A milestone in the sale of a business is the execution of a letter of intent (LOI) with a prospective purchaser. This LOI lays out the price, terms and timeframe under which the parties agree to proceed, all subject to completion of due diligence, drafting of the closing legal documents and, in most cases, final confirmation of financing arrangements. But don’t uncork the champagne just yet!
First of all, the seller should insist that the LOI’s very existence remain confidential. This is because nothing is so certain to undermine a company’s employee focus and morale, as well as relations with suppliers, customers and other prospective buyers, as the knowledge that a sale is imminent. Besides upsetting normal operations, this shifts all the negotiating leverage from the seller to the buyer because the seller’s having to announce that “the deal is off” is too awful to contemplate.
The seller should organize a team, usually headed by the CFO, to respond to the buyer’s due diligence questions. While this process is frustrating, it is fundamental to the buyers being able to proceed. Then both sides should meet in person or via video call to discuss each question. For many due diligence questions, a simple “yes,” “no” or “that doesn’t apply to us” will suffice. For others, some “financial archeology” will be needed to compose the response. Frequent checklist reviews and video calls will keep the process efficiently on track.
If the seller’s monthly performance suffers during the period between LOI and closing, most buyers will request a price reduction. Yet managers can only maintain results if they somehow do their regular jobs while assisting with due diligence. That is why those involved in the transaction should plan to work many extra hours during this critical time. We recommend that owners pay a closing bonus to staff whose doing two jobs at once makes the closing possible.
Many buyers want to delay drafting the definitive purchase agreement (DPA) until after due diligence is done. This is a non-starter for multiple reasons: 1) The LOI should have included a mark-up of the seller’s draft purchase agreement, highlighting critical issues, 2) the most important due diligence items can be addressed first, allowing the DPA drafting to proceed under the assumption that the other items will be resolved and 3) delaying the DPA drafting will make it virtually impossible to close in a timely manner.
Most important, the prompt drafting of the DPA will surface the devils in the details. If these cannot be resolved, it’s best to discover this quickly so the seller can promptly terminate negotiations and move to the No. 2 buyer before he/she loses interest. Sometimes we have used this stutter step to sign an LOI with the No. 2 buyer without their ever realizing that there was a No. 1 buyer.
There is an inside joke among M&A professionals: Question: What is a letter of intent? Answer: An expensive form of wallpaper. Since almost all M&A transactions take the form of an LOI before closing, this is clearly not always accurate. However, the joke reinforces that the time to break out the champagne is after the closing, and not one minute before.
Mark A. Filippell is Managing director at Citizens Capital Markets.
