Chapter 13
LOI and Behold: Making or Receiving an Offer
In This Chapter
Understanding the LOI’s purpose
Looking at the LOI’s inner workings
Considering extending exclusivity
Moving forward after the letter is signed
Although many things — an indication of interest (see Chapter 9), a term sheet, a phone call where Buyer says, “We’re interested and we’re willing to pay $10 million” — can be an offer in the M&A world, not all offers are created equal. In the world of offers, the letter of intent (LOI) is in a class of its own; it’s the gold standard of offers. This chapter gives you the lowdown on this document, including its important parts and some considerations to keep in mind while reviewing it.
Signaling Sincerity with a Letter of Intent
An LOI is basically a marriage proposal from Buyer. Both parties promise to stop seeing others and signal to each other that they’re very serious about wrapping up the deal. In dating, that deal is wrapped up at the wedding; in M&A, it happens at the closing.
As the name implies, the LOI lays out the intent of both parties: Seller states she is willing to sell for the proposed terms, and Buyer states what he is willing to pay. They are both agreeing to move forward to close a deal based on the terms in the document. It’s not binding, which means it’s not enforceable in court (well, except for the parts about confidentiality) and it doesn’t bind Buyer to the deal. In fact, either side can still walk away for any reason.
Buyer submits the LOI to Seller. If Buyer is working with an investment banker or other M&A advisor, that advisor will most likely submit the LOI to Seller (or to Seller’s advisor, if she has one). Buyer’s lawyer may be the one to actually craft the LOI, although the lawyer works under the direction of Buyer’s advisor to make sure the business terms are what Buyer wants. After the LOI is ready to be submitted, sending it via e-mail is perfectly permissible (I don’t recommend sending a marriage proposal that way, though).
The LOI is an important step because it lays out the basics of the final deal: the purchase price and terms, closing date, length of exclusivity, approvals, and much, much more. (See the nearby section “Understanding the Salient Issues in the LOI” for more detail.) However, the LOI isn’t necessarily the final deal. Rather, it’s the framework or roadmap for that final deal. Based on what each side discovers during due diligence, and/or whether the profits of the company decline, the deal may change.
For most people, the transaction to buy or sell a business will be the biggest deal of their lives and careers. It usually involves lots of money and even more risk. When you buy or sell a pack of gum or a bottle of wine, for example, you don’t need to issue an LOI. You simply buy or sell the object. If you sell some bad gum or wine, you may have to refund some money, but neither example will ruin you. Given the size and complexity of a company, on the other hand, one bad merger or acquisition may well ruin you. Because of the risk of buying or selling a company, you need to take gradual steps.
Think about buying a house. Most people don’t wake up one morning, decide to go out and buy a home, and expect to own one an hour later. Instead, they talk to a real estate agent, look at a bunch of houses, find one they like, and make an offer. If the seller accepts that offer, the buyer signs an agreement that sets the terms of closing the deal and usually allows the buyer to inspect the house; if the house meets the buyer’s satisfaction and the buyer can obtain the financing, the house is sold.
In M&A, the LOI acts as an important step in closing that deal. It defines the terms and the timing, and Seller agrees to stop talking to other potential Buyers. And assuming the company passes the inspection (see Chapter 14 for more info on due diligence) and assuming Buyer has (or can get) the dough, the deal closes.
The LOI’s more specific terms provide protection for Buyer. The LOI allows Buyer to get serious about closing a deal without having to worry about another Buyer swooping in at the last minute and stealing it. The LOI also allows Buyer to get a close look at the company without having to lay out the money to buy the company.
Understanding the Salient Issues in the LOI
Although no one-size-fits-all approach applies to writing an LOI, the basics include some boilerplate legalese and some detail about the specific deal at hand. In the following sections, I lay out some of the main areas of coverage you’re likely to see in an LOI. Check out the appendix for an example LOI.
You may notice that I don’t include a section for a break up fee (a fee Buyer pays Seller if Buyer walks away from the deal). The truth is that most Buyers don’t care to include those clauses for obvious reasons, so the odds of getting one in an LOI are slim. Sellers can ask for them, but they shouldn’t get their hopes up.
Salutation and preamble
The LOI starts with basics, like any other business letter. After a flowery greeting, Buyer usually provides a lengthy preamble with some comments about how excited he is to submit the LOI and how beautifully Seller and Buyer will fit together after a deal is done. This section is simply cosmetic politeness: nice, but not important.
Valuation and deal structure
Valuation (which I cover in Chapter 12) is the key number everyone looks for. Usually the valuation appears in the third or fourth paragraph of the LOI. Buyers often load up their LOIs with a bunch of boilerplate in hopes of differentiating themselves from other Buyers, but this boilerplate isn’t what’s important; the valuation is. The valuation in the LOI should be a static number (as opposed to the range typically seen in the IOI).
The structure of the deal is also very important, and frankly, many first-time Sellers overlook it. The valuation may provide an eye-popping number, but the devil is in the details. Here are some deal-structure questions to consider:
How much of that valuation does Buyer pay in cash at closing? Cash at closing (I’m repeating myself here for dramatic effect) is the most important detail for any Seller because Seller can’t spend a note, an earn-out, or stock. Cash is king, and a wise Seller places a premium on getting actual cash as opposed to a promise to maybe get some cash at some point in the future.
How much of the valuation is in the form of a contingent payment? Contingent payments include earn-outs, notes, and even stock in Buyer’s company (see Chapter 12 for more). I consider these forms of payment contingent because Seller may or may not eventually receive that money.
If the LOI includes contingent payments, what are the details?
• How much money is in the form of a note? What is the interest rate, and when does Seller receive that money? Does the interest accrue (all the interest is paid when the principal is paid)? Is the note amortized (Seller receives interest and principal payments)? Or is the note interest only (Seller receives regular interest payments and a balloon payment at the end), and if so, how often are the interest payments due?
• What are the specifics of any proposed earn-out? Seller should be most concerned with one thing: how she gets her money! You can structure earn-outs in virtually limitless ways, but in my strongly held opinion, the earn-out should be simple and easy to understand. The more complex the deal, the less likely Seller ever sees any money from the earn-out. Check out Chapter 21 for some earn-out ideas.
• How easily can Seller convert any stock to cash? If the stock is thinly traded (doesn’t trade many shares daily) and is on a lesser exchange (OTC or Pink Sheets), Seller has a lower probability of converting that stock to cash than if the stock were a high-volume stock on NYSE or NASDAQ.
No single contingent payment structure is right or wrong for any given deal. Each deal is different. Seller needs to confer with her advisors and weigh the merits of a particular offer.
Holdback and escrow
Most deals delineated in an LOI include a holdback, an amount Buyer withholds from Seller for a period of time just in case the company has some sort of problem (usually a breach of a representation or warranty, which is covered in Chapter 15) after the deal closes. The holdback goes into a third-party account called escrow. This escrowed money is released to Seller, assuming Buyer doesn’t make claims to the money.
Some Sellers view the escrow as money they’re not receiving, but Sellers should remember that Buyers need to come to the closing meeting with that money. Just because Seller doesn’t immediately receive that money doesn’t mean Buyer isn’t providing it. If the purchase price is $10 million with $1 million to be placed in escrow, Buyer needs to come to the closing with $10 million!
Representations and warranties
Buyer and Seller agree to a slew of representations and warranties (sometimes abbreviated reps and warranties or R&W). Representations and warranties are legal promises regarding past and future events, and you should take them very seriously. I provide more detail about reps and warranties in Chapter 15.
Sellers can and often should provide Buyers with R&Ws for past events such as the previous year’s financial statements. But providing R&Ws for future events is a mistake because the future has no guarantees. Asking Seller to provide R&Ws that, say, the company’s top customer will still be the top customer in one year is an unreasonable request.
The R&Ws tend to be biased against the Seller, and so Sellers usually provide far more R&Ws than Buyers do because Buyers have many more worries about the deal than Sellers.
The biggest concern for Seller is that Buyer shows up at closing with the money; Seller isn’t too preoccupied with getting Buyer’s R&Ws. After the deal closes, Seller doesn’t have financial responsibility for the company; Buyer does. That’s why Buyer is so keen on Seller providing some reps and warranties.
For Buyer to have the ability to claim some of the escrow money against Seller, a problem usually needs be the result of Seller’s failure to disclose something to Buyer, or worse, of some sort of fraud or malfeasance by Seller. If the problem is the result of Buyer making a mistake post-close, it’s Buyer’s problem, and Buyer can’t claim a breach of a rep or warranty.
If the business takes a nose dive due to a general economic decline, that’s not the fault of Seller, and Buyer will not be able to claim a breach of a rep or warranty.
Financing
Most LOIs contain some info about where Buyer proposes to obtain the dough needed to effect the transaction. I heartily recommend Sellers pay very careful attention to this part of the LOI. The phrase you’re on the lookout for is financing contingency.
A financing contingency is a hedge for Buyer. He’s saying he may not have the money right now and hopes to obtain it before closing, but he wants a way out of the deal in the event that he can’t get the necessary money.
Due diligence and timing
Due diligence (which I explore further in Chapter 14) is the inspection period for Buyer. It comprises a short section, perhaps just a single sentence, in the LOI where Buyer indicates how long he needs to complete it. After Buyer successfully concludes due diligence, he can close the deal.
Sellers should pay close attention to the length of time Buyer seeks; if it’s too long, Seller shouldn’t proceed until Buyer agrees to conduct due diligence and close the deal in a shorter, more reasonable amount of time. As a guideline, Buyer should be able to conduct due diligence and close within 60 days of signing the LOI.
Approvals and conditions
This section is usually more boilerplate where the Buyer may reference certain executives who need to sign off on the deal before it can close. Buyer may also ask Seller to make sure her ducks are in a row, so to speak, so that whoever needs to approve the transaction on her side is willing to do so.
Role of management
An LOI may define the expected role of the company’s management after the deal closes, including Buyer’s intent to retain certain employees in the current roles and at their current compensation levels.
Access to information
Seller agrees to furnish Buyer with all information necessary for Buyer to conduct due diligence and close the deal.
Expenses
This section is an important bit of boilerplate. The LOI usually stipulates that the expenses incurred by Buyer are Buyer’s responsibility and the expenses incurred by Seller are Seller’s responsibility.
Exclusivity
Exclusivity (also known as no shop) is one of the main differences between an IOI and an LOI. It’s the clause where Seller agrees to halt all other conversations with other potential Buyers. The length of exclusivity should coincide with the amount of time Buyer requires to conduct due diligence (see the earlier “Due diligence and timing” section). From my experience, 60 days should be sufficient; I wouldn’t agree to an LOI that had more than 60 days, but in practice the due diligence and contract-writing sometimes take longer than 60 days. Check out the later section “Agreeing to and Extending Exclusivity” for more on exclusivity issues.
Non-disclosure and publicity
More boilerplate. Both sides simply agree to not tell anyone (outside of those in their respective inner circles) about the proposed deal. This provision is especially important for Seller because premature release of news about the pending sale may harm Seller’s business by spooking customers, employees, and/or vendors. Flip to Chapter 7 for more on confidentiality.
Nonbinding agreement
Just in case the nonbinding nature of the LOI isn’t clear, the letter includes language that indicates the document isn’t binding in a court of law. This text is usually boilerplate, but it’s important boilerplate for Buyer because it gives him a clear out should he want to walk away.
Governing law or jurisdiction
In the case of a dispute that needs to be adjudicated in a court of law, both parties agree to the state where that adjudication will take place. If Buyer and Seller are in the same state, that decision is pretty easy because they typically agree to use their mutual home state.
However, if Buyer and Seller are in different states, each party will naturally want to use its own home state. In these examples, most Buyers simply list their home state in the LOI. Therefore, Seller has to pay close attention to the designation in this section of the letter and suggest a change of venue. Buyer may agree to use Seller’s state, but in most cases, a neutral state is the best option.
Agreeing to and Extending Exclusivity
Buyers often prefer to negotiate deals without the nuisance of competition. Strike that; Buyers always prefer to negotiate deals without the nuisance of competition. Who can blame them? Removing competition puts Buyer in a stronger position. That’s why Buyers often want to lock Sellers down with an exclusivity clause (which I discuss in the earlier section “Exclusivity”). In the following sections, I give you the skinny on giving your exclusivity away appropriately and deciding whether to extend expiring exclusivity.
Considering exclusivity in pre-emptive bids
An exclusivity clause prevents you as a Seller from engaging in M&A talks with other Buyers, so I recommend Sellers wait until the IOI stage before agreeing to exclusivity. Competition is a boon to any Seller; as a Seller, the odds of closing a deal are lower when you have only one potential Buyer. Play the field until you have multiple offers.
Buyers sometimes ask to make a pre-emptive bid (an offer made before the due date for offers from other Buyers), which usually includes exclusivity. I’m all for reviewing and considering any offer, but I recommend pursuing a pre-emptive bid only if Buyer is willing to forgo exclusivity. This way, you have protection if the pre-emptive Buyer backs out (the process has been continuing, so you don’t lose any time). Otherwise, you can lose momentum and essentially end up back at square one. Remind such Buyers that if they’re genuinely interested in making a pre-emptive bid, that bid ought to reflect your potential lost opportunity cost. In other words, that pre-emptive bid ought to have some sort of premium in the price.
Asking for a breakup fee (a fee Buyer pays you if he ultimately walks away without closing a deal), may not be a bad idea. Note that most Buyers are reluctant to include a breakup fee (in both pre-emptive bids and regular bids) in a deal, though, so the odds of getting one are rather low.
Running out of time: Prolonging exclusivity
If Buyer is unable to close the deal in the time the LOI allots, you as Seller should confer with your advisors to determine whether Buyer is having problems that may compromise the deal. For example, Buyer may be stalling for time because she doesn’t yet have the money lined up. If you and your advisors believe Buyer isn’t able to close the deal, you may be better off refusing to grant her continued exclusivity. If you think Buyer is stalling, informing her that you’ll begin to talk with the other interested parties is often a good technique to get her to wrap up the deal and close.
However, before refusing to extend exclusivity, consider whether your own actions caused or contributed to the delay. Have you released information in a timely manner? If you’ve been slow in providing Buyer with needed due diligence information, you’re partially responsible for her slow pace and should take that into account when evaluating the situation.
Buyers, do your work quickly and push as hard as possible to close the deal within 60 days. Based on the situation, Seller may not decide to extend exclusivity if you need more time and may instead reengage conversation with other interested parties.
You Have a Signed LOI — Now What?
Signing an LOI doesn’t mean you have a deal. In many ways, the LOI is simply the beginning of the process. As Seller, the deal isn’t done until the money hits your account! As Buyer, the deal is done when everyone has signed all the documents at closing day (see Chapter 16) and the money has been wired to Seller.
In the meantime, Sellers should continue to run the business as though they haven’t made a deal, focusing on profitability and controlling costs as they normally would. Buyers should place the escrow with a third party, usually a bank, and give an escrow agent a set of instructions detailing when to release the money to Seller. Sometimes all the money is released at one time, but in some cases, the escrow may be released over a period of time. The staggered release can be a good way to satisfy both Seller, who undoubtedly wants the money as soon as possible, and Buyer, who may want to keep money in escrow for a longer period of time. See the earlier section “Holdback and escrow” for more on escrow.