M&A Basics | The Letter of Intent

Executive Summary

Major Characteristics of a Letter of Intent

What are the major terms and characteristics of an LOI, and what impact do these have on negotiations?

• Non-Binding: The terms in the majority of LOIs are non-binding. The purpose of the LOI is to come to an agreement on the major terms, such as price, and to allow the parties to begin the due diligence period. The only elements of the LOI that are usually binding are the exclusivity, confidentiality, and no-hire provisions.
• Moral Obligation: The LOI can be thought of more as a moral obligation as opposed to a legal obligation. Unscrupulous buyers can, therefore, use an LOI to their advantage.
• Preliminary Agreement: The LOI is a preliminary agreement that will be replaced by a purchase agreement. The LOI allows the parties to begin due diligence. It reduces their legal costs by preventing the parties from having to prepare a longer and much more detailed purchase agreement at a stage when they aren’t ready to commit to a purchase agreement. The LOI represents a critical juncture in the sales process that marks the beginning of due diligence. The content of the purchase agreement varies based on what the buyer discovers during due diligence.
• Basis of Negotiations: The LOI is used as the basis for negotiations and for drafting the purchase agreement. 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 in which the seller must agree to take the business off the market and cease negotiations with other buyers. This weakens your negotiating position.
• Limited Information: In most cases, the buyer has received limited information on the business and has not yet conducted due diligence. The terms of the transaction may change based on what the buyer discovers during due diligence. The buyer may find additional issues that were not disclosed prior to submitting the LOI, and the price and key terms will change as a result.
• Contingent: The LOI is contingent on the buyer’s successful completion of due diligence. If the buyer is not satisfied with the results of due diligence, the buyer can walk away from the negotiations in nearly every instance.
• Momentum: The LOI presents an opportunity for each party because it enables them to resolve problems before becoming deeply entrenched in a position emotionally and financially.
• Highlights Unresolved Issues: The LOI also highlights any potential undefined issues, such as the terms of an ongoing employment agreement with the seller or the terms of an earnout.

Introduction

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?

• Is working capital included in the price?
  • If this isn’t defined in the LOI, you better believe this will be included in the price. Not only will it be included in the price, but the finer points of exactly how working capital is calculated will also be worded to the buyer’s advantage. The result? Depending on the size of your business, this can cost you hundreds of thousands of dollars, and sometimes even millions of dollars.
• How long is the training and transition period?
  • If this isn’t defined in the LOI, again, this will be structured in the buyer’s favor and in many cases, will be excessive.
• How long is the exclusivity period?
  • The savviest buyers will attempt to include language in the LOI that grants them exclusivity for as long as you and the buyer are negotiating in good faith. If you sign such a clause, a less well-intended buyer may drag you along for months and months as they whittle away at your purchase price. A well-drafted LOI limits the length of the exclusivity period and imposes deadlines and other requirements to ensure the exclusivity period isn’t abused.
• Is there a holdback or escrow? If so, for how much?
  • Many LOIs don’t mention an escrow or holdback at the outset, but the seller is often shocked to later see a large holdback of the purchase price requested in the purchase agreement. If you don’t settle this in the LOI, you will be left to negotiate this in the purchase agreement, the stage at which all of your negotiating leverage has been exhausted.
• How is the purchase price defined?
  • Some LOIs offer a price range instead of a specific price. For example, the LOI may define the purchase price as “between $5 million to $7 million, based on the buyer’s findings during the due diligence period.” I’ve got news for you: if you accept an LOI with a price range, you’ll likely find it’s actually not a range but rather one price – the lower one.
• How are the terms defined?
  • How is the buyer financing the transaction? If the buyer is securing third-party financing, are they also asking you to hold a note? If so, you will be in a junior position. Do the terms include an earnout? If the terms aren’t defined, guess what? Lo and behold, the buyer will express disappointment with the findings from their financial due diligence and tell you the results are less than they expected and that they believe EBITDA was overstated. What’s the result? An earnout, strong representations and warranties (reps & warranties), and several other mechanisms designed to lower the purchase price and the buyer’s risk.

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.

Why bother if the agreement is non-binding?

• Obligation: Most parties prefer the comfort of knowing that each party has a written moral obligation that offers a preliminary framework for the major terms in a transaction before they incur significant expenses conducting due diligence and negotiating a definitive purchase agreement.
• Test Commitment Level: The LOI tests the parties’ seriousness and commitment before they invest a significant amount of time and energy in the transaction. Asking a buyer to submit an LOI is also a useful tool for the seller to test the buyer’s degree of seriousness before committing to continuing the negotiations. Think of it this way: An LOI is an engagement, while a purchase agreement is the marriage ceremony. The parties progress toward consummating the transaction in steps due to the potential risks.
• Morally Commits: The LOI also morally commits each party to the transaction and is a test of good faith and evidence of sincerity. In some circles and industries, word leaks if a buyer enters into an LOI without serious intent, and their reputation can become harmed as a result.
• Expresses Intentions: The LOI expresses the parties’ intentions and is a valuable tool for discovering their true intentions and priorities regarding a transaction. For example, is the buyer planning on paying cash or asking you to finance a significant portion of the purchase price?
• Clarifies Key Terms: Despite being non-binding, an LOI memorializes the key terms so there is no confusion later in the transaction when the purchase agreement is being prepared and negotiated. The result is less disagreement or confusion.
• Grants Exclusivity: Few buyers will commit the time and energy to conduct due diligence without having a commitment from the seller that they will not shop the offer for a better deal.
• Reduces Uncertainty: By defining the major terms of a sale, an LOI, even if non-binding, dramatically 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 also clearly defines what must happen before the transaction takes place, in the form of conditions or contingencies.
• Enables Financing Pre-Approval: An LOI is required by most lenders before they will commit to the expense of underwriting a loan.
• Grants Permissions: The LOI also allows the parties to conduct due diligence on one another to make sure they would like to proceed with the transaction before committing to the expense of preparing and negotiating a purchase agreement.
• Agree on Price: The LOI allows the parties to agree on a price before committing to the time and expense of performing due diligence.

Problems & Solutions

• Problem: Terms never improve for the seller after signing the LOI. A buyer can use almost any excuse for renegotiating the terms of a transaction after the LOI has been signed.
  • Solution: Define as many terms as possible when you have the maximum amount of leverage. But remember that doing so is a balancing act because buyers have access to a limited amount of information at this stage.
• Problem: Undefined terms will always be slanted in the buyer’s favor.
  • Solution: Define as many terms as possible in the LOI.
• Problem: The longer the exclusivity period, the lower your negotiating leverage. Most exclusivity periods range from one to three months, while some buyers propose an open-ended exclusivity period.
  • Solution: Keep exclusivity periods as short as possible. Include milestones in the LOI for the buyer to continue to be granted exclusivity.
• Problem: Signing the LOI disarms you. You give up nearly all of your bargaining power the moment you sign the LOI.
  • Solution: Take your time negotiating the LOI. Rush to close the transaction once you have signed the LOI.
• Problem: Problems discovered during due diligence will result in a less favorable price and terms.
  • Solution: Prepare for due diligence.

Is the LOI Binding?

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:

• Exclusivity
• Confidentiality
• Due diligence access – the buyer’s right to conduct due diligence, inspect the seller’s books and records, and meet with key employees.
• Earnest money deposit – whether it is refundable
• Expenses

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.

Contents of a Letter of Intent

The key terms of an LOI are the following:

• Purchase price and terms
• Assets and liabilities included, especially working capital
• Form of consideration, such as cash, stock, earnout, or notes
• Legal transaction structure (asset sale or stock sale)
• Seller’s ongoing role and compensation
• Conditions to close, such as financing contingency
• Due diligence process
• Exclusivity
• Deadlines or transaction milestones

Less commonly included terms:

• Escrow or holdback obligations
• Confidentiality obligations
• Earnest money
• Allocation of purchase price
• Representations, warranties, and indemnification
• Covenants (e.g., conduct of the business prior to closing)
• Access to employees and customers
• Termination

What follows is a discussion of the major components of an LOI.

Introductory Paragraph

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.”

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 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.

Purchase Price & Terms

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:

• Petty cash for retail businesses
• Furniture, fixtures, and equipment
• Vehicles, if used in the business
• Leasehold improvements
• Training and transition period
• Covenant not to compete
• Business name, website, email addresses, phone number, software, etc.
• Business records, financial records, client and customer lists, marketing materials, contract rights, etc.
• Trade secrets (whether registered or not), intellectual property, such as patents, trademarks, etc.
• Transfer of licenses and permits
• Assumption of product warranties

The following assets and liabilities are usually included in the purchase price only if the buyer is a corporate buyer:

• Working capital
  • Accounts receivable
  • Inventory, supplies, and work in progress
  • Prepaid expenses
  • 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 may be purchased separately
• Assumption of long-term debt
• Your entity, unless the sale is structured as a stock sale or merger

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:

• Cash at closing
• 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? 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 does the seller have if a lender has a senior security interest? What are the terms of the note (term, interest rate, etc.)? Is the note fully amortized, or is there a balloon? Is the buyer willing to personally guarantee the note?
• Stock: What is the trading volume of the stock? What exchange is the stock traded on? How easily can the seller 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 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 breaches of reps & warranties. If so, what are the terms (amount, basket, cap) of the escrow and of the reps & warranties (basket, cap, etc.)?

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:

• Cash at Closing: 50% to 90%. This includes bank financing since cash is delivered to the seller at closing.
• Seller Note: 10% to 30%
• Earnout: 10% to 25%
• Escrow: 10% to 20%
• Stock: Not common unless the buyer is publicly traded. Some buyers (most commonly private equity firms) will ask the seller to “rollover” 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 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:

• 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 actually 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 time period (but not yet written off as uncollectible) would be held until collection or write-off and paid out to Sellers 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 Willy Williams.
• 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 LOI.

Working Capital

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:

• Current assets
  • Cash: Cash is usually excluded from the calculation, except for petty cash that may be used in a retail operation.
  • Accounts receivable
  • Inventory: This also includes supplies and work in progress.
    Prepaid expenses
• Current liabilities
  • Accounts payable: This includes short-term payments due to suppliers that have granted you credit.
  • Accrued expenses, such as payroll
  • Short-term debt

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:

• How is inventory 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 LIFO or FIFO?
• How are accounts receivable calculated? When is an account receivable considered bad? Is a receivable still good at 91 days? 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 are accounts payable 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?

There are ways of reducing conflicts in calculating working capital:

• Methods the seller can implement before the sale: You should scrub the 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 changes in working capital. In addition, purge any obsolete inventory and late accounts receivable from the books – liquidate obsolete inventory and write off bad accounts receivable. A clean set of financial records leads to increased confidence on the part of any buyer. Clean records send a signal to the buyer that you have excellent control of the business, and some buyers will reduce the thoroughness of their due diligence as a result.
• Methods that can be used when negotiating the LOI: The other method is to clearly define the method for calculating the working capital in the LOI and the purchase agreement. Unfortunately, such a definition is usually lengthy and therefore not usually suitable to the mood and tone of an LOI, which is why most LOIs don’t include a detailed definition of how working capital is calculated. Yes, it kills the mood. As a result, sellers must accept the ticking time bomb nature of an unclear definition or be prepared to invest (invest, not “spend”) the time defining working capital in sufficient detail in the LOI. We never told you selling a business was easy.

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.

Key Dates & Milestones

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:

• The proposed closing date
• The expiration date for the due diligence period
• A deadline for submitting a commitment letter from the lender, if there is 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, 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.

Confidentiality

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.

Due Diligence

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.

Exclusivity

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:

• Limit the duration of the exclusivity period, ideally to 3o to 45 days.
• Include the following milestones or deadlines in the LOI. Remember that the exclusivity period can be mutually extended at any time. If the buyer fails to meet the hurdle dates, the exclusivity period should expire.
  • 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
  • Presenting a financing commitment letter to the seller – 30 to 45 days from signing the LOI
• Include a statement in the LOI that if retrading occurs, the exclusivity period ends. This allows you to terminate the buyer’s exclusivity if they attempt to renegotiate or propose a significant change in the price or terms of the transaction, commonly called retrading.
• Include an “Affirmative Response Clause” along the lines of the following.
  • 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

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.

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 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:

• 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, vehicles, etc. – $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.

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 (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.

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 & 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:

• 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 interest from the escrow account?

Reps & Warranties

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.

Conditions (Contingencies)

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.

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 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.

Seller’s Role

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:

• Consulting: Many sellers must consult with the buyer for an extended period of time to assist with the transition. This is most common either in complex businesses in which the seller has a lot of knowledge of how to operate the business in their head or in businesses in which the buyer requires intensive assistance from the seller to assist with the transition.
• Sales only roles: It sometimes makes sense for the seller to retain a role as a commission salesperson post-closing. This is especially true if the seller particularly enjoys sales, is proficient at it, and is 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 the seller flexible hours.
• Sales to financial buyers: Most private equity groups expect the seller to remain to operate the business post-closing. At a minimum, the private equity firm will want the seller to stay long enough for them to find a replacement. Otherwise, most PE firms prefer that the seller stay long-term. To make it worthwhile for the seller, most financial buyers will compensate the seller with equity – usually in the range of 10% to 30% of the purchase price. In this scenario, the seller sells a majority of the business now, then sells their minority interest in a second sale in three to seven years. This often makes sense for a seller because it allows them to diversify some of their 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 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.

Management’s Role

There are two primary issues in an LOI that relate to the employees of the business: 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 “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:

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

There are two key elements in deciding to inform your employees:

• 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 their lips sealed. Otherwise, the general consensus is that you shouldn’t tell them too soon (they may leave) or too late (they may feel betrayed).
• 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 the 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 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.

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 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.

Non-Compete

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.

Termination

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.

Miscellaneous

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.

The Letter of Intent Process

Here is a description of the variety of processes and styles of negotiating the letter of intent:

• Who prepares the LOI: Most LOIs are drafted by the buyer, particularly if the buyer is a corporate buyer. An LOI may be drafted by the seller if the seller has a strong negotiating position and is negotiating with multiple parties simultaneously or if the buyer is an individual or smaller competitor who doesn’t want to bear the cost of an attorney at this stage in the transaction. As the seller, you should always seize the opportunity to prepare the LOI, if possible.
• Number of Pages: Some LOIs can be as short as one page, whereas others can be as long as six to seven pages. Most range from about two to four pages.
• Skipping the LOI: Some parties choose to skip the LOI and jump straight to a definitive purchase agreement, but this is rare. This would be most common if the seller has a strong negotiating position, the buyer has already performed some preliminary due diligence, or if the buyer is a direct competitor and engaging in due diligence would be a risky proposition for the seller. I estimate this happens less than 2% of the time.
• Format – Letter vs. Agreement: Most LOIs are a mix between a letter and a more traditional legal agreement. There is no legal requirement for it to be prepared in any specific format. Most begin with a few paragraphs of introductory niceties and then segue into the proposed terms of the transaction. Most buyers prefer the LOI to be as informal as possible and contain the minimum amount of information to move to the next step in the transaction, due diligence. You should always strive for the LOI to be as detailed and specific as possible.
• Who prepares the first draft: The buyer normally prepares the first draft. The downside to this for the seller is that the party preparing the first draft exerts the most control over the content of the agreement. In some cases, the party preparing the first draft may write a very one-sided agreement in which significant changes to the document must be made. This slows the process and causes momentum to be lost. In these cases, the seller’s attorney or M&A advisor may counter with a reverse LOI – or an LOI that is a new draft. This is practical in cases in which the first draft is so off the mark that it would be more suitable to prepare a brand new draft than red-line the buyer’s draft.
• Process of making changes: It’s customary for the buyer and seller to exchange red-line versions of the LOI in Microsoft Word. If the buyer prepares the first draft, the buyer often initially sends the LOI in PDF format and sends the Word format only upon request from the seller’s attorney. The two sides then trade red-lined versions until an agreement is reached. It’s wise to start each new round of negotiations with a clean draft (with no changes tracked), as tracking successive changes can become difficult after the second round.
• Discussing issues on the phone: It’s also wise to discuss any potential issues on the phone to help the parties understand each other’s motivations behind the requested changes. This allows each side to propose creative alternatives that meet both parties’ needs in order to reach a mutual agreement.
• Timeframe to sign an LOI: Most LOIs take one to three weeks to negotiate. Most sellers will think this amount of time is unreasonable, but this has been my experience. Each round of negotiations usually takes one to three days per side, so one round of negotiations for both sides might take two to six days. On average, most negotiations take two to three total rounds of changes, for a total of four to 18 days. Throw in a couple of weekends, and the average works out to between two and three weeks. If you are negotiating with other buyers, negotiations can take even longer as most sellers will wait to receive an LOI from all parties before moving forward with any one.
• When the LOI is signed: Most LOIs are signed one to two months after a non-disclosure agreement is executed. In some cases, a buyer may take as long as six months or more, as they sometimes evaluate other opportunities before returning to express interest in the business. A buyer usually spends the first one to three weeks reviewing the confidential information memorandum (CIM), asking the seller questions, and requesting additional information. If the buyer is interested at this point, the buyer may request a face-to-face meeting or may have questions regarding the financial statements. The buyer may then spend two to three weeks contemplating the acquisition, analyzing the financial statements, and preparing a valuation model to determine their offering price. Altogether, this process takes most buyers, on average, a month or two before they are prepared to submit an LOI. Of course, some buyers move much more quickly, but they are the exception rather than the rule.
• Negotiating tactics: Some buyers initially offer a high price with the intention of working the price down over the next months. Other buyers take a middle-of-the-line approach and make a reasonable offer they plan to stick with. The only way to tell the difference between the two types of buyers is to attempt to flush out their motivations through more thorough negotiations and to pin them down on specifics. Buyers with insincere motives will attempt to avoid agreeing to specifics such as milestones, deadlines, and other measures.
• Seriousness: Some buyers, such as so-called search funds, aren’t sure if they can obtain financing and therefore attempt to quickly agree to an LOI so they can begin their search for financing. It’s important to gauge a buyer’s ability to consummate the transaction.
• Degree of detail: Some parties negotiate only the high-level terms of the transaction, such as purchase price, while others nail down all of the specifics. I obviously recommend to the seller that you attempt to nail down as many specifics as possible without overly sacrificing momentum. This takes more time but ensures mutual alignment and keeps you from unnecessarily locking up your company. It also reduces the risk that you will have invested a significant amount of time and money performing due diligence, becoming more financially and emotionally invested in the transaction, thus resulting in less negotiating leverage. Achieving the right level of detail is a delicate balancing act that any experienced M&A attorney can assist with.
• The final offer: We have all heard it before: “This is my final offer.” This is an amateurish negotiating gambit that some buyers may use. I suggest you ignore the “final offer” warning – it’s rarely true.
• Public companies: Public companies often avoid submitting an LOI because doing so is considered a material agreement and triggers a reporting obligation, which can then ramp up competition for the acquisition.

LOI Recap: Just the Facts, Ma’am

Major Terms & Characteristics of an LOI

Following are the major terms and characteristics of an LOI and the impact they have on the negotiations:

• Non-Binding: The terms in the majority of LOIs are non-binding.
• 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 to 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.
• Binding Provisions: The following provisions are typically drafted to be binding – exclusivity, confidentiality, due diligence access, earnest money deposit, and expenses.

Why bother if the agreement is non-binding?

• 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.
• Agree on Price: The LOI allows the parties to agree on a price before committing to the expense of performing due diligence.

Problems & Solutions

• Problem: Terms never improve for the seller after signing the LOI.
  • Solution: Define as many terms as possible.
• Problem: Undefined terms will always be slanted to the buyer’s favor.
  • Solution: Define as many terms as possible in the LOI.
• Problem: The longer the exclusivity period, the lower your negotiating leverage.
  • Solution: Keep exclusivity periods short and include milestones.
• Problem: Signing the LOI disarms you.
  • Solution: Take your time negotiating the LOI. Rush once it’s signed.
• Problem: Problems discovered during due diligence will result in a less favorable price and terms.
  • Solution: Prepare for due diligence.

Contents

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:

• Cash at closing: Usually 50 to 90%.
• Bank financing: Does the lender have a senior position? When will the buyer provide a commitment letter from the bank? 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 does the seller have if a lender has a senior security interest? What are the terms of the note (term, interest rate, etc.)? Is the note fully amortized, or is there a balloon? Is the buyer willing to personally guarantee the note? If so, this is usually 10% to 30%.
• Stock: What is the trading volume of the stock? What exchange is the stock traded on? How easily can the seller convert the stock to cash (most stock in M&A transactions is restricted and can’t be traded for a period of time)? This is not common unless the buyer is publicly traded.
• Earnout: What are the terms of the earnout? Earnouts are a loaded topic and a potential landmine for any seller. They are usually between 10% and 25%.
• Escrow/Holdback: What are the terms (amount, basket, cap) of the escrow and of the reps & warranties (basket, cap, etc.)? These are usually from 10% to 20%.

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:

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

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:

• Limit the duration of the exclusivity period, ideally to 3o to 45 days.
• Include the milestones or deadlines in the LOI. If the buyer fails to meet the hurdle dates, the exclusivity period should expire.
• Include a statement in the LOI that if the buyer attempts to renegotiate, the exclusivity period ends.
• Include an “Affirmative Response Clause.”

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.

Process

Here is a description of the process and negotiating styles:

• Who prepares the LOI: Most LOIs are drafted by the buyer. An LOI may be drafted by the seller if you have a strong negotiating position and are negotiating with multiple parties simultaneously. As the seller, you should always seize the opportunity to prepare the LOI, if available.
• Skipping the LOI: Some parties skip the LOI and jump straight to a definitive purchase agreement, but this is rare.
• Format (letter vs. agreement): Most LOIs range from two to four pages and are a mix between a letter and a more traditional legal agreement. The seller should always strive for the LOI to be as detailed and specific as possible.
• Process of making changes: It’s customary for the buyer and seller to exchange red-line versions of the LOI in Microsoft Word. Start each round with a clean draft as tracking successive changes can become difficult after the second round.
• Discussing issues on the phone: Discuss potential issues on the phone to understand the other party’s motivations behind a requested change.
• Timeframe to sign an LOI: Most LOIs take one to three weeks to negotiate. Most LOIs are signed one to two months after a non-disclosure agreement is executed.
• Negotiating tactics: Some buyers initially offer a high price with the intention of working the price down over the succeeding months. Other buyers take a middle-of-the-line approach and make a reasonable offer they plan to stick with. The only way to tell the difference between the two buyers is to flush out their motivations through more thorough negotiations and pin them down on specifics. Buyers with insincere motives will attempt to avoid agreeing to specifics, such as milestones, deadlines, and other measures.
• Seriousness: Some buyers, such as so-called search funds, aren’t sure if they can obtain the financing and therefore attempt to quickly agree to an LOI so they can begin their search for financing. It’s therefore important to gauge a buyer’s ability to consummate the transaction.
• Degree of detail: Some parties negotiate only the high-level terms of the transaction, such as purchase price. Others nail down all the specifics. Nail down as many specifics as possible without overly sacrificing momentum.
• The final offer: “This is my final offer” is an amateurish negotiating gambit. Ignore the “final offer” warning – it is rarely true.