Considerations for Buyers & Sellers When Negotiating a Letter of Intent

Published: Dec 7, 2023
By: Phil Bergamo; Robert S. Esposito
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A letter of intent (LOI) serves as an important milestone in a merger and acquisition (M&A) transaction by setting the preliminary parameters, structure, and terms for the negotiation of a definitive sale purchase agreement between a buyer and seller of a business. The LOI is utilized to define many of the key terms of a proposed transaction including:

Legal parties to the transaction;
Assets, liabilities, and/or shares to be acquired;
Purchase price (including form and timing of payment of the purchase price);
Anticipated closing date;
Exclusivity periods;
Transition periods;
Termination provisions; and
Obligations and important conditions of closing.

Although many of the terms of LOIs are non-binding and subject to negotiation, the LOI sets the “tone” and “expectations” of the parties up front prior to the commencement of due diligence and sale and purchase agreement drafting. It is critical for both parties to communicate openly and clearly with a full understanding of the key terms of an LOI to facilitate a smoother transition to a definitive purchase agreement. If the key terms of the LOI are not fully understood, it may lead to disputes or failed expectations between the parties, and ultimately may result in a delayed, abandoned. or more costly transaction.

The following is a representative (not all-inclusive) list of some of the more important and critical path issues that should be considered by the buyer and seller when negotiating an LOI:

Is the proposed structure of the acquisition clearly defined in the LOI? There are many different ways to structure an M&A transaction, for example, all of the stock of a company can be purchased, or the purchase can be limited to certain identified business assets and liabilities, such as a particular product or service. There are significant tax implications that would need to be considered depending on the agreed-upon structure. Additionally, the due diligence, timeline, and purchase price (including payment terms and conditions) of the transaction could vary significantly depending on the negotiated structure. If the framework of the structure is agreed to in the LOI stage, expectations can be set as to the due diligence and contract negotiation process, net proceeds, and timeline of the transaction. Buyers and sellers should consult with qualified transaction professionals (accounting/tax advisors, legal counsel, bankers, etc.) before executing an LOI to mitigate the risk of the negotiated terms being improperly vetted or incorrectly understood by buyer and seller before executing the LOI.
What is the basis and methodology for determining the purchase price (EBITDA multiple, revenue multiple, asset valuation, etc.) and how will the purchase price be structured, (cash, stock, earn-out, hold-back, or combination thereof)? If valuation is based on EBITDA or revenue multiples, what time periods will serve as the base period? If stock is included in the transaction, how will the valuation and timing of the shares be determined? Will the stock consideration be limited to stock in company sold or stock in the buyer’s entire company? Additionally, transaction structures can include roll-over equity. Roll-over equity is a portion of the proceeds (generally a minority share) from the sale of a business reinvested into the company by seller to serve as an incentive for a seller to stay involved and committed in the sold company post-transaction, as well as to a provide buyer with a vehicle to partially finance the overall purchase of the company. An understanding of the significant components of the consideration at the LOI stage would allow for better tax planning.
Is the basis of accounting for 1) the financial statements, including EBITDA, 2) net working capital (NWC), 3) revenue and margin, etc. clear in the LOI (GAAP, accrual, modified accrual, cash, tax, or specific company basis of accounting, etc.)? If the LOI lacks clarity of the basis of accounting upon which financial results, EBITDA, revenue, margin, and NWC are defined, it could result in potentially significant unexpected financial results and purchase price implications as the transaction progresses. One of the most negotiated terms in an M&A transaction is NWC and many LOIs include a provision which requires a seller to leave a “normalized level of net working capital” at the closing date. NWC is broadly defined as current assets less current liabilities; however, there are nuances to the calculation of normalized NWC and those nuances could significantly impact the calculation and resultant financial proceeds at closing. It would be important for both buyer and seller to have a clear understanding of the accounting method used to calculate NWC. Will NWC be calculated using the seller’s historical method of accounting, GAAP, or a different method of accounting? Additionally, the LOI could clearly define which current assets and liabilities will be included or excluded in the definition of NWC. It is also important for the buyer and seller to be in complete agreement on the definition and basis of accounting for other key financial metrics such as EBITDA, revenue, margin and debt.
If the M&A transaction includes an earn-out provision, are the terms of the earn-out provision clearly outlined and defined, including an example calculation and the basis of accounting that will be used for the earn-out (historical seller accounting, buyer accounting, or some variation thereof)? Earn-outs represent additional consideration that a seller of a business can receive based on the future performance of the business sold. Earn-outs can be structured based on EBITDA, revenue, gross margin and/or net income realized, or other metrics such as NWC, cash flow or debt levels at certain pints in time. Both parties should agree upfront to the metrics of an earn-out, including the basis of accounting that the earn-out will be calculated, to alleviate unintended surprises during the definitive purchase agreement negotiation or post-transaction disputes when the earn-out is calculated.
Do the parties understand how the valuation of the business is being determined? Is there an understanding of how/if the purchase price will be revised if more current financial results improve or decline? Clear and open communication as to how the company valuation was determined (e.g., multiple of EBITDA, revenue, or another financial or operating performance metric) can help facilitate discussion and agreement of how a change in the seller’s financial performance during the transaction due diligence and contract negotiation process would impact the purchase price. M&A processes can take a considerable amount of time and expense to negotiate and close, and a well-conceived and written LOI can alleviate surprises or disagreements as the M&A transaction progresses to close.
Does the LOI include the timeline of the due diligence and transaction process, including the types of due diligence being performed and the exclusivity period? The exclusivity period is the timeframe that a seller is prohibited from marketing the business or continuing with activities that relate to the sale of a business with parties other than the prospective buyer with whom they have signed the LOI. Exclusivity periods should allow for enough time to facilitate a thorough buyer (and seller) due diligence process and workout the terms of a definitive agreement without either party taking undue risk. The LOI should also detail the party’s ability to extend the exclusivity period as well as the termination provisions. The key diligence workstreams should also be clearly described in the LOI so that the parties can be best prepared.
Who will pay the transaction-related fees, including representation and warranty Insurance? There may be an opportunity to include a breakup fee (including whether the terminating party is responsible for the transaction costs of the terminated party) to protect both the buyer and seller if the transaction is terminated after significant level of effort and cost has been incurred.
Have post-transaction employment, consulting, and non-compete agreements been negotiated for key employees and owners? Key terms of such agreements could be agreed during drafting of the LOI so there are agreements of the compensation, benefits, and obligations of the owners moving forward. The compensation package and responsibilities for the ownership group and executives of a business could be significantly different pre- and post-transaction close.

Buyers and sellers should always obtain advice from their professional service team before executing an LOI to make sure there is a clear understanding of the key terms as well as the implications resulting from executing the LOI.