Negotiating the Letter of Intent

Executive Summary

The price and terms you ultimately receive are affected more by how strongly you negotiate the LOI than by how strongly you hammer out the purchase agreement. Let that sink in. For most sellers, how you negotiate the LOI is more important than how you negotiate the purchase agreement. Signing a strong LOI that protects your interests is like getting the ball 30 yards from the endzone, whereas signing a weak LOI is like starting on your own 20-yard line with 80 yards to go.

This article tells you everything you need to know about negotiating the letter of intent.

Tips for Negotiating the LOI

Balance of Power

The balance of power changes the moment the seller grants the buyer exclusivity. The advantage shifts to the buyer because you will have much more to lose if negotiations collapse. If the buyer walks, the buyer has little to lose. But if you bow out, you must start negotiations all over again, which is often difficult since buyers may view the business as tarnished.

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

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

Take Your Time

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

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

Move Fast

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

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

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

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

Preventing Retrading

The absolute biggest risk to you, the seller, after accepting the LOI is the possibility that the buyer renegotiates key terms after conducting due diligence. I have found this to be the case around 20% to 30% of the time.

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

What causes retrading, and why is it effective? Retrading is always due to two reasons:

• The buyer discovers issues during due diligence that were not previously disclosed. Maybe the buyer discovers that your financial statements were not prepared in accordance with generally accepted accounting principles (GAAP). Maybe they discover that some of your key employees won’t stay after the sale or that you forgot to mention that you don’t have non-competition or non-solicitation agreements with your key employees. Regardless, if the buyer discovers issues during due diligence that you haven’t previously disclosed, you should expect to renegotiate the terms of the transaction.
• The buyer is seeking a lower purchase price or more attractive terms. They may have planned to renegotiate all along, or they believe you are desperate or that your negotiating position has significantly weakened during the process and they think they can renegotiate as a result.

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

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

How do you prevent retrading? Do the following:

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

Run the Business

A signed LOI is not a done deal but rather just the start of the process. Once you have signed the LOI, you should continue to focus on running the business just as if you weren’t going to sell it. Your top priority should be maintaining profitability and keeping the sales pipeline full.

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

Read the Buyer

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

Prepare for Due Diligence

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

Confidentiality

A confidentiality agreement is not bulletproof. You should avoid sharing some sensitive information during the due diligence process even if you have a signed confidentiality agreement in place, especially if the buyer is a direct competitor.

If you must disclose sensitive information, wait until the tail end of the due diligence process to do so. If the information is highly sensitive, all remaining contingencies should be resolved. The buyer should sign off on the successful completion of the due diligence process, with the exception of the last bit of remaining information.

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

Disclosure

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

Thoroughness

The LOI should ideally encapsulate all of the major terms of the transaction and should not leave any provisions to be negotiated later in the process. As I have already mentioned, negotiations later in the process will always result in unfavorable terms for the seller.

Remember that the purchase agreement naturally flows from the LOI. In the smoothest negotiations, all key terms are negotiated in the LOI, and the purchase agreement simply explains these terms in much more detail but does not introduce new particulars to the transaction. While every purchase agreement does involve some negotiations between the parties, they should be as few as possible and restricted to legal issues.

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

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

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

Working Capital Adjustments

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

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

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

Milestones to Consider Including in the LOI

I recommend including the following milestones, deadlines, and clauses in your letter of intent if you have agreed to an exclusivity period. These are in approximate chronological order. If any deadlines or milestones are not met, the buyer should lose exclusivity.

• Providing proof of funds available to complete the transaction (three days): This is critical if you are not 100% sure of the buyer’s access to liquid funds to cover the down payment if they are obtaining financing or their ability to pay cash. I have been involved in numerous transactions in which the buyer led us to believe they were more than financially qualified to complete the transaction but, in fact, didn’t have the necessary funds. In some cases, this came to light only after the sellers spent over $100,000 in legal fees and took their business off the market for 90 days. Fundless investment groups and competitors that quietly attempt to obtain financing without informing you upfront are particularly nettlesome. This clause serves to inform you of the buyer’s intentions up-front. Here is some suggested language:

To demonstrate Buyer’s ability to complete the transaction, Buyer will provide bank statements (or other evidence satisfactory to the Seller) showing that Buyer possesses immediately available funds sufficient to consummate the transaction according to the terms outlined in this letter of intent.

• Submitting a firm commitment letter from the lender (45 days): If there is a financing contingency, the buyer should submit a firm commitment letter (not a pre-approval letter) as soon as possible. A firm commitment letter is just that – firm. A firm commitment letter is a lender’s promise to provide the buyer with a stated amount of debt under specified terms. It will contain a few conditions, but this letter will provide you with assurances that the buyer can obtain financing. If the buyer is obtaining financing through the Small Business Administration, 45 days from signing the letter of intent is a reasonable period of time to receive a firm commitment letter. Otherwise, the buyer should consult with their bank and ask how long it will take to receive a firm commitment letter. This clause is critical because it sets the expectations of the parties. I have also been involved in numerous transactions in which the buyer kept us in the dark regarding their plans for funding and then informed us several days before the closing that they could not obtain financing. This clause prevents last-minute surprises, serving to protect you from unnecessarily investing in the transaction if the buyer cannot obtain financing.
• First draft of the purchase agreement (30-45 days): The buyer should begin preparing a draft of the purchase agreement while they are conducting due diligence. The purpose of this clause is to prevent the buyer from preparing a one-sided purchase agreement and presenting it to you at the last minute as a negotiating tactic. Requesting this clause requires the buyer to present the purchase agreement to you in a reasonable period of time, which allows you to assess the reasonableness of the buyer’s first draft as early as possible in the transaction.
• Sign-off on successful completion of due diligence (as specified): The buyer should also be required to explicitly sign off on the successful completion of due diligence once the time period for due diligence has expired. This clause requires the buyer to explicitly state any concerns they have or issues they have uncovered during the due diligence period. This prevents them from withholding these issues until the last minute (e.g., several days before the closing) and using them as negotiating leverage later in the transaction.
• Closing date (90 days): All LOIs should have a drop-dead date in which the letter of intent and exclusivity terminate, such as, “The closing shall occur on or before xx/xx/20xx.” This prevents the seller from intentionally dragging out the process. Of course, the closing date can be mutually extended if there are delays, but requiring your mutual consent prevents the buyer from stalling and wearing you out as a negotiating tactic.

You should include a clause in the LOI stating the buyer will lose exclusivity if they fail to meet the proposed deadlines mentioned above. This stipulation can easily be added to the exclusivity section of any LOI using language similar to the following:

… provided that the Buyer shall meet the following deadlines. If any of the following deadlines are not met, the parties may continue to negotiate the transaction and work toward a closing, but exclusivity shall be immediately terminated.

The purpose of the milestones outlined above is to ensure the buyer moves as quickly as possible once the letter of intent is signed. Including these milestones motivates the buyer because failing to meet them will cause the buyer to lose exclusivity, which is their greatest weapon. They will need to move at a steady pace to meet the deadlines. If you would like to give the buyer a bit more wiggle room, you can extend the deadlines by another 30% to 50%.

If there are other potentially contentious issues to negotiate, you could consider including these as milestones as well. Here are a few examples of potentially contentious issues that should be negotiated as soon as possible:

• The allocation of purchase price
• A consulting and/or employment agreement between the buyer and seller
• The lease for the premises if you own the real estate and will be leasing the real estate to the buyer
• A non-competition agreement if you will continue to work in the industry.

These milestones can also help prevent retrading. Include a clause in the LOI that states that exclusivity immediately terminates if either party attempts to make material changes to the terms of the transaction for any reason.

The degree to which you can include these milestones in the LOI depends on your negotiating leverage. If your negotiating leverage is strong, you will be in a much better position to include these protections.

Recap: Just the Facts, Ma’am

Following is a summary of the tips for negotiating the LOI:

• Balance of Power: Take your time to ensure the LOI is as specific as possible. The less precise the LOI, the more opportunities the buyer will have to renegotiate the terms later in the transaction.
• Take Your Time: Take your time when negotiating the LOI. Regardless of what the buyer says and how urgent they appear to be, go slowly when negotiating the LOI.
• Move Fast: Take your time negotiating the LOI, but get hopping the moment it’s signed. The longer it takes to close the transaction, the more that can go wrong.
• Preventing Retrading: Price and terms are always subject to some revision based on what the buyer discovers during due diligence. The question is what is going to change, and how much is it going to change by? The answer depends on what the buyer uncovers during due diligence and the negotiating postures of you and the buyer. The more the buyer wants your business, the less likely the terms will change. Do the following to prevent retrading:
  • Take your time negotiating the LOI – it should be as specific as possible.
  • Include deadlines in the LOI.
  • Commit to the shortest exclusivity period possible.
  • Move as fast as possible once you have accepted the LOI.
  • Prepare for due diligence.
• Run the Business: Once you have signed the LOI, focus on running your business just as if you weren’t going to sell it. Your top priority should be maintaining profitability. By preparing for due diligence, you help ensure the due diligence process doesn’t derail your focus.
• Read the Buyer: There is no standard LOI. If you suspect the buyer is going to be particularly picky about certain issues such as the reps & warranties or with access to the employees during due diligence, address those issues in the LOI.
• Prepare for Due Diligence: Preparing for due diligence dramatically speeds up the process. Delays caused by the seller are common. The main documents most buyers will request should be highly organized and uploaded to a virtual data room or other location that can be easily accessed by third parties.
• Confidentiality: A confidentiality agreement isn’t bulletproof. Avoid sharing sensitive information even if you have a signed confidentiality agreement, especially if the buyer is a direct competitor. If you must disclose sensitive information, wait until the tail end of due diligence. Make sure that all contingencies have been resolved and have the buyer sign off on the successful completion of the due diligence, with the exception of the last bit of remaining information.
• Disclosure: Disclose all problems about your business early in the negotiations on your terms so you can control the narrative and position the problem how you want, ideally in a positive light.
• Thoroughness: Do everything possible to nail down every key term of the transaction before you consider accepting it. The LOI should be as thorough and precise as possible. Eliminate all terms that are vague or confusing.
• Working Capital Adjustments: The language in the LOI regarding how working capital is to be calculated should be as specific as possible.