Legal Mistakes Founders Make When Selling Their Business

Hue Partners is proud to share the Spring M&A Confidential article authored by Danielle Lemberg, Partner at Seward & Kissel, LLP.

Selling a business is a significant milestone for any founder, filled with opportunities but also fraught with potential pitfalls that can have real commercial and legal implications. As a partner in the business transactions group at a leading law firm focused on the investment management industry, I often help guide wealth managers and other investment advisory clients through the complexities of this process and the particular issues that are unique to their businesses. By understanding common areas of concern, founders can improve their sale process and increase the likelihood of a successful transaction. Drawing from my experiences in the field, including a few deal anecdotes that illustrate these lessons, I explore key legal considerations that can mitigate risks and help accomplish a closing.

The Importance of Proper Preparation (aka Know Yourself)

One of the foremost lessons in the M&A process is the necessity for sellers to get their "house in order" before entering negotiations. It is critical for sellers to be proactive in addressing any potential issues that could arise during a due diligence process that is sure to capture an advisor’s compliance regime, regulatory history, and internal practices.

For instance, I recall a target who had been downplaying an SEC deficiency letter for weeks. They insisted it was no big deal while their lawyers communicated the same sentiment. However, when we finally obtained the letter, it turned out to be a 30-page document detailing numerous violations. This situation highlighted the importance of transparency; had the sellers been upfront about the issues, we could have sooner addressed the sharing of risk following closing in a way that satisfied all parties (as our client ultimately still wanted to get the deal done!). Instead, the evasive approach only amplified concerns, caused unnecessary tension, and delayed the process. Buyers know an RIA may not be “perfect” and deficiency letters are common; what matters is explaining the SEC’s findings and what you did to address any problems.

We recommend that managers, in advance of a potential transaction, conduct periodic compliance audits to identify and rectify any deficiencies. Transparency is critical; if a seller has a history of regulatory challenges, it’s better to disclose these proactively rather than allowing buyers to uncover them during their investigations. A well-prepared seller can address issues head-on, demonstrating to potential buyers that they are responsible and capable of managing risks.

Understanding Buyer Expectations on Governance

Founders sometimes make the mistake of underestimating the importance of aligning with the right buyer. It’s crucial for sellers to find a buyer whose vision aligns with their own. This alignment includes cultural fit and support for the overall business strategy, but can also be reflected in the approach as to governance – an area in which I am frequently involved from the legal side.

For example, in one transaction, we represented a seller whose company had a unique management structure, relying on a collaborative decision-making process involving partners. The buyer intended to impose a more corporate hierarchy, which would have disrupted the existing governance (and potentially, generated some ill-will from the existing partners).

It is essential for the seller to clarify how much control they would retain over day-to-day operations. Key legal provisions regarding governance structure, consent rights, and budget controls should be carefully negotiated to ensure that the seller is comfortable with the level of post-closing decision-making flexibility.

Navigating Employee-Related Issues

Another common area where legal pitfalls arise is in employment-related matters. Sellers often overlook the necessity of reviewing employee compensation structures and employment agreements with an eye towards the sale. Buyers typically scrutinize these aspects closely and may require adjustments to align compensation with market standards.

In one instance, we encountered a seller with several employees who were overcompensated relative to industry standards. The buyer was understandably reluctant to inherit a workforce with inflated salaries. To address this (and mitigate future changes to bonus calculations), we recommended offering stay bonuses.  This approach not only retained key employees during the transition but also ensured the buyer felt comfortable moving forward with the deal. To note, stay bonuses and similar transaction-based bonuses are usually paid out of the purchase price.

Another employer protection to be mindful of is establishing restrictive covenants to protect the value of the business post-sale. This may be a condition for the buyer but parties should also be cautious to ensure that these covenants are enforceable in the applicable jurisdiction.

The Client Consent Process

Handling client consents can be one of the most daunting aspects of an M&A transaction. Founders often underestimate the complexity involved in obtaining proper client approvals for the deemed transfer of advisory agreements  due to a lack of clarity regarding what their investment advisory agreements stipulate for assignment and consent.

Determining the right client consent process can add significant delay to closing the transaction. I recall working with a client who faced challenges in navigating the client consent process. They had several different types of client agreements, each with varying requirements for assignment. Understanding these nuances took considerable time and effort, which could have been mitigated with better preparation in advance of commencing the transaction.

Sellers should work closely with legal advisors to navigate these requirements, ensuring they understand whether client consent is required (under both the Investment Advisers Act and their advisory contracts), if required, whether affirmative written consent must be obtained (or if negative consent is sufficient), and if negative consent is permissible, the proper waiting period therefor. On top of this, sellers and their counsel should work together to determine, from an administrative perspective, how to most efficiently run the consent process.

With all that being said, obtaining consent is usually only daunting because of the process itself and not due to substantive issues. We find that most clients are supportive of a sale, remain invested, and see the transaction as an opportunity for growth. It is rare for us to encounter a deal where consent is not ultimately obtained.

Post-Transaction Equity Structures

Once the deal is closed, founders must recognize that they will have to live with their new partners for the long term. Founders should ensure that the terms of the sale allow for a smooth transition and continued alignment of goals.

For example, it may be important for a seller that the deal provides for a framework that supports the next generation of leadership within the firm. This may involve creative solutions regarding equity structures, profit-sharing arrangements, and management continuity, and implicate issues such as ease of issuing incentive equity, determining how dilution resulting from such issuances is shared among the partners (including the buyer), and length of service terms for the founders.

In a recent transaction, we worked with founders who were keenly aware of the need to prepare the next generation for leadership. They wanted to ensure that the new partners were motivated and aligned with the firm's long-term vision. Together, we brainstormed profit-sharing arrangements that would incentivize the next generation while maintaining continuity in management for the period the buyer anticipated.

Ensuring a Successful Business Transition

Selling a business is a complex process that requires careful navigation of legal intricacies. Founders can significantly enhance their chances of a successful sale by avoiding common pitfalls related to diligence, employee issues, client consent, and going-forward governance and structure. By taking proactive steps and working closely with experienced advisors, founders can ensure that their transition is as smooth and successful as possible. Ultimately, understanding and addressing these legal considerations will not only protect the founder’s interests but also pave the way for a prosperous future for the business they have built.