How to Understand and Evaluate a Letter of Intent (LOI)
The Terms of an LOI (and How to Evaluate Them)
As you receive LOIs, you need to understand their terms to evaluate offers. Almost every term in an LOI is negotiable (if a potential buyer says otherwise, this could be a red flag), but there are a few provisions that will put legal obligations on you as the seller once you sign the LOI. This article summarizes the main terms in the LOI to discuss with your attorney advisor.
The LOI identifies the assets the prospective buyer wants to acquire. Usually, this will be blanket language stating the buyer wants to purchase all of your assets. If you run multiple businesses, applications, products, websites, and so on through the same corporation or LLC, avoid selling something that you need to continue operating those other businesses. Communicate with the buyer so that you both know what’s on the acquisition table.
Next is the purchase price, payment schedule, and a description of how the buyer will pay. Purchase price is the headline number and what gets bragged about on social media, but the payment terms are also critical. Payment terms can include many different possibilities – all cash at closing, deferred payments (also known as seller financing), earn-out payments, equity compensation, and any combination of these and other possibilities.
You need to make sure you understand the payment terms and the purchase price. Don’t be afraid to ask your lawyer to explain every part of this to you so that you know where you should focus during negotiations.
The prospective buyer doesn’t want you to sell your startup one day and start an identical business the next. Most prospective buyers will put the terms of the non-compete in the LOI. There are three main terms to a non-compete agreement: duration, scope, and geography.
As for duration, the shorter the better as far as you are concerned. Scope can be trickier and will involve plenty of negotiation as you define what the business is, what market it serves, and what services it provides. Define this provision as narrowly as possible while still striking a balance to retain buyer interest.
You know your business much better than any prospective buyer. As part of the transaction in selling , the buyer will want you to be available for a transition period to answer operations questions and respond to similar requests. This will probably be the case even if you haven’t agreed to an earn-out or deferred payments in the transaction.
When negotiating these terms, clarify what the buyer can expect from you: How many weeks or months will the transition period last? How many hours will you provide services? How much of your time can the buyer request in a day or week?
You’ll want to provide some amount of transition services so that the handover is smooth and the startup you’ve worked so hard to build continues to succeed, but you don’t want to be at the beck and call of the buyer indefinitely or at all hours.
Conditions to Closing
You should also expect standard LOI conditions such as the prospective buyer being satisfied with the due diligence process, the buyer securing financing to make the purchase, and you both agreeing on the definitive deal documents for the transaction to close. This is mainly legal boilerplate, but your lawyer should still check it carefully to make sure there isn’t a trap in these clauses.
Not every transaction involves escrow and not every LOI will outline the escrow process. It’s best practice, though, to understand the mechanics of the buyer putting money and you putting business assets into escrow. Having the prospective buyer spell out the escrow process in the LOI is one way to ensure you understand how the transaction will close before you commit to exclusivity. If you have any questions about the escrow process, your lawyer can help explain the process to you.
The LOI will contain an outline of the prospective buyer’s due diligence schedule. It’s just a rough timeline. More important for you, though, is that this section also describes the level of access to your customers, facilities, records, employees, advisors, and so on that the prospective buyer needs to carry out due diligence. You might want to place limits on this access to prevent disruption to your business during due diligence.
By signing the LOI, you commit to stop communicating with other potential buyers for a period of time. This allows the buyer to conduct due diligence under the assurance that another buyer won’t come in at the last minute, hijack the deal, and put their efforts to waste.
You want this period to be shorter (maybe even as little as seven days), and buyers want it to be longer. Exclusivity periods of 30 or 60 days are common, and you should expect a longer exclusivity period as the transaction size increases since larger transactions mean more diligence. This is one of the few provisions of an LOI that is legally binding and could be enforced through a court injunction, so you should take this term seriously if and when you sign an LOI.
In exchange for exclusivity, you could ask the prospective buyer to pay an earnest-money deposit. This is more common in a real estate transaction or the purchase of a brick-and-mortar business, but the mechanics would be the same for a digital business. The prospective buyer pays a non-refundable deposit (subject to limited exceptions) of maybe 1-2 percent of the total purchase price that’ll be credited towards the purchase price if the transaction closes.
You and the buyer might already have an NDA in place before you receive an LOI. If so, the LOI should clarify that the existing NDA covers the LOI and all subsequent diligence and communications. Otherwise, ensure the buyer signs an NDA before you send any of your sensitive business or financial data as part of the diligence process after the LOI is signed.
You should expect to see several other terms in an LOI such as choice-of-law provisions and forum selection clauses. These will almost always be set by the prospective buyer and are often not worth fighting about. You should still review these provisions to make sure there is nothing amiss, but spend most of your energy on the terms above.
Receiving an LOI is a proud and exciting moment. But don’t get carried away by the headline numbers – ask your attorney and your Deal Maker to review the terms with you so you know exactly what’s in the offer.
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IAG M&A Advisors is a business intermediary consulting firm, facilitating the buying & selling of businesses. With over 100 years of combined experience, the IAG team has been a leader in the industry by helping the owners of privately held companies “cash in” on all their hard work and get the best payoff possible.
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