The Sale of a Business

---

By Richard E. Clark

The good news: you and your colleagues have worked long and hard at your business, developed several new products and wish to capitalize on your success by selling the business. The bad news: your collective scientific skills are second to none, but none of you have any real idea of the process and issues related to the sale of a business.

The following is an overview, primarily from a seller’s perspective, of the process and some of the issues related to the sale of a Canadian-owned corporation. Although the culmination of the sale process will be the closing — or completion — of the transaction many weeks or months in the future, such a sale is a relatively complex process akin to the development and commercial exploitation of your own products. There are several themes that will reappear throughout:

Always be prepared.
Try to control the process.
Timing is critical — any deal will fall apart given enough time.
Always keep your eye on the ball — in this case, the closing of the transaction.
Objectives

Although your primary objective may be to exit the business with the greatest cash purchase price, there may be other objectives that you may wish to consider, such as retaining a portion of the equity of the ongoing business or ensuring that you and your colleagues continue to have position(s) in the business.

It is critical that your objectives are consistent or harmonized with those of your colleagues and are always communicated to your advisors.

Choosing Advisors

You may be wonderful scientists and engineers, and the skill set that is required in selling a business may require many of the same attributes — such as diligence, organization, hard work and persistence. However, there are other skills that are equally as important to the selling process — including marketing, sales and negotiating abilities — that you may not possess. Thus, it is always wise to consider interposing an intermediary, not only to shield you from constant direct contact with potential buyers, but also to provide the contacts, experience and negotiating skill to achieve the best possible deal.

If the transaction is large enough, you might consider the merger and acquisition (M&A) section of a large investment banking firm — particularly one that has experience in the biotech industry — or the comparable arm of a major accounting firm (such as KPMG LLP or Deloitte & Touche) or a specialized M&A boutique, some of which may have access to buyers outside Canada. For example, Goldsmith Agio Helms of Minneapolis, Minn. has had a long and successful history in selling small- to medium-sized businesses in the North American marketplace. These firms will be experienced in the process and therefore you will spend more time dealing with business issues — including price — rather than the process.

In addition, you will require smart and capable lawyers and accountants who have experience in dealing with transactional matters. A local lawyer or accountant might have been fine to get you where you are but may not have the depth of experience required to effect a complex sale when you finally decide to sell your business. Be careful not to be penny-wise and pound-foolish in selecting proper advisors. Experienced counsel and accountants will have higher hourly rates, but it is the total cost that you should be concerned with. In addition, experienced counsel and accountants should be prepared to give you estimates based on prior experience.

However, always remember that professionals, like everyone else, will fill the time given, and the longer it takes from the start of the process to the date of closing, the more the transaction is going to cost. In addition, smaller deals typically cost just as much as the larger deals and in many cases can even be more expensive since more effort is spent on dealing with individuals and their idiosyncrasies. Finally, if you are a picky person and ask your advisors to leave no stone unturned, the costs will rise accordingly.

Sale Process

There are a wide range of potential courses for determining potential buyers in your marketplace, including your competitors, existing investors in your own business and word-of-mouth. However, a properly organized, documented and handled sales initiative through an intermediary will often provide the best results.

If you anticipate significant buyer interest in the potential sale, a controlled auction can be a very effective way of not only eliciting a wider range of potential buyers, but also controlling the entire sale process. A typical controlled auction process would consist of the following:

The completion of seller’s due diligence and taking corrective action to prepare the business for sale (see below).
The determination of an appropriate structure for the sale, including the sale of the shares of the company (or all or substantially all of the assets of the company). This may involve personal tax or estate planning activities.
The preparation and dissemination of a short “teaser” document that will outline the nature of the business for sale and indicate a general outline of the process and timing.
The preparation of a properly drafted confidentiality agreement to be signed by each interested buyer.
The preparation and dissemination of a more comprehensive information memorandum concerning the company and its business, preferably accompanied by a draft form of definitive purchase agreement, prepared by the seller.
Entering into a letter of intent, setting forth the basic terms of the transaction, along with comments from the buyer on the form of a draft definitive purchase agreement.
The establishment of a data room to provide controlled access to company documents (due diligence).
The arrangement for controlled access to various key executives and managerial personnel.
Entering into a definitive purchase agreement following negotiation.
The pre-closing and closing taking place at some point following further due diligence and the execution of the definitive agreement.
Seller’s Due Diligence

It is essential that the company and the business be in proper order before entering into the sale process. In the context of a biotechnology company, this may require the following:

Since buyers typically prefer audited financial statements and are generally suspicious of unaudited management statements, it may be necessary to anticipate a sale a year or two in advance and arrange for audited financials.
As part of the company’s intellectual property (IP) policy, ensure that the crown jewels of the business — the products or processes — are properly protected through patents, trademarks and copyright(s) registrations.
In addition, ensure that all appropriate personnel of the company have entered into non-disclosure agreements (NDAs), which would confirm that all IP developed in the course of their employment/consulting arrangements are the property of the company, that any patents have been assigned to the company, “moral rights” are waived, confidential information will only be for the benefit of the company and not disclosed to, or used for the benefit of, any third party, etc.
If selling shares, ensure that the corporate records are up-to-date and complete, that all stock option or purchase plans are properly documented and that all share certificates have been issued and are held in safekeeping.
Try to regularize and document all other legal aspects of the business including commercialization and distribution arrangements, real property leases, equipment leases, banking arrangements, employee arrangements, etc.
Assets Versus Shares and Other Tax Issues

A critical part of any sale transaction is the tax analysis and planning, which should be considered as soon as practicable. Factors that should be considered from the seller’s perspective include:

Sellers generally prefer to sell shares since such a sale (i) most likely will give rise to capital gains (only half taxable), (ii) may permit an exemption of up to $500,000 of such gains for Canadian resident individual sellers if the company is a “Canadian-controlled private corporation,” and certain other conditions are met (iii) may permit the seller to reduce its taxable gain by declaring “safe income” dividends (see below), (iv) may permit the seller to reduce its gain if the seller’s tax cost of the shares (“outside basis”) is higher than the company’s tax cost of the assets (“inside basis”), and (v) may permit a seller the opportunity to claim a reserve for any portion of the sale price that is not due until a later year.
A corporate seller may be able to receive tax-free dividends before closing in the form of “safe income” dividends (i.e., from tax-paid retained earnings) or capital dividends. Such dividends will reduce the gain realized on the sale.
A share sale as contemplated herein will result in a “change of control” that triggers a year end for tax purposes, requiring the company to file a tax return (the purchase agreement may have to deal with the basis of filing such a return). Provisions of the Income Tax Act will impose restrictions on the use, after closing, of non-capital business losses (generally such losses may only be offset against income from such business and from similar businesses) and generally prohibit the use of capital losses and property losses after closing.
If the company has significant tax loss carry-forwards, the seller may want to consider selling assets to generate income or capital gains that can be sheltered against such losses. Elections are available to write up the tax cost of the assets of the corporation and use the losses to shelter any resulting gains.
Buyers, on the other hand, generally prefer to buy assets for reasons which include the opportunity to write off all or part of the purchase price (e.g., depreciable property, inventory, goodwill, prepaid expenses, etc.) and, equally important for non-tax reasons, to buy only selected assets and to pick and choose the liabilities, if any, that the buyer wishes to assume.
An asset sale may give rise to GST/retail sales tax/property tax issues that need to be considered.
There may be other potential tax issues for the seller depending on the specific transaction, including the treatment of payments under a deferred purchase price or earnout. If the consideration is to include shares of the purchaser, the transaction should be structured to take advantage of available tax deferrals or “rollovers.” In addition, if, for example, the “real” buyer is a publicly traded U.S. or foreign buyer and wishes to use its stock, in whole or in part, as consideration for the shares in the company, and the resident Canadian sellers wish to defer the capital gain that would otherwise arise from the sale (i.e., obtain a “rollover”), then the use of exchangeable shares to be issued by a Canadian corporate subsidiary or other affiliate of the foreign buyer (such shares being exchangeable into the publicly traded shares of the foreign buyer) might be considered. It has been reported that amendments will be made to the Income Tax Act to permit a rollover, under certain conditions, with respect to such share-for-share exchanges where the resident Canadian sellers directly receive the publicly traded shares of the foreign buyer.

Confidentiality Agreement

It is imperative that any prospective buyer enters into a well-drafted confidentiality agreement. The agreement should ensure, among other things, that all “confidential” information provided to the buyer, whether written or oral, and whether labelled as “confidential“ or “proprietary,” is covered. In addition, such agreements often deal with the non-solicitation of employees for a stipulated period of time (a so-called “non-piracy” provision).

Letters of Intent

A letter of intent (LOI, also referred to as a memorandum of understanding, heads of agreement or a term sheet), can serve a variety of purposes in the process of selling a company. It can memorialize the basic terms of any deal, provide sufficient evidence to obtain regulatory and other third party consents, provide guidance in the drafting of definitive documentation and, with binding provisions, deal with certain other matters.

Most modern letters of intent have a number of provisions that are non-binding (usually the “deal” terms, such as the commitment to buy/sell, the price, the terms of payment, major conditions, etc.) and certain provisions that are binding. The more common binding provisions would provide:

a period of exclusivity in dealing with a particular buyer (also called a “no-shop” period);
that each party shall bear its own expenses;
access for due diligence;
the rules for public announcements of any transaction;
an outside “drop dead” date to enter into a definitive purchase agreement;
possibly, break-up fees if the transaction does not proceed; and
confidentiality provisions (if a separate confidentiality agreement has not already been obtained).
However, please be warned that the case law is replete with examples of provisions of so-called letters of intent being held to be binding where one party did not intend to be so bound. In this context, please consider the following guidelines:

If some of the provisions are to be binding and some not, divide the letter of intent accordingly into two parts.
Use words like “proposal,” “intention,” “discussion points” or “points of preliminary consensus.”
Use words like “would” and “should” rather than “will” and “shall.”
Insert specific conditions within your control such as, “approval of Board of Directors and/or shareholders.”
Be very careful in contractually agreeing to negotiate in good faith.
Consider having the entire LOI as non-binding.
As a final suggestion, don’t negotiate the deal twice — once in the LOI and then in the definitive agreement. Usually a simple LOI serves the purpose of setting forth the basic terms of the deal and provides deal momentum. In addition, a well-drafted, non-binding LOI is exactly as stated (that is, “non-binding”) and therefore do not be surprised, for example, if the purchase price is reduced or other terms are changed following due diligence.

Definitive Agreement

The next stage in the sale will involve entering into a comprehensive agreement of purchase and sale, which deals with such matters as the purchase price, the mechanics of payment (including, possibly, post-closing net worth adjustments), comprehensive representations and warranties dealing with the seller and — more importantly — the target company, certain preclosing and closing covenants, the conditions of closing and provisions dealing with indemnities.

Rather than deal with the details of such provisions, please note the following non-exhaustive list of techniques that could be considered in protecting you as a seller under an agreement of purchase and sale:

Minimize the number and extent of representations and warranties.
Make copious use of “materiality” (with reference to the business and assets taken as a whole) and “knowledge” qualifications and, in the latter case, define “knowledge” to be the actual knowledge of particular individuals — usually senior officers of the company.
Use objective or factual representations and warranties (e.g., “the company has not received written notification of any breach of any of its material contracts in the past two years”) rather than subjective representations and warranties (e.g., “the company is not in breach, in any material respect, of any of its material contracts”) or the dreaded “full disclosure” warranty.
If selling shares, indemnify only the buyer and not the buyer and the company itself.
Limit the survival period of representations and warranties (e.g., one year following closing for most representations and warranties with longer periods for matters such as environmental liability of, say, three to five years following closing and taxes for, say, the relevant limitation period(s)).
Try to preclude a buyer from seeking damages or other remedy for breach if it can be shown that the buyer had knowledge of the breach prior to signing the agreement and/or prior to the closing of the transaction.
Exclude consequential, indirect and similar heads of damages and, even though loss of profits may not be consequential damages, try to lump all of these heads of damages together as exclusions.
In the indemnity provisions, provide not only for the rules applicable to making any claim (e.g., written notice, particulars, etc.) but also consider limits of liability on the aggregate claims that can be made. The U.S. practice of limiting total claims to a percentage of the purchase price has been creeping into Canada and it is now common to see a ceiling as low as 20 per cent of the purchase price as a limit on claims.
Consider inserting thresholds for making claims (or better still, actual losses incurred) as a deductible (e.g., $100,000 or one per cent of the purchase price) rather than a threshold or de minimus where claims go back to the first dollar.
Always expressly include provisions requiring the buyer to mitigate its damages and to offset any tax benefits, insurance or other amounts received by the buyer.
If the transaction is entirely domestic it probably is not advantageous to arbitrate any decision (arbitrators tend to “split the baby”). But if considering a cross-border transaction, consider using arbitration provisions particularly to avoid the potential of costly jury awards.
Try to provide that claims under the indemnity provisions (with appropriate qualifications and limitations) are the exclusive remedies of the buyer (i.e., no rescission or rectification of the agreement).
One final comment: in any transaction, the devil is in the detail, and time spent on the definitive agreements will always be worthwhile.
Due Diligence

The buyer will insist on comprehensive due diligence of the company and its business and assets, both before signing a letter of intent (usually as a basis for determining a purchase price) and entering into a purchase agreement and up to the time of closing. It is always better to anticipate such requests and it may be helpful to have a data room established within the company’s facilities or, better still, at a third party location such as the lawyers’ or accountants’ offices. This not only greatly facilitates control of access to the documentation but also avoids the unpleasantness of having various buyers interfering with the day-to-day operations of the business and possibly asking awkward questions of company employees. Also consider, if feasible, making documents available through a secure Internet data room.

In the biotech area, we are also seeing very sophisticated due diligence on products (testing, etc.) and “infringement” opinions.

Governmental Regulation and Third Party Consents

In many cases, sale of all of the shares of the company would be exempt from the takeover bid or other applicable provisions of relevant provincial securities legislation. For example, in Ontario, a proposed offer to buy all of the shares of the company will be exempt if the company is not a “reporting issuer” and the number of holders of shares is not more than 50 (exclusive of employees or former employees of the company or any affiliate).

If the transaction is large enough, there will be at least two additional, potential legislative requirements. In the event that the buyer is a non-Canadian (which would include the Canadian subsidiary of a foreign company), the Investment Canada Act would have to be considered. The threshold for review under that Act is very high for buyers controlled by investors in World Trade Organization countries, such that the transaction is only reviewable if the value of the assets of the business exceeds $223 million Cdn for 2003 ($150 million Cdn in constant 1992 dollars, adjusted annually).

In addition, pre-merger notification is required under the Competition Act (Canada) for certain larger transactions, namely those where the parties to the transaction and their affiliates have, in the aggregate, more than $400 million Cdn in gross assets or annual revenues from sales in, from or into Canada and the acquired business must have assets in Canada or annual gross revenues from sales in or from Canada of more than $50 million Cdn.

It should be also noted that irrespective of whether the transaction is notifiable, the substantive merger provisions of the Competition Act (Canada) apply, such that the Competition Tribunal may make an order with respect to a merger or proposed merger if it finds that the merger “prevents or lessens, or is likely to prevent or lessen, competition substantially” in a relevant market.

There may also be third party consents that are required in connection with a share transaction, including software licences, loan agreements, and other similar documents with “change of control” provisions. It will take time to obtain these consents and that is why, in most cases, a period of time is provided between the signing of a definitive purchase agreement and the closing of the transaction.

Closing

Immediately following the entering into of the definitive purchase agreement, it is extremely useful to prepare and circulate a comprehensive closing agenda. Not only will this document clarify all required closing steps and documents and the relevant responsibilities, but it also provides an excellent motivational device to focus on closing.

Transactions of any magnitude basically take two days to complete. It usually takes one day (the “messy day,” or preclosing) when documents are assembled, final documents and opinions settled and other matters of a similar nature are completed. This practice then makes for a very smooth closing the following day and leaves time to deal with unanticipated matters arising at closing.

The closing is the moment when share certificate(s) are exchanged for a cheque and when, in reality, tens if not hundreds of documents can be exchanged dealing with various matters including corporate authority, copies of documents, regulatory approvals, etc.

Although all M&A transactions are unique in some respects, the foregoing should provide a roadmap to the successful sale of your business. Good luck.

Richard E. Clark, B.Sc. (Chemical Eng.), B.Comm., MBA, LLB is senior partner at Stikeman Elliott LLP, Barristers & Solicitors (Toronto, ON). He may be contacted with questions at rclark@stikeman.com