Negotiating a Favorable LOI

Here are several of the most important tips to bear in mind when negotiating the letter of intent.

Remember the Balance of Power

The balance of power changes the moment you grant the buyer exclusivity. The advantage shifts to the buyer because you’ll have much more to lose if negotiations fall apart. If the buyer walks, the buyer has little to lose. But if you bow out, you must start negotiations all over again, which is often difficult since buyers may view your business as tarnished if a previous deal were to collapse.

Due to this dramatic shift in the balance of power, take your time to ensure the LOI is as specific as possible regarding the material terms. Failure to give proper attention to the terms in an LOI can be disastrous for you. The buyer prefers an LOI with as few specifics as possible so that it can be broadly interpreted. The less precise the LOI, the more opportunities the buyer will have to renegotiate the terms later in the transaction. To counteract this weakness, you’ll want to pin down as many specifics as possible in the LOI.

At the same time, an LOI that includes an attractive price for your business can be used as leverage in negotiations with other interested parties. A carefully managed LOI presents a prime opportunity to create a competitive auction that could ultimately result in placing a higher value on your business. 

The balance of power changes the moment you grant the buyer exclusivity. The advantage shifts to the buyer because you will have much more to lose if negotiations collapse.

Take Your Time Before Signing

Many LOIs seem too good to be true. But that seductive deal the buyer may be dangling may be nothing more than a ruse to lock you in for some time before coming back with a lower price after you’ve been out of the market for an extended period. Even if the buyer doesn’t have dishonest intentions, they may not be able to line up the financing to close the transaction.

So, take your time when negotiating the LOI. Most buyers will be in a rush to sign the LOI and get you to commit to exclusivity as soon as possible. Don’t fall into their trap – this is the last moment in the transaction when you have a strong negotiating position. Regardless of what the buyer says and how urgent they appear to be, move slowly when negotiating the LOI.

Move Fast After Signing

Take your time negotiating the LOI, but get hopping the moment it’s signed. Why? Time kills all deals. The longer it takes to close the transaction, the more things can go wrong. The buyer can discover additional problems with your business, or its value can be affected by adverse changes in the economy or industry.

Because the LOI – and most of its terms, such as the price – is non-binding, the terms can be subject to last-minute changes until the purchase agreement is signed. This is why time kills deals. The buyer’s perception of value could change as you near the closing table. The longer it takes between signing the LOI and closing, the more information about your business the buyer may discover, decreasing their perception of value. Buyers are on the lookout for any negative finding right up to the closing. Maintaining momentum is the best antidote – the faster you move, the less that can go wrong, and the higher the chance you’ll maximize the purchase price. How can you do this? Keep the buyer motivated and excited throughout the process. 

You should constantly introduce the buyer to new information regarding the attractiveness of your business. This can include new opportunities in your sales pipeline, new developments in your industry, new products you’re considering developing, or any other element of your business the buyer may find exciting or appealing. 

The ideal situation is one in which you can demonstrate to the buyer that your business is continuing to grow after you accept the LOI and that new developments in your business may make you ambivalent to the idea of selling in the first place. Project the attitude that if the buyer backs out now, it’s no big deal because you could spend a few more months capitalizing on these opportunities before putting your business back on the market at a much higher price.

Prevent Re-trading

The absolute biggest risk to you after accepting the LOI is the possibility that the buyer will want to renegotiate key terms after conducting due diligence. I’ve found this to be the case around 20% to 30% of the time.

Price and terms are always subject to some revision based on what the buyer discovers during due diligence. The price you accept in the LOI is the maximum you can hope to receive. Due diligence and purchase agreement negotiations only serve to scale back the terms as problems, and other issues, are discovered during due diligence. The questions are what’s going to change and by how much. The answers depend on what the buyer uncovers during due diligence and the negotiating postures of you and the buyer. The more the buyer wants your business, the less likely the terms will change.

What causes re-trading, and why is it effective? Re-trading is always due to one of two reasons:

1. Undisclosed Issues: During due diligence, the buyer discovers your financial statements weren’t prepared in accordance with generally accepted accounting principles (GAAP). Or perhaps they discover that some of your key employees won’t stay after the sale, or you forgot to mention that you don’t have non-competition or non-solicitation agreements with your key employees. Regardless, if the buyer discovers issues during due diligence that you didn’t disclose, expect to renegotiate the terms of the transaction.
2. Change in Leverage: Some buyers may have planned to renegotiate all along. Others might attempt to re-trade because they believe you’re desperate, or they think your negotiating position has significantly weakened during the process, and they believe they can renegotiate as a result.

Re-trading is effective because the buyer knows that if you walk away from the deal, you’ll have to go back to the market or to other buyers with whom you’re negotiating. Those buyers will view your business as inherently flawed. Other potential buyers are likely to consider your business as stigmatized and may offer a lower purchase price due to the increased perception of risk. Why did the other buyer back out? Regardless of what you tell them, the new buyer will be suspicious.

Re-trading isn’t always targeted at the sales price. Sometimes other terms may be renegotiated. For example, the buyer may propose an earnout to reduce their risk or change other terms, such as the amount of the down payment or the terms of an escrow or promissory note.

How do you prevent re-trading? Do the following:

• Take your time negotiating the LOI – it should be as specific and detailed as possible.
• Include milestones and deadlines in the LOI.
• Commit to the shortest possible exclusivity period. 
• Move as fast as possible once you have accepted the LOI.
• Prepare for due diligence – doing so will speed up the process and reduce the possibility of re-trading.

Focus On Running Your Business

A signed LOI is just the start of the process. Once you’ve signed the LOI, continue to focus on running your business as if you weren’t going to sell it. Your top priorities should be maintaining profitability and keeping your sales pipeline full.

If the revenue or profitability of your business declines after you’ve accepted the LOI, expect the buyer to attempt to renegotiate the price or terms. To prevent this, do everything in your power to maintain the revenue and profitability of your business after you accept the LOI. By preparing for due diligence well in advance of the sale, you’ll help ensure the due diligence process doesn’t derail your focus on your business and affect the revenue.

Read the Buyer

There’s no “standard” LOI. If you suspect the buyer will be particularly picky about certain issues, such as the reps and warranties or access to employees during due diligence, be sure to address those matters in the LOI. It’s much better for the deal to blow up at this point than for you to take your company off the market for three months and then spend tens of thousands of dollars conducting due diligence, only for the deal to derail later because you failed to address sensitive issues upfront. This is where experience is vital. An experienced M&A intermediary or investment banker can be instrumental in anticipating which areas a buyer is likely to be most concerned about and can ensure these issues are addressed in the LOI.

Prepare for Due Diligence

Preparing for due diligence can dramatically speed up the process. Some buyers submit a due diligence list to you that contains a request for hundreds of documents. It takes some sellers over a month simply to compile all the documents necessary for the buyer to conduct due diligence. This is why due diligence can sometimes take two months or longer. Delays caused by the seller are common. The main documents most buyers will request should be ready and available to pass along to them the moment you’ve accepted the LOI. They should be highly organized and uploaded to a virtual data room or other location that can be easily accessed by third parties. Because this takes significant time to do, you should begin this procedure three to six months before you begin the sales process. If you don’t prepare, you can expect due diligence to negatively impact your focus on the business, and your revenue may decline as a result.

Maintain Confidentiality

Confidentiality agreements aren’t bulletproof. Avoid sharing some sensitive information during the due diligence process, even if you have a signed confidentiality agreement in place, especially if the buyer is a direct competitor. If you must disclose sensitive information, wait until the tail end of the due diligence process to do so. If the information is highly sensitive, all remaining contingencies should be resolved before you disclose the information. The buyer should sign off on the successful completion of the due diligence process, except for the last bit of remaining information.

If the buyer requests confidential information before they’ve made an offer, prompt them to submit one. Every time they request additional information, consider it an opportunity to request an offer. For example, if the buyer asks for confidential information, you can say, “I’ve compiled all information required for due diligence in a virtual data room, and you’ll have immediate access to this information the moment we agree to a letter of intent.”

Disclose Beforehand

Disclose all problems about your business before the buyer makes an offer. If you disclose new, negative information after you accept the LOI, the terms of your deal will change. The sooner you fess up, the better. Disclose this information early in the negotiations on your terms, so you can control the narrative and position the problem how you want, ideally in a positive light. Failing to disclose key problems will enable the buyer to exploit these issues when they discover them later in the process. Every company has problems, and most problems can be framed in a positive light if they’re disclosed early in the process.

Be Thorough

Ideally, the LOI should encapsulate all the major terms of the transaction and not leave any significant provisions to be negotiated further along in the process. As I’ve already mentioned, negotiations later in the process will always result in unfavorable terms for you. Remember that the purchase agreement flows from the LOI. In the smoothest negotiations, all key terms are negotiated in the LOI, and the purchase agreement simply explains these terms in greater detail, but it doesn’t introduce new particulars to the transaction. While every purchase agreement involves some negotiations between the parties, they should be as few as possible and primarily restricted to legal issues. 

The worst LOI to accept is one that offers a range for the purchase price or one that leaves out other major terms of the transaction, such as the amount of the escrow, key provisions of earnouts, or the terms of a promissory note. Some LOIs specifically include a clause that the purchase price is subject to change based on what the buyer discovers during due diligence.

While buyers strongly prefer LOIs that are as vague as possible, you should do everything you can to nail down every key term of the transaction before you accept it. For example, buyers may include a clause that states, “Seller’s ongoing role and compensation will be established during due diligence.” I shouldn’t have to tell you at this point that agreeing to this is a terrible idea. We see many buyers of businesses with EBITDA of $2 million to $3 million propose to pay the seller only $100,000 per year to continue operating the business. 

The worst-case scenario is that you should include language in the LOI stating that certain terms will be agreed to no later than xx days (e.g., 20 days) from the execution of the LOI. Every substantive term needs to be covered in the LOI before it’s executed. Not only should all terms be covered, but the LOI should be as thorough and precise as possible – the clearer and more direct, the better. Eliminate all terms that are vague or confusing – for example, if working capital is included in the price, how is working capital defined, and what does it include?

The LOI should ideally encapsulate all the major terms of the transaction and not leave any significant provisions to be negotiated later in the process.

Define Working Capital

The biggest pitfall for most sellers is what is known as a working capital adjustment. Most transactions in the middle market include working capital in the purchase price. The difficulty here is defining exactly how working capital is to be calculated. Typically, the parties prepare a preliminary calculation of the value of working capital at closing. Then the buyer does a final count 60 to 120 days after the closing, and an adjustment to the purchase price is made based on the difference between the estimate before the closing and the final calculation.

If you want to avoid the working capital adjustment time bomb, the language in the LOI regarding how working capital is to be calculated should be as specific as possible. Working capital is normally calculated as the difference between current assets (inventory, accounts receivable, and prepaid expenses), and current liabilities (accounts payable, accrued expenses, and short-term debt). 

Exactly how each component of working capital is calculated is subject to interpretation. For example, is all inventory included in the calculation, or only salable inventory? How is salable inventory determined – after 30 days, 90 days, or 180 days? And what about accounts receivables? Is the buyer paying for 100% of your accounts receivables? How does a reserve for bad debt affect the calculation of the accounts receivables? How is short-term debt calculated? Is a line of credit included in this calculation? How do seasonal changes in the business affect the calculation? The actual closing working capital amount will not be known until the closing audit of your balance sheet is completed, usually 60 to 90 days after the change in ownership. Clearly defining the elements of working capital will keep this final calculation from becoming contentious.

Conclusion

This bears repeating – the letter of intent is the most significant document in an M&A transaction. With that in mind, the following are the major terms and characteristics of an LOI and the impact they have on the negotiations:

• Preliminary Agreement: The LOI is a preliminary agreement that will be replaced by a purchase agreement and allows the parties to begin due diligence. Any terms of the transaction that aren’t defined in the LOI will be drafted in the buyer’s favor in the purchase agreement.
• Exclusivity: Most LOIs contain an exclusivity clause.
• Limited Information: The terms of the transaction and content of the purchase agreement may change based on what the buyer discovers during due diligence. 
• Contingent: The LOI is contingent on the buyer’s successful completion of due diligence. 
• Momentum: The LOI presents an opportunity for each party because it enables them to resolve problems before becoming deeply entrenched in a position.
• Highlights Unresolved Issues: The LOI highlights any potential undefined issues.
• Non-Binding Except for These Provisions: Most of the terms in the majority of LOIs are non-binding. However, the following provisions are typically drafted to be binding:
  • Exclusivity
  • Confidentiality
  • Due diligence access
  • Earnest money deposit
  • Expenses

So, if the agreement itself is non-binding, why bother? Here’s why:

• Tests Commitment Level: The LOI tests the parties’ seriousness and commitment before they invest time and energy in the transaction. 
• Morally Commits: The LOI morally commits each party and is a test of good faith.
• Expresses Intentions: The LOI expresses the parties’ intentions and is helpful in discovering a party’s true intentions and priorities.
• Clarifies Key Terms: An LOI memorializes the key terms.
• Grants Exclusivity: The LOI grants exclusivity to the buyer so they can spend money on conducting due diligence.
• Reduces Uncertainty: An LOI reduces the likelihood that the parties will disagree on the terms of a transaction in later stages of the negotiations.
• Clearly Defines Contingencies: The LOI clearly defines the conditions or contingencies.
• Enables Financing Pre-Approval: An LOI is required by most lenders before they underwrite a loan.
• Grants Permissions: The LOI allows the parties to conduct due diligence before they commit to the expense of preparing and negotiating a purchase agreement. 
• Facilitates an Agreement on Price: The LOI allows the parties to agree on a price before committing to the expense of performing due diligence.

Now that you’re well-versed in the whys and wherefores of an LOI, I’ll explain the structure of the deal next.