Small and medium-sized enterprises (SMEs) undergoing business succession pose significant challenges for M&A advisors, particularly when it comes to determining the key fundamentals of the business. This is especially evident in the context of a business sale mandate. Even in 2021, medium-sized companies in Germany often lack a formal business plan, unlike large companies in the industrial or retail sectors. This is true not only for SMEs but also for mid-cap companies.
Transparency of Company Data
When preparing for a company sale, one of the first tasks for the M&A advisor is to gain an overview of the existing fundamentals of the target company. With a view to the due diligence that the acquirer will conduct later, it makes sense to first simulate a due diligence process for the seller and determine whether the essential foundations for tax, legal, financial, environmental, and commercial due diligence are in place.
For the M&A advisor of a medium-sized company that is up for sale, it is advisable—even if it seems overly extensive at first glance—to strictly follow the relevant templates for conducting due diligence, just as would be done for a large international company.
This is because, while a smaller medium-sized company will not exhibit all the characteristics of a large corporate group, it nevertheless often raises issues such as an equity interest in another company, the existence of a sales subsidiary abroad, resulting transfer pricing issues, employees posted abroad, or long-term raw material contracts.
Many small and medium-sized enterprises are also characterized by the fact that, due to their high level of innovation, they hold a large number of industrial property rights. This then raises questions regarding patent protection or employee invention rights. Furthermore, the complexities of existing hardware and software solutions in small and medium-sized enterprises are often no less complex than those in large industrial companies.
The diverse communication channels, cloud solutions, apps, and the like always raise the question of who owns them or on what basis they may be used and under what conditions. Even though these technological tools are subject to constant change, the basis for determining who owns the rights or who is permitted to use them is always civil law—specifically, the German Civil Code (BGB) and its ancillary laws, as well as international contractual frameworks and general terms and conditions.
It is precisely this entire area of a company—which usually falls under the purview of IT and legal departments—that is still often neglected in small and medium-sized enterprises and rarely mapped out clearly. As a result, consultants are called upon—particularly in this area—to first identify all existing rights and determine the resulting economic implications.
Time and again, legal and economic uncertainties regarding whether all rights to a piece of software are in place prove to be deal-breakers, particularly in cases where these rights play a central role in, for example, the products of the company being sold. Therefore, when advising a medium-sized company in the early stages of a sale, it is particularly important to present these fundamentals transparently so that a potential buyer is not unsettled when examining this issue.
As a rule, medium-sized companies do not have formal business planning in place. These companies are managed based on monthly financial reports and the owners’ assessment of the order backlog and cash balance. Undoubtedly, this works well in many cases, as the owners have grown alongside their companies, which they usually founded themselves. However, precisely when such companies reach the threshold of becoming industrial enterprises or expand their business internationally, they reach their limits without proper business planning.
Since medium-sized companies are often sold to larger companies—usually those with corporate group structures—or to investment funds, the lack of business planning proves to be a major shortcoming. The medium-sized business owner then feels overwhelmed by the sudden need to develop a business plan at short notice for the sale process. The same is often true for their tax advisor, who may lack experience in this area; consequently, it can be an important task for the advisor engaged for the sale process to initiate such business planning early on, before the prospective buyer even asks for it.
After all, it is reassuring for a prospective buyer to know that such a plan exists. Having to draft this plan only during ongoing sales negotiations unnecessarily complicates the sales process and, in the worst-case scenario, can even lead to the breakdown of sales negotiations if the prospective buyer realizes that the seller is clearly overwhelmed by the task of preparing a coherent business plan.
It is therefore important for the advisor to the small-to-medium-sized business owner to make it clear from the outset that such business planning is not merely academic in nature, but is also of great significance to the prospective buyer when it comes to determining the purchase price.
Due Diligence and Its Legal Implications
The legal significance of due diligence conducted as part of a business sale must not be overlooked. For the seller, it initially represents a considerable burden, as gathering and preparing all the data for the individual due diligence topics can be very extensive and thus labor-intensive.
However, the effort is worthwhile for the seller, because by making the company’s essential data and fundamentals transparent—whether in the areas of contracts, accounting, production, or IT—the seller lays the groundwork for exculpation under civil law. In short, in short, whatever information regarding the company is disclosed to the buyer prior to the conclusion of the purchase agreement—including any resulting weaknesses of the company—cannot be used by the buyer against the seller after the purchase agreement is concluded to justify a reduction in the purchase price or withdrawal from the contract.
For the buyer, however, due diligence is of great importance in order to mitigate or eliminate the risks of the acquisition. It is intended to enable the buyer to avoid having to “buy a pig in a poke.”
Early Preparation of Due Diligence Data
The advisor to a medium-sized company that is to be sold should therefore explain to the seller as early as possible how due diligence is conducted, specifically which data needs to be prepared and what consequences—both legal and economic—may arise for the seller if they do not take all necessary steps at this stage to facilitate a professional due diligence process.
This is because even if the sale of the company takes place later, the buyer—if they were only able to conduct an inadequate due diligence—will seek to protect themselves through numerous warranties, which can then lead to incalculable consequences for the seller after the purchase agreement is concluded. Particularly with regard to the contractual structuring of earn-out clauses, it is especially important for the seller to have made all material data regarding the company transparent by a specific cutoff date, so that the buyer cannot, due to deficiencies in the disclosure of material data, reduce or entirely exclude a subsequent partial payment of the purchase price.
All of this highlights just how complex a business acquisition is and why due diligence must be regarded as the cornerstone of the sale. Therefore, it is particularly important for M&A advisors to small and medium-sized enterprises—even if this is an unfamiliar task for the SME entrepreneur—to work with the entrepreneur to present the company up for sale as transparently as possible and to use business planning to illustrate the company’s potential future success.
However, this should under no circumstances result in the seller guaranteeing a specific level of business success in the sense of a legal guarantee. The business plan is intended only to highlight opportunities that will then motivate the buyer to pay the purchase price the seller has in mind.
Experience shows that it is a great help to the seller of a medium-sized company when the consultant presents the cloud-based due diligence workspace, so that the seller can see which components they are required to provide. The advisor must weigh whether to choose a cloud provider whose data is stored in Europe or the U.S. This decision must be made on a case-by-case basis in consultation with the buyer, as it concerns the issue of data security.
Since gathering data can be more difficult when selling a medium-sized company than in a large corporation, the fee for this phase should not be performance-based—as might be the case for the actual sale—but rather this part of the sale should be agreed upon as a preparatory measure with a fixed fee. Whether this fee should then be credited against the variable portion of the total fee is left to the consultant’s negotiating skills. Furthermore, this portion of the fee should be paid on a monthly basis, as it involves ongoing consulting services to prepare for the sale.
Finally, with regard to the sale process, the question arises as to what extent the advisor—who takes the lead in preparing the due diligence and populating the data room—is legally responsible for errors in the data or missing documents and is thus liable. It is highly unlikely that the seller’s advisor would be directly liable to the seller; rather, the advisor acts as the seller’s agent, meaning the seller is liable to the buyer. However, should the seller be held liable for errors, it will likely attempt to hold its advisor liable.
Advising medium-sized companies during the sale process is multifaceted and challenging, yet also lucrative. That is why it is important for a medium-sized company that is to be sold to select the right advisor.
It is entirely legitimate to ask the advisor for references to get an idea of whether they possess the necessary expertise. Legal and tax advisors, auditors, and M&A advisors are usually required to address the various issues involved.
Since the typical owner of a medium-sized company usually sells a business only once in a lifetime, it is important to begin planning such a sale early on and to seek out the appropriate advisors.
For many years, Von Fürstenberg Seminare has been training tax advisors, certified public accountants, and attorneys to become specialists in business succession, with the aim of familiarizing them with the specific issues involved in selling a business.
