A Letter of Intent (“LOI”) is an expression of the buyer’s intent to acquire a seller’s business on specific terms and conditions. It is considered a milestone in the transaction process, primarily because it is predicated on the concept that the seller and buyer have agreed upon the basic terms, assuming that due diligence supports assumed facts.
An LOI is generally non-binding as to substantive terms (price, transaction structure, and forms of consideration) but is often binding as to process items. These include access to seller’s information, cooperation by the parties, seller’s exclusivity obligations, seller’s obligation to conduct business in the ordinary course, governing law, confidentiality, and allocation of expenses.
Sellers need to manage their expectations and be aware that buyers can still walk away from the deal even after they have reviewed sellers’ sensitive information provided in due diligence. If the buyer is a direct competitor, this can have unintended consequences for the seller, notwithstanding well-drafted non-disclosure agreements with limitations on use of the information. For example, will a strategic buyer determine through due diligence that investing the purchase price in their own business is more cost-effective than paying an acquisition premium? It is critical that the seller and his/her advisor carefully evaluate all offers and determine if the buyer has the actual intent and financial wherewithal to close the transaction before signing the LOI.
Here are some basic considerations for evaluating an LOI.
- Is the deal too good to be true? Reasonable business practitioners do not offer consideration or terms well above the norm. Such offers often end in re-trades or worse, in a long period of failed efforts to secure acquisition financing, during which time the seller’s business is off the market because of exclusivity.
- How will the buyer finance the transaction? Cash at closing or bank debt. Third-party financing adds significantly to the complexity and timing considerations of the transaction. The seller should consider requiring satisfactory evidence of a financing commitment early in the process, with the ability to break exclusivity, and perhaps recover out of pocket costs if it is not provided in a timely manner.
- How will the seller be compensated? Will the seller receive the full purchase price in cash at closing? What indemnification provisions (how much for how long) apply? Is rollover equity a component of the deal? Is stock of the buyer a component of consideration?
- Is the transaction cash-free/debt-free? If so, does the seller’s balance sheet indicate that a substantial portion of sale proceeds go to retirement of debt?
- Does the transaction include a working capital adjustment? Assuming that value is based upon a stream of cash flows, a “normal” level of working capital (that historically facilitated the income streams used to determine value) will be required at closing. Careful attention must be given to how this issue is treated in the LOI, and in the asset or stock purchase agreement, because working capital adjustments (based upon factors determined in a quality of earnings review) are often used as an effective re-trade by sophisticated buyers.
- What post-closing involvement is required of the seller? Will the seller be required to continue in the business post-closing? For how long and for what compensation?
- What non-competition requirements are required? Most acquisition agreements include a non-competition provision that lasts from two to five years. The points for consideration include geographic location, limitations on the type of business precluded, passive investment versus active participation, and the overall length of time the limitations are effective.
It is crucial to understand that an LOI is not the end of the transaction process, but for legalities. It is, in effect, just the beginning. Due diligence and quality of earnings review, drafting the asset purchase agreement, and financing the acquisition are all yet to come. The terms of the LOI can have a serious affect on the seller’s ability to realize his expectations through this process.
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