What is the Letter of Intent?
When buying or selling a business, the first written document that outlines the terms of the deal is the Letter of Intent, often referred to as the “LOI.” Sophisticated and unsophisticated buyers and sellers frequently use an LOI. The LOI is always (and should always be) a non-binding document. This means that the terms, conditions, and other items are not binding but are documented with the intent to close a deal in the future. However, certain elements, such as confidentiality terms, may be binding.
The LOI often includes, but is not limited to:
- Price
- Asset deal versus equity deal
- Earnouts
- Seller financing
- Holdbacks and escrows
- Conditions to close
- Seller and buyer obligations
- Key employment terms
- Closing date
- Purchase Price Adjustments (e.g., Net Working Capital Changes, one of the most critical and often misunderstood items in an LOI).
At The Strategic CFO, LLC, we often assist buyers or sellers with transactions at the CFO level, working alongside attorneys and other professionals to ensure a smooth process. Based on our extensive M&A experience, one of the most misunderstood areas in an LOI is Purchase Price Adjustments related to working capital.
The Risks of Overlooking Working Capital
For those unfamiliar with selling or acquiring a business, working capital is often improperly addressed. In some cases, we’ve seen LOIs signed before our involvement, with statements that working capital would be agreed upon after the transaction closes. This approach is a recipe for disaster.
What is a Purchase Price Adjustment?
A Purchase Price Adjustment is a change to the sale price of a business from the date the LOI is signed to the closing date.
Why does the purchase price change? Several factors can impact the purchase price between the LOI signing and closing:
- Changes in working capital
- Findings during due diligence
- Material changes in business operations
- Material changes in business economics
- Other considerations
Common Mistakes in a Letter of Intent
From what we have observed after participating in dozens of transactions, there are two very common mistakes in an LOI.
- Buyers and Sellers often think that the LOI is something they can draft on their own without input from the attorney. This is a big mistake.
- Not understanding Working Capital and Net Working Capital.
Let’s dive into both of these common problems in the LOI and how to avoid a bad LOI.
Using an Attorney to Draft the Letter Of Intent:
Even though the Letter of Intent is a non-binding document, the LOI should be as detailed as possible.
There are two philosophies in business regarding the LOI. The first is: make the LOI as short, as general and less detailed as possible. People that believe in this philosophy think it is good to sign a generic LOI with little detail and capture the details in the final purchase and sale document (the actual contract for the sale of the business).
The second philosophy in business is to make the LOI as detailed as possible capturing as many terms and conditions as possible so that it basically mirrors the terms and conditions that will go into the purchase and sale agreement. This LOI does take more time to complete and finalize than the latter, but it will save you a lot of pain before closing and at closing. The reason why this is important is because it takes time, a lot of time, between the signing of the LOI and the signing of the final purchase and sale documents.
This is why it is important to get your attorney engaged as soon as you start thinking about selling your business. We all want to watch out and minimize expenses, but having a detailed LOI that states all the key items will make your closing much smoother and your attorney and your CFO working together will help you get there. The pain and stress of doing it wrong is overwhelming. I have seen many deals die or sellers settling for less due to “deal fatigue”. This can all be avoided by making the investment in your attorney and CFO.
How Long Does it Take to Sell a Business?
It takes time to sell a business, how long will depend on some of the following items:
- Condition of books and records. Is your accounting up to date, in accordance with GAAP?
- Size of business
- Complexity of business
- Number of locations
- Regulator approval
- Environmental conditions
- Number of products and services
- Organization structure
- Number of shareholders (the more owners involved the more complex, consider having one owner represent all parties selling).
- Capital expenditures required to get a business ready to sell
- Many more items
From the time an owner decides to sell, to closing a transaction is at least 6 months for a small, simple business. One year or more for a larger, more complex business. We think it’s safe to say that no substantial business will sell in 6 months or less. Plan on one year to be safe, and it may take longer.
Understanding Purchase Price Adjustments and Working Capital
Purchase price adjustments related to working capital or net working capital are commonly misunderstood or mishandled. We’ve encountered LOIs that:
- Do not address working capital adjustments
- Define working capital incorrectly
- Postpone working capital discussions until after closing (a disastrous approach).
What is Net Working Capital? Net Working Capital is calculated as follows:
- Current Assets (excluding cash) minus Current Liabilities = Net Working Capital
The LOI should contain the Net Working Capital calculated as of the day the LOI is signed. This is now a stake in the ground and measured going forward. This is why you want the time between LOI and closing to be as short as possible. The longer the time between signing the LOI and closing, the greater the risk for fluctuations that impact purchase price adjustments.
The net working capital could move up or down from the day the LOI is signed to the day the deal closes. That difference is a purchase price adjustment up or down. This needs to be very well understood and agreed to by buyer and seller BEFORE the LOI is signed. We’ve seen purchase price adjustments be very small and very large. Every deal is different, and this topic needs to be clearly discussed and defined with the CFO early on.
When this is not clearly defined and understood, this one item, purchase price adjustment based on working capital changes, can kill a deal at closing.
In Summary:
The Strategic CFO, LLC recommends that the buyer and seller consider the following related to a Letter of Intent:
- Make the LOI as detailed as possible
- Consider a timeline to have as little time as possible and practical between the LOI and closing. The longer it takes the more close the risk for a deal.
- Engage your attorney early on, have the attorney involved when drafting the LOI
- Have your CFO involved and part of the LOI especially when defining purchase price adjustments and working capital changes.
- Make sure your accounting is current and per U.S. GAAP BEFORE you take your company to market.
For more information and detail on guidance through the purchase or sale of a business, schedule your free consultation here.
