Insights

The “Marriage Proposal” of M&A
POSTED 10.22.19 M&A

The Letter of Intent (LOI) – sometimes called a term sheet – is a vital first step in many M&A transactions. With an LOI, Buyers show that they’re serious about acquiring a business. And it allows the Buyer and Seller to have conversations to discover whether the vision each has for the deal lines up with the other… before they spend time and money on negotiations and due diligence.

It’s like the marriage proposal before the wedding, which is when the deal closes and the purchase sale agreement – which often contains very similar terms to the LOI – is signed.

An LOI is non-binding. But it shows commitment, outlines the basic structure of the deal, lays out a path forward, and contains an agreement to not talk to any other potential Buyers.

What Should Be in a Letter of Intent

LOIs typically vary in length from about two to 10 pages, depending on a number of factors. Some argue a shorter LOI can help speed up the negotiating process as it centers the conversation around the most important elements of the deal. If there’s not agreement there, the logic goes, there’s no need to discuss other factors.

But in general, it pays – literally – to be very detailed in your LOI, especially for Sellers. What’s dangerous about a simple, two-page LOI is if there are any questions or disputes about terms, the Buyer has all the advantage and leverage. So you want to have as much spelled out as early as possible. This makes terms much easier to agree to later – and you can always pull out a term. But it’s a lot harder to add language to the LOI after it’s signed.

During the LOI stage, Buyer and Seller should talk indemnity. This, of course, is when the Seller is liable to the Buyer financially if the Seller’s reps and warranties weren’t accurate and not uncovered in the due diligence process. There’s a remedy that makes this discussion virtually non-confrontational.

It’s at this point that the Seller should build in an option for Representations and Warranty (R&W) insurance. Any escrows or withholds (which will be substantially reduced) will be based on the amount of R&W insurance in place. And if there is a breach, a third party – the insurer – will pay the damage, so the Buyer is protected, and the Seller is off the hook.

At the LOI stage, you don’t need to determine how much coverage is needed, or the cost. As a Seller, you just want that option there. But you should reach out to a broker. With the proposed purchase price, details on how much indemnity the Buyer is expecting- say 10% or 20% of purchase price, and what, if any escrow or withhold the Buyer is seeking, the broker can come back with a quote and a proposed policy. Having knowledge of the R&W cost in advance provides leverage when negotiating who pays (equal shares is very common).

With that info, the Seller can say, “We agree to the escrow and indemnity cap if we can have R&W insurance to cover it”. That puts some power back in their hands. This usually also accelerates the Seller’s acceptance of the LOI, shows good faith, and removes fear on the Seller’s part.

The other components of an effective LOI include:

  • Purchase price
  • Deal structure

Is the transaction a stock or asset purchase? What are the forms of payment? This can include cash, stock, seller notes, earn-outs, rollover equity and contingent pricing.

  • Exclusivity period

When the parties agree not to shop around. The Seller can’t talk to any other potential Buyers. This is typically a binding clause requested by the Buyer, who wants to ensure that Sellers are negotiating in good faith. It’s typical for Buyers to request an exclusivity period from 30 to 120 days, while Sellers will typically want as short a period as possible.

Because the Seller has taken themselves off market, if the Buyer drags their feet, the target can go back out to market. It happens often enough. On this note, Sellers have to be very careful when Buyers offer big topline numbers subject to lots of terms that are left nebulous.

  • Confidentiality agreement

Sensitive information shared during talks will not be shared. The Buyer can’t share the secret sauce recipe. Both parties have likely already signed an NDA earlier in the process, but this clause further ensures that all discussions regarding the proposed transaction remain confidential.

  • Closing date

An agreement for the signing and closing to be at a specific target date. It’s always subject to change. But if the Seller sets this deadline, it incentivizes the Buyer to take action.

  • Closing conditions

What are the tasks, approvals, and consents that need to be obtained before or on the closing date? For example, the amount of cash that should be in the business at closing, what happens to employees – what percentage remain, and debts or obligations that must be resolved/paid. The company must also be operating at the same level as it did as negotiations began.

NOTE: Closing conditions are viewed by courts as literal. If the condition was for $400K in operating costs to be left in the business, and at closing you only have $375K, it’s a serious violation of the terms. The Buyer will deduct the shortfall from the purchase price, or the Buyer can literally walk away from the deal with no liability.

In short, Buyers don’t want to acquire a company to find they defaulted on lease payments or loans or has other issues.

  • Breakup fee

Compensation if either party stalls or delays. This clause is also typically binding, though breakup fees are less common in the lower middle market. In larger deals (>$500MM), breakup fees of approximately 3% are typical.

  • Management compensation

Which members of the senior management will stay on? Who will be provided equity plans? This aspect of the deal may be vague at the LOI stage before due diligence has been conducted.

  • Indemnity
  • Approvals

Does the Buyer or Seller need any approvals (e.g., from a board of directors, regulatory agencies, customers) to complete the transaction?

  • Due diligence

How will due diligence will be conducted? This includes the nature of information (financial, technical, etc.) that will be disclosed and the manner in which it will be disclosed. A sample term would be the need to speak with three of the Seller’s largest clients. Or a requirement to interview certain people in management.

  • Indemnity Provision

Includes size of escrow or holdback. This is the IDEAL place to include wording referring to Indemnity to be paid by R&W insurance. This will not appear fully until the purchase agreement, but sometimes the Buyer will include summary terms of their expected escrow terms for holding back some percentage of the purchase price to cover future payments for past liabilities, and this is where the Seller can counter (reduce) the Buyer’s amounts using R&W.

  • Representations and Warranties

This also may not be finalized until the purchase agreement, but if there are contentious or non-standard terms, the Buyer may include them in the LOI.

Where to Go from Here

The Letter of Intent (LOI) is an important step in most M&A transactions. It serves in some ways as a preview or summary of the deal terms that would be expected to appear in the purchase agreement down the line. 

It’s not unheard of for Buyer and Seller to skip over the LOI and go straight to the purchase agreement. However, an LOI can be useful for a number of reasons.

It helps ensure that Buyer and Seller have similar (or at least similar enough) expectations around deal structure, scheduling, and other big concerns. It also means that any potential deal-breakers come up earlier in the process, so that the parties can either a) stop the transaction process before significant resources are spent on due diligence and drafting deal documents or b) figure out a resolution sooner.

The LOI is also a nice way to ensure that Seller and Buyer are on the same page about how due diligence will be conducted. In addition, the LOI’s terms serve as important protection for all parties in a deal (e.g., exclusivity periods protect Buyers, while breakup fees protect Sellers).

Representations and Warranty insurance can be a key part of your next M&A deal, and timing is critical. It’s vital that this coverage and its impact on the indemnity cap and amount of withhold be included in the LOI.

As a broker, I’d be happy to discuss this specialized coverage with you at your convenience. Please contact me, Patrick Stroth, to set up a call at pstroth@rubiconins.com.