Takeaway: In a business purchase letter of
intent, just like in an apartment lease, the party producing the document will
attempt to stack the deck in their favor.
Surprisingly, there are many similarities between signing an
apartment lease and a letter of intent.
They relate to risk reduction, the balance of power between the parties to the
transaction and the level of experience of the buyer and seller.
Why Would I Sign This Document?
As a seasoned business owner, If you were to read an
apartment lease today, your reaction would probably be, "Why would I sign
this document with everything possible favoring the landlord?” Thinking from
that perspective, let's compare this to an unsolicited letter
of intent to buy your company.
It's All About Risk Reduction
The apartment lease accounts for everything that could
possibly go wrong between landlord and tenant and makes the contractual outcome
favor the landlord in every case. From rent late fees to security deposits to
notice requirements to stains on the carpet, these agreements cover it all. The
landlord is completely protected for every eventuality and bears very little
risk from this relationship — to the extent that the landlord writes the
contract to reduce her risk, the tenant is the recipient of this risk.
Business Buyers Have the Experience
Just like the apartment lease, the letter of intent is
written by the experienced party. The landlord has completed hundreds of
successful rentals, while the renter is a novice. The buyer has likely acquired
several companies and attempted to acquire dozens more, while this is likely
the owner’s first sale. So just like the apartment lease favors the landlord,
the letter of intent is written to the advantage of the buyer.
A Non-Binding LOI Provides the Buyer Plenty of Wiggle
Room
The first clue is that it is a non-binding letter of intent.
During the early stages of the mergers and
acquisitions process, limited financial data and high level customer
information is exchanged. This enables the buyer to judge whether or not the
company is a good fit and meets their acquisition criteria. If the buyer wants
to proceed further, they produce a letter of intent that requires a buyer
sign-off and guarantees that the seller will not shop the deal while due
diligence is completed. This is fair, because both parties will invest
significant resources going through due diligence. The due diligence period
typically lasts from 45 to 90 days and is exhaustive. The principal of the
letter of intent is to spell out the terms and conditions for the
acquisition, pending no due diligence surprises that are material to either the
value or the risk of the transaction.
Buyers Often Abuse the Due Diligence Process
On top of that, they play brinkmanship: If you don't agree,
we walk away. These professional buyers are emotionally
detached from this transaction, unlike the sellers. They will just move on
to the next one if they don't get what they want. The seller can either cave in
and take a haircut or walk away from a deal they have invested six months of
emotion and effort into.
The Buyer's "Experts"
One quality of earnings report we experienced was an opinion
that the benefits package for the employees was below market. To get it up to
market would cost $100,000 and, since our purchase price was based on a 5 X
EBITDA multiple, we are dropping the purchase price by $500K. It was
completely arbitrary and not accurate to compare our small market client with
the Boston market compensation package. Our client's benefits package was
reasonable and customary for their current market. On another transaction, the
quality of earnings opinion was that last year's growth was unusual so we are
just going to normalize EBITDA over
the last 3 years to take a $750 K adjustment to our current purchase offer.
Forgive my French, but total arbitrary BS.
The Power of Options
Back to our apartment lease comparison. Why this behavior?
The landlord has plenty of other renters waiting in line for the apartment. The
buyers typically have multiple acquisition interests in process at any one
time. If you don't like our terms…. Next!
Counter Offer With Precise Language
Much of this balance of power trouble for the business
seller can be avoided with an intelligently worded letter of intent negotiated prior
to agreeing to dual signing it and taking your company off the market. Once the
LOI is signed, the price and terms never improve for the seller — they only go
in one direction that favors the buyer. So, oftentimes during due diligence,
the performance of the business will suffer because the owner and CFO are
distracted by all of the demands of the deal. The experienced buyer will often
demand a change in purchase price based on this drop in performance.
If they are going to operate this way, why not turn the
tables around? You could counter offer the language in the letter of intent
with, "The purchase price is based on a multiple of EBITDA of 5.34 times.
Based on the September 30th trailing twelve months that reference
purchase value based on $1.0 million of EBITDA is $5.34 million. For the final
purchase price, we will use the trailing twelve months to the closing
date EBITDA X 5.34.” The buyer should not be able to reasonably
disagree with this. It is like a mutual NDA: What is good for one is good
for both.
Net Working Capital Is a Key Buyer Target
Another poorly worded clause (in favor of the buyer and to
the detriment of the seller) in the letter of intent is about setting the level
of net working
capital. The typical LOI clause prepared by the buyer's experts is: This
proposal assumes a cash free, debt free balance sheet and a normalized level of
working capital at closing. And, of course, they try to leave this open so that
they have huge wiggle room for their quality of earnings report opinion which
may set the level arbitrarily at $600,000 late in the due diligence process.
Being a savvy seller, you’re going to enter competitive
negotiations and give a counter proposal of $200,000, for example, and define
how you will calculate it. Tips and tricks like this can be learned (over time
and with some cost) or can be hired out in the form of an advisor; either way,
the seller has more options than the buyer wants you to think!
Be Careful With Earn Outs
Another area where the sellers potentially get their pockets
picked is clever expert language. It has to do with earnouts.
Often the buyers will put an all-or-nothing earnout condition that says, for
example, the seller must grow revenues by 10% per year to get the earnout and
if the seller falls short, she receives nothing. A better way for the seller is
to calculate a factor to multiply each year's revenues by in order to arrive at
the earnout payment for that year. For example, total revenues X 0.11.
One additional earnout trap is the multiple conditions
earnout. You have to achieve a specific revenue growth target plus a profit
goal in order to receive the earnout. This is terrible for the seller because,
first, a multiple condition earnout is very hard to consistently hit and,
second, once you sell your company, controlling the profitability is much more
difficult due to such factors as corporate overhead allocation.
Final Thoughts
Dave Kauppi is a Merger and Acquisition Advisor and President of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology, software, and other technology based companies. Dave is also the editor of the Exit Strategist Newsletter and author of the Book Selling your Software Company - An Insider's Guide to Achieving Strategic Value
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