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5 Things to Include in Your LOI (Besides the Purchase Price)

Your letter of intent (LOI) is a critical piece of the business acquisition puzzle. But if that’s the case, then why are so many LOIs poorly constructed? At the end of the day, sellers are going to compare terms from one LOI to another, and these terms are what set you apart from other interested buyers.

What sellers are looking for is the “Baby Bear” of LOIs. Some LOIs are too complicated and detailed, scaring off the seller. While others are too simple and lacking, leaving the seller with a number of questions.

In this quest for the LOI that’s “just right,” you have to first understand what makes some LOIs too complicated and others too simple.

Remember that you can’t negotiate the entire transaction in the LOI. Buyers who try to put every possible deal point in the LOI are missing the objective of that agreement. The LOI is a non-binding document – it should be designed to get everyone on the same page concerning the terms the buyer is offering, and the steps needed to get to closing. Too many times, however, buyers can’t fight the urge to include every little detail of the transaction in the LOI, turning the document into something that resembles a purchase agreement rather than an LOI.

On the other hand, some buyers will go the opposite direction and present an LOI that has very little thought put into it. Buyers guilty of this approach tend to be the type who just want to move on to the next step in the process. By presenting an LOI, they are hoping to get access to the next level of information to evaluate the business. While that’s the true objective of the LOI, if there’s no thought put into the LOI sellers aren’t going to feel comfortable moving forward.

So then what do you need to know and consider when drafting an LOI that has enough detail to make the seller feel good about your interest, but at the same doesn’t overwhelm them with details?

Obviously, the purchase price is the highlight of the LOI, but assume for a minute that every LOI the seller gets is going to have a price in the same ballpark that you are proposing. How do you make your LOI stand out to the seller? What specific items do you need to make sure are addressed? Here are five things to make sure are included in your LOI.

  1. Timing of the Transaction

Every seller wants to know how long it’s going to take to close the deal. While there are literally hundreds of steps needed to close the transaction, a handful of these steps are especially important and need specific timelines or deadlines spelled out in the LOI.

These major benchmarks in the acquisition process are:

  • Financial Review – in most cases, financial review should take 30-45 days from the date you receive your requested materials. Which brings up another detail associated with financial review – you should also specify deadlines concerning the delivery of your document request list and the seller’s response to that request. Typically, you should need two days from the date the LOI is signed to provide your request list, and give the seller 10 business days to provide the material.
  • Financing Approval – assuming you’re utilizing some additional source of funds other than your liquid cash, you need to establish a deadline associated with that function. If it’s an SBA loan, for example, it’s reasonable to request 30-45 days from the date the LOI is executed to secure a commitment letter from the lender.
  • Draft Purchase Agreement – getting all of the documents needed to close a business transaction does take some time, but everything starts with the buyer delivering the purchase agreement draft. Typically, the deadline for delivery of the draft purchase agreement is 10-15 business days following the buyer’s acceptance of the financing terms.
  • Closing Date – every transaction is certainly going to be unique and timing details will differ, but as a general rule on most transactions, closing should occur within 90-120 days of the date the LOI is signed.

It’s also a good idea to include extension language in your LOI regarding deadlines. For example, “this date can be extended if both parties agree in writing.” This way, while there are still specific deadlines in the LOI, there is also an understanding that the objective is to close the transaction and the parties can agree to extend the process if needed.

  1. Funding the Acquisition

Sellers need to know where your money is coming from. By signing an LOI, they are agreeing to take the business off the market and share critically confidential information about their company with you. In turn, you should have no issue demonstrating to the seller that you have the ability to close the transaction.

This goes beyond spelling out how you’ll be funding the deal. While that’s an important detail to include in the LOI, you should also attach additional support to the LOI. If you’re paying cash for the business, attach a bank statement or other account statement that shows the available funds. If you’re utilizing third-party financing, attach a pre-qualification letter from the bank. If you’re getting the money from a family member or investor, provide their financial statement.

  1. Terms of the Purchase Price

While the total purchase price is the most important aspect of the LOI, don’t forget about explaining how that price will be paid. Another critical aspect of the LOI is defining those terms.

If you are going to require the seller to carry a portion of the purchase price in a seller note, go ahead and spell out the specific terms of that note. If you are going to suggest an earn-out, define the mechanics of that compensation. If you plan to offer the seller a post-closing employment or consulting opportunity, go ahead and get that on the table in LOI so the seller can consider it in the big picture of the price.

More LOIs are either declined or accepted based on the actual terms of how the seller gets paid, than they are based on the total purchase price.

  1. Earnest Money

Let’s first define what earnest money is in the context of buying a business. Many buyers are resistant to the idea of earnest money until they understand it better. Earnest money is simply a deposit made into an escrow account that shows the buyer’s good faith, and is ultimately applied to the buyer’s down payment for the business. Essentially, you’re “buying” time and opportunity to closely examine a potential business acquisition without fear of competition.

Earnest money is meant to be a refundable deposit. However, it can be at risk if you violate certain terms of the LOI. Typically earnest money will “go hard” after specific steps have been achieved in the due diligence process, but even then there are certain instances that can still trigger a refund – things out of your control, such as the landlord being unwilling to offer you a lease, or the bank not approving your loan.

Earnest money shows a commitment on your part that sellers recognize and appreciate. Without it, sellers will be hesitant to move forward, and even if they do agree to sign the LOI they will undoubtedly lack confidence in you and the deal.

  1. Seller’s Post-Closing Responsibilities

There are a number of factors that will dictate what you need from the seller after the transaction closes. How involved in the business is the seller? Does the seller perform a specific function that no one else in the company can? What experience do you have in the industry? How much time do you plan on spending in the business?

Based on the answers to those questions, along with many others, you can start to formulate a plan concerning what type of training, transition and non-compete terms are needed to make the deal work. These are important details to the seller – they want to know what’s being expected of them after selling the company.

A Bonus 6th Thing to Include in Your LOI

These five suggestions for your LOI relate to each and every business transaction, and should be addressed in each and every LOI. However, there are some items that are equally important but only specific to that particular business and transaction.

Figure out what’s important to you about the business and the transaction, and put it in the LOI.

If there’s something you know you’ll need to address eventually, go ahead and get it out there in the open and on paper so everyone is aware of it and it doesn’t become a deal-killer weeks down the road.

It may be that it ends up being something that doesn’t actually get covered in the LOI, but at least you’ll be able to move forward knowing the seller is aware of that specific item.

Commons Photo Credit: Source

How To Sell A Machine Shop

So you think you are ready to sell your machine shop business? After all the years of dedication you have put into starting and building a successful machine shop, you'll want to cash in on that investment.

The machine shop and precision machined products industry is a very desired business type and thus can be very sellable. While only a professional business broker can provide a thorough business valuation, looking at the following six factors can give you a little idea of how your machine shop business stacks up. 

Customer Concentration is a Key Risk Factor

"Customer concentration" refers to the resiliency of your customer base to risk of lost customers. For example, if you only have four customers who account for 25% each of the annual revenue of $1M dollars, loss of a single client (for whatever reason) would result in an immediate 25% drop in revenue. This is a high customer concentration business and carries a lot of risk. Compare that to a business with the same annual revenue, but with 100 customers with average tickets of $10,000 and loss of a single client, even a 10, doesn't have near as much impact on the bottom line. This would be a low customer concentration business and is less risky. Customer concentration affects value because it has the potential to determine the success or risk of a business future and can significantly affect the closing price. Business buyers want to buy a business that does not have too high a level of risk.

You can do your own preliminary assessment of customer concentration with a simple report available on Quickbooks -  “Income by Client Summary” (Here's how you can open the report)  This report shows how total revenue is distributed among your customer base.

Types of Customers Help Predict Future Business Growth

Manufacturing in the United States is very sensitive to effects of shifts in the economy, many of which are outside of your control. Your customers will be effected by these changes, which will then affect your business success.  Look at the industries that your clients serve - medical, automotive, aerospace, oil and gas, maintenance products, construction, retail, something else - each one of these sectors are affected by supply and demand, changing regulations, and other economic factors. For example, if your customers are in the fossil fuel industry, that industry is likely to shrink and shrink your revenues along with it. If your customers are in the alternative energy segment, they are more likely to grow over time and your business with them likely to grow as well. Business buyers are looking to buy a machine shop that is, or has the potential to grow rather than shrink.

Certifications Will Increase Value

Businesses that have well-organized processes are more valuable than those that have less structure. Certifications are a good objective indicator of systems and process that you have in place for your business. The International Organization for Standardization (ISO) provides a certification that is important to strategic buyers (buyers that are currently in a similar industry or an industry that could benefit from owning a machine shop) and has an impact on the impression of financial buyers (this is a buyer that is primarily interested in the profitability of the business). Certifications such as ISO 9000 traditionally help the value of the machine shop significantly.

Key Employees Is Essential

From Skilled machinists to an experienced Quality Control personnel, good employees are difficult to find, so if you have them, that provides an important value component to your machine shop. Customer base or past revenue numbers don't mean much if a new buyer cannot continue on with a predictable level of skilled work. Employee turnover is always a issue with shop help; machine shops with low turnover rates are more desirable to potential buyers, especially key employees. You may even need to lock-in contracts for key personnel as part of the business sale.

Technology Should be Up-To-Date

The condition of machines and the level of technology within the shop are significant influences that can affect the price of your machine shop. Short run machine shops using design and prototyping capabilities can demand a premium. Any equipment that needs to be repaired or replaced should be taken care of before attempting to sell your machine shop. A business buyer wants to know that the existing technology will allow the business to remain competitive and profitable after sale, even if there are later plans to further upgrade equipment.

WIP and Raw Materials Are Indicators of Steady Business

Work in progress is extremely important when selling your machine shop, as are raw materials. Production costs include materials and labor used in producing goods as well as allocated overhead. Backlog, a line-item expense for repairs and maintenance, availability of qualified labor, and client industry trends are all issues a potential buyer will investigate in valuing a machine shop. If your records of these things is not in accord with industry standards, it can dramatically and negatively affect the value of your business. No fear, however, such things can be corrected before placing the business for sale with the guidance of an experienced business broker.

Are you ready to see what your machine shop is worth?

Once we have accessed the area’s above we can begin looking at the financial performance of the machine shop. While only a professional business broker has the proper expertise to provide the business valuation of your machine shop, the following formulas can give you an idea of what the value of your business will be and how our business brokers determine the sales price.

In general, increased revenues and cash flow result in higher valuation multiples.

  • 50 to 65 percent of annual revenues include inventory
  • 2 to 3 times SDE plus inventory
  • 5 to 7 times EBIT
  • 3 to 5 times EBITDA

Now that you have an overview of some key factors in valuation and sale of a machine shop business, you can begin the first part of your exit planning journey which is getting a business valuation with a professional business broker. Sigma's professionals have sold numerous machine shops over the years and have the expertise to guide you in preparing your business for sale at its best price, and then finding you the right buyer. Sigma will provide you with a no cost, no obligation business valuation before doing anything else. Feel free to contact us today and we can get that process started for you.

 

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