Leveraging the Letter of Intent
You’ve just spent months preparing your business for sale. Completing lengthy diligence request lists, developing complex financial forecasts, creating extensive marketing materials, reviewing IOI’s, and spending time in management meetings and Q&A sessions with potential buyers. The amount of time and energy invested in the process has been great. But you’ve finally reached the apex of your negotiating power – the LOI.
The letter of intent (“LOI”, sometimes called the “term sheet”) serves as an outline of key provisions and is used to help facilitate the preparation and negotiation of a definitive purchase document. A non-binding LOI is often negotiated in good-faith, meaning any deviations from the terms stated in the LOI typically require justification.
In most circumstances, the LOI represents the last opportunity for the seller to fully exert his or her bargaining power in the transaction. This loss of leverage results from an “exclusivity-clause”, a common LOI feature precluding the seller from speaking with any other interested parties. Once an LOI is executed, a seller’s negotiating power often diminishes.
Private equity groups and other sophisticated buyers have a great deal of experience in utilizing an LOI to defer specific language on key transaction points. These groups will intentionally keep language on key issues vague in the LOI to preserve flexibility in drafting a final purchase agreement that weighs in their favor. Key phrases often used to preserve buyer flexibility include:“to be mutually determined”, and “subject to customary exceptions” or “obligations which are reasonable for transactions of this size and type.”An experienced advisor will guide their client by inserting specific, comprehensive language covering key negotiating points.
A common practice used by a transaction advisor is the comparison of key features of each bidder’s LOI to reveal potential shortcomings. By identifying unclear or ambiguous terms to relevant bidders, the advisor seeks to improve specific LOI terms within the backdrop of a competitive bidding process. This aids in negotiations and often works to improve key transaction terms.
Key terms such as transaction structure, working capital, financing arrangements, indemnification obligations, and deal timelines can often be modified to preserve transaction leverage in the seller’s favor.
A seller usually prefers a stock deal as it typically affords the most favorable tax treatment. Buyers typically prefer an asset deal, which gives them the ability to “cherry pick” preferred assets, avoid corporation specific liabilities, and provides them with a stepped-up basis on assets, producing a lower taxable gain in the event of a future sale of those assets. A well-informed seller with a clear picture of proposed tax implications resulting from both an asset sale or a stock sale is encouraged to specify the preferred transaction structure while negotiating an LOI.
Another important piece in negotiating the transaction structure is to clearly define which entities will be involved in the proposed transaction. Sellers must define the specific legal entities that will be involved in the transaction, along with the potential for the sale of any related real estate holdings. By having a clear picture of which entities will be involved in the transaction, sellers can achieve greater clarity in the allocation of purchase price amongst their portfolio of holdings.
A seller often has the most leverage in negotiating a favorable working capital outcome prior to signing an LOI. Under ideal circumstances, both parties would be able to agree upon a working capital target at the LOI stage. In the absence of an agreed upon target, both parties should at least agree upon a working capital methodology which defines the working capital accounts to be included in the working capital calculation. A common methodology is for buyers to agree to the target being determined by using trailing twelve month working capital average.
When a transaction involves financing leverage, sellers should encourage buyers to provide potential financing commitments to improve the certainty of fulfilling funding obligations. The sources and timing of approvals for finance should also be disclosed to better assess the likelihood of closing.
The buyer of a business may offset a portion of potential risk related to breaches of seller reps and warranties by asking the seller to hold-back, or escrow, a percentage of the total transaction value. This enables the buyer to file a claim against the escrowed amount to recoup a portion of the purchase price if a material breach is found. The seller should seek to clearly define the amount required for escrow (usually 5-10% of the purchase price), the survival period of escrow (typically between twelve and eighteen months), and a quantification of specific fundamental representations during the negotiation of the LOI.
Alternatively, sellers and buyers can agree to use reps & warranties insurance in lieu of an indemnity agreement that requires escrowed funds. Reps & warranties insurance can provide the benefit to the seller of receiving a greater amount of purchase price at closing while reducing legal costs, collection concerns and increasing the indemnity period.
To prevent the disclosure of confidential information on a contemplated transaction to employees or key customers, a transaction advisor needs to be aggressive in negotiating a defined timeline for site visits, management discussions, and customer discussions. By having a pre-approved timeline, the seller minimizes unintended disclosure. The clearly defined deal timelines reduce the risk of disruptions in customer and supplier relations, employee satisfaction, and workforce morale. A speedy and efficient deal timeline is critical in limiting the chances of renegotiations, and often works to provide greater certainty of close.
For the seller, the LOI often represents the apex of his or her negotiating leverage in a transaction. Seeking the counsel of an experienced transaction advisor who can guide the seller in negotiating key transaction terms is critical in structuring the LOI to ensure a speedy deal timeline, reducing the risk of renegotiations which can erode value, and maximizes financial value to the seller.
© Copyrighted by EdgePoint. Tom Zucker can be reached at 216-342-5858 or at firstname.lastname@example.org