Seller Considerations When Negotiating a Letter of Intent

Negotiating and signing a Letter of Intent (LOI) is a key inflection point in the process of selling your business. Buyers and sellers both want the LOI to ensure a base level of understanding on certain key terms such as price, the structure of the deal, exclusivity, and confidentiality. However, sellers generally want, and should push for, additional details before agreeing to exclusively negotiate with a potential buyer. Below are some of the key items that sellers should ensure they have a full understanding of:

1. Strategic vs. Financial Buyer. Sellers should understand who the proposed acquirer is and what their motivations are for the potential acquisition. Generally speaking, a strategic buyer will focus on synergies between the businesses, gaining a competitive advantage, and/or expanding into new markets. Additionally, strategic buyers will usually offer a higher price than a financial buyer and will likely offer a deal where the purchase price is paid in cash and/or stock of the buyer. Financial buyers, on the other hand, will be more focused on the company’s financial metrics and are more likely to offer a deal that requires financing, includes an earnout, and requires the sellers to roll over a portion of their equity, offering the sellers a proverbial second bite at the apple in a subsequent sale.

2. Indemnity & Representations and Warranties Insurance. The LOI should detail the proposed terms for indemnification of the buyer by the sellers and if Representations and Warranties Insurance (RWI) will be used or not. The indemnification provisions should detail the time period in which claims can be made against the sellers, what the cap on the seller’s liability will be, what escrows will be required, what the deductible or tipping basket will be, and if any of the seller’s representations will be considered fundamental representations (which generally have a longer period of survival when claims can be made and are not subject to the general cap or deductible/tipping basket, meaning the sellers will be liable for the first dollar of any loss and usually have a higher cap on their potential liability with respect to such representations). The use of RWI typically greatly improves the seller’s indemnification package and reduces the amount of negotiation on the scope and substance of the seller representations given in the ultimate purchase agreement. For instance, RWI usually results in a much lower amount of exposure for the sellers (which generally equals one-half of the retention under the RWI policy or up to 0.5% of the total purchase price which is placed in a seller indemnity escrow).

3. Purchase Price Adjustments. In US M&A the standard is for businesses to be purchased on a cash-free, debt-free basis and delivered with a normalized level of working capital. It is common for LOIs to simply leave it there; however, sellers should evaluate if it is favorable to have a bespoke calculation of working capital (i.e. specifically including or excluding certain items) and/or separate credits or adjustments to the purchase price for other items such as tax assets. Additionally, sellers should evaluate if a working capital collar (i.e. a band surrounding the working capital target where no adjustment up or down is made) is appropriate to avoid nickel and diming in the ultimate working capital adjustment. Addressing these points at the LOI stage is more likely to yield a positive result for the sellers as the buyer is more likely to make concessions at this point in order to secure the deal and get the sellers to sign the LOI and agree to exclusivity.

4. Earnout Considerations. Generally speaking, sellers should resist the inclusion of an earnout and instead negotiate for additional upfront consideration as the inclusion of an earnout will greatly increase the costs of negotiating the deal and the likelihood of post-closing litigation. With that said, in some instances earnouts are a necessary tool to bridge valuation gaps and are often used by financial buyers to reduce the amount of cash needed to close the deal. In these instances, sellers should focus on negotiating clearly defined and objective earnout targets and robust protective covenants on how the buyer will operate the business post-closing. Failing to do so at this stage will likely result in targets that are easily manipulated and covenants that offer very little, if any, protection.

1. Target Type. Sellers should push for objective, easily measured metrics such as net sales, revenue, obtaining regulatory clearances or approvals and if possible avoid targets based upon EBITDA, complying with an integration plan or product development milestones tied to the buyer’s determination of a commercially viable product. To the extent an earnout is based on EBITDA, the parties should negotiate the definition of EBITDA tailored to the business being sold.
2. Protective Covenants. In negotiating an earnout, sellers should be mindful that the buyer will control the business following the closing and will strongly resist any restrictions on its ability to operate its new business in a way that it sees fit. As such, it is incumbent on the sellers to push for covenants that protect their interests in the earnout payments. These covenants can include requiring the buyer to operate the business to maximize the earnout payments (or use commercially reasonable efforts to do so), barring the buyer from diverting sales to affiliated companies, and provide for acceleration in the event the buyer sells the company. Additionally, the sellers should push for bespoke covenants that are tailored to the seller’s business and the metrics the earnout is tied to. For example, is a certain level of marketing or R&D spend necessary to achieve the earnout or is maintaining certain distribution and/or supply relationships necessary?

5. Rollover Considerations. It is very common for financial buyers to require the selling shareholders to roll over a portion (usually between 10 to 40%) of their proceeds in connection with the transaction. This serves two primary purposes, first, it reduces the amount of cash the buyer needs to come up with at the closing to fund the purchase price and second, it incentivizes the selling shareholders to continue supporting the business after the closing as they will be looking at another exit in 3 to 7 years at hopefully an increased valuation. In evaluating a rollover, sellers should understand if their business will be the platform business or an add-on to an existing business of the buyer. The sellers should also ensure they are comfortable with the following deal points of their investment in the buyer:

1. Type of Equity. Sellers should push for the equity they are rolling into to be treated pari passu with the equity held by the buyer. While some aggressive buyers may resist this and in some cases require such equity to be subject to vesting, at the end of the day the seller’s consideration (in the form of the rollover) is just as good as the buyer’s cash and should be treated the same and not be subject to forfeiture; however, the rolling sellers can expect their rollover equity to be subject to repurchase by the buyer in the event the rolling sellers are terminated for cause or breach restrictive covenants.
2. Minority Protections. While the scope of the protective covenants a rollover seller can obtain will largely be influenced by the size of their rollover and if they are a platform acquisition or an add-on to an existing portfolio company, at a minimum sellers should push for a bar on affiliate transactions, standard information rights, preemptive rights and tag along rights on the buyer’s ability to exit the platform.
3. Sources and Uses. It is important for sellers to understand how the buyer is financing the proposed acquisition and the size of the buyer’s transaction expenses (which necessarily increase the buyer’s equity check). This is especially true when the sellers are expecting to roll into a certain percentage of equity at the closing.
4. Management Fees. In choosing to go forward with a deal with a financial buyer that includes a rollover, sellers should understand what fees the buyer will charge the company after the closing and how that will impact their potential return on their rollover investment. While not every financial buyer charges fees to their portfolio companies, some do and in the aggregate these fees can be substantial. Examples of the types of fees charged can include, monitoring fees, transaction fees, management fees, and refinancing fees.

6. Exclusivity & Binding Provisions. As we mentioned above, the LOI should ensure a base level of understanding between the buyer and the sellers. It is not meant to lay out every aspect of the transaction and generally should be nonbinding. With that said, it is common for a few provisions of the LOI to be binding on the parties. These usually include what law will govern any disputes, what venue any dispute will be heard in, the confidentiality provision, and the exclusivity provision. In terms of exclusivity, sellers should generally be willing to agree to a certain period of time where it will only negotiate with the buyer (typically ranging from 30 to 45 days). Buyers will often try to build in automatic extensions to that exclusivity period to avoid having to obtain extensions while negotiating the definitive agreements. If the sellers agree to this, they should limit it to one automatic extension. This is because the sellers’ ultimate leverage in any negotiation is that the buyer may lose the deal and having the sellers tied up under exclusivity lessens the sellers’ negotiating position.

Obtaining an understanding on these points at the LOI stage can help to expedite the drafting process and lead to a smoother transaction overall. Experienced M&A counsel will help you strategically navigate these issues and ensure you have maximized your negotiating position prior to agreeing to exclusivity. Mintz’s Mergers and Acquisitions team routinely assists sellers and buyers through all stages of the sales process – from M&A preparedness through post-closing matters. If you have any questions, please reach out to your primary Mintz point of contact. Alternatively, register to attend our May 8th panel focused on best practices for business owners contemplating a sale of their business: Register here.

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