Preparing for a sale process
Getting your house in order
The key to moving forward efficiently to completion of a sale is having your house in order before you begin.
Here are some key issues to get ahead of:
Your management team and professional advisors
The quality of the management team is crucial and the buyer will, to a great extent, see the transaction as an investment in the team staying on, so you will need to choose your team carefully from the start. You'll need to ensure that, in addition to all-round strength, the individual members of the team have the different capabilities and attributes required in the key business areas and that each justifies their inclusion on merit.
Getting the right management team on board is crucial, but so is making sure they are rewarded, motivated and retained. Their remuneration and incentive structure, whether options, equity, bonuses, etc., should be carefully considered. Equally important is making sure the business is protected with appropriate service contracts for key management, including provisions to prevent management competing if they leave the business.
Choosing the right professional advisors (including accountants, corporate finance advisors, W&I brokers, etc.) is also key to the success of a transaction. Management might need their own advisors. We can help you in getting the right advisors in place.
Protecting the business
During the sales process, the buyer will want to learn as much as possible about you, your team, the company, its products, and your business plan (and perhaps the wider market). As part of this "due diligence", a buyer will require those "in the know", usually the management team, to disclose information so that they can make an informed assessment of the value and potential of the company. Legal due diligence will form only a part of this exercise. The financial and tax due diligence will be also key and there will also typically (depending on the nature of your business) be commercial, IP, insurance, technology and ESG due diligence exercises undertaken at the same time. Problems, or even potential problems, could lead to a reduction in the value of your business or even the transaction going off the rails completely.
The disclosure process can be a difficult, stressful, and time-consuming exercise, but you can avoid a lot of headaches if you and your team are prepared for it and problems are dealt with in advance. One of the best ways to prepare is for your own lawyers to undertake due diligence before the buyer (a process called "vendor due diligence") so that issues can be identified and ironed out where possible and otherwise presented in the most favourable light to the buyer. Even if the sale does not proceed, this can be helpful to the business going forward.
At the same time, you also need to give sufficient time to running the business. It's important that performance continues to be in line with expectations during the sales process to ensure you receive the best possible valuation. Having the right advisors on board, who can help take things relating to the sale preparations off your plate, is important to ensure you can balance your time appropriately.
Areas to focus on to smooth the process of the transaction include:
Commercial relationships
Formally documenting the terms of key commercial relationships, such as those with suppliers, customers, agents, and distributors, will give potential buyers clarity and confidence in what they are investing in and underpin the business plan. Having complete and signed copies of those terms is important and ideally these would be prepared or reviewed by the company's lawyers.
Key contracts
You should review and appraise the contractual basis of strategically important financial commitments, supplier arrangements, and revenue generating relationships (e.g., property and equipment leases and customer contracts) so as to understand the degree of flexibility available to change strategy or manage costs, the reliability of revenue streams, and the effect the transaction may have. In particular, you should check if these contracts can be terminated or amended, require notification, or permit your counterparty a right of first offer or refusal if a buyer takes control of the company (a "change of control" clause). If there is a change of control clause, this may require careful handling depending on the counterparty and importance of the contract. Understanding what's out there and considering how best to deal with it before the buyer unearths it can help to avoid delay and disruption.
Intellectual property ("IP"), know-how, trade secrets and brands
Putting in place measures to manage and protect these assets from infringement or onward disclosure is essential. Buyers will want certainty that the company either owns or has the right to use any IP relevant to the business and will expect a company to be able to articulate clearly:
- who was involved in the development of your IP and the contractual conditions under which it was developed. Defective IP ownership provisions almost always need fixing before closing a sale, so undertaking a review in advance will help smooth the process (and avoid a situation where the deal is being held up or jeopardised by one or two missing signatures from lost or intransigent former employees);
- what open source software ("OSS") or copyleft components are contained in, distributed with, or used in the development of your IP and the terms governing their use. Certain OSS licences require, as a condition of use, that changes to the code are made available free of charge for use by others in a collaborative manner. Increasingly buyers are using "Black Duck scans" to identify OSS in software code, which often means a remediation process is needed. A comprehensive register of all OSS used by the business should be kept; and
- how the company manages infringement risk. In particular, has the company properly registered all of its registrable IP (trademarks, patents, design rights) and does it have in place a process for monitoring, identifying and resolving possible infringements? Where possible IP infringement has been identified, this should be adequately resolved by the business ahead of any sale. For unregistrable IP (e.g., trade secrets), can the company show appropriate procedures to prevent its dissemination?
Disputes
Actual and potential disputes and investigations (whether litigation, arbitration, or regulatory investigation/intervention) should be monitored, assessed, and managed to minimise their impact on the value of the business. Whilst you might not be able to avoid or resolve a dispute, it's important to conduct a proper assessment of relevant risks, and to maintain clear records of decision-making processes. Showing the risks have been properly considered and addressed and being able to explain and evidence the current position, and that advice has been sought where appropriate, will be important to getting a buyer comfortable. You should also consider key compliance related risks in relation to the "failure to prevent" offences (i.e., in relation to bribery, tax evasion and economic crime) and that adequate/reasonable procedures are in place.
Employment
You should maintain good employee records, such as formally documenting employment and service contracts and regularly updating the company's policies and employee handbook.
Options
As a crucial starting point when it comes to the German tax implication of equity incentive programs for employees, a fundamental differentiation has to be made between genuine shares and stock options.
- While a beneficiary receiving shares may benefit from preferential capital gains taxation schemes under German tax law (flat tax, partial income method or capital gains exemption), the recipient of options that are not exchange traded (which can only be the case for listed companies) are subject to full income taxation (subject to certain limited relief rules) upon exercise of the option. In other words, neither the granting nor the vesting of such options qualifies as a taxable event for German tax purposes.
- As a consequence, the income taxation of options cannot be accelerated but should only materialize when exercising the option. If the exercise of the option occurs concurrently with (or close to) an exit, the capital gains realized as a result of the exit do not benefit from any preferential taxation scheme.
- A transfer of genuine shares (rather than options) is often not intended under an existing incentive program.
In the following we would like to briefly highlight some of the wage tax implications arising from an option program at the level of a target limited liability company (GmbH) in its capacity as employer of the German tax resident beneficiaries:
- Assuming that a strike price per share falls short of the prevailing fair market value of a share upon exercise of the option, the target GmbH as employer of the beneficiary will have to comply with certain requirements under German tax law.
- The delta between the fair market value of a share and the strike price qualifies as part of the total compensation received by the beneficiary and is subject to German wage tax.
- In the first place, the target GmbH will have to deduct the amount of wage tax on the delta (and social security contributions, if any) from any cash salary payable to the relevant beneficiary and remit the wage tax amount to the tax office in charge.
- Should the cash salary of the beneficiary not be sufficient to cover for the wage tax amount, the target GmbH will have to claim the required wage tax amount in cash from the beneficiary.
- If the wage tax amount cannot be fully recovered from the beneficiary, the target GmbH will have to notify the exercise of the option and transfer of the shares to its tax office in order to be released from any secondary liabilities for wage tax.
- If the target GmbH fails to give notification to the tax office, it will be exposed to a secondary liability for any wage tax to be imposed on the beneficiary.
- The aforementioned procedure applies irrespective of whether, prior to maturity, the options will be held by the beneficiary as an individual or through a vehicle controlled by the beneficiary.
- However, in terms of claiming the wage tax amount from the beneficiary to avoid any secondary liability, it is typically the more prudent approach to grant the options to the beneficiary (rather than to a vehicle) to ensure that the beneficiary as direct owner of the shares and, hence, recipient of exit proceeds will be able to cover for the wage tax amount in cash to be claimed by the target GmbH.
Please note that the afore-mentioned treatment does not apply to a holder of shares or stock options who has received such shares/options as consideration under an M&A transaction instead of a full purchase price payment in cash. In such scenario, the holder will be taxed on the capital gain realized under the M&A transaction and any income or capital gains generated from the shares/options going forward should not be subject anymore to wage tax but qualify as investment income to which certain tax benefits can apply.