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For many business owners (particularly those actively looking to sell their companies), few things are as exciting as receiving a Letter of Intent (“LOI”) from a prospective purchaser. Beyond the sense of personal validation stemming from the fact that a sophisticated counterparty sees an asset worth paying for, many business owners likely view LOIs (specifically the purchase price outlined within them) as a just reward for decades of hard work, sacrifice, and illiquidity.
Understandable as these reactions may be, I would argue that they are premature at best, and misleading (or even incorrect) at worst. I say this because:
(1) Contrary to the beliefs of some business owners, LOIs don’t represent an end in any real sense of the word. Instead, they represent the very beginning of an M&A process, a large percentage of which never close, and substantially all of which tend to be longer, harder, and more emotional than even the most conservative forecasts may suggest.
(2) Savvy acquirors can (and do) utilize LOIs strategically, for purposes well beyond the simple act of papering their desire to purchase your company exactly as outlined in the document.
This blog post attempts to speak to prospective sellers of small or medium-sized businesses about what LOIs are (and more importantly, what they are not), and how experienced buyers may strategically utilize them as tools to further their own objectives, sometimes at the expense of those of the seller.
If you’re looking for a more tactical overview of LOIs (including a walk-through of many of the terms that are typically contained within them), I would suggest reading my other post, “Busting the Biggest Myth About Selling Your Business“.
What is a Letter of Intent?
In its most basic form, a Letter of Intent outlines the price and basic terms under which another party may be willing to purchase your business. The most important thing to understand about an LOI is that, save for specific sections, substantially everything contained within it is not legally binding (most terms tend to be subject to a caveat that says something to the effect of “subject to further due diligence”). This means that purchasers are usually free to change (or completely walk away from) the proposed agreement at any time, for any reason, without any recourse.
From a purely legal perspective then, one can make a reasonable argument that LOIs are hardly worth the paper that they’re printed on. They can however be valuable from a commercial or strategic perspective however, as we articulate in further detail below.
There are only a few sections that tend to be legally binding in any given LOI. More specifically:
- Confidentiality: Often valued more highly by the seller, this section describes how the buyer is to treat all information received as highly confidential, and to use it solely for the purpose of evaluating the suitability of the proposed investment. (It’s worth noting that prior to the issuance of an LOI, a non-disclosure agreement has likely already been put in place between the prospective buyer and seller, and as a result the confidentiality section of a LOI can be argued to be somewhat redundant).
- Exclusivity: Often valued more highly by the buyer, this prescribes a given period of time (typically anywhere between 30-120 days) during which the seller is not legally permitted to speak with any other prospective buyers. From the perspective of the buyer this is commercially reasonable, as they’re likely to expend considerable time and resources in evaluating the company, and these costs would be difficult to bear if the target was free to continually shop the deal to the next highest bidder at any time. It’s important to recognize that exclusivity is often strategically valuable to the buyer, as a) It precludes their competitors from evaluating the company in question; b) it gives them time to perform detailed company and industry analysis, and c) absent a “break fee”, they’re free to walk away at any time and for any reason.
- “Break Fees”: Though these aren’t terribly common in small business M&A, a “break fee” is essentially an agreed upon dollar amount that one party owes to the other if the transaction in question is not successfully consummated.
Other Ways in Which Buyers May “Strategically” Utilize LOIs
In addition to gaining the valuable benefit of exclusivity, buyers often use LOIs to:
- Surface the Seller’s Value Expectations Early: Time is the most valuable asset of the prospective purchaser (especially those who are quite literally in the business of buying companies), and the most frequently cited waste of time among buyers is spending too much time with a seller whose valuation expectations were never going to align with what that buyer was willing to pay. One way to combat this potential waste of time is to issue an LOI rather quickly, to gauge how the seller reacts to the valuation that is proposed within it. If the seller doesn’t completely balk, then the buyer may reasonably conclude that the transaction in question is worth spending at least a little more time investigating. If the seller does balk however, then the buyer has successfully prevented spending (or wasting) time on a transaction that was highly unlikely to close in the first place. Though of course valuation expectations can simply be discussed verbally in the absence of an LOI, from the perspective of the seller there does seem to be something especially resonant about receiving that proposed valuation within what appears to be an official legal document.
- “Anchor” the Seller’s Valuation Expectations: Though the vast majority of us aren’t usually consciously aware of it, “anchoring” is one of the most common and powerful psychological biases that human beings are subject to. Anchoring describes a phenomenon whereby somebody’s estimate of a particular value tends to stay reasonably close to a number that had been previously proposed to them. For this reason, it is often in the best interest of the buyer to first propose a valuation for the company, because even if the seller disagrees with it, the anchoring effect suggests that she is likely to offer a counterproposal closer to the original suggestion of value than she otherwise would have. If the seller’s counterproposal is sufficiently close to the original proposal (as the anchoring effect would suggest), then the surface area of a deal may begin to present itself. If not, then the buyer has yet again been efficient with her time, and quickly moves on to the next target.
- Build “Switching Costs”: At a general level, the more time, energy, and effort that a seller expends with a single buyer, the less willing that seller becomes to expend similar levels of time, energy and effort with a new buyer, especially if it requires her to start the process all over again. In part, this may explain why deals are more likely to fall apart in month 1 than in month 8 (though unfortunately, the latter still happens). To illustrate an extreme example: Some (unscrupulous) private equity firms have developed a reputation for shaving value off of the agreed upon purchase price in the very late stages of a transaction, often as late as weeks or even days before closing. In doing so, they’re effectively taking advantage of all of the switching costs that have been built throughout the course of the deal: Given all of the time, energy, and effort that the seller has already expended with them, that seller is more likely to begrudgingly accept a slightly lower value in the interest of finally getting the deal done than they are to completely restart the process from scratch with a new buyer.
It’s likely worth mentioning here that, naturally, not all buyers are created equally. Though there are indeed some buyers who regularly act in bad faith late in the process as described above, most (rightly) do not, due in no small part to the irreparable damage that doing so would have on their reputations as buyers. It’s likely also worth mentioning that some of the dynamics above can simply be a natural consequence of an LOI (for example: higher switching costs in the later stages of a deal), as opposed to the result of the deliberate efforts of a conniving buyer looking to “pull a fast one” on a less experienced seller.
Non-Price Considerations in a LOI
When sellers first receive a LOI, in almost all instances their eyes immediately go to the purchase price being proposed. Though understandable, sellers must realize the countless number of levers – beyond just the purchase price – that can materially impact both the money that they receive and the risk that they will continue to bear, even after the successful consummation of the transaction.
A small sampling of such terms includes: Earn-outs, seller notes, equity rolls, cash vs. stock consideration, asset v. share sales, reps, warranties, & escrow, the working capital adjustment, indemnities, and many others.
To better understand the countless terms – beyond purchase price – that you must pay careful attention to when selling your business, please see my other blog post, “Busting the Biggest Myth About Selling Your Business”. Indeed, no discussion of LOIs would be complete without carefully considering these hugely important non-price terms.
The Reoccurring Debate: Should LOIs be Detailed, or Written at a High Level?
Given that most of the terms in a LOI are not legally binding, some don’t particularly see the point of negotiating additional details beyond the basic broad strokes of valuation and structure. People who fall into this camp may prefer to “stage” the time and effort that they commit to any given transaction, preferring to leave these details until later in the process once they have learned more about the business in question (which usually only happens after exclusivity has been attained). Why spend time negotiating specific details if you don’t yet know enough to know whether this is a deal that you even want to do?
Others, however, prefer the LOI to be as detailed as is reasonably possible. These people would likely argue that it is in everybody’s best interest to get the possible sticking points on the table as early as possible, to prevent a situation where countless hours have been expended by both parties in due diligence, only to eventually hit a stalemate that otherwise could have been surfaced much earlier in the process. These people may also argue that detailed LOIs tend to expedite, simplify and streamline the eventual negotiation of the purchase agreement, which is otherwise an incredibly time-consuming process.
So, who is right?
As you likely already know, there isn’t a single objectively true answer to this question, as both approaches come with their respective pros and cons.
Though there will indeed be exceptions to this, buyers may be more likely to fall into the former camp, for many of the reasons that have already been mentioned. As a buyer, there is indeed quite a lot of value in gaining exclusivity to take a closer look under the hood of any given company, and their best alternative to a negotiated transaction (“BATNA”) is reasonably strong, as they likely have several other companies and transactions lined up if this particular one doesn’t work out. Further, their switching costs are reasonably low, especially if they’re mindful about how much time they dedicate to a deal before they come into possession of the critical details that only tend to present themselves later in most deal processes. Lastly, recall that there is very likely a large asymmetry of transaction experience between buyer and seller (in favor of the buyer). This means that while the seller may think that a signed LOI is effectively a done deal in-waiting (making them more willing to grant exclusivity to a single buyer), the buyer knows better, and specifically knows that the negotiating leverage largely transfers over to them (all else being equal) once an LOI is signed.
Again, speaking broadly, sellers may be more likely to fall in the latter camp. Selling a company is an incredibly disruptive and time-consuming process (which, in small companies that are still dependent on their Founder or CEO, can negatively impact the operational and financial performance of the company). For that reason, before expending the enormous amounts of time and effort required to satisfy all of the buyer’s diligence requests, sellers want to have as much certainty as is reasonably possible that pursuing the transaction in question will be a worthwhile use of their time. This is especially true if sellers know something about their companies that isn’t immediately apparent to any given buyer, but may serve as a potential sticking point later in the process (change of control provisions within customer contracts, technical debt in the software code base, key-person risk residing within long-tenured employees, and so on). In these cases, it may be most efficient to table these issues early and often to prevent the potential for wasted time.
In their most basic form, Letters of Intent outline the price and basic terms under which another party may be willing to purchase a business. However, many business owners often fail to appreciate that savvy acquirors can (and often do) utilize LOIs strategically, for purposes well beyond the simple act of papering their desire to purchase a company exactly as outlined in the document.
The next time that you receive an LOI, you would do well to watch carefully for each of the dynamics discussed above, especially when contemplating the decision of whether or not to grant any given buyer with exclusivity.
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