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.
- 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.
- 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.
- 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.
- 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.
- 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.