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Letter of Intent (LOI)
A letter of intent is the preliminary agreement entered into between a buyer and a seller. This document summarizes the terms and conditions that a buyer is proposing. When a LOI is executed, then the Buyer and Seller have in principle agreed to the terms and conditions of the transaction. We will generally be taking the Buyers point of view as in previous posts.
- Structure - it is important to know how the deal is structured from tax and legal perspectives. For example, is it an asset purchase or stock purchase? Will there be a 338(h)(10) election? Structure is very important for the Seller as it determines the amount of taxes it pays. Likewise, a Buyer may be able to pay more for a company depending on how an acquisition is structured.
- Price and Terms of Consideration - outline of the total consideration being paid to the Seller, the type of consideration being paid and the timing of the consideration being paid.
- For example, a Seller may be receiving $10 million up front plus another $5 million that is contingent based on earnings performance over a three-year period. This should all be outlined so that the Seller understands the nature of consideration that it is receiving.
- Included Assets and Liabilities - LOI should always state the assets included and excluded in the transaction so there is no confusion. Typically, a Buyer doesn’t want to take any liabilities other than standard accounts payable, if that.
- Working Capital Adjustment – this is always a sticking point for Buyers and Sellers. Sellers always believe their businesses are able to run with lower working capital and therefore want to include a smaller amount for the Buyer. However, Buyers obviously have a different perspective. A Buyer will argue that the historical level of working capital is an accurate representation of steady state needs and will want as the Buyer calls it – an appropriate level of working capital. For a general guideline, Buyers will seek 60 days of working capital.
- Access to Information / Due Diligence & Closing – Sellers want to know that Buyers will try to close the transaction in an efficient and quick manner. They don’t want something dragging out or worse yet, the Buyer backing out of transaction. Meanwhile, Buyers want to be able to investigate and conduct various types of due diligence to confirm that they are not overpaying for something. It’s good for both sides to have a some timeframe for due diligence and notification of any dealbreaker issues. Generally, 45-60 days is a good timeframe to allow for the Buyer to investigate and close the deal.
- Conditions to close – Buyers will caveat its ability to close the transaction by listing some conditions to close. The following are typical conditions and language that are in most, if not all, LOIs.
- Negotiation of Satisfactory Purchase Agreements – remember, a LOI is preliminary and there is still a lot of work and detail that goes into documenting the transaction in granular detail. If a Buyer and Seller cannot agree and some of the finer points, the transaction may not occur. A Buyer does not want to incur significant legal fees so this is why a Buyer generally hold of on complete legal documentation (the Purchase Agreement) until they have conducted some due diligence and feel relatively good that it will close the transaction.
- No material adverse change (MAC) – if something drastic happens, a Buyer wants to be able to have an out. A no material adverse change, or MAC as it’s commonly referred to, basically gives a Buyer the opportunity to back out of terms or transaction altogether. For example, buyout firms backed out their purchase of Sallie Mae because they said that a MAC had occurred.
- Execution of senior management agreements (SMAs) - if the Buyer cannot agree to terms with the Seller’s key management, then the Buyer likely doesn’t want the pursue the transaction.
- Required Consents and Approvals - Any required consents/approvals from owners, service vendors, customers, etc. This shouldn’t be surprising as a Buyer needs to ensure that the company it is buying has a stable customer base. Afterall, this is the basis for which the Buyer is buying the Target.
- Provisions That Are Typically Binding - these provisions are typically binding in a LOI so let’s walk through them.
- Indemnification for Brokerage Fees – buyers do not want to be responsible for paying a Seller’s broker, or a person providing advice and representing the Seller. Again, this seems valid (although many small brokers will try to work this into the language in a NDA. As a Buyer, you need to be careful when evaluating businesses for sale as you want to make sure that you are not liable for a Seller’s fees).
- Buyer and Seller Responsible For Own Broker and Intermediary Fees - basically this just means that Buyers and Sellers are responsible for paying their own fees to those companies that are helping each evaluate and investigate the transaction. Sometimes, Buyers will pay part of an audit if the Seller is a relatively small company and does not typically have audits performed each year.
- Exclusivity – once a LOI is signed, the Buyer typically has some right of exclusivity granted. This means that the Seller cannot actively solicit other offers. Buyers obviously do not want to worry about a Seller constantly trying to find a slightly better offer during the entire process. The term is typically 30 to 45 days. Buyers will typically include language that grants them an automatic 15 day extension. The thinking on the extension is that something always arises during diligence or information takes longer than expected to gather, etc. so why not just get an extra 15 days to cover such things.
- Non-Disclosure- Buyers do not want Sellers sharing its offer with anyone unless it’s the Sellers own advisors. Buyers will usually state that a Seller needs written consent from the Buyer to disclose any information that is not required by applicable law. This shouldn’t surprise a Seller as a Seller doesn’t want a Buyer disclosing the Seller’s information except to the Buyer’s own advisors.
- Acceptance - Buyers do not want a Seller to have unlimited time to think about accepting an offer. Therefore, Buyers include a deadline for the Seller to accept. Typically, a Buyer will give the Seller one week to accept its LOI.
- Governing Law – Sellers want to have the governing law where they are based or that’s more favorable to them. Buyers obviously want the opposite. Buyers (especially investment firms) come from the perspective that they buy companies for a living and thus, they cannot be expected to be familiar with all the various states laws. Therefore, Buyers argue that the governing law should be where they are located for efficiency and practicality.
Keep Your Eyes Open
If you are looking to buy a company, you want to be sure and keep your eyes wide open. While you should generally stick with an industry you have experience with, it sometimes might be advantageous to consider companies or industries that you outside the box. If you feel you are a good operator and are able to get up to speed on an industry, then you should widen the range of industries you are evaluating.
For example, AEA investors appears to be acquiring convict monitoring company Behavioral Interventions Inc. (www.bi.com) according to Dow Jones. Not many people would actually think to acquire a convict monitoring company. We aren’t suggesting that you should try to find a similar company. Instead, we are just illustrating that you should keep your options open. If interest in a particular company is small, you may be able to get a better deal since it will be less competitive. however, you may also experience the same thing when you look to sell so be careful.
A non disclosure agreement (NDA) is a confidentiality agreement between two parties. This basically prevents one of the parties from disclosing the information specified in the agreement. This helps to ensure proprietary and sensitive material is kept confidential. This confidentiality agreement is also used in contract discussions, etc.
For example, let’s assume you are looking to buy a business. The owners of the business are going to be providing sensitive financial information to you such as earnings, customer information and employee information. Obviously, these owners expect you to keep this information confidential and not share with competitors or anyone else except your own consultants. Therefore, when you evaluate a businesses for sale, you will almost always have to sign a NDA. A NDA usually contains the following key items.
- Definition of Confidential Information
- Buyers will usually want to include language that does protect information they find out prior to or independent of any information exchange with the target. Typically, this is agreed to by Sellers. However, Sellers will try to put language in protecting against a Buyer disclosing information that is non-public even if the Buyer discovers it through independent sources.
- Non-Disclosure of Discussions
- Both Buyers and Sellers should ensure that a NDA contains language clarifying that any and all discussions between the parties regarding the transaction are confidential. This confidentiality should also ensure that the identities of both Buyers and Sellers are kept private. In addition, Buyers do not want any terms of its bids being made public so that is a typical clause.
- If the Buyer (aka acquiring company) needs financing for the transaction, there should be language allowing information to be disclosed to financing sources.
- Legally Required Discussions
- Both sides should always want language that allows each to disclose information if required by law. There should also be language ensuring each side must provide notification to one another in the event that one must disclose information.
- Return / Destruction of Materials
- This always seems to be a sticking point. The Buyer will usually want to retain a copy of all materials for any possible legal issues arising later. Basically, having a hard copy of the information allows the Buyer to demonstrate what information it was actually provided. Sellers do not like that the Buyer is going to retain its confidential information. A potential compromise could be that the Buyers legal representation retain this one copy for archival/evidentiary purposes.
- Buyers and Sellers will also differ on whether materials need to be returned or just confirmed destroyed. This should be explicitly stated so that there is no confusion.
- Non-solicitation / Employment
- Buyers want this to be as minimal as possible. Generally, the Buyer will seek to have language that only specifies “key” employees from the Seller that cannot be hired by the Buyer. This way, the Buyer or a company the Buyer already owns won’t be restricted from hiring lower level employees. In either event, it’s good practice for a Seller to ensure that anyone the Buyer meets during a process may not be hired.
- Buyers also will want a clause that allows for them to hire employees from the Seller that reply to a general solicitation (e.g., newspaper add, internet posting). Ultimately, the Seller needs to decide how hard it will push on these terms.
- Term
- Buyers want a term as short as possible while Sellers want a much longer term. The average term is between 12 to 24 months. A good compromise is generally 18 months.
A NDA also allows you to share information with your service providers (e.g., accountants, attorneys). However, when working with such providers, be sure to get a signed due diligence engagement letter.
Engagement Letter
An engagement letter is a combination of items – it’s a proposal, contract and listing of services to be provided. It formalizes the relationships between a customer (you or the person needing the services) and service provider (e.g., a consultant). Key items included in an engagement letter include the work to be performed, project deliverables (e.g., presentation, written work) and timing / structure of any payments. Engagement letters are important in several different cases – whether you are trying to buy or sell a business, hiring consultants to evaluate your industry, conduct customer surveys, evaluate new product lines, etc.
In all of these terms, it’s important to be reasonable and compromising. You need to think of what’s fair and be willing to give on points. Part of negotiating is compromising on points you don’t really need nor want, which helps to create good faith. Understanding and negotiating an engagement letter is good practice for someone looking at a businesses for sale. It could be viewed as good prep for negotiating to buy a business.
- Scope of Work
- This is a description of the work that a provider is going to perform for you. Key items discussed are deliverables and how much of the providers time is required and/or expected.
- This should include the specific deliverables the provider needs to have for you. For example, does the provider need to provide a written report? an oral presentation? both? Including these include details helps to ensure that the provider and you are on the same page. In other words, defining the deliverables helps to set expectations appropriately.
- Again, in order to set expectations for both sides, it’s important for the provider to be aware what you expect from a time perspective. For example, do you need the consultant full-time for three weeks?
- This is a description of the work that a provider is going to perform for you. Key items discussed are deliverables and how much of the providers time is required and/or expected.
- Timeframe
- Engagement letters typically reference a timeline that provides an outline of when the work will begin and any key milestones. In general, a good engagement letter outlines the following:
- When will the work start?
- When will it be completed?
- Are parts due at different time? If you want key datapoints or summaries during the project, you should be sure to include that in the engagement letter. First, it helps to make sure you are receiving good information and a good check that the provider is doing good work.
- What are you expecting from the provider in terms of response times to your requests? What happens if the provider is late in responding to requests, etc.? these should be clearly outlined in the agreement, particularly the penalty for lack of response.
- Engagement letters typically reference a timeline that provides an outline of when the work will begin and any key milestones. In general, a good engagement letter outlines the following:
- Fees
- It is important to outline the fee structure for the project since you don’t want any misunderstanding over how provider is compensated. Key concepts defined in the fees section include:
- What’s the billing methodology – hourly, fixed fee, daily, contingent? Is it some combination? Is it something completely different?
- How much does the project cost? Or, how much is it estimated to cost? It’s important to get an estimate for the number of hours the provider expects the project to take.
- In addition, it’s a good idea to include language that requires the provider to alert you if it expects to exceed the estimated time (especially if the provider’s compensation is based on hourly rates).
- It is important to outline the fee structure for the project since you don’t want any misunderstanding over how provider is compensated. Key concepts defined in the fees section include:
- Travel Expenses
- Are travel expenses included or billed separately? For example, is travel time included in the billable hours (if methodology is hourly)? Again, you want to be sure you are on the same page with the provider so be precise is outlining what is included / billable.
- Will the provider receive any reimbursement for out-of-pocket expenses (e.g., special equipment, industry consultants, supplies, etc.)? Again, be specific as this will help to ensure that everyone is on the same page.
- Payment Terms
- Providers want to know how and when they are going to get paid. Key points addressed typically include:
- Is a deposit required before the provider will start work?
- What’s the timing of payments? Are there any key milestones or project deliverables that must be met before a certain payment is made to the provider?
- Examples include (i) completion of project milestones, (ii) fixed time schedule, (iii) end of project?
- Do you receive any discount for early payments? It cannot hurt to inquire when trying to negotiate and engagement letter. Some providers may provide a discount because you are paying ahead of schedule.
- Additional fees assessed for missed / late payments? Obviously, providers want to get paid in prompt fashion so they will want to include a fee for missed or late payments. It’s up to you to make sure the late fees are reasonable.
- Providers want to know how and when they are going to get paid. Key points addressed typically include:
M&A Basics
There is a general process that holds true for M&A processes. For purposes of this discussion, we will be taking the potential buyers point of view. This walk through is of course a simplified, high-level walk through but it should provide a useful base. We will be adding more details and examples around the M&A process soon. If you are already familiar with the M&A process, then skip to the businesses for sale. The M&A process can be broken up into a couple segments as shown below. The M&A process includes several documents including:
- Non Disclosure Agreement (NDA)
- Engagement Letter
- Indication of Interest (IOI)
- Letter of Intent (LOI)
- Purchase Agreement (APA, SPA, PA)
- Escrow Agreement
- Senior Management Agreement (SMA)
- Source the Deal. Potential buyers must source deals so they have targets to acquire. To source deals, investment professional utilize several channels including intermediaries, investment bankers, family and friends, etc.
- Execute NDA. Once a deal is sourced, a Non Disclosure Agreement (NDA) should be executed before any information is exchanged.
- Information Exchange. Receive basic information from target, including financial statements, customer concentration, etc.
- Evaluate Investment. Now, the deal must be evaluated against the investment criteria set forth. Does the deal meet your investment objectives? If not, this is the end for this particular process. If the deal does, we proceed to the next step.
- Submit a Letter of Intent (LOI). This document provides an initial indication for the target. If your initial indication is sufficient, you will proceed to the next step.
- Conduct due diligence. This is a catch-all for all the analysis that you have to perform to get comfortable with the deal. Areas of due diligence include the following below. If the due diligence all checks out, you will proceed to documentation.
- Financial Due Diligence - typically, a buyer will hire accountants to perform detailed financial due diligence. The accountants verify the process and procedures of the target’s accounting controls and ensure the accuracy of the financial statements. In addition, the buyer often has the accountants analyze the financials of key clients.
- Business Due Diligence – the buyer usually has its own managers and operators conduct the business due diligence.
- Insurance Due Diligence - buyer has insurance benefits provider review the target’s current benefits and insurance plans. The insurance benefits provider may identify some areas for cost savings or identify potential issues that could lead to increased expense later.
- Legal Due Diligence – buyer has its lawyers review the target’s existing customer contracts, supplier agreements, employment agreements, any intellectual property, patent wards, etc.
- Technology Due Diligence - If the target has a large technology component to it, the buyer will review the target’s existing technology (either uses someone in-house or hires a consultant). This is to verify that the technology is legitimate and worthy of the consideration the buyer has agreed to pay.
- Customer Due Diligence – A target is generally extremely apprehensive to have its customers talk with potential buyers until the target is 100% certain the transaction is going through. Therefore, customer due diligence usually doesn’t happen until just before the transaction closes. Obviously, this will vary depending on buyer and target, etc.
- Legal Documentation of Transaction. Documentation is the legal documentation of the transaction and includes all associated agreements with the closing. Generally, documentation begins during the due diligence once it seems likely there are no issues. The reason the buyer waits is to avoid large legal bills resulting from the documentation. The key documents include the following below. Sometimes deals may fall apart during the documentation phase.
- Purchase Agreement - outlines all aspects of the transaction in painstaking detail – who is getting paid what, how much, when, employee roles and compensation, etc. We will be providing a detailed walk through of an purchase agreement soon.
- Escrow Agreement – outlines how much of the transaction consideration is being held back and for how long. It’s typical for buyers want to hold back part of the transaction proceeds and deposit it into a bank account to earn interest while waiting for one full audit cycle. This is done to help protect the buyer against any issues that may arise post-closing. Again, amounts may vary widely depending on the size of transaction, customer concentration, if the owner is going to be continue to be involved.
- Senior Management Agreement (SMAs)- a buyer will want to execute SMAs with key employees of the target. This is to ensure that they are incented and fully aligned with the buyer and cannot leave to help a competitor.
- Stock Option Plan – legal documentation of a company’s stock option plan.
- Equity Option Award - outlines the number and vesting schedule for equity options for plan participants. Again, buyers use equity option awards to incent and retain key employees.
- Closing and Transfer of Funds. If no issues arise during documentation, the deal is completed. Now, the hard work begins as the buyer must now operate the new company effectively to earn a good return on its investment.
Documents & Terms
There are several documents that you should be familiar with if you are involved in buying or selling a business. These include those mentioned above (NDA, IOI, LOI, APA, SPA, SMA) as well as others. View are overviews of merger and acquisition documents and terms that are used to buy or sell a company.
Types of Review of Financial Statements
There are several different tasks an accounting firm or auditor performs for a company. When you are considering buying or selling your company, you should want audited financials as these are the most detailed and provide the most comfort in terms of the financials. View our explanation of the types of review of financial statements.
