How to Evaluate an LOI When Selling Your Business.
Boosting Your Business Value with Monthly Recurring Revenue
September 11, 2023
WORKING CAPITAL: Often Misunderstood But Always Important
November 17, 2023Since it is non-binding, a business owner needs to be aware that buyers can still walk away from the deal even after they have reviewed sellers’ sensitive information provided in due diligence. If the buyer is a direct competitor, this can have unintended consequences for the seller, notwithstanding well-drafted non-disclosure agreements with limitations on use of the information. If the process is handled by a professional M&A Advisor representing the seller, it is not unusual withhold actual customer information until immediately prior to closing.
Here are some basic considerations for evaluating an LOI:
Cash at Close – The offer should
detail how much cash shall be transferred to the owner at the time of closing
that is not contingent upon any future performance. This is different from the
Total Enterprise Value which adds up all the components and adjusts for the
value of the money over time. The higher the amount of the TEV you receive as
guaranteed payment, the better the LOI.
Seller Note – In some cases a buyer may ask the seller to provide some financing in the form of a seller note. This is typically interest bearing and has a term of 2-5 years. As long as this is a small portion of the sales price, it is common to see in most transactions. The note will typically, be subordinate to bank debt and much emphasis will be placed on the security of the note.
Earnout – The buyer is “derisking” their investment by paying some portion of the total price for a period (typically 1-2 years) based on continued performance or growth of the company. This is a very complicated part of a transaction with pros and cons outlined in another blog article. It can be a useful tool when the buyer and seller cannot agree on a price for the business. Most often we recommend that the future performance be tied to top line revenue or Gross Profit rather than EBITDA. The reason being that EBITDA can potentially include expenses that were not agreed upon by the seller and thus reduce the profits (for example the hiring of additional employees or management fees). An experienced M&A attorney can reduce most risks associated with an earnout, but the future performance needs to still be achievable.
Escrow – This is a percentage of the purchase price that is set aside at closing and held by a third party And very standard in most transactions. This provides security to the buyer in case the seller violates or has violated reps and warrantees. The escrow is typically released to the seller after 12, 18 or 24 months.
Equity Rollover – The buyer may ask for the seller to invest in the “NewCo” as a
minority shareholder. This provides some upside for the seller and some
confidence for the buyer. This is optional in most transactions and is sometime
referred to as the “second bite of the apple.” You will sell your rolled equity alongside the buyer when they exit the business.
Financing – How will the buyer finance the transaction? Third-party financing adds significantly to the complexity and timing considerations of the transaction. The seller should consider requiring satisfactory evidence of a financing commitment early in the process, with the ability to break exclusivity, and perhaps recover out-of-pocket costs if it is not provided in a timely manner. This can be presented in the form of a cap table if the deal structure has complicated investors. Knowing this will help determine the certainty of a transaction to reach closing.
Net Working Capital Adjustment – Assuming that value is based upon a stream of cash flows,
a “normal” level of working capital (that historically facilitated the income
streams used to determine value) will be required at closing. Careful attention
must be given to how this issue is treated in the LOI because working capital
adjustments (based upon factors determined in a quality of earnings review) are
often used as an effective re-trade (re-trade is when post LOI where a buyer
finds an issue in due diligence and no longer wants to pay the offer on the
LOI. Typically, we want to avoid a re-trade since you are no longer in the best negotiation position.) by sophisticated buyers. Reaching an agreement during the LOI negotiation can avoid that during the process.
Net Working Capital Adjustment – Assuming that value is based upon a stream of cash flows,
a “normal” level of working capital (that historically facilitated the income
streams used to determine value) will be required at closing. Careful attention
must be given to how this issue is treated in the LOI because working capital
adjustments (based upon factors determined in a quality of earnings review) are
often used as an effective re-trade (re-trade is when post LOI where a buyer
finds an issue in due diligence and no longer wants to pay the offer on the
LOI. Typically, we want to avoid a re-trade since you are no longer in the best negotiation position.) by sophisticated buyers. Reaching an agreement during the LOI negotiation can avoid that during the process.
