The following article is part of a series of articles on “The Anatomy of a Deal”. This article is co-authored by Eric Duffee, Director and Co-Chair of the Mergers & Acquisitions Practice at Kegler Brown Hill and Ritter, and Josh Curtis, Managing Director of our Investment Banking Affiliate, Footprint Capital, both of with whom GBQ Partners has done a number of transactions.
Most people have a good functioning understanding of a letter of intent (oftentimes shortened to “LOI”); it’s a non-binding expression of the intent of two (or more) parties to pursue some transaction. Simple stuff, right? And if it’s non-binding, who cares if we get something wrong? We can just fix it later, right?
Well, maybe. It’s true that an LOI – if properly constructed – doesn’t bind you to deal terms that can’t be changed, but LOIs are critically important for both Buyers and Sellers and require expert advice from the outset, primarily for three reasons:
- Ensuring that certain portions of the LOI actually are legally-binding while ensuring that others are not legally-binding;
- The LOI represents an important stage in the parties’ relative leverage, and failure to recognize and preserve that leverage in the LOI may result in a lost opportunity; and
- A well-constructed and properly detailed LOI serves as a springboard for the quick and efficient completion of the deal by ensuring alignment on key points that (hopefully) won’t have to be negotiated later.
Many times the business principals decide to negotiate the LOI on their own and only then present the final letter of intent to their advisors to “paper” the deal. Unfortunately, the result of this approach is that the LOI sometimes lacks key terms that perhaps should have been negotiated in to preserve leverage and to facilitate the most efficient completion of the deal. Additionally, many LOIs negotiated between principals lack specificity, which can lead to varying perspectives as the deal advances – often causing one or both parties to be dissatisfied, or the deal to not reach closing.
So, if the goal is to use the LOI as a catalyst for a successful deal, just what exactly should go in the LOI? We’re glad you asked.
1. Purchase Price, Payment Terms, and Assumptions.
This one seems obvious. After all, what’s the point of even having an LOI if it doesn’t address the price? What might be overlooked, however, is how much detail is necessary regarding the price. Will the price be paid entirely in cash at closing? If not, what are the payment terms? Is the Buyer financing the purchase price? If so, it’s important to make clear that the purchase price is dependent upon the Buyer obtaining the necessary financing. Alternatively, from the Seller’s perspective, if the Buyer says they don’t need outside financing, it’s a good idea to spell that out in the LOI, especially when the Seller is considering competing offers that are contingent upon outside financing.
If any portion of the purchase price involves Seller financing, deferred payments, and/or earn-outs (e.g., purchase price that is contingent upon some post-closing event – we will cover these in more detail in a future installment of this series), then it’s critical to spell these out in the LOI. With Seller financing or deferred payments, the LOI should at least describe the interest rate (if any), the payment terms, maturity date, and any guarantees or security for the loan. For earn-outs, the LOI should include even more detail about how the earn-out is calculated, when (and how) it’s paid, what events (if any) might result in the earn-out being either forfeited or accelerated, and what rights the Buyer and Seller have post-closing with respect to information and operational matters that affect the earn-out. Negotiating these key terms up front in the LOI may seem like a roadblock, but our experience has shown that reaching alignment on these key terms at the LOI stage will most often result in a more efficient closing, as these items won’t be addressed for the first time only when the first draft of the purchase agreement arrives.
Finally, it’s common to include a basis on which the purchase price was calculated. For example, if the purchase price is a 5x multiple on the target’s annual EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), then stating this in the LOI gives the Buyer a basis for adjustment to the purchase price if its due diligence shows that the target only produced $500,000 in EBITDA, rather than $1 million. It also helps the Seller understand how the Buyer arrived at its purchase price for the business.
2. Transaction Structure.
Transaction structure is almost as important as the purchase price and has a direct effect on the economics of the deal. As such, both Buyers and Sellers should be certain to address structure in the LOI.
Most acquisition transactions are structured as stock purchases, asset purchases, or mergers (which can be either “forward” mergers or “reverse” mergers, each having different consequences). And there are further possible variations with respect to each structure. Each of these transaction structures carries with it differing treatment for tax purposes, as well as legal distinctions that can have an impact both on risk-allocation between the parties and speed/certainty of closing.
For example, an asset purchase is often viewed as Buyer-favorable, because the Buyer gets to “write-up” the purchase price for tax purposes – which permits additional future tax depreciation deductions by the Buyer – and also gets to pick-and-choose the specific assets and liabilities it is acquiring, leaving the rest with the Seller to deal with. On the other hand, Sellers often prefer a stock purchase as the entire purchase price is taxed at more favorable capital gains rates for the Seller, and the Buyer purchases all of the assets and liabilities of the business, leaving the Seller with a clean break. In addition, a stock purchase usually reduces the number of third parties who have to consent to the deal, which provides additional speed and certainty to closing.
While these general rules often hold true, there’s no one-size-fits-all transaction structure that’s right in every case. In any event, the LOI negotiation is the right time to address these key issues before going too far down the road toward a deal.
3. Purchase Price Adjustments.
Most deals involve some adjustment to the purchase price. Oftentimes, these adjustments take the form of a “working capital” adjustment which is designed to ensure that the Seller delivers a “turn-key” business that’s ready to operate on Day 1 without immediate additional investment by the Buyer post-closing. In other words, the Buyer’s payment of the purchase price assumes that the necessary ingredients will be there immediately after the closing to permit the Buyer to run the business in the same manner as the Seller. While Buyers are generally accustomed to working capital remaining in the business, first-time Sellers, on the other hand, do not always understand why giving up accounts receivable generated under their ownership is customary. It may take some explanation and time to ensure the concept is properly understood.
While the theory of working capital adjustments is fairly straightforward, there is opportunity for Buyers or Sellers to game the system to their advantage. It’s generally a good idea to spell out how working capital will be calculated for the acquired business, as well as the appropriate “target” against which closing working capital will be measured. If we can’t determine the target right now, then it’s at least advisable to describe how you’ll set a target.
For example, in many deals, the working capital target is a historical average of the monthly working capital over the preceding 12 month period. It is broadly defined as current assets minus current liabilities excluding cash and any current portion of debt owed. That said, this doesn’t work for all businesses. So, it’s important to make sure everyone is on the same page about how working capital, and the working capital target, will be determined to avoid nasty surprises down the road.
We talked more about closing adjustments in last month’s installment of this series.
4. Indemnification Terms.
On this topic, we veer even further into the world of items that most business principals aren’t even thinking about when striking a deal. However, these terms are critically important to both Buyers and Sellers. For Buyers, it’s important that they have some comfort about the risk they’re taking with respect to any unwelcome surprises that are revealed after closing. For Sellers, the goal is not only to receive the full purchase price, but also to keep it.
We’ll go more in-depth on indemnification limits in a subsequent installment of this series, but essentially, the LOI should specify what recourse the Buyer may have for claims after the closing, how those obligations are funded, and what limitations apply. For example, does the Buyer expect that a portion of the purchase price will be held back by the Buyer or placed into escrow with a bank or other third party to fund post-closing claims? If so, how much of the purchase price is held back or placed in escrow, and when will those funds finally be distributed to the Seller?
The limitations are often an area of heavy negotiation, but the market for acquisition transactions gives us some guidelines. Limitations generally fall into three buckets: (1) time limits during which the Buyer may make a claim against the Seller for claims relating to pre-closing periods (known as “survival” periods); (2) thresholds that must be reached before the Buyer may assert such a claim (known as “baskets”); and (3) the maximum aggregate liability of the Seller to the Buyer for such claims (known as “caps”). There are many different permutations of each, and many exceptions that apply. But, especially from the Seller’s point of view, it’s extremely important to pin down the key limitations – and the key exceptions – in the LOI. Otherwise, the Seller will be negotiating these key terms at a point in time when the Buyer has greater leverage after being granted exclusivity (as described below).
5. Post-Closing Arrangements.
This category captures all kinds of things that might be relevant in a given transaction. For example, many transactions require a non-competition agreement from the Seller. If so, the LOI should specify the duration, scope and territory. In addition, the Buyer may require some post-closing assistance from the Seller. The LOI again is the right place to outline the key requirements and any related costs.
In some deals, post-closing employment and compensation arrangements with the Seller or certain key employees are important conditions to the successful completion of the deal. These key requirements should be specified in the LOI. In addition, if the Seller is retaining certain assets (e.g., real estate) that the Buyer will need post-closing, the LOI is the right place to outline the key terms of those arrangements.
As this particular area can cover so many things that may or may not be relevant in a given deal, both Buyers and Sellers should ask themselves the following simple question: “What are the critical items I need for me to be willing to do the deal?” Whatever they are should be specified in the LOI.
The first 5 items describe deal terms that are generally “non-binding” in the LOI. But, the LOI usually does include certain binding terms, and one of the most important of those binding terms is the exclusivity provision.
Smart Buyers aren’t interested in investing the time and resources necessary to complete exhaustive due diligence on the target company and fully negotiate a transaction without (1) conceptual alignment on the important deal terms, as described in the LOI; and (2) an agreement from the Seller that it’s not going to be negotiating with other potential Buyers in the meantime. The exclusivity provision formalizes this second point: the Seller is agreeing that, for some period of time after signing the LOI, the Seller will not negotiate, discuss, or pursue a transaction with another prospective Buyer.
Just as this is an important term for the Buyer, the Seller must be equally focused on what this means. Once the Seller grants the Buyer exclusivity, the Seller loses – for some period of time – its most important piece of leverage: the option (or at least the threat) of doing a deal with someone else. As such, the longer the survival period, the more leverage swings in favor of the Buyer.
Typical survival periods may run anywhere from 30 to 90 days after the signing of the letter of intent. Once the Seller grants exclusivity, the Buyer no longer has much concern that the Seller might walk away to pursue another deal. Moreover, if the Seller engaged in a competitive “auction” process to find a Buyer, the longer survival period will make it difficult for the Seller to keep the runners-up on the hook in case things don’t work out with the chosen Buyer. As such, smart Sellers (1) negotiate to keep the exclusivity period as short as possible; and (2) include protections that will terminate the exclusivity period immediately if the Buyer tries to change the key deal terms outlined in the LOI (another good reason to insist on a sufficiently-detailed LOI), does not complete due diligence milestones in predetermined periods of time, walks away from the deal, or is unable to finance the deal.
7. Confidentiality (Sometimes).
Before sharing any information, the Seller should always insist on a robust and binding confidentiality agreement with the potential Buyer. The importance of this is obvious. In most cases, there will be some exchange of confidential information in advance of an LOI. As such, the confidentiality agreement should already be in place pre-LOI and should only be referenced in the LOI. If, however, the parties have not yet entered into a confidentiality agreement, the LOI should include legally-binding confidentiality obligations that explicitly protect information shared both before and after the date of the LOI.
Finally, the LOI should include a termination provision. In most cases, either party may terminate the LOI and walk away from the deal without obligation simply by notice to the other. In addition, most LOIs will provide for automatic termination in the event the deal doesn’t close by a specified “outside date.”
A carefully-constructed LOI will make clear that neither party will have liability for termination of the LOI, and, consequently, the negotiations regarding the potential deal. Failure to be crystal clear on this point could lead to nasty surprises when the spurned party calls up their litigator.
What happens to the binding provisions of the LOI upon termination? The confidentiality obligations – whether specified in a separate agreement or in the LOI – should always extend beyond termination. Once in a while, you’ll see an LOI in which the exclusivity provision terminates along with the LOI, but more often the full exclusivity period runs even after termination (unless the termination is due to the Buyer’s breach, proposal to change the key deal terms, abandonment of the deal, or inability to obtain financing). Buyers generally don’t want the Seller to have the unilateral ability to terminate exclusivity simply by terminating the LOI.
As you can see, structuring an LOI isn’t quite as simple as scratching out the purchase price on the back of a napkin. And an inadequate LOI could, at best, cause additional time and expense, or, at worst, lead to potential litigation if things go south between the parties. But if properly constructed, the LOI can provide much-needed certainty for both Buyers and Sellers, limit conflict as the deal advances, and streamline the process of getting to a successful closing. As such, investing time and effort on the front end while preparing the LOI can save time, money, and headaches later down the road.