As I introduced in Part 1 of the Founder's Guide, valuations of startups are typically based on a combination of the company’s EBITDA and a multiplier. The negotiation of the multiplier is often where business owners make or lose millions, or, in the case of those majestic unicorns, billions of dollars. Given there are market conditions and business aspects that influence the multiplier, but the ability to negotiate an above-market multiplier or being forced to take a below-market multiplier is generally a function of (1) buyer or investor comfort with the cleanliness of the deal, (2) whether there are off-balance-sheet value enhancers, like good will, and (3) an overall lack of risk being assumed.
The first impressions that a potential buyer is going to have of the inner workings of your business is in the data room where all of the due diligence documents will be stored. This article is going to focus on the how to keep your data room clean and really impress potential buyers and investors.
Financial Statements and Accounting Abnormalities
The most important area of due diligence is your company's financials. One item of information that a potential buyer or investor is going to look into is whether there are any abnormalities in your accounting practices that would justify a reduced multiplier or an EBITDA adjustment.
Entity Formalities and Governance
Potential investors are also going to want to see that you have kept up with your entity documents and formalities. More specifically, investors and buyers are going to want to see that you have kept accurate entity records, such as:
- Formation documents.
- Minutes & Written Consents.
- Stock or Unit Certificates and Ledger & Transfer Documents if applicable.
- Equity Options or Warrants or rights to distribution or liquidation.
Solid Employment and Separation Agreements
Potential buyers and investors are going to want to see that you have a solid, enforceable employment agreements that have protective and enforceable provisions, like non-compete, confidentiality, non-solicit, and non-circumvent clauses. Also make sure that you get and keep signed copies. It is sad that I have to say this, but it is amazing how many businesses fail to keep good records of signed employment agreement.
In addition to solid employment agreements, it is important to have good separation agreements with employees when your employment relationships sour. Getting enforceable releases from employees when employment disputes arise can definitely decrease any indemnification escrow reserves. This means more money in your pocket at closing.
Fully Executed and Freely Assignable Contracts
Another aspect of keeping a clean data room is making sure that you have fully-signed and freely-assignable contracts. One thing potential investors are going to want to see is that you have binding agreements with your vendors, suppliers, software providers, and other third party relationships, and something investors are going to love is to see that these agreements are freely assignable to potential buyers. Buyers want to make sure that they can easily and seamlessly continue operating your business. It will also save you the hassle of having to track down and get the approval of all of those contracting parties. Less attorneys fees means more money to you at closing.
Other Information Regularly Requested
Other information that buyers and investors regularly request in due diligence requests are the following:
- Tax Returns
- Customer Lists and Contracts
- Real Estate (Leases and Ownership)
- IP Lists
The advice "keep your room clean" is unfortunately good advice in many areas of life, even with your business. The cleaner your financials, accounting, corporate structure, employment contracts, and third-party contracts, the better negotiating position that you are going to be in to maximize the valuation of your business and the amount of money you are going to leave the closing table with.