If you’re a small business owner looking to sell a successful small business, the Letter of Intent (LOI) is going to be one of the most important documents in the process. Letters of Intent set the foundation for the Definitive Agreement and subsequent discussions, and a well-crafted LOI can help make for a smoother negotiation.
This article will give you a solid understanding of what you need to know about a Letter of Intent to sell a business. You’ll learn what an LOI is specifically, what’s included in one, and why it’s so critical in business deals.
What Is a Letter of Intent to Sell a Business?
The initial sales process calls for the seller (or, more likely, the seller’s representatives) to begin looking for potential buyers. Once a potential buyer for the seller’s business has been found, there is a period of time when initial discussions occur. It’s during this time that both parties get to know each other and try to figure out whether a deal is possible. The parties negotiate in good faith at a high level as they begin to identify what the potential terms of the deal would look like.
Once the two parties agree that a sale is possible, advisors and/or legal counsel for the buyer will draft a Letter of Intent. The LOI states the mutual interest the two parties have in completing a business transaction together. It covers basic terms and the most important elements that came about during initial negotiations.
The Letter of Intent is not a formal purchase agreement, nor is it a binding contract. Instead, it serves as the foundation for drafting the Definitive Agreement and the discussions that follow.
Although the LOI is not the final agreement between two parties, that doesn’t mean it should be taken lightly. Requests to modify the deal structure (by either party) after signing a LOI can:
- Erode trust between the two parties
- Throw a wrench into negotiations
- Potentially derail the deal completely
If the LOI is drafted well and covers all of the main points, including the top priorities of both the buyer and the seller, then the rest of the merger or acquisition process should go much more smoothly.
What Is the Timing of the Letter of Intent?
The LOI is the first formal document in the merger or acquisition process. It outlines some of the basic elements discussed during initial negotiations between a buyer and seller.
Typically, at this point, high-level financial information has been shared between the parties. However, that doesn’t necessarily mean that either party has been able to pore over one another’s financial statements. Those finer details are typically reserved for the due diligence process. The due diligence process comes after both parties have signed the LOI. If the due diligence process goes well, it will eventually lead to a Definitive Agreement.
It’s important to note that many buyers will push to enter the due diligence stage prior to submitting an LOI. However, sellers should not let this happen for a few reasons:
- It could send buyers away before you have a chance to even enter formal negotiations
- There’s no point in divulging sensitive information about your business (and spending your valuable time) without knowing some basic deal terms like purchase price. If the buyer intends to offer you half of what you think your business is worth, negotiations may not need to progress any further.
- If the buyer is a competitor, they could be on a so-called fishing expedition. A Letter of Intent typically signals how serious the buyer is about moving forward with a purchase. The LOI is a tool for quickly eliminating buyers who are not serious, reasonable, or otherwise unqualified.
When you consider that only 20% of small to mid-sized businesses listed for sale actually sell, it’s crucial that you take every lead seriously and follow the legal advice set forth by the team you trust. Remember, an LOI is a non-binding agreement. If a buyer is serious about purchasing your company, they should have no problem signing one to usher in the next phase of negotiations.
Perhaps the most important thing to emphasize is that a good business broker or M&A advisor can help you through the sales process. Having a trusted team in place is invaluable, helping to increase the likelihood that you convert indications of interest into an actual sale.
What Does the Letter of Intent Typically Include?
Though each buying process is unique, a Letter of Intent will typically cover three main things:
- Terms and Conditions
Below is a closer look at each of these three key elements.
When it comes to pricing, the LOI should clearly spell out the purchase price and terms of payment. It should also include language about what is specifically included in the purchase price and what is not. For example, it may say that 80% of the payment is due upfront, and the other 20% is due after the seller completes a six-month consultancy. All of these details should have come up during initial negotiations between the buyer and seller.
Again, the LOI is non-binding and some things can change during future negotiations. But doing so can potentially erode trust. By the time both parties are ready to sign an LOI, the valuation gap should have been addressed and overcome.
For instance, if a buyer enters into an LOI with the premise that they will pay in full within six months of the closing date, and then later say that they will pay monthly installments for five years, the seller may have second thoughts about the deal. The pricing structure and purchase price set forth in the LOI should remain relatively consistent throughout the remainder of the negotiation process.
The Letter of Intent to sell a business should contain a breakdown of intended timelines. It should specify proposed dates for closing and may also outline details such as options on real property and when those expire. The LOI should also clearly outline the seller’s obligations post-sale. For example, if they are to stay on board in a consulting role for six months after the sale, this too should be outlined in the LOI.
Terms and Conditions
The Letter of Intent should outline the primary elements of the proposed deal structure as well as relevant terms and conditions. It will likely spell out under what conditions the LOI is terminated. The LOI will also likely contain an exclusivity clause, otherwise known as a no-shop clause.
These clauses are disclaimers that state a buyer and seller are exclusively entered into negotiations with one another and that the seller cannot continue to solicit offers or negotiate with other potential buyers. Although an LOI does not bind either party to a sale, it is a legal document. Signing an LOI means that both parties intend to move forward in good faith.
What does that mean? It means that should a seller sign this clause and then continue to negotiate with other interested parties, the potential buyer named in the LOI would be able to take legal action against the seller. Again, having a trusted M&A advisor and law firm can help you avoid these precarious situations during the negotiation process.
How Can a Good Letter of Intent Help Complete a Business Sale?
As mentioned previously, only 20% of mid-market businesses listed for sale are actually sold. The entire merger or acquisition process can take years to complete. You’ve already done a lot before signing a Letter of Intent to get yourself to this position.
When you sign an LOI with a potential buyer, there’s a strong chance that you’re going to have to stop searching for other offers. By signing an LOI, all of your eggs are in one basket, at least for that moment in time.
Again, Letters of Intent are not legally binding, but a deal that falls through can be deflating for owners. You will need to start your sales process all over again, finding and vetting potential buyers. That’s not to say you won’t eventually find a buyer, but it could take some time until you find the right fit. Ultimately, you want to find a deal that’s right for you. If something comes out during future negotiations and your team of advisors recommends you walk away, don’t hesitate to do so.
Having said that, a strong LOI reduces the likelihood of a deal falling through. A well-written Letter of Intent explicitly spells out the expectations that both the buyer and the seller have before entering into the due diligence process. It should reduce potential surprises, thereby increasing the chances of completing a sale.
A Strong LOI Increases the Chances of Selling Your Business
After you and your team find a potential buyer, the next step is for both parties to sign a Letter of Intent. A Letter of Intent to sell a business is critical, as it formalizes many of the details discussed during initial negotiations. Specifically, the LOI will address pricing, timelines, and terms and conditions.
Although an LOI is a non-binding agreement, there are likely exclusivity clauses that prevent the seller from continuing negotiations with other prospects. As such, having a thorough LOI is essential and increases the likelihood of moving from the due diligence process to a Definitive Agreement.
An LOI is a legal document, so it’s essential to know what you’re signing. As is the case throughout the entire M&A process, seek guidance from your team of experts, including your attorney, CPA and your business broker or M&A advisor.