After the confidentiality agreement, the Letter of Intent is the next step in the sale of a business and is intended to be a non-binding document which outlines the material deal points of the transaction. Sellers want to know what the material terms of the offer are, and Buyers want to know that their offer will be accepted, before substantial resources are devoted to investigating the feasibility of the transaction. This article explores common provisions found in a Letter of Intent for a business transaction.
Most Letters of Intent include the purchase price. It is the components of the purchase price that need to be addressed. Is a portion of the purchase price paid into an escrow to insure a fund from which the Buyer can recover for a breach of a representation and warranty? Is the portion of the purchase price deferred or subject to an earnout where the business must meet certain revenue or earnings targets post-closing? In addition to putting these funds at risk of not receiving them, the escrow is commonly ten percent of the purchase price and the deferred payments and earnout can be substantially more, so that the after-tax proceeds available to the Seller at closing are substantially reduced.
If the Seller is going to be providing services post-closing, the Letter of Intent should outline the terms of the employment, including salary, bonus, car allowance and other benefits. The term of the agreement should be set, with an outline of the conditions upon which the Buyer may terminate the Seller and whether the compensation is continued post-termination.
For the Buyer to feel comfortable that it is going to be able to capitalize on the goodwill it is purchasing, it will usually require the Seller to sign restrictive covenants such as confidentiality, non-solicitation and noncompetition provisions. The term, geographic scope and any applicable exceptions should be set forth in the Letter of Intent, so the parties understand the expectations post-closing.
Is the Buyer purchasing stock or assets? Determining and setting the structure is important so the Seller may determine its income tax obligations on the proposed transactions. Some Buyers are elusive with the type of structure and may initially indicate a desire to purchase stock but will include language that along the lines of wanting to “maximize the tax and accounting benefits to the parties.” Thus, giving them authority to convert the structure to an asset sale for tax purposes. In situations where the Seller is relying the sale of stock, it should negotiate a tax gross up payment to compensate for the difference in structure. For a discussion of different structures see https://www.deangelislegal.com/business-services/mergers-acquisitions/
Tax Gross Up Payment
This is an adjustment to the purchase price where the Buyer agrees to add compensation to the Seller for converting the transaction from a stock sale to an asset sale. If the Seller qualifies for 199A treatment, the Buyer is often better off making this payment and structuring the transaction as an asset sale for income tax purposes. Because the income tax obligation is unknown at the time of the Letter of Intent, the document usually incorporates a set amount, a formula for determining the tax payment or simply an indemnification obligation as a post-closing item. More sophisticated Buyers will determine what they are willing to pay and then set the amount, so the risk of any changes falls to the Sellers.
Working Capital Adjustments
Buyers in stock transactions desire the Seller to leave a minimum of working capital in the business at the closing. Typically, cash and accounts receivable. And if the amount is below the target, the purchase price is adjusted accordingly. Rather than setting the minimum number, some Buyers will provide a formula for determining the working capital or simply state that the Seller will deliver “an amount sufficient to support its operations” at closing. Then, at or near closing they provide the number they believe is required, which is often much higher than what the Seller anticipated. Sellers should have their accountant review the working capital requirement before the Letter of Intent is signed, insist on setting the working capital target in the Letter of Intent and should insure the purchase price is adjusted up or down or include language allowing them to distribute any excess funds at or before closing to insure themselves the ability to take pre-closing profits.
Similar to the working capital adjustments, the inventory adjustments are added to Letters of Intent for businesses with substantial inventory. These adjustments allow for a physical count of the inventory on or near closing and typically contain a formula for adjusting the purchase price if inventory falls below a certain target or range. Sellers should review their financials and write off obsolete or outdated inventory, as these items will not be counted and deducted from the purchase price and make sure the provision provides for an upward adjustment of the purchase price if the inventory exceeds the target or range.
The Letter of Intent should outline whether the Buyer is relying on its own resources, third party financing or seller financing to close the transaction. Each of these financing arrangements impact the complexity of the transaction and the Seller’s risk.
Representations and Warranties
The Buyer will require representations and warranties regarding the operations of the business and its assets. The breadth of the representations is determined by the size of the transaction and the relationship of the parties. Mid-market transactions between unrelated parties are going to have much more comprehensive provisions than a small market transaction between family members, friends or employees. Most Letters of Intent simply state that the definitive agreements will have the standard representations and warranties. However, given most Seller’s desire to limit their downside, these representations should be limited to (i) those amounts above a threshold amount (often called a basket) between half and one percent of the purchase price, (ii) limited to a period from one to five years from the closing date, (iii) the liability associated with their breach capped at an amount between five and twenty-five percent of the purchase price. These terms should be added to the Letter of Intent.
Sellers should insist on knowing the contingencies to the transaction closing. Common contingencies include financial, operational and legal due diligence, agreeing on transaction documents and receiving any third-party consents, such as the Seller’s landlord and the Buyer’s lender.
Hopefully the parties have already entered into a comprehensive confidentially agreement so the Buyer could review the Seller’s financials. This provision should simply refer to that confidentiality agreement, so it is incorporated into the Letter of Intent. Otherwise, the parties should provide that the information disclosed during due diligence, the terms of the transaction and the fact that the parties are discussing a potential transaction should remain confidential.
Buyers want exclusivity and these provisions prevent the Seller from shopping the business or even entertaining other offers. The problems is once a Seller enters into a Letter of Intent with an exclusivity provision, it must rely on the termination provisions or wait until the Letter of Intent expires before exploring other alternatives. This can be stressful if the Buyer is not proceeding in timely manner.
Most Letters of Intent have a deadline for signing but fail to provide for an outside date upon which the definitive agreement or closing must occur. To keep the parties moving forward and not lock up the business, the Letter of Intent should set forth an outside date upon which the Letter of Intent expires, and the exclusivity period terminates.
Break Up Fees
The trend over the last few years is to enter into the letter of intent, perform due diligence and then close the transaction. The problem with this structure is that the Seller has no recourse if the Buyer fails to close or substantially reduce its purchase price. In situations where a Seller will have to involve its employees to gather the due diligence, the Seller should attempt to negotiate a non-refundable payment to cover its costs if the transaction and stay bonuses to such employees if the transaction fails to close. An advance deposit is a great way to determine whether a Buyer is serious about timely closing the transaction.
Governing Law and Jurisdiction for Resolving Disputes
Not all Letters of Intent include these provisions. However, they are important if the parties are not based in the same state. Most Arizona based entities prefer to use Arizona law and venue, but most out of state private equity groups prefer to use New York or Delaware. Settling these matters up front will save the parties time and energy later when negotiating the definitive transaction documents.
To avoid any confusion, the document should explicitly state that the parties intend it to be non-binding term sheet outlining the discussions of the parties and that it is not a binding contract creating an obligation on any party to enforce the agreement.
The time to review the letter of intent is before you sign it. This is when you have the most bargaining power. In addition, by resolving these issues at the beginning of negotiations, you will achieve definitive documents that are more in your favor and save time and money negotiating their terms. If you would like us to prepare or review your letter of intent to insure it is appropriate for your business transaction, please give us a call.