The letter of intent (LOI) is one of the most important documents in a transaction. For my money, the LOI is the most significant agreement in an M&A transaction, even eclipsing the importance of the purchase agreement.
A buyer will typically submit an LOI after spending some time looking at the target and determining the business might be a good fit for them. Among the items included in the LOI are purchase price and terms, the assets and liabilities included in the deal, exclusivity, and conditions to close. Once an LOI is signed, the parties move into the next stage of the transaction – due diligence.
For sellers, mistakes made at the stage of negotiating the LOI are far more common than mistakes made in the purchase agreement. Most sellers dramatically underestimate the importance of the LOI and are in a hurry to move on with the transaction. Savvy buyers are in a rush to sign the LOI and quickly move into due diligence. Why? Most LOIs contain an exclusivity clause in which the seller agrees to cease all negotiations with third-party buyers and take the business off the market. The moment you sign an LOI that contains such an exclusivity clause, your negotiating position disintegrates. Any experienced buyer is familiar with how the dynamics of the relationship change once you sign such a document, which is why they’ll often attempt to rush you to sign.
Some buyers’ strategy is to get you to invest as much time and money as possible in the deal before they begin to slowly chip away at the price and terms later in the negotiations. At this point, many sellers have already spent thousands of dollars with their attorneys to negotiate the purchase agreement, and they simply don’t have the stamina to go back to square one and begin negotiations with a new buyer. As a seller, you’re in sole negotiations with the buyer. Corporate buyers, on the other hand, may be in negotiations with multiple sellers simultaneously. This dramatically weakens the seller’s negotiating position.
On top of this, an experienced buyer knows that if you walk away from the deal and put your business back on the market, then other buyers you were previously negotiating with will think you have damaged goods. They will then conduct much more thorough due diligence, often downgrading their valuation.
And what about all those terms you failed to define in the LOI? Every one of those terms will be worded in the buyer’s favor in the purchase agreement if you don’t pin them down in the LOI. Don’t forget that the buyer’s attorney usually prepares the purchase agreement, and the party presenting the first draft of the agreement often sets the tone for the negotiation.
What terms could go undefined in the LOI?
This is just a small sample of what can go wrong if critical terms aren’t defined in the LOI. In the following pages, I walk you through everything you need to know about the LOI, including an in-depth discussion of each important term that can be contained in an LOI.
The bottom line is that you have all the leverage when you’re negotiating the LOI. Use it. Spend as much time as you like negotiating the LOI. Savvy buyers will use momentum and pressure to get you to sign the LOI as quickly as possible. Don’t do it. Take your time negotiating a document that will maximize your price and terms and help you maintain your negotiating position. This article shows you exactly how. Forget about “The Art of the Deal;” read this instead.
Most LOIs are drafted to be non-binding, with the exception of a few provisions that are intended to be binding. The non-binding provisions include those relating to price and terms, such as the purchase price, how working capital is to be calculated, the form of the transaction, how the price is to be allocated, the amount of escrows, etc. The binding provisions relate to how the process is to be governed, such as maintaining confidentiality, exclusivity, buyer’s access to information to conduct due diligence, payment of expenses, and termination. Regardless, the parties should be sure to clearly express which provisions are intended to be binding.
The following provisions are typically drafted to be binding:
A provision stating that the LOI is intended to be non-binding is usually concluded by the courts to be non-binding. However, some courts have ruled that an LOI is binding in certain circumstances. The courts typically look at the parties’ intent, the language used in the agreement, and the degree to which performance has already been completed. The courts have also ruled that the parties have a duty to negotiate in good faith even when the agreement does not explicitly state such an obligation. This should give you comfort if you are negotiating with a direct competitor and are concerned they may be attempting to appropriate trade or other secrets.
The key terms of an LOI are the following:
Less commonly included terms:
What follows is a discussion of the major components of an LOI.
Most LOIs begin with a few relatively meaningless niceties, such as a salutation and preamble, similar to any business letter. After a short introduction, most buyers attempt to differentiate themselves from other potential suitors by including some commentary about their level of excitement to acquire your company, or perhaps comments regarding the strategic fit or long-term plans for your business.
Some LOIs then transition into a basic description of the acquisition, such as the purchase price, form of the proposed transaction, or other high-level terms. While the introductory section is commonly cosmetic, some important terms can be buried in this section. While sellers prefer clarity, buyers often prefer ambiguity, which can be later used to a buyer’s advantage.
Here is a less sexy, more straightforward sample introduction from an LOI:
“This Term Sheet summarizes the principal terms of a proposed transaction for the purchase of Acme Incorporated (the “Transaction”). This Term Sheet is for discussion purposes only, and there is no obligation on the part of any negotiating party until a definitive written agreement is signed by all parties. Neither party will be obligated to proceed with, or successfully conclude negotiations regarding a transaction or to conduct negotiations in any prescribed manner.”
Any well-drafted LOI should clearly state the parties’ intentions regarding the extent to which they desire the LOI to be binding. Some LOIs state such an intention in the introduction or title of the LOI, such as by including a title named “Non-Binding Letter of Intent.”
Other LOIs separate the binding provisions, such as confidentiality and exclusivity, from the non-binding provisions (purchase price, etc.) and clearly label each section as binding or non-binding. Other LOIs wrap up with a paragraph listing the binding and non-binding sections with a sentence such as “This agreement is non-binding with the exception of clauses 5, 7, and 10, which are intended to be binding.” Either approach is acceptable as long as the binding and non-binding provisions are clearly identified and separated.
Why are nearly all LOIs non-binding?
Most LOIs are non-binding because the terms of the transaction may change based on what the buyer discovers during due diligence. Prior to due diligence, the seller is making representations that the buyer must accept at face value, without any verification. Not until an LOI is accepted will the buyer have the opportunity to confirm those representations – hence, due diligence is often called “confirmatory” since the seller’s representations are “confirmed” during this period. With a non-binding LOI, the parties don’t intend to be bound to the transaction until a purchase agreement is signed, which usually occurs sometime after the completion of due diligence or, in many cases, at the closing.
A common mistake in many LOIs is to indicate that the entire LOI is non-binding. This can be problematic if clauses are included in the LOI that should be binding, such as confidentiality, expenses, deposits, exclusivity, etc. Regardless, courts will look to the parties’ intentions if the LOI is silent regarding whether or not it is binding.
What’s Included in the Purchase Price
While the purchase price is perhaps the most important clause in the LOI, you can’t always determine the “true” or “total” purchase price solely from looking at the purchase price number. Why? Many LOIs include additions and subtractions from the purchase price that are listed in a separate section of the LOI.
For example, the purchase price may include inventory and working capital (accounts receivable, plus inventory and prepaid expenses, minus accounts payable, short-term debt, and accrued expenses) as in the following example:
If the purchase price is $10 million, and there is $2 million in working capital, the purchase price could be defined as either $10 million or $12 million depending on whether or not working capital is included in the price.
Example A: Purchase price is $10 million, which includes $2 million in working capital. Seller will realize $10 million at closing.
Example B: Purchase price is $10 million but does not include working capital. Seller will realize $12 million at closing, assuming buyer separately purchases working capital at closing.
Another common mistake made by sellers is to look only at the purchase price and ignore what assets and liabilities are included. Most corporate buyers structure their offers to include working capital in the price, which I will discuss in detail in a later section. When receiving such an offer, you should analyze it in a spreadsheet along with current balances for each of the assets and liabilities that comprise working capital (specifically cash, accounts receivable, inventory, accounts payable, short-term debt, and accrued expenses) so you can compare multiple offers on an apples-to-apples basis.
Other LOIs fail to define working capital, leaving the definition and calculation to be determined at a later date, though this will never be in your favor due to your diminishing negotiation position as the seller.
The following assets are usually included in the price:
The following assets and liabilities are usually included in the purchase price only if the buyer is a corporate buyer:
The following assets and liabilities are not normally included in the purchase price:
The LOI should clearly indicate which assets and liabilities are included in the purchase price.
How the Purchase Price is Paid
The LOI should also clearly lay out how the price is to be paid. Here are the most common forms of consideration for the purchase price:
A seemingly attractive offer with an apparently strong valuation may not be attractive once you dig deeper and analyze the offer. For example, is any portion of the price contingent, such as a seller note, earnout, or escrow? If so, what are the terms and conditions of the contingent payment? And what is the financial strength of the buyer?
Here are common ranges for how the purchase price is paid (not the maximum range, but the most common) for transactions in the lower middle market from $1 million to $30 million in purchase price:
Fixed Purchase Price vs. A Range or Formula
The purchase price should ideally be a fixed number (for example, $10 million), as opposed to a range such as $8 million to $12 million. Ranges are commonly used in indications of interest (IOI) for larger transactions ($100 million+) but should be avoided in lower middle-market transactions. If the buyer proposes a range, I suggest giving the buyer access to more financial information so they can firm up the price before moving to confirmatory due diligence.
Valuations based on a formula should be avoided if possible (for example, 4.5 times the trailing twelve months’ EBITDA). Such a formula is nearly always subjective, such as how EBITDA is calculated, and any subjective terms are likely to slant in the buyer’s favor as the transaction progresses due to your diminishing negotiating position. Some formulas include a cap on the purchase price. Unless you like gambling on a coin toss with a double-sided coin, I suggest avoiding a cap.
With a formula, the buyer attempts to adjust the purchase price based on a change in revenue or EBITDA. If you do agree to such a provision, the adjustment should go both ways – both up and down – based on the value of the metric. In other words, 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 uncovered that you understated EBITDA by $500,000 when it’s really $1 million, the buyer should pay you $5 million in the purchase price.
Here is a sample purchase price clause:
Buyer will acquire 100% of the common stock of Seller for total consideration equal to $15,000,000, plus adjustments for Cash, Indebtedness, and Net Working Capital.
Here is a more detailed purchase price clause:
In summary, make sure the purchase price, what’s included in the price, and details on how the purchase price is to be paid are all clearly defined in the LOI.
Corporate buyers almost always include working capital in the purchase price. Why?
Corporate buyers characterize working capital as any other asset that is required to operate the business, such as a piece of machinery, vehicle, or other equipment. Working capital is an asset that must remain in the business for it to operate and is, therefore, no different than any other resource required to operate the business. I unfortunately reluctantly agree with this point. You will rarely be able to negotiate to exclude working capital. However, there are methods you can employ to protect yourself from this clause turning around and biting you in the butt later in the transaction.
Working capital is defined as current assets minus current liabilities as follows:
The amount of working capital fluctuates on a daily basis in nearly all businesses. The two primary components of working capital are accounts receivable and inventory. Most LOIs that include working capital make an assumption regarding the current level of working capital required to operate the business, and then an adjustment is made after the closing based on calculating the actual amount of working capital. This is the fun part for buyers. If the definition is less than comprehensive, most buyers will work the definition in their favor. The result? Less money in your pocket.
If there is a difference between the pre-closing and post-closing amount of working capital, the purchase price will be adjusted accordingly. Since working capital is a moving target, such a clause commonly results in post-closing disputes. In fact, I recently spoke with one intermediary who had just wrapped up a working capital dispute that left the seller with $1 million less in their pockets.
Here is a sample clause that includes working capital:
The Purchase Price would be determined by adding or subtracting, as applicable, the Adjustment Amount, to or from the Base Purchase Price. The Adjustment Amount would be defined as: (a) the amount of cash and cash equivalents on the balance sheet on the Closing Date (“Cash”), minus (b) indebtedness of the Company at Closing (which, for the avoidance of doubt would be paid at Closing as a reduction of Closing proceeds to the Sellers) (“Indebtedness”), plus (c) Net Working Capital (as defined below) on the balance sheet at Closing. Prior to Closing, the Sellers, on behalf of the Company, would 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” would be defined as current assets (other than Cash) minus current liabilities, and would be calculated in accordance with the Company’s historical accounting practices. There would be a customary post-Closing true-up of Cash, Indebtedness, and Net Working Capital, to reconcile differences from the estimate, with the Buyer preparing the initial calculation.
Most LOIs are not specific regarding how working capital should be calculated. For example:
There are ways of reducing conflicts in calculating working capital:
While the LOI may not include specific language regarding a post-closing working capital adjustment, nearly every purchase agreement will, if the buyer is well-advised … and most are. So don’t overlook this section. This isn’t boilerplate accounting language – this is a hidden weapon that any buyer can use against you if they so desire. It’s no different than buying a car that includes a stick of dynamite in the trunk – but the catch is that the buyer keeps a remote for three months after you purchase the car. If that idea makes you uncomfortable, and it should … then nail this down before you move on.
Most LOIs submitted by buyers will contain few, if any, deadlines. Why would the buyer want to self-impose deadlines? They wouldn’t, so they don’t.
The antidote is simple – include deadlines and milestones in your counteroffer.
As a seller, do not, under any circumstances, overlook the importance of adding deadlines and milestones in the LOI. Your negotiating leverage disappears the moment the LOI is signed. Why? Most LOIs contain an exclusivity clause that requires you to cease negotiations with all third parties. The result is that you must take your business off the market once you sign the LOI, and you end up susceptible to the pressures of “sunk costs” (money that’s been spent and can’t be recovered). Buyers know this and use it to their advantage. Don’t let this happen to you.
Ideally, the LOI should contain a list of the following key dates and milestones:
Tip: If you have significant negotiating leverage over the buyer, you should include a clause in the LOI in which the buyer will lose exclusivity if they fail to meet the deadlines. Such a clause will keep all buyers on their toes and helps ensure you maintain as much negotiating leverage as possible as the transaction progresses.
Any buyer who’s negotiating with a seller who is represented by an M&A intermediary will execute a confidentiality agreement prior to submitting an LOI. However, some LOIs will reaffirm the confidential nature of the negotiations. Others will expand upon the original confidentiality agreement that was signed, either in the form of an additional clause in the LOI or in a separate supplemental agreement.
I strongly recommend a supplemental confidentiality agreement in cases in which you may be negotiating with a direct competitor. The agreement can contain specific language regarding the non-solicitation of customers, employees, and suppliers, and also address any other specific concerns you have regarding confidentiality, such as trade secrets, non-public pricing information, names of employees, or names of customers.
Why isn’t a comprehensive NDA signed earlier in the transaction? An NDA with excessively onerous terms is likely to be met with more resistance than necessary in the preliminary stages of a transaction, especially when the buyer hasn’t yet decided if they are sufficiently interested in the company to take a deeper dive. Once the buyer has taken a closer look and is sufficiently motivated to make an offer, they may be willing to spend more time negotiating such language, especially given that they will now be privy to much more sensitive information than in earlier stages in the transaction, such as information contained in the confidential information memorandum (CIM).
If third parties assist the buyer in conducting due diligence, you can also request that these third parties sign an NDA. Note that CPAs and attorneys can usually be excluded from an obligation to sign an NDA as their license may carry an implied duty of confidentiality.
Most LOIs presented by buyers include one or two sentences regarding due diligence, usually addressing the length of due diligence and access to the necessary information to conduct due diligence. Most buyers request 60 to 90 days. I recommend countering with 30 to 45 days. The process can always be mutually extended if necessary. The more effort you have invested in preparing for due diligence, the shorter the due diligence period can be.
Ideally, the LOI should describe the due diligence process in more detail, including the procedure and its scope. You should resist providing access to customers and employees unless this is absolutely necessary. In most cases, I feel it’s best to remain silent regarding these issues in the LOI. If the buyer insists on meeting with key customers and employees, you should put off doing so until the tail end of due diligence or ideally after the purchase agreement is close to being signed and all contingencies have been resolved.
A commonly used tactic by some buyers is to gradually wear the seller down over time with numerous requests for information during the due diligence period. In their view, the more time and money the seller spends in conducting due diligence, the more likely they are to concede in negotiations later on. (For more information, research “sunk cost fallacy” – the tendency to follow through on an endeavor if you’ve already invested time, effort, or money into it.) This tactic is highly effective, especially against first-time sellers or any seller with a strong emotional attachment to their business.
The buyer will also likely engage third parties to assist in conducting due diligence, such as their accountant, attorney, and third-party consultants (e.g., environmental, technological, etc.). The LOI should either require that these third parties sign an NDA, or the buyer should remain liable for breaches caused by any third parties the buyer employs.
Here is a sample clause addressing the nature of the due diligence period:
The entry into the Definitive Agreement and Closing would be subject to Purchaser completing financial and legal due diligence. It is the parties’ expectation that due diligence would be completed within 30 days after the date of this Term Sheet.
The exclusivity clause prohibits the seller from soliciting, discussing, negotiating, or accepting other offers for a period of time (usually 30 to 90 days) following acceptance of the LOI. This clause is also called a stop-shop or no-shop clause. The precise length and activities that are prohibited vary based on the exact language contained in the clause. As the seller, you are usually prohibited from contacting both current and future buyers and this clause effectively allows the buyer to lock up the business for an extended period of time. Exclusivity is a critical concession that you should make with great care.
Corporate buyers usually demand an exclusivity provision because they will invest a considerable amount of time and money in performing due diligence and don’t want you shopping their offer with third parties. If your buyer is a corporate buyer, negotiating to remove a no-shop clause is rare because corporate buyers aren’t willing to invest the necessary time to close a transaction if you are simultaneously courting other buyers or shopping their offer.
Buyers don’t want to make this investment only for you to accept an offer from another buyer or attempt to renegotiate the terms of the LOI based on a better offer you may have received from a buyer since signing the LOI. It’s reasonable for buyers to want to lock the transaction up for a period of time so they have assurance you won’t shop their offer since they must invest a significant amount of time and money conducting due diligence, negotiating the purchase agreement, and preparing for the closing. The exclusivity period gives the buyer the time necessary to work on the details of the transaction without worrying about losing the deal to another buyer.
Exclusivity is a critical consideration that no seller should ever take lightly. I rarely make absolute statements, but I feel that an absolute statement is necessary here. Far too many sellers overlook their commitment to exclusivity and fail to realize the impact that an extensive exclusivity period can have on their negotiating leverage. You should grant exclusivity very carefully and do everything possible to limit the amount of time you are prevented from speaking or negotiating with other buyers.
Length
Most “stop shops” range from 30 to 90 days. Most buyers request stop-shop clauses ranging from 45 to 90 days, and I have seen stop shops as long as 120 days. As a general rule, you should negotiate exclusivity periods for 30 to 45 days – or 60 days maximum. While most transactions take at least three to four months to close, the exclusivity period can be mutually extended once key milestones have been met, which are outlined below.
Shorter exclusivity periods encourage the buyer to move quickly and penalize them for dragging their feet. Longer exclusivity periods encourage both parties to endlessly haggle over the legal points in final negotiations. The LOI should clearly list the exact duration of the exclusivity period and ideally list the precise date the exclusivity period expires.
As a seller, you should be on the lookout for buyers who strongly negotiate for longer exclusivity periods that allow the buyer to wear you down over time. Exclusivity periods longer than 60 days are generally unnecessary and encourage the buyer to take their time. The longer the transaction takes, the more your negotiating leverage will be lost.
Types of Exclusivity Periods
The exact language of the exclusivity clause varies from agreement to agreement, but most prohibit the seller from actively marketing the business and continuing any discussions or negotiations with any third parties. Following is a typical clause you may see in an LOI:
Seller agrees to deal exclusively with Buyer from the date of this letter through October 10, 20xx (the “Exclusivity Period”), and will not, directly or indirectly, solicit, entertain or negotiate any inquiries or proposals from any other person or entity regarding the acquisition of the Company or the Company’s assets. As of the effective date of this letter, the Seller will (a) terminate any existing sale discussions, (b) not enter into any new sale discussions, and (c) pause all marketing activities, including by the removal of any online listings.
Some overreaching LOIs require the seller to share any offers they receive during the exclusivity period with the buyer. The buyer wants to know what others are willing to pay for the business and will use that number against you – if it’s lower than their offer, of course. Don’t agree to such a provision. Other clauses are less restrictive and allow you to continue marketing your business but exclude you from accepting a competing offer. Obviously, the less restrictive the clause, the better it is for you.
The Impact of Leverage
Once the exclusivity period is signed, time is on the buyer’s side. The more the buyer draws out the process, the weaker your negotiating leverage becomes. This is not hypothetical – every seller should be aware of the implications of agreeing to an exclusivity clause. The deal will never get better for the seller – once the LOI is signed, it can only get worse. And the longer the time between signing the LOI and closing, the more likely the terms of the transaction will change. For you, the shorter the exclusivity period, the better.
Other interested buyers usually move on to other deals or other corporate development projects once they learn you have accepted an offer. The result is that you will end up losing the best buyers – and the current buyer you’re negotiating with likely knows this.
Unfortunately, some buyers intentionally make a high offer they know they will never follow through on. They then take three months to conduct due diligence and wear down the seller with a multitude of requests. They may also plant seeds of doubt in the seller’s mind regarding their business and do everything possible to poke holes in the business during due diligence. In their mind, the more time and money the seller spends on due diligence, the better. Then, at the last moment, they start nibbling away at the purchase price – or take a chainsaw to it.
What’s the result? It’s usually not pretty for the seller. The business has now been off the market for months, and discussions with other buyers have cooled off to the point where they may be difficult to revive. If the business goes back on the market, other buyers may view it as tainted goods and expect a price concession at best or refuse to submit another offer at worst. Regardless of the time period, reentering the marketplace puts sellers at a great disadvantage.
Preventing Retrading with Milestones, Deadlines & Other Methods
So, what’s the solution?
To protect yourself from this happening, you should do the following:
While an earnest money deposit is common in transactions under $1 million to $5 million, a deposit is less common in mid-sized transactions. Why?
Buyers in the middle market view their financial investment in performing due diligence as a demonstration of their earnest intent and an equal substitute for an earnest money deposit. Correctly performing due diligence requires an enormous investment of both time and money. While I agree that due diligence requires a serious investment, you should nevertheless be careful if you’re negotiating with a direct competitor.
How much is enough when it comes to a deposit? For smaller transactions, 5% is generally sufficient. But for larger transactions, a specified dollar figure is usually more appropriate (5% of $50 million is $2.5 million, which is far too much). For larger deals, $50,000 to $250,000 is usually sufficient.
Another question to consider is the extent to which the deposit is refundable and under what conditions. Most buyers will request that the deposit be refundable until a purchase agreement is signed, while some sellers prefer some portion of the deposit be non-refundable. The primary objective to avoid is requesting a fully non-refundable security deposit. I have encountered a few sellers who demanded a non-refundable security deposit before due diligence has been conducted, and as fast as you can say “Abracadabra,” … poof …. the buyer is gone. Asking for a non-refundable deposit is seen as unreasonable by most buyers, and such a request may make them disappear.
A compromise can be made in which the deposit is progressively non-refundable upon the occurrence of certain events, such as completion of due diligence, preparing the purchase agreement, or receiving a financing commitment letter. In practice, this is difficult and time-consuming to negotiate and usually isn’t worth the time unless you’re dealing with a direct competitor.
The purchase price may also be affected by the tax implications of the transaction, which is generally a key factor in determining whether the transaction is structured as an asset purchase or stock purchase. Ideally, the LOI should specify how the purchase price will be allocated for tax purposes. This specification can prevent serious problems later in the transaction. How the purchase price is allocated has major implications for both you and the buyer and has the potential to kill a deal if both parties refuse to compromise.
While negotiating the allocation is simple in theory, if both parties involve their CPAs, you will find that both parties may propose widely different allocations. Reaching a middle-ground may require you both to significantly alter your initial proposed allocation.
Here is a sample allocation for a $12 million transaction:
Negotiating the allocation early is often met with much less resistance because both you and the buyer are far less entrenched in your positions and are often more willing to make quick compromises in the spirit of moving the deal forward.
Alternatively, you could both agree to allocate the price based on the tax basis in the assets, which will usually work out in your favor, as in the following example:
For tax purposes, the Purchase Price will be allocated according to the Company’s tax basis in its assets.
Another important consideration is whether the transaction will be structured as an asset or stock sale. Sellers usually prefer a stock transaction because their net proceeds (proceeds net of taxes) will often be far greater than an asset sale. Buyers usually prefer an asset sale because this limits the possibility of contingent liabilities and the buyer can receive a stepped-up basis in the assets, which reduces the taxable income for the buyer post-closing by maximizing the amount of depreciation they can write off.
The reality is that most transactions in the lower middle market are structured as an asset purchase. If the sale is structured as an asset sale, the LOI should define what assets and liabilities are included in the price.
The form of the transaction, particularly whether it’s an asset or stock sale, can also impact the other terms of both the LOI and the purchase agreement, especially the reps & warranties.
Most LOIs are silent regarding the amount of the purchase price that will be held back in an escrow account to satisfy any indemnification claims for breaches of reps & warranties in the purchase agreement. In most middle-market transactions, a portion of the purchase price (usually 10%) is held back for a fixed period of time, usually 12 to 18 months. This serves as a form of insurance in case you (the seller) made any claims such as representations or warranties in the purchase agreement that later prove to be false, or for other claims such as a breach of a post-closing covenant.
Ideally, the LOI should address whether a percentage of the price will be escrowed or held back, and if so, the amount of the holdback. Here is a sample clause:
10% of the Purchase Price payable at Closing will be deposited in a third-party escrow account to be held for a period of twelve months after Closing as security for Buyer’s indemnity claims under the Purchase Agreement.
Here are the major points to consider regarding the escrow:
Regardless of how thoroughly the buyer conducts their due diligence, they will never be confident that they have discovered every possible problem or defect with the business. Reps & warranties are designed to cover what the buyer may have missed in due diligence and can be one of the most contentious sections to negotiate in the purchase agreement. Unfortunately, most LOIs say little beyond the fact that the reps & warranties will be customary – with no mention of exclusions, knowledge qualifiers, caps (maximum liability), or the basket (minimum liability).
In most cases, this is the best the parties can do, and both you and the buyer must move forward based on good faith and confidence in each other. Your goal is to minimize your exposure while the buyer will seek the broadest exposure possible. Most LOIs state that the LOI is subject to the preparation of the purchase agreement, which will contain reps & warranties that are customary or appropriate for a transaction of its nature.
Following is a sample clause:
The Purchase Agreement would include such representations and warranties as are appropriate [or customary] for a transaction of this nature, including representations and warranties covering capitalization, authority, environmental matters, taxes, employee benefits and labor matters, violations of law, and customary matters relating to the business, such as its financial statements.
Some LOIs also require each party to represent that entering into the LOI or purchase agreement will not conflict with or breach any other contract. This is normally a formality and rarely negotiated.
Most LOIs also include conditions for consummating the transaction, such as the need for regulatory or license approvals, completion of due diligence, obtaining financing, third-party consent to the assignment of critical contracts, obtaining employment agreements with key employees, lack of a material adverse change in the business or prospects of the target company, and the execution of the purchase agreement. Because most LOIs are non-binding, conditions to the sale aren’t required for the parties to move forward. But conditions serve one important purpose: they set the expectations of the parties.
In effect, conditions allow the buyer, and sometimes the seller, to cancel the transaction if the conditions can’t be met – notwithstanding the fact that most LOIs are non-binding anyway. Regardless, most state laws require the parties to act in good faith and use their best efforts in an attempt to resolve the conditions. Most LOIs are silent regarding the extent to which efforts are required (such as best efforts, commercially reasonable efforts, etc.), and the parties must rely on state law to determine to what extent effort is required.
In practice, proving that the buyer didn’t make a reasonable effort is difficult, and the transaction is normally canceled if the conditions aren’t met. The only scenario in which this is likely to come into play is if a competitor makes an offer on your business with the sole objective of obtaining competitive information and they don’t make reasonable efforts to resolve the conditions outlined in the LOI.
The most common condition is a financing contingency. The financing condition allows the buyer to cancel the sale if they’re unable to obtain funds to finance the transaction. You may argue that if the buyer is confident of obtaining financing, they should be willing to bear the risk if financing can’t be obtained. If you have multiple competing offers on the table, you may be able to negotiate to remove financing contingencies or require a commitment letter from lenders within a specified number of days after accepting the LOI. Alternatively, you could require the buyer to reimburse you for your out-of-pocket expenses if they can’t obtain financing.
Note that most banks will require significant documentation on the business to be willing to provide a commitment letter. This documentation is normally only provided from the seller to the buyer during the due diligence period and, therefore, only after an LOI is accepted.
Another option is for you to agree to finance the transaction if the buyer cannot obtain financing, but the terms of the seller note should be unattractive enough that it motivates the buyer to aggressively seek third-party financing.
The degree to which a financing contingency is common depends on the type of buyer with whom you’re negotiating. Most well-capitalized companies have the funds on hand to complete smaller transactions. Private equity firms, on the other hand, nearly always seek third-party financing in addition to the committed capital they may already have access to.
The biggest downside to a financing contingency for a seller is that all the buyer has to do if they don’t want to follow through on the deal is to claim that they can’t obtain financing. This effectively serves as a “blanket contingency” for a buyer. The degree to which this is important is debatable, given that most LOIs are non-binding anyway.
The biggest issue to watch out for as a seller are buyers who have little money on hand and seek to finance a large portion of the purchase price. These buyers may seldom have existing relationships with banks and may not have any contacts or experience in the industry. This means they may have a very difficult time obtaining financing. The biggest warning sign is if the buyer is planning to shop for investors after signing the LOI.
In law, a covenant is a promise to do or not do something. In an LOI, covenants primarily relate to how the business will be conducted prior to the closing, such as “between the date of this Letter of Intent and the closing, the sellers agree to operate in the ordinary course of business.”
The buyer essentially wants a guarantee that the business will continue to operate in the ordinary course of events until the closing occurs. This effectively requires you to continue all marketing efforts and not make any material changes to the business prior to the closing, such as terminating key employees, liquidating assets, or declaring large bonuses. Some LOIs prohibit such changes, while others require the buyer’s approval before making the changes.
The buyer’s goal is to prevent you from making radical changes that can affect the value of the business. Most buyers simply desire that the seller continue to operate the business as they normally would but they often ask that the seller run key decisions by them before implementing them. I have encountered some sellers in the past who have made drastic changes to the business prior to closing, such as terminating major advertising contracts, firing key employees, discontinuing lines of business, selling major pieces of equipment, and so on. As the seller, you should continue operating your business as usual and obtain the buyer’s approval before you make any major changes.
Another key element of any LOI is what role the seller will play in the business after the closing. If you will continue to play a key role in the business, the key terms of the employment or consulting agreement, such as the salary, should ideally be worked out prior to accepting the LOI.
In most cases, it isn’t worth it financially for you to continue working in the business. If the EBITDA in the business is $3 million per year, few sellers will be willing to continue working in the business at a salary of $300,000 per year. Why would they take a 90% pay cut? Most aren’t willing to do so. It’s best to find out now what the buyer’s expectations are regarding your continued role and potential salary. If you can’t agree on the terms of the employment agreement, then it makes little sense to accept the LOI.
There are three primary instances in which it may make sense for you to play a continued role in the business:
If you don’t want to stay on with the business, then you should seek out buyers who don’t require you to do so. Alternatively, you should focus on building up your management team and identifying a potential successor CEO or manager several years in advance.
There are two primary issues in an LOI that relate to the employees of the business: disclosure and retention.
One of the most challenging issues faced by sellers is deciding which employees to tell about the sale and when to tell them. Most sellers prefer to keep the sale a secret until the day of closing. Perhaps they may disclose the sale to their CFO and professional advisors, but “loose lips sink ships,” and the more people who are told, the more likely it is that word will end up in the wrong ears.
This is in direct contrast to buyers, who often want access to key employees before the closing occurs. Their objectives for talking to the key employees are usually two-fold:
There are two key elements in deciding to inform your employees:
You can couple this disclosure strategy with a retention agreement with your key employees. If you prepare a formal retention bonus agreement, you can also include a confidentiality and non-solicitation agreement that can be assigned to the buyer.
If you do agree to allow the buyer to talk to your employees, then you should only let this happen at the tail end of due diligence. Ideally, the purchase agreement should be fully negotiated.
The second issue buyers are concerned about is retaining your employees. Some LOIs contain a contingency that states that the buyer won’t move forward unless the buyer can obtain employment and non-compete agreements from key employees. In some cases, this process unfolds uneventfully, especially if the buyer is well-capitalized and agrees to a salary increase with your key people.
But you should be particularly careful before agreeing to such a clause. If employees catch wind of the fact that they can hold up the sale, they often will. As a business owner, the last thing you want to happen is to be held hostage in your own business by your employees.
I worked on one transaction nearly a decade ago in which several of the key employees made outsized demands to the buyer. These employees knew the position they were in and decided to hold the buyer and seller hostage. What was the result? The buyer didn’t acquiesce to the employees’ demands and fired the employees the day after the closing. As the saying goes, sometimes the squeaky wheel gets the grease, and sometimes the squeaky wheel gets replaced.
While nearly all buyers expect the seller to agree not to compete with the buyer after the closing, such an agreement is usually implied and not explicitly stated in the LOI. Despite this fact, it doesn’t hurt to include one line in the LOI stating that the buyer expects the seller to sign a non-compete at closing for a specified number of years and within a certain geographic area. If you desire to engage in something related to the business after the closing, you should specifically carve out the desired activity to make sure it won’t conflict with the non-compete.
In most LOIs, termination is tricky if the LOI is non-binding. If the LOI is non-binding, then it should be cancellable without effect. Some LOIs include breakup or walk-away fees, but these fees are rare in lower middle-market transactions. Some savvy buyers also include a clause that requires the seller to reimburse their expenses if the seller walks from the deal. You may seek a reciprocal clause if the buyer walks. Such is the give and take of negotiating any LOI. In practice, momentum is as important for each party as nailing down all of the specifics. Regardless, all LOIs should terminate if you and the buyer fail to reach an agreement by a specified date.
Expenses
Some LOIs include a provision that addresses how fees and expenses will be allocated between the parties. Most specify that expenses will be paid by the party that incurs them. Some LOIs require that the seller reimburse the buyer for their expenses if the deal doesn’t happen. Most sellers consider this to be unreasonable and refuse to sign it.
Governing Law
Governing law isn’t an issue if the parties are both located in the same state. If the buyer and seller are located in different states, the buyer usually proposes their home state as the governing law. The seller often agrees if the state is Delaware or if the buyer has significantly more negotiating leverage. Otherwise, the parties compromise and choose a neutral state.
Legal Authority
Some LOIs also require that the parties confirm their legal ability to consummate the transaction.
Here is a description of the variety of processes and styles of negotiating the letter of intent:
Following are the major terms and characteristics of an LOI and the impact they have on the negotiations:
Introductory Paragraph: Most LOIs begin with a few niceties, such as a salutation and preamble. Some LOIs then transition into a basic description of the acquisition, such as the purchase price, form of the proposed transaction, or other high-level terms.
Binding vs. Non-Binding: Any well-drafted LOI should clearly state the parties’ intentions regarding the extent to which they desire the LOI to be binding. Some LOIs state such an intention in the introduction or title, while other LOIs separate the binding provisions from the non-binding provisions and label each section as binding or non-binding. Other LOIs wrap up with a paragraph listing the binding and non-binding sections. A common mistake in many LOIs is to indicate that the entire LOI is non-binding.
Purchase Price & Terms: You can’t always determine the “total” purchase price solely from looking at the purchase price number. Many LOIs include additions and subtractions from the purchase price that are listed in a separate section of the LOI. When receiving an offer, you should analyze it in a spreadsheet along with balances for each of the assets and liabilities that comprise working capital (accounts receivable, inventory, accounts payable) so you can compare multiple offers on an apples-to-apples basis. The LOI should specify what assets are included in the price. The purchase price should ideally be a fixed number (e.g., $10 million), as opposed to a range (for example, $8 million to $12 million). Valuations based on a formula should be avoided, if possible, such as a valuation that is 4.5 times the trailing twelve months’ EBITDA. If you do agree to such a provision, the adjustment should go both ways – both up and down, based on the value of the metric.
Consideration: The LOI should also clearly lay out how the price is to be paid. Here are the most common forms of consideration for the purchase price:
Working Capital: Corporate buyers almost always include working capital in the purchase price. Working capital is defined as current assets minus current liabilities. Most LOIs that include working capital make an assumption regarding the current level of working capital required to operate the business, then an adjustment is made after the closing based on calculating the actual amount of working capital. If there is a difference between the pre-closing and post-closing amount of working capital, the purchase price will be adjusted accordingly. The LOI should clearly define the method for calculating the working capital in the LOI and the purchase agreement.
Key Dates & Milestones: The LOI should include deadlines and milestones for the buyer to maintain exclusivity. The LOI should contain a list of the following key dates and milestones:
Confidentiality: Some LOIs reaffirm the confidential nature of the negotiations. Others expand upon the original confidentiality agreement that was signed, either in the form of an additional clause in the LOI or in a separate supplemental agreement. If you’re negotiating with a direct competitor, include a supplemental confidentiality agreement that addresses the non-solicitation of your customers, employees, and suppliers, and addresses trade secrets, non-public pricing information, names of employees, or names of customers.
Due Diligence: Most buyers request 60 to 90 days. Counter with 30 to 45 days. The process can always be mutually extended if necessary. The more effort you have invested preparing for due diligence, the shorter the due diligence period can be. Resist providing access to customers and employees unless absolutely necessary. The LOI should require that third parties sign an NDA, or the buyer should remain liable for breaches caused by any third parties the buyer employs.
Exclusivity: The exclusivity clause prohibits the seller from soliciting, discussing, negotiating, or accepting other offers for a period of time following acceptance of the LOI. The precise length and activities that are prohibited vary based on the exact language contained in the clause. You should negotiate exclusivity periods for 30 to 45 days – or 60 days maximum. Shorter exclusivity periods encourage the buyer to move quickly and penalize the buyer for dragging their feet. To protect yourself from this happening, you can do the following:
Earnest Deposit: While an earnest money deposit is common in transactions under $1 million to $5 million, a deposit is less common in mid-sized transactions. For smaller transactions, 5% is generally sufficient. For larger deals, $50,000 to $250,000 is usually sufficient.
Allocation: Ideally, the LOI should specify how the purchase price will be allocated for tax purposes. Negotiating the allocation early is often met with much less resistance because the parties are far less entrenched in their positions and are often more willing to make quick compromises in the spirit of moving the deal forward.
Legal Form of Transaction: Sellers usually prefer a stock transaction because their net proceeds will often be far greater than an asset sale. Buyers usually prefer an asset sale because this limits the possibility of contingent liabilities. The buyer can also receive a stepped-up basis in the assets, which reduces the taxable income for them post-closing by maximizing the amount of depreciation they can write off. Most transactions in the lower middle market are structured as asset purchases. If the sale is structured as an asset sale, the LOI should define what assets and liabilities are included in the price.
Escrow (Holdback): The LOI should address whether a percentage of the price will be escrowed or held back, and if so, the amount of the holdback.
Reps & Warranties: Most LOIs state that the LOI is subject to the preparation of the purchase agreement, which will contain reps & warranties that are customary or appropriate for a transaction of its nature.
Conditions (Contingencies): Most LOIs include conditions for consummating the transaction. Because most LOIs are non-binding, conditions aren’t required, but they set the expectations of the parties. The biggest downside to a financing contingency for a seller is that all the buyer has to do if they don’t want to follow through on the deal is to claim that they can’t obtain financing. This effectively serves as a “blanket contingency” for a buyer.
Covenants: Covenants primarily relate to how the business will be conducted prior to the closing, such as “between the date of this Letter of Intent and the closing, the Sellers agree to operate in the ordinary course of business.” This effectively requires you to continue all marketing efforts and not make any material changes to the business prior to the closing, such as terminating key employees, liquidating assets, or declaring large bonuses. The buyer’s goal is to prevent you from making radical changes that can affect the value of the business.
Seller’s Role: If you will continue to play a key role in the business, the key terms of the employment or consulting agreement, such as the salary, should be worked out prior to accepting the LOI. If you don’t want to stay on with the business, seek out buyers who don’t require you to do so. Alternatively, you should focus on building up your management team and identifying a potential successor CEO or manager several years in advance.
Management’s Role: Couple your disclosure strategy with a retention agreement with your key employees. If you prepare a formal retention bonus agreement, include a confidentiality and non-solicitation agreement. Make sure it can be assigned to the buyer. If you allow the buyer to talk to your employees, only let this happen at the tail end of due diligence and after the purchase agreement has been negotiated. Some LOIs contain a contingency that states that the buyer won’t move forward unless they can obtain employment and non-compete agreements from key employees. You should be particularly careful before agreeing to such a clause. If employees catch wind of the fact that they can hold up the sale, they often will.
Non-Compete: While nearly all buyers expect you to agree not to compete with the buyer after the closing, such an agreement is implied and not explicitly stated in the LOI. If you desire to engage in something related to the business after the closing, specifically carve out the desired activity to make sure it won’t conflict with the non-compete.
Termination: If the LOI is non-binding, it should be cancellable without effect. Some LOIs include breakup or walk-away fees, but these fees are rare in lower middle-market transactions.
Miscellaneous: Most LOIs wrap up with a clause covering how expenses will be paid, governing law, and legal authority.
Here is a description of the process and negotiating styles:
