Be Careful What You Wish for: Drafting a Letter of Intent

Entrepreneur hands signing contract in the night at home

By David Grossman

In the March-April issue of Cleanfax, I laid out an overview of best practices for the business-buying process. In this article, find a deep dive into drafting the letter of intent (LOI) with an example letter and a point-by-point examination of its components. In upcoming parts of this series, you’ll find information on the due diligence process as well as general tips for a better overall experience.

Read part one.

A former colleague was fond of saying, “Be careful what you wish for because you just might get it.” An acquisition done under the wrong terms can make for a poor investment, even if the target company is fundamentally solid. Much of a deal’s risk is determined early in the process—when the buyer and seller initially settle on price and terms.

Below is an example LOI, which outlines the key terms for a transaction. It was drafted by the buyer, as is customary procedure.

[infobox title=’LETTER OF INTENT’]

John I. Candothis

President, Newco

1 Park Ave.

New York, NY 10016

 

June 16, 2021

 

Jane Beachbound

Owner, Target Company

1 California St.

San Francisco, CA 94111

 

cc: Bob Middleman

Owner, Middleman Business Broker Services

 

Dear Jane,

Newco, a corporate entity to be formed by John I. Candothis (the “Buyer”), is interested in acquiring the assets of Target Company (“Target”) from Jane Beachbound (the “Seller”). The following letter of intent (the “LOI”) is a non-binding offer that is to remain confidential between Target and Newco and each of its representatives. This LOI is subject to a number of conditions including, but not limited to, full legal and business due diligence, financing, and no material changes in the business or market conditions.

 

Terms are as follows:

  1. Accompanying this LOI, the Buyer shall submit ten thousand dollars ($10,000) of good-faith money to be deposited in a dedicated escrow account (the “Buyer Escrow”) held by Middleman Business Broker Services (the “Business Broker”). The Buyer Escrow shall be immediately refundable at the Buyer’s discretion and upon termination of this LOI.
  2. The Buyer shall make a cash payment to the Seller of an additional one hundred ninety thousand dollars ($190,000) (the “Cash Down Payment”) upon closing.
  3. The Buyer shall issue to the Seller a note of one hundred thousand dollars ($100,000) (the “Seller’s Note”) to be due three (3) years after closing. The Seller’s Note shall bear an annual interest rate of five percent (5%) with interest paid quarterly. Principal shall be repaid quarterly in equal installments, although no principal installment shall be paid until the end of the sixth (6th) month after closing, at which point, payment for two (2) quarters shall be made. There shall be no penalty for prepayment, and the Seller’s Note shall be senior in preference to all other capital in Newco except a debt facility of up to one hundred thousand dollars ($100,000).
  4. At the discretion of the Buyer, existing management shall have the ability to exchange a portion of the Seller’s Note for equity in Newco prior to closing on terms to be determined.
  5. Newco shall acquire all assets of Target except any cash balances and accounts receivables existing upon closing.
  6. An amount of twenty thousand dollars ($20,000) of the Cash Down Payment will be held in escrow (the “Seller Escrow”) for ninety (90) days after closing in order to cover any adjustments, representations, or warranties. Any decreases in Target’s inventory or fixed assets shall reduce the Seller’s portion of the Seller Escrow on a dollar-for-dollar basis.
  7. The Buyer expects the Seller to remain and cooperate for a period of up to twelve (12) weeks to transition Target to the Buyer. A forty (40) hour per week commitment is expected. Beyond this period, the Buyer shall consider an employment agreement with the Seller to remain with Newco after closing under terms of any such arrangement to be determined.
  8. The Seller shall enter into a standard multi-year, non-compete confidentiality agreement.

 

The Buyer is requesting an exclusivity period of forty-five (45) days commencing upon execution of this LOI, during which time Target shall not solicit, encourage nor engage in any discussions for financing other than that which is in the ordinary course of business. This offer is valid for a two (2) week period from the date above, at which point it shall expire.

Within ninety (90) days of the execution of this LOI and subject to the Buyer’s satisfactory completion of due diligence, the Buyer and the Seller shall enter into a definitive purchase and sale agreement.

I am extremely bullish about the prospects of the business and look forward to working together to continue to build significant value in Target. I await your response.

 

Sincerely,

John I. Candothis

Newco

[/infobox]

Exploring the letter of intent

Let’s now walk through this LOI to see the best practices for building such a letter. The opening paragraph spells out the parties involved (Jane [seller], John [buyer], and Bob [broker]) and that this will be an asset purchase. The decision between a stock acquisition and an asset sale is beyond this article’s scope, and a lawyer should help with this decision. Clearly stated are the conditions that this LOI is not to be shown to others and that the buyer can back out of this transaction for many reasons with no repercussions.

Terms 1-3

These points state that Newco, the company to be formed to make the acquisition, is proposing to acquire Target for a total of $300,000, of which, $200,000 will be paid in cash upon closing. The balance will be paid over a three-year period.

It is common for the seller (and business broker if there is one) to request a small amount of money upon execution of the LOI to show the buyer’s seriousness. Make sure this money is fully refundable and deposited into a dedicated escrow account not accessible by the holder for other purposes.

Note that Term 1 is only included because the buyer was told before submitting this LOI that it was a requirement.

Determining the value of a business is clearly one of the most important exercises a buyer performs. As a general rule, companies under $10 million in value are sold for three to five times the previous year’s cash flow. However, there is a broad range, and the exact price should be adjusted by a number of factors including change in revenue over the past several years: A business growing greater than 20% per year would warrant a higher multiple than one that is experiencing declining sales, high customer concentration, and significant ongoing capital expenditures.

Term 3

The Seller’s Note warrants further discussion. Here are some important points to keep in mind:

  • John set the payback schedule of the Note only after carefully projecting the anticipated future financial performance of Target. The cash flow after all expenses, taxes, interest payments, and capital expenditures are expected to be sufficient to meet the requirements of this Seller Note.
  • A grace period is helpful because once John takes over the business, there inevitably will be unforeseen road bumps during the transition. Examples range from the loss of a major customer to the need to buy new software, which both lower the amount of available cash. In reality, if an occasional payment is late or the initial payments must be deferred for a short period, most sellers are accommodating. Remember that Jane wants the business to succeed so that her Seller’s Note will ultimately be repaid.
  • Prepayment without penalty keeps open the buyer’s options in the event that, at some point during the repayment period, the seller finds an alternative, better financing source that can replace the Seller’s Note. This can take the form of an increased or less expensive facility obtained elsewhere, among other things.
  • The “senior in preference” clause is intended to create a balance. On one hand, the seller has the concern that she may not be repaid if the business does not perform well. On the other, the buyer has the hesitation of incurring additional debt, either to help finance the purchase of Target or to grow the business after closing. For businesses without tangible assets, obtaining bank financing may not be realistic, but for some companies it is an option. Here John is proposing to allow $100,000 of additional debt to be incurred without Jane’s permission, but no more.
  • Not covered in the LOI is “repayment security.” It is very common for the seller to request a personal guarantee for the money owed her. This pledge from the buyer to make good on the note, regardless of the performance of the business, is customary, in addition to the seller having claim to the value of all the assets of the business, thereby affording her added protection.
  • Naturally, a personal guarantee is cause for serious introspection, and the buyer will want to push back on this provision, as it can result in a large personal liability should the business not succeed. That said, more often than not, if the buyer is not able to make good on the Seller’s Note, a manageable financial resolution between the two parties is typically reached as opposed to the seller personally going after the buyer for the full amount outstanding.
  • For negotiating, two provisions are included: a 5% interest rate and a quarterly payment timeframe. The interest rate can be raised and the payments made monthly with relatively minimal impact to Newco. If needed, John can make these accommodations during the negotiation process in exchange for obtaining more important concessions from Jane.

Term 4

The seller sometimes requests this addition, but, in this case, the buyer wanted to include it for two reasons:

  1. While he would give up some of the ownership, replacing debt with equity capital would lower the cash requirements of servicing the Seller’s Note.
  2. The provision is intended to test the seller’s faith in the buyer and the business. If she is interested in investing in the buyer, then it is a signal of her confidence, and the buyer should interpret that as a positive sign; conversely, the buyer should not be discouraged if this option is not exercised.

Term 5

This term specifies what John is purchasing and what he is not. For an asset sale, it is typical for the seller to keep the cash and receivables outstanding at the time of closing. Typically, the buyer would then collect any receivables on behalf of the seller in exchange for a 4% administration fee. In a stock sale, this provision is not necessary—as all assets and liabilities are typically transferred to the buyer.

Term 6

Term 6 addresses any shortfalls in the actual condition of Target at closing relative to what was expected from previous financial statements. A small reserve is held to cover such items as: less equipment present at closing; settling vendor disputes that were incurred by the seller (Note that, while in an asset purchase John would not be liable for such items as vendor, supplier, or trade payables, he may want to settle any discrepancies regardless to maintain positive relations with an important partner); and any decrease in value of the inventory.

Terms 7-8

These speak to Jane’s requirements, both during and after the transition. Should she not live up to these responsibilities, remedies stipulated in the longer, more detailed closing documents can be enforced. Measures can include not paying her the full Seller Escrow, deducting money from the Seller’s Note, and taking legal action.

Closing

The final paragraphs set realistic timeframes both parties should strive to achieve. While a thorough due diligence effort is warranted, transactions must maintain momentum, lest they decrease the sale’s likelihood. John is also requesting an exclusive look at the business so Jane cannot shop the deal during his due diligence.

The document ends on a positive note because the LOI should also serve as a sales piece for John. After all, at this point Jane still has the leverage, a situation that will change once the agreement is executed.

Bob is copied to include him in the process. Often the LOI will go first to the business broker who will present it to the seller. Regardless, the buyer will want to establish the strongest relationship possible with the broker since he has influence over the seller.

A few final points

This article does not cover negotiating strategy. A buyer should form in his own mind, before submitting any LOI, acceptable terms given what he knows of the target company at that point. This set of conditions should be considered the bottom line. An opening position should leave sufficient negotiating room to come off your initial proposal while satisfying your “must haves.”

Even after signing this document, these terms should be frequently revisited since more will be learned about the business and its industry, competitors, employees, etc. All terms in the LOI will be explored in more detail in the closing documents.

By the end of the due diligence process, if you are not comfortable with the established terms—and you must be honest with yourself—you have two choices: renegotiate or walk.


David Grossman is president of Renue Systems Inc., a global franchisor and operator of specialized deep-cleaning services businesses to the hospitality industry. He can be reached at [email protected] with more information available at www.renuesystems.com.

David Grossman

David Grossman is president of Renue Systems Inc., a global franchisor and operator of specialized deep-cleaning services businesses to the hospitality industry. He can be reached at [email protected] with more information available at renuesystems.com.

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