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Session #7: Contents of a Letter of Intent
Making the Initial Offer
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So, you’ve found a business you like and you’re ready to make your first offer?
But how? And what should it include?
We’re glad you asked!
In this session, we’ll walk through the structure and contents of a letter of intent (often referred to as an LOI).
Our goal in today’s session is to arm you with the information you need to develop an effective offer that both improves your chance of success while simultaneously protecting your interests.
Welcome to the 7th Session of this Business Buying Masterclass.
Let’s get started!
Did you know that Kevin and Eric have launched a new podcast called Mundane Millionaires?
Each week, we publish and audio and video podcast of interviews with incredible entrepreneurs just like you who building time and financial wealth as entrepreneurs.
This week, we sat down with Katherine Dextraze, who recently acquired Your Solar Mate. Katherine’s path to entrepreneurship includes degrees in nuclear engineering and medical physics, and 11th hour busted deal, and a successful closing process that included her wedding right in the middle!
What Is an LOI?
A letter of intent (often referred to as an “LOI”) is a short-form document utilized by a buyer and seller to negotiate certain material, preliminary terms of a potential acquisition.
Sometimes you’ll hear other terms thrown around, like indication of interest (“IOI”), memorandum of understanding (“MOU”), or term sheet.
While there are some key differences between each of these documents and their intended use, by and large when used in the small business acquisition space, the differences are immaterial.
The principal characteristic of each them is all focused on the same outcome – to document a preliminary, non-binding understanding between buyer and seller that is intended to create a strong foundation for the negotiations to come.
Why is the LOI step necessary? Wouldn’t it be more efficient to skip this step and move on to negotiating the purchase agreement?
It can be, at times, sure.
However, in most instances, before you spend the considerable time and cost necessary conducting fulsome due diligence and negotiating a purchase agreement, it makes sense to confirm that you and the seller are on the same page with regard to major components of the deal, including most notably the purchase price, the deal structure (asset -vs- equity), the time frame, non-compete covenants, the exclusivity period, and certain other deal terms.
Waiting until you’re at the three-yard line to find out that you and the seller are not on the same page regarding any “deal breaker” terms would be a waste of time and money and a major set back for your search!
The Non-Binding Nature of LOIs
Even though the LOI is of critical importance, it is also of critical importance (in almost every case) that the LOI be non-binding.
In other words, the LOI is intended to summarize key terms of an eventual transaction, but neither party should be able to legally enforce the terms of the LOI on the other party.
That seems crazy, right?
The LOI is a “hand-shake agreement” on fundamental transaction terms intended to find and flush out any material differences between the parties’ expectations that make abandoning the transaction before incurring meaningful fees and expenses possible.
However, the LOI is by definition not a complete agreement. The buyer has not yet had a chance to properly diligence the target company.
In other words, preserving optionality after the LOI stage is in everyone’s best interest.
Practice Tip: Don’t make the mistake of assuming that an LOI will automatically be non-binding. Courts have, at times, held certain LOIs to be binding agreements, placing the parties in very difficult situations as a result. Be sure to make it 1,000% clear that your LOI is non-binding in the text of the LOI itself. State it on every page if you need to. The last thing you need is a grumpy seller claiming “But I thought we had a deal!” and suing you when you have to walk away from the deal as a result of mis-stated financial statements or otherwise.
Standard Terms of an SMB LOI
The following is a category-by-category analysis of the terms of a typical LOI, and how to think about each:
1. Buyer Introduction
It’s always a good idea to introduce yourself and your strengths as a buyer at the outset of an LOI. Be sure to explain what it is that attracts you to the business and why you’re interested in acquiring it.
But remember that a seller is usually less interest in the amazing returns you expect to get on your investment (and in fact may use that information to negotiate a higher multiple).
Be smart here - try to identify those things that the seller cares most about during the preliminary diligence process, including in the confidential information memorandum (CIM) and discussions with the broker and seller.
Recognize things like the “strong brand equity and reputation,” “skilled and dedicated workforce,” etc., and mention how you want to continue the legacy that the Seller built.
Remember: You’re selling yourself as a buyer as much as the seller is selling their business.
2. Transaction Description
With pleasantries out of the way, you’ll move immediately into the substance of the LOI.
There are a number of ways to do this, but it’s not uncommon to use an “outline” format with numbered headings.
The Transaction Description.
The LOI should provide a clear description of the transaction, including WHO is buying WHAT from WHOM?
Is this an asset or equity deal? Who is the actual buyer (you personally, an existing entity, or a new entity to be formed during the transaction process)?
All of these items should be addressed here.
Practice Tip: It’s easy to gloss over the accuracy of the “buyer” in the LOI, but you do so at your own peril! Oftentimes an LOI will be drafted describing “John Doe” as the buyer, when in reality John Doe has every intention of forming a new entity for purposes of the acquisition.
Now assume for a second you have some seller financing in the deal that John Doe doesn’t want to personally guarantee. By not clarifying who the “buyer” is, the seller may think John Doe, individually, is the buyer and, therefore, all of John Doe’s personal assets are available to enforce the seller note. This is not a good outcome for John Doe if he didn’t want his personal assets guaranteeing the note!
Even if something seems trivial, it may have broader implications that you’re not thinking of. Make sure you’re consulting the right experts throughout the LOI process to make sure you don’t inadvertently include or omit something important at the LOI stage, making it more difficult to negotiate what you want down the road!
For example, a simple transaction description could look like the following:
At the closing of the Acquisition (the “Closing”), a new entity to be formed by John Doe (the “Buyer”) will purchase from [Target Company] (the “Seller”), and the Seller will sell to the Buyer, all of the assets of the Seller used or held for use in the Business.
Make special note of that last clause.
Take extra care to make sure that you accurately describe the structure of the transaction!
As we discussed in Session #6 - Structuring the Deal, the structure of your transaction has far reaching consequences on fundamental deal points that drive significant value, such as liabilities being assumed by the buyer, taxes, third-party consents needed for closing, and more.
The last thing you want to do is describe an stock acquisition in an LOI when what you really meant was an asset acquisition, or vice versa. It can be very costly if you can’t walk back such a seemingly innocent mistake!
3. Purchase Price
The next section is easy… sort of!
Here you’ll describe how much is going to be paid, and in what form it will be paid!
This may be as simple as a sentence saying the full purchase price will be paid in cash at the closing.
More likely than not, though, it will include some combination of two or more of following:
Seller promissory note
Assumption of debt
Transfer of in-kind property (i.e., tangible property like equipment)
Equity interests in the buyer entity (or holding company of the buyer entity)
Escrows and holdbacks
Future, performance-based earn out payments (which in turn can be paid in one or more of the foregoing methods)
When describing any of the above, there’s a balance to be struck.
You want to provide enough detail that it avoids future disagreement over fundamental terms, but you don’t want to provide so much detail that you end up engaging in protracted negotiations with the seller on “legalese” at the LOI phase.
For example, if you intend to include seller financing, you may simply state the size of the note, the amortization period and maturity date, the interest rate, and whether it will be secured or unsecured and/or guaranteed by the buyer principals.
As an example, a sample purchase price provision could look like the following:
The purchase price for the Company (the “Purchase Price”) would be $___________, [and would be paid in cash at the Closing] [payable in the following manner: [describe if holdback, escrow or earnout or if noncash consideration is being used]].
In most cases, you may want to include some agreed level of working capital in your transaction. If so, you’ll want to at least mention it in the LOI.
You may be wondering “how can I determine the need for working capital without having conducted a full due diligence process?”
Typically, you can’t. So you want to include general language. For example, you might include the following in your LOI:
The purchase price assumes that the assets will include a normalized level of working capital consistent with the past practices of the Company at a level to be mutually agreed by the parties in the Definitive Agreement and determined in accordance with the Buyer’s third-party quality of earnings review.
4. Representations and Warranties and Indemnification
Negotiating fulsome representations and warranties and an accompanying indemnification provision is generally beyond the scope of the LOI stage.
That said, the LOI should typically state that the purchase agreement will contain “customary” representations and warranties to avoid any disagreement over whether or not the buyer is purchasing the business “as is.”
Additionally, the LOI should lay out any agreed-upon terms in the indemnification section.
Practice Tip: For those of you familiar with the M&A process, you may be tempted to include some level of detail surrounding indemnification, such as the survival period for representations and warranties, baskets or deductibles, and indemnification caps.
Tread carefully here!
The reality is that many sellers and their counsel in the “main street” M&A space aren’t as savvy as their private equity counterparts when it comes to indemnification. We often see more buyer-friendly indemnification terms in small business transactions, so being too detailed in the LOI could actually backfire. You may end up giving away more than you need to!
The negotiation of representations and warranties and indemnification can often be a point of frustration for first-time buyers and sellers.
Why does it take so long and why do these provisions even matter?
Well sit tight and stay tuned, because we’ll cover indemnification in MUCH more detail later in the course!
5. Conditions to Closing
This section will describe all of the “contingencies” that the transaction hinges on.
The last thing you want to do is set the expectation with the seller that you will close the transaction before you’re ready!
In this section of the LOI, you will list several customary closing conditions, but you should feel free to add any deal or buyer-specific conditions if they are important to the ability of the buyer to close the transaction.
Practice Tip: The seller is almost always going to be nervous through the entire deal process that the transaction is going to fall apart and the buyer will walk away. Transparency is your best friend here. Communicate expectations and requirements clearly and early to avoid any unnecessary stress caused by surprises during the deal process!
Some common conditions to closing may include:
Receipt of any required third-party consents, such as landlord consents or customer contracts.
Receipt of any regulatory approval and/or permits.
Financing conditions, including receipt of debt financing, as well as receipt of equity financing (if raising outside capital), in each case on terms acceptable to buyer.
Execution and delivery of definitive agreements.
Acceptance of offers of employment by certain key employees.
Any other action the consummation of which is critical for purposes of closing the deal.
6. Non-Compete / Non-Solicitation
If the seller will be agreeing to a non-competition or non-solicitation covenant (i.e., agreeing not to compete with the buyer in the subject business area for a certain period of time or hire the buyer’s employees after closing), this should be stated clearly in the LOI.
A brief note on the enforceability of non-competes:
Non-compete provisions have historically been viewed skeptically by the courts.
The rationale is simple: telling a human being they can’t earn a living is generally frowned upon except in certain limited instances. One of those instances that is common accepted by courts is the sale of a business.
In short, if the seller is allowed to open up a competing business across the street the day after you close, you’re SUNK. After all, they know the market, the customers, the employees, and literally everything else about the business at a level it will take you years to achieve.
Therefore, most courts will approve a non-compete so long as it is reasonably tailored in both SCOPE (i.e., geography and type of business) and DURATION (i.e., how long) solely to the extent necessary to protect your LEGITIMATE BUSINESS INTERESTS.
As an example, telling the seller of a car wash in California that they can’t open a competing car wash anywhere in America wouldn’t be reasonable in SCOPE. If, however, you told them they couldn’t open a competing car wash across the street (or even anywhere in the county), you’re likely on safe ground.
You get the idea.
Be careful not to negotiate non-compete terms that are so restrictive that they are subject to legal challenge.
Practice Tip: The law governing non-competes varies significantly from state to state. You should speak with a competent transaction attorney with experience in this area regarding what is allowed in your jurisdiction.
One provision that’s often overlooked in an LOI is the confidentiality provision.
Before a buyer begins negotiating an LOI with a seller, the buyer often executes an non-disclosure and confidentiality agreement with the seller’s broker. As a result, it’s easy to think that the parties are covered by confidentiality, and that may be the case, as many broker NDA’s cover the seller as well.
But the seller is generally not a party to the broker’s NDA and the broker’s NDA usually only cover’s information shared by the seller with the buyer, and not the other way around.
For all those reasons, it’s important to include a confidentiality provision in an LOI that covers the sharing of information by both seller and the buyer.
8. Exclusivity and No-Shop
Arguably the most important provisions of the LOI is the exclusivity and “no-shop” provision.
The exclusivity and no-shop provision prohibits the seller from continuing to market the business and negotiate with alternate buyers while your transaction is pending.
Many sellers - and especially their brokers - may resist agreeing to exclusivity on the theory that they shouldn’t have to stop marketing the business in case the buyer leaves the seller “at the alter.”
While a buyer may empathize with that argument, it’s a flawed one.
The buyer is making a substantial investment of cost and time on due diligence and other elements of the negotiation process. If the seller is free to continue to negotiate with other potential buyers, there’s nothing stopping the seller from causing you to spend substantial time and resources (financial and otherwise), only to drop the buyer at the 11th hour in favor of another buyer with a slightly higher offer.
A buyer should always resist any attempt by the seller and/or broker to permit continued marketing of the business once the LOI is signed.
Any refusal by the seller and/or broker to enter into exclusivity is a red flag and a buyer should strongly consider walking away from the deal.
A example of an exclusivity and no-shop provision could look like the following example:
Until the later of (a) [number] days after the Signing Date and (b) the Termination Date, Seller will not, directly or indirectly, and will cause its affiliates and its and their respective directors, officers, employees, members, managers, agents, advisors and representatives not to, (i) solicit or encourage any inquiries, discussions or proposals regarding, (ii) continue, propose or enter into negotiations or discussions with respect to, (iii) provide non-public information relating to or in connection with or (iv) authorize, recommend, propose or enter into any confidentiality agreement, term sheet, letter of intent, purchase agreement or other agreement, arrangement or understanding regarding an acquisition of all or part of, an investment in, or a business combination or consolidation or the formation of a partnership or joint venture with, or the issuance of equity securities representing more than 10% of the outstanding equity securities of, the Company or any of its affiliates, in each case other than involving only Buyer or any of its affiliates. Until the Termination Date, Seller agrees to inform [Buyer] promptly of any inquiry, discussion or proposal from any person or entity of the type referred to above, including the terms thereof.
9. Limited Binding Effect of the LOI
At this point, you may be asking yourself:
“Wait a second, I thought you said back at the start that LOIs should not be binding agreements. What good is an exclusivity and no-shop provision if it’s not binding?”
That’s a great question!
While the LOI generally is non-binding (especially the deal terms!), certain portions of the LOI should, indeed, be binding!
For the reasons discussed above, a buyer doesn’t generally want to be obligated to any commercial terms or to even close a transaction without conducting thorough post-LOI due diligence review on the business.
But certain provisions of the LOI must be binding. Examples of binding clauses in an LOI will include:
Exclusivity and no-shop provision
A simple example paragraph that an LOI may include regarding the binding and non-binding nature of an LOI is as follows:
“Except for paragraphs [list paragraphs that should be binding], each of which shall be binding on the parties, this letter, including the first paragraph hereof, is intended to express only a mutual indication of interest in the Acquisition and does not represent any form of legally binding commitment or obligation on the part of Buyer or Seller.”
LOIs are an important part of the transaction process. In addition to negotiating and clarifying certain important terms of a deal, it’s also an opportunity to set the tone and get a preview at the seller’s, the broker’s, and the seller’s legal counsel’s approach and demeanor.
A preview of things to come!
Use it to your advantage.
You can use the LOI process to build a lot of goodwill with the seller.
But beware! You can burn goodwill with a seller just as fast (if not faster) than you can build it.
So be professional, be thoughtful, and be constructive.
Now for a few required disclaimers. Sorry in advance!
This course is being presented strictly for educational and informational purposes, and not for the purpose of marketing any legal services or seeking legal employment and is not motivated by pecuniary gain.
The opinions stated in this course from the authors represent the opinions of such individual author and not the opinions of any other person or organization.
Nothing contained in this course or otherwise from the authors hereof is to be interpreted as legal, financial, tax, investment and/or any other form of advice. Please consult your own legal, financial, tax, investment and/or other advisors.
The authors are not your lawyer, and no information provided in the course of this class or otherwise has the affect of forming an attorney-client relationship between you and the authors. In short, get your own lawyer!
This course is being presented by The SMB Center LLC and has no affiliation or relationship SMB Law Group LLP.
About the Authors
The authors have worked for some of the most elite law firms in the world.
During their time in BigLaw, they regularly worked on transactions in the hundreds of millions to billion dollar plus range for some of the most recognizable companies in the world and have extensive experience with M&A.
The authors have since begun investing in select SMB acquisitions and have co-founded an SMB-focused law firm where they’ve collectively worked on hundreds of millions of dollars in SMB-focused M&A.