Business Sale 101 – The Letter of Intent

By Douglas C. Alexander
SAALFELD GRIGGS PC

For many business owners, the culmination of a lifetime of building a successful business is its sale. Just as strategic planning is an important element in the successful operation of a business, advance planning is also critical to the success of a sale. This article will briefly explore the preparation that leads up to a sale, and the first step in initiating such a transaction; the execution of a Letter of Intent.

GROWING OPERATIONS

The time to sell is not when you lose the passion for your business. Some business owners wait to decide to sell until they are burnt out and can hardly wait to quit. The old adage of “Buy low, sell high” is particularly true in the context of a business sale. The time you want prospective buyers looking at your business is when business is strong and growing, your management team is excited and motivated, and your customer base is expanding. Buyers want to purchase growing businesses, and growing businesses command a higher price. Thus, it makes sense to periodically look ahead and consider when you think you will be ready to sell. Plan for your exit in advance by meeting with your legal and financial advisors, develop a strategy and time frame, and then work toward a target.

STRONG FINANCIALS

The corollary to selling at a time when operations are strong and growing is to make sure that your company financials are strong. Of course it is always important to watch the financial statements carefully and make sure that the company is doing well, but this is particularly true leading up to a sale. Keep an eye on key profitability indicators, and measures of successful operation. Make sure your accounts receivable aging is under control, that bad accounts are kept to a minimum and accounts are collected quickly. Closely monitor expenses to make sure they are and stay within historical norms. Profitability is critical. Key measures of profitability typically evaluated by buyers include EBITDA (i.e., earnings before interest, taxes, depreciation and amortization), and EBIT (i.e., earnings before interest and taxes). It is a good idea to work with your accountant to look at these and other financial indicators both presently and on an historical basis to spot trends and highlight ways to improve profitability leading up to the projected sale date. Two to three years before an expected sale date is not too soon to begin a careful review of your financials and a concerted effort to improve the picture they paint for a prospective buyer. Keep in mind that many businesses are valued as a multiple of some form of earnings. The change of $100,000 in the bottom line can result in a much greater change in the purchase price.

COMPLETE LEGAL RECORDS

In many closely held businesses, operations continue with little attention paid to accurately documenting what is being done. Keeping legal records up to date is not only important for liability protection purposes, but it will become critical when a buyer begins reviewing company records in connection with due diligence being done leading up to a purchase. If you have let your records slip, now is a great time to correct this deficiency. Visit with your legal team to make sure that key documents are up to date. Consider the following as a partial list of documents to consider: annual corporate minutes; promissory notes evidencing loans to or from the company; real property leases; equipment leases; key contracts with customers and vendors; employment agreements; non-competition and non-disclosure agreements; and patents, trademarks and other intellectual property. While this list is not exhaustive, it is designed to serve as a basic checklist of the kinds of documents that should be evaluated and kept up to date. Contracts that may be important to a buyer should be evaluated to determine if they can be assigned. If not, consider negotiating for the right to assign these contracts the next time they come up for renewal and renegotiation.

THE LETTER OF INTENT

Once the business is ready for sale and a prospective buyer is found, the next step is typically to negotiate the terms of a Letter of Intent (“LOI”). The purpose of the LOI is not to create a binding agreement between the parties or to negotiate all of the essential terms of the deal. Instead, it is intended to set the framework for the deal, ensuring that all parties are on the same page and ready to continue their negotiations in good faith toward an eventual closing. Usually, the buyer’s counsel drafts the LOI and submits it to the seller for review and approval. If it is not acceptable, then the seller’s counsel modifies the LOI for submission to the buyer.

The most important rule to remember when considering an LOI is that it should be non-binding. Basic terms to be outlined include the structure of the deal, for instance will it be a sale of assets or a sale of stock, the anticipated purchase price, terms of payment, assets both included and excluded, and important warranties and limitations. The LOI anticipates that the parties will be (a) conducting due diligence which will enable them to better evaluate the proposed terms, the assets and liabilities included, and the ability of the respective parties to consummate the deal, (b) drafting formal contracts which will include far greater detail regarding the terms of the sale, and (c) finalizing the timing and conditions for closure of the transaction. These activities, by their very nature, will give rise to additional negotiation between the parties. A seller will not want to be bound to sell if during due diligence it is concluded that the terms are unacceptable or the buyer is not truly qualified to purchase. Likewise, a buyer will not want to be obligated to purchase if it discovers some previously undisclosed problems or liabilities, or if the seller is unwilling to provide reasonable warranties and representations in the final purchase agreement. Thus, it is in the best interest of both parties to make the letter non-binding, and to be sure that this is clearly stated.

However, it is important to bind the parties in certain respects. Typically, the buyer wants to know that the seller will not negotiate with other prospective purchasers while the buyer continues to negotiate in good faith. Thus, the LOI will usually state that the seller cannot discuss a sale with any other person until the anticipated closing date has passed. The seller wants the assurance that the buyer will not use for itself or disclose to others any confidential or proprietary information of the seller obtained during the due diligence process. The parties can also agree on who will prepare the contracts, when the closing date will be, and how the transaction can be terminated. Great care should be taken before either asking for or agreeing to deposit earnest money. If a mistake is made in drafting an LOI, it can seriously impair the rights of either buyer or seller and can turn a potentially profitable sale into a legal disaster.

The bottom line – Although the concept of an LOI seems simple, it plays a critical role in getting the business sale off on the right foot, and its drafting should not be done without legal guidance. A lifetime of building a successful business can be damaged by improperly handling the LOI at the outset.

Future articles will discuss additional aspects of business sales, including the due diligence process, transaction structure, tax implications, contract terms, and traps for the unwary. Our lawyers have extensive experience in handling business sales and acquisitions of all sizes, successfully representing both buyers and sellers in these critically important business transactions. Contact us if we can be of assistance.