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The Letter of Intent – Unlocking the M&A Superpower

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Nonbinding does not mean unnecessary.

On the surface, a Letter of Intent (LOI) may seem an unnecessary waste of time and money to clients. However, negotiating a transaction on the fly, without a guide or roadmap, consumes more time and resources overall and can cause needless friction between buyers and sellers. Taking the time upfront to determine people’s intentions in a transaction can be challenging but is essential to a successful deal. That is the function of the LOI. It sets the expectations for a transaction and serves as a guide for deal structure and negotiations.

The LOI is a safe place to detail the critical points of the deal, especially for entrepreneurs and shareholders who lack transaction experience. They need to learn all the issues likely to arise throughout the process. The LOI process can both educate and protect them. Having an experienced investment banker and M&A attorney aggressively negotiating details on their behalf is imperative because a good LOI covers more than the purchase price. It answers crucial strategic questions, such as:

  • What will employment agreements look like?
  • Are non-compete provisions critical to the deal?
  • What are the tax implications? Is there rollover equity?

The purchase price is, agreeably, one of the most essential points of a deal, but multiple variables can impact the agreed-upon purchase price. For instance, if a business is seasonal, its current reported assets and liabilities may change drastically after the signed LOI. Investment bankers will dive deep into financials before the LOI is final. They can uncover the fluctuations and their impact on working capital while the M&A attorney ensures the LOI contains appropriate provisions to address the business seasonality.

Often, parties do not focus on working capital as they are worried about potential headlines, or sellers may need to be sure who is keeping what assets or receivables. Figuring out the working capital target and what the determining factors are can clarify issues and generate significant value, if addressed during the LOI stage.

Representation and Warranty Insurance (RWI) is an increasingly crucial protection for sellers and buyers and one that is often overlooked if not negotiated in the letter of intent. During mergers and acquisitions, RWI can benefit both parties against breaches and inaccuracies in statements of fact, such as inaccurate financial reporting. Sellers, especially, are relieved of a significant percentage of potential post-close liability for indemnity claims brought by the purchaser. Buyers can file claims with an insurance provider rather than a potentially emotional seller. It is important to note that RWI often carves exclusions for instances such as fraud or other actions, so it does not completely protect against all activity.

Investment banking and legal advisors spend considerable time educating clients on the benefits of obtaining representation and warranty insurance and negotiating who will pay for the policy, among other details, to help bridge a deal when there are concerns about risk allocation issues for both parties during the LOI process. RWI offers coverage that leaves more dollars in the client’s pockets at closing by lowering the potential risk profile. Instead of having a 6-10% escrow, the out-of-pocket is typically only 0.5% of the transaction value, and the insurance covers the rest if there is an indemnity claim.

With RWI and a well-negotiated LOI in place, the purchase agreement is often much easier to negotiate. Why? Protection. All parties must agree on the provisions in the LOI, which, along with the protections offered by an RWI policy, allow everyone to move forward with increased confidence. When negotiating the letter of intent, sellers also gain the chance to get the buyer to split the cost. Both parties can negotiate if it is an “all indemnity” where there is no sharing of the retention or negotiate what shared retention looks like and who is paying for the policy.

Another detail to include in the LOI is the structure of the deal. The transaction could consist of an asset sale, stock sale, with or without a rollover, or a blend of these structures. It may include a “Section 338” election, allowing taxpayers to classify qualified stock purchases as asset acquisitions for federal income tax purposes. The decisions made here will affect the tax recognition for the seller and set tax boundaries down the road for the buyers. The transaction structure also establishes the flow of the deal.

LOIs often include exclusivity provisions stating that if the material terms of the LOI change within “x” number of days, either party can terminate exclusivity. The time allowance is usually 30-60 or even 90-120 days; however, parties often feel they can change terms without a legitimate reason or rationale, often driven by shareholder or founder fatigue with the process. The propensity of buyers to want to change terms “because they can” or engage in a practice called “retrading” is driving aggressively shorter timelines in exclusivity provisions.

What is Retrading? Simply put, it happens when a buyer renegotiates or lowers the purchase price after agreeing to purchase at the higher price. Or a seller starts shopping for a new buyer that will pay more for their business.

There are legitimate reasons to change terms after a signed LOI, such as the financial results being wrong, a critical issue surfaced, or there being unforeseen skeletons in the closet. If that is the case, the parties are incentivized to return to the table and renegotiate to find a solution. For example, if a seller states they did $10 million in EBITDA, and it turns out they only did $9 million, every potential buyer will have that same issue. Based on this latest information, negotiating a new price is in everyone’s best interest.

If the LOI is well-crafted, it can be used to outline the deals’ more meaningful terms and conditions, making the weeks and sometimes months of work toward a closing easier. Most provisions in an LOI are non-binding, such as purchase prices, payment of the purchase price, or adjustments to the purchase price, and therefore, may not be legally enforceable. Still, the document sets the expectations for the resulting transaction. It is the job of the financial and legal professionals on the deal team to educate the client on the benefits of following the LOI throughout the transaction. It helps manage expectations as the deal progresses and helps keep the seller and buyer on cordial terms. The state of their relationship is essential, especially in the case of rollover equity, where they are negotiating with their future partner. Keeping the relationship cordial and dealings open is in everyone’s best interest.

Ideally, LOIs should reflect what the deal will be if what comes out of due diligence is materially the same as the pre-diligence expectations outlined in the LOI. The deal should remain unchanged if there are no significant revelations.

Engaging an investment banker and M&A attorney early in the process can ensure both the buyer and seller are engaged in the right transaction and are negotiating the right terms in the right way for a successful transaction outcome.

Want to learn more?
Check out our Cascade Conversation: Understanding the Power of a Letter of Intent