Negotiation

What You May Not Know About a Letter Of Intent

Of the many legal forms and documents used in a business sale transaction, perhaps one of the most misunderstood is the letter of intent.  It is important to understand that it is not legally binding, but helps to facilitate the negotiation and due diligence process.

As we dive deeper into how to you sell your business in a way that leaves all parties satisfied and legally safe with no loose ends or unpleasant surprises, remember that there is a logical order to each of these processes, and that each is designed to keep both parties safe.

We will start with the difference between a letter of intent, term sheet, and a purchase agreement – and when to use each one.

Purchase agreement

Purchase agreements are final and binding documents that can be enforced in a court of law. These agreements are meant for the final stages of the merger and acquisition process. While drafts of purchase agreements can be written up immediately by the buyer or the seller, they undoubtedly will undergo many revisions before the final version.

Letter of Intent

Neither side of the bargaining table should feel rushed to finalize a purchase agreement or be pinned down by binding promises made in the early stages of discovery. At the same time, waiting until every detail has been ironed out for the final purchase agreement will significantly slow down the sales process. This delay is resolved by the letter of intent. The letter of intent is a preliminary non-binding agreement written in letter form that states both parties’ agreement to enter negotiations for the sale of the business. In addition to providing a blueprint for both buyer and seller to outline preliminary terms of the sale, the letter of intent also provides safeguards for both parties should the deal fall apart.

Term Sheet

A term sheet accomplishes the same thing as the LOI but forgoes wordy prose and formalities by jumping straight to the negotiation points. While a letter of intent can be more readily transformed into final copy for the purchase agreement, term sheets are useful as preliminary non-binding documents characterized by brevity and bullet points that provide a working outline of the intended agreement.

Seller Beware!

Once you receive the letter of intent make sure to do your own due diligence on the buyer before signing. It’s better to invest a small amount of time ensuring the buyer is financially and operationally qualified than to spend a large amount of time on the sales process only to find the buyer isn’t a viable option. This is also the time to make any necessary counter offers to letter of intent terms and negotiate revisions so that you and the buyer are starting off on mutually agreed upon terms from the outset.

Doing the best at this moment puts you in the best place for the next moment! Oprah Winfrey

Before You Sign on the Letter of Intent Dotted Line

It would be prudent to involve your accountant and attorney at this juncture as there are many financial and legal elements that will require their expertise. In addition to the buyer’s financial qualifications and the letter of intent term counteroffers and negotiations, you will also need to review the items below before signing. These items should be included in any standard letter of intent and their terms agreed upon before granting your signature:

Price and financing structure

It is typical for the buyer to offer less than your asking price, which can become a point of later negotiation. The buyer will also detail how much will be paid in cash at closing and what kind of financing will be necessary. You will want to discuss the financing structure with your accountant, as each type of payment structure comes with tax ramifications.

Asset or share sale

Most small business sales are asset sales, but a few are share sales. The buyer will propose one or the other, likely based on the structure you have stated in your sale listing.

Price allocation

Price allocation greatly affects how sale proceeds are taxed and the IRS requires both you and the buyer to agree. Obtain your accountant’s advice before discussing or accepting proposals about price allocation.

Purchase exclusions or additions

Exclusions and additions to your sale offering can greatly affect how sales proceeds are taxed and your liabilities after the sale is closed. Get the advice of your accountant and attorney.

Length of due diligence period

Due diligence for an asset only purchase should take less than a month. However, businesses with real property, extensive physical assets, or those selling as entity sales will often take more time.

Warranties and representations

You will need to guarantee that the facts you’ve presented about your business are accurate to the best of your knowledge. Your attorney should review the warranties and representation clause.

Seller’s future involvement

The buyer may want your continued involvement for a transitional period or request a non-compete agreement. Your attorney can negotiate the timeframe for your future involvement and non-compete specifics.

Status of business operations during the closing period

Will the business continue to operate, or will all major agreements/purchases be on hold?

Clarifying that the offer is nonbinding

The letter of intent needs to specifically state its nonbinding nature.

Cancellation options

Agreed upon reasons that allow both sides to cancel without legal consequence.

Exclusivity agreement preventing consideration of competitor offers during the due diligence period

You can negotiate a shorter exclusivity time period than the buyer proposes.

Agree or Counter Offer

After considering the terms of the letter of intent, you can either agree to the original version or make a counteroffer. Once negotiated changes have been mutually accepted it’s time for you and the buyer to sign! Signing the letter of intent is an exciting step, as it signifies agreement to a purchase offer. However, the letter of intent only marks the beginning of your journey, as the entire sales process can take several months to complete.

What Happens Next?

  • If you are using a broker, they will collect (typically) 5-10 percent deposit of the proposed purchase price from the buyer, to be held in an escrow account.
  • If you are not using a broker, your sales advisors and you will decide whether to require a deposit from the buyer. Requiring a deposit is strongly recommended, as this will help to guarantee that the buyer is sincere about following through with the purchase.

Move to the Due Diligence Stage

Once you have verified the buyer’s qualifications and signed the letter of intent, it’s time to look at your company through the buyer’s eyes. If you were buying your company, what information would you want to know? Anticipate and provide all the information your buyer will need to make the due diligence process more efficient. The letter of intent will help prepare you for what information you will be expected to provide during the due diligence process. This is your first step in achieving a smooth profitable sale and moving forward to your next successful venture!

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