Negotiating the Letter of Intent

Once a buyer is prepared to make an offer, they will submit an LOI. Most sellers are in a rush to sign the LOI and move on with the transaction, as they impatiently eye the end-zone. “Just a few more yards to go,” they think. Not so fast! When accepting an LOI, you’re still on the 30-yard line, meaning there’s 70 more yards to go. It’s important to understand what an LOI does, how it functions, and how you should think about it. Let’s discuss that here. 

The Term Sheet

A term sheet is used to start negotiations by allowing the parties to focus on the key terms of a transaction. Its primary objective is to enable each party to focus on the key elements of the transaction before preparing a detailed LOI or purchase agreement. 

The term sheet is a short bullet list of the key points of the transaction, such as the selling price, earnest money deposit, down payment, financing terms, length of time for due diligence, training agreement, non-compete agreement, contingencies, and other essential terms.

I have seen many parties spend dozens of hours and thousands of dollars in attorney fees when they haven’t agreed on the basic terms and structure of a transaction. A term sheet can be as simple as a sheet of paper with your agreement regarding the basic terms. 

You don’t need to involve your attorney until you agree on the essential elements.

Use a term sheet for discussion purposes only. It allows you to focus on structuring the key elements of the transaction without concerning yourself regarding the language required to document those terms. If you can agree on the term sheet, you can move straight to an LOI or a purchase agreement.

You’ll want to agree on the following basic terms of the transaction:

  • Selling price
  • Earnest money deposit, if applicable – corporate buyers don’t usually provide an earnest money deposit
  • Down payment
  • Holdback, if applicable
  • Seller note, if applicable – including amortization period and interest rate
  • Due diligence length
  • Training length
  • Non-compete agreement
  • Any contingencies

It doesn’t make sense to prepare a lengthy purchase agreement if you can’t agree on the basic terms listed above. I see many sellers make the mistake of calling an attorney before they have an agreement. You don’t need to involve your attorney until you agree on the essential elements.

A term sheet isn’t usually necessary if the buyer is a private equity group or sophisticated corporate buyer – in these cases, the buyer usually prepares an LOI and presents it directly to you.

Shifting Positions of Power

When buying or selling a business, it’s important to understand the shifting positions of power between the buyer and seller as the transaction progresses. Naturally, both buyer and seller will push for concessions when they’re in the greatest positions of power and try to limit concessions when they’re in a weaker negotiating position. 

As the seller, you have the greatest leverage early in the process. But this leverage instantly shifts to the buyer the moment an LOI is signed. Before an LOI is signed, you’re free to negotiate with multiple parties, but once the LOI is signed, you’re limited to exclusively negotiating with one buyer, assuming the LOI contains a “no-shop” clause, which most do. This obligation for you to exclusively negotiate with the buyer dramatically reduces your leverage from the moment you sign the LOI and throughout until closing. 

The Role of the Letter of Intent 

What is the difference between an LOI and a purchase agreement? 

An offer is usually one to five pages long and doesn’t contain all the language necessary for the closing. It’s signed immediately before the due diligence period begins and is normally structured to be binding. An earnest money deposit often accompanies an offer. An LOI is similar in length but usually isn’t intended to be binding. The purchase agreement is signed after due diligence is finished, normally at the closing, and is often 20-to 50-plus pages long. 

What happens after the LOI is signed?

Once the LOI is signed, the arduous process of due diligence begins. Unfortunately, most sellers are woefully unprepared for just how grueling the remaining 70 yards can be. The process from signing the LOI to closing can take several months or more, and less than half of companies make it to the endzone.

This is the most critical stage of the process for you. Your leverage instantly evaporates the moment you sign the LOI. Unfortunately, many sellers are excited and impatient at this stage and prefer to blindly sign the LOI while overlooking other crucial terms once they agree on a price. Caution is advised. The LOI contains critical provisions that will govern the dynamics of the relationship between the parties all the way until closing.

In most cases, the majority of the terms in the LOI are non-binding, with the exception of a few clauses, such as confidentiality and exclusivity. Most LOIs also state that the parties will begin preparing the purchase agreement within a certain timeframe. They will also stipulate that the purchase agreement will contain the representations, warranties, covenants, and indemnification-obligation language customary for a transaction of the size and type being contemplated. 

The process from signing the LOI to closing can take several months or more. As the seller, you have the greatest leverage early in the process. 

The LOI never includes the full scope of the reps and warranties, but the parties may choose to document any potentially contentious reps and warranties in the LOI in an attempt to avoid these becoming deal breakers later on. 

It’s best to negotiate contentious issues during the LOI stage instead of delaying their negotiation until later in the transaction. If an M&A advisor suspects that certain issues may become contentious, they’ll work to negotiate comprehensive language addressing these potential issues upfront before the LOI is signed. It’s better to negotiate these issues early on and potentially risk losing the buyer than to spend tens of thousands of dollars and several months negotiating with a buyer only to be hit with a last-minute deal-killer. If these issues are held until later, the buyer will have significant negotiating leverage over you, and it’s likely you will simply cave to the buyer’s demands, even if they’re unreasonable.

Here is sample language that may be included in the LOI:

The Purchaser will prepare and deliver to the Seller within 10 days of the conclusion of Purchaser’s Due Diligence Review a definitive Purchase Agreement (the “Purchase Agreement”). The Purchase Agreement will contain terms and conditions customary in transactions of this type (including standard representations, warranties, covenants, and indemnifications), or which are reasonably necessary as a result of the Due Diligence Review. Representations regarding the Company will, for most items, survive closing for three years, and for other items, including without limitation, environmental, taxes, ERISA, and title, the survival shall be for longer periods (and in some cases indefinite).

Following is sample language that may be included in the LOI that addresses reps and warranties made in the LOI:

The purchase transaction contemplated under these proposed terms is subject to the following conditions: Negotiation and execution of a definitive agreement setting forth representations and warranties of the two entities, covenants, and any other provisions customary in transactions of this nature. 

Unfortunately, LOIs don’t include all of the important terms of the transaction, so you can’t assess the full scope of the terms until later in the transaction. For example, LOIs often contain language that the purchase agreement will include “representations, warranties, and indemnification that are customary for a transaction of this size and type.” But customary based on whose definition? Some LOIs include specifics regarding more contentious issues, such as the amount of earnouts and escrows. Less frequently, the LOI may include information regarding thresholds, such as caps or baskets.

Timing and Due Diligence

When negotiating an LOI, the buyer hasn’t performed due diligence and has limited information on the business; therefore, the buyer isn’t in a position to know exactly what reps and warranties they will request from you. Only after the buyer has conducted due diligence will they be in a position to pin down the specifics. Ideally, the purchase agreement should be prepared in tandem with the due diligence process so the parties can negotiate the language as soon as possible in the transaction.

Sunk Cost Principle

Some buyers attempt to use time to their advantage and will attempt to wear you down using the “sunk cost” principle. The buyer figures that the more time and money they can get you to invest, or sink, in the negotiations, the more likely you will give in on major deal points later in the transaction to recover those sunk costs. This strategy can be countered by including milestones in the LOI, such as the dates for completion of due diligence and preparation or signing of the purchase agreement. 

The more buyers with whom you’re negotiating, the stronger your negotiating posture will be.

How Leverage Changes Throughout a Transaction

As a seller, you have the most leverage early in the transaction, before the LOI is signed. Once you sign the LOI, you lose leverage and are beholden to the buyer’s timetable. Most LOIs contain an exclusivity clause and require you to take your business off the market and cease negotiations with other parties, which further weakens your negotiating posture. For this reason, you should carefully negotiate all the terms of the LOI. If you’ve never sold a business before, it’s critical that you hire an experienced professional to handle the negotiations on your behalf. 

The more buyers with whom you’re negotiating, the stronger your negotiating posture will be. If you’re negotiating with multiple parties, it may be suitable to move to a much more detailed LOI and outline in detail the components of the purchase price, such as price, terms, escrows, caps, baskets, survival periods, earnouts, and allocation of the purchase price. This will help you evaluate offers as opposed to blindly accepting an LOI with vague terms, only for it to blow up later in the process. 

The Impact of Current Market Conditions on Negotiations

The current state of M&A activity – and the extent to which it’s a seller’s or buyer’s market – heavily influences the scope of negotiations. Market conditions impact not only the price of companies but also the terms of the transactions – and may dictate the prevailing definition or notion of what’s considered “reasonable” or “fair.”

Market conditions can influence the following:

  • Price and Terms
    • EBITDA multiples
    • Terms, such as the amount of cash down and the amount of equity purchased vs. rolled over
    • Amount of contingent payments, such as earnouts 
  • LOI Terms
    • Exclusivity periods, which are much shorter in a seller’s market
  • Protective Mechanisms
    • Scope of indemnification
    • Size of escrow or holdback
    • Indemnification limitations, such as baskets and caps

The Process

The LOI doesn’t contain the necessary language for a closing since it will be replaced by a purchase agreement prior to the closing. Still, it allows both parties to agree to the essential terms of the transaction so they can begin the process of due diligence. 

The individual who writes the offer exerts the most control over the timing and structure of the deal. I suggest that you prepare the offer if the buyer is an individual or a smaller company. If the buyer insists on preparing the offer, it’s customary to let them do so.

Once the offer or LOI is accepted, the parties begin due diligence, and the purchase agreement is usually prepared simultaneously while due diligence is being conducted. 

Here are the primary elements of the LOI or offer:

  • Transaction Structure
    • Asset sale vs. stock sale
  • Purchase Price and Terms
    • Earnest money deposit
    • Seller note, including length and interest rate
    • Bank financing
    • Earnout
    • Holdback
  • Due Diligence – Length
  • Contingencies
    • Bank financing
    • Third-party approvals, such as landlord, franchisor, and distributor approvals
    • Licensing 
  • Exclusivity or No-Shop Provision 
    • This prohibits you from negotiating with other buyers during the exclusivity period. A “no-shop” or “go-shop” clause may be included in this section.
  • Confidentiality
    • Some offers include language addressing confidentiality that supplements the initial non-disclosure agreement.
  • Expiration Date
    • The LOI should include an expiration date so you don’t have an open-ended commitment.

When is an LOI versus an offer customarily used? 

LOIs are common for large transactions when the buyers are larger corporations or private equity groups. These types of buyers generally have credibility and have sometimes successfully completed dozens of transactions. For smaller transactions, I recommend accepting an offer to purchase along with an earnest money deposit. For an individual, walking away is too easy with a non-binding LOI and no earnest money deposit. On the other hand, buyers of larger companies invest a significant amount of money and time, and this negates the need for earnest money deposits in cash.