Selling the Company

[ LiB ]

Selling your development companymost likely to a publisher interested in making you an internal studiois the goal of many entrepreneurs. Other developers prize their independence and control more than the security and payday of selling the company. If you are a big enough star, you can negotiate a favorable price and maintain control.

If you are looking to sell your company, you may want to wait until you have at least two interested parties. Your leverage will be much greater. When choosing a buyer, look beyond the dollar signs to find: a company whose future you believe in (since you are likely to receive some compensation in stock); a company culture that values your staff; powerful distribution and marketing in your preferred platforms and genre (s); a buyer who is willing to allow your company autonomy, for instance, the ability to stay in your current location and to choose future development projects.

A publisher looks for a developer with a stable team and a track record of delivering hit games on time and on budget. The publisher is usually buying a team first and foremost, but it will pay a much higher price if there is valuable proprietary technology (like a great AI for war sims) and/or content (like a game franchise) attached.

While a sale can be full of more plot twists than a soap opera, it will usually follow this script:

Buyer and seller establish mutual interest and negotiate a letter of intent , a letter signed by both parties that sets out the basic terms of the sale. The letter of intent is usually valid for a short period of time, around 30 days, during which time the seller cannot shop the company around.
During the exclusivity period, the buyer performs a due diligence examination of the target company, looking into its financials, liabilities, making sure that it owns all of its intellectual property, and so on. At the same time, lawyers for both parties are assembling the contracts necessary for the sale.
If due diligence turns up unexpected liabilities (example: it turns out that the seller owes $50,000 in back taxes, or the seller does not have clear title , or ownership, to one of its intellectual properties), the parties will renegotiate terms of the purchase.

The parties sign the documents and exchange property at a closing .

Figure 3.7. Due diligence:Too bad it doesn't come with laughing gas.

graphic/03fig08.gif

NOTE

Consider hiring an investment banker to represent you in your sale. These are companies who study the market for certain kinds of transac tions in an industry and specialize in getting the best price at the best terms for a company. Naturally, you pay a commission for this represen tation, but it may pay for itself if you get a significantly higher premium.

Valuation

An old investment banking adage is that a company is worth whatever the highest bidder thinks it's worth. That said, there are a few benchmarks that publishers use when deciding how much to spend on a company. This section will discuss some of the ways that purchasers size you up, and how you can use that language to justify your own valuation. The biggest impact on your valuation will be the presence or absence of valuable content or technology rights, your team's experience, and your title history.

Comparables

One of the most important guidelines is what is being paid for comparable companies. Most publishers are public companies and report the price of their acquisitions. Find a company similar to yours in size, release history, genre- and platform-focus. The presence (or absence) of valuable proprietary technology or content will make the other company more or less comparable to yours. If you can't find a similarly sized company that has sold recently, you can still extrapolate data from another sale to come up with a benchmark by using multiples , discussed in the next paragraph.

Multiples

If a comparable company (in terms of release history and intellectual property assets) has 75 employees and sold for $17,000,000, it is not outrageous to estimate your company's value at $260,000 per employee. If a comparable company sold 450,000 console units in the two years prior to sale, and your company has sold 500,000 console units in the past two years , it is not outrageous to think that your company should fetch a higher price. Of course, you cannot base your estimates on any one particular number, because a company's value is determined by so many other factorsfuture projects, R&D that may not be public, among others.

Another common multiple used in pricing development companies is based on earnings, meaning that your company is worth X to Y times its annual revenue.

IRR

Depending on whether an MBA is at the wheel, your purchaser may talk about IRR when justifying a price for your company. IRR means internal rate of return. Purchasers who think in these terms look at what kind of profit they need to make on their investment three, four, five years outsay 40 percent. Then they look at the cash flow your company is likely to throw off, based on your income statement for the previous years and any other relevant factors (like if you've got a great game based on a big movie coming upyour income will probably rise considerably). Now that they know how much money they will see each year, and what kind of a return on their investment they require, they can figure out how much they can pay for your company and still make their desired return.

NOTE

This example is extremely simpli fied to sketch the idea of IRR and does not take into account basic principles of finance, like the time value of money.

Example: Company is likely to have cash flow of $10 in year one after purchase, $15 in year two, and $20 in year three, and would fetch $50 if sold at the end of year three. Purchaser wants a 40 percent return on its investment within three years. For every dollar that purchaser puts in, it expects to take out $1.40 at the end of year three. Purchaser prices the company as (Year 1 + Year 2 + Year 3 + 50)=1.4 * $XX. $XX=67.85. The purchaser is willing to buy the company for $67.85 now.

NPV

NPV stands for "net present value." A dollar tomorrow is worth less than a dollar today. If I give you a dollar today, a bank will pay you interest all year for the privilege of using your money. If I give you that dollar next year, you lose out on the chance to earn the interest, and you also bear the risk that inflation has made that dollar even less valuable.

Net present value is a calculation that applies a discount factor to let you figure out what a dollar tomorrow or 10 years from now would be worth in today's dollars. It is a way of calculating the value of future payments in terms of what they are worth today. A company can be thought of as a machine that cranks out a cash payment once a yearprofits in year one, profits in year two, and so on. If you can project your profits for the next 5 to 10 years, you can apply a discount factor (a financial formula based on the interest rate and time period) to each year's profit, tally them up, add the discounted value of the sales price at the end of the five or ten years and you get the value of the machine today.

Example:

Assume:

Interest rate = 10%

	Year 1	Year 2	Year 3	Year 4	Year 5	Sale Price @ end of Year 5	Total Present Value
Expected Profit	$10	$10	$10	$10	$10	$100
Present Value	$9.09	$8.26	$7.51	$6.83	$6.20	$62.09	$99.98

Letter of Intent

Before settling into the meat of the letter of intent ("LOI"), decide on a time frame. How long do you want the purchaser to have an exclusive option to buy the company? What is your target sale date? Be careful that all of your commitments to the purchaser have deadlines, or the due diligence/closing process can drag on for months and then collapse. Furthermore, how binding do you want your LOI to be? Do you want an agreement that, barring any unforeseen issues coming up in due diligence, the purchaser is obligated to complete the purchase? If so, the LOI needs to be renamed "Binding Short Form Purchase Agreement."

The letter of intent should cover the headline issues such as:

What are they buying? The purchase can be structured as a sale of the assets or as a sale of the stock. In an asset sale, the purchaser usually buys all of the target's assets except cash, and leaves the liabilities behind. These assets are subsumed into the purchaser entity. The target then uses the proceeds from the sale to satisfy its debts and distributes the rest to the owners . A sale of assets generally benefits the buyerit can escape the target's liabilities (like federal and state income taxes, payroll withholding taxes and legal actions) and gains tax bonuses. In a stock sale, the acquiror purchases all of the target's stock, meaning that the acquiror steps into the shoes of the target entity (Devco, Inc.) and the acquiror takes over all of the assets and liabilities of the target. Note that the structure of an acquisition is often dictated by tax considerations for the acquiror and the selling shareholders.

NOTE

CAUTION

In choosing to structure a deal as a stock transaction, the seller should be aware that the sale of stock in a closely held corporation falls under the umbrella of federal securities laws.This places a greater burden on the seller in a stock transaction to fully disclose all material information about the com pany. Failure to do so exposes the sell er to the risk of securities anti-fraud rules.Also, if the target shareholders are receiving stock of the acquiror, the acquiror is making an offering and therefore must comply with securities regulations and/or exemption criteria.
Most acquirors hedge against surprise liabilities by requiring the seller to make certain representations and warranties about the financial condition of the company, and retaining the right to reduce future payments by the amount of any surprise liabilities.
Is the purchaser buying all of the company, or only some? Keep in mind that a 51 percent share of a company is usually worth more than 51 percent of the assets: a premium will likely be paid for control. Some would argue that it never makes sense to sell only 51 percent of your company on the theory that if you give away the milk, nobody buys the cow (in other words, you're giving away all of the control of the company for only some of its cash value).
What is the price, and how/when will it be paid? The three main currencies are cash, acquiror stock, and assumption of debt (in other words, if you owe a $100,000 electricity bill, the acquiror will pay it and consider that part of the purchase price). The precise mix is a subject of intense negotiation: $35,000,000 in stock is a lot different from $35,000,000 in cash. Will all of the compensation change hands at the closing, or will the purchase price be paid in installments? Keep in mind that $35,000,000 in a lump sum is worth a lot more than $7,000,000 every year for the next five years and not just because of the time value of the moneythis is a volatile business and publishers go under, too. Are there contingencies/bonuses? For example, if the company ships its next product on time, it receives $1,000,000.
What happens to the status quo at the company? Will all the employees remain? Will they receive the same or better compensation and incentives? Will the office remain where it is? Where will the company fit into the reporting structure of the acquiror?
Key men. Employment agreements, non-competes and non-solicits (for example, nopoaching rules) will need to be negotiated for key executives. It is likely that key employees will be required to stick around for a certain amount of time, or risk losing stock options or other compensation.

Due Diligence

After the LOI is signed (though they may start the financial/valuation diligence before it's signed), the acquiror does its due diligence on the target company, the equivalent of kicking the company's tires. The acquiror (or its attorneys , more likely) will comb over your financial records, dig through your contracts, read any of your corporate (or LLC or partnership) documents, and poke and prod wherever necessary to get a solid understanding of your company's position. One of the most important portions of the due diligence is the intellectual property audit, in which the acquiror researches what you own, the conditions and terms of any licenses, and any problems with your title (ownership) to the property (like an independent contractor who worked on your license without signing an assignment of invention agreement).

NOTE

You will need to have an NDA, reviewed by your attorney, signed and in place before the due dili gence process begins.

Purchase Agreement

The purchase agreement contains the terms of the LOI, but adds in a lot of representations and warranties, conditions to closing, and post-closing covenants as well as other provisions that will flesh out the terms of the LOI. If significant problems came up during due diligence, they will be addressed here. The purchase agreement will also make reference to several other documents that are likely to be included as exhibits, such as the key executives' employment agreements with the acquiror, the target's outstanding publishing agreements, the target's original shareholders' agreement, an escrow agreement (if some shares are put into escrow for purposes of a future purchase price adjustment), and many more.

Special note on the employment agreements: these are sometimes left until the 11th hour because both sides think that they have an "understanding" as to the employment arrangements. On the contrary, employment arrangements deal with more personal issues (what's my title, who do I report to, how do my new stock options vest?), and they are often the subject of the most heated negotiations. If you are a founder or key employee, make sure everyone is on the same page about your arrangement; otherwise , you may get accused of holding up the deal and may feel pressure to cave in on important issues.

[ LiB ]