The Importance and Pitfalls of a Letter of Intent (LOI): Setting the Stage for Deal Success

Matt Goss, CPA/ABV

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When it comes to business transactions, particularly in the realm of mergers and acquisitions, a Letter of Intent (LOI) plays a pivotal role.

An LOI is a document that outlines key terms of an agreement between two parties, typically a buyer and a seller. Despite its non-legally binding nature, it sets the stage for the entire transaction, making it a crucial step in the process.

What to Include in an LOI

A well-structured LOI clearly defines key terms such as the parties involved, timeline of the transaction, structure of the transaction, purchase price, assumptions on how the purchase price was established, employment agreements, and termination conditions. It also outlines how potential liabilities like unresolved lawsuits or indemnification claims are handled. By defining these terms clearly, the LOI sets the tone for negotiations and the definitive agreement, ensuring all parties are on the same page from the onset.

Primarily, an LOI saves both time and money for all parties. It serves as a blueprint for the final agreement, laying out the foundation upon which the definitive agreement is built. By agreeing on the major terms upfront, parties expedite the closing process as well as avoid various pitfalls that could come up later in the transaction process.

Key LOI considerations/negotiations

A well-crafted LOI should contain several key elements:

1. Definition of Parties Involved – Clearly defining the parties to the transaction upfront saves administrative hassle and negotiations down the line. 

2. Structure of the Transaction – Considerations such as whether the transaction is a sale of stock or assets could have massive tax implications for both buyer and seller. Defining this up front allows both parties to more accurately predict their after-tax cash flow at time of closing and beyond. Defining the tax treatment of a sale upfront can even allow for negotiations of purchase price and other conditions for the parties, ultimately leading to a more favorable deal for either party.

3. Purchase Price and Assumptions – A well-written LOI details the purchase price as well as any anticipated holdbacks, contingent consideration, or rollover equity that are part of the transaction. Most purchase prices are based on some sort of cash flow metric, typically earnings before interest, taxes, depreciation, and amortization (EBITDA). A good LOI defines what EBITDA assumptions the purchase price is based on. This sets the stage and allows a mechanism for future purchase price negotiation, both for buyer and seller, as the transaction gets closer to seller. 

4. Net Working Capital (NWC) – The LOI should address NWC as this is often one of the more complicated, yet overlooked, parts of a transaction. Transactions are typically set up such that a seller has to deliver a buyer sufficient NWC to run the business post-acquisition. However, what is “sufficient” is ultimately up for debate amongst the parties. Issues such as deferred revenue, Generally Accepted Accounting Principles (GAAP) discrepancies, customer deposits, accrued vacation, and debt-like items can blur the lines of what is truly NWC. Defining how this will be negotiated, how the parties will define these components, and how certain items will be treated at time of purchase is crucial to protect all parties from significant swings in purchase price.

5. Representations and Warranties – As part of any transaction, the parties will make certain representations and warranties regarding the assets, liabilities, and contracts that are part of the transaction. These typically come up later in the transaction process, but it is advised to begin addressing this early in the LOI process. That way, no surprises come up later and both parties have a chance to negotiate terms and conditions upfront. Doing so protects both parties and, again, eliminates surprises.

6. Employment Agreements – Agreements between the parties regarding employment contracts, salaries, length of employment, expectations for management, or changes to employee benefits should all be addressed within the LOI. Getting this all out of the table early ensures all parties are aligned with future expectations and ensures no surprises pop up towards the end of the process.

7. Timeline – This includes considerations on exclusivity periods, due diligence timelines, expectations for delivery of information/reports, and the timeline to closing. Transactions take significant time and energy from all parties so it is important to clearly define timelines and expectations. Doing so saves time and money for all parties and increases the likelihood of a transaction closing.

Summary

Any changes to the terms after the LOI is signed can create friction. To avoid this, it’s crucial to approach an LOI with the same seriousness as the final agreement. Consult with experienced professionals such as attorneys, brokers, CPAs, and wealth managers to ensure your interests are well-protected and that you maximize value in the transaction process.

Transactions are often a once in a lifetime event and must be treated as such, and it all starts with the LOI.