Negotiating the Letter of Intent

The price and terms you ultimately secure are significantly more influenced by your firm negotiation of the LOI than by your negotiation of the purchase agreement. Let that resonate. For the majority of sellers, your negotiation skills in the LOI hold greater importance than those in the purchase agreement. Affixing your signature to a robust LOI that steadfastly safeguards your interests is akin to gaining possession of the ball just 30 yards from the endzone, while opting for a weak LOI is akin to commencing from your own 20-yard line, with a challenging 80 yards ahead.

Rest assured, this article will equip you with the comprehensive knowledge required to master the art of negotiating the letter of intent.

Tips for Negotiating the LOI

Balance of Power

The dynamics of power undergo a significant transformation once the seller grants the buyer exclusivity. This shift places the advantage firmly in the buyer’s court, as the stakes become much higher if negotiations were to falter. Should the buyer decide to walk away, they have relatively little to lose. However, for the seller, stepping back means starting negotiations from scratch, a process that can prove challenging, particularly since potential buyers may perceive the business less favorably.

Given this profound alteration in the balance of power, it is paramount to invest ample time in crafting an LOI that is exceptionally specific. Neglecting to meticulously define the terms within an LOI can lead to dire consequences. The buyer typically prefers a loosely outlined LOI to allow for broad interpretation. The less precise the LOI, the greater the buyer’s room to renegotiate terms at a later stage of the transaction. To counteract this vulnerability, it is essential to pin down as many specifics as possible within the LOI.

Simultaneously, an LOI featuring an enticing offer for your business can serve as a valuable tool in price negotiations with other potential buyers. Skillfully managing the LOI can create a competitive auction scenario, potentially driving up the value of your business.

Take Your Time

While many LOIs may initially appear enticing, it’s essential to maintain a level of skepticism. The attractive deal the buyer presents could potentially serve as a strategy to secure your commitment before returning with a lower offer once you’re no longer in the market. Even in cases where the buyer has no deceptive motives, they might encounter challenges in securing the necessary financing to complete the transaction.

Therefore, it’s imperative to exercise patience during the LOI negotiation process. Most buyers may push for a swift LOI agreement and your commitment to exclusivity. However, it’s crucial not to succumb to this pressure. This phase represents the final opportunity in the transaction where you hold a robust negotiating position. Regardless of the urgency conveyed by the buyer, it is wise to proceed cautiously and deliberately when navigating the LOI terms.

Move Fast

While it’s important to take your time when negotiating the LOI, it’s equally crucial to act swiftly once the ink is dry. Why, you ask? Because time has a tendency to undermine even the most promising deals. The longer the transaction remains open, the greater the opportunity for complications to arise. The buyer might stumble upon unforeseen issues within the business, or external economic and industry shifts could impact its valuation.

Since the LOI, including most of its terms like the price, is non-binding, it leaves room for last-minute alterations until the purchase agreement is finalized. This is where the time factor becomes a deal-breaker. The buyer’s perception of the business’s worth can fluctuate as the closing date approaches. The more time elapses between the LOI signing and closing, the more chances the buyer has to uncover information that could diminish their valuation. Buyers remain vigilant for any negative discoveries right up to the closing moment. Maintaining a swift pace is your best defense – the quicker you proceed, the fewer opportunities for setbacks, and the greater the likelihood of maximizing your sale price. So, how do you achieve this? By keeping the buyer engaged and enthusiastic throughout the transaction.

Consistently introduce the buyer to fresh information that highlights the allure of your business. This could encompass new prospects in your sales pipeline, industry advancements, potential product developments, or any aspect of your business that could spark the buyer’s interest.

The ideal scenario is one where you demonstrate that your business continues to thrive after accepting the LOI, making you reconsider the notion of selling altogether. Convey the attitude that if the buyer were to withdraw, it’s not a major setback because you could spend a few more months capitalizing on these opportunities before re-listing your business at a higher price.

Preventing Retrading

The most significant concern for you, the seller, once you’ve accepted the LOI, revolves around the potential for the buyer to reopen negotiations on critical terms post-due diligence. In my experience, this situation arises approximately 20% to 30% of the time.

It’s essential to recognize that both price and terms are inherently subject to some adjustments based on what the buyer uncovers during the due diligence phase. The price agreed upon in the LOI represents the highest amount you can expect to receive. However, the due diligence process and subsequent negotiations for the purchase agreement often lead to revisions as issues and challenges come to light. The key question is, what will change, and to what extent? The answer depends on the findings during due diligence and the negotiation stances adopted by both you and the buyer. Generally, the more enthusiastic the buyer is about acquiring your business, the less likely it is for the terms to undergo significant alterations.

Retrading, or the act of renegotiating, typically occurs due to two primary reasons:

• The buyer unearths undisclosed issues during due diligence. For instance, they might discover that your financial statements weren’t prepared in accordance with generally accepted accounting principles (GAAP). Perhaps they find out that some key employees are not planning to stay on after the sale, or you failed to mention the absence of non-competition or non-solicitation agreements with crucial staff members. In such cases, it’s only natural to expect renegotiations of the transaction terms.
• The buyer aims for a reduced purchase price or more favorable terms. This could be part of their initial strategy, or they may perceive you as being in a potentially vulnerable position, making them more inclined to pursue renegotiations.

Retrading proves effective because the buyer understands that if you decide to withdraw from the deal, you’ll find yourself back in the market or dealing with other potential buyers in negotiations. Regrettably, this shift can cast your business in a less favorable light. To new buyers, it may appear inherently flawed, potentially resulting in lower purchase offers due to increased perceived risks. The lingering question will be: Why did the previous buyer back out? Regardless of your explanation, the new buyer is likely to approach the situation with a degree of skepticism.

It’s important to note that retrading isn’t solely focused on the sales price. Sometimes, other terms may also be up for renegotiation. For instance, the buyer might suggest an earnout arrangement to mitigate their risk or propose alterations to various terms, such as the down payment amount or the specifics of an escrow or promissory note.

To safeguard against retrading, consider these proactive measures:

• Invest time in negotiating the LOI, ensuring it is as specific as possible.
• Incorporate clear deadlines within the LOI.
• Commit to the briefest exclusivity period feasible.
• Once you’ve accepted the LOI, move swiftly.
• Prepare diligently for the due diligence process; this preparation can expedite proceedings and diminish the likelihood of retrading.

Run the Business

A signed LOI marks the beginning of a journey, not the final destination. Even after putting pen to paper on the LOI, your focus should remain firmly on running your business as if the sale were not on the horizon. Your primary goal should be sustaining profitability and consistently nurturing a healthy sales pipeline.

Should your business’s revenue or profitability experience any downturn after accepting the LOI, it’s reasonable to anticipate the buyer’s inclination to seek price or term adjustments. To forestall such scenarios, it’s imperative to go to great lengths to maintain your business’s revenue and profitability post-LOI acceptance. By diligently preparing for the due diligence process well in advance of the sale, you can ensure that it doesn’t divert your attention from the business or negatively impact its revenue streams.

Read the Buyer

There is no one-size-fits-all LOI. If you have reason to believe that the buyer might have specific concerns, such as a keen focus on representations and warranties or access to your employees during due diligence, it’s crucial to proactively address these matters in the LOI. It’s far more advantageous for any potential deal-breakers to surface at this stage than to commit your company to a three-month hiatus, accompanied by significant expenses for due diligence, only to see the deal fall apart later due to unresolved sensitive issues. This is where experience plays a pivotal role – a seasoned M&A intermediary or investment banker can play a crucial role in foreseeing the buyer’s likely concerns and facilitating negotiations to ensure these concerns are effectively addressed in the LOI.

Prepare for Due Diligence

Efficiently preparing for due diligence can significantly expedite the entire process. Some buyers present sellers with extensive due diligence checklists, comprising hundreds of document requests. For some sellers, the sheer task of compiling these necessary documents can take over a month. It’s precisely this phase that can sometimes extend due diligence to a two-month or even longer timeline, with seller-induced delays being a common occurrence.

To mitigate these potential slowdowns, it’s imperative that the key documents most buyers will request are not only ready but also readily accessible the moment you accept the LOI. These documents should be meticulously organized and ideally housed in a virtual data room or a similarly accessible location for third parties. Given the time-consuming nature of this task, it’s advisable to initiate this process three to six months before embarking on the sales journey. Failure to prepare adequately could indeed result in due diligence negatively impacting your business focus, potentially leading to revenue fluctuations.

Confidentiality

While a confidentiality agreement provides some protection, it’s important to recognize that it isn’t foolproof. When dealing with sensitive information during the due diligence process, especially when the buyer is a direct competitor, exercising caution is paramount.

If you find it necessary to disclose such sensitive details, it’s advisable to wait until the latter stages of the due diligence process. Ideally, by this point, all major contingencies should be resolved, and the buyer should have signed off on the successful completion of due diligence, except for the most confidential tidbits.

If the buyer requests access to confidential information before making a formal offer, consider encouraging them to submit an offer first. Each time they seek additional information, view it as an opportunity to request a formal offer in return. For instance, if the buyer asks for confidential data, you can respond with confidence, saying, “I’ve diligently compiled all the necessary due diligence information in a secure virtual data room. You’ll gain immediate access to this information as soon as we reach an agreement on a letter of intent.”

Disclosure

It’s crucial to be upfront about any issues in your business before the buyer presents an offer. If you wait to disclose new, negative information after accepting the LOI, it’s almost certain that the deal’s terms will be altered. The key here is to come clean sooner rather than later. By revealing such information early in the negotiation process, you can maintain control over the narrative and present the problem in a favorable light. Failing to disclose significant issues allows the buyer to exploit them once they come to light down the road.

It’s important to remember that virtually every company encounters challenges, and with careful consideration, most of these challenges can be framed in a positive manner.

Thoroughness

The LOI should ideally encompass all the major terms of the transaction, leaving no room for provisions to be negotiated later in the process. As I’ve emphasized earlier, negotiations at later stages typically lead to less favorable conditions for the seller.

It’s essential to understand that the purchase agreement naturally evolves from the LOI. In the most seamless negotiations, all critical terms are hammered out in the LOI, with the purchase agreement serving to elaborate on these terms in greater detail, without introducing new elements to the transaction. While some negotiations between the parties are expected in any purchase agreement, they should be kept to a minimum and primarily focused on legal matters.

The least desirable LOI to accept is one that provides a price range or omits crucial transaction details, such as the escrow amount, significant earnout provisions, or the terms of a promissory note. Some LOIs even include clauses that allow the purchase price to change based on what the buyer uncovers during due diligence.

While buyers may prefer vague LOIs, your aim should be to solidify every key term of the transaction before considering acceptance. For instance, some buyers may propose a clause stating that the “seller’s ongoing role and compensation will be determined during due diligence.” It’s crucial to avoid such open-ended agreements. We’ve seen instances where buyers of businesses with an EBITDA of $2 million to $3 million suggest paying the seller just $100,000 per year to continue operating the business.

To safeguard against such scenarios, it’s prudent to include language in the LOI specifying that certain terms must be agreed upon no later than a specified timeframe (e.g., 20 days) from the LOI’s execution. Every significant term should be explicitly covered in the LOI, leaving no room for ambiguity or confusion. Clarity is key, and you should strive to eliminate any vagueness or uncertainty – for instance, if working capital is part of the price, the LOI should precisely define how working capital is calculated and what it encompasses.

Working Capital Adjustments

One of the most significant challenges for many sellers is what’s commonly referred to as a “working capital adjustment.” In a vast majority of middle-market transactions, the purchase price incorporates working capital. However, the real complexity lies in precisely defining how working capital is to be determined. Typically, the involved parties compile an initial estimate of the working capital’s value at the closing. Subsequently, the buyer conducts a final assessment 60 days after the closing, leading to a purchase price adjustment based on the variance between the pre-closing estimate and the ultimate calculation.

To steer clear of the potential time bomb of a working capital adjustment, the language in the LOI outlining the working capital calculation should strive for maximum specificity. Working capital typically encompasses the difference between current assets (including inventory, accounts receivable, and prepaid expenses) and current liabilities (comprising accounts payable and other short-term debts).

The nuances of calculating each element of working capital are open to interpretation. For example, should all inventory be included in the calculation, or only inventory that is readily marketable? How do we determine what qualifies as marketable inventory – after 30 days, 90 days, or 180 days? What about accounts receivables? Does the buyer assume responsibility for 100% of your accounts receivables, and how does a bad debt reserve affect this calculation? How do we calculate short-term debt? Does it encompass a line of credit? And how are seasonal fluctuations in the business considered? The actual working capital amount at closing remains unknown until the completion of the closing audit of your balance sheet, typically occurring 60 to 90 days after closing.

Milestones to Consider Including in the LOI

For a smoother transaction process and to safeguard your interests during the exclusivity period, I strongly recommend incorporating the following milestones, deadlines, and clauses into your letter of intent. These should be organized in approximate chronological order, and if any deadlines or milestones aren’t met, the buyer should forfeit their exclusivity.

• Proof of Funding (Three Days): This step is crucial, especially when you have uncertainties regarding the buyer’s access to liquid funds for covering the down payment, particularly if they’re securing financing or using cash. I’ve encountered numerous situations where the buyer appeared financially qualified to complete the transaction but ultimately lacked the necessary funds. In some instances, this revelation occurred after the sellers had already incurred substantial legal fees and taken their business off the market for an extended period, often around 90 days. It’s particularly vexing when fundless investment groups or competing parties quietly pursue financing without upfront disclosure. To preempt such situations, consider including the following language:“To demonstrate the Buyer’s capability to fulfill the transaction, the Buyer shall furnish bank statements (or alternative evidence deemed acceptable by the Seller) demonstrating immediate access to funds sufficient to execute the transaction in accordance with the terms outlined in this letter of intent.”

To ensure a smooth and transparent transaction process, I recommend including the following milestones, deadlines, and clauses in your letter of intent, particularly if you’ve agreed to an exclusivity period. Arranged in an approximate chronological order, these provisions act as safeguards, and failure to meet them should result in the loss of exclusivity for the buyer.

• Submission of Firm Commitment Letter from Lender (45 Days): In cases involving a financing contingency, it’s imperative for the buyer to promptly provide a firm commitment letter (not merely a pre-approval letter). A firm commitment letter represents a lender’s unequivocal commitment to extend a specified amount of debt under defined terms. While it may include a few conditions, this letter offers you the assurance that the buyer can secure the necessary financing. If the buyer plans to obtain financing through the Small Business Administration, 45 days from signing the letter of intent is a reasonable timeframe to obtain a firm commitment letter. In other cases, the buyer should consult their bank to determine the anticipated duration. This clause holds great importance as it establishes clear expectations between the parties. I’ve encountered situations where buyers kept their funding plans opaque until just days before closing, revealing their inability to secure financing. Including this clause safeguards you against last-minute surprises and unnecessary investment if the buyer cannot secure financing.
• First Draft of the Purchase Agreement (30-45 Days): The buyer should initiate the preparation of a purchase agreement while conducting due diligence. The purpose of this clause is to prevent the buyer from presenting a one-sided purchase agreement at the eleventh hour as a negotiating ploy. By stipulating this clause, you compel the buyer to furnish the purchase agreement within a reasonable timeframe, enabling you to assess its fairness and reasonableness early in the process.
• Sign-off on Successful Due Diligence (As Specified): It’s crucial to require the buyer to explicitly confirm the successful completion of due diligence once the due diligence period elapses. This clause compels the buyer to disclose any concerns or issues identified during the due diligence phase. It prevents them from withholding such matters until the last minute, just days before closing, and then leveraging them as negotiation tactics later in the transaction.
• Closing Date (90 Days): All LOIs should include a clearly defined closing date, a drop-dead deadline that signifies the termination of the letter of intent and exclusivity. For instance, it can read, “The closing shall occur on or before xx/xx/20xx.” This provision prevents intentional delays by the seller and underscores the importance of adhering to agreed-upon timelines. Of course, mutual consent can extend the closing date in case of legitimate delays, but this requirement prevents the buyer from employing stalling tactics to wear you down during negotiations.

It is advisable to incorporate a clause within the LOI that stipulates the loss of exclusivity for the buyer if they fail to adhere to the aforementioned proposed deadlines. Such a provision can be seamlessly integrated into the exclusivity section of any LOI, utilizing language similar to the following:

“…provided that the Buyer shall adhere to the subsequent deadlines. In the event that any of the following deadlines are not met, the parties may continue negotiations toward the transaction and work toward a closing; however, exclusivity shall be immediately forfeited.”

The primary objective behind establishing these defined milestones is to encourage swift progress once the letter of intent is executed. Inclusion of these milestones serves as a motivating factor for the buyer, as failure to meet them results in the loss of exclusivity, a potent negotiating tool. This impels the buyer to maintain a steady pace to ensure compliance with the specified deadlines. If a bit more flexibility is desired, it is possible to consider extending the deadlines by an additional 30% to 50%.

In the interest of a smoother negotiation process, you might also consider incorporating potential contentious issues as additional milestones. Here are a few examples of such issues that should be addressed promptly:

• Purchase Price Allocation: Determining how the purchase price will be allocated.
• Consulting and Employment Agreements: Establishing any consulting and/or employment agreements between the buyer and seller.
• Lease for Real Estate: If you own the real estate and intend to lease it to the buyer, sorting out the lease terms.
• Non-Competition Agreement: If you plan to remain in the industry, defining the terms of a non-competition agreement.

These additional milestones can serve as proactive measures to prevent retrading. Consider including a clause in the LOI that stipulates the immediate termination of exclusivity should either party attempt significant alterations to the transaction terms for any reason.

The extent to which these milestones can be incorporated into the LOI hinges on your negotiating leverage. If your position is strong, you’ll have a better chance of securing these protective measures.

Recap – Letter of Intent

Here’s a concise recap of key tips for navigating the LOI negotiation process:

• Balance of Power: Invest time in crafting a highly specific LOI. Precision is your ally; it minimizes the buyer’s room for later renegotiations.
• Take Your Time: Resist rushing through LOI negotiations, even if the buyer appears urgent. Your negotiating position remains strong at this stage.
• Move with Purpose: Once the LOI is signed, shift gears swiftly. A prolonged transaction period increases the potential for complications.
• Preventing Retrading: Price and terms can evolve during due diligence. To prevent unfavorable changes:

– Thoroughly negotiate the LOI with precision.
– Set clear deadlines within the LOI.
– Opt for the shortest exclusivity period possible.
– Maintain momentum once the LOI is accepted.
– Prepare diligently for the due diligence phase.

• Maintain Business Momentum: After signing the LOI, keep your business on course as if no sale were impending. Your foremost objective is sustaining profitability. Adequate preparation for due diligence ensures it doesn’t divert your focus.
• Tailor the LOI: Recognize that there’s no one-size-fits-all LOI. If you anticipate particular sensitivities on the buyer’s end, such as concerns about representations and warranties or employee access during due diligence, proactively address these issues in the LOI.
• Streamline Due Diligence: Preparing meticulously for due diligence expedites the process. Seller-induced delays are common pitfalls. Essential documents, often requested by buyers, should be impeccably organized and stored in a readily accessible virtual data room or a similar platform for third-party access.
• Confidentiality Caution: Remember that a confidentiality agreement, while important, isn’t foolproof. Exercise discretion when sharing sensitive information, especially if the buyer is a direct competitor. If disclosure is necessary, reserve it for the later stages of due diligence, ensuring all contingencies are resolved. Seek the buyer’s sign-off on due diligence completion, barring minor pending details.
• Transparent Disclosure: Be forthright about any issues within your business early in the negotiation process. This enables you to control the narrative and portray challenges in a favorable light.
• Exhaustive LOI: Leave no stone unturned when finalizing key transaction terms within the LOI. Aim for precision and clarity. Weed out any ambiguities or complexities.
• Working Capital Precision: When it comes to working capital calculations, insist on explicit and comprehensive language within the LOI. Specificity minimizes potential discrepancies down the line.