Selling Your Company or Raising Capital: Preparing for Capitalization Review

Michael C. Knowles, – Consulting

In a previous Frank, Rimerman + Co. LLP article dated April 28, 2010, we outlined how the due diligence process can give a buyer the time and—for an unprepared seller—the opportunity to renegotiate key deal terms such as purchase price, timing of payments, indemnification, representations and warranties, and others. On June 4, 2010, we presented an article discussing how a company’s Intellectual Property can affect due diligence. In this article, we examine due diligence considerations related to a company’s equity capitalization.

Once a Letter of Intent is signed, sellers should undertake to close their transaction as quickly as possible. Said another way: Time is the ally of no deal.

Your company’s capitalization—that is, the number and type of shares of stock your company has issued (including common, preferred, options and warrants) and who owns them—is an important object of any due diligence review. Although issues involving a seller’s “cap table” typically do not impact valuation or major deal terms, questions involving capital transactions frequently arise during a transaction and can require time to resolve.

When a company is sold, each equity stakeholder possesses economic rights and preferences that must be satisfied. These may include preemptive and price protection rights, dividend accruals and participation calculations, authorization entitlements and others. Computing net distributable funds, fully diluted ownership positions and related amounts owing to lenders and each class of equity holder can be complex, especially if the company’s capitalization includes multiple lenders or multiple series of preferred stock. Before due diligence begins, company management should prepare a pro forma use of proceeds to identify and resolve potential issues and clarify outcomes with stakeholders in advance of closing.

Other important equity stakeholders include the company’s option and warrant holders who frequently are key employees or partners of the company. In today’s environment, buyers are especially focused on retaining key employees and fostering good relationships following a transaction. It is important that option and warrant holders receive accurate allocations of value in the transaction.

In addition, board authorizations and minutes that document board decisions made in connection with financing activities need to be up-to-date and accurate as they will be reviewed as part of buyer due diligence. It is not unusual to find that these items and others—such as required shareholder approvals—are not current or properly documented. Buyers are rightfully sensitive to these issues as shareholder discontent and even litigation can result from not satisfying and documenting all shareholder rights.

These tips are sound advice for any seller, but each company should conduct a pre-transaction due diligence risk assessment that is unique to its particular circumstances. Frank, Rimerman + Co. LLP offers Transaction Readiness Services that are tailored to your company’s needs. Our unique team—with expertise in investment banking and transactional, valuation, tax, and accounting skills—provides a highly effective and efficient risk assessment to help you prepare for due diligence. Our Transaction Readiness team can provide you with an extraordinary return on your investment by helping you protect the key terms in a sale or financing transaction.

To discuss your company’s pre-transaction needs, please contact Mike Knowles in our Transaction Readiness group at [email protected].