The value of legal entity management

A company with immaculately managed books conveys a sense of order and trustworthiness. Buyers don’t have reason to question general counsel or the management team; they can see that everything is as it should be. “Better entity management gives the buyer more confidence in the organization,” according to John Easterday, a partner at Deloitte Tax LLP.

If, on the other hand, a business hasn’t exercised care in maintaining its entities’ corporate records, buyers may start to wonder what else has escaped the management team’s focus—and what other problems they may be buying with this deal. In our research, 59% of respondents said that poor entity management causes buyers to question whether subsidiaries are, in fact, wholly owned by sellers.

Organized LEM can help sellers prepare to compete in a tight market. Not only does it give buyers more confidence in what they’re buying, but it also helps them thoroughly—and quickly—evaluate the transaction. The less friction due diligence encounters, the more the deal timeline can be accelerated.

But when organizations haven’t engaged in thoughtful, diligent LEM, deals can go awry. Buyers must be able to trace each subsidiary’s capital structure, stock interests, subsidiary ownership, options, puts, voting rights and more. Sellers commonly need to scramble to collect the corporate records that support this understanding, including stock records, bylaws and the like. But if they have to fill gaps in the corporate record, serious issues can arise.

Managing entities carefully is, of course, a two-way street. Due diligence memos should be entirely factual. Risks should be both limited and clearly apparent. But due diligence memos are not always completely accurate. Management may not be fully aware of problems, even where they exist. Or they may admit—directly or indirectly—that they haven’t been able to tie out the capitalization of their subsidiaries.

Deals are priced on the assumption that entities and their records have been managed carefully, and that what the buyer sees is what the buyer is going to get.

Should questions arise about entity management, though, both buyer and seller can suffer significant consequences. If the buyer risks additional exposure or embarrassment or if issues surface that must be remedied before going to market, a conversation about price may ensue.

Well-managed companies generally have more and better deal structuring options. Poor entity management, on the other hand, may limit the deal structures available to sellers. Half of our interviewees suggested that poor LEM can cause a change in deal structure.

If buyers aren’t comfortable with the status of subsidiaries, a stock deal, which would transfer all of the seller’s assets and liabilities to a buyer, can turn into an asset deal, where the buyer takes on only the risks of the specific assets that are sold. That allows the buyer to avoid dealing with the liabilities in the subsidiaries, but it leaves sellers—who must still wind down the subsidiaries—with a real problem. Buyers may also balk at a deal if they’re worried about the tax advantages of an asset sale.

A smooth transaction between well-managed companies should not encounter extravagant legal or other fees. Yet when a seller is discovered to have poorly managed its entities, buyers tend to underestimate the hassle and cost of remediation. Dormant subsidiaries can be particularly thorny for buyers to address, as the longer ago a problem arose, the more it costs to remediate. This is especially true if there are issues surrounding directors’ and officers’ resignations.