Letter of Intent (LOI)

Introduction

The Letter of Intent (LOI) stands as a cornerstone in any transaction. In my perspective, it reigns supreme as the most significant agreement in an M&A deal, surpassing even the purchase agreement.

Typically, a buyer will submit an LOI after carefully assessing the target and determining that the business aligns with their goals. Key elements within the LOI encompass the purchase price and terms, the inclusion of assets and liabilities, exclusivity, and the conditions for closure. Once the LOI is inked, it ushers the parties into the next phase of the transaction – due diligence.

When it comes to sellers, errors during the negotiation of the LOI are more common than missteps in the purchase agreement. Often, sellers underestimate the pivotal role of the LOI and are eager to advance the transaction swiftly. On the other hand, astute buyers are keen to swiftly seal the LOI and progress into the due diligence phase. Why the hurry? Most LOIs incorporate an exclusivity clause, in which the seller commits to halt negotiations with third-party buyers and withdraw the business from the market. The moment you sign an LOI with such an exclusivity clause, your negotiating leverage diminishes. Experienced buyers are well-versed in how the dynamics shift once this document is signed, which is why they often strive to expedite the process.

Certain buyers employ a strategic approach aimed at enticing you to invest substantial time and resources into the deal before gradually chipping away at the price and terms during later negotiations. At this juncture, many sellers have already expended significant funds on legal counsel to negotiate the purchase agreement, leaving them without the stamina to revert to square one and initiate negotiations with a new buyer. As a seller, you find yourself in exclusive negotiations with the buyer. In contrast, corporate buyers may be concurrently negotiating with multiple sellers, significantly eroding the seller’s bargaining power.

Furthermore, seasoned buyers are well aware that if you withdraw from the deal and reintroduce your business to the market, other potential buyers with whom you were previously negotiating may view your offering with skepticism. They are likely to conduct more comprehensive due diligence, often resulting in a reduced valuation.

And what about those terms left undefined in the LOI? Failure to clarify each of these terms in the LOI leaves the door open for them to be worded in favor of the buyer in the purchase agreement. It’s important not to overlook that the buyer’s attorney typically takes the lead in drafting the purchase agreement, and the party presenting the initial draft often sets the tone for the entire negotiation.

Which terms might remain undefined in the LOI?

• Is working capital encompassed within the pricing structure?

Rest assured, if the LOI fails to provide clarity on this matter, working capital will inevitably find its way into the pricing equation. Furthermore, the intricate specifics of how working capital is computed will undoubtedly be framed to favor the buyer. The outcome? Depending on the scale of your business, this oversight can potentially translate into significant financial implications, ranging from hundreds of thousands to even millions of dollars.

• What is the duration of the training and transition phase?

Should the LOI lack explicit terms on this subject, be prepared for a scenario where the buyer’s interests dominate, often resulting in an excessively protracted transition period.

• How extensive is the exclusivity timeframe?

The most astute buyers may endeavor to incorporate provisions in the LOI that grant them exclusivity for the entire duration of your negotiations, so long as they are conducted in good faith. By agreeing to such terms, you risk being tethered to a less honorable buyer for an extended period, during which they may steadily erode your selling price. A meticulously drafted LOI, on the other hand, constrains the length of the exclusivity window and introduces deadlines and other stipulations to prevent any abuse of this privilege.

• Is there a holdback or escrow arrangement in place? If so, what is the specified amount?

While many LOIs might initially overlook the mention of an escrow or holdback provision, sellers frequently find themselves taken aback when a substantial holdback of the purchase price is later proposed in the purchase agreement. Failing to address this matter in the LOI leaves you with the task of negotiating it in the purchase agreement phase, where your bargaining power has significantly diminished.

• Defining the Purchase Price:

In some LOIs, rather than a specific purchase price, you might encounter a price range. For instance, the LOI could state the purchase price as “between $5 million to $7 million, contingent on the buyer’s findings during the due diligence period.” Here’s the inside scoop: if you agree to an LOI with a price range, chances are it’s not really a range; it’s more likely just the lower figure.

• Defining the Terms:

How is the buyer financing the deal? Are they securing third-party funding, and are they also requesting you to hold a note? If that’s the case, you might find yourself in a less advantageous position. Do the terms involve an earnout? If these details aren’t clearly defined, brace yourself because, surprise, the buyer may express disappointment with their financial due diligence results, claiming that earnings were overstated. What follows? An earnout, robust representations and warranties (reps & warranties), and various other mechanisms designed to reduce the purchase price and the buyer’s risk.

This is just a glimpse of the potential pitfalls when critical terms remain undefined in the LOI. In the pages that follow, I’ll guide you through every aspect of the LOI, delving into a comprehensive discussion of each essential term that could appear in this document.

Here’s the bottom line: When you’re negotiating the LOI, you hold all the cards. Make the most of it. Take your time to negotiate a document that optimizes both your price and terms while safeguarding your negotiating position. This article provides you with precise guidance. Forget about “The Art of the Deal”; read this instead.

Overview

Major Characteristics of a Letter of Intent

• Non-Binding Nature: In the majority of LOIs, it’s crucial to understand that the terms are non-binding. The primary purpose of an LOI is to reach an agreement on essential elements, like the purchase price, and kickstart the due diligence phase. Typically, only certain aspects, such as exclusivity, confidentiality, and no-hire clauses, carry legal weight.
• Moral Commitment: Think of the LOI more as a moral commitment rather than a legally binding one. Unfortunately, this can be exploited by unscrupulous buyers who may use the LOI to their advantage.
• Preliminary Agreement: The LOI serves as a preliminary agreement that will eventually be replaced by a comprehensive purchase agreement. It allows parties to initiate due diligence while avoiding the costly preparation of a detailed purchase agreement prematurely. This marks a pivotal stage in the sales process, as it signifies the commencement of due diligence. The specifics of the purchase agreement hinge on the findings during due diligence.
• Foundation for Negotiations: The LOI forms the foundation for negotiations and serves as the blueprint for drafting the purchase agreement. Any undefined transaction terms in the LOI tend to tilt in the buyer’s favor when drafting the purchase agreement.
• Exclusivity Clause: Most LOIs include an exclusivity clause, which requires the seller to withdraw the business from the market and cease negotiations with other potential buyers. This can weaken your negotiation position.
• Limited Information: Typically, buyers have limited information about the business at this stage and haven’t conducted due diligence. As due diligence progresses, transaction terms may evolve based on the buyer’s findings. Undisclosed issues can come to light, resulting in changes to the price and key terms.
• Contingency: The LOI hinges on the successful completion of the buyer’s due diligence. If the buyer isn’t satisfied with the findings, they can almost always walk away from the negotiations.
• Momentum and Issue Resolution: The LOI offers both parties an opportunity to address potential challenges before becoming deeply committed emotionally and financially.
• Highlighting Unresolved Matters: Additionally, the LOI sheds light on any unresolved issues, such as the terms of ongoing employment agreements with the seller or the specifics of an earnout arrangement.

Why bother if the agreement is non-binding?

• Commitment Assurance: Parties involved typically seek the assurance of a written moral commitment that establishes a preliminary framework for the major terms in a transaction. This step provides a sense of security before significant investments in due diligence and negotiation of a definitive purchase agreement.
• Testing Commitment: The Letter of Intent (LOI) serves as a litmus test for the parties’ seriousness and dedication to the transaction. It’s a way to gauge the level of commitment before they dive into the extensive time and effort required. Requiring a buyer to submit an LOI also allows the seller to assess the buyer’s sincerity in pursuing the deal. Think of it as the engagement phase, with the purchase agreement as the marriage ceremony. Transactions progress incrementally to manage potential risks.
• Morally Binding: Additionally, the LOI carries a moral commitment from each party, demonstrating good faith and sincerity. In certain circles and industries, word spreads if a buyer enters into an LOI without genuine intent, potentially tarnishing their reputation.
• Expressing Intentions: The LOI lays out the parties’ intentions and serves as a valuable tool for uncovering their true motives and priorities regarding the transaction. For example, it clarifies whether the buyer plans to make a cash purchase or requests seller financing for a significant portion of the price.
• Clarity on Key Terms: Despite its non-binding nature, an LOI documents key terms to prevent confusion during the later stages of preparing and negotiating the purchase agreement. This helps reduce disagreements and uncertainties.
• Granting Exclusivity: Few buyers will commit to extensive due diligence without a seller’s commitment not to seek a better deal elsewhere, granting exclusivity.
• Reducing Uncertainty: By defining major sale terms, even in a non-binding manner, the LOI significantly reduces the likelihood of later-stage disagreements over transaction terms.
• Clear Contingencies: The LOI explicitly outlines the conditions or contingencies that must be met before the transaction can proceed.
• Facilitating Financing: Most lenders require an LOI before committing to the costly process of underwriting a loan.
• Permission for Due Diligence: The LOI permits both parties to conduct due diligence, ensuring they want to proceed with the transaction before investing in the preparation and negotiation of a purchase agreement.
• Price Agreement: Importantly, the LOI allows the parties to agree on a price before committing to the time and expenses associated with due diligence.

Problems & Solutions

• Challenge: Sellers often find that terms rarely improve once the LOI is signed, as buyers can exploit almost any reason to renegotiate the terms post-LOI.

Solution: Seize the opportunity to define as many terms as possible when your negotiating power is at its peak. However, bear in mind that this is a delicate balancing act since buyers have limited information at this stage.

• Challenge: Undefined terms tend to favor the buyer.

Solution: Mitigate this risk by specifying as many terms as possible within the LOI.

• Challenge: The longer the exclusivity period, the weaker your negotiating position becomes. Most exclusivity periods span one to three months, with some buyers even proposing open-ended exclusivity.

Solution: Maintain control by keeping exclusivity periods as brief as feasible. Embed milestones in the LOI that require the buyer to meet conditions to extend their exclusivity.

• Challenge: Signing the LOI can disarm you, leaving you with minimal bargaining power.

Solution: Don’t rush the LOI negotiation process. Instead, invest the necessary time to secure favorable terms. Once the LOI is signed, be prepared to move swiftly to close the deal.

• Challenge: Issues uncovered during due diligence can lead to less favorable pricing and terms.

Solution: Prepare meticulously for due diligence to minimize surprises and maintain a strong negotiating position.

Is the LOI Binding?

In the world of LOIs, the common practice is to draft them as non-binding documents, with a few exceptions deliberately designed to be binding. These non-binding aspects cover critical elements like pricing, terms, the calculation of working capital, transaction structure, price allocation, and escrow amounts. Conversely, the binding provisions govern the procedural aspects of the deal, encompassing confidentiality maintenance, exclusivity, the buyer’s access to due diligence information, expense allocation, and termination. It’s imperative that both parties explicitly articulate which provisions fall into the binding category.

Typically, the following provisions are purposefully rendered as binding:

• Exclusivity
• Confidentiality
• Due diligence access – outlining the buyer’s rights to delve into the seller’s financial records, engage with key personnel, and conduct due diligence investigations.
• Earnest money deposit terms, including whether it’s refundable.
• Expense-related clauses

While it’s generally accepted that a provision explicitly stating the LOI’s non-binding nature is indeed non-binding, it’s important to note that some courts have, in specific circumstances, deemed an LOI to be binding. In such cases, courts evaluate factors such as the parties’ intent, the language employed in the agreement, and the extent to which performance has already been executed. Additionally, courts have upheld the principle that parties must negotiate in good faith, even if the agreement doesn’t explicitly state such an obligation. This knowledge can provide reassurance, especially when negotiating with a direct competitor and concerns arise regarding potential misappropriation of trade secrets or proprietary information.

Contents of a Letter of Intent

Here are the key components typically found in an LOI:

• Purchase price and terms
• Inclusions of assets and liabilities, notably working capital
• Consideration format, such as cash, stock, earnout, or notes
• Legal transaction structure (asset sale or stock sale)
• Seller’s ongoing role and compensation
• Conditions for closing, including financing contingencies
• Due diligence process
• Exclusivity
• Deadlines or transaction milestones

Less frequently included elements comprise:

• Escrow or holdback requirements
• Confidentiality obligations
• Earnest money
• Allocation of purchase price
• Representations, warranties, and indemnification
• Covenants (e.g., business conduct prior to closing)
• Access to employees and customers
• Termination

Next, we delve into a detailed discussion of these crucial LOI components.

Introductory Paragraph

Many LOIs commence with conventional formalities, including greetings and preambles akin to typical business letters. Following a brief introduction, buyers often aim to distinguish themselves from other potential suitors by expressing their enthusiasm for acquiring your company or outlining their strategic alignment and long-term vision for your business.

Subsequently, some LOIs delve into fundamental details of the acquisition, covering aspects like the purchase price, proposed transaction structure, and other high-level terms. While the introductory section may appear routine, it’s worth noting that certain critical terms can be embedded within this seemingly innocuous segment. While clarity is preferred by sellers, buyers may opt for a degree of ambiguity, which can be strategically advantageous in later negotiations.

Here’s a more straightforward, less embellished example of an LOI introduction:

“This Term Sheet outlines the primary terms of a proposed transaction for the acquisition of Acme Incorporated (the ‘Transaction’). It is important to clarify that this Term Sheet serves as a basis for discussion and does not impose any obligations on the negotiating parties until a comprehensive written agreement is signed by all parties involved. Neither party is bound to proceed with or conclude negotiations in any specific manner or to execute a transaction unless explicitly stated in the finalized agreement.”

Binding vs. Non-Binding

Every well-crafted LOI should explicitly outline the parties’ intentions regarding the binding nature of the document. Some LOIs make this intention clear right from the start, often in the introduction or title, perhaps by labeling it as a “Non-Binding Letter of Intent.”

Alternatively, certain LOIs take a more detailed approach by segregating the binding provisions, like confidentiality and exclusivity, from the non-binding ones, such as the purchase price. They clearly mark each section as either binding or non-binding. Another approach involves summarizing the binding and non-binding sections in a closing paragraph, explicitly stating which clauses are intended to be binding. Either method is acceptable as long as it effectively distinguishes the binding and non-binding aspects.

So, why do most LOIs lean towards being non-binding?

The primary reason is the potential for changes in transaction terms during due diligence. Prior to this critical phase, the seller makes representations that the buyer must accept without verification. Due diligence, often termed “confirmatory” because it confirms these representations, offers the buyer the chance to validate these claims. In a non-binding LOI, both parties agree not to be bound to the transaction until a purchase agreement is signed, typically after the completion of due diligence or even at the closing.

One common mistake in LOIs is to declare the entire document as non-binding. This can be problematic when certain clauses, like confidentiality, expenses, deposits, or exclusivity, should indeed be binding. Nevertheless, in cases where the LOI remains silent on its binding nature, courts will interpret the parties’ intentions to determine whether it is binding or not.

Purchase Price & Terms

What’s Included in the Purchase Price

While the purchase price stands as a pivotal clause in the LOI, deciphering the “true” or “total” purchase price isn’t always straightforward by merely glancing at the numerical figure. Why? Because many LOIs incorporate additions and subtractions from the purchase price, often detailed in a separate section of the document.

For instance, the purchase price may encompass elements like inventory and working capital (comprising accounts receivable, inventory, and prepaid expenses, minus accounts payable, short-term debt, and accrued expenses), as illustrated in the following example:

If the purchase price is stated as $10 million, and there’s $2 million attributed to working capital, the purchase price can be defined as either $10 million or $12 million, contingent upon whether working capital is included in the price.

Example A: Purchase price is $10 million, inclusive of $2 million in working capital. The seller will receive $10 million at the closing.

Example B: Purchase price is $10 million but does not encompass working capital. In this case, the seller will receive $12 million at closing, assuming the buyer separately acquires working capital during the closing process.

Another common oversight made by sellers is fixating solely on the purchase price while disregarding which assets and liabilities are part of the deal. Many corporate buyers structure their offers to include working capital in the price, a topic I’ll delve into in more detail in a later section. When presented with such an offer, it’s advisable to dissect it in a spreadsheet, factoring in the current balances for each of the assets and liabilities that constitute working capital (namely cash, accounts receivable, inventory, accounts payable, short-term debt, and accrued expenses). This enables you to evaluate multiple offers on a consistent basis.

Furthermore, some LOIs neglect to precisely define working capital, deferring its definition and calculation to a later stage. However, this seldom works in your favor, as your bargaining power as the seller diminishes with time.

Typically, the price encompasses the following assets:

• Petty cash for retail businesses.
• Furniture, fixtures, and equipment.
• Vehicles, if they’re part of the business operations.
• Leasehold improvements.
• Training and transition period.
• Covenant not to compete.
• Business assets like the name, website, email addresses, phone number, software, etc.
• Business-related records, financial documentation, client and customer lists, marketing materials, contract rights, etc.
• Trade secrets (whether registered or not) and intellectual property, such as patents and trademarks.
• Transfer of licenses and permits.
• Assumption of product warranties.

However, if the buyer is a corporate entity, the purchase price may also include the following assets and liabilities:

• Working capital.
• Accounts receivable.
• Inventory, supplies, and work in progress.
• Prepaid expenses.
• Accounts payable.
• Short-term debt.
• Accrued expenses.

The purchase price typically excludes certain assets and liabilities, which are as follows:

• Real estate and land – These may be subject to separate purchase agreements.
• Assumption of long-term debt – Long-term debt obligations are generally not part of the purchase price.
• Your entity – Unless the sale is structured as a stock sale or merger, the entity itself is not typically included in the transaction.

It is essential for the Letter of Intent (LOI) to explicitly specify which assets and liabilities are encompassed within the purchase price.

Payment Structure

The LOI should also provide a clear outline of how the purchase price will be paid. Common forms of consideration for the purchase price include:

• Cash at closing.
• Bank financing: If bank financing is involved, details such as the lender’s position, commitment letter timing, and potential financing contingencies should be outlined.
• Seller Note: If a seller note is part of the deal, the LOI should address whether business assets are used as collateral, security in case of a senior lender, note terms (including duration and interest rate), amortization details, and any personal guarantees by the buyer.
• Stock: If stock is offered as part of the consideration, information such as trading volume, stock exchange listing, and restrictions on trading should be specified.
• Earnout: If an earnout arrangement is included, the LOI should define the terms and conditions of the earnout, which can be a complex aspect of the transaction.
• Escrow/Holdback: Many M&A transactions involve a holdback, where a portion of the purchase price is held in escrow to cover potential post-closing indemnification obligations related to representations and warranties. The LOI should outline the terms of the escrow, including the amount, basket, and cap, as well as details regarding the representations and warranties.

While an initial offer might appear alluring at first glance with an apparently robust valuation, it’s essential to conduct a thorough analysis to determine its true attractiveness. Take, for instance, any contingent components of the price, such as a seller note, earnout, or escrow. It’s imperative to scrutinize the terms and conditions governing these contingent payments. Additionally, assessing the financial strength of the buyer is paramount.

For transactions within the lower middle market, typically ranging from $1 million to $30 million in purchase price, the following payment structures are commonly observed:

• Cash at Closing: Typically falls within the range of 50% to 90%. This encompasses cash delivered to the seller upon closing, which may also include bank financing.
• Seller Note: Typically ranges from 10% to 30%.
• Earnout: Commonly spans from 10% to 25%.
• Escrow: Typically falls between 10% to 20%.
• Stock: This payment method is less common unless the buyer is publicly traded. In certain cases, especially with private equity firms, sellers may be requested to “rollover” their equity into the new entity, usually accounting for 10% to 25% of the seller’s company’s value.

Fixed Purchase Price vs. A Range or Formula

The purchase price should ideally be a fixed amount, like $10 million, rather than a range such as $8 million to $12 million. Ranges are commonly used in indications of interest (IOI) for larger transactions ($100 million+), but they’re best avoided in lower middle-market transactions. If the buyer proposes a range, it’s advisable to provide them with more financial information to help firm up the price before moving to confirmatory due diligence.

Valuations based on a formula should be avoided if possible, for instance, using 4.5 times the trailing twelve months’ EBITDA. Such formulas tend to be subjective, especially in how EBITDA is calculated, and these subjective terms can tilt in the buyer’s favor as the transaction progresses due to your diminishing negotiating position. Some formulas even include a cap on the purchase price. Unless you enjoy taking unnecessary risks, it’s wise to steer clear of caps.

When a formula is employed, the buyer may attempt to adjust the purchase price based on changes in revenue or EBITDA. If you do agree to such a provision, it’s crucial that the adjustment works both ways – both up and down – based on the value of the metric. In simple terms, if EBITDA increases or is found to be higher than your initial claim, the purchase price should also increase. For example, if the buyer agrees to pay 5.0 times EBITDA and you initially claimed EBITDA was $950,000, but due diligence uncovers that you understated EBITDA by $500,000 when it’s actually $1 million, the buyer should pay you $5 million in the purchase price.

Here’s a sample purchase price clause for clarity:

Buyer will acquire 100% of the common stock of Seller for a total consideration of $15,000,000, with adjustments for Cash, Indebtedness, and Net Working Capital.

Here’s a more detailed purchase price clause:

• Purchase Price: $7,000,000, calculated on a cash-free, debt-free basis, with working capital to be addressed as an additional payment, as detailed below (referred to collectively as the “Purchase Price”).
• A capped earnout, not exceeding $1,500,000 in total, equivalent to 10% of revenue over $8.5 million for a duration of 5 years. This calculation will be based on an annual 12-month period and paid within 60 days following the end of each 12-month period. It’s important to note that this measurement will align with past accounting practices as historically presented.
• An initial Working Capital Advance of $900,000 to be paid at the Closing. The remaining balance of the Working Capital Payment will be reconciled four (4) months after the Closing. The cumulative working capital amount constitutes the “Working Capital Payment.”
  The Working Capital Payment will be computed using the Closing balance sheet and will amount to 90% of the total collected Accounts Receivables, plus inventory, minus current liabilities.

Accounts Receivables existing at the Closing and subsequently deemed uncollectible by the Buyer will not factor into the Working Capital Payment. Any Accounts

Receivables not collected within the four (4) month period (without being declared uncollectible) will be retained until either collected or written off, with payment to Sellers upon collection.

Inventory should be accurately represented at its Closing value, valued at cost in accordance with the Company’s historical practices. No adjustments will be made to the inventory item values.

The Working Capital Payment, equal to 90% of the total working capital, aligns with the purchase of 90% of the Company by the Buyer.

Specifically, the Working Capital Payment excludes pre-paid items, work-in-progress, and any other assets, which are incorporated into the calculation of the purchase price. Projects will be billed truthfully and accurately through the Closing.

• Payment Terms. The purchase price will be structured as follows (subject to any adjustments detailed below):

– A $250,000 good faith deposit (the “Good Faith Deposit”) to be held by your attorney upon signing the LOI, serving as a credit towards the purchase price.

– $2,000,000 in cash to be paid to your attorney upon the parties signing the purchase agreement.

– $500,000 designated as a Working Capital Advance, payable at the Closing.

– The remaining portion of the Working Capital Payment will be reconciled four (4) months after the Closing and paid as and when the outstanding Accounts Receivables at Closing are collected.

– 10% rollover equity interests in Buyer will be issued to Willy Williams.

• Purchase Price Adjustments. The purchase price will be subject to the following adjustments:

– Cash: Any remaining cash on the balance sheet at Closing will increase the final price.

– Debt: Any outstanding debt on the balance sheet at Closing will decrease the final price.

– Non-Cash Working Capital: This is excluded and addressed in Section xx above.

– Claims: Any claims or liabilities resulting from the Company’s operations prior to Closing will reduce the purchase price and may be offset against ongoing payments owed to any of the Sellers.

Working Capital

Corporate buyers nearly always incorporate working capital into the purchase price. Why?

Corporate buyers regard working capital as no different from any other essential asset required for business operations, such as machinery or vehicles. Working capital is a vital asset that must stay within the business for its ongoing functioning. I reluctantly concede this point. Negotiating to exclude working capital is rarely successful. Nevertheless, there are strategies you can employ to safeguard yourself from this clause potentially causing issues later in the transaction.

Working capital is defined as current assets minus current liabilities, including:

Current assets

• Cash: Typically excluded, except for petty cash in retail operations.
• Accounts receivable
• Inventory, which encompasses supplies and work in progress, as well as prepaid expenses

Current liabilities

• Accounts payable, including short-term payments to credit-granting suppliers.
• Accrued expenses, like payroll.
• Short-term debt

Working capital fluctuates daily in most businesses. The primary components are accounts receivable and inventory. In most Letters of Intent (LOIs) involving working capital, there is an assumption about the current working capital level required for business operation. An adjustment is then made post-closing based on the actual working capital amount calculated. This is where buyers often find opportunities. If the definition is vague or incomplete, buyers tend to interpret it in their favor, resulting in less money in your pocket.

In the event of a variance between the pre-closing and post-closing working capital, the purchase price will be adjusted accordingly. Given the dynamic nature of working capital, it’s common for such clauses to lead to post-closing disputes. In fact, I recently spoke with an intermediary who had just resolved a working capital dispute, resulting in the seller receiving $1 million less than expected.

Here’s a sample clause that incorporates working capital:

The Purchase Price will be determined by adding or subtracting, as necessary, the Adjustment Amount to or from the Base Purchase Price. The Adjustment Amount is defined as: (a) the amount of cash and cash equivalents on the balance sheet as of the Closing Date (“Cash”), minus (b) the Company’s indebtedness at Closing (which, for clarity, will be deducted from the Closing proceeds to the Sellers) (“Indebtedness”), plus (c) Net Working Capital (defined below) on the balance sheet at Closing. Before Closing, the Sellers, acting on behalf of the Company, will provide the Buyer with an estimate of the Cash, Indebtedness, and Net Working Capital of the Company as of the Closing Date (“Estimated Adjustment Amount”) for review and acceptance.

“Net Working Capital” will be defined as current assets (excluding Cash) minus current liabilities and will be calculated following the Company’s historical accounting practices. A customary post-Closing reconciliation of Cash, Indebtedness, and Net Working Capital will be conducted to resolve any differences from the estimate, with the Buyer preparing the initial calculation.

Many LOIs lack specificity when it comes to the calculation of working capital. For instance:

• How do we compute inventory? What’s the protocol for handling obsolete inventory? At what point is inventory deemed obsolete? Is it after 61 days, 91 days, 121 days, or some other timeframe? Are obsolete items completely written off, or is there a discounted valuation? Is inventory accounted for under LIFO or FIFO?
• What’s the methodology for calculating accounts receivable? When do we categorize an accounts receivable as bad debt? Does an account receivable still hold its value at 91 days? Is it assessed at the full amount or at a discounted figure? How does an allowance for bad debt factor into the accounts receivable calculation?
• How do we determine accounts payable? What specifically falls under accounts payable? How do we distinguish accounts payable from long-term debt – is it after 12 months or some other timeframe? How are overdue accounts payable addressed?

There are effective strategies to minimize conflicts when calculating working capital:

• Pre-sale Seller Actions: Before initiating the sale process, sellers should meticulously review their financial records and all elements of working capital. It’s advisable to maintain a monthly calculation of working capital and monitor any fluctuations. Additionally, the removal of obsolete inventory and the resolution of overdue accounts receivable should be prioritized. This proactive approach ensures clean financial records, instilling confidence in potential buyers. A well-maintained financial trail communicates to buyers that the business is under excellent management, potentially leading to reduced due diligence efforts on their part.
• Negotiating LOI Terms: Another approach is to clearly outline the working capital calculation method in both the Letter of Intent (LOI) and the purchase agreement. However, it’s important to note that LOIs typically maintain a concise and positive tone, which may not accommodate a detailed definition of working capital calculation. This can be perceived as a mood-killer. Consequently, sellers must either accept the risk associated with an unclear definition or invest the necessary effort to define working capital meticulously in the LOI. Selling a business is not without its complexities.

While the LOI may not delve into specifics regarding post-closing working capital adjustments, it’s a standard inclusion in nearly every purchase agreement, especially when buyers are well-advised, which most are. Therefore, it’s crucial not to overlook this section. It’s not just routine accounting language; it’s a concealed tool that buyers can employ if needed. It’s akin to purchasing a car with an unseen stick of dynamite in the trunk, and the buyer holds the remote for three months after the sale. If this concept raises discomfort, as it should, then it’s essential to address and clarify these terms before proceeding further.

Key Dates & Milestones

The majority of buyer-submitted LOIs tend to be devoid of deadlines. Why, you might wonder? Simply put, buyers have little motivation to impose such constraints upon themselves.

The solution, however, is straightforward – infuse your counteroffer with clear deadlines and essential milestones.

As a seller, it is paramount that you do not, under any circumstances, underestimate the significance of incorporating deadlines and milestones into the LOI. The moment that LOI is inked, your bargaining power diminishes significantly. Why, you ask? Well, most LOIs feature an exclusivity clause that mandates you to cease negotiations with any other potential suitors. This means that upon signing the LOI, you effectively take your business off the market and become vulnerable to the pressures associated with “sunk costs” – money spent that cannot be reclaimed. Savvy buyers are well aware of this dynamic and leverage it to their advantage. Your goal should be to avoid falling into this trap.

Ideally, the LOI should outline a comprehensive list of key dates and milestones, including:

• The proposed closing date
• The expiration date for the due diligence period
• A deadline for submitting a commitment letter from the lender, if there’s a financing contingency
• A deadline for the first draft of the purchase agreement
• A deadline for signing the purchase agreement

Pro Tip: If you find yourself in a position of substantial negotiating leverage over the buyer, consider including a clause in the LOI that stipulates the loss of exclusivity should the buyer fail to meet the established deadlines. Such a clause not only keeps all potential buyers on their toes but also safeguards your negotiating leverage as the transaction unfolds.

Confidentiality

Buyers engaged in negotiations with a seller represented by an M&A intermediary typically enter into a confidentiality agreement before submitting an LOI. However, the nature of these negotiations can vary. Some LOIs reiterate the importance of confidentiality, while others elaborate on the original confidentiality agreement, either within the LOI itself or through a separate supplemental agreement.

In cases where negotiations might involve a direct competitor, I strongly recommend the use of a supplemental confidentiality agreement. This additional agreement can include precise language regarding non-solicitation of customers, employees, and suppliers, and can address other specific confidentiality concerns such as safeguarding trade secrets, non-public pricing details, employee names, or customer identities.

Now, you might wonder why a comprehensive NDA isn’t signed earlier in the transaction. The reason is that an NDA with overly burdensome terms can encounter resistance, especially in the initial stages when the buyer is still assessing their level of interest in the company. It’s only when the buyer has delved deeper into the process and is motivated to make an offer that they may be more open to negotiating the finer points of such an agreement. This is particularly true because, at this stage, they gain access to highly sensitive information, such as that found in the confidential information memorandum (CIM).

Additionally, if third parties are involved in the buyer’s due diligence process, you can also request that these third parties sign an NDA. It’s worth noting that CPAs and attorneys often have an implied duty of confidentiality and may not be required to sign a separate NDA.

Due Diligence

In the majority of buyer-submitted LOIs, you’ll find a brief mention of due diligence. Typically, this covers the duration and the access needed for conducting due diligence, with most buyers requesting 60 to 90 days for this process. My recommendation is to counter with a more efficient timeframe, suggesting 30 to 45 days. Remember, extensions can always be negotiated if required.

Ideally, the LOI should provide a more detailed overview of the due diligence process, outlining its scope and procedures. When it comes to granting access to customers and employees, it’s often best to remain silent on these matters in the LOI, unless absolutely necessary. If a buyer insists on meeting key customers and employees, it’s advisable to postpone such interactions until the later stages of due diligence, or ideally after the purchase agreement is close to finalization and all contingencies are resolved.

A tactic some buyers employ is gradually increasing their requests for information during the due diligence period, essentially wearing down the seller over time. Their belief is that the more time and resources you invest in due diligence, the more likely you are to make concessions in later negotiations. This tactic can be highly effective, especially against first-time sellers or those emotionally attached to their business.

Additionally, buyers often engage third parties like accountants, attorneys, and consultants to aid in due diligence. In the LOI, it’s important to stipulate that these third parties must also adhere to a confidentiality agreement (NDA), or alternatively, the buyer should remain accountable for any breaches caused by these third-party actors.

Here’s a sample clause that outlines the nature of the due diligence period:

“The execution of the Definitive Agreement and Closing are contingent upon the Purchaser’s successful completion of financial and legal due diligence. Both parties anticipate that due diligence will conclude within 30 days from the date of this Term Sheet.”

Exclusivity

The exclusivity clause, often referred to as a stop-shop or no-shop clause, serves as a vital component in the negotiation process. It essentially bars the seller from seeking, entertaining, or accepting other offers for a specified period, typically lasting anywhere from 30 to 90 days after the LOI is accepted. The exact details of this clause, including its duration and the prohibited activities, can vary based on the specific wording within the contract. As a seller, it’s crucial to approach this concession with meticulous consideration.

Corporate buyers typically insist on having an exclusivity provision in place, and understandably so. They commit a substantial amount of time and resources to conduct due diligence and craft their offer, and they want assurance that you won’t entertain offers from other parties simultaneously. For corporate buyers, the prospect of negotiating without exclusivity is rare because they are unwilling to invest significant effort in a transaction if they suspect you are actively seeking alternative offers.

From the buyer’s perspective, it’s reasonable to expect an exclusivity period. They don’t want to invest substantial time and capital in due diligence, negotiations, and preparations for closing, only to have you accept a better offer from a different buyer or attempt to renegotiate the LOI terms based on a superior offer received after LOI acceptance. Exclusivity grants the buyer a window of time to work out the transaction details with confidence, knowing that the deal won’t be lost to another party.

Exclusivity, without a doubt, demands careful consideration. While I don’t often make unequivocal statements, I believe it’s essential to emphasize here. Many sellers underestimate the impact of an extended exclusivity period on their negotiating leverage. Therefore, it’s imperative to approach exclusivity commitments with caution and make efforts to limit the duration during which you are restricted from engaging with other potential buyers.

Length

In the realm of “stop shops,” these clauses commonly span from 30 to 90 days, although some buyers push for exclusivity periods of 45 to even 120 days. As a savvy seller, a golden rule to remember is to aim for exclusivity periods of 30 to 45 days, with 60 days being the outer limit. While most transactions typically unfold over three to four months, the beauty of exclusivity lies in its flexibility. It can be extended by mutual agreement, contingent upon hitting predefined milestones, which we’ll delve into shortly.

Opting for shorter exclusivity periods sends a clear signal to the buyer: a nudge to act swiftly and a gentle warning of potential consequences for procrastination. On the contrary, prolonged exclusivity periods can inadvertently spark prolonged negotiations, with both parties fixated on intricate legalities during the final stretch.

A well-crafted Letter of Intent (LOI) should explicitly state the exclusivity period’s duration, ideally pinpointing the precise expiration date. Now, as a seller, here’s where your strategic prowess comes into play. Be vigilant for buyers who insist on extended exclusivity, as this can grant them undue leverage over time. Generally, exclusivity periods exceeding 60 days are excessive and could encourage unnecessary delays, eroding your negotiation strength in the process.

Types of Exclusivity Periods

The wording of the exclusivity clause can vary in different agreements, but most commonly, it bars the seller from actively promoting the business and engaging in discussions or negotiations with third parties. Below is a typical clause you might encounter in a Letter of Intent (LOI):

The Seller commits to an exclusive arrangement with the Buyer starting from the date of this letter until October 10, 20xx (referred to as the “Exclusivity Period”). During this time, the Seller shall not, either directly or indirectly, seek, entertain, or engage in any discussions or proposals from any other individuals or entities regarding the acquisition of the Company or its assets. Starting from the effective date of this letter, the Seller will (a) terminate any ongoing sale discussions, (b) refrain from initiating new sale discussions, and (c) suspend all marketing activities, including the removal of online listings.

Some overly demanding LOIs may require the Seller to disclose any offers received during the exclusivity period to the Buyer. The Buyer’s aim is to ascertain what others are willing to pay for the business, which they may leverage if the offer is lower than theirs. It’s advisable not to agree to such a provision. Other clauses are less restrictive and permit you to continue marketing your business but prevent you from accepting a competing offer. Naturally, the less restrictive the clause, the more favorable it is for you.

The Impact of Leverage

Once you commit to the exclusivity period, the advantage shifts in favor of the buyer. The longer the buyer prolongs the process, the weaker your bargaining position becomes. This is not a hypothetical scenario – every seller must understand the consequences of agreeing to an exclusivity clause. The deal won’t improve for the seller; once the Letter of Intent (LOI) is signed, it can only become less favorable. Furthermore, the more time that passes between LOI signing and closing, the greater the likelihood of changes to the transaction terms. For you, a shorter exclusivity period is preferable.

Typically, when other potential buyers discover that you’ve accepted an offer, they tend to move on to other opportunities or corporate projects. Consequently, you may lose out on the best buyers, and the current buyer you’re negotiating with is likely aware of this fact.

Regrettably, some buyers deliberately make generous offers they have no intention of following through on. They may take three months to conduct due diligence, inundating the seller with numerous requests and sowing seeds of doubt about the business. In their perspective, the more time and money the seller invests in due diligence, the better. Then, at the eleventh hour, they may start chipping away at the purchase price or even slash it substantially.

The outcome? It often doesn’t bode well for the seller. The business has been off the market for months, and interest from other potential buyers has likely cooled to the point where reviving discussions could prove challenging. If the business returns to the market, other buyers might perceive it as less attractive or demand price concessions at best, or at worst, they may decline to make another offer. Regardless of the timeframe, re-entering the market puts sellers at a significant disadvantage.

Preventing Retrading: Using Milestones, Deadlines, and Other Strategies

So, what’s the solution to avoid retrading in your business deals? Here’s what you should confidently do:

• Limit the Exclusivity Period: Ideally, restrict the exclusivity period to 30 to 45 days.
• Incorporate Milestones and Deadlines: Remember, you can mutually extend the exclusivity period, but if the buyer fails to meet these milestones, the exclusivity period should expire. Here are the key milestones:

– Completion of Due Diligence: Allow 30 to 45 days from the LOI signing.
– First Draft of Purchase Agreement: Aim for 15 to 30 days from LOI signing.
– Purchase Agreement Signing: Target 45 to 60 days after LOI signing.
– Presentation of Financing Commitment Letter to the Seller: Ensure it happens within 30 to 45 days from LOI signing.

• Include a Retrading Clause: Insert a statement in the LOI that explicitly states that if retrading occurs (meaning the buyer tries to renegotiate or proposes significant changes in price or terms), the exclusivity period automatically ends.

Affirmative Response Clause: Implement an “Affirmative Response Clause” like the one below:

“While acknowledging that this Letter of Intent is generally non-binding, the Seller retains the right, on one/two/three or more occasions during the exclusivity period, to request a written affirmative response from the Buyer. This response should confirm that the Buyer does not anticipate any substantial changes to the deal terms outlined in this Letter of Intent. Failure to respond will result in the automatic termination of the exclusivity provisions in this Letter of Intent.”

Earnest Deposit

Why is it that while an earnest money deposit is customary in transactions ranging from $1 million to $5 million, it becomes less prevalent in mid-sized deals? Let’s delve into the reasons.

Buyers operating in the middle market often perceive their commitment to rigorous due diligence as a clear demonstration of their earnest intent. They consider this investment of both time and financial resources to be a credible substitute for an earnest money deposit. While it’s true that conducting thorough due diligence is a serious undertaking, it’s important to exercise caution when negotiating with direct competitors.

Now, the question arises: How much should you allocate for a deposit? In smaller transactions, around 5% typically suffices. However, in larger deals, it’s more practical to specify a dollar amount (for instance, 5% of a $50 million transaction amounts to a staggering $2.5 million, which is often excessive). For substantial transactions, a range of $50,000 to $250,000 is usually deemed adequate.

Another crucial consideration is the refundability of the deposit and the conditions surrounding it. Most buyers prefer a refundable deposit until the signing of a purchase agreement, while some sellers may seek a portion to be non-refundable. What should be avoided at all costs is insisting on a fully non-refundable security deposit. I’ve come across instances where sellers demanded such deposits before any due diligence had even begun, resulting in the swift departure of potential buyers. Requesting a non-refundable deposit is generally viewed as unreasonable by most buyers and could lead them to withdraw from the negotiation table.

A potential compromise could involve progressively making the deposit non-refundable based on specific milestones, such as completing due diligence, drafting the purchase agreement, or securing a financing commitment letter. In practice, this can be a complex and time-consuming negotiation process, often justifiable only when dealing with direct competitors.

Allocation

The purchase price of a transaction can significantly hinge on the tax implications, making it a pivotal factor in determining whether the deal should take the form of an asset purchase or stock purchase. Ideally, the Letter of Intent (LOI) should explicitly outline the allocation of the purchase price for tax purposes, a crucial detail that can prevent complications down the road. How this allocation is determined holds significant weight for both parties involved and can even make or break a deal if compromise is elusive.

In theory, negotiating the allocation may seem straightforward, but when both parties involve their Certified Public Accountants (CPAs), you’ll likely encounter varying proposals. Finding common ground may necessitate significant adjustments to your initial allocations.

Consider this sample allocation for a $12 million transaction:

• Class I: Cash and bank deposits — $0
• Class II: Securities, including actively traded personal property and certificates of deposit — $0
• Class III: Accounts receivables — $500,000
• Class IV: Stock in trade (inventory) — $2,000,000
• Class V: Other tangible property including furniture, fixtures, vehicles, etc. – $2,500,000
• Class VI: Intangibles, including covenant not to compete — $1,000,000
• Class VII: Goodwill — $6,000,000
• Total Purchase Price: $12,000,000

Initiating discussions about the allocation at an early stage often meets with less resistance, as both parties are more open to swift compromises, fostering a spirit of progress and cooperation.

Alternatively, you may consider jointly agreeing to allocate the price based on the tax basis in the assets, an approach that typically works in your favor. Here’s a simplified example:

For tax purposes, the Purchase Price will be allocated according to the Company’s tax basis in its assets.

Legal Form of Transaction

Another vital consideration in your deal is determining whether it will be structured as an asset sale or a stock sale. This decision often hinges on the preferences of the parties involved.

Sellers typically lean towards a stock transaction. Why? Because it frequently results in higher net proceeds, after accounting for taxes, compared to an asset sale.

Buyers, on the other hand, often favor asset sales. Why? Because it minimizes the potential for contingent liabilities, and it provides the buyer with a stepped-up basis in the assets. This, in turn, reduces taxable income for the buyer post-closing by maximizing depreciation write-offs.

In the lower middle market, it’s important to note that the majority of transactions are structured as asset purchases. If your sale falls into this category, it’s crucial for the Letter of Intent (LOI) to clearly define the assets and liabilities included in the price.

It’s worth mentioning that the form of the transaction, whether it’s an asset or stock sale, can also ripple into other terms outlined in both the LOI and the purchase agreement, particularly affecting representations and warranties. By confidently considering and addressing this aspect, you set a solid foundation for a successful transaction.

Escrow (Holdback)

In many Letters of Intent (LOIs), there’s often a noticeable absence of details regarding the amount of the purchase price that will be set aside in an escrow account to cover potential indemnification claims arising from breaches of representations and warranties outlined in the purchase agreement. Typically, in middle-market transactions, a portion of the purchase price (usually around 10%) is earmarked for this purpose, and it’s held in escrow for a specified period, which commonly ranges from 12 to 18 months. This serves as a protective measure in case the seller’s claims, such as representations or warranties made in the purchase agreement, later prove to be inaccurate, or for addressing other issues like breaches of post-closing covenants.

Ideally, the LOI should explicitly state whether a percentage of the price will be held in escrow and, if so, specify the exact amount of the holdback. Here’s an example clause:

10% of the Purchase Price, payable at Closing, will be deposited into a third-party escrow account. It will be held for a period of twelve months following the Closing date, serving as security for Buyer’s indemnity claims as per the terms of the Purchase Agreement.

When dealing with escrow, it’s crucial to address these key points:

• Escrow Conditions: Define the circumstances under which the escrow funds can be accessed.
• Escrow Amount: Clearly state the amount of money to be held in escrow.
• Control of Release: Specify who has control over the release of escrowed funds.
• Escrow Duration: Determine the length of the escrow period.
• Remedy for the Buyer: Clarify whether the escrowed amount is the sole remedy available to the buyer.
• Interest Accrual: Indicate who is entitled to any interest earned on the escrow account.

Reps & Warranties

It’s a universal truth that no matter how comprehensive a buyer’s due diligence efforts are, they can never be entirely certain that every potential issue within a business has been unearthed. This is where representations and warranties come into play, designed to safeguard against any oversights during due diligence. Negotiating the terms of these can be a contentious aspect of the purchase agreement. Unfortunately, many Letters of Intent (LOIs) tend to be vague on this subject, often mentioning only that the reps & warranties will be “customary.” Specifics such as exclusions, knowledge qualifiers, caps (maximum liability), or the basket (minimum liability) are frequently left out.

In most cases, this represents the best approach, and both parties must proceed in good faith, trusting in each other’s integrity. Your objective as the seller is to limit your exposure, while the buyer will naturally seek the broadest protection possible. It’s common for LOIs to state that they are subject to the preparation of the purchase agreement, which will ultimately contain representations and warranties that are customary or appropriate for a transaction of this kind.

Here’s an example clause to consider:

The Purchase Agreement will incorporate representations and warranties suitable for a transaction of this nature. These may encompass matters such as capitalization, authority, environmental considerations, taxes, employee benefits and labor affairs, legal compliance, and customary aspects related to the business, including its financial statements.

Additionally, some LOIs may include a standard provision wherein each party represents that entering into the LOI or purchase agreement will not conflict with or breach any other contract. Typically, this is a formality and rarely a point of negotiation.

Conditions (Contingencies)

In business deals, most Letters of Intent (LOIs) come with a set of conditions that outline the requirements for finalizing the transaction. These conditions cover various aspects, including regulatory approvals, due diligence completion, securing financing, obtaining third-party consents for critical contracts, securing employment agreements with key personnel, ensuring there’s no significant adverse change in the target company’s business or prospects, and executing the purchase agreement.

It’s important to note that while many LOIs are non-binding, these conditions play a vital role in establishing the expectations of all parties involved. Essentially, conditions provide an exit route for the buyer, and occasionally the seller, if they cannot be met. This holds true even in non-binding LOIs. Additionally, most state laws mandate that the parties act in good faith and make their best efforts to resolve these conditions.

Interestingly, most LOIs do not specify the level of effort required to fulfill these conditions, such as whether “best efforts” or “commercially reasonable efforts” are expected. Parties typically turn to state law to determine the extent of effort needed.

In practice, demonstrating that a buyer did not make reasonable efforts to meet the conditions can be challenging. Generally, if the conditions cannot be satisfied, the transaction is canceled. The exception arises when a competitor submits an offer with the sole aim of gaining competitive insights and does not genuinely attempt to address the conditions outlined in the LOI.

The financing contingency is a common clause in purchase agreements, but its importance varies depending on the type of buyer. Well-capitalized companies typically have the funds on hand to complete a transaction, while private equity firms often need to secure third-party financing.

As a seller, the biggest downside of a financing contingency is that it gives the buyer an easy out. If the buyer changes their mind, they can simply claim that they were unable to obtain financing. However, this is not as big of a risk as it may seem, since most letters of intent (LOIs) are non-binding anyway.

The biggest red flag for sellers is a buyer who has little money on hand and is seeking to finance a large portion of the purchase price. These buyers may not have existing relationships with banks or any experience in the industry, making it difficult for them to obtain financing. If the buyer is planning to shop for investors after signing the LOI, this is a major warning sign.

Covenants

In the realm of law, a covenant signifies a steadfast commitment to either undertake specific actions or refrain from doing so. Within the context of a Letter of Intent (LOI), these covenants primarily revolve around the manner in which business operations will unfold leading up to the finalization of the deal. For instance, one might encounter language like, “Between the date of this Letter of Intent and the closing, the sellers solemnly pledge to continue conducting business in its ordinary course.”

Essentially, the buyer seeks an ironclad assurance that business activities will proceed as usual until the closing takes place. This entails an unwavering commitment to sustaining ongoing marketing efforts and refraining from making any significant alterations to the business landscape before the deal is sealed. Such alterations could encompass actions like terminating key personnel, liquidating assets, or disbursing substantial bonuses. In some cases, LOIs explicitly forbid such changes, while in others, they necessitate the buyer’s green light before any modifications can be implemented.

The buyer’s underlying objective is to safeguard against radical shifts that might have an adverse impact on the business’s overall value. Typically, buyers are interested in the seller maintaining business operations in their usual fashion, albeit with a customary request to consult them on pivotal decisions before implementation. It’s worth noting that I’ve encountered instances where sellers have made sweeping changes prior to the closing, such as terminating significant advertising contracts, dismissing crucial personnel, discontinuing specific lines of business, or divesting substantial equipment assets. As a seller, your course of action should align with business as usual, and major changes should only be contemplated following the buyer’s explicit approval.

Seller’s Role

Another pivotal aspect within the realm of LOIs revolves around determining the seller’s post-closing involvement in the business. If your intention is to remain a key player in the operations, it’s prudent to address essential details of your employment or consulting arrangement upfront, including salary considerations, before formally accepting the LOI.

In most instances, it may not align with your financial interests to persist in your role within the business. For instance, if the business generates an annual EBITDA of $3 million, it’s improbable that many sellers would be willing to continue their involvement for a mere $300,000 annual salary, essentially accepting a substantial 90% pay cut. The majority would understandably balk at such an arrangement. Consequently, it’s advisable to ascertain the buyer’s expectations regarding your ongoing role and potential compensation at this stage. If a consensus on the terms of the employment agreement proves elusive, it would be pragmatic to reconsider the acceptance of the LOI.

There are three main scenarios where your continued involvement in the business can be considered:

• Consulting: This often arises when sellers possess invaluable knowledge crucial for a smooth transition. It’s particularly common in complex businesses or when the buyer requires extensive guidance from the seller.
• Sales-Only Roles: In cases where sellers have a knack for sales and wish to supplement their retirement income, retaining a commission-based sales position can be beneficial. Many sellers opt for this if they prefer sales over management. It can be a mutually beneficial arrangement, especially if the buyer offers flexible working hours.
• Sales to Financial Buyers: Private equity groups typically expect sellers to remain involved post-closing, at least until they secure a suitable replacement. Many prefer long-term seller involvement. To incentivize sellers, financial buyers often offer equity, typically ranging from 10% to 30% of the purchase price. This arrangement allows sellers to diversify risk by selling a majority stake upfront and potentially cashing in their remaining equity in a future sale, typically within three to seven years.

If you have no intention of staying on with the business, it’s advisable to seek buyers who do not mandate your continued involvement. Alternatively, consider the proactive approach of building a robust management team and identifying a potential successor CEO or manager several years before the transition.

Management’s Role

Within an LOI, we encounter two fundamental concerns tied to the workforce of the business: disclosure and retention.

Disclosure

One of the most formidable challenges faced by sellers revolves around the delicate matter of determining which employees should be informed about the impending sale and when this revelation should occur. For most sellers, the preference leans toward safeguarding this information as a closely guarded secret until the very day of closing. Occasionally, limited disclosure might be extended to trusted individuals like the CFO and professional advisors. After all, as the saying goes, “loose lips sink ships,” and the more people privy to such information, the higher the risk of it reaching unintended ears.

Interestingly, buyers often adopt a contrasting approach, seeking access to key employees even before the finalization of the deal. Their motivations for engaging with these key personnel generally encompass two primary objectives:

• Due Diligence: Key employees can provide invaluable insights for the buyer’s due diligence process. They may offer candid perspectives on the business’s culture that the seller might not, or they may shed light on critical aspects of the business that the seller may have inadvertently omitted.
• Retention: Ensuring the retention of key employees is another critical aim. Buyers recognize the significance of retaining talent that is vital to the business’s ongoing success.

Two pivotal considerations come into play when deciding how to approach employee communication:

• Timing: The timing of when to inform your employees hinges largely on your business’s existing culture. In cases where a healthy and tight-knit culture prevails within a small team, early disclosure before the sale can be a viable option—provided you’re confident in their discretion. However, the conventional wisdom suggests avoiding extremes: don’t disclose too prematurely (risking premature departures) or too belatedly (potentially causing feelings of betrayal).
• Method: In most scenarios, it’s prudent to commence with the disclosure to key managers, allowing them to set the tone. Subsequently, the sale can be revealed to the broader employee group in a collective setting. This approach is particularly effective when key managers command respect within the organization. For larger teams, key managers can undertake this responsibility for their respective groups.

Additionally, you can complement this communication strategy with a retention agreement tailored to your key employees. By formalizing a retention bonus agreement, you can include confidentiality and non-solicitation clauses that are transferable to the buyer.

Should you opt to permit the buyer to engage with your employees, this should ideally occur towards the conclusion of the due diligence phase, preferably after finalizing the purchase agreement.

Retention

Another significant concern for buyers pertains to employee retention. Some LOIs include a provision stating that the buyer’s commitment is contingent on securing employment and non-compete agreements from key staff members. This process can proceed smoothly, especially if the buyer has substantial resources and is willing to offer competitive compensation packages to retain your key personnel.

However, it’s essential to exercise caution before agreeing to such a clause. If employees become aware that they hold leverage over the sale, they may exploit this situation. As a business owner, the prospect of being held hostage by your own employees is far from ideal.

I recall a transaction from nearly a decade ago where several key employees made exorbitant demands of the buyer, fully aware of their bargaining position. Ultimately, the buyer did not yield to these demands and terminated the employees the day after the closing. It’s a stark reminder that sometimes, those who make the most noise find themselves replaced.

Non-Compete

While it’s generally understood that sellers are expected to refrain from competing with the buyer after the closing, this commitment is often implicit rather than explicitly outlined in the LOI. However, it’s a prudent practice to include a single line in the LOI, clearly stating that the buyer anticipates the seller’s agreement to sign a non-compete agreement at closing, specifying the duration and geographic scope. If you intend to pursue any business-related activities post-closing that could potentially overlap with the non-compete, it’s advisable to define and address those activities to ensure they do not conflict with the agreement.

Termination

In the realm of LOIs, termination can be a delicate matter, especially when the LOI is non-binding. In such cases, it should ideally be easily cancelable without any lasting impact. While certain LOIs may incorporate breakup or walk-away fees, it’s worth noting that these fees are relatively uncommon in lower middle-market transactions.

Some astute buyers may also insert a clause that obligates the seller to reimburse their expenses should the seller opt to withdraw from the deal. In turn, sellers may consider seeking a reciprocal clause if the buyer decides to walk away. Such negotiations are par for the course when crafting an LOI.

In practice, maintaining momentum in the negotiation process is just as crucial as ironing out the finer details. Nevertheless, it’s a fundamental principle that all LOIs should include a termination clause, stipulating that the agreement will cease to be valid if you and the buyer fail to reach a consensus by a specified date.

Miscellaneous

Expenses

Certain LOIs contain provisions addressing the allocation of fees and expenses between the parties involved. Typically, these provisions dictate that each party is responsible for covering the expenses they incur. However, some LOIs take it a step further by stipulating that if the deal falls through, the seller must reimburse the buyer for their expenses. This requirement is often viewed by most sellers as unreasonable and is typically met with resistance.

Governing Law

Determining the governing law is straightforward when both parties are located in the same state. However, if the buyer and seller are situated in different states, the buyer often proposes their home state’s laws as the governing jurisdiction. The seller may agree to this, particularly if it’s Delaware or if the buyer holds significantly more negotiating leverage. In cases where a middle ground is sought, the parties typically opt for a neutral state as the governing authority.

Legal Authority

Some LOIs may also necessitate that the parties confirm their legal capacity to execute the transaction.

The Letter of Intent Process

Let’s delve into the various negotiation approaches and styles when it comes to crafting a Letter of Intent (LOI):

• LOI Authorship: Typically, the responsibility of drafting the LOI falls upon the buyer, especially if the buyer is a corporate entity. However, there are exceptions. Sellers may take the reins in drafting the LOI if they hold a strong negotiating position, are simultaneously engaging with multiple parties, or if the buyer is an individual or a smaller competitor looking to minimize legal expenses at this stage. As a seller, if the opportunity arises, it’s wise to take charge of preparing the LOI.
• Length Variation: LOIs come in a spectrum of lengths, ranging from concise one-page documents to more comprehensive six to seven-page agreements. Most commonly, LOIs span two to four pages.
• Skipping the LOI: While unusual, some parties opt to forgo the LOI and directly dive into a definitive purchase agreement. This route is more prevalent when the seller wields significant negotiating power, the buyer has conducted preliminary due diligence, or if the buyer is a direct competitor where due diligence is sensitive. This route accounts for less than 2% of transactions, in my estimation.
• Format Blend: LOIs often strike a balance between a friendly letter and a traditional legal agreement. There are no strict format requirements, but most commence with courteous introductory paragraphs before delving into the proposed transaction terms. Buyers typically favor a more informal tone with minimal details, geared toward advancing to the next phase – due diligence. However, sellers should aim for maximum detail and specificity in the LOI.
• Initial Draft Origin: The buyer commonly takes the lead in preparing the initial draft of the LOI. One downside for the seller is that the party preparing the first draft wields significant influence over the document’s content. In some instances, this can lead to one-sided agreements that necessitate substantial revisions, slowing the negotiation process and impeding momentum. In response, the seller’s attorney or M&A advisor may counter with a reverse LOI – essentially, a fresh LOI draft. This approach proves practical when the initial draft is so far from the mark that it’s more efficient to create an entirely new document rather than heavily edit the buyer’s draft.
• Navigating the Process of Change: Typically, when it comes to revising the LOI, it’s customary for both the buyer and seller to exchange red-line versions using Microsoft Word. If the buyer initiates the first draft, they often begin by sending a PDF version of the LOI and provide the Word format only upon the seller’s attorney’s request. The two parties then engage in a back-and-forth of red-lined versions until they reach an agreement. It’s a practical practice to commence each new round of negotiations with a clean draft (with no tracked changes), as tracking multiple alterations can become cumbersome after the second round.
• Effective Communication: It’s also advisable to engage in phone discussions to address potential issues. This verbal exchange helps both parties gain insight into each other’s motivations behind requested changes. It allows room for creative alternatives that can align with the needs of both parties, facilitating the path to a mutual agreement.
• Timeline for LOI Signing: The negotiation of most LOIs typically spans one to three weeks. While some sellers might find this timeframe unreasonable, it aligns with common practice. Generally, each round of negotiations consumes about one to three days per side. Thus, one round of negotiations for both parties usually totals two to six days. On average, negotiations go through two to three rounds of changes, totaling four to 18 days. Factoring in weekends, the average timeline falls between two and three weeks. If you are negotiating with multiple buyers, it may extend further, as most sellers wait to receive LOIs from all parties before proceeding with one.
• LOI Signing Timing: LOIs are most commonly signed one to two months after executing a non-disclosure agreement. In some instances, a buyer might take as long as six months or more, as they might explore other opportunities before returning to express interest in the business. Typically, the initial one to three weeks involve reviewing the confidential information memorandum (CIM), posing queries to the seller, and seeking additional information. If the buyer remains interested, they might request a face-to-face meeting or seek further clarification on financial statements. Subsequently, the buyer might spend two to three weeks evaluating the acquisition, analyzing financial data, and preparing a valuation model to determine their offering price. On average, this process takes buyers one to two months before they are ready to submit an LOI. While some buyers move swiftly, they represent the exception rather than the norm.
• Negotiation Strategies: Buyers employ various tactics in negotiations. Some may initially present a high offer with the intention of gradually lowering it over the following months. Others take a more moderate approach, offering a reasonable deal they intend to stick with. Differentiating between these two buyer types often involves delving into more extensive negotiations and pressing for specifics. Buyers with insincere motives tend to evade committing to details such as milestones, deadlines, and other concrete measures.
• Assessing Buyer Commitment: It’s crucial to evaluate the level of commitment from potential buyers. Some, like search funds, may rush into an LOI without certainty about their financing capabilities, aiming to kickstart their quest for funds. It’s essential to gauge a buyer’s ability to follow through with the transaction.
• Level of Detail: Negotiation approaches vary. While some parties focus on high-level terms like the purchase price, others dive deep into the nitty-gritty specifics. From a seller’s perspective, striking a balance that maximizes detail without excessively sacrificing momentum is advisable. While it may take more time, it ensures alignment and prevents premature commitment. It also reduces the risk of heavy investments in due diligence, which can lead to diminished negotiating leverage down the road. Achieving this balance is a nuanced task where the guidance of an experienced M&A attorney proves invaluable.
• The “Final Offer” Myth: We’ve all encountered the “final offer” statement in negotiations – a tactic occasionally employed by buyers. It’s prudent to view such declarations with skepticism, as they are seldom genuinely final.
• Public Companies and LOIs: Public companies often steer clear of submitting an LOI. Doing so constitutes a material agreement, triggering reporting obligations and potentially intensifying competition for the acquisition.

LOI Recap

Major Terms & Characteristics of an LOI

Let’s delve into the primary terms and features of an LOI and how they influence the negotiation landscape:

• Non-Binding Nature: The majority of LOIs feature non-binding terms.
• Preliminary Agreement: The LOI serves as a preliminary agreement, destined to be superseded by a purchase agreement. It acts as the starting point for due diligence. Any transaction terms not explicitly defined in the LOI tend to tilt in favor of the buyer when detailed in the purchase agreement.
• Exclusivity Clause: Most LOIs include an exclusivity clause.
• Limited Information: The specifics of the transaction and the content of the purchase agreement often evolve based on discoveries made during due diligence.
• Contingency: The LOI hinges on the successful completion of due diligence by the buyer.
• Momentum Builder: The LOI offers an opportunity for both parties to tackle issues before becoming entrenched in their positions.
• Spotlight on Unresolved Matters: It brings to light any potential issues that remain undefined.
• Binding Provisions: Certain provisions, such as exclusivity, confidentiality, due diligence access, earnest money deposit, and expenses, are typically structured to be binding.

Why bother if the agreement is non-binding?

• Evaluating Commitment: The LOI serves as a litmus test for the parties’ dedication and seriousness before they plunge into the intricacies of the transaction.
• Moral Commitment: Beyond the legal aspect, the LOI establishes a moral commitment for both parties, affirming their intentions and good faith.
• Declaration of Intent: It articulates the intentions of the involved parties, shedding light on their true priorities and objectives.
• Key Terms on Record: The LOI immortalizes the essential terms of the deal, offering clarity and a reference point.
• Exclusivity Privilege: Granting exclusivity to the buyer, it empowers them to invest in due diligence without competition.
• Diminished Uncertainty: By ironing out significant transaction details, the LOI minimizes the chances of later-stage disagreements.
• Clear Contingencies: It provides a clear framework for conditions and contingencies.
• Lender’s Prerequisite: Many lenders require an LOI before considering loan underwriting.
• Due Diligence Authority: The LOI authorizes both parties to conduct due diligence, a pivotal step before the commitment of resources to draft and negotiate a purchase agreement.
• Price Agreement: Crucially, the LOI facilitates a consensus on the purchase price before committing to the expenses associated with due diligence.

Problems & Solutions

• Issue: Terms rarely improve for the seller post-LOI signing.
  • Solution: Define as many terms as possible upfront in the LOI.
• Issue: Undefined terms typically favor the buyer.
  • Solution: Thoroughly outline as many terms as possible within the LOI.
• Issue: Extended exclusivity weakens your negotiation position.
  • Solution: Opt for shorter exclusivity periods while incorporating milestones.
• Issue: Signing the LOI can diminish your leverage.
  • Solution: Take the time to negotiate the LOI meticulously, and expedite proceedings after signing.
• Issue: Problems uncovered during due diligence can lead to less favorable pricing and terms.
  • Solution: Be well-prepared for due diligence to mitigate potential issues.

Contents

Introduction: The majority of LOIs kick off with pleasantries, including greetings and a preamble. Following this, some LOIs transition into a fundamental overview of the acquisition, encompassing details like the purchase price, the proposed transaction format, and other high-level terms.

Binding vs. Non-Binding: A well-crafted LOI should unequivocally state the parties’ intentions regarding the binding nature of the document. Some LOIs clarify this in the introduction or title, while others distinctly separate binding and non-binding sections. Alternatively, some LOIs conclude with a paragraph that delineates the binding and non-binding aspects. An all-too-common mistake in LOIs is labeling the entire document as non-binding.

Purchase Price & Terms: Determining the “total” purchase price isn’t always straightforward by just glancing at the purchase price figure. Many LOIs include additions and deductions to the purchase price, itemized in a separate section. When evaluating an offer, it’s prudent to dissect it in a spreadsheet, accounting for each asset and liability contributing to working capital (e.g., accounts receivable, inventory, accounts payable). This approach enables apples-to-apples comparisons among multiple offers. The LOI should expressly specify which assets are encompassed within the price. Ideally, the purchase price should be a fixed amount (e.g., $10 million), rather than a range (e.g., $8 million to $12 million). It’s advisable to steer clear of valuations based on formulas, such as a price set at 4.5 times the trailing twelve months’ EBITDA. If you do agree to such a provision, ensure that the adjustment is bilateral – accounting for both upward and downward shifts based on the metric’s value.

• Consideration: The LOI should provide absolute clarity on how the purchase price will be structured and paid. These are the most prevalent forms of consideration for the purchase price:
• Cash at Closing: Typically ranging from 50% to 90%.
• Bank Financing: Key questions here include the lender’s seniority, the timing for obtaining a commitment letter from the bank, and whether the LOI encompasses a financing contingency.
• Seller Note: If the business’s assets secure the note, what protections does the seller have if a lender holds a senior security interest? The terms of the note, including its duration, interest rate, amortization, presence of a balloon payment, and the buyer’s willingness to personally guarantee it (typically within the range of 10% to 30%).
• Stock: Factors to consider include the trading volume of the stock, the stock exchange where it’s listed, and the ease of converting the stock to cash (note that most stock in M&A deals is restricted and can’t be traded for a period). This option is relatively rare unless the buyer is publicly traded.
• Earnout: Understanding the terms of the earnout is crucial, although it’s a complex and potentially risky area for sellers. Earnout percentages typically fall between 10% and 25%.
• Escrow/Holdback: The LOI should outline the specifics of the escrow, including the amount, basket, and cap, as well as the terms of representations and warranties (basket, cap, etc.), which generally range from 10% to 20%.

Working Capital: Corporate buyers almost invariably incorporate working capital into the purchase price. Working capital is calculated as current assets minus current liabilities. In most LOIs that involve working capital, there’s an assumption about the necessary level of working capital to run the business. Then, after the closing, an adjustment is made based on the actual working capital amount. If a variance exists between the pre-closing and post-closing working capital, the purchase price gets adjusted accordingly. The LOI should provide a clear method for calculating working capital, both within the LOI itself and in the subsequent purchase agreement.

Key Dates & Milestones: The LOI should feature deadlines and milestones crucial for the buyer to retain exclusivity. It should encompass:

• The due diligence period’s expiration date.
• A deadline for delivering a lender commitment letter (if a financing contingency exists).
• A deadline for producing the initial draft of the purchase agreement and executing it.
• The proposed closing date.

Confidentiality: While some LOIs reaffirm the confidential nature of negotiations, others expound on the initial confidentiality agreement. This may manifest as an additional LOI clause or a separate supplementary agreement. When negotiating with a direct competitor, it’s wise to include a supplemental confidentiality agreement covering non-solicitation of your customers, employees, and suppliers, along with safeguarding trade secrets, non-public pricing data, employee names, or customer identities.

Due Diligence: Buyers often request a 60 to 90-day due diligence period. A counterproposal of 30 to 45 days is reasonable, with the possibility of mutual extensions if needed. The level of effort put into due diligence preparation can influence the duration – more preparation may mean a shorter due diligence period. It’s advisable to resist granting access to customers and employees unless absolutely necessary. The LOI should mandate third parties to sign an NDA, or the buyer should bear responsibility for any breaches by third parties they employ.

Exclusivity: The exclusivity clause restricts the seller from seeking, discussing, negotiating, or accepting other offers for a defined period after LOI acceptance. The exact duration and prohibited activities depend on the clause’s language. Negotiating a 30 to 45-day exclusivity period (or a maximum of 60 days) is prudent. Shorter periods encourage buyer promptness and discourage delays. To safeguard against renegotiation tactics, you can:

• Limit the exclusivity period to 30 to 45 days.
• Include milestones or deadlines in the LOI; failing to meet them should end exclusivity.
• Specify in the LOI that attempting renegotiation terminates exclusivity.
• Incorporate an “Affirmative Response Clause.”

Earnest Deposit: While customary in deals ranging from under $1 million to $5 million, earnest deposits are less frequent in mid-sized transactions. For smaller deals, 5% is usually sufficient, while larger transactions may require $50,000 to $250,000.

Allocation: Ideally, the LOI should outline how the purchase price will be allocated for tax purposes. Negotiating this early often encounters less resistance, as parties are more open to quick compromises to advance the deal.

Legal Form of Transaction: Sellers generally favor stock transactions due to potentially higher net proceeds. Buyers typically prefer asset sales to limit contingent liabilities and benefit from stepped-up asset basis for tax purposes. In the lower middle market, most transactions are structured as asset purchases. If so, the LOI must specify which assets and liabilities are included in the price.

Escrow (Holdback): The LOI should outline if a percentage of the price will be held in escrow, and if so, the amount.

Reps & Warranties: LOIs often reference that they are subject to the purchase agreement, which will contain customary or relevant representations and warranties for the transaction’s nature.

Conditions (Contingencies): While non-binding, LOIs often include conditions, setting party expectations. A financing contingency can be concerning for sellers, as it can be used as a broad buyer escape.

Covenants: Covenants relate to pre-closing business operations, typically requiring the business to continue as usual. This prevents significant changes that might affect the business’s value.

Seller’s Role: If you plan to stay involved, key terms of your employment or consulting agreement, like salary, should be negotiated before accepting the LOI. If not, look for buyers who don’t require your ongoing role or focus on grooming a successor.

Management’s Role: Consider coupling your disclosure strategy with retention agreements for key employees. A formal retention bonus agreement with confidentiality and non-solicitation clauses, assignable to the buyer, can be beneficial. If the buyer talks to your employees, ensure it happens late in due diligence, after negotiating the purchase agreement. Be cautious about buyer contingencies related to employee agreements, as they can hinder the sale if employees catch on.

Non-Compete: Buyers generally expect a non-compete agreement post-closing, though it’s often implied in the LOI. If you plan any business-related activity after the sale, specify it to ensure it complies with the non-compete.

Termination: In non-binding LOIs, termination should have no consequences. Some include breakup fees, though they’re uncommon in lower middle-market transactions.

Miscellaneous: Most LOIs conclude by addressing expense allocation, governing law, and legal authority.

Process

LOI Process and Negotiation Styles:

Drafting the LOI: Typically, buyers draft most LOIs. However, if you’re a seller with a strong position and multiple negotiations, consider taking the opportunity to prepare the LOI yourself.

Skipping the LOI: While some parties skip the LOI and directly jump into a definitive purchase agreement, this is an uncommon practice.

Format (Letter vs. Agreement): Most LOIs are around two to four pages long, blending elements of a letter and a legal agreement. Sellers should aim for maximum detail and specificity in the LOI.

Making Changes: Customarily, buyers and sellers exchange red-line versions of the LOI in Microsoft Word. It’s advisable to start each negotiation round with a clean draft to avoid confusion.

Discussing Issues: Engaging in phone discussions can help uncover the motivations behind requested changes and facilitate mutual understanding.

Signing Timeline: Most LOIs take one to three weeks to negotiate and are usually signed one to two months after executing a non-disclosure agreement.

Negotiation Tactics: Buyers may initially offer high prices intending to negotiate down later. Others make reasonable, committed offers. Distinguishing between the two requires thorough negotiations, focusing on specifics like milestones and deadlines.

Assessing Seriousness: Some buyers, like search funds, may rush to agree on an LOI to kickstart financing exploration. It’s crucial to evaluate a buyer’s ability to complete the transaction.

Detail Level: While some negotiate only high-level terms like purchase price, others delve into specifics. Striking a balance that captures essential details without sacrificing momentum is key.

The “Final Offer”: Declarations of “This is my final offer” are often a novice negotiating tactic. In practice, it’s usually not the final word, so take it with a grain of salt.