A common question for entre­preneurs and owners of small, privately-held businesses is: What is my company worth? Although natural curiosity can raise this question almost any-time, there are three situations in which it is most relevant: when the company is raising capital; when the company is being sold; or when the princi­ple owner has passed away. My colleagues who practice trusts and estates law are most inter­ested in the last of these events, but as a capital markets and mergers and acquisitions attor­ney, I am involved only in the first two situations. What I have observed is that many smaller private enterprises fail to take fundamental actions before they try to raise capital or sell the business that would enhance the value of the business for potential investors or buyers. Some of these steps are much more costly to implement later in a company’s development. And many times they are imple­mented too close to the valuation event to have a meaningful

impact. This article briefly out-lines a few steps private companies should consider undertaking so that they realize maximize value, whether in connection with raising capital or a sale.

Management Depth

You Can Be Too Thin

An important factor in deter-mining a company’s value is management depth. For exam­ple, assume an entrepreneur runs a profitable smaller middle market company (“XYZ Co.”), with $21 million of annual rev­enue, and $1 million of pre-tax profit net of expenses, including the entrepreneur’s $1 million salary and the $850,000 in annual rent paid to a real estate venture controlled by the entre­preneur (which has an annual carry of only $400,000). Since its inception, XYZ Co. has never incurred a loss and has experienced fairly steady growth in sales and profits. The entrepreneur, who is in her early forties, has decided it is the right time to sell and to try her hand at a new venture.

When she tests the waters, she is extremely surprised to be offered an up-front payment that is less than half of what she believes to be the “true value” of the enterprise, with the remainder of the consideration to be paid in long-term payouts. Prospective buyers and bankers alike are unanimous in their reasoning: the owner “is” the business and the risk that she will not be there to transition to a more substantial manage­ment team is far too great to pay her the bulk of the purchase price upfront.

In this hypothetical, if the entrepreneur is willing to spend two or three additional years and to invest more money – assume a $500,000 net increase in salaries – to develop a deeper management team, she might well be able to negotiate a sale price at a significantly greater multiple and with most of the consideration paid upfront in cash. However, she still will have paid a price for not rec­ognizing the importance of management depth before test-

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ing the market the first time: two or three additional years of investment risk – risk that she could have avoided with a little more foresight. Arguably, her risk-adjusted return will be greater if she sells out earlier. She also will have alternative investment opportunities that may yield more during that time period.

Management Depth Doesn’t Equal Shorter Hours Although increasing manage­ment depth may increase the value of a business, it would be a mistake for an owner to con­clude that having added management depth, he or she can kick back, relax, and let the new team take charge. In one situation I observed, an owner retained an independent valuation firm to provide an indication of his company’s market value. He was told it was worth approximately $20 million, but would be signifi­cantly higher if he had a stronger management bench. He decided it would be better to wait, build up his company’s senior management, and then sell. To accomplish this, he promoted a number of people internally, made his head of sales the primary contact for the company’s major customers and designated his chief operations officer as the primary contact for all the company’s vendors. With these changes in place, he decided he could afford to cut back to working two and one-half days a week. Everything went fine until he re-started the sales process and his head of

sales and chief operating officer walked out the door with the business. After all the litigation concerning the non-competition agreements was settled, what had been a potential $20 million sale yielded only $400,000 to the owner after liquidation.

Material Agreements Confidentiality and Non-Competition Agreements

The mere existence, or lack of, confidentiality agreements and non-competition agreements – not only with key employees, but also across the spectrum of individuals and entities with whom a company has signifi­cant business dealings – can have a dramatic effect on a com­pany’s valuation. The importance

of these agreements is amplified for technology companies. The need for confidentiality agreements and non-competi­tion agreements in the employee-employer relationship is obvious, but a company should constantly evaluate their neces­sity for independent contractors, joint venture partners and customers. In fact, any business relationship that could enable a third party to damage the company’s competitive advantage could reasonably be covered by a confidentiality agreement and,

if warranted, a non-competition agreement. It also is important to note that the time to secure these agreements is at the start of the relationship. The failure to obtain a non-competition agreement from a chief technol­ogy officer of a software compa­ny prior to the attempted sale of the business might enable him or her to extract a payment if, as is likely, that becomes a closing condition to the sale of the business.

Assignment Provisions

The phrase “boilerplate” often is used to describe contract language that seems to be standard and without any real importance. However, when negotiating confidentiality

agreements and non-competi­tion agreements, it is important to take care that the scope and coverage of the agreement – including the “boilerplate” – are sufficient to meet the company’s needs in a variety of situations. Assignment clauses are a good example. I have seen situations in which a company that is testing the waters for a possible sale, required potential acquirers to enter into confidentiality agree­ments and, under the presumed protection of such agreements,

provided the potential acquirers with non-public information. To the company’s chagrin, the agreements failed to provide that the company’s rights under the confidentiality agreement could be assigned or transferred to any party acquiring the com­pany – thus calling into question whether a purchaser of the company’s assets would obtain the benefits of the agreements.

With an eye towards providing maximum flexibility in the context of a sale of a business, companies should seek to nego­tiate the most liberal assignment provisions, in their favor, in their material contracts. Having to get consents for “changes of control” and similar provisions sometimes leads to protracted negotiations and, in some cases, the need to make pay­ments for the consents.

Corporate Records

If a public company has com­plied with the securities laws by making relevant material infor­mation available to the public, one can get a good sense of its value by reviewing the compa­ny’s public filings. In valuing a private company, potential investors have no such publicly available base of information from which to start. Therefore, a private company that main­tains good corporate records and documentation will see the benefit at times when it counts the most. Each hole in a company’s corporate records – missing attachments to material con-tracts, missing tax schedules, etc. – is likely to reduce value in the minds of investors or

purchasers because of the inherent risk that the missing document might be problematic.

As time goes by, and as a pri­vate company grows larger, the cost of rectifying a situation in which the corporate records are incomplete increases exponen­tially, not linearly. However, it is work that probably will be necessary if an owner is to make the appropriate represen­tations and warranties and the company’s counsel is to give the legal opinions required in most sale and investment transactions.

How much added expense is involved? If a small, privately-held middle-market company, only a few years old, has failed to keep accurate records, then in a sale of that company in a fairly uncomplicated stock transaction, the cost of “corpo­rate clean-up” – i.e., creating stock ledgers, tracing whether options were granted or not, confirming actual ownership against S-Corp. tax returns, etc. – could easily represent a signifi­cant portion of the company’s legal bill. It is an unnecessary expense if, from the outset, a company maintains good corpo­rate records and documentation.

Corporate Governance

Independent Directors and Improved Disclosure

The enactment of the Sarbanes-Oxley Act of 2002 (the “Act”) led to the adoption of sweeping rules and regulations aimed at improving corporate governance and increasing disclosure. Although the Act and the rules and regulations promulgated thereunder apply to public com­panies, a private company may benefit from adhering to some of the requirements mandated by the Act and those rules and regulations. Although a private company may view audit, com­pliance, compensation and simi­lar board committees as impractical or unnecessary, outside investors increasingly impute added value to a company with independent directors and procedures to provide better disclosure, on the theory that independent directors usually bring added value to a board and that if a company’s internal and external disclosure proce­dures are more developed and closely adhered to, it is less likely that hidden problems, which could affect value, exist. Faced with an investment opportunity where existing corporate gover­nance practices are weak, venture capitalist and other investors not only will discount valuations due to the added risk involved, but may also factor in additional costs needed to improve the governance practices after their investment is made.

Farther down the road, in the context of an initial public offering, private companies with a history of good corporate

Lab To Wall St r e    e  t

governance and disclosure may command better pricing. With the heightened sensitivity regarding internal controls and accurate disclosure, many rep­utable investment banks will not bring a company public until they are comfortable that the company has the means to deal with the rigorous burdens of public disclosure.

The Business Judgment Rule

Increasingly, directors and officers of closely held companies find their decisions subject to legal challenge in shareholder actions. However, as a general matter, officers and directors are protected from liability under the so-called business judgment rule provided (1) there was both corporate and management authority for their action, and (2) they acted with “due care,” and in the good faith belief that they were acting in the best interests of the company. The business judgment rule applies regardless of whether a compa­ny is public or private. The potential liability of officers and directors, for their actions or failure to act, provides additional incentive for a private company to adopt and enforce good cor­porate governance procedures. To gain the protections of the business judgment rule, directors or officers must demonstrate that in making the decision or carry­ing out the action in question, they exercised due care and complied with their duty of loyalty. Corporate records can be excellent evidence to demon­strate this, if they confirm that the directors or officers informed

themselves of the relevant facts, carefully considered the alterna­tives and their implications, acted in what they believed to be the best interests of the company, and there was no conflict of interest involved in their decision.

It is important to note that standards of “due care” have evolved over time and that shareholder-plaintiffs may claim that the adoption of the Act and the rules and regulations promulgated thereunder, evidences a new standard for “corporate best practices” – even for officers and direc­tors of private companies.

Intellectual Property Portfolios

It is rare to find a technology company with weak protection surrounding its intellectual property, particularly its patents, but when you do, you usually are looking at a company that has squandered substantial value. Diligent patent prosecu­tions and other steps to protect intellectual property are not inexpensive, but are a worth-while investment. And, unlike recreating a stock ledge to trace ownership interests, many IP deficiencies cannot be fixed and will cause a permanent reduc­tion in value.

Audited Statements

Is it worth it for a private com­pany to pay for audited finan­cial statements? Under the federal securities laws, three years of audited financial state­ments generally are required for a company to go public. So pri‑

vate companies that intend to have an initial public offering eventually should consider whether now is the time to begin having their financial statements audited. Invariably, it is less expensive to have cur-rent audits conducted than to go back and have prior years audit-ed. But even private companies that are not considering an IPO may benefit from having audited financial statements, since both potential acquirers and investors take more comfort in audited than unaudited finan­cial statements and, in many cases, will not close a transac­tion until an audit is completed. In today’s environment, private companies with audited finan­cials often obtain better pricing across their entire capital struc­ture, with even senior-debt lenders offering better pricing to such companies.

Conclusion

Many of the steps and practices described in this article repre­sent common sense approaches to creating and protecting value that can be realized in a capital raising or sale situation. All of them involve some incremental cost, and yet all of them are like­ly to more than repay the own­ers of private companies, by enabling higher valuations when the time for an outside investment or a sale of the busi­ness arrives.

Christopher Doyle is a partner in the Securities Practice Group of Stroock & Stroock & Lavan, LLP.