As part of negotiating the purchase of a business, the buyer and seller will enter into a letter of intent (LOI) that sets out the framework for a deal. While the terms of the deal as set out in the LOI are non-binding, the LOI does bind the buyer and seller with respect to:
1. the confidentiality of the offer; and
2. the period of exclusivity that the buyer is afforded in order to conduct due diligence on the seller's company, and to negotiate the purchase agreement.
This second point is critical. Sellers tend to have the upper hand in negotiations up to the point that they give exclusivity to one buyer. Once a buyer is afforded exclusivity, they have the negotiating advantage. The dynamics of the negotiations between the buyer and seller can be graphically depicted in what is sometimes called the "buyer-seller advantage curve."
BUYER-SELLER ADVANTAGE CURVE
The seller initially has the negotiating advantage because of his/her ability to conduct an auction for the sale of the business and have potential buyers compete against each other. However, once the seller affords exclusivity to a single buyer, that buyer has the negotiating advantage. This is because the seller is restricted from entering into discussions with another buyer for the length of the exclusivity period, which usually ranges from 60 to 120 days. After that time, it's difficult for the seller to re-engage other interested buyers, who will be wary as to why the deal did not close. At the very least, the seller will find him/herself in a much weakened negotiating position with other buyers, and consequently may receive a lower price or less favourable terms. Therefore, it's important for the seller to "bet on the right horse" and to know exactly what he/she is getting into.
Furthermore, once a particular buyer is granted exclusivity, they will have access to highly sensitive information regarding the seller's business as part of the due diligence process. This includes such things as customer names, payroll records and trade secrets. If the seller does not strike a deal with the buyer to whom it affords exclusivity, the seller runs the risk of having a competitor with detailed knowledge of its operations. While the parties may have executed a non-disclosure agreement, such agreements provide limited protection. As a practical matter, a breach of confidentiality is both difficult to prove and costly to enforce.
THE SELLER'S PERSPECTIVE
As evidenced from the buyer-seller advantage curve, the seller's negotiating strategy should be to defer giving a buyer exclusivity for as long as practical, and to execute a relatively short exclusivity period. The seller's greatest exposure is between the time that the LOI is signed and the deal is closed.
From the seller's perspective, it's critical to negotiate a comprehensive LOI that clearly sets out all of the major elements of the transaction. While the terms of an LOI are non-binding, it's more difficult for a buyer to change a written agreement, at least without adequate justification (such as new material information) or offering something in return. The negotiation of the LOI is the pinnacle of the seller's negotiating advantage. If the seller can't negotiate a strong LOI, he/she will never be in a position to negotiate a favourable purchase agreement.
In many cases, the buyer will state that it's not possible to be specific as to terms in the LOI because they have not been afforded the opportunity to conduct detailed due diligence. While this may be true, the seller should offer the buyer certain assumptions that they can use to construct the LOI. Once those assumptions are confirmed in the due diligence process, it provides the seller with greater comfort as to what the terms of the transaction will be.
Another reason for insisting on detailed terms in the LOI is to facilitate the finalization of the purchase agreement. The purchase agreement is normally negotiated between the seller's and buyer's counsel, using the LOI as a template. The more comprehensive the LOI, the less room there is for the lawyers to disagree on the intention of the parties. This can help to significantly reduce the cost and time required to finalize the purchase agreement.
THE BUYER'S PERSPECTIVE
As evidenced from the buyer-seller advantage curve, the buyer should strive to attain exclusivity at an early stage, and secure an exclusivity period as long as possible in order to maximize their negotiating leverage.
While the seller will want a comprehensive, unambiguous LOI, the buyer will usually want the opposite in order to maximize their negotiating flexibility once afforded exclusivity. This doesn't mean that buyers should look for excuses to "grind down" the seller. Rather, added flexibility will provide the buyer with greater opportunity to structure a transaction that meets their needs, and which addresses the buyer's findings during due diligence.
Caution is warranted, however. By negotiating an LOI that is too broad, the buyer may be setting the stage for deal failure if there is not an adequate understanding of what the transaction will look like. This can prove to be a waste of time and money for both the buyer and seller. Therefore, a balanced approach is advisable.
CONTENTS OF THE LOI
The specific contents of the LOI will vary depending on the nature and complexity of the deal. As noted above, from the seller's perspective the LOI should be as specific as possible, whereas the buyer will want to have less specificity. The following items are usually negotiated as part of the LOI:
- the offer price or price range in dollar terms. Where the LOI contains a statement such as "the purchase price will be established as a multiple of 5x normalized EBITDA" it requires an interpretation of what adjustments should be made to determine "normalized EBITDA." As noted above, sellers prefer specificity while buyers will prefer generalization;
- whether the offer is for the shares or assets of the company. When the offer is for the assets, the major assets to be acquired and liabilities to be assumed by the buyer should be set out. From the seller's perspective, it's also advisable to get an indication of how the aggregate purchase price will be allocated among the various asset classes acquired since such allocation can have a material impact on the tax consequences of the deal. The buyer will want to assign as much value as possible to depreciable capital assets in order to reduce their future tax liability. However, such an allocation has adverse tax consequences to the seller, who generally prefers that a significant portion of the purchase price be allocated to "goodwill", which is only 50% taxable in Canada;
- the forms and terms of payment, including (where applicable):
- the amount of cash paid on closing,
- holdback amounts, and the conditions and timing for their release. Holdbacks in the order of 5% to 15% of the purchase price, for a period of 6 to 24 months are not unusual,
- promissory notes, including the time period of payment, interest rate thereon, security and conditions for non-payment,
- share exchanges, including any restrictions placed on the seller for liquidating the shares within a specified time period, and
- earnouts or similar contingency-type arrangements, including specifics about performance metrics and duration. As a practical matter, earnout provisions are complex to document in the purchase agreement. Therefore, greater specificity in the LOI with respect to the provisions of the earnout will help to reduce legal costs;
- the salient provisions of any management agreement or consulting contract with the seller, including the duration and basis of compensation (e.g. salary, performance incentives and employment benefits);
- whether the offer is subject to financing, regulatory approval or other conditions. Where the offer is subject to financing, the seller will often be wary of the buyer's ability to raise the necessary capital and close the deal;
- the length of time the buyer is afforded exclusivity to conduct their detailed due diligence and to negotiate the purchase agreement. This normally ranges from 60 to 120 days. As noted above, sellers prefer a shorter period, whereas buyers prefer a longer period. The parties can agree to extend the exclusivity period at a later date if the deal is moving along well;
- significant balance sheet requirements such as target working capital, net worth and debt levels at the closing date. Balance sheet targets are not often specified in an LOI and sellers frequently find themselves faced with an unpleasant surprise just prior to closing;
- significant income statement or cash flow requirements (if any), such as minimum levels of EBITDA and capital expenditures;
- whether the buyer is required to make a deposit upon the execution of the LOI. As a practical matter, deposits in mid-market transactions are uncommon. Furthermore, it's costly and time consuming to construct an agreement governing the conditions for a deposit refund in the event that the transaction does not proceed;
- responsibility for costs and break fees. Many buyers will insist that the seller agrees to compensate them for due diligence costs and legal expenses in the event that the seller subsequently elects not to proceed with the transaction on the terms agreed to in the LOI. Break fees are also common in the acquisition of public companies, given the "go-shop" provisions that allow the target company's board of directors to find a better offer, in order to fulfill their fiduciary duties;
- any significant or unusual representations and warranties that the seller will be asked to agree to (e.g. those regarding environmental liabilities); and
- the major terms of a non-competition and non-solicitation agreement that the seller and possibly certain key employees of the target company, will be asked to enter into.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.