Anatomy of a Letter of Intent
A primer for business owners on terminology commonly included in a letter of intent.
Most small business owners only sell a company once, so the process of selling a company can be opaque... to put it kindly. One of the most difficult steps can be understanding and negotiating a letter of intent—the document that outlines the terms and conditions of an offer from a buyer and to a seller.
This article will attempt to explain, in plain English, the components included in the letter of intent that our firm would issue to mid-market business owners. Here is a sample Hadley Capital LOI that can be used as an illustration.
Structure of Transaction
Right up front, our letter of intent states that Hadley Capital is buying the target company’s assets. The vast majority of businesses in the U.S. are S corporations, and the seller of an S Corp is generally neutral (in terms of taxes) regarding a sale of assets or a sale of stock. However, a buyer benefits from buying assets instead of stock.
In this sample letter of intent, Hadley Capital is offering the seller total sale proceeds of $5.0 million: $4.0 million in cash plus a seller note of $500,000 and a consulting and non-compete agreement of $500,000. A large percentage of small business sales include some form of seller financing—in this case a seller note and a consulting and non-compete agreement. While overall market estimates vary, nearly all Hadley Capital acquisitions include a small portion of seller financing.
Assets Being Purchased
All of the assets required to operate the business are sold including hard assets (like machinery), operating assets (like inventory) and intellectual property assets (like customer lists). Certain assets may not be included in a sale, such as buildings and land (a buyer may elect to rent the existing facility from the seller) and personal assets like cars and boats. In most asset transactions, the sale is structured as a debt-free/cash-free transaction where the seller keeps all debt and all cash.
Liabilities Being Assumed
Again, like most asset purchases, the only liabilities acquired by the buyer are accounts payable. All other liabilities, whether known or unknown, stay with the seller. For example, a seller would be required to repay all debt, settle all accrued vacation and paid-time-off pay, etc.
Purchase Price Adjustments
Let’s start with the easy one first; this asset transaction is structured as a debt-free/cash-free transaction so the Net Debt adjustment is meant to clarify what is considered debt and, therefore, remains an obligation of the seller not to be acquired by the buyer. If the buyer has to settle any debts, the purchase price would be reduced by these amounts.
Working capital adjustments are used in nearly all transactions to adjust the purchase price for movements in the working capital accounts (usually accounts receivable, inventory and accounts payable) between the execution of the letter of intent and closing. A working capital adjustment is designed to ensure that a business is sold with an appropriate level of working capital (usually defined as the working capital target). It is not designed to benefit or penalize either the buyer or seller.
Sources of Financing
Disclosing the sources of financing is intended to provide the seller with comfort that Hadley Capital has the expertise and resources required to finance the acquisition. If a buyer will not or cannot provide specifics regarding their proposed sources of financing, a seller should question that buyer’s ability to complete the acquisition.
Conditions to Closing
This portion of the letter of intent highlights the expectations and obligations of both the buyer and seller and are often specific to the circumstances of the individual business. The conditions also outline important procedural items from due diligence to financing to negotiating legal documents (like a definitive purchase agreement).
Buyers and sellers agree to a 90-120 days of exclusivity in order to focus their efforts on the steps required to get from a letter of intent to a closing. Generally, these steps include due diligence, financing and legal documentation. Hadley Capital typically closes a transaction 90 days after signing a letter of intent.
Good Legal Advice
This summary serves as a primer for business owners contemplating a sale of their business or actively negotiating a letter of intent. It's obviously not a replacement for good legal counsel in a sale transaction... a topic probably worth of yet another article.