ENL 10

 

Step 8, Negotiating the Letter of Intent  

What Is the Letter of Intent (LOI)?

It is a confidential document, usually prepared by the buyer, which outlines in general terms the purchase agreement between the buyer and seller.  

Most of the time it is not a legally binding commitment to buy or sell. However, certain provisions such as confidentiality stand still and payment of consultants during the diligence period should be and usually are binding. I refer to the LOI as a “handshake in writing.  

The main purpose is to assure that buyer and seller agree on the general terms of the deal before starting due diligence. Without the terms written, the buyer and seller expose themselves to crucial ambiguities and omissions.  

What Is Covered?

You can’t buy a standard for of a LOI in a stationery store. A new one needs to be drafted for each situation.  

It should identify and confirm agreement on all significant issues of the potential transaction. The following is my basic checklist:  

·         What’s being sold? Is it a stock sale or an asset sale? What specific items are included are included or excluded?

·         The price including security instruments and other money issues. This defines all consideration that will potentially change hands as a result of the transaction. This includes, purchase price, consulting agreements, non-compete agreements, employment agreements, royalty agreements earn-outs and any other such agreement.

It is usually a good idea to make the latest published Balance Sheet as the base price document and adjust the purchase price at closing to reflect any gains or losses to that Balance Sheet. This is fair; the Seller gets credit for profits or losses all the way to the actual closing.

·         Terms. Will it be all cash at closing or will there be financing. The LOI also describes what security agreements are to be created for any future payments.
If there is third party financing ahead of seller financing, The LOI should include the seller’s right to approve such financing and establish a date for a financing commitment to be in place from the third party.

·         The payment provisions. These define how and when the payments take place.

·         The allocation of the price to the various layers of the deal.  (For example, what is the value of the Non-Compete Agreement and how much of the purchase price is allocated to it.) This is often postponed until later with the proviso that the parties will agree to allocations such as to minimize taxes on the deal. Putting off is bad. Since tax issues that benefit one party many hurt the other, later negotiation is not a good deal. I insist with my clients that allocations are agreed on up front and included in the LOI.

Allocation is key to minimizing taxes and should be reviewed with your accountant and financial planner prior to signing the LOI.

·         A definition of what is being sold and what is not. List the categories of items. A good place to start is the current balance sheet and list exceptions or add-ons as appropriate.

·         Work to be done by consultants and advisors before a Definitive Agreement is signed and who pays for that work. Many times the buyer and sell will spend significant sums during the due diligence period on outside advisors.

·         Definition of which party is responsible for drafting the Definitive Agreement. In my experience, the buyer’s lawyer usually does this. The LOI should have a target date for the completion of this.

·         Exclusivity during the term of the LOI (Stand Still). The buyer is going to spend a lot of time and effort during the due diligence phase to check on the information given him or her by the seller. The buyer will not be willing to move forward with the process without the assurance that the seller will not shop the business during this period.

The net effect is that the seller gives the buyer an exclusive option to buy the business for the due diligence period. Many times sellers resent this and say the buyer should pay for this option or at least put up some escrow money.

I discourage my clients from insisting on good faith deposits. Typically the buyer is spending a lot of money for the due diligence. He or she wouldn’t be doing that without serious intent.

The biggest fear that a buyer has is that the seller won’t sign the final papers and the buyer loses all costs of investigating the opportunity. Sometimes buyers ask for back-out fees in case the seller backs out.

·         Confidentiality provisions. This is the agreement to keep the LOI itself confidential.

·         Time allowed for due diligence. This can be a few days to a few months. Sometimes buyers insist on a full audit.

·         Statement of the non-legality except for confidentiality, exclusivity and payment of advisors.

·         Establishment of a target closing date. This gives all the parties and their advisors a target date to shoot for. Without such a date, the priority may slip in some advisor areas.

·         Provisions for termination of the LOI. The LOI should have a drop-dead date after which each party has no further moral obligation to proceed with the deal.  

You should review your LOI with your lawyer, accountant, tax advisor and intermediary before signing it. 

The Letter of Intent will reduce the hazards between the handshake and the bank. Don’t move forward without it.