The day you receive your first LOI is pretty special. Regardless of whether the offer is too low or right in your ballpark, someone on the outside perceives value in the company you have spent years building. It’s basically an outside validation of your efforts that someone is actually going to give you hard, cold cash (amongst other things) for your years of effort. Of course, you may have already gotten an IOI, (see my earlier post on that), but an LOI is more serious and really gets down to the nitty gritty.
If you are NOT currently in the market, this post is still for you as you never know when an unsolicited offer may come your way, and you want to be educated and prepared for that moment.
For those of you who need a brush up on what an LOI is:
A letter of intent (LOI) is a document declaring the preliminary commitment of one party to do business with another. The letter outlines the chief terms of a prospective deal. Commonly used in major business transactions, LOIs are similar in content to term sheets. One major difference between the two is that LOIs are presented in letter formats, while term sheets are listicle in nature. The concept is similar to a head of agreement (common term in the UK), term sheet, or memorandum of understanding (MOU).
I am not going to get into what an LOI should cover (there are plenty of posts on that on the internet), but you can download a sample LOI (specific to our industry) as it might be useful to follow this post better. Be sure to read this post to the end as I talk about a must do before signing the LOI and how to approach it.
Top questions regarding the LOI from sellers (buyers pay attention too)
Ok, so you have this wonderful document in hand, but now what? All sorts of questions start popping up in your head, so I will address the most common ones here:
- Is the LOI negotiable? A: Yes of course. Not only are the terms negotiable, but you might want to add or change components in the document. In the sample download, I address nine key sections that you should have in every LOI: transaction overview, financing sources, proposed timeline, due diligence timeline, employment and non-compete terms, buyer required approvals, exclusivity, non-binding language, and governing law. This is really the time where you want to get all parties on the same page with the big deal points. Once the LOI is signed, the attorneys use this as their guide for drafting the definitive agreements.
- How long can you sit on the LOI? A: Many LOIs contain a termination date and time so you will want to abide by that. Others do not. Even if it does not, the LOI isn’t going to be available forever. If you are in a situation where you are expecting one or more other LOIs and you are trying to buy yourself time on this first one, then start asking for changes which can slow the process down a bit while you wait for your others to land.
- Should I have my attorney and/or M&A advisor review it? A: Absolutely. You want your advisor to review it to make sure it is not missing big components or contains language that is ambiguous. You will want your attorney to review it for definitions, clarity and governing law at a minimum. Here is a real example: Not that long ago, I was brought into a transaction where the seller had just received an LOI and was super happy with the terms he had negotiated thus far. He brought me in to mainly help with the definitive agreement. I took one look at the LOI and told the seller he needs to fix 5 things, the most important being that the earnout was written as an all or nothing. This means that if the seller missed the mark by just $1, he would lose millions. He never caught that until I pointed it out. Even if you think you have caught everything on your own, another pair of “experienced” eyes, might still find an issue or present a further opportunity (like an upside to an earnout).
- What if it doesn’t have all the terms you suggest? A: Have your attorney or advisor add them. Remember, just because you didn’t draft it doesn’t mean you can’t add components to the LOI. Recently I had to send back an LOI from a large investment banker because it was so vague and so short on details. I graciously gave them a list of all the items I wanted included and told them to resend when complete. This is NOT a time to be shy about asking for terms. Going into a purchase agreement without the major items flushed out in advance on the LOI could spell disaster later.
- How long can I expect to wait to get a final version of the LOI? A: I have seen LOIs take up to a month to work out between both parties. Timing depends on complexity and the time available by both counsels to make the changes. Regardless of how much time it takes now to produce a final LOI, I promise it will save you time and money later when it comes time to draft the definitive agreements. So don’t stress on how long it takes. Remember, you are not looking for all the specific legal language, but instead an outline of the major deal points.
- What if the buyer wants to proceed without an LOI? A: This oddly is not an uncommon occurrence, especially if the buyer and seller know one another well or relatively well. It is also common if the buyer knows they are the only one you are speaking with. This exact thing happened to me on the sale of one of my companies where I knew the buyer well. In the end, my attorney drafted the LOI, and they responded with their changes and redlines. Don’t be shy to be the one that provides it if the buyer does not. In most cases, you do NOT want to enter into an agreement without an LOI in place. You might also consider how real the offer is from the buyer if they don’t produce an LOI. But also consider that the buyer may never have made an acquisition before and may need some assistance, so feel free to provide your own.
- What if the LOI doesn’t have an exclusivity clause? A: This is very, very unusual. I am not entirely sure I would point that out if there isn’t one there already. However, I would suggest getting counsel’s advice on that one. You may also need to look at the specifics of the deal, so I don’t want to give you a generalized response.
- What about a breakup fee? Should I ask for one? A: First off, a breakup fee (or reverse breakup fee), also known as a termination fee, is a cost that happens if either the buyer or seller backs out of the deal. It gives compensation to the potential purchaser/seller for the time and resources they used to create the deal. Breakup fees are usually between 1 and 3 percent of the deal’s total value. That said, I don’t see too many breakup fees for deals less than $25M in value, but as the value of the deal increases and the possible disruption to the seller’s business grows, you’ll want to make sure the exchange includes a breakup fee. Finally, you might also consider a breakup fee if you have multiple buyers, and you know you will lose your second choice if this deal doesn’t happen (due to timing or other aspects). In that case, I would also include a breakup fee.
I am sure there are a number of other questions that may arise as part of the LOI negotiation process, but at least you are now armed with the answers to the question most sellers and buyers ask.
The Bonus Section
I am always surprised at how many sellers do not ask for “proof of funds” before they commit to an LOI. You wouldn’t commit to selling your house these days without proof of funds from the buyers, so why would you consider selling your company without one, right? Trust me, sellers are always shy to ask. If you are not being represented by a broker (and even if you are) demand proof of funds before you sign the LOI. You don’t want to head down a path of due diligence for two or three months and find out the buyer doesn’t have the money. Yep, that’s happened more than once to unbeknownst sellers.
Even as an M&A advisor, I don’t like asking for proof of funds, especially from larger buyers, but it is something I never forget to do. And it’s not just the P&L I ask for; it’s the balance sheet too. Remember the skeletons can be found on the balance sheet in the form of little cash, high receivables, high payables, or numerous outstanding loans, all of which can bankrupt a very profitable company (as it appears on the P&L). So here is my line……. “Hey guys, I need to “paper my file” so please send me over proof of funds”. Simple, easy, it’s nothing personal; just part of the process. It works every time. If someone is giving you a hassle about it, make it clear you won’t proceed with signing the LOI until it is available for review. Oh, one last tip: don’t accept just a note in an email. You want it on letterhead and signed by an authorized company representative.
Well, this certainly turned out to be a much longer post than normal, but I hope you can pull a few nuggets from here, or at least begin the process of better understanding what to expect with a Letter of Intent.Feel like you have a handle on this? Then head over to my M&A terms quiz to really test your grasp on terms.
The Good and Bad of an IOI