What is the Purpose
of a Letter of Intent?
The typical process for selling a
company involves the seller disclosing general information about their
company, and if an agreement can be reached on the price and terms of the
business sale, then one buyer moves on to due diligence where intimate
details of the company are released to the buyer. The Letter of Intent
(LOI) is a written document outlining the major terms in an agreement
between a buyer and a seller, in order to establish a “meeting of the
minds”. It is one of the most important agreements the seller will sign.
Although LOI’s resemble written contracts,
they are usually not binding on the parties in their entirety. Many LOI’s,
however, contain provisions that are binding, such as non-disclosure
agreements, covenants to negotiate in good faith, or "stand-still" or
"no-shop" provisions promising exclusive rights to negotiate to the
potential buyer. The LOI is the entry point to the due diligence
phase, where the buyer examines in varying degrees of detail, important
trade secrets of the company. These may include customer lists, contracts,
employee details, supplier agreements, etc. Because this
information is so important, and in many cases, critical to your business,
the LOI serves to let only the right buyers through the door.
Following successful completion of the due diligence phase, the LOI is
replaced by the final purchase and sale agreement.
The letter of intent should state the
material terms of the transaction with enough clarity and detail to avoid a
misunderstanding which could delay, increase the cost of, or even
jeopardize the transaction. For example, if the buyer expects a
certain level of working capital to be left in the company and the seller
expects to leave a lesser amount of working capital in the company,
depending on the difference, a potentially unresolvable difference can
develop, preventing consummation of the deal.
Structure of Your Deal
Not all business sales are created equal.
Fundamentally, there are two ways to sell your company; you can sell shares,
or you can sell assets. In a share sale, a buyer would normally
purchase all of the outstanding shares of the company. If this occurs,
they will normally assume all liabilities, excluding intercompany accounts
and bank debt, however, if the assets are sold instead of stock, the
presumption is that the seller will maintain all of the liabilities, even
those associated with the sold assets.
Another structuring consideration is the tax
impact of a sale of your business. CRA is waiting in the wings
of course with their hands outstretched. A share sale for qualifying
shares of a Canadian controlled private corporation has the benefit of a
$750,000 capital gains exemption, whereas an asset sale does not have such
an exemption. If the LOI does not say what the structure of the deal
is, and the seller assumes it is a share transaction, and the buyer does
not, this will materially affect the after tax proceeds on the sale.
Is the Price Conditional on Accounts Continuing for
a Period After Closing?
If the buyer requires a guarantee of
accounts, the seller should fully understand the terms and conditions of
this guarantee. Some items that should be included are:
- What is the
- What is the
multiple used to deduct for accounts lost?
- Will the
seller get credit for any accounts brought in during the guarantee
- How will the
credit be calculated?
- Can the
credit exceed the loss, thus allowing for a price increase?
It is important for the seller to determine,
how the company will be managed during the guarantee period? Which
employees will be retained? Will the owner be retained for a period of
time? Will the seller be protected if customers leave due to a price
increase, or poor service by the buyer?
How Creditable is the Offer?
Once the letter of intent is signed, the
company goes off the market and due diligence begins with one buyer.
This means that the seller should assess the likeliness of the buyer being
able to close the transaction before it closes the doors on other potential
buyers. Some of the questions the seller should ask are:
- Is the buyer
relying on the bank to provide financing for the deal? If so, is the
bank on board?
- Has the buyer
thoroughly reviewed the selling memorandum (the "book" that presents the
company for sale, usually prepared by the transaction intermediary
representing the seller)?
- Are there any
issues resulting from the memorandum that need to be resolved before the
transaction advances any further?
- What is the
buyer's approval process? Does it require Board of Directors' approval?
The seller should also ask the transaction
intermediary what the track record of the prospective buyer is in approving
purchases that have made it to LOI stage. Has the buyer completed the due
diligence on past deals, and not gone through with the purchase? If
not, why not? Determining that a suitor is a perennial “run-away
bride” can save the seller considerable time and money.
The vast majority of business sale
transactions include a non-compete agreement, however, the terms vary widely
depending on the individual situation. If the seller is selling a
guard business, can the seller open an alarm business? What if the
seller has an alarm business, can they then open an investigative business?
What if the seller moves to another part of the country, can they start up a
security business there? The answers to these questions need to
covered off in the non-compete agreement, if the seller has any intention of
pursuing opportunities such as those listed above.
In conclusion, any seller of a business needs
to consider the many items discussed above, prior to signing a letter of
intent. Prepared correctly, an LOI not only maximizes the probability of a
successful transaction, but also tends to “smoke out” situations that are
likely lead to a closing, thereby saving time, money and protecting
confidentiality in the process.