have the assurance of knowing they have some job security, and the entrepreneur does not have to worry about shoring up key relationships at a critical time.
Simple distribution agreements provide another opportunity. For example, assume a business starts selling a new product which the entrepreneur feels has potential. In order to realize that potential, the business must incur additional expenses and take other steps to develop the business. Since these steps must be taken anyway, why not, as a condition of carrying the product, enter into an exclusive distribution agreement with the manufacturer for exclusive distribution rights, for a certain period of time, in a certain area? Such agreements can add enormous value to a company in a sale.
• What’s involved. By training, lawyers habitually try to consider every possible scenario in drafting a contract. However, for most of the relationships referred to in this article, attempting to get the other side to sign a 20-page contract can result in delays and even spook the other party. Many times, because the business relationships are already in effect, a simple agreement or written memorialization covering all of the key points is an easily accomplished first step. (Caveat: you can and should consult counsel to make sure each essential point is addressed.) Once an agreement has been in effect and operating smoothly for a certain period of time, you can always go back and suggest that the arrangement be “formalized.”
• Conclusion. We have seen numerous instances where two-page letter agreements have added substantial value to businesses. The lack of a longer, more comprehensive agreement may still make the buyer nervous. However, having something in place evidencing valuable relationships and the terms on which they can be maintained in the future is better than having nothing, or attempting to document something when the other side knows a sale is pending. In cases where one or two key relationships affect the entire value of the business, that simple piece of paper may make all the difference in the world in determining whether you have something of value to sell or not.