Early in the process of selling your company, it’s exciting to receive a “letter of intent,” or “indication of interest” (sometimes referred to as “LOIs”) from a buyer outlining the basic acquisition terms and describing how motivated they are to acquire your company. Typically, buyers don’t issue an LOI without doing business diligence, obtaining internal approvals, and developing a strong business case for the acquisition. That means that an LOI is a huge vote of confidence in the business you have built.
Most companies, eager to capitalize on the momentum of the deal, want to sign an LOI right away and move on to closing the transaction. Although that desire is understandable, once an LOI is signed, the seller’s leverage decreases substantially, and very minor legal language in the letter of intent can have a significant on the stockholder’s return. We always recommend taking the time to talk with an attorney experienced in acquisitions and consider the issues involved before signing. Here are ten things you should watch for when evaluating an M&A letter of intent with your attorneys, accountants, tax, and HR professionals.
- 1. Is it important to have a lawyer review an LOI before signing?
An LOI by its nature focuses on the most significant business terms and issues in a transaction. However, there are a number of reasons why you should strongly consider having an attorney experienced with acquisitions review an LOI before you sign it.
Most LOIs have been prepared and reviewed by attorneys for buyers. They are strategically crafted to highlight issues that are important for buyers and minimize or are silent on issues important to sellers. Moreover, even seemingly simple phrases can gloss over or imply a whole array of detailed terms that may not be obvious to a non-lawyer.
LOI are typically non-binding, meaning that except for some specific terms that are expressly called out, either party can walk away from the deal at any time. However, it is often difficult to negotiate away something in the final transaction agreements that was referenced in the LOI.
The only typical exceptions to the non-binding nature of an LOI are the exclusivity provisions (also colloquially known as a “no-shop”) and confidentiality provisions. Once you sign an LOI, you will likely be prohibited from pursuing other acquisition or financing alternatives. It’s critical to read these provisions through and make sure there are appropriate exceptions written in for any activities that you need to continue during the negotiations with the buyer.
- 2. What deal terms should I focus on? – Purchase Price
Generally, the first and most important term you will look for in an LOI is the purchase price. In some cases, the purchase price will have been discussed and negotiated prior to the LOI, so in such cases you naturally will want to confirm that the purchase price in the LOI is as expected. If you have not already negotiated purchase price, this will be the first place to focus on when you start to think about responding to an LOI with a counter-offer.
In an LOI, the purchase price is typically stated in terms of the total consideration to be paid for the business, inclusive of cash, stock or other equity, earnouts, debt, and the assumption of any liabilities. As a result of differences in the forms of consideration and the timing of payment, although the top line purchase price serves as a starting point, it is rarely the amount that is actually paid to the business owners, which we discuss in further detail below.
Purchase price is most often stated on a “debt free/cash free” basis, meaning that the price paid assumes that the business has no cash, and no debt. If the business has excess cash, the buyer typically expects that to be distributed before closing, and any debt assumed by the buyer would be subtracted from the purchase price.
- 3. What deal terms should I focus on? – Purchase price adjustments.
The purchase price stated in an LOI is usually subject to adjustment, often both at the time of closing and for a short period of time following closing. The most common adjustment relates to the amount of working capital the selling business is required to have on hand at the time of closing. The parties will typically agree on a “target” amount of working capital. On the closing date, if the actual working capital is greater than the target, the purchase price is increased, and if the actual working capital is less than the target, the purchase price is reduced. Because it’s usually difficult to determine exactly what the “actual” working capital is on the date of closing, the parties often estimate the number on the closing date, perform an initial purchase price adjustment, and then true-up the amount based on a post-closing audit conducted by the buyer.
For an operating business, working capital is often thought of as the amount of “cash runway” the business needs to keep on hand to pay ordinary course of business expenses. Business owners tend to view it in terms of the number of months of runway needed to cover the cash needs of the business.
In the context of the sale of a company, however, “working capital” is almost always defined technically as the amount of certain current assets less the amount of certain current liabilities, as shown on a company’s balance sheet, and the technical definitions and accounting methodology are subject to negotiation. Once the definitions and methodology have been agreed upon, the “target” working capital is usually determined by looking at the historical working capital balance of the company over some historical timeframe like 6 or 12 months and taking an average of those balances.
Because buyers typically employ large accounting firms to analyze the seller’s finances, they will sometimes propose accounting definitions and methodologies that are different than the accounting methodologies historically used by the business. When the historical working capital is recalculated, often only days before closing, using the new definitions, the resulting “target” working capital can be dramatically higher than the working capital amounts that the selling business has historically kept. The “target” will also not usually take into account seasonal or other trends in the business that might argue for lower working capital needs.
As a result of the technical nature of the working capital adjustments, and the potential for large, often unexpected, last-minute changes in the purchase price created by these adjustments, it is critical that sellers have a strong accounting partner on the deal team. If possible, it’s ideal to do the working capital analysis and negotiation prior to the signing of the LOI so there are no last-minute surprises.
- 4. What deal terms should I focus on? – Deal structure
After purchase price, the next most important item to focus on is the transaction structure, which usually has a significant impact on the tax to be paid by the sellers.
Broadly speaking, transactions can be structured as an acquisition of assets or an acquisition of the company entity itself, either through a merger or by a direct acquisition of all outstanding equity of the target company from its stockholders (a stock acquisition). The structure of the transaction can have significant (and often deal-breaking) impacts on the tax payable by the seller or its stockholders, and the internal and third-party approvals that are required to complete the transaction.
Buyers will often look to structure the transaction as an asset transaction, or an entity acquisition that is treated for tax purposes as an asset transaction. This lowers their potential liability in the transaction and generally gives them tax benefits.
Sellers, on the other hand, will often want an entity acquisition, which can result in lower or deferred taxes, and will often be simpler and impose fewer post-transaction obligations.
It is critical to understand what the buyer is proposing and work with legal, accounting and tax advisors to understand the tax and other impacts of the structure. Sometimes the parties can achieve a “win-win” structure that achieves the goals of all parties, but more often than not the decision on structure will be to one party’s benefit and the other party’s loss, meaning that changes to structure will ultimately impact purchase price.
- 5. What deal terms should I focus on? – Escrows/Holdbacks
Typically, a portion of the purchase price is not paid to the sellers at the time of closing. Instead, it is placed in escrow, or made subject to a “holdback” – both of which are a way of saying that it will be paid later, if at all. If an LOI mentions either an escrow or holdback, or is silent on the matter, it is important to clarify the parties intention so there are no surprises later.
Generally, the portion of the purchase price (which often ranges from 5% – 15% of the total purchase price) that is placed in escrow or subject to a holdback is paid out some number of months after the deal closes (often 6 to 24 months). Before paying out this deferred amount, the buyer deducts some amount to account for costs it incurs to “fix” problems discovered by the buyer after closing, sometimes referred to as an “indemnity bucket”.
Exactly what expenses and how much can be deducted is a matter of intense negotiation, and it will benefit the seller to be as specific as possible before signing an LOI. In practice, it is rare that the full amount is paid out at the end of the period.
- 6. What deal terms should I focus on? – Earnouts
Like escrows and holdbacks, an “earnout” is a portion of the purchase price that is payable sometime after closing. Unlike escrows and holdbacks, however, earnouts are ways to increase the purchase price based on some post-closing event or business outcome. Often, it is used as a way to bridge the gap between the overall purchase price amount the seller wants to achieve and what the buyer is willing to pay. The seller, of course, argues that the business is going great, and the buyer is skeptical. To bridge the gap, the buyer agrees to a certain closing amount, and then if the business actually performs as expected after closing, agrees to pay more. The amount may be fixed, target-based, or determined by a formula (a percentage of revenue or EBITDA is common).
From the seller’s perspective, it is important to remember that the buyer will be in control of the company following the acquisition, and may not have any incentive to hit the earnout targets. The seller should take extra care to understand exactly how the earnout will be calculated, what the incentives of the buyer will be post-closing, and align the parties expectations and incentives as closely as possible. Even then, except in the most unusual circumstances, the seller should anticipate that the earn-outs will not be fully met.
- 7. What deal terms should I focus on? – Rollover Equity
The most common ways that the purchase price is paid in acquisitions of investor backed companies are cash, stock or other equity of the buyer, or some combination of both. When buyer equity is used to pay a part of the purchase price, that part is called “rollover equity.” Before accepting payment of the purchase price in rollover equity, sellers should take extra care.
First, payment in the equity of the buyer is an investment and should be treated the same as an investment. This means that the seller should do diligence on the buyer company just as if the seller were considering a direct investment of cash. Investor diligence varies from deal to deal, but often includes a review of the capitalization structure and documents, a review of material contracts, a review of historical financial performance and projections, and analysis of the market size, the executive team, the technology, competitors, barriers to entry, and IP protections, among other factors. Because payment in stock is an investment by the seller in the buyer, it is also subject to all of the regulations that apply to issuers and investors, which may significantly complicate the transaction and raise expenses.
Second, rollover equity can still be subject to taxation at closing, which means sellers will have to pay tax at closing on the value of the equity they receive, even though they are not receiving cash to pay the tax. It is therefore extremely important in any deal involving equity to make sure that tax counsel is consulted to make sure that the deal can be structured to defer tax on equity.
- 8. What deal terms should I focus on? – Employee Issues
Another area to make sure is clearly understood at the LOI stage is what the role of management and other employees will be following closing. Some deals are structured as an “exit” where management and other employees are no longer affiliated with the business after closing, while others depend heavily on the continuing participation of seller’s management and employees. It’s important to have those discussions up front so that expectations regarding salaries, benefits, equity compensation and other employment terms are aligned. If the seller has employees, HR and benefits advisors may need to be involved to make sure that the parties’ goals can be achieved without tax or HR issues.
In addition, many transactions will require an analysis of any payments being received by employees to make sure that those payments are not subject to an excise tax. That analysis is very complicated (i.e. expensive) and it’s best to start the conversation with tax professionals at the LOI stage in order to minimize the expense and potential for tax issues later in the process.
Finally, the buyer may require that certain employees of the seller agree to restrictive covenants or non-competes as a condition of the acquisition, as they view the continued involvement of certain key employees as a key part of the “value” of the business they are acquiring. While in the past states such as California have banned employee non-competes, and in April 2024 the US Federal Trade Commission (FTC) issued a rule banning non-compete clauses nationwide, in the context of an M&A transaction, non-competes and restrictive covenants are still generally enforceable. Sellers should closely scrutinize LOIs that contain such provisions, as they may impact the ability of employees and management of sellers to work in their industry or field if they leave the buyer post acquisition.
- 9. Payout Waterfall
Once the entire purchase price structure is understood, the selling company will need to understand which of its various stakeholders will receive the purchase price. Often the selling company has various stakeholders with varying priorities of claims, including taxes, employees, secured and unsecured creditors, convertible debt, preferred stockholders, common stockholders, warrants, and option holders.
Although it’s not typically covered in an LOI (because the seller is largely indifferent), understanding who will receive the purchase price will impact how the deal is perceived by the company’s various stakeholders and, ultimately, whether they will approve or challenge the transaction.
Understanding how the purchase price is divided between these groups (the “waterfall”) can be very complicated. Much of the basic framework will be set out in the company’s certificate of incorporation and other equity documents, but the details (particularly when the deal involves escrows, holdbacks, earnouts or other delayed payment features) are sometimes negotiable and in any event need to be determined. The waterfall analysis is even more complicated where the purchase price may not cover liquidation preferences or the exercise price of outstanding convertible securities like options and warrants. Having accounting, tax and legal counsel expert in transaction modelling will be critical to making sure that the transaction is approved smoothly.
The waterfall can be dependent on the deal structure, so it’s critical to do this analysis at the LOI stage in case changes to the deal structure need to be proposed.
- 10. Consents and process
Every company sale will need approval, at a minimum, of the selling company board of directors and stockholders. Often, in addition, the approval of other parties will be required, depending on the deal structure and selling company agreements. These other parties can include (a) particular investors or groups of investors, who often have blocking rights with respect to transactions, (b) banks and other lenders, (c) government regulatory agencies, (d) licensees and other vendors, and (e) customers.
In some cases, these consents can take a long time to achieve and may disrupt the seller’s relationships with important stakeholders. A seller should consider reviewing the consents that will be needed at the LOI stage to determine if changes to the deal structure will be needed in order to minimize any disruption to the seller’s business.
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