Terms to Consider Before Signing an M&A Letter of Intent

Once both sides of an M&A deal have negotiated the terms of the deal, they memorialize that understanding by signing a letter of intent (LOI). The LOI is an important step and should be fully understood prior to signing. To increase your chances of a successful closing, consider these things before signing an LOI.

What are the conditions of escrow?

How much money is held in escrow, and who controls its release? In a very general sense, the amount of money held back in escrow should be 10 percent or less of the purchase price, and that money should be released to Seller within 12 to 18 months. Other considerations include how the reps and warranties are associated with that escrow and who receives the interest from the escrow account.

How does the deal settle working capital issues post-closing?

Does the deal include a working capital adjustment (adjustments made to the purchase price after closing, based on the actual balance sheet values)? A working capital adjustment can be a major lurking surprise, especially for Sellers. Sellers should make sure all current liabilities are in fact current! If not, Seller may face a substantial post-closing adjustment.

Along those lines, Buyers should note whether all Seller’s receivables and payables are current or whether she’s slow to collect receivables and pay her bills, especially if Buyers are assuming the accounts receivable and accounts payable as part of the deal. Buyers need to be careful about assuming payables that should have been paid months ago. Paying overdue bills is Seller’s responsibility!

Is the inventory 100 percent salable?

Inventory can be another pain point for Buyers and Sellers. A Buyer operates under the assumption that she can sell all the Seller’s inventory. If the Seller has obsolete inventory, the Buyer may press for a post-closing adjustment.

Hiding obsolete inventory from a Buyer is an unwise plan. A Seller who doesn’t address the issue of inventory salability is asking for trouble! Sellers need to bite the bullet and either write off inventory prior to close (thus reducing earnings and possibly the valuation) or brace for a large post-closing adjustment.

Who pays off any long-term debt and what happens to the line of credit?

Make sure you’re clear on who’s responsible for the Seller’s long-term debt and any short-term lines of credit. Either the Buyer assumes it or the Seller pays it off.

Seller shouldn’t assume Buyer will simply pay off the debts of the business. If Buyer is going to pay off the business’s debts, he’ll first subtract those debts from the proceeds of the business sale.

What are the tax implications of the seller’s accounts receivable?

Another lurking surprise for some Sellers is the taxability of accounts receivable. Taxing authorities may consider a company’s receivables as income and therefore tax the receivables at Seller’s marginal income tax rates rather than capital gains rates.

Sellers, confer with your tax advisors about the proper tax treatment of your company’s accounts receivable as the result of the sale of your company.

Is the seller signing a noncompete agreement with the buyer?

Many deal-makers often overlook and underappreciate the noncompete agreements that accompany most deals. These agreements prevent Seller from competing with Buyer for some length of time and in some defined geographic area.

Sellers need to remember that part of the purchase price is wrapped up in the noncompete agreement. Buyers won’t be willing to pay the full price unless Sellers agree not to compete.

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