One of the first significant steps in the route to buying or selling a business is the signing of the Letter of Intent (LOI). The purpose of the LOI is to express certain understandings and agreements between the buyer and seller of the prospective business and can be viewed as the first step in formalizing the negotiation process. The LOI is non-binding contract between the buyer and seller but may include some binding provisions such as an exclusivity period and confidentiality provisions. This document represents the end of preliminary due diligence and the beginning of the formal due diligence process where the buyer and seller will determine whether this company is the right fit.
While the letter of intent should be detailed enough to ensure that the main material issues are brought to light and potentially negotiated early on, it is also important to understand that more detailed discovery’s will happen during the formal due diligence process. During the formal due diligence process additional issues may surface that were previously not outlined in the LOI and may need to be negotiated prior to the final purchase agreement. Generally speaking, the more that is covered in the LOI the smoother the process will tend to go.
It is common that the LOI will be prepared by the buyer’s attorney and presented to the seller’s Business Broker or M&A Advisor. While it is the M&A Advisors role is to manage the negotiations of the purchase price and deal terms of the agreement, it is strongly recommended that the seller engages a transaction attorney to review and approve the agreement prior to execution as the LOI will set the tone for transaction going forward.
While information will vary depending on the business, some specific items to include in the LOI are:
This section should outline the price offered based on the perceived value of the company, often determined by a multiple of EBITDA as well as many other factors that are specific to the business. Some LOI’s will include an explanation of the assumptions that were used to come to the purchase price. This amount could vary by the time the actual Purchase Agreement is signed and could be subject to change based on various findings during the formal due diligence process. Therefore, including an explanation of the method used could help with any potential adjustments if required. One option to reduce the likelihood of a buyer reducing their purchase price later in the process is to provide additional preliminary due diligence information prior to buyer prior executing an LOI. We have found this especially useful when receiving offers from multiple buyers.
Transaction or Deal Structure
The transaction structure outlines the deal and will determine how the sale of the company will occur as well as cover debt terms and forms of payment. The deal structure can become acomplex part of the process as it can have many multifaceted variables including tax management and financing options. While the two main types of sales are Asset and Stock sales, there are many variables in between such as what is being sold (entire business, partial interest or investment). The deal structure is one of the areas where having a professional advisor such as a Business Broker or M&A Advisor can be a valuable benefit. Often a buyer or seller may focus solely on the purchase price. However, there could be an economic benefit to both sides when seller financing is structured for part of the purchase price. The seller will typically be able to achieve a higher value and be able to defer some of the taxes on an installment sale. The buyer will be more comfortable with moving the deal forward if the seller has a little “skin in the game”. Due to the complexities involved, the transaction structure is a crucial part of the process that if completed appropriately can benefit both parties of a transaction.
Working Capital Amount
Working capital can be a hot topic and often a sticking point in the deal negotiations where both sides may have strong opinions. The working capital is the amount of cash on hand and/or Accounts Receivable that is left in the business to cover general operating expenses once the buyer takes over the business. According to the HBR Guide to Selling a Small Business, “the thorniest LOI term is the working capital peg, because the appropriate amount of detail is uncertain.” Because the amount can be difficult to estimate at the actual closing date of the business it is difficult for both the buyer and seller to propose what they believe to be a realistic sum. As a result, some options can be agreed to such as estimating a rough total in the LOI based on the previous 6 months of operations then including the ability to adjust up or down after the sale. While the working capital consideration is one of the most difficult items this is one piece that should be covered early in the process and properly defined in the LOI as it can often be a major sticking point in the end of a deal if not hashed out early.
Timing of closing and exclusivity period
Timing of closing will include the target date for closing the deal. The parties will hold an exclusivity agreement to protect the buyer from competing interests from the date of the LOI signing to either the closing date or the termination of the LOI by either party.
Transition period and length of a post sale
The Transition period should include a timeline for specifics after close such as training new management and understanding the operations of the business, and any potential agreements between the seller staying on board for a certain amount of time.
Non-Compete, Confidentiality and Non-Solicitation agreements (client & employee)
This section will outline the terms for any non-compete agreements between the buyer and seller. In many cases the seller will be restricted from owning or operating another business that would be considered as a competitor. Non-Solicitation agreements prevent the seller from directly or indirectly soliciting employees or customers of the company for any business relationships. The Confidentiality agreement states that the parties shall not disclose or use confidential information for any purpose other than set out in the terms of the agreement
While the above items are considered some of the key points to include, the Letter of Intent can vary depending on the business and will be just a small summary compared to the final Purchase Agreement. The final draft of the LOI usually includes roughly four pages while the Purchase Agreement can be upwards of forty. While the specifics of the deal will be finalized in the purchase agreement, it is important to spend time drafting the LOI to ensure there are enough details included to agree upfront on the key deal points. Drafting the LOI correctly ensures a better chance of steps going more smoothly during the due diligence process and helps to streamline any adjustments to assumptions that will be included in the final purchase agreement.