Ready to sign that letter of intent (LOI)? When you're selling your business, after all the negotiating is done, a buyer will put forward an LOI for you to sign. This is when things really get serious, so you need to be sure you want to take this step.
So what is an LOI and what happens after you sign one? We'll let you in on the six main components of this key document.
The Six Components of an LOI
- Identifies the Buyer
Typically, the buyer is an operating company or a new holding company incorporated for the purpose of completing the transaction. When assessing the buyer, business owners need to ensure that any company making an offer has the financial backing and capabilities to complete the transaction.
- Identifies the Type of Transaction
The letter of intent will state whether the transaction is being completed as a share or asset deal. Each type of structure has different due diligence and tax implications for the seller. The LOI will also identify what assets and operations are being purchased and if there are any redundant assets, such as real estate or working capital, that are not part of the deal.
- Documents Purchase Price and Consideration
Sellers get stuck on the enterprise value or purchase price. It's human nature to want to know this number, but it's not what the business is ultimately worth. That aside, it's just as important to understand how you will get paid. The best way, of course, is all cash, but buyers very seldom do this. The consideration may be all or some in non-cash remuneration such as equity in the acquiring company, vendor take back financing, an earnout, etc.
- Sets the Buyer's Conditions Precedent
A buyer will likely have a number of conditions on the LOI that need to be satisfied before closing. Examples of two major conditions for capital-intensive businesses include: 1) that a certain level of non-cash working capital be delivered and 2) that an asset appraisal be done to satisfy a specified fair market value (FMV) for the capital assets. The buyer is looking to substantiate the tangible net assets of the business and minimize the goodwill paid. A smart buyer will include the required net working capital and FMV of capital assets that are to be included as part of the deal in the letter of intent. There may be a "dollar for dollar" reduction in the purchase price if working capital or capital assets don’t match the values pegged. A smart seller will ensure that this clause also allows for an upward revision dollar for dollar (not just down, but up as well) if a higher value of working capital or capital assets is delivered.
- Discloses Due Diligence
There are three objectives to due diligence: 1) to vet valuation assumptions, 2) to identify the cost savings or revenue-increasing opportunities of the combined entity, and 3) to identify any "hair" your company may have that may reduce the purchase price. The due diligence process can be exhaustive, so being organized and knowing what to expect is a must. If you know there are issues with the business, it's a good idea to disclose them early, but be prepared to defend the price you are getting for your company regardless. Preparing the due diligence package will be time consuming, so you need to allocate time to prepare and compile an adequate package.
- Specifies Timing and Closing Steps
A quick close is always better than a slow close. Experienced and motivated buyers are able to close a transaction in 45 to 60 days after the LOI is signed, but a more typical timeline is 90 to 120 days. The letter of intent will specify key milestones such as the receipt of the due diligence package (a seller needs to build the preparation time into the timeline), receipt of a purchase and sale agreement for review, receipt of employment and/or non-competition agreements for managers and principals, and the proposed closing date. Make sure that your entire deal team is aware and committed to this timing, since delays may create undue stress for both the seller and the buyer.