As an entrepreneur, you should know how to evaluate an LOI for your startup acquisitions. For a good reason, a letter of intent (LOI) is frequently among the first documents prepared in a merger and acquisition transaction. An LOI is a vital first step since it establishes an essential foundation for the acquisition, which aids in the negotiation of the final agreements.
Furthermore, by holding all stakeholders to accepted duties and expectations, the LOI aids in the transaction running smoothly.
Accepting an LOI (Letter of Intent) is the first true indicator that a buyer is serious about proceeding with a potential acquisition, so it must be treated as such.
Remember that mastering the storytelling side and how you are positioning your business is critical when it comes to engaging and speeding up the process. This is done via your acquisition memorandum. This is super important to reach a successful acquisition. For a winning acquisition, memorandum template take a look at the one I recently covered (see it here) or unlock the acquisition memorandum template directly below.
Here is the content that we will cover in this post. Let’s get started.
- 1. What is a letter of intent (LOI)?
- 2. Why do you need an LOI?
- 3. How to evaluate a Letter of Intent?
- 4. 1. How will the buyer finance this deal?
- 5. 2. Does it seem like the offer is too good to be true?
- 6. 3. How will the buyer compensate the seller?
- 7. 4. Will the offer be an asset or stock deal?
- 8. 5. Will the seller be responsible for long-term debt payments?
- 9. 6. Will the transaction include working capital adjustment?
- 10. 7. What will the seller’s post-closure involvement be?
- 11. 8. Will the seller need to sign a non-compete agreement?
- 12. Can a letter of intent become legally binding?
- 13. The Value of a letter of intent
- 14. Pros and Cons of an LOI (letter of intent)
- 15. Pros
- 16. Foundation of trust
- 17. Outlining the key terms of the transaction
- 18. Dealing with the real issues
- 19. The deal’s handbook
- 20. Cons
- 21. Putting your intentions on display
- 22. Letter of intent could possibly be legally binding
- 23. Shopping for bargains
- 24. Conclusion
What is a letter of intent (LOI)?
In mergers and acquisitions, a Letter of Intent (LOI) is a written, non-binding document that describes an acceptable deal for the buyer to purchase the seller’s business, specifying the suggested price and terms. The Letter of Intent specifies the basic business terms agreed to by the stakeholders, which will eventually serve as the basis for and form part of the Definitive Purchase Agreement and some other agreements and paperwork that record a business sale.
A jointly signed LOI is required before the buyer begins the due diligence part of the transaction. In addition to the transaction price and payment terms, the LOI includes confidentiality and often an exclusivity provision, also known as a “no-shop clause,” a description of the assets to be acquired, the conditions of the seller’s non-compete agreement, any liabilities, and the time frame for due diligence.
Why do you need an LOI?
Letters of intent can be used for a variety of objectives by various stakeholders. Before negotiating and finalizing all of the fine points and specifics, stakeholders might utilize an LOI to describe some of an agreement’s essential conditions. It explains and establishes all previous negotiations and offers the seller of the business a comprehensive view of what the buyer and seller are willing to provide.
The importance of documentation in a successful M&A deal cannot be overstated. If you want a fair transaction in which the seller and buyer are protected, documentation that covers the vital terms and conditions is essential.
An LOI should aim to achieve the following purposes:
• Severe as a record of the initial negotiations’ progress.
• Safeguard all stakeholders involved in the transaction.
• Identifies items that must be resolved prior to a final agreement.
• Serves as a foundation for the buyer to secure financing from a lender.
• Specifies aspects like a no-shop provision or a holding period during which the seller must, or is not permitted to negotiate with third parties.
• State the type of the transaction, such as a strategic alliance or a merger of two companies.
• Reduces the amount of time and money wasted for both the seller and buyer. If no agreement can be reached during this stage, it may be better for each party to walk away as the probability of reaching an agreement in the final stages is not likely.
Take the time to understand how to evaluate an LOI for your startup acquisitions to make sure you meet the objectives.
One of the most critical facets of an acquisition is calculating your company’s price. If you need more information about how to value a startup without revenue, check out this video I have created.
How to evaluate a Letter of Intent?
1. How will the buyer finance this deal?
Questions such as will the buyer use cash or obtain finance from a bank for the purchase need to be answered. Third-party financing significantly increases the transaction’s complexity and time considerations. Early in the process, the seller might consider seeking adequate evidence of a financial commitment. If the funding appears to be unrealistic, the likelihood of closing the contract decreases.
2. Does it seem like the offer is too good to be true?
If the deal may seem unrealistic, take some time to think it through. Read through all the fine print and make sure you familiarize yourself with all the details. Sometimes you may get lucky and find that you have stumbled upon a great deal.
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See How I Can Help You With Your Fundraising Efforts
3. How will the buyer compensate the seller?
Many questions need to be asked regarding compensation. You will want to be clear from the beginning about the financial details of the transaction so that you can plan accordingly. This is a list of questions that should be considered:
- Would the seller receive the whole purchase price in cash at the time of closing?
- Is there an earn-out component, and is it contingent on the company reaching specific criteria in the future?
- Will you be required to place any funds in an indemnity escrow as the seller? How much of the funds would this be, and for how long would it need to be in escrow?
- Would rollover equity be part of the deal?
- Is the buyer’s stock a factor in the equation?
When learning how to evaluate an LOI for your startup acquisition, you’ll understand how to include this information.
4. Will the offer be an asset or stock deal?
What assets and liabilities will the buyer assume if the transaction is an asset transaction? Bear in mind that a stock and asset transaction with the same purchase price may have unique tax repercussions for you as the seller.
5. Will the seller be responsible for long-term debt payments?
Some transactions are done on a debt-free, cash-free basis, which frequently implies the seller is liable for settling outstanding debts.
6. Will the transaction include working capital adjustment?
If it is then, how is the typical working capital base determined? If the value is predicated on a series of cash flows, it is expected that a regular level of working capital will be delivered at the close. Working capital adjustments based on characteristics discovered in a quality of earnings review are frequently utilized as a successful re-trade by sophisticated buyers; thus, care must be taken in addressing this problem in the LOI and the asset or stock purchase agreement.
7. What will the seller’s post-closure involvement be?
Would the seller be able to walk away once the transaction is completed, or will they need to remain connected with the organization for a certain length of time? If the seller is obliged to be involved, how will their engagement and compensation be structured after the sale? These are some of the factors to work out when planning an acquisition.
8. Will the seller need to sign a non-compete agreement?
What does this contract prevent you from doing in the future? The majority of transactions will necessitate a non-compete agreement lasting between two and five years. Constraints on the type of business prohibited, geographic location, passive investment versus active engagement, and the length of time for the limitations are all factors to consider.
You must also understand how to evaluate an LOI for your startup acquisitions.
Can a letter of intent become legally binding?
In many cases, the first stage in negotiating a merger and acquisition deal is to agree on the transaction’s business terms in the form of a letter of intent. This document can have legally binding consequences if not handled carefully. Thus it should be reviewed by a lawyer before being concluded and executed.
Depending on how the letter is written, a party that signs a letter of intent (LOI) may be legally compelled to honor it. A letter of intent in a business-to-business transaction will typically include a provision declaring that the letter is non-binding. While such language may not be present, a court may decide that the letter is merely an indication of intent. A letter of intent should not be based on assumptions.
When assessing whether a letter of intent is binding, a court considers two factors:
- Written declaration of intent contained in the letter
- And tangible acts made by both parties after the letter of intent is signed.
It may be deemed legally binding if the letter of intent is viewed as a contract.
The Value of a letter of intent
When engaging in a merger or acquisition, it is critical to grasp the significance of a letter of intent. Even though it is not always legally binding, it provides a solid framework for the subsequent transaction and acts as a guide for what you must undertake and by what date.
Simultaneously, it brings possible debate areas to the surface early in the discussions, allowing the buyer and the seller to work together to discover appropriate and effective resolutions. Due to the complexity, while drafting a letter of intent, you should consult an M&A advisor with experience in acquisitions in your industry.
Keep in mind that in fundraising or pitching for an acquisition, storytelling is everything. In this regard for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.
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Pros and Cons of an LOI (letter of intent)
When understanding how to evaluate an LOI for your startup acquisitions, also learn about the pros and cons.
Foundation of trust
Although the basic elements of a transaction usually are not legally enforceable at the LOI stage, identifying purchase terms may make a party feel committed to that term. Furthermore, the execution of an LOI will reflect one or both party’s commitment to completing the transaction.
Outlining the key terms of the transaction
The letter of intent phase enables both of the parties to concentrate on the critical elements of a transaction, such as the sales price, loan amount, rent, and closing date, without negotiating and determining the particular legal details prematurely. Getting to the point early helps all parties save money and save time.
Dealing with the real issues
Often a significant issue arises in a transaction, and if it is not handled early on, the agreement will not be completed despite the other terms. For cases like these, the parties may wish to reach an agreement on these concerns before proceeding.
The deal’s handbook
A letter of intent (LOI) can be submitted to the seller’s or buyer’s shareholders and directors as a handbook to the transaction, eliminating the need for those individuals to go through final documentation in order to evaluate a transaction. Furthermore, a letter of intent serves as guidance for each party’s lawyers and other M&A advisors in creating and negotiating the legal paperwork.
Putting your intentions on display
Accepting a letter of intent from a buyer may signal to customers, competitors, vendors, and staff that you have intentions of selling your business which can have severe commercial effects even if the transaction is never completed. This intention can cause a state of panic amongst employees and vendors, causing your business to lose critical resources if the sale is not successful, as these key players in your business may start to feel insecure.
Letter of intent could possibly be legally binding
Since most due diligence is still to be completed at the LOI level, the stakeholders should prefer the crucial aspects of a transaction as stated in an LOI to be non-binding. Nevertheless, if the wording of the LOI is not meticulously drafted, even when it indicates that it is non-binding, the LOI may generate a legally binding contract.
Shopping for bargains
Letters of intent, in essence, signify a party’s willingness to enter into a contract, but this may not always be the case. Another potential drawback is that the other participant to the transaction is simply completing the LOI in order to utilize it to gain more information.
It is critical to recognize that an LOI is not the end of the transaction process but rather the beginning of the legal procedure. The quality of earnings evaluation, due diligence, financing of the acquisition, and the drafting of the asset purchase agreement are all tasks that still need to be completed. The conditions of the letter of intent can significantly impact the seller’s ability to achieve his goals through this process. So, do take the time to learn how to evaluate an LOI for your startup for acquisitions.
The total value is usually a major issue, but it is critical to recognize that there are other elements to consider before committing to a letter of intent. Working with an experienced M&A team that includes lawyers, investment bankers, and accountants can assist you in negotiating the most profitable deal possible for your business.
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