Business & Marketing
What a seller should know before signing a letter of intent
By Rhonda Downey
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.”
By Rhonda Downey
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 stock 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 stock 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 time period?
- What is the multiple used to deduct for the accounts lost?
- Will the seller get credit for any accounts brought in during the guarantee period?
- 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 will the company 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 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.
Rhonda L. Downey, CA, CPA, CF,MSM, is the President of Regelle Partners Inc.