Letter of Intent

Assuming your non-binding proposal meets with a positive response, presumably after a bit of back and forth, the next step is to prepare a more formal document known as a letter of intent (LoI). While most LoIs provide the buyer with an "out," it is a somewhat more formal document than the proposal discussed above. Therefore, we recommend that you don't submit a LoI until your lawyer has reviewed it. Note that some experienced buyers often start with the LoI instead of the proposal that we recommend.

The LoI is basically a formal version of the proposal with the modifications as agreed to by the parties. While a LoI is a long way from a closing, it is a legal document that commits the parties to certain steps and restrictions and it defines, or at least outlines the steps that will be taken toward the closing.

We advise that you put the agreed terms in writing in plain English first and let your lawyer revise it as necessary, adding necessary protections for you.

The letter of intent is a detailed outline of the deal. While LoIs vary, most include the following stipulations

• Price
• Payment terms
• Target closing date
• Contingencies (i.e, deal may be dependent on financing such that if buyer can't obtain financing, deal can be cancelled without penalty)
• Stipulation for due diligence (as a contingency)
• Initial deposit (if any)
• Restrictions on the seller against further marketing of the business for a stated period of time
• and probably more, depending on the situation

Price

The price that you pay is obviously very important to the success of the deal. Determining a reasonable price is covered in detail in chapter

Payment Terms

The terms of a deal can be as important as the price. The right terms may allow you to reduce the total amount that you pay, to finance part of the purchase with earnings from the business that you acquire, and to have the seller retain some of the risk for a period of time.

Seller Provided Notes

Will the owner be taking back paper to finance part of the deal? What interest rate will you pay on the note? What collateral is required to secure the note? From your perspective as a buyer, the business itself would be a good thing to pledge as security. Should it turn out that the business had really severe problems that you somehow missed, you can give it back and lose only the down payment. A seller, on the other hand, will see things differently; he's handing you a money-making business and if you mess it up he doesn't want a money-losing business back, so he may want additional security.

Earn Out Provisions

You may be able to have the current owner accept some of the purchase price in the form of an earn-out provision. In this scenario, you offer a percentage of sales or profits (typically gross profits) for some period of time after the sale.

Claw-backs

These are rare, but can be useful in certain situations. Usually they are used to deal with situations in which the purchase of a particular business has an extraordinary risk associated with it. Here are a couple of examples:

Example 1: A purchaser is buying a business where 80% of the sales are from three large customers. The seller assures the buyer that the business has solid relationships with these customers and that they are unlikely to leave, but the buyer is wary. Forty percent of the purchase price is placed in an escrow account and paid out to the seller in 24 equal monthly payments. In the event that a major customer fires the company in the first two years, the money that remains in the escrow account is paid out to the buyer.

Example 2: A seller maintains that 35% of his business is done in cash and he has not reported that income to the IRS. The buyer insists on having the bulk of the purchase price remain in escrow for a year and the buyer and seller agree on a formula to distribute the escrow fund if sales are less than say 95% of the amount claimed by the seller during that year.

Non-compete Agreements

You do not want to buy a business only to find that the former owner opens a competing establishment that limits the prospects of the business that you just acquired. To make sure that this does not happen, you include a covenant not to compete in the purchase and sale agreement.

A covenant not to compete can not be so broad as to make it impossible (or nearly impossible) for the former owner to make a living or a court will hold it to be unenforceable. So, you want to craft it in a way that makes it difficult for the former owner to compete without making the former owner unemployable. How you craft it depends on the nature of the business that you are buying. For example, if you were purchasing a dry cleaning business where most of the customers were local you might design a non-compete agreement that prevented the owner from working for a retail business within 250 miles of any location of the dry cleaning business that you are buying. By contrast, if you are buying a software company that makes software for colleges and universities worldwide, the covenant might restrict the former owner's employment by any company that derives a substantial portion of its revenues from providing software to educational institutions.

Target Closing Date

Choose a target closing date that allows sufficient time for due diligence, acquiring bank financing, and other needed tasks. Consult your lawyer and accountant about time needed to perform these steps. Generally, closing happens 60 to 100 days after the LoI is signed.

Contingencies

The LoI can be made contingent on the ability to raise funds for the acquisition, results of Phase I or Phase II environmental assessments, assuring that the business contracts are transferable, and any other thing that needs to occur for the buyer to be comfortable closing the transaction. Acceptable performance in due diligence is required and usually acceptable is defined as at the sole discretion of the buyer, allowing the buyer to back out easily (see below).

Stipulation for Due Diligence

Technically, due diligence is a contingency, but one that deserves its own category. Virtually all LoIs grant the buyer the right to verify that all that was represented to him regarding the selling company is accurate and complete. The items that are examined during due diligence includes financial information (going back several years) and much more. It is the buyer's right, indeed, his responsibility, to examine all aspects of the business he is about to acquire. The severity of this stipulation varies. In some instances it will state that the buyer may cancel the deal, for example, if he finds material inaccuracies in due diligence. In other cases, the buyer may cancel the deal based on anything he learns in due diligence that doesn't meet his approval. Be careful that the due diligence language is broad enough to allow you to cancel or renegotiate the deal without penalty if you find any surprises that will impact on the company's value or suitability for your intended purpose in making the acquisition.

Initial Deposit (if any)

Often, a small amount of money (maybe 5% of the purchase price) is deposited in escrow with either the buyer's or the seller's lawyer. The deposit is usually fully refundable if the buyer is unhappy with anything that he discovers during the due diligence period. The money serves as an indicator that the buyer is serious and committed to closing the transaction. Sometimes this deposit can be refered to as "earnest money."

Restrictions on the Seller Against Further Marketing of the Business for a Stated Period of Time

The LoI usually requires that the seller take the company off the market as soon as it is signed. This means that the seller must cease negotiations with other potential buyers. The seller can resume marketing the business if either the buyer indicates that he wants to back out of the transaction because one of the contingencies is not satisfied or if the closing does not occur by the stated date.

The stipulations discussed above are the most common ones that are contained in most every LoI for a business acquisition. Depending on the situation, there can be many other LoI stipulations and requirements. A LoI is a legal document that binds the buyer and the seller in several ways. That is why we recommend that you don't sign a LoI without obtaining the advice of an attorney experienced in business acquisitions.

Payment in Stock

You may be able to interest the seller in taking some, or all, of the purchase price in the form of stock in the combined entity or stock in the acquired company (if it will continue to be operated as a separate legal entity). If you want to convince the seller to accept equity, the first question is how much equity do you want the seller to retain. If either party holds a minority interest, it will want assurances that its interests will still be respected. A majority shareholder can pay himself (or his family members) an inflated salary, make purchases from or sales to other companies that he owns at prices that are inflated, or engage in any number of other methods to deprive the minority shareholder of fair value. To ensure that this does not happen the offer will often contain a big stick that the minority shareholder can use - allowing the minority shareholder to force a sale of the entire company, for example. Other decisions may require a super-majority vote of shareholders.

The scenario in which the seller retains equity works best if the seller will continue to operate the business independently.

Deal Details

Real Estate

Often, a business includes significant real estate holdings. While it might be advantageous to acquire the real estate as part of the transaction, there are a number of scenarios in which it might make more sense to allow the seller to retain the real estate and sign a lease at closing, leasing the real estate back from the seller.  After all, you want to invest in the business, not speculate on property values. You need to consider how integral the real estate is to the operation of the business, how important the location is, and what would it cost to move the business.

If you decide to acquire real estate, it is vital that you understand any environmental and zoning issues, and have the real estate and buildings independently inspected and appraised. Alternatively, if you allow the seller to retain the real estate, you need to negotiate a lease that is signed as part of the closing process.

There will always be current assets and liabilities when you close a deal. Generally, cash and cash equivalents are retained by the seller. However, the accounts receivable and payable can be more complex.

With all but a few cash businesses, whenever you close there will be accounts receivable. The seller will usually want to include the receivables as part of the sale since it will be easier for you to collect them, both in terms of having staff and because customers will not want to harm the ongoing relationship with you, the seller gets the cash immediately at close, and the buyer then assumes the credit risk. However, paying for the account receivables at closing increases the cost of the acquisition and exposes you to credit risk. On the other hand, having the seller retain A/R draws customers' attention to the ownership change can result in customer confusion about which invoice is due to which party, and the seller may have issues cashing checks since the business name is usually included in the sale.

A reasonable compromise on the treatment of Accounts Receivable is to have the seller retain the A/R, but have the buyer agree to collect them on the seller's behalf. The agreement may need to specify how payments that are received will be treated--should a payment be applied to oldest balance vs. applied to a recent invoice whose dollar total is the same as the amount of the payment, for example. The agreement should also specify how often the buyer will remit collected funds to the seller, specifics about what type of services and reporting will be provided, and what charges if any the buyer can charge for the collection services.

There will also be accounts payable at closing. Usually, the seller is responsible for A/P up to the day of closing. Bills that span the closing date (utility, phone, etc.) are pro-rated.  A small amount of money from the closing price can be left in escrow and used to reimburse the buyer for A/P that the buyer pays for which the seller is responsible. After some period of time (60 to 90 days) any funds remaining in the escrow account are distributed to the seller.

Customer Retention

If the business has significant customer concentration, where a few customers are responsible for the bulk of the sales, or the primary value of the business is the customer base that is being acquired, as in the payroll service example, then the deal may require a customer retention clause. This allows the buyer to mitigate the risk of acquiring the business only to see the customers leave. Customer retention can be guaranteed by escrowed funds or an earn-out provision.

Employment Contracts

As a buyer, you may want to include employment contracts as part of the purchase. Contracts can be used to lock in key employees, including the seller. A generous employment contract may be a way to sweeten an offer without requiring additional cash up front. The employment agreement also allows the seller to feel comfortable that he won't be forced out after closing.

Dealing with multiple owners

Many businesses, even small ones, have more than one owner. When trying to deal with multiple owners, it is important to determine whether all of the major owners are truly willing to sell.  If a major owner, especially one that is active in the business, does not want to sell, it can easily scuttle the deal. If possible, meet with all of the owners relatively early in the process and assess their commitment to doing a transaction. It can be helpful to pose questions such as "Do you want to retain some equity?" to guide you in proposing a deal structure that will be acceptable to the various owners.

We have seen professional buyers insist before entering into negotiations that all owners agree to allow a single shareholder to vote their shares on issues related to the transaction. This approach can work when dealing with a family owned business, where shareholders can rely on one family member to act in their best interest, but is impractical in a situation with many unrelated shareholders.

Purchase and Sale Agreement

After the LoI is signed, both parties have agreed legally and in principle to consummate a deal pending that all contingencies are met and that due diligence results are satisfactory to the buyer. Invariably, there will be some issues that need to be ironed out after the LoI is signed and before the P&S is signed, but the momentum is toward finalizing the acquisition as defined in the LoI.

Often, the lawyers will be working on the Purchase and Sale agreement while due diligence is being carried out.