CHAPTER 16

The Offer

With your decisions about the price you are willing to pay for the prospect and the key terms of your proposed deal, you are ready to make an offer. This is a big step. If your offer is accepted, you will spend much of the next several months completing the transaction and then, perhaps, a significant period of your life managing the business.

The offer itself takes the form of a formal letter of intent (LOI). In this document, you’ll state your proposed deal terms, including an initial offer price and the specifics of the next phase of the acquisition. Ideally, the seller will accept your LOI by formally signing it, but more often, some negotiation has to happen first.

Letter of Intent (LOI)

Your LOI is a detailed agreement that describes your deal. First, it specifies in writing the key terms of the deal: the purchase price, the amount and terms of seller debt, any business assets not included in the sale, the amount of working capital delivered at the closing, the length of a postsale noncompete from the owner, and any other material deal points. If you go forward with the acquisition, the LOI will be succeeded by a much more detailed and binding purchase agreement. But the LOI insures that there is mutual understanding of the key terms before everyone does a lot more work. While the LOI doesn’t commit either you or the seller to complete the proposed acquisition at its price and terms, it anchors both of you. Of course, the deal might change as a result of any new information that comes up in due diligence, but the LOI is a handshake and it allows both parties to proceed with reasonable confidence.

The only terms that are legally binding in the LOI are those that have to do with the structure of the closing: the exclusivity of your offer and your own promises regarding confidentiality of the information and nonsolicitation of the seller’s customers and employees. The exclusivity is important to you because you are about to invest a lot of time into confirmatory due diligence and raising debt and equity financing—you want to know that the seller is working in good faith with you and only you. The confidentiality and nonsolicitation are important to the seller in case your proposed deal doesn’t close.

If you have already submitted an IOI on this prospect, there will be much overlap between the IOI and the LOI. The LOI is likely to have more details because the back and forth during the IOI process helped define the seller’s concerns and your responses. Also, you’ll now know more about the prospect and the likely financing opportunities.

Items to include

Your LOI should specify the key terms of the deal that you’ve worked out over the past few chapters, including the following:

• Offer price
• Transaction structure (purchase of stock or assets)
• Amount and terms of seller debt
• Amount of working capital delivered at the closing (the working capital peg)
• Timing of closing and exclusivity period
• Transition period and length of a postsale non-compete from the owner
• Your confidentiality and nonsolicitation agreement

You can see what an LOI looks like in appendix B, a hypothetical LOI for Randy’s acquisition of Zeswitz. While the letter closely resembles Randy’s actual LOI, we’ve changed some of the details to protect Randy and the seller. So while you can use the sample LOI as a starting point, you’ll probably need to customize it for issues unique to your deal or things that your seller is particularly focused on. And if you’re not comfortable with your own reading of the LOI and its terms, you should have your attorney review it before sending it to the seller.

How much detail is enough

You’ll need to decide how much detail should be included in your LOI. The primary advantage of a detailed LOI is that material issues are identified and negotiated before a lot of time and expense is spent. The primary disadvantages are that the seller may not be ready to negotiate through a set of difficult issues early on. Remember: It is likely that the seller is selling a company for the first time and doesn’t have a good grasp of all the steps to complete a transaction. Forcing the seller into early, uncomfortable discussions may damage your relationship with the seller and make a deal harder to complete.

Perhaps the thorniest LOI term is the working capital peg, because the appropriate amount of detail is uncertain. As explained in chapter 15, this peg specifies the amount of working capital that will be left in the business. Sellers seem to understand the concept of a cash-free, debt-free deal yet balk at leaving a set amount of working capital in the business. Often, the seller simply doesn’t have the detailed monthly financial statements that would be used to estimate the working capital on the closing date. Consequently, you, the buyer, will have difficulty proposing a specific amount, and the seller will be hesitant to accept it. None of the choices are perfect:

1. You could insist on resolving the dollar amount of the working capital peg in the LOI. That will delay the LOI, perhaps by several weeks, as the seller collects the historical financial information. During that time, you will either delay the next steps in the deal—risking frustration by the seller—or will invest heavily in the deal without an exclusivity agreement.
2. You could ignore the working capital issue in the LOI and negotiate it when you negotiate the purchase agreement. The advantage is that the financial information will be available; the disadvantage is that the seller may treat this as renegotiating the deal and terminate discussions.
3. You could specify that the deal will include a working capital peg and describe its calculation but do not assign a specific dollar amount. For example, you could agree that the peg will be equal to the average net working capital over the six months prior to the LOI.

We have seen searchers pursue all three of these paths. We like the first choice the least because our experience is that sellers are not ready for the discussion, and good deals are too likely be abandoned over the issue. We don’t like the second path much, either. We have seen deals be delayed for months—and the relationship between the buyer and the seller severely damaged—by delaying the discussion of the working capital peg until the purchase agreement negotiations. For these reasons, we recommend the third choice—defining the issue and establishing the formula—as a reasonable balance between the desire to resolve issues in the LOI and the expediency of delaying them.

The working capital peg is, of course, only one of many issues that you’ll need to settle by the time you complete the transaction. Thus, the balance between resolving issues and delaying them is a judgment call throughout much of the LOI. It is likely that you will need to let some of these issues remain vague while others will be resolved early. Terms that are easily defined should be defined—for example, the interest rate, maturity date, and principal repayment schedule on the proposed seller note. Keep in mind that an LOI typically runs 4 pages long; your binding purchase agreement is about 40 pages. You want to agree only on key deal points in the LOI; greater detail is reserved for the purchase agreement.

Getting the Seller to Sign

As you weigh whether to resolve issues up front or to delay negotiations until later, be careful not to compromise on terms in the LOI. You don’t want to make it so easy for the seller to sign that you struggle to get the acquisition completed down the road—your ultimate goal. You shouldn’t enter into an LOI if you are unwilling to complete the acquisition on the terms you describe.

The LOI is your offer, and though you are hoping that the seller will accept, at least four responses are possible. First, and most disappointing, is no response at all. Second, the seller might reply with a higher price and different terms. Third, the seller might use the offer as an opportunity to provide you with more information about the company in hopes of raising your perception of the value of the company. And fourth, the seller may accept the offer with only a few, minor revisions and return to you a countersigned LOI. With the first response, you’re out of luck; with the fourth, you’re very lucky. With the second and third responses, you will consider any new information or renegotiate in response to their counteroffer until either both of you sign an amended LOI or it becomes clear you can’t agree and you move on.

Next Steps

If the seller doesn’t sign the LOI, you’ll need to try to negotiate a deal that works for both of you. Sometimes, the seller really cares about a particular provision of the LOI, and because the provision is less meaningful to you, a revised deal is easy to craft. Other times, a renegotiated deal is much tougher but still possible. And, of course, many times, there is no common ground and you’ll need to move on to another prospect. If that happens, be sure to check back with the seller periodically; sellers often find deals more appealing after they’ve gone several months without a better offer or after a seemingly better deal with another buyer fell apart.

If the seller signs the LOI, the next steps are bringing the proposed transaction to a successful completion. You need to complete confirmatory due diligence, arrange debt and equity financing, and structure the detailed description of the acquisition in the binding asset purchase agreement. All of these steps are covered in part V, “Completing the Acquisition.”