What is a Letter of Intent?

By Generational Equity

11/11/2019

So you have successfully marketed your company to a list of potential buyers and you have met with a number of interested parties who signed your NDA (non-disclosure agreement).

You have done your research on several of them and you have narrowed your list of suitors down.

One more round of meetings and you and your partner have decided which one of the finalists you believe will grow the legacy you have created (and pay you handsomely for doing so).

What comes next?

At this point your buyer (assuming they are just as interested in moving forward as you are) should submit a Letter of Intent to you (LOI). If you have never sold a company before, this is where the details really matter and should be examined very carefully.

At its most basic level, a Letter of Intent “allows buyers to signal that they’re serious about a potential deal and to make sure that their vision lines up with the seller’s before they spend significant resources on a full due diligence process”. 

So the LOI plays an important role in the M&A process because it allows both parties to truly see how intentional they are about moving forward and, if not, prevents a lot of wasted hours going through the due diligence process (something everyone involved would want to avoid).

According to our good friends with Axial, an LOI typically will contain the following items:

1. Deal Structure: Is the transaction a stock or asset purchase? 
2. Consideration: What are the forms of payment? This can include cash, stock, seller notes, earn-outs, rollover equity and contingent pricing.
3. Closing Date: What is the projected date for closing the deal? 
4. Closing Conditions: What are the tasks, approvals, and consents that need to be obtained before (or on) the closing date? 
5. Exclusivity Period: This is typically a binding clause requested by the buyer, who wants to ensure that sellers are negotiating in good faith. It’s typical for buyers to request an exclusivity period from 30-120 days, while sellers will typically want as short a period as possible. 
6. Break-up Fee: This clause is also typically binding, though break-up fees are less common in the lower middle market. In larger deals (>$500MM), break-up fees of approximately 3% are typical. 
7. Management Compensation: Which members of the senior management will stay on? Who will be provided with equity plans? This aspect of the deal may be vague at the LOI stage before due diligence has been conducted. 
8. Due Diligence: How will due diligence will be conducted? This includes the nature of the information that will be disclosed and the manner in which it will be disclosed.
9. Confidentiality (Binding): Both parties have likely already signed an NDA earlier in the process, but this clause further ensures that all discussions regarding the proposed transaction remain confidential. 
10. Approvals: Does the buyer or seller need any approvals (e.g. from a board of directors, regulatory agencies, customers) to complete the transaction?
11. Escrow: This may not appear until the purchase agreement, but sometimes the buyer will include summary terms of their expected escrow terms for holding back some percentage of the purchase price to cover future payments for past liabilities. 
12. Representations and Warranties: This also may not be agreed until the purchase agreement, but if there are contentious or non-standard terms, the buyer may include them in the LOI. 

To this very thorough list we would add that working capital is also a key discussion point that is often is beneficial to be included in the initial LOI. It may not need to be the actual amount, but it is defined which will become very important later in the transaction.

Ah the details….

As you can see, at the LOI stage of a transaction, things often get really complicated, this is especially true if you are not using the guidance of an experienced M&A advisory firm. At a minimum, you will need the support of an M&A attorney, someone who has been part of reviewing documents like an LOI before. 

Odds are good that if you have done your marketing process correctly, you will now be talking with a firm that has experience in acquiring businesses. If large enough, they may even have an M&A team on staff who are quite skilled at creating LOIs that work efficiently, but also contain terms that are favorable to the buyer, not necessarily the seller.

And I say that not to impugn the character of buyers, but to point out that logically they will want to acquire your business with a deal structure and terms that are more beneficial to them.

Therefore, if you are not using an M&A advisory firm, be very careful and negotiate anything that causes you concern in the LOI. If a buyer is not willing to negotiate, especially regarding structure and consideration, be prepared to walk away from the deal no matter how attractive.

Keep in mind that the LOI opens the door to the most challenging period of time in any transaction: Due diligence. If you don’t structure the LOI to your satisfaction, you may waste several months’ time in due diligence only to see the deal fall apart over something that could have been prevented with better LOI negotiations.

This is why we recommend that before you sign an LOI you hire an M&A advisory firm to guide you. Realistically, you should hire them long before you get to the LOI stage because you will need their guidance to first value your business accurately (so you know which offers to entertain) and to effectively approach the right set of buyers for your business, helping you obtain an optimal offer eventually. 

The good news is that before even starting your exit process, you can learn a significant amount about how to optimally exit your business by attending a Generational Equity exit planning conference. After attending one of our complimentary conferences, you will be much better equipped to navigate the waters of a transaction for your business. Although, within our conference agenda we cover the entire process from beginning to end, we do focus heavily on areas pertaining to the LOI, including:

• Negotiating Mistakes to Avoid
• Deal Structures Designed to Give You More Cash and Less Risk
• Increasing Your Total Purchase Price through Stock, Royalties, License Fees, and Consulting Fees
• Making Your Business “Pay” You Even After You Exit
• Important Legal and Tax Considerations

If these topics have piqued your interest in learning more, attending one of our conferences should be in your future. You can learn how to find one near you by clicking here. Or call us at 972-232-1121 and ask to speak to one of our Senior Business Advisors about attending. 

If you are unable to attend and don’t hire an M&A advisory firm, be careful negotiating your LOI with any buyers. Before you sign, ensure that you are very comfortable with the items outlined in it. Otherwise, during the heat of due diligence, issues might arise that could scuttle your deal.

Carl Doerksen is the Director of Corporate Development at Generational Equity.

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