The Letter of Intent (LOI) is a pre-contractual written instrument prepared by the buyer for the seller, which is usually the preliminary understanding of both parties. Other names used for LOI are Memorandum of Understanding and Agreement in Principal. The LOI precedes the Acquisition Agreement, better known as the Purchase and Sale Agreement. It is a non-binding agreement subject to the buyer obtaining satisfactory financing and subject to satisfactory due diligence by both parties.
This is how the LOI has been defined by Stanley Foster Reed, author of The Art of M&A: “A Letter of Intent is a pre-contractual written instrument which defines the respective preliminary understandings of the parties about to engage in contractual negotiations. In most cases, such a letter is not intended to have a binding effect except for certain limited provisions. The Letter of Intent crystallizes in writing what has, up to that point, been oral negotiations between the parties about the basic terms of the transaction. While the Letter of Intent is usually non-binding, it does create a moral commitment and allows the buyer to proceed with the extensive due diligence process with a feeling of confidence. Conversely, the seller is required to withdraw the company from the marketplace and not discuss the potential sale with anyone else.”
Letters of Intent are written after the two parties have had a serious discussion on the price, terms, conditions, and time period of the proposed transaction. In my experience buyers will usually submit a LOI after they feel they understand the parameters of what a seller will accept.
In many cases, the buyer uses the LOI as the initial basis of negotiating. If there is reason to believe that the two parties are fairly close to agreement, the buyer will draft a second LOI. If the buyer is experienced or is working with an experienced intermediary, it may not be necessary to involve a lawyer at this time. It should be noted, however, that lawyers resent being pulled into the deal after the LOI, and if it is necessary to make a material change in the future, it becomes very difficult to do so.
The LOI is at the heart of the transaction and reveals key issues early on in the process. Before you, as the seller, sign the LOI, I urge you to solicit a second or third opinion from a transaction attorney, a competent intermediary, or a corporate appraiser. A few hours spent with these professionals at approximately $200 to $300 per hour would be well worth the expense. Although their advice should be taken seriously, ultimately you have to make the decision.
Deconstructing the Letter of Intent
The elements of the Letter of Intent are as follows:
• The price of the company
• The form of purchase: is it a stock or asset sale? What is being purchased and what is not?
• The structure: cash, notes, stock, non-compete or consulting agreements, contingencies?
• Management contracts: for whom, duration, and incentives
• Closing costs and the responsibilities of the buyer and seller, such as environmental due diligence and title searches
• Representations and Warranties: boilerplate legal statements
• Brokerage fees: who pays and how much
• Timing for completion: drop-dead date for due diligence and financing period as to how long before money is exchanged and final closing takes place
• Insurance: proof of insurability; what happens with policies?
• Disposition of earnings before closing and viability of non-ordinary expenditures before closing (conduct of business)
• Access to books and records, key customers, and key employees prior to closing
• Disclosure of any outstanding non-compete agreements or obligations with third parties
• Stipulation of confidentiality of buyer (a breach could cause the seller to sue the buyer): The buyer promises not to disclose information about the seller to outsiders and to not disclose that negotiations are underway.
• Seller will take the company off the market for a designated period of time of forty-five to sixty days (a breach could cause the buyer to sue the seller).
Data Needed Before Reaching a Letter of Intent
Let us assume that the buyer has visited the seller two or three times; he or she has received three years of financials, understands the compensation and add-backs, and is now ready to make an offer. Based on all the information at hand and on the buyer’s best judgment, he or she tells you that they are prepared to draft a Letter of Intent with a purchase price of $5 million of which $3 million would be paid at closing. Additionally, he or she states their intention of making an asset purchase or stock purchase.
If the seller indicates you are close enough to have the buyer draft a Letter of Intent, then the following items will probably be requested:
• Annual financial statements with footnotes for last three years
• Listing of shareholders and key managers showing name, age, shares owned, current position, years of service, annual salary, fringe benefits, last raise, and breakdown of bonuses between discretionary and formula basis
• List of all contractual obligations
• List of top twenty customers, substituting letters for actual names followed by annual sales for last three years
• Description of bonus or incentive system
• List of accounts receivable at signing
• Add-backs or any earning adjustments that probably would not be incurred under new ownership
• Real estate, machinery, and equipment appraisals (if any)
• Breakdown of inventory between raw, finished, and work in process (Banks do not lend against the latter.)
• Amount and description of capital expenditures for last three years and estimate of future needs
• If a stock purchase, then a copy of loan documents
• If a stock purchase, then listing of life insurance policies showing insured, face value, any cash surrender value, and annual premium
Once the LOI Has Been Delivered
The next step is for the buyer to deliver the Letter of Intent, preferably in person to the seller and to explain each item point by point. There are now a number of issues you will have to be aware of, including price, terms, the chemistry with the buyer, non-financial issues, and how fast the buyer can close.
Usually, when the buyer and seller strike a deal, the quicker the buyer can secure the financing, complete the due diligence, and draft the Purchase and Sale Agreement, the less chance both parties will change their mind. After the Letter of Intent is signed, an expeditious closing will take place between sixty and ninety days, assuming there are no major glitches such as environmental issues. It will be a time-consuming job to bring the deal to a successful close.
When the Letter of Intent is delivered, neither party wants to lose momentum. Allow plenty of time for discussion. Expect to come to an agreement on the non-binding Letter of Intent by at least the second meeting.
The intermediary and owner should predetermine their negotiation strategy. Before you begin negotiating the LOI, you should know your lowest price (although you may not play it), identify key issues to both the owner and the buyer, and anticipate the responses of the buyer. You should also determine before the meeting whether you or your advisor will be the major spokesperson. Perhaps if there are some negative comments about the buyer that need to be expressed, they should be mentioned by the intermediary (bad guy) but not the owner (good guy). Such negatives could include previous aborted deals or a perceived lack of capital for acquisitions. Such comments would show the buyer you have a good understanding of the merger and acquisition business. Furthermore, the owner can tell the buyer he cannot sell the business for less because he has other potential buyers who have expressed interest in purchasing the company.
The signing of the Letter of Intent triggers the buyer’s commencement of the due diligence process and his ability to secure the necessary financing. The seller’s team will want to check out the buyer to know whether he or she is creditworthy and whether the buyer is committed to completing the deal. An individual’s credentials should be examined more closely than if the buyer is a corporation.
A buyer will probably verify his or her financial strength by presenting detailed financial statements and emphasize their liquid assets. As the seller’s intermediary, you should request that the buyer submit a list of potential lenders or investors for this proposed acquisition. Aside from the buyer’s financial posture, you will want to know about his or her personal characteristics, so take time to meet with the buyer socially. You want to maximize the likelihood of a successful sale.
Make no mistake, this is likely a do-or-die period. According to hearsay, 50 percent of all deals fail at the Letter of Intent stage. Another 25 percent of all deals fail at the due diligence stage, and 15 percent of all deals fail at the documentation stage. Only 10 percent of all potential deals make it all the way to closing.
The Critical Ingredients
The critical ingredients in the Letter of Intent include the following:
1. The proposed purchase price
2. What the down payment would be
3. The size, length, and interest rate of a note and how it would be secured
4. Other considerations affecting the price, such as partial earn-out based on a predetermined formula
5. A list of contingenciesThe contingencies would include the arrangements under which you, the seller, would stay on. If the seller leaves, then an agreement on the length and terms of any training period as well as a non-compete agreement should be addressed. Other contingencies that will probably be requested by the buyer include: a review of the company’s financial records, an examination of insurance policies, the availability of vendor and customer contracts, and assignment of the lease.
It is customary for agents who broker small companies with sales of less than $1 million to ask the buyer for a good-faith deposit of $5,000 to $10,000, but this is not common for middle-market transactions.
The cost for due diligence is the burden of the buyer. Depending on the complexity of the due diligence, it can cost the buyer of a middle-market company between $10,000 and $100,000. If the seller backs out of the deal for any number of reasons including “seller’s remorse,” the buyer has no recourse unless he has a so-called breakup fee written into the LOI. While the latter is desirable for the buyer, it is very hard to persuade the seller to comply.
The success or failure of completing the transaction hinges on the LOI. Upon signing the agreement, both parties are morally but not legally committed to do their utmost to complete the transaction. The outcome depends on the results of the due diligence, the ability to put the deal back on track if it is temporarily derailed, and attention to detail and speed without loss of momentum.
The important goal is the signing of the Purchase and Sale Agreement after the due diligence has been completed. The buyer’s greatest fear is not knowing everything about the company; that due diligence did not uncover everything. And the seller’s fear is that information will leak out—that the employees, customers, and suppliers will hear about the deal prematurely—or the buyer really does not have enough money after all.
Checklist of Items in Letter of Intent
This is what you will see when you receive a Letter of Intent:
1. Description of the buying organization, such as place of business and owners.
2. Statement of price, structure, contingencies, and exactly what is being purchased.
3. Description of any notes: their interest rate, term, amortization provisions, whether or
not they are secured or unsecured, negotiable or non-negotiable: Will the buyer have
the “right to offset” part of the note if the seller does not meet
certain conditions in the Purchase and Sale Agreement?
4. Specification of management contracts: for whom, duration, and what the incentives are.
5. Explanation of closing costs, including intermediaries fees as to who pays what.
6. A statement that representations and warranties will be a part of the Purchase and Sale Agreement.
7. Description of profit-sharing arrangements.
8. A list of contingencies that have to be resolved in order for the transaction to be completed
(environmental studies, title transfers).
9. Planned changes to be made, such as management and continuity items (will the plant be relocated?).
10. Estimated date of closing.
11. Transferability of insurance.
12. Reconciliation of debts or collections with shareholders.
13. Continuity of business until closing date.
14. Access to books and records.
15. Description of consulting and non-compete agreements.
16. The adherence to confidentiality by both parties and the understanding that the
Letter of Intent is non-binding and that the seller will take the company
off the market for a specified period of time.
17. A consideration of whether the parent company (if there is one) should also
sign the Letter of Intent and/or if the guarantors of the selling company’s obligations
(if there are any) should also sign the document.
18. Whether to create an escrow account to handle post-closing adjustments to the
purchase price to reflect changes in inventory, final audited financials, or collections
of accounts receivable to offset seller’s contractual claims.Conclusion
Because the LOI is a non-binding agreement, if so stated, the buyer has the comfort level of knowing he or she can back out. The chances are slight, however, that either the buyer or seller can materially change the price and terms of the deal after both parties have entered into the LOI, except if there is a sudden and unexpected downturn in the company’s performance.
One of the biggest concerns you may have is whether the buyer has the financial resources to complete the transaction and to have the reserves in case the business needs another infusion of capital. The seller is entitled to receive financial information from the buyer.
David Broadwin, transaction attorney for Foley, Hoag & Eliot in Boston, says: “You
should devote careful attention to LOI [Letters of Intent] not only because they memorialize the terms of a proposed transaction and give the principals a feeling that they have reached an understanding, but also because they exert a profound influence on the definitive documentation of the transaction.”
