Chapter 19

Ten Considerations Prior to Signing an LOI

In This Chapter

Getting a handle on the deal and payment setup

Keeping an eye out for warning signs

Moving forward with an M&A deal means that both sides sign a letter of intent (LOI). Although the LOI is an important step, rushing and carelessly signing an LOI without fully understanding it can create plenty of problems. To help you avoid problems and increase the odds of a successful closing, this chapter presents ten issues to consider before signing an LOI. Check out Chapter 13 for the nitty-gritty on LOIs.

Is the Deal Too Good to Be True?

This caution is especially true for Sellers. That great deal that Buyer is dangling may be nothing more than a Trojan horse, a ruse to lock up you, the Seller, with exclusivity for a period of time before coming back with a lower price after you’ve been out of the market and are therefore in a weaker position. Even if Buyer isn’t trying to pull a fast one, he may not be able to line up the capital needed to actually close the deal he’s offering (see the following section).

As a Seller, you need to be brutally honest with yourself about your company’s value. Frankly, an experienced advisor can be a huge help here. Does the company really warrant the high price Buyer is offering? See Chapter 12 for more on valuation.

How Is the Buyer Financing the Deal?

Does Buyer have the cash, is she planning to tap a bank line, or is she asking Seller to help with the financing? Does Buyer already have access to sources with cash, or is she planning to shop for investors after signing the LOI?

As a Seller, carefully vet potential Buyers and their fund sources. If Buyer is private and is unwilling to share financials, ask for a letter from her bank stating that the bank supports her acquisition plan.

How Much Cash Is in the Offer?

A great offer with a high valuation may not be what it initially seems to be. Does Buyer pay 100 percent of the proceeds at closing? Is any hold back or any sort of contingent payment (such as notes or earn-outs) involved? Is stock part of the offering price? In other words, does Seller have to jump through hoops to get his money?

Weigh all the merits of each deal and not just the valuation number; an offer with a lower deal value but all cash at closing may be a better deal than a higher valuation comprised of contingent payments, because the former may be more likely to result in your being paid in full.

What Are the Conditions of Escrow?

How much money is held in escrow, and who controls its release? In a very general sense, the amount of money held back in escrow should be 10 percent or less of the purchase price, and that money should be released to Seller within 12 to 18 months. Other considerations include how the reps and warranties are associated with that escrow and who receives the interest from the escrow account. Chapter 15 digs into escrow in more detail.

Is the Deal a Stock or Asset Deal?

The age-old issue in M&A is the stock deal versus the asset deal. Sellers usually prefer stock deals because of preferential tax treatments. Buyers usually prefer asset deals because those deals lower Buyers’ risks of successor liabilities (legal problems for Buyer as a result of issues that occurred before the company was sold).

Frankly, perhaps the better question here is, “Does the deal type even make much difference to you?” Depending on variables far too numerous and disparate to recount here, Seller’s specific tax situation may mean the difference between the tax consequences of a stock deal and those of an asset deal is negligible. And Buyers may not really need an asset deal. If the reps and warranties are strong enough, the successor liabilities issue may not be as large as it seems.

Both Buyers and Sellers should speak with their attorneys about the specific deal at hand and their specific situations when determining what type of deal to accept.

How Does the Deal Settle Working Capital Issues Post-Closing?

Does the deal include a working capital adjustment (adjustments made to the purchase price after closing, based on the actual balance sheet values)? A working capital adjustment can be a major lurking surprise, especially for Sellers. Sellers should make sure all current liabilities are in fact current! If not, Seller may face a substantial post-closing adjustment.

Along those lines, Buyers should note whether all Seller’s receivables and payables are current or whether she’s slow to collect receivables and pay her bills, especially if Buyers are assuming the accounts receivable and accounts payable as part of the deal. Buyers need to be careful about assuming payables that should have been paid months ago. Paying overdue bills is Seller’s responsibility! Flip to Chapter 17 for more on post-closing issues.

Is the Inventory 100 Percent Salable?

Inventory can be another pain point for Buyers and Sellers. A Buyer operates under the assumption that she can sell all the Seller’s inventory. If the Seller has obsolete inventory, the Buyer may press for a post-closing adjustment.

Hiding obsolete inventory from a Buyer is an unwise plan. A Seller who doesn’t address the issue of inventory salability is asking for trouble! Sellers need to bite the bullet and either write off inventory prior to close (thus reducing earnings and possibly the valuation) or brace for a large post-closing adjustment (see Chapter 17).

Who Pays Off Any Long-Term Debt and What Happens to the Line of Credit?

Make sure you’re clear on who’s responsible for the Seller’s long-term debt and any short-term lines of credit. Either the Buyer assumes it or the Seller pays it off.

Seller shouldn’t assume Buyer will simply pay off the debts of the business. If Buyer is going to pay off the business’s debts, he’ll first subtract those debts from the proceeds of the business sale.

What Are the Tax Implications of the Seller’s Accounts Receivable?

Another lurking surprise for some Sellers is the taxability of accounts receivable. Taxing authorities may consider a company’s receivables as income and therefore tax the receivables at Seller’s marginal income tax rates rather than capital gains rates.

Sellers, confer with your tax advisors about the proper tax treatment of your company’s accounts receivable as the result of the sale of your company.

Is the Seller Signing a Noncompete Agreement with the Buyer?

Many deal-makers often overlook and underappreciate the noncompete agreements that accompany most deals. These agreements prevent Seller from competing with Buyer for some length of time and in some defined geographic area. (Chapter 17 provides more info on these agreements.)

Sellers need to remember that part of the purchase price is wrapped up in the noncompete agreement. Buyers won’t be willing to pay the full price unless Sellers agree not to compete.