Founder Mistakes That Kill Business Deals & Exits ft. Winta Asefaw

[0:04] Okay, I think we probably have some folks online with us here.

[0:18] So, thanks everyone. I appreciate you joining today and welcome to Out of the Weeds Live. My name is Nish Sampath. I'm the founder of Switch Advisory. Most business owners today don't really think about exit when they're signing their first shareholder agreement. They certainly don't when they're structuring their hold co or when they're doing their first deal with a co-founder. But 10 years later, those are the decisions that can come back to bite them on the ass. What we're talking about today are the decisions that founders make often early in the days that can cost them pretty significantly at exit.

[0:54] My guest today is Wina Asafal, partner in corporate and M&A law at Castles, one of Canada's top law firms. She advises business owners through some of the most significant transactions of their lives.

[1:07] Wina, welcome. Thank you so much for joining us today. Would love for you to give the audience a little bit about yourself, a sense of who you are, and the kind of work you do before we kick it off.

[1:17] Thank you, Nish. Thanks for having me, and thank you everyone for taking the time to be here today, especially on a Friday. We appreciate that. As Nish said, I help founders and businesses through all stages of the business process. So that includes the formation process, all of the corporate commercial needs — agreements, divestitures, USA, different whatever the needs are depending on what the business is — and then also on exit. Exit can be obviously a very fun and exciting process for a founder, but also can be fraught with a few — I don't want to say issues — but a few prickly scenarios which are hopefully after this easy for you to avoid and understand. So that's what we're here to talk about today. Looking forward to it and Nish, I'll let you continue on.

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Chapter 1: Early Mistakes That Cost Founders at Exit

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[2:05] Amazing. All right. So let's kick it off. First question — let's talk about a time that you ran into when you were doing diligence on a sale and realized that something the founder had done in the early days was about to cost them as they're going to sell.

[2:22] Yeah. So that's a great question. We have had a few scenarios where we find out — unfortunately when we're representing the seller — much later than we would like, that the seller has made some sort of a promise, for example, to another shareholder, an equity holder, or an employee that will be triggered by the sale. And unfortunately because of the lag in time between when that verbal promise was made — or even if it was written, if it's not properly documented — to the time of the sale, there can be a lot of questions that come up on diligence. What are the terms and conditions for this payment? And it becomes a negotiation of where that money is going to come from on the sale. Oftentimes if the buyer is not aware of it until that diligence process, and it's not disclosed, and it's a significant amount — then what happens is that's usually a haircut for the seller, and that can lead to a lot of frustration and difficult negotiations.

[3:22] This did actually happen — one of the last deals I had done involved us as buyer, and we found out very late that there was a significant six-figure trigger — basically a payment that was going to be triggered from the sale. There was no documentation. So what we had to do was negotiate again with the seller on what their purchase price ultimately would be, where the funds would come from, whether those funds would come from pre-closing cash flow or post-closing cash flow. And ultimately it was a last-minute problem that we had to work through and smooth over. It got settled, but it was obviously a bit costly, and it was something that could have been very easily avoided had the founder anticipated that this would be an issue on sale and properly documented everything.

[4:19] Yeah, that's super interesting. And you know the most common version of that we see on the operational side is really that ambiguity around decision-making across partners or even between co-founders where maybe somebody has stepped out of the organization. They were really heavily involved and then they stepped out over a period of time. And even with coupled organizations — a spouse relationship leading a business — they haven't actually defined who has the authority to make what kinds of decisions, especially things around exit. And by the time that exit comes about, that ambiguity becomes almost a real cancer. People are fighting, and instead of moving towards a positive outcome, it becomes so stressful. So from your seat — is that something that can actually be managed at inception, like in the USA or shareholder agreements? Or is it always going to be a fight downstream?

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Chapter 2: Shareholder Agreements — The Business Prenup

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[5:18] So I would say a significant amount of the issues that might come up on sale involving third parties can be properly or significantly mitigated by proper agreements such as a USA. The USA is a significantly beneficial and effective tool for managing how people enter and exit a business, and also what their rights are throughout their time as an equity holder — and most importantly, who gets control or what happens. It lays the foundation and gives you really a kind of a process that you can follow upon a sale, or if a founder is looking to exit from the company. And it's just such an effective tool.

[6:06] Everybody — I think it doesn't matter if you're husband and wife — it's just a good way not only to look optically very organized and show that you've thought about some of these things to a third party if you need additional investors down the line, but it also signals to the buyer that you have properly thought about some of these items and you are going to be in a very good and strong position to properly negotiate during that process and get all of your stakeholders in a position to sell. So it's an exceptional tool. Highly recommend anybody with more than one shareholder look into it, ask their advisers whether they need it, and they can give them a breakdown of why they're effective, what the key terms we would see in them are, and why they would be beneficial even if the business or the founders don't think they need it now, why it would be beneficial down the line. It's a form of insurance, and it's a great one.

[7:02] It's almost like a prenup to some degree for your business, right?

[7:07] Yeah. And it's funny you say that because there have been scenarios where even husband and wife or partners dissolve a marriage, and it's effective again to have that USA in place — because for your other shareholders, for example, if party A is married and party A gets divorced, well, shares are considered assets that are divisible throughout that divorce process. So they want to ensure that they're in business with who they actually signed up to be in business with — which is partner A — but not partner A and their spouse, or whatever the case may be. So it's a very effective tool. We've seen it come in handy especially in that type of disintegration of relationships, which also includes marriages. Cannot speak highly enough about the USA. Definitely make sure you know about them and you utilize them.

[8:07] What are some of the key elements that you would recommend people focus on when they're putting a USA together? What are some of the top clauses that make sense?

[8:15] Yeah. So if you are a founder and you receive a genuine offer from a third party to purchase your shares, you want to be able to drag your other shareholders along with the sale — basically ensure that they participate on the same terms and conditions that you've signed up for. Because as a buyer, nine times out of ten, they're going to say, "Well, we want to own the company in its entirety, or at least be able to select who we leave equity with on the table." So if you own less than 100% of the shares, you want to ensure that when you exit, you're able to have the other shareholders participate so that the buyer is actually satisfied with the number of shares or the percentage of shares that they'll own.

[9:07] Okay. And I'm assuming that includes decision rights — who gets to determine how much we sell for, who we're going to sell to, the structure of the deal, etc.?

[9:21] No, that's exactly correct. The USA would contain that at a high level. Essentially saying that if the third party offeror provides terms X, Y, and Z — those are the material terms — all of the shareholders then have the right, sometimes a right to participate, other times the founder has the right to drag them along and ensure that they participate in that sale. But the terms and conditions you get to govern — in the case of a drag-along, you get to essentially ensure that you are the person negotiating those terms. The idea is: if they're good enough for you as the founder or the majority shareholder, then in theory they should be good enough for the others. And that's how minority shareholders protect themselves as well, because the offer has to be on the same terms and conditions, and a genuine offer from a third party — rather than, you know, my holding company offering 1 cent on the dollar for each share just to trigger it.

[10:21] Oftentimes it's pretty fair, but it also allows you to ensure that the intention of where control is supposed to be is actually maintained there for the majority shareholder — often the founder or founders. And that's really important because by default under the law, there are certain rights that minority shareholders have. So the USA works well because it considers those, but also considers the actual relationship dynamics, the risks, the nature of the business. I always say it's kind of like the bible for how things are going to proceed in the business. It's a very effective tool when things get tough — egos can be high, frustrations can be high — and it can also be a very effective tool to protect you if you're maybe not the most liquid partner, but you are the person who started the business and are maybe the brains behind it. It's a good way for you to leverage your position if you don't have the cash to do certain transactions, buy out your partners at certain times — it allows you to still maintain control.

[11:41] So it's contextually applied, but very good, very effective. And I think just having the rules of the road set up before any major decisions happen allows you to preserve relationships frankly — you don't want to be going out of this breaking key friendships or relationships with partners.

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Chapter 3: IP, Corporate Structure, and Early-Stage Setup

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[12:02] So kind of continuing down that stream — what are some of the other things that in the early days we should be considering when we're setting up a business around company structure, intellectual property? What have you seen that have really unfortunately lit a fire at exit?

[12:20] Yeah, so that's a great question and those are two key points you've touched on. For example, IP. If the nature of your business relies heavily on IP — you have something very proprietary — but you have had poor documentation along the way in terms of who actually owns the IP. Does the corporation actually own the IP? If there were founders that have exited, have they ensured they contributed their IP, have they made assignments, have they waived moral rights? Essentially — does the corporation at the time of sale own what it says it owns?

[12:52] And if you aren't able to prove that you actually own what you say you own, what happens is the seller is ultimately going to be burdened with additional reps and warranties — which are essentially promises. It's fancy legal ease for promises the seller will make to the buyer. But those promises are very important because if they are later found not to be true and there's a cost to the buyer or the business, then essentially that's money out of the seller's pocket. But if that rep and warranty doesn't exist and something happens post-closing, the seller's liability is reduced significantly or in this case, removed.

[13:50] The cleaner your documentation, the more you can prove you own what you own — including IP, which obviously in today's market is very relevant. And if that hasn't been done from the get-go, then unfortunately what that means oftentimes is a longer indemnity period, stronger reps and warranties in favor of the buyer, or a discount to the purchase price. Or sometimes what we do is a hold back. And obviously, money today is better than money tomorrow.

[14:19] Yeah, so it just creates a lot of deal complexities that maybe didn't need to be there, but it also adds to the breadth and the length of what the seller is going to be on the hook for after the deal closes.

[14:39] So tell me — how do we create that protection? Is that employment agreements, subcontractor agreements? Where do we usually put that kind of protection in place before we run into trouble?

[14:49] Yeah. Those two are exactly correct. Employment agreements — key. Contractor agreements — correct. Really, it's any party that's engaging with the business, any third party, including employees and contractors. What you want to do is ensure it's very clear on who owns what after the terms of engagement. That is exactly correct — you hit it nail on the head.

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Chapter 4: Tax Structure and Timing

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[15:18] Amazing. Anything else that you think the folks listening should know around early-stage decisions and corporate structure?

[15:29] Yeah. So you touched on tax too, and I think that's an extremely important point to bring up because the seller is obviously going to get a ton of money at the end of the deal, but they want to be sophisticated in how they receive the purchase price, but also structure the deal in order to ensure that it's tax friendly for them.

[15:52] So with that in mind, the corporate structure from the onset is critical. If the corporate structure is done well with anticipation — and it doesn't necessarily have to be right at onset, right at onset is very important for liability mitigation — but from a strict tax perspective, there are often restructurings that can happen from the time of inception to the time of sale.

[16:18] However, a strategic seller will ensure that they do that slightly before the buyer is engaged. And I say that because if the buyer is involved — which we have been on the buyer side and we've had this also on the seller side — what can happen is the buyer will then have an opportunity to review it as a pre-closing transaction. So the buyer will have an opportunity to say, "Well, hey, you want to do this? Actually, that might have an adverse effect on me or the corporation, so that's not going to work." And we did have a deal — a cross-border deal — where we were ready to close and then last minute there was an issue where the buyer said, "You know what, this is actually not going to work for us as proposed." And that just translates to additional time, costs, and negotiations that probably would have been better suited to happen much earlier. So getting your tax advice to ensure your corporate structure is done well is important — well before you engage the buyer, if you want to have the opportunity to present it to the buyer as you wish. But the second the buyer is engaged, it's open for negotiation, and that goes into their purchase price.

[17:36] So what's the optimal window? Is that 18 months? Is that 36 months before you even consider? Like, you're probably heading down this path and saying to yourself, "We're looking for an exit event in the next couple of years." When should they be thinking about these changes?

[18:03] I think as you noted — early on, talking to a tax adviser early on is always important. Engaging a tax adviser before you start soliciting bids — I would say 6 months probably sounds like a happy medium. Because that gives you enough time to complete the transaction but also enough time to ensure you have adequate opportunity to consider the different options your tax adviser may present you with. And at that time it's close enough to the sale that you also know who is going to participate in it actively. It might be a scenario for example where you've talked to one of the shareholders and you know they're retiring in 3 months — so they might actually by way of the USA automatically have their shares purchased by the company or the other shareholders and they won't actually be a party to the transaction. So you'll have a clearer picture of who the shareholders would be, what the company's operations would be, what the corporate structure would be closer to that time. So I'd say maybe 6 months would be a good happy medium.

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Chapter 5: Founder Dependency

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[19:08] Awesome. All right, let's switch gears a little bit. Tell me about a deal where it was obvious that the founder was the business — where the founder dependency is so significant that red flags start popping up because the buyer sees the implications and it's going to impact deal structure.

[19:24] Right. There's one person who is the majority of the business. If during the diligence phase or any part of the transaction there's a document or item of clarification that we're requesting and nobody on the team can produce it because the seller is on vacation and unavailable — which happens more often than I'd like to see — then obviously there's an issue. It might just be that the founder hasn't adequately shared how those processes work or where that information is. But for us, that's a red flag, because that means that if we're having the seller engaged as an adviser to the business for transitional services post-closing, and there's a risk that they for some reason don't complete the term as we wish, then we might be in a position where no one knows how to operate the business post-closing — because that operational knowledge is not available for us to absorb before the seller is unavailable.

[20:37] And we have had that, and that is a very unfortunate situation. Because post-closing the purchaser is trying to get to know its employees, trying to make sure the third-party contractors have a good relationship. There's a lot of relationships they're looking to maintain. But what they're really also looking to do is ensure that the seller is helping with that transition — helping them find out where they need to make this payment to, or who they go to if a light bulb goes out and there's an electrical issue. These are the small things that if the founder has kept all of that knowledge in their own head and nobody else is available to assist — can be quite frustrating. It might seem very trivial and insignificant, but it can have a material impact on such a key timeframe post-closing.

[21:24] Yeah. You know, from our perspective — the buyer's perspective — we've seen them become pretty significantly gun-shy around businesses that are built on the backs of that single person. The founder dependency is so high, and it turns out it's a significant red flag because the buyer's not sure that the business is scalable. If it's one person driving this, can the rest of the folks that are left behind or coming with the deal help scale the business? And when the buyer sees that, we've seen people walk away quite often because they don't believe that the machine can be appropriately scaled without rewriting the entire operating system of the business.

[22:08] And they also — we've had a lot of concern where the financials and the P&L tell a story, but the buyer doesn't think it represents the actual resource cost required to manage the business — because the founder's doing 14 different jobs. They've been running off their feet, doing it all themselves just to keep higher margins. But the reality is to scale this business, it's going to take more people. And even if you inject more money into it, there's no operating system that allows it to scale.

[22:39] Yeah. I think that's a great point. Oftentimes we'll ask the buyer: do you have a sense of how many hats, operationally, the founder is wearing? Because once they leave, you might need to rehire for three full-time positions. What does that look like?

[22:54] And on top of that — it's funny as you were talking about this — I thought of another big key piece I think founders sometimes miss, especially when they're starting off a bit smaller: do not use the company's credit card, finances, and bank accounts as your personal account. There needs to be a delineation between corporate expenses and personal expenses. Not blurring those lines early on and having very healthy practices on how you document your finances — finances are so important. It just signals to the buyer very early on that you're organized, you understand that there is a separation. It's a piece that has become a problem in the past. So just important to keep that in mind.

[23:45] So you're saying the yacht is not a legitimate capital expense.

[23:48] I mean, you could take a client on it once in a while. It's probably a question for the tax advisors, but yeah.

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Chapter 6: Earnouts and Deal Structure

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[23:55] So when a founder-dependent deal does close — what does that structure usually look like? Are these deals where the founder ends up trapped in a three-year, five-year earnout where they're working for the buyer for a long period of time? I'm guessing in most cases that's pretty opposite to what they were envisioning when they were looking to sell.

[24:17] Yeah, that's right. And they've just gotten this huge chunk of money and a beach is calling them. The last thing they want to do is go back to a place where they were running the show — to now being an employee or a contractor. It's a very difficult shift. I'm sympathetic to that transition. However — you're right — it shows up in two ways. Oftentimes we have them locked in for a transitional period. Usually we'll try to have a hold back so that we can ensure they actually stick around and properly complete the tasks they're agreeing to do during that negotiation phase, so that their post-closing transition is smooth for everyone. The other way it shows up — as you said — is earnouts.

[24:58] You're confident as a founder, as a seller, that the business — the cogs are going to be turning and the machine is greased. But if the buyer is not confident, they'll say, "Okay, so then essentially — put your money where your mouth is." We'll maybe agree to this purchase price, however, we're going to have a long earnout period because we want to ensure that everything you're telling us is true. For example, that these relationships are not contingent on just me as founder — that I've integrated my team into those relationships — that post-closing we're still going to have those relationships, we're still going to make money, and our employees are still going to stick around. Employees are obviously the crux of every business. If you don't have good people running the business, unfortunately it's going to be very tough to be profitable. So those are the kinds of things that will lock the seller in for a long time.

[25:49] And then it's again that concept of the time value of money — money today is better than money tomorrow. Having these kind of handcuffs or restrictions on what you do post-closing is — I imagine it would be very difficult because you want to go enjoy this next phase but you're kind of in a transitional period yourself. That's how it shows up.

[26:15] Yeah. I mean, when I speak to owners, I think oftentimes when they hear earnout they think, "Okay, this is how I'm going to take part in the upside." But often — do those earnouts actually pay out the way they were sold to the seller, or do you see it turning out not as profitably as they were hoping?

[26:33] I've seen a mix. And sometimes it could be that the purchase price the seller thinks in their head is actually not realistic — it's, in a nice way to say it, maybe inflated based on what they perceive to be the value of the business. And so as a result, the earnout thresholds are calibrated proportionately to what those promises and the founder's idea of what that profitability will be post-closing. So sometimes earnouts aren't met, and as a result it is effectively just a haircut on the purchase price — but they're probably a truer reflection, a better reflection, of what market would be for that business based on how it was operating at the time of sale.

[27:25] It's tricky though, because once an earnout is involved, the buyer and seller are going to be in a position where they might have different ideas post-closing on what's acceptable — for example, if it's an EBITDA-based threshold, then spending obviously matters. The buyer might say, "Well, there's a great opportunity for us to refresh our assets here. It's going to be a big spend but it's worth it." Or: we want to hire and grow our team, scale the business, bring in AI, whatever the case may be. And the seller will say, "Well, hey, listen — that's actually going to impact my ability to meet this earnout threshold." So the negotiation during that period becomes, you know, there are obviously differing views on what those restrictions should look like.

[28:19] And it's just — ultimately, if you can be in a position to not have to go through a process where you have an extremely long earnout period caused simply by the fact that the buyer is apprehensive about post-closing because they think you are too critical to the business — then that's not great. If you have an earnout because you have a potential to share in the profitability and it's almost like a profit share — then that's great, you're probably going to get more than market for your transaction. So it kind of depends, but you definitely don't want it to be triggered by fear.

[28:54] Yeah. And I think that's exactly where building that repeatable operating system within the organization is so critical. If you can build that confidence that this thing can run without you — and if you put a little more fuel on the fire it can continue to grow — well, if the seller has that fuel, all the power to them. But once you sell, you lose the power to control that conversation. The buyer now has that power and they can impose additional expenses that are going to draw you down. And that's unfortunate, but that's sometimes where they live.

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Chapter 7: Negotiation — Where Founders Leave Money on the Table

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[29:30] All right, coming to a close pretty soon. Let's talk quickly about negotiation dynamics. Where do you see founders most consistently leaving money on the table just because they don't actually realize that's part of a deal they could negotiate — reps and warranties, indemnity, etc.?

[29:47] I think not getting their advisers engaged early, and then having to discuss some of these issues that we've raised with the buyer during their negotiation, creates a position where the buyer is going to be able to say, "Well, hey, this is a risk — we're flagging it," and as a result, oftentimes it's an impact to the purchase price or the liability of the seller. So getting your advisers in early, cleaning up house early, making sure that when you come to the table to negotiate you already have your answers to these questions — everything's kind of neat and tidy, or you at least have a plan and idea of how to address them — I think that will give the buyer confidence. And then the seller is not left just choosing between a few options the buyer is presenting. They've come prepared and organized, and they can kind of lead the negotiation. And that's important.

[30:44] Having the right team sounds like a pretty critical element to that, right?

[30:47] Just the right advisers from the financial side, the operational side, the legal side — making sure the machine's running well.

[30:54] This has been awesome, Wina. Thank you so much for your conversation today. It's exactly what owners really need to be thinking about earlier on in their journey. For anyone watching who wants to connect with Wina or learn more about Castles and their M&A practice, you can find her on LinkedIn. I'll drop her profile in the comments afterwards. But genuinely appreciate everyone joining us today.

[31:15] Thank you so much and we'll see you soon.

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