Following the nondisclosure agreement, the letter of intent (LOI) is typically the first step in formalizing the company sale process when a company auction process is not involved. The LOI stage is usually an exciting time for the seller—the seller is full of optimism, there is no deal fatigue, and the new relationship with the buyer has not yet been tested by heated discussions.
The LOI can accomplish a lot. At a fundamental level, it establishes whether there really is a deal on key issues. Often times, first time entrepreneurs and those who have not been through a company sale process are willing to proceed with a lengthy “no shop” or “no talk” exclusivity requirement, based only on a non-binding agreement on price. While purchase price is obviously an important term, it by no means is the only important term.
In most deals, a seller in a company sale process has the most leverage at the LOI stage of negotiations. The seller has not invested a lot in the deal and it’s the easiest point at which to just say “no” to a request of a buyer. Rarely, however, do terms get better for the seller after the LOI stage. On the flip side, buyers will typically take aggressive positions after the diligence process or on the initial draft of the purchase agreement. They know sellers have committed a lot to the deal and at some point in the process, become committed to making the deal happen for a variety of reasons. Often, a seller is willing to concede more at a later stage than what the seller would have been willing to do earlier. As a result, it’s typically a good idea for a seller to get tentative agreement at the LOI stage on key terms that inevitably have to be negotiated.
From a seller’s perspective, here are some of the areas worthy of consideration of including in the LOI:
- Deal structure, especially if the seller is looking for capital gains treatment
- Items that affect net proceeds at closing
- Escrow holdback amount and time period for the escrow, or a statement that there will be no escrow
- Working capital adjustment amount or a statement that there will be none
- Earn-out (if any) or a statement that the listed purchase price does not include one
- Duration of the survival period of seller’s representations and warranties
- Basket and cap for post-closing liabilities
- Indemnification cap exclusions
- Employment requirements of key individuals or at least which individuals or types of individuals the buyer intends to retain, post deal (e.g., 80% of software engineers)
- Targeted closing date
Buyers will often resist some of the provisions under the guise that, “we don’t know enough information at this point, so we prefer to agree upon those terms after the diligence process.” The same thing though could be said of the purchase price. The reason to negotiate the points earlier is that it places the burden on the buyer to change them later. Once a term is in the LOI, the parties usually tend to feel sort of a “moral” obligation to adhere to those terms. Buyers frequently need a major diligence finding to justify a modification to a term contained in the LOI, even though those terms are usually nonbinding.
Including more deal points in the LOI also helps to limit surprises later that may surface, such as, “we always require sellers to have no indemnification cap for breaches of representations related to intellectual property.” Moreover, without touching on the key deal points at an early stage, it’s hard to determine whether the parties have a basic meeting of the minds, even with the assumption that there will be no material surprises in the diligence process.
As with most other things, deciding on the appropriate amount of detail in the LOI is a balance. On the one hand, it requires including enough detail to help ensure that there really is likely a deal, while also, from the seller’s perspective, taking advantage of the leverage that a seller typically has at the LOI stage. On the other hand, the seller should not put too much pressure on the buyer at the formative stages in adding too much detail and unnecessarily elongating the time period of the LOI stage. Striking the right balance is the first step in a successful sale process.