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Playbook Advisory resources, Business Broker 101 for buyers & sellers

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Playbook Advisory Resources - Business Broker 101

Letter of Intent - Best Practices for Buyers & Sellers

At our firm, the business sales & transaction team have worked on a wide range of engagements over the past six years. This post will address some of the key issues buyers and sellers have encountered during the process of closing on the sale of a small business. We start with the Letter of Intent.

First, a Letter of Intent ("LOI") is commonly used in the great majority of written offers made to our business owners and they are used to establish a framework for the transaction without creating legally binding obligations.

A LOI helps the parties to work through the key issues early on in the negotiation process and identify any deal breakers before unnecessary expense has been incurred. If agreement is reached on key terms, the LOI can establish a moral (if not legal) obligation to attempt to negotiate a purchase agreement in good faith.

Is the Letter of Intent - Binding or Non-binding?

The letter of intent should clearly state that it is non-binding, except for sections that are expressly designated as binding. Many LOI's create confusion because they are stated to be letters of intent only, but then are written as if they are binding agreements. Commonly only a few of the sections are designated as binding, such as exclusivity, confidentiality and obligation to negotiate.

Settle key deal terms early in the LOI

It is usually in the interest of the seller to settle key deal terms in the LOI, particularly price. By contrast, the buyer may wish to leave wiggle room in the LOI to retain the flexibility to negotiate key terms based on its due diligence findings (although care should be taken not to negotiate an LOI that is so vague that the deal falls apart later on when the parties realize they didn’t agree on the basic terms). The parties may find a middle ground by agreeing to key terms based on certain assumptions being confirmed by the due diligence process.

Note: It’s important to balance the benefit of settling key terms in the LOI against the risk of early burnout from over-negotiation of the LOI. We often see even sophisticated buyers attempting to fully settle working capital, inventory and reps and warranties issues on deals under $2mm. Simplicity and preserving confidentiality are important elements to a successful transaction. 

The letter of intent letter should set out the following five elements:

  1. How much cash will be paid at closing to the Business Owner.
  2. What are the terms and timing of any post-closing adjustments for inventory and working capital, if applicable.
  3. Any escrow or holdback amounts and the conditions on which such funds will be released to the seller. Term & Caps are important points to address early on with Buyers.
  4. Any earnout, including a description of the performance metrics and the length of the earnout (the seller will prefer greater specificity regarding any earnout terms).
  5. Establish dates or milestones for Buyers to agree to adhere to during the due diligence phase of the transaction. Buyers should multi-task or deals can drag on for months and incur significantly more legal costs than necessary for each party.

Addressing Price in the Letter of Intent

The seller will likely prefer that the LOI set a fix price, however, the buyer may be more comfortable with a price range or formula, leaving wiggle room to set the final price after it conducts it due diligence. 


Assets

The LOI should set out the major assets being acquired and liabilities being assumed by the buyer, as well as any material assets that are to be excluded from the sale. In a share sale, any major assets or liabilities of the target that will be removed from the target before closing should be specified. The parties may also choose to broadly determine how the purchase price will be allocated between asset classes, as this has important tax implications for both sides. The buyer will prefer to allocate as much as possible to the depreciable assets. The seller will prefer to allocate an amount equal to the cost base of the depreciable assets (so as to avoid a recapture) and the remainder to goodwill (taxable).

Financing

If the deal is subject to the buyer obtaining SBA Financing, the Seller will want to know the following; 1) Name and contact person at the bank, 2) Proof the buyer has been pre-qualified, 3) Average length of time to close (typically 60-75 days), 4) What is the deal structure- how much is the Buyer putting down as their injection of equity-the range can be 10-25% of the purchase price, 5) Are there any Seller note issues that the Seller needs to be aware of prior to agreeing to the letter of intent, for example, is the bank requiring a standby note for up to two years, any issues with possible lease terms (If Seller owns property). 

Exclusivity Period

The buyer will often require the seller to commit to deal only with the buyer for a certain period of time, so it doesn’t waste its time and money carrying out due diligence and negotiating a purchase agreement while the seller is shopping the deal to other interested parties. The exclusivity period is generally somewhere between 45 and 120 days.

The seller should not agree to an exclusivity period unless it has a reasonable degree of confidence that the buyer is likely to go through with the transaction. Exclusivity not only takes the seller’s business off the market for a significant period of time, but, if the negotiations with the buyer fail, means the seller will likely have to go back to the same pool of potential parties to find an alternate buyer – parties who may be less enthusiastic about the deal knowing that the seller’s negotiations with its preferred buyer failed.

Confidentiality

Whether set out in a separate non-disclosure agreement or in the LOI, the parties (and the seller in particular) should ensure that confidential information disclosed as part of the due diligence process is protected. The confidential information disclosed to a party should only be usable for the purpose of assessing and completing the transaction.

Representations and Warranties

An exhaustive list of representations and warranties is generally not set out in the LOI. But, the buyer should include any representations it considers particularly important or that the seller may not anticipate, and provide that the representations set out in the LOI are not exhaustive.

The parties may wish to set out the often controversial terms regarding post-closing claims for breaches of representations in the LOI, such as the survival periods for representations, as well as indemnification caps, thresholds and carve-outs.

Closing Conditions

An exhaustive list of closing conditions is not necessary, but the buyer should set out the key conditions that will need to be met in order for it to close the deal (eg. key government or third party consents, non-competition agreements from principals, financing, etc.).

Termination Fee or Deposit

A strong buyer may seek a break up fee to cover its expenses if the seller decides not to proceed with the transaction after the buyer has completed its due diligence.A Seller may insist on a deposit either at the execution of the LOI or upon the signing of the purchase agreement.

If you have any questions regarding the sale of your business contact Jim Peddle at 312-525-9622 or by email at president@playbookadvisory.com.

 

Author, Jim Peddle, Business Broker, All rights are reserved