How to write a good letter of intent when buying a company?
Why a letter of intent?
In a business purchase, the buyer often uses the letter of intent (LOI) to outline the planned transaction. The LOI is a legally non-binding document and should state the commercial terms of the transaction in simple language. The document is intended to serve as a basis for negotiations with the seller and ensures both parties have the same understanding of the planned transaction, before actually executing on it, therefore reducing the risk of any material misunderstanding.
The LOI should be used once the buyer has a clear idea about the value of the business and how much he is willing to pay for it. Thus the LOI normally comes before going into due diligence phase. The transaction process at a glance:
- Company Search
- Financial Analysis and Valuation
- Letter of intent
- Due Diligence
- Sales and Purchase Agreement
The LOI thus is a very important document and in most cases is one of the first official documents the seller receives from the buyer. Thus, the LOI de facto serves as the business card of the buyer. Although for legal reasons the character of the document is non-binding, it nevertheless needs be serious and thought-through, because clarity creates trust and thus makes the transaction happen.
Which points does the LOI need to address when buying a company?
The LOI needs to be adressed to the owners of the company and defining what assets or legal entities exactly are included in the scope of the offer. If any important assets are excluded, the LOI should state this as well.
Nature of the LOI
The LOI is legally non-binding which needs to be reflected through adequate language. The reason is the buyer still only knows a certain part of the business and needs to reserve some flexibility in case he finds out in the future that some of his assumptions are not true. The LOI is a private document by nature, confidential and shall not be disclosed to any other third parties.
The buyer should write a short overview about himself, his track record and capabilities. The buyer needs to create confidence with the seller that he is the right buyer, he can continue to operate the business and thus differentiate himself from less credible buyers.
Furthermore the buyer should shortly outline what his motivation is to buy this business and what he intends to do with it, be it to grow the business further or to create synergies.
The suggested purchase price and payment schedule needs to be specified. Also the buyer might want to holdback a certain amount as a security for required guarantees. In case there are shareholder loans in the company, it needs to be clarified if they are included in the purchase price or will be paid back separately.
As the closing date will be in the future, the account balances of the balance sheet items will be different than what the buyer used in his valuation model. Therefore the parties might want to define an adjustment mechanism of the purchase price at the exact closing date. Therefore the buyer needs to define the required level of Net Working Capital, the maximum allowed Net Debt, required Fixed Assets which will be needed at date of closing.
Also some sellers will try to extract assets of the business prior to closing a deal, e.g. through dividends or repayment of a shareholder loan. The buyer will be punished as the business looses valuable assets, thus he needs to prevent that behaviour of the seller through adequate wording in the LOI.
The timetable should state the target closing date. Till that date, a variety of work has to be completed: Due Diligence, Share and Purchase Agreement, Preparation of the Final Balance Sheet, Negotiations of Key Management Contracts, etc. In case the timetable cannot be met, the Buyer might want to define what happens in that case.
A good letter of intent needs to address the management team, how the company will be run and what happens to the existing management team. Important is to send clear positive signals to key people which are important to continue running the business.
Important Terms, Representations and Warranties
The buyer should state any important condition which needs to be met in order that the transaction can close. E.g. that the business keeps operating normally, the buyer receives full comfort during his due diligence, and that the seller will be responsible to assume any undisclosed liabilities created before the transaction date.
Furthermore the buyer needs guarantees from the seller, that all information received is true and correct, that all listed assets indeed are in the possession and ownership by the company to be acquired and that no material information was withheld.
The buyer needs to protect himself from eventual competition of the seller post transaction. Given the seller knows everything about the business, he could simply recreate the business and even steal away clients from the buyer. This option has to be prevented right from the beginning. Therefore, they Buyer will usually add a non-compete clause in the LOI asking for a 2 – 3 years period (depending on the country) and also forbid to contact clients during that time.
A period of time (typically the required time till closing) should be specified where the seller will not negotiate with any other buyer. This allows the buyer to go ahead, spend money on due diligence and undertake serious efforts to get the transaction to close.
Other important elements
There can be more important elements which need to be added to an LOI, but it depends case by case. Just to name some more aspects:
Due Diligence – requires access to certain information and the seller’s cooperation
Restructuring plans – if there are any plans, they should be outlined
Capital expenditures – the buyer might need to confirm his commitment to such plans
Costs –each party should carry his own costs related to the transaction
Confidentiality – information received should be treated as confidential
When to issue the LOI
The LOI should not come as a surprise to the seller. Best is to first discuss orally the terms of the intended LOI and clarify the price expectations of the seller. An LOI should only be issued if there is no big price gap and the seller gives a clear signal that the price of the offer is of interest to him. If not, the buyer might have to wait till the price expectations of the seller become realistic.