Photo of Cameron MacCarthyBy Cameron MacCarthyJuly 13 2015
Business Law

Are You Ready? Preparing Your Business for Strategic Alternatives

As depressed oil prices persist and new domestic and international uncertainties mire an already battered energy sector, many businesses are being forced to evaluate strategic alternatives and develop contingency plans.  

Should oil prices not rebound in the next six to nine months, or if regulatory changes fundamentally affect the viability of previously profitable business models, many businesses may need to refocus, restructure and recapitalize in order to remain competitive, profitable or viable.

High volatility and market uncertainty has perpetuated the natural tendency of businesses to focus on core competencies, often at the expense of long-term market and strategic factors.  However, strategic and financial buyers and investors are increasingly evaluating the durability of potential investments rather than focusing chiefly on profitability-based metrics.  This shift makes it important for potential targets to ensure that they have a clear understanding of their business model and ensure that it is structured to support future investment.

This blog post discusses of some issues and topics that decision makers of potential targets should consider when evaluating strategic alternatives.

Understanding Your Business

One of the greatest challenges for businesses is gaining an audience with strategic buyers and institutional investors.  In current markets, management teams who cannot speak intelligently about their business, the market in which it operates and medium term growth opportunities will experience significant difficulties getting past the initial screening process.

A clear understanding of the competitive advantages and durability of a business is critical for attracting and securing investment.  Recent volatility has many investors questioning the predictive value of historic profitability metrics and instead focusing on balance sheet and market share based factors when evaluating a potential target.  To this end, we are aware that fundamental changes in global energy markets and regulatory uncertainty will likely result in a period of long-term consolidation.  In response, potential targets should focus on developing a concise and realistic narrative that addresses why their business will survive and grow its market share in a consolidated market and why their competitors will not be able to attain the same success.

As a starting point, potential targets should understand the size of the market in which they operate and how their products or services add value in the product chain.  For instance, does the product or service enable clients to reduce costs or enhance productivity in a manner not attainable through the use of competing technologies?  If so, these savings or gains should be fully quantified so as to facilitate an understanding of the total economic impact of the product or service.  When evaluating the nature of the market, it is important to be able to articulate how the market has changed and is being impacted by current economic conditions and the future impact of continued volatility and/or regulatory changes.

In this context, potential targets need to evaluate what steps are or should be taken to protect and leverage this competitive advantage. In technology intensive sectors, businesses need to develop an intellectual property strategy that includes robust contractual protections for intellectual property and trade secrets, which incorporates an active monitoring system to detect infringements of these rights.  To the extent that a business’ technologies are not being fully utilized, potential targets should be exploring opportunities to license patents so as to maximize their productivity and value.  Ultimately, the value of any intellectual property held by a business is only valuable if it can be protected and applied to a productive purpose.

Similarly, a clear understanding of and ability to communicate the economies associated with a product or service is critical for developing a credible narrative on how the business has grown its market share and how it intends to continue do so in depressed markets.  For energy sector participants, this should include a fulsome understanding of the non-energy sector applications of particular products or services.  Understanding how a product or service can be cross-leveraged into new markets is increasingly being viewed by investors as a hedge against further instability in the energy sector.

Presenting Your Corporation in the Best Light

When a target has attracted the interest of investors, the presentation of the business’ books and records strongly influences a prospective investor’s perception of the quality and competence of its management.  Properly documented business relationships and well-maintained minute books reflect the care and attention given to a business’ operations and the professionalism with which the business is managed.

All non-arm’s-length relationships should be documented through legally enforceable contracts on commercially reasonable terms.  Any blurring of personal and corporate assets is commonly seen as a significant ‘red-flag’ for potential investors.  More importantly, if these relationships are not appropriately documented or have terms that are not commercially reasonable, it will be necessary for investors to incur substantial costs and time to renegotiate these agreements.

All securities and financing activities should be authorized by the board of directors and fully reflected in the minute books.  Improperly documented distributions, repurchases of shares, and conversions of convertible securities can create significant delays and add costs to the due diligence process.

Private corporations should have professionalized corporate governance standards which emulate those of publicly traded corporations.  When appointing directors to their board, corporations should actively seek out experienced individuals who are independent from management of the corporation.  Formal directors’ meetings with agendas and minutes should be held at least quarterly so as to monitor and evaluate the operation of the corporation and the strategic direction of the business.  Although such meetings can occur on an informal basis throughout the year, regularly scheduled meetings with minutes of the proceedings provides an increased comfort for investors regarding the professionalism of a corporation’s operational and governance processes.

In addition, any employment or consulting agreements should be formally documented and contain provisions which incentivize performance and protect the corporation upon the departure of key employees.  Because of the prominent role of key employees in managing client relationships, employment agreements should be regarded as a primary instrument for corporations to stabilize their client base and workflows. Appropriate incentive structures are essential for rewarding employees for their contribution to the profitability of the business.  Equally important to these agreements is the need for robust non-solicitation and non-competition covenants designed to prevent employees from soliciting former clients and competing with the potential target.  In evaluating the quality of a target business, the presence of properly documented employment agreements provides investors with substantial assurances regarding the stability and durability of a target’s customer and client bases.

Conclusion

Proper planning for the sale of a business or financing activities should begin long before management considers whether to make one’s business a potential target.  Attempting to address deficiencies in corporate records or developing a saleable understanding of a business’ competitive advantages in the days leading up to a meeting is often too late.  

Moreover, delays attributable to issues identified in the diligence process can prolong transaction timelines and substantially reduce the likelihood of deal completion.  However, quality advisors can help management teams develop best practices to mitigate these risks and ensure that the business is always presented in the best possible light.

Invitation for Discussion:

Should you like to discuss this blog in greater detail, or any other business, contract or securities law related matters, please do not hesitate to contact one of our lawyers in the Business Law group at Shea Nerland LLP.

Disclaimer:

Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.

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