Crafting an Effective Letter of Intent (LOI) for SMB Acquisition

The Letter of Intent (LOI) is a critical document that lays the foundation for a small business acquisition. It acts as an initial proposal, capturing essential elements of the deal such as the purchase price, core assumptions about the business, and transaction structure. The way you write an LOI can greatly influence the outcome of your acquisition in a positive or negative direction. In this article, we break down the fundamentals of crafting an impactful LOI for a successful business deal. 

The Importance and Timing of a Letter of Intent

In the Small Business Acquisition process, sending the Letter of Intent (LOI) comes at a key point. It follows the signing of a Non-Disclosure Agreement (NDA) and a careful review of the Confidential Information Memorandum (CIM). Deal participants emerge from the LOI with a framework for the transaction and its related due diligence. Understanding this sequence is crucial to the acquisition process, so it might prove useful to review the 42 steps to Acquiring a Small Business in order to better understand the context of LOI.

To summarize, upon finding a potential acquisition target, buyers commence their outreach. The NDA ensures a confidential environment between the buyer and seller. Next, the seller provides the buyer with the CIM, which includes additional details about the business, such as its history, financial health, operations, and future strategies. 

If the details in the CIM and initial seller conversations are appealing, the buyer then sends an LOI to the seller, indicating their genuine interest in acquiring the business. This marks the start of negotiations. If the seller accepts the LOI, both parties move forward to the due diligence phase. This stage allows the buyer to verify and expand upon the information in the CIM, assess potential risks, and confirm their assessment of the business’s value.

In conclusion, the LOI sets the stage for a purchase agreement, based on key information and assumptions to be confirmed and tested during due diligence.

Do’s and Don’ts of an Effective Letter of Intent

There are some general rules you should keep in mind when preparing an LOI. It should clearly state the terms and assumptions underpinning your acquisition offer. It should identify the core elements to be explored in due diligence in order for the transaction to close such as customer information, condition of key assets, and working capital needs. While the LOI is non-binding, allowing you to walk away from the deal if you discover material issues during due diligence, it should be used with care. When it comes to style, use clear, concise language that avoids ambiguity or confusion. The LOI should be understandable for both parties and their advisors. 

Your LOI should ideally encompass the following elements:

Proposed Price and Payment Terms: Be straightforward about the purchase price and how you plan to make the payment.

Details of the Transaction: Outline the proposed deal, highlighting key points about assets and liabilities.

Seller’s Role Post-Acquisition: If applicable, outline the role and compensation structure for the seller after the business changes hands.

Consulting Services and Non-competition: If necessary, outline any agreements about the seller providing consulting services post-acquisition or any non-compete clauses.

• Due Diligence: Indicate the extent and anticipated duration of your due diligence process.

• Exclusivity: Set a period during which the seller won’t entertain other offers.

• Timelines: Define clear milestones and deadlines for negotiations.

When preparing an LOI, be mindful of certain pitfalls to avoid:

• Ambiguity: Unclear terms can lead to misunderstandings, disputes, and could potentially derail the transaction.

• Overpromising: Be sure not to commit to more than you can deliver.

• Overlooking Non-Financial Factors: Don’t underestimate the importance of factors like cultural compatibility, shared values, and future vision for the business.

• Signing an LOI you don’t intend to uphold: while it may be tempting to offer a high price in an LOI with the intention to force the purchase price down later in the process, this can be a dangerous strategy. This strategy can damage your credibility with the seller and broker, potentially killing your deal (especially bad if this happens after you spend thousands of dollars on due diligence).

Industry experts debate the level of detail that should be included in a Letter of Intent. Lawyers often advise against including excessive detail or complexity in the LOI, as finer points and contingencies can be addressed in the purchase agreement and other related documents. However, other experts, like broker Clint Fiore (Texas Business Buyers), believe that a highly detailed LOI can prevent lawyers from taking over the deal. According to him, while legal counsel is essential to closing a deal, an unstructured or broad LOI tends to invite overzealous negotiation between the buyers’ and sellers’ attorneys. This can lead to useless back-and-forth, resulting in increased costs due to the expensive nature of legal services and potentially killing the deal due to an unneeded disagreement.

In a recent episode of Private Market Insights, Kaustubh Deo shared a similar opinion. During his acquisition of Blooma Tree Experts, he was careful to include working capital needs in his LOI in order to bring transparency to that potentially contentious point later in the negotiation process.

Exclusivity After LOI Acceptance

A Letter of Intent often contains a mix of binding and non-binding components. It outlines the initial terms of a possible transaction, while still allowing for revisions after the due diligence phase. Nevertheless, certain elements of the LOI, such as exclusivity agreements and confidentiality clauses, could potentially be legally enforceable. The binding nature of an LOI can depend on various factors, including its interpretation, applicable local laws, and the specific phrasing of the document. Hence, it’s crucial to clearly differentiate the binding and non-binding terms to avoid future conflicts.

When a seller accepts an LOI, they typically become subject to an exclusivity clause. This clause restricts them from initiating discussions or negotiations with other potential buyers for a specified duration. This designated period provides the buyer with the time to conduct a thorough due diligence process. If the seller breaches the exclusivity clause, they might face potential legal consequences.

It’s worth highlighting that the buyer has the freedom to reconsider the purchase in case any unfavorable aspects are revealed during the due diligence stage, providing them with the opportunity to make a well-informed choice.

Ongoing LOI Debates 

In the Small Business acquisition space, buyers often debate whether “re-trading”, or planning to re-negotiate an offer after obtaining exclusivity through an LOI, is an acceptable practice. Ultimately, renegotiating the price may be justifiable based on significant new findings. However, members of the Twitter ETA community considered re-trading to be an unethical breach of trust in a recent Twitter poll.

A second debated practice is the use of multiple LOIs. Some buyers choose to submit LOIs on more than one business at the same time to increase their chances of a successful acquisition. This is another practice that we don’t recommend. This tactic can lead to potential legal challenges, damage to the buyer’s reputation, and ultimately strain the buyer’s resources due to the costs of managing several different deal processes simultaneously. Therefore, before deciding on such a strategy, buyers should consider all these factors carefully and seek legal counsel.

Final Thoughts

A letter of intent communicates the buyer’s interest in purchasing a business, and also serves as the bridge between the search phase and due diligence phase of the acquisition process. Considering the significance of this document, it is crucial for buyers to approach their Letters of Intent carefully, with appropriate care and legal counsel. 

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