[This article is part 3 of an 8-part series covering the key elements involved in the sale of IP-based and professional services businesses.]

Introduction

As mentioned in a prior article in this series, although every business sale is unique, most transactions typically involve similar elements and follow a similar path.  Before the owners of a Knowledge-Based Enterprise (“KBE”) can seriously consider a purchase offer, it is critical that they first conduct some internal investigation and “housekeeping” so that they can maximize their sale value and minimize any obstacles to a successful transaction.

The purpose of this article is to discuss what a pre-sale review is, the reasons a pre-sale review is important, and several common areas that KBEs should address as part of their pre-sale review.

What is a Pre-Sale Review?

A pre-sale review is essentially a “dress rehearsal” for the due diligence requests that will come from the purchaser later in the transaction process.

Although each review will vary somewhat depending on the KBE’s structure and operations, a typical Pre-Sale review for a KBE will involve: gathering a list of assets and determining their value, reviewing company documents and records, gathering financial records, preparing an inventory of intellectual property (IP), and reviewing the KBE’s key contracts.  In addition, the KBE should identify any potential liabilities or other issues and should address them prior to the sale.

A pre-sale review may be conducted solely by the KBE, but in most cases will also involve the assistance of third parties such as the KBE’s selling broker (if any), attorneys, and a CPA firm.

Why is a Pre-Sale Review Important? 

A KBE internal pre-sale-Sale review is important for a number of reasons, such as:

• The process of gathering information about the KBE’s assets and liabilities will provide a true picture of the value of the enterprise, so that the KBE will know a reasonable purchase offer when it comes. 

• For many KBEs who are run by entrepreneurial founders more focused on building the enterprise than buttoning-down corporate procedures and other formalities, a pre-sale review will identify legal gaps and other oversights so that they can be remedied.

• Purchasers of KBEs place significant value on intellectual property (IP) registrations.  As such, the intrinsic and implied value such registrations can create for a KBE will positively affect the sale price.  In conducting the pre-sale review, the KBE may be able to identify unregistered IP assets and take action to enhance its legal rights by filing for patent, trademark, and/or copyright registration applications in the US and elsewhere.

• A pre-sale review can identify potential impediments that can derail – or significantly devalue - a sale transaction. This could include the existence of liens against assets, cloudy ownership of IP, potential IP infringement claims, pending lawsuits or other potential disputes, and other situations that can make potential purchasers very nervous.  Identifying these issues early will allow the KBE additional time to get them resolved.

What are the Elements of a Pre-Sale Review?

Even though the specific elements of a KBE’s pre-sale review will depend on the KBE, itself. At a minimum, the KBE should gather information relating to its financial records, corporate documents, IP, key contracts, and any liabilities.

• Financial Records

  Because a purchaser will want a thorough understanding of a target company’s financial situation, financial records are an important part of any proposed business sale transaction, including those involving KBEs.  For early-stage companies, of course, these records will have less significance than for KBEs that have been operating for some time. But, a purchaser will want to see records relating to the capital of the company, operating expenses, debts owed, and taxes paid.

  Common financial records requested by a potential purchaser will include profit and loss reports, balance sheets, copies of loan agreements and promissory notes, as well as several years of tax returns (where applicable).  In addition, the KBE should be prepared to provide an inventory of all real and personal property, equipment, IP, vehicles, product inventory, and all other assets.

• Corporate Records

  The entity documents and corporate records of the KBE will be important to a purchaser, and must be complete and in order, especially where the sale relates to the stock of the KBE.  Regardless of the type of transaction, however, purchasers need to ensure the parties to the transaction are properly empowered by the KBE to enter into and consummate the deal.  Moreover, a purchaser must feel confident that there are no potential issues relating to KBE ownership or legal authority that could threaten the purchaser in the future.

  As such, a purchaser will likely request copies of all corporate documents from the KBE such as the certificate of formation/articles of incorporation (any amendments), board and shareholder meeting records and written consents, records of stock issuances and transfers, all state and local registrations and filings, and other documents related to the formation and operation of the KBE.

• Intellectual Property (“IP”)

For a KBE, having comprehensive knowledge of its IP assets is critical to understanding its overall value. Conducting a pre-sale IP review also permits the KBE to clean house and ensure that all registrations, licenses and assignments are current, properly executed and recorded – which can help avoid problems that might impede a smooth closing.

Thus, as part of the pre-sale review, the KBE must compile a full and accurate inventory of all IP assets (an “IP Asset Inventory”), which is comprised of both public and non-public IP assets.  

Much information in regards to pending and registered patents, trademarks, copyrights and domains is publicly available via the U.S. Patent and Trademark Office (USPTO) and the U.S. Copyright Office, as well as foreign registries and databases, social media pages, and other online resources.  In addition to registration and ownership information, these sources often contain details regarding the IP assets such as prosecution history, chain of title, and security interests.

Therefore, the public portion of the IP Asset Inventory may include:

·      Published patent applications

·      Patents

·      Trademark applications and registrations (state, USPTO, and/or international)

·      Trade names

·      Advertisements, newsletter and similar public communications

·      Copyrights registered with US Copyright Office 

·      Domain URLs 

·      Social media accounts

In addition to these public IP assets, a KBE will typically own a number of non-public IP Assets, such as:

·     Non-published patent applications and related materials such as patentability or prior art searches;

·     Unfiled or unregistered trademarks and related materials such as clearance searches;

·     Trade secrets and confidential business information; 

·     Licenses and assignments relating to the IP assets; 

·      Employee manuals and training materials; and

·     Letters and other communications relating to litigation, claims of infringement, title disputes, or other adverse action related to the IP assets.  

After compiling the IP Asset Inventory, the KBE can more fully evaluate the risks and benefits associated with its IP assets.  Although each situation is unique, an IP Asset Inventory evaluation should involve the following steps:

1.    Review the IP Asset Inventory to determine the KBE’s rights with respect to each of those IP assets (e.g., owner, co-owner, license, etc.). 

2.    Review any active litigation, settlements, coexistence/consent agreements, assignments, and any other agreements affecting the KBE’s rights in the IP assets.

3.    Ensure that the IP is enforceable, and registrations are current, and note any expirations dates.

4.    Assess the value of the IP as it relates to current operations and future expansion of the business.

• Key Contracts

Key contracts include those between the KBE and its employees and contractors, vendors, clients, leases, lenders, and shareholders.  These contracts represent both assets and obligations for the KBE, and as such a purchaser will want to review them.  

For a KBE, especially one in which the services or IP created by key employees represents a great deal of value to the company, the employment agreements with those key employees will be important to the purchaser.  

In addition, many contracts have provisions that are triggered by a company sale or “change in control”, and as such may require the KBE to obtain prior consent from the contracting parties before consummating the sale.

• Liabilities

 A KBE’s liabilities can include any number of issues that present risk to a potential purchaser, such as security interests against assets or equity, loans owed or guaranteed by the KBE or its owners, leases, mortgages, installment loans on vehicles or equipment, and other obligations that are associated with the KBE and/or its assets.  These liens or obligations will impugn the value of the KBE’s assets, and as such the KBE must be aware of all such liabilities so that the KBE can better estimate its net value.

In addition, the KBE may be aware of a potential dispute related to a current or former partner, vendor, employee, or contractor.  Or perhaps a third party may be making a claim that the KBE is infringing on its IP rights. These current and potential disputes represent risks to a potential purchaser that, in some cases, could far exceed the value of the transaction itself.

Once liabilities are identified, the KBE should take action as soon as possible to resolve them.  Or, if they cannot be resolved quickly, the KBE should disclose them to the purchaser and determine if the liability can be resolved at closing, will transfer to the purchaser, or will stay with the KBE after the closing of the sale.

In virtually all instances, disclosing a liability or potential liability early in the sale process will be viewed more favorably by a purchaser than one that is discovered later.

Conclusion

As discussed above, a pre-sale review is important for KBEs to truly understand their value, and to identify and hopefully resolve any impediments to a sale.

About the Author:

Jim Chester is a 20+ year business and technology attorney, professor, and entrepreneur.  He is a recognized authority in buying and selling technology businesses, global technology transactions, and providing strategic legal counsel for innovators and industry disruptors.  For more on Jim, visit here. He may be reached at jim.chester@klemchuk.com.

To view the previous articles in this 8-part series:

1 - Transferring Intangible Assets: Playbook for Buying & Selling Knowledge-Based Enterprises

2 - Transferring Intangible Assets: Playbook for Selling a Knowledge-Based Business - Overview of the Process

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