Surprisingly, there are many similarities between signing an apartment lease and a letter of intent. They relate to risk reduction, the balance of power between the parties to the transaction and the level of experience of the buyer and seller.
Why Would I Sign This Document?
As a seasoned business owner, If you were to read an apartment lease today, your reaction would probably be, "Why would I sign this document with everything possible favoring the landlord?” Thinking from that perspective, let's compare this to an unsolicited letter of intent to buy your company.
It's All About Risk Reduction
The apartment lease accounts for everything that could possibly go wrong between landlord and tenant and makes the contractual outcome favor the landlord in every case. From rent late fees to security deposits to notice requirements to stains on the carpet, these agreements cover it all. The landlord is completely protected for every eventuality and bears very little risk from this relationship — to the extent that the landlord writes the contract to reduce her risk, the tenant is the recipient of this risk.
Business Buyers Have the Experience
Just like the apartment lease, the letter of intent is written by the experienced party. The landlord has completed hundreds of successful rentals, while the renter is a novice. The buyer has likely acquired several companies and attempted to acquire dozens more, while this is likely the owner’s first sale. So just like the apartment lease favors the landlord, the letter of intent is written to the advantage of the buyer.
A Non-Binding LOI Provides the Buyer Plenty of Wiggle Room
The first clue is that it is a non-binding letter of intent. During the early stages of the mergers and acquisitions process, limited financial data and high level customer information is exchanged. This enables the buyer to judge whether or not the company is a good fit and meets their acquisition criteria. If the buyer wants to proceed further, they produce a letter of intent that requires a buyer sign-off and guarantees that the seller will not shop the deal while due diligence is completed. This is fair, because both parties will invest significant resources going through due diligence. The due diligence period typically lasts from 45 to 90 days and is exhaustive. The principal of the letter of intent is to spell out the terms and conditions for the acquisition, pending no due diligence surprises that are material to either the value or the risk of the transaction.
Buyers Often Abuse the Due Diligence Process
Buyers have their team of experts, usually consisting of internal resources, plus an outside accounting firm and legal counsel. They instruct their outside accountants to perform a quality of earnings report. This is where the abuse comes in. In its purest form, the quality of earnings report is a check and validation that the information they based their purchase offer upon is accurate and correct. At its most unsavory, it is the buyer instructing the accounting firm to render opinions that are designed to attack the value and terms originally set forth in the letter of intent. Deep into this exhaustive process where the competitive bidders are long gone and the seller is experiencing deal fatigue, the buyer will use these "expert opinions" to require price adjustments to the deal.
On top of that, they play brinkmanship: If you don't agree, we walk away. These professional buyers are emotionally detached from this transaction, unlike the sellers. They will just move on to the next one if they don't get what they want. The seller can either cave in and take a haircut or walk away from a deal they have invested six months of emotion and effort into.
The Buyer's "Experts"
One quality of earnings report we experienced was an opinion that the benefits package for the employees was below market. To get it up to market would cost $100,000 and, since our purchase price was based on a 5 X EBITDA multiple, we are dropping the purchase price by $500K. It was completely arbitrary and not accurate to compare our small market client with the Boston market compensation package. Our client's benefits package was reasonable and customary for their current market. On another transaction, the quality of earnings opinion was that last year's growth was unusual so we are just going to normalize EBITDA over the last 3 years to take a $750 K adjustment to our current purchase offer. Forgive my French, but total arbitrary BS.
The Power of Options
Back to our apartment lease comparison. Why this behavior? The landlord has plenty of other renters waiting in line for the apartment. The buyers typically have multiple acquisition interests in process at any one time. If you don't like our terms…. Next!
Counter Offer With Precise Language
Much of this balance of power trouble for the business seller can be avoided with an intelligently worded letter of intent negotiated prior to agreeing to dual signing it and taking your company off the market. Once the LOI is signed, the price and terms never improve for the seller — they only go in one direction that favors the buyer. So, oftentimes during due diligence, the performance of the business will suffer because the owner and CFO are distracted by all of the demands of the deal. The experienced buyer will often demand a change in purchase price based on this drop in performance.
If they are going to operate this way, why not turn the tables around? You could counter offer the language in the letter of intent with, "The purchase price is based on a multiple of EBITDA of 5.34 times. Based on the September 30th trailing twelve months that reference purchase value based on $1.0 million of EBITDA is $5.34 million. For the final purchase price, we will use the trailing twelve months to the closing date EBITDA X 5.34.” The buyer should not be able to reasonably disagree with this. It is like a mutual NDA: What is good for one is good for both.
Net Working Capital Is a Key Buyer Target
Another poorly worded clause (in favor of the buyer and to the detriment of the seller) in the letter of intent is about setting the level of net working capital. The typical LOI clause prepared by the buyer's experts is: This proposal assumes a cash free, debt free balance sheet and a normalized level of working capital at closing. And, of course, they try to leave this open so that they have huge wiggle room for their quality of earnings report opinion which may set the level arbitrarily at $600,000 late in the due diligence process.
Being a savvy seller, you’re going to enter competitive negotiations and give a counter proposal of $200,000, for example, and define how you will calculate it. Tips and tricks like this can be learned (over time and with some cost) or can be hired out in the form of an advisor; either way, the seller has more options than the buyer wants you to think!
Be Careful With Earn Outs
Another area where the sellers potentially get their pockets picked is clever expert language. It has to do with earnouts. Often the buyers will put an all-or-nothing earnout condition that says, for example, the seller must grow revenues by 10% per year to get the earnout and if the seller falls short, she receives nothing. A better way for the seller is to calculate a factor to multiply each year's revenues by in order to arrive at the earnout payment for that year. For example, total revenues X 0.11.
One additional earnout trap is the multiple conditions earnout. You have to achieve a specific revenue growth target plus a profit goal in order to receive the earnout. This is terrible for the seller because, first, a multiple condition earnout is very hard to consistently hit and, second, once you sell your company, controlling the profitability is much more difficult due to such factors as corporate overhead allocation.
So if you are negotiating the sale of your company, try to change the dynamic from that of an apartment renter to one of a commercial real estate lessee. You can balance the power by seeking several competitive bids, employing experts who know the industry norms and the market, and through the use of counter offers that add clarity and precision to the terms and conditions written into the original letter of intent by the buyer's team of experts.