Major Clauses

The key terms of an LOI include the following:

• Purchase price and terms
• Assets and liabilities included, especially working capital
• Form of consideration, for example, how the purchase price is paid, such as cash, stock, earnout, or notes
• Legal transaction structure – asset or stock sale
• Seller’s ongoing role and compensation
• Conditions to close, such as financing or other contingencies
• Due diligence process
• Exclusivity
• Deadlines or transaction milestones 

Less common terms include the following:

• Escrow or holdback obligations
• Confidentiality obligations
• Earnest money deposit
• How the purchase price will be allocated for tax purposes
• Representations, warranties, and indemnification
• Covenants, such as conduct of the business prior to closing
• Access to employees and customers
• Termination

Here are details and considerations to keep in mind for each section of the letter of intent.

Introductory Paragraph

Most LOIs begin with a few standard niceties, such as a salutation and preamble, similar to any business letter. After a short introduction, many 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 within it. While sellers prefer clarity, buyers often prefer ambiguity, which can be used to their advantage later in the negotiations.

Here’s a straightforward introduction to 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.

Binding vs. Non-Binding Provisions

Any well-drafted LOI should clearly state the parties’ intentions regarding the extent to which they desire the LOI to be binding. Some LOIs clarify the objective in the introduction or title of the LOI, such as “Non-Binding Letter of Intent.” 

Other LOIs separate the binding provisions, such as confidentiality and exclusivity, from the non-binding provisions like the purchase price, and then 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.

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, and exclusivity. Regardless, courts will look to the parties’ intentions if the LOI is silent regarding whether it’s binding. 

Purchase Price and Terms

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 by 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. 

What’s Included in the Purchase Price

A key example of inclusions (as opposed to exclusions) to the purchase price is working capital. Working capital is defined as accounts receivable, plus inventory and prepaid expenses, minus accounts payable, short-term debt, and accrued expenses. Does the amount the buyer intends to pay include working capital? Here’s an example illustrating the importance of defining whether working capital should be included in the purchase price: 

If the purchase price is $10 million, and the business requires $2 million in working capital to operate, the purchase price could be defined as either $10 million or $12 million, depending on whether 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.

A common mistake sellers make is to focus solely on the purchase price while ignoring what assets and liabilities are included in the price. Most buyers structure their offers to include working capital in the price, which I’ll discuss in detail in a later section. When receiving 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. Doing so will give you a more accurate assessment of their offer. It will also allow you to compare multiple offers on an apples-to-apples basis. Many LOIs fail to define working capital, leaving the definition and calculation to be determined later. That ambiguity will almost never be in your favor due to your diminishing negotiation position as the seller.

The following assets are usually included in the purchase price:

• Furniture, fixtures, and equipment
• Vehicles used in the business
• Leasehold improvements
• Transition period
• Covenant not to compete
• Business name, website, email addresses, phone number, and software
• Business and financial records, client and customer lists, marketing materials, and contract rights
• Trade secrets – whether registered or not, and intellectual property, such as patents and trademarks
• Transfer of licenses and permits
• Assumption of product warranties
• Working capital
  • Current Assets
    • Accounts receivable
    • Inventory, supplies, and work in progress
    • Prepaid expenses
  • Current Liabilities
    • Accounts payable
    • Short-term debt
    • Accrued expenses

The following assets and liabilities are not normally included in the purchase price:

• Real estate and land – this is customarily purchased separately
• Cash
• Assumption of long-term debt
• Your entity, unless the sale is structured as a stock sale or a merger

The LOI should clearly indicate which assets and liabilities are included in the purchase price, and specifically list any assets or liabilities that are excluded.

You can’t always determine the “true” or “total” purchase price solely from looking at the purchase-price number.

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:

• Cash at Closing: Will the buyer provide cash at the closing table?
• Bank Financing: If bank financing is involved, does the lender have a senior position? When will the buyer provide a commitment letter from the bank to you before the closing? Does the LOI also include a financing contingency?
• Seller Note: Are the assets of the business being offered as security for the note? What security do you have if a lender has a senior security interest? What are the terms of the note, such as the interest rate and amortization period? Is the note fully amortized, or is there a balloon payment? Is the buyer willing to personally guarantee the note?
• Stock: What is the trading volume of the stock? On what exchange is the stock traded? How easily can you convert the stock to cash? One consideration is that most stock in M&A transactions is restricted and can’t be traded for a period of time. 
• Earnout: What are the terms of the earnout? Earnouts are a loaded topic and a potential landmine for any seller.
• Escrow/Holdback: Most M&A transactions include a holdback, in which a portion of the purchase price is held in escrow for a period of time to satisfy post-closing indemnification obligations for any breaches of the reps and warranties. If that’s the case, what are the terms of the holdback, such as the amount, basket, and cap of the escrow and of the reps and warranties?

A seemingly appealing offer with an apparently strong valuation may not be attractive once you dig deeper. 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 ranges for how the purchase price is commonly paid. Please note that these percentages do not represent the maximum range, but the most common range for transactions in the middle market from $2 million to $100 million in purchase price:

• Cash at Closing: 50% to 90%. This includes bank financing since cash is delivered to the seller at closing.
• Seller Note: 10% to 20%
• Earnout: 10% to 20% 
• Escrow: 10% to 20% 
• Stock: Not common unless the buyer is publicly traded. Some buyers, usually private equity firms, will ask the seller to “roll over” their equity into the new entity, usually 10% to 25% of the value of the seller’s company.

Fixed Purchase Price vs. a Range or Formula

The purchase price in an LOI should ideally be a fixed number as opposed to a range such as $8 million to $12 million. Ranges are commonly used in indications of interest (IOI) for larger transactions of more than $100 million, but I don’t recommend them for transactions less than $100 million. If the buyer proposes a range, I suggest giving the buyer access to more detailed financial information, so they can firm up the price they propose in their LOI before moving forward to confirmatory due diligence. 

Valuations based on a formula – such as 5.5 times the trailing twelve months’ EBITDA – should be avoided, if possible. These formulas are subjective, such as how EBITDA is calculated, and any subjective terms are likely to slant in the buyer’s favor as the transaction progresses. Some formulas include a cap on the purchase price, which can only hurt you. Unless you like gambling on a coin toss with a double-sided coin, avoid a cap. 

With a formula, the buyer can adjust the purchase price based on a change in revenue, EBITDA, or some other financial metric. If you 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 a 5.0 multiple of EBITDA and you initially claimed EBITDA was $2.5 million, but due diligence uncovered that you understated EBITDA by $500,000 so that the total is $3.0 million, the buyer should pay you $15 million for the purchase price.

Here’s 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’s a more detailed purchase price clause:

• Purchase Price: $7,000,000 on a cash-free, debt-free basis, with working capital paid as an additional payment as described below – collectively, the “Purchase Price.”
• Capped earnout equal to 10% of revenue over $8.5 million for 5 years, measured on an annual 12-month basis and paid within 60 days of the end of each 12-month period. The earnout would be capped at $1,500,000 in aggregate. This measurement is to be consistent with past accounting practices as presented. 
• $900,000 of Working Capital Payment paid as an additional payment at Closing – the “Working Capital Advance.” The remaining outstanding amount of the Working Capital Payment will be reconciled four (4) months after the Closing. The total amount of working capital constitutes the “Working Capital Payment.”
  • Working Capital Payment is calculated based on the balance sheet at Closing and would be 90% of the sum of the Accounts Receivables collected, plus inventory, minus current liabilities. 
  • Accounts Receivables as of the Closing that are subsequently written off by Buyer as uncollectible are not included in the Working Capital Payment. Accounts Receivables not collected by the four (4) month period – but not yet written off as uncollectible – would be held until collection or written off and paid out to Seller if and when collected.
  • Inventory should be stated truthfully and accurately as of Closing and valued at cost in accordance with the Company’s historical practices. No increase or other adjustment would be made to the value of any item of inventory.
  • The Working Capital Payment would be equal to 90% of total working capital to reflect that 90% of the Company is being purchased by Buyer.
  • Explicitly, the Working Capital Payment would exclude pre-paids, work-in-progress, and any other assets. These are included in the calculation of the purchase price. Projects are to be billed truthfully and accurately through the Closing.
• Payment Terms. The purchase price would be paid as follows subject to any adjustments set out below:
  • $250,000 good faith deposit (the “Good Faith Deposit”) held by your attorney against the purchase price upon signing the LOI.
  • $2,000,000 cash paid to your attorney upon the parties signing the purchase agreement. 
  • $500,000 of Working Capital Advance paid at Closing.
  • Remaining Working Capital Payment reconciled four (4) months after Closing and paid as and when the Accounts Receivables outstanding at Closing are collected.
  • 10% rollover equity interests in Buyer issued to Seller.
• Purchase Price Adjustments. The purchase price would be subject to the following adjustments:
  • Cash: Any cash left on the balance sheet at Closing increases the price.
  • Debt: Any debt left on the balance sheet at Closing decreases the price. 
  • Non-Cash Working Capital: Excluded and addressed in Section xx above.
  • Claims: Any claims or liabilities resulting from the Company’s operations prior to Closing reduce the purchase price and can be offset against ongoing payments owed to any of the Sellers.

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 letter of intent.

Working Capital

Buyers almost always include working capital in their offer price. Why? 

Buyers characterize working capital as any other asset that’s required to operate the business, such as a piece of machinery, vehicle, or any other piece of 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. I reluctantly agree with this point. You’ll 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 later in the transaction. In this section, I’ll cover them in more detail.

Working capital is an asset that must remain in the business for it to operate, so it is no different than any other resource. 

Working capital is defined as current assets minus current liabilities as follows:

• Current Assets:
  • Cash: Cash is usually excluded from the calculation, except for petty cash that may be used in the business.
  • Accounts Receivable: Accounts receivable are usually purchased at a discount, such as 90% to 95% of face value.
  • Inventory: This usually also includes supplies and work in progress (WIP).
  • Prepaid Expenses: This may include insurance premiums and any other expenses that are paid in advance.
• Current Liabilities:
  • Accounts Payable: This includes short-term payments due to suppliers that have granted you credit.
  • Accrued Expenses: This includes payroll and other short-term, accrued expenses.
  • Short-Term Debt: The definition of short-term debt is usually included in the LOI and may include any other indebtedness with a term of less than 12 months.

The amount of working capital fluctuates on a daily basis in all businesses. For most businesses, the two largest components of working capital are accounts receivable and inventory. Most LOIs make an assumption regarding the current level of working capital required to operate the business, and then make an adjustment after the closing based on the actual amount of working capital (called a “true-up”). This is the fun part for buyers. If the definition of working capital is less than comprehensive, most buyers will work the definition in their favor. The result? Less money in your pocket and more money for the buyer. This is why buyers love unclear definitions in the letter of intent – because they can work them to their favor later in the negotiations after you’ve become emotionally and financially committed to the transaction.

If there’s a difference between the pre-closing and post-closing amount of working capital, the purchase price will be adjusted accordingly after the closing, typically calculated three to four months after the closing. For example, if the working capital target – also called the working capital peg – is $3 million, but working capital is calculated as $2.5 million after the closing, there will be a post-closing purchase price adjustment of $500,000 to make up for the difference. This adjustment isn’t usually made until several months after the closing.

Since working capital is a changing target, such a clause commonly results in post-closing disputes. In fact, I recently spoke with one intermediary who just wrapped up a working capital dispute that left the seller with $1 million less in their pockets. To avoid such a dispute, include a strong definition of working capital like the one below.

Here’s 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 aren’t specific regarding how working capital should be calculated. Here are some important questions that often go undefined:

• How Inventory Is Calculated: How is obsolete inventory accounted for? When is inventory considered obsolete? At 61 days, 91 days, 121 days, or some other time frame? Is obsolete inventory written off completely, or is a discounted value assigned? Is inventory valued at last in, first out (LIFO) or first in, first out (FIFO)?
• How Accounts Receivable Are Calculated: Are accounts receivable valued at face value, or a discount of face value? When is an account receivable considered bad? Is a receivable still good at 91 days? If late, will it be valued at the full amount or some discounted number? How does an allowance for bad debt affect the calculation of accounts receivable?
• How Accounts Payable Are Calculated: What exactly is included in accounts payable? How are accounts payable differentiated from long-term debt – at 12 months, or at some other number? How are late accounts payable handled?

In the face of the above problems, let’s examine some ways to avoid conflicts related to calculating working capital:

• Methods To Implement Before the Sale
  • Scrub the Books: A clean set of financial records leads to increased buyer confidence when analyzing a business. Clean your books and all components of working capital before the sale process begins. Ideally, you should then calculate the working capital balance on a monthly basis and track any major changes in the value of working capital. 
  • Purge Obsolete Inventory: Clearing obsolete inventory and late accounts receivables from your books is another key factor in creating clean financial records. Remember, clean records communicate to the buyer that your business is well run, which might lead some buyers to conduct due diligence more quickly. 
• Methods Used During Negotiations
  • Clearly Define Working Capital: The other method is to clearly define the method for calculating the value of working capital in the letter of intent and the purchase agreement. Unfortunately, such a detailed definition is usually lengthy and not suitable for the tone of an LOI, which is why most LOIs don’t include them – it kills the mood. Ideally, working capital should be clearly defined in the LOI. If working capital is undefined, sellers must accept the inherent risks as a result of an unclear definition. 

While the LOI may not include specific language regarding a post-closing working capital adjustment, nearly every purchase agreement will do so if the buyer is well-advised, and most are. So don’t overlook this section early on. A post-closing working capital adjustment isn’t boilerplate accounting language – this is a hidden weapon any buyer can use against you, especially if it’s not defined. Be assured that if a clear definition for calculating working capital isn’t laid out in the LOI, the buyer will use it against you when it comes time to negotiate the purchase agreement. If that idea makes you uncomfortable – and it should – nail this definition down before you move on.

Your negotiating leverage disappears the moment you sign the letter of intent.

Key Dates and Milestones

Most LOIs submitted by buyers contain few, if any, deadlines. And, from the buyer’s point of view, why should they?

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 to the LOI. Your negotiating leverage disappears the moment you sign the LOI. Why? Most LOIs contain an exclusivity clause that requires you to cease negotiations with all third parties after you accept the LOI. 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” with this buyer. Buyers know this, and some intentionally use it to their advantage. Don’t let it happen to you.

Ideally, the LOI should contain a list of the following key dates and milestones:

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

Tip: If you have significant negotiating leverage over the buyer, 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 the buyer on their toes and helps ensure you maintain as much negotiating leverage as possible as the transaction progresses. 

Confidentiality

Any buyer who’s negotiating with a seller who’s represented by an M&A intermediary will execute a confidentiality agreement prior to submitting an LOI. 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 if you’re negotiating with a direct competitor. The agreement can contain specific language regarding the non-solicitation of your customers, employees, and suppliers. It can also address any other particular 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? A highly restrictive NDA is likely to be met with resistance in the preliminary stages of a transaction, especially when the buyer hasn’t yet decided if they’re interested in digging deeper into your company. 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 of the transaction, such as information contained in your confidential information memorandum (CIM).

Due Diligence

Most LOIs presented by buyers include one or two sentences regarding due diligence, usually addressing the length of time requested for the process and access to the necessary information to conduct due diligence. Most buyers request 30 to 60 days, and many request an indefinite term. I recommend countering with 30 to 45 days. The process can always be mutually extended if necessary. If you’ve invested time into preparing your business for due diligence, the due diligence period can be at the shorter end of the range.

Ideally, the LOI should describe the due diligence process in more detail, including the procedure and scope. You should resist providing access to your customers and employees unless 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, put off doing so until the tail end of due diligence or, ideally, after the purchase agreement is ready to be signed and all contingencies have been resolved.

A common tactic some buyers use is to gradually wear you down over time with numerous requests for information during the due diligence period. In their view, the more time and money you invest in conducting due diligence, the more likely you are to concede in negotiations later in the process. This strategy plays on the sunk cost fallacy, in which people tend to follow through on an endeavor if they’ve already invested time, effort, or money into it. This wearing-down 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, such as environmental advisors. 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. Still, 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’s a sample clause addressing 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 more effort you have invested in preparing for due diligence, the shorter the due diligence period can be.

Exclusivity 

Most exclusivity clauses prohibit you from soliciting, discussing, negotiating, or accepting other offers for 30 to 90 days after you accept the LOI. This clause is also commonly 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’re usually prohibited from contacting both current and future buyers. This clause effectively allows the buyer to lock up your business for an extended period. Exclusivity is a critical concession you should make with great care. 

Corporate buyers normally demand an exclusivity provision because they’ll invest considerable time and money in performing due diligence, so they don’t want you shopping their offer with third parties in an attempt to get a better deal. Negotiating to remove a no-shop clause is rare because buyers aren’t willing to invest the necessary time to close a transaction if you’re simultaneously courting other buyers or shopping their offer.

It’s reasonable for buyers to want to lock up the transaction to have the assurance you won’t shop their offer as they invest significant time and money conducting due diligence, negotiating the purchase agreement, and preparing for the closing. The exclusivity period gives the buyer the necessary time to work on the details of the transaction without worrying about losing the deal to another buyer.

I rarely make absolute statements, but here’s an exception – far too many sellers overlook their commitment to exclusivity. They fail to realize the impact that a far-reaching exclusivity period can have on their negotiating leverage. You should grant exclusivity carefully and do everything possible to limit the time you’re prevented from speaking or negotiating with other buyers.

Far too many sellers overlook their commitment to exclusivity. They fail to realize the impact that a far-reaching exclusivity period can have on their negotiating leverage. 

Length

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 isn’t hypothetical – every seller should be aware of the implications of agreeing to an exclusivity clause. The deal will never get better for you once you sign the LOI – it can only get worse. Therefore, the longer the time period 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.

Most buyers request stop-shop clauses ranging from 45 to 90 days, though I have seen stop shops as long as 120 days. As a 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 the 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 cite the exact duration of the exclusivity period and, ideally, list the precise date the exclusivity period expires.

As a seller, you should be wary of buyers who strongly negotiate for longer exclusivity periods. Exclusivity periods that go beyond 60 days are generally unnecessary and encourage the buyer to take their time. These buyers want to wear you down. The longer the transaction takes, the more negotiating leverage you’ll lose.

Types of Exclusivity Periods

The exact language of the exclusivity clause varies from agreement to agreement, but most prohibit you from actively marketing your business and continuing any discussions or negotiations with any third parties. Here’s a typical exclusivity 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 any new sale discussions, and (c) pause all marketing activities, including the removal of any online listings.

Some overreaching LOIs require you to share any offers you receive during the exclusivity period with the buyer. The buyer wants to know what others are willing to pay for your business and will use that number against you. 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. You should always be negotiating for less restrictive clauses if you can. 

The Impact of Negotiating Leverage

Other interested buyers usually move on to other deals or other corporate development projects once they learn you’ve accepted an offer. The result is that you’ll end up losing the best buyers after you sign an LOI that includes an exclusivity provision – and the current buyer you’re negotiating with likely knows this. 

Unfortunately, some buyers intentionally make a high offer, never intending to follow through on it. They then take three months to conduct due diligence and wear you down with a multitude of requests. They may also plant seeds of doubt in your mind regarding your business and do everything possible to poke holes in your business during due diligence. In their mind, the more time and money you spend 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 you. Your business has now been off the market for months, and discussions with other buyers have cooled to the point where they may be difficult to revive. If your 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, re-entering the marketplace puts you at a great disadvantage. 

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. 

Preventing Renegotiations

So, what’s the solution? 

To protect yourself from a buyer’s attempt to renegotiate the price during the due diligence period, you should do the following:

• Limit Exclusivity Period: A shorter exclusivity period of 3o to 45 days will keep the buyer on their toes and limit the amount of time they have to poke holes in your business.
• Include Milestones: Remember that the exclusivity period can be mutually extended at any time, so include milestones in the LOI for the exclusivity period to continue. If the buyer fails to meet these hurdle dates, the exclusivity period should expire. Here are some common milestones to keep your buyer moving through due diligence:
  • Presenting a financing commitment letter to the seller: 30 to 45 days from signing the LOI
  • Completion of due diligence: 30 to 45 days from signing the LOI
  • Preparation of the first draft of the purchase agreement: 15 to 30 days from signing the LOI
  • Signing the purchase agreement: 45 to 60 days after signing the LOI
• Prevent Re-trading: Include a statement in the LOI that terminates the buyer’s exclusivity period if they attempt to re-trade or renegotiate the price or transaction terms.
• Include an “Affirmative Response Clause” along the lines of the following sample text:
  • Without changing the fact that this Letter of Intent will be, except as otherwise provided herein, non-binding on the parties, the Seller reserves the right to request on one/two/three, etc., occasions during the exclusivity period a written affirmative response from the Buyer stating that the Buyer contemplates no material changes in the deal terms outlined in this Letter of Intent. Buyer’s failure to respond will automatically terminate the exclusivity provisions of this Letter of Intent.

Earnest Deposit

Buyers in the middle market view their financial investment in performing due diligence as a demonstration of their earnest intent and consider it an equal substitute for an earnest-money deposit, so they don’t commonly offer or agree to provide 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, and it may be wise to request an earnest money deposit.

How much is enough when it comes to a deposit? A good rule of thumb is 1% to 2% of the purchase price. For a $10 million transaction, this equates to a $100,000 to $200,000 deposit. Or, for a $50 million transaction, a $500,000 would be sufficient, in most cases. 

Another question to consider is the extent to which the deposit is refundable and under what conditions it may be refunded. Most buyers request that the deposit be refundable until a purchase agreement is signed, while sellers often prefer some portion of the deposit be non-refundable. I’ve 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 will likely send them packing.

A compromise can be made in which the deposit is progressively non-refundable upon the occurrence of certain events, such as the 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.

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.

Allocation

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 or stock purchase. Ideally, the LOI should specify how the purchase price will be allocated for tax purposes. Determining the allocation at this early stage can prevent this from becoming a serious problem 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, it’s common for both parties to propose widely different allocations. Reaching a middle ground may require you both to significantly alter your initial proposed allocations.

Here’s a sample allocation for a $12 million transaction:

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

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.

You can find more information about the classes of assets and common allocations in Chapter 20, which addresses deal structures.

Legal Form of Transaction

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 after taxes will often be far greater than an asset sale. Buyers usually prefer an asset sale because this limits the possibility of contingent liabilities. Also, 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 middle market are structured as asset sales. 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 and warranties.

Most transactions in the lower middle market are structured as an asset purchase. 

Escrow – Holdback

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 and warranties in the purchase agreement. In most middle-market transactions, a portion of the purchase price – typically 10% – is held back for a fixed period, usually 6 to 18 months. This serves as a form of insurance in case you make any representations in the purchase agreement that later prove to be false or for other issues, 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’s 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 12 months after Closing as security for Buyer’s indemnity claims under the Purchase Agreement.

The major points to consider regarding escrow include:

• What are the conditions of escrow?
• How much money is held in escrow?
• Who controls its release? 
• How long is the escrow period?
• Is the escrowed amount the sole remedy for the buyer?
• Who receives the interest from the escrow account?

Representations and Warranties

Regardless of how thoroughly the buyer conducts their due diligence, they’ll never be confident they’ve discovered every possible problem or defect with your business. Reps and warranties are designed to cover what the buyer may have missed during 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 and warranties will be customary – with no mention of exclusions, knowledge qualifiers, caps (maximum liability), or the basket (minimum liability). 

In most cases, that’s 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 and warranties that are customary or appropriate for a transaction of its nature.

Here is a sample clause that commonly appears in LOIs:

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 won’t conflict with or breach any other contract. This is normally a formality and rarely negotiated.

Reps and 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. 

Conditions – Contingencies

Most LOIs also include conditions for consummating the transaction, such as the following:

• Regulatory or license approvals
• Completion of due diligence
• Securing 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
• 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 you, to cancel the transaction if they 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 to attempt to resolve the conditions. But most LOIs are silent regarding the extent to which action is required, such as best efforts and commercially reasonable efforts, 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.

Financing Contingencies

The most common condition is a financing contingency. The financing condition allows the buyer to cancel the sale if they can’t secure the funds to finance the transaction. You may argue that if the buyer is confident they can obtain 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 require significant documentation on your business before they will provide a commitment letter. This documentation is normally only provided 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 can’t obtain financing, but the terms of the seller note you’re proposing 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 you’re negotiating with. 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 you is that all the buyer must 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 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 difficult time obtaining financing. The biggest warning sign is if the buyer is planning to shop for investors after signing the LOI.

Covenants

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 seller agrees 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 that you avoid making any material changes to your 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 you continue to operate the business as you normally would, but they often ask that you run key decisions by them before implementing them. I’ve encountered some sellers who have made drastic changes to their 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 to your business.

Seller’s Role

Another key element of any LOI is the role you’ll play in your company after the closing. If you’ll continue to be involved, the key terms of your employment or consulting agreement – such as salary – should be worked out prior to accepting the LOI. 

In most cases, it isn’t worth it financially for you to continue working in your business. If a business generates $3 million in EBITDA 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, it makes little sense to accept the LOI. The primary exception to this rule is if you sell your business to a private equity firm and retain the equity in your business post-closing.

There are three primary instances in which it may make sense for you to play a continued role in the business:

1. As a Consultant: Many sellers must consult with the buyer for an extended period to assist with the transition. This is common in complex businesses where the seller is one of the few people in the business that has in-depth knowledge regarding how to operate the business or in businesses where the buyer requires your intensive assistance to help with the transition.
2. As a Salesperson: It may make sense for you to remain as a commission salesperson post-closing. This is especially true if you enjoy sales, are proficient at it, and are seeking extra income during retirement. Sellers are usually quite open to this idea if they don’t enjoy managing the business but love sales. This can be a win-win situation for both parties, especially if the buyer is willing to offer you a flexible schedule.
3. When a Buyer Offers You Equity: Finally, it may be worthwhile to stay if the buyer offers you a significant amount of equity in the business. For example, most private equity groups expect you to remain to operate the business post-closing. At a minimum, the private equity firm will want you to stay long enough for them to find a replacement. Otherwise, most PE firms prefer that you stay long-term. To make it worthwhile for you, most financial buyers will require you to roll over some of the sale proceeds into equity in the new entity – usually in the range of 10% to 30% of the purchase price. In this scenario, you sell a majority of the business now, then sell your minority interest in a second sale in three to seven years. This often makes sense for you because it allows you to diversify some of your risk by taking some chips off the table now while potentially having another bigger exit in the future.

If you don’t want to stay on with your business, 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 several years in advance that can continue to run the business after you’ve made your exit.

If you’ll continue to play a role in your business after the sale, the key terms of your employment or consulting agreement – such as salary – should be worked out prior to accepting the LOI. 

Management’s Role

There are two primary issues in a letter of intent that relate to your employees – disclosure and retention. 

Disclosure 

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 keep in mind the infamous WWII slogan – loose lips sink ships. The more people who are told, the more likely it is that word will end up in the wrong ears.

At the same time, buyers often want access to key employees before the closing occurs. Their objectives for wanting to speak with employees are usually two-fold:

1. Due Diligence: To help with their assessment of due diligence. For example, the employees may be more frank regarding some aspects of the business than the seller, or they may be more frank regarding issues the seller may have failed to disclose regarding the business.
2. Retention: To ensure key employees are retained.

As I have discussed in previous chapters, there are two key elements in deciding to inform your employees:

1. When: When to tell employees depends on your business’s culture. If your culture is particularly healthy and your team is small, it may make sense to inform your employees in advance of the sale – if you believe they can all keep mum. Otherwise, the consensus is that you shouldn’t tell them too soon because they may leave or too late because they may feel betrayed.
2. How: In most cases, it makes sense to inform your key managers first and then disclose the sale in a group setting to the remainder of your employees. Your key managers can set the proper tone when you make the disclosure in the group setting, assuming they’re well respected. If your team is large, your key managers can inform their subordinates in their own group settings.

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 agree to allow the buyer to talk to your employees, you should only let this happen at the tail end of due diligence. Ideally, the purchase agreement should be fully negotiated and ready to be signed.

Retention

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 they can obtain employment and non-compete agreements from your 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 be careful about agreeing to such a clause. If employees catch wind of the fact 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. 

For example, I worked on one transaction in which several of the key employees made excessive demands on 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. Sometimes the squeaky wheel gets the grease, as the saying goes, but other times the squeaky wheel gets replaced.

Non-Compete

While nearly all buyers expect you 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 you 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.

Termination

Termination of most LOIs is tricky if the LOI is non-binding. If the LOI is non-binding, it should be cancellable without effect. Some savvy buyers also include a clause that requires you to reimburse their expenses if you walk away 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 the specifics. Regardless, all LOIs should terminate if you and the buyer fail to reach an agreement by a specified date.

Miscellaneous

Here are several miscellaneous clauses that most LOIs include:

Expenses

This provision 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 you to 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 in different states, the buyer usually proposes their home state as the governing entity. The seller often agrees if the state is Delaware or the buyer has significantly more negotiating leverage. Delaware is considered a favorable choice because of the extensive experience of its courts. Delaware has a more well-developed body of case law than other states, which serves to give corporations and their counsel greater guidance on matters of corporate governance and transaction liability issues. 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.