Going through the buy-sell of a business is a complex, intense, and detailed process that involves a lot of negotiating, research, and due diligence. Before getting into the nitty-gritty of the acquisition, parties should use a Letter of Intent (LOI) to sketch out the blueprint of the transaction.
The letter of intent is the crucial first step in purchasing of a business. While the letter is non-binding and not part of the formal purchase agreement, getting the letter right is critical. A well-written letter saves confusion later down the road on the purchaser’s wishes, expectations, and terms when negotiations starts, whether that be days, weeks, or months later. LOI’s allow parties to draw the fundamental terms of a potential agreement before spending the substantial costs of going into full negotiations. Each party can get the deal-breaker points agreed upon before delving into great detail on the smaller issues. They can also preliminary start obtaining due diligence and obtaining required third-party approvals. Additionally, they parties can put in place binding safeguards in case the deal falls through such as non-disclosures agreements and escrow funds.
Below are some items that a buyer should include to optimize the letter of intent:
- Intent – This almost goes without saying, but make sure that the LOI states it is not a binding contract to purchase the business. The LOI needs to specify that the it is the inquirer’s intention to purchase the business.
- Good Faith – The parties should include a clause that each party is required (many states require) to negotiate in good faith. This clause prevents one party from using the process, especially the due diligence period, to collect information for other purposes.
- Assets or Stock – The LOI should state whether the deal is for the purchase of stock or assets. If an asset sale, the LOI should assign certain prices to certain assets on the balance sheet. The allocation of prices is extremely important since that will determine tax consequences for the current seller, and establish a cost basis for the acquirer.
- Price and assumptions – A well-drafted LOI will not only include the price, but the basis behind the price. During later negotiations and due diligence period, many assumptions that were used to calculate the offer price could easily be different.
- Method of Payment – Cash? Seller financing? Bank financing? Each party needs to be on the same page when it comes to how the deal will be funded and for what obligations each party is responsible. Also will there be multiple investors? If so, it is important that all the regulatory requirements around venture capital purchases and qualified investors are met.
- Any other Deal Breakers – Any other deal breakers that the parties have should be dealt with in the beginning, otherwise months of due diligence might go by only to come across a non-negotiable point of either party. Such crucial items could be key employee retention, non-compete agreements, assumption of liabilities, etc.
There are a few downsides to using a Letter of Intent. For example, upper management time, focus, and resources might be expended on the letter and a deal never happens. Another issue is opportunity costs. Many times a LOI might contain a non-solicit clause where the seller is not allowed to shop other potential buyers and could easily lose out on better market opportunities. Additionally, the buyer may have locked themselves into a price that was reasonable but the market has dropped.
Before entering into a Letter of Intent, it is critical that each party set forth their big-ticket, non-negotiable items and each be represented by experienced business law counsel. Any buyer of a business should retain competent counsel to draft their Letter of Intent.
Ryan Nevin is an attorney in Nashville, Tennessee where he advises individuals, families, and business owners on Estate, Trust, and Business Planning law. Ryan also is an avid legal writer for blogs, journals, and other legal websites.