Buying & Selling a Business Part 2: Letter of Intent
This is Part 2 in a series on buying and selling a business. Part 1 provided an overview of asset and stock acquisitions. Part 2 covers negotiating an important document in the deal process: the letter of intent.
Before spending significant resources pursuing a deal to purchase a business, the parties set forth the key terms of the transaction in a non-binding “letter of intent” or “term sheet” (“LOI”). If you are in the early stages of buying or selling a business, and you’ve settled on the type of acquisition that best suits your business goals and needs, here are a few points to consider as you negotiate the LOI:
- Non-disclosure or confidentiality agreement (“NDA”). The NDA is usually a separate agreement executed by the parties in anticipation of negotiating a deal together. Since much of the information to be exchanged by the parties is confidential and proprietary, the NDA identifies what kind of information is deemed “confidential” and how the parties must treat the confidential information through the negotiation process and after (even if the deal does not materialize). NDAs can be “one-way” protecting only the disclosing party or “mutual” where both parties exchange confidential information. They may also include non-solicitation or other protections for the target company to ensure that information gleaned in the deal process is not improperly used by the buyer to poach customers or employees of the target company if the deal falls apart.
- The purchase price. How is the buyer paying for the assets and/or stock of the seller—cash, seller-financed note, traditional bank loan, or a combination? If the seller agrees to finance the purchase, how will the seller note be secured or collateralized? Will any portion of the purchase price will be paid up front versus held in escrow? (See below.)
- Working capital and price adjustments. If the purchase price will be adjusted based on the working capital of the business at closing, the LOI should include a general description of how the working capital is to be calculated, and what the target working capital is and how the target will be determined. Is there a contingent component to the purchase price (for instance, will the purchase price be adjusted after closing pursuant to an earnout mechanism)?
- Earnest money deposit. Will the buyer be making an earnest money deposit at the outset or at certain milestones in the deal process (i.e. at mutual acceptance of the LOI, execution of the definitive agreement, the end of due diligence, and/or at closing)? In what instances will the earnest money deposit(s) be refundable to the buyer?
- Escrow. Who will close the deal for the parties? How involved will the closing agent be and under what terms? Will escrow also secure indemnification obligations on behalf of seller and for how long (i.e. is there an “indemnity holdback” in favor of buyer)? On what basis will funds be released from escrow as a remedy for seller’s breach or otherwise?
- Exclusivity. Buyers prefer to negotiate the deal without worrying about competing offers from other buyers. An exclusivity clause provides buyers with that assurance by prohibiting the seller from negotiating with or soliciting offers from other potential buyers for a certain period of time. If the seller agrees to an exclusivity period, when does it start and how long will it last?
- Consulting agreements/non-compete. Will any of the principals of the selling company be needed in a consulting capacity after closing? If so, on what terms? Will the selling parties be restricted from competition following closing? If so, to what extent?
- Due diligence. Due diligence is the process by and period within which the buyer of the business conducts a comprehensive investigation of the business to confirm whether the business (and its finances, books, and records) is in the condition represented by seller and satisfactory to buyer. Typically, due diligence investigations include the following areas of the company:
- Financial statements.
- Corporate documents.
- Debts and liabilities (including past litigation).
- Employee benefits, policies, and compliance issues.
- Internal systems and procedures.
- Customer contracts.
- Intellectual property.
- Condition of assets.
The LOI should confirm the buyer’s access to the company (employees, books, and records, namely) for the purpose of conducting its due diligence review and identify the length of the due diligence period. Any contingencies tied to due diligence should address whether satisfaction or waiver of such contingencies will affect the earnest money deposits discussed above.
- Representations and warranties. What is the scope of the seller’s representations and warranties to buyer? Which representations and warranties will be subject to a “knowledge” and/or “materiality” qualifier? And how long will the representations and warranties survive post-closing? In what instances will the indemnification holdback (if any) will be available to buyer for breach of the representations and warranties?
- Timeline. What is the expected timeline for delivery and execution of the definitive agreement, due diligence, and closing? Can the parties extend such deadlines? If so, under what circumstances?
- Employees. Will employees be terminated and re-hired at closing? What are the parties’ pre- and post-closing obligations to current employees of the business? Special care should be given to accrued vacation, benefits, and the possible triggering of change of control payments in employment contracts.
- Conduct of business. The seller will often agree to operate the company only in the ordinary course of business and refrain from certain material actions (non-routine capital transactions, for example).
- Fees and expenses. It’s customary for each party to bear its own costs and expenses incurred in negotiating the deal, executing the definitive agreement, and closing the transaction. If the parties agree to a different arrangement, such should be set forth in the LOI.
Remember that with the exception of certain designated provisions such as confidentiality, exclusivity, fees and expenses, and conduct of the business, most LOIs are non-binding meaning that either party may decide not to pursue the deal even after the parties have executed the LOI.
If you are considering buying or selling a business, the lawyers of Stokes Lawrence’s Business practice can assist with the transaction and answer questions regarding your specific situation.
In Part 3 of this series, we will discuss successor liability issues that can arise after closing of the transaction.