Letters of Intent: Mutual Commitment to the Process
Strategic and Tactical Considerations of Preliminary Transaction Documents in SMB Interest Transfers – Part 5 in a series.
Once the Preliminary Doc is signed, both buyer and seller are going to spend a great deal of time and money to move the contemplated transaction toward closure. In addition, the parties’ respective business vision is going to be dependent upon the successful outcome of the deal.
For the seller, the intensity of due diligence requests, questions and contract negotiations can be very disruptive on the day-to-day operations of the business. It can also play havoc with emotions and add a new layer of personal and family stress.
Why would either the buyer or seller enter into a Preliminary Doc and incur the attendant expenses unless they thought the other party was serious and committed to the process?
Although there may not be a true meeting of the minds, each party to a Preliminary Doc wants to be comfortable enough with the seriousness of the other’s intent in order to justify the time and expense that comes with moving to the due diligence and contract negotiating phase.
There are a number of items that can be included in a Preliminary Doc that address the issues of commitment and seriousness:
Negotiate in good faith: There are plenty of issues that may arise and threaten to knock a contemplated transaction off the tracks. After all, the Preliminary Doc is just an agreement to agree. However, a good faith clause can provide a measure of confidence that the parties are not “playing games.”
An Example of Negotiating in Bad Faith
In the days before expert advice from experienced intermediaries and advisors was readily available to Sellers, there was a questionable buying technique called “send the Sellers to Tahiti.” In this negotiating technique Tahiti is a metaphor for the Seller’s vision of life after the deal closes. The Seller visualizes himself sitting on a pristine beach sipping their favorite libation, enjoying the fruits of his years of hard work and sacrifice.
Sending the Seller to Tahiti works like this: first, the buyer reviews the initial materials provided by the Seller (or their unwitting representative) and then meets with the Sellers. The Buyer just falls in love with the business—it’s the perfect fit, a match made in Heaven. The Sellers are delighted to find a Buyer who appreciates and values their hard work and accomplishments. That delight turns to absolute glee when the Buyer submits a very generous cash offer.
The Buyer leads the Seller to believe that this is practically a done deal. The Seller can now make plans for that metaphorical trip to Tahiti. Just one teeny-weeny detail: the Buyer will have his people take a look at the financials to finalize the deal, but “no worries, this is just a formality, you go ahead and get ready for Tahiti.” At this point the Seller naively turns his attention to the next chapter of his life and becomes psychologically committed to the deal.
At the same time, the Buyer starts looking at the financials—just a formality—and after a couple of weeks of information requests, the Buyer asks to meet with the Sellers. The Buyer shows up holding reams of computer analysis and while doing his best Lieutenant Colombo imitation, indicates that he just has a few questions about the numbers. Turns out the guys in the back office can’t make sense of the valuation.
Now the trap set. If the Seller has mentally exited the business, the Buyer will use time and seemingly endless questions about the ‘valuation not making sense” to grind the Seller to make price concessions. This tactic of “there’s just one more thing…” would go on until the Seller either gave in or gave up. In the end, the Buyer either gets a much lower price or walks away telling the Seller something along the lines of “after seeing the numbers, the valuation just doesn’t make sense.” No deal, no Tahiti—a total waste of time and money for the Seller. This is bad faith negotiating.
Sending a Seller to Tahiti exploits an inexperienced Seller’s vulnerabilities with the conscious intent of grinding the price. (This is quite different than negotiating purchase price adjustments as a result of legitimate issues that surface during due diligence.) Fortunately, today’s intermediaries make a market for an SMB and can protect their clients from shenanigans such as that trip to Tahiti.
A “negotiate in good faith” clause is something that you want to talk to your counsel about before you put it in writing, but one way for the parties to assure each other that they will “negotiate in good faith” is to add a clause to that effect.
The problem with good faith clauses is what happens and how the clause will be interpreted if one of the parties accuses the other of acting in bad faith. There is value in assuring the other party that you will negotiate in good faith—as long as such an assurance doesn’t become a snare.
Earnest money to be deposited and how it will be treated: Nothing says “I am serious” like depositing cash in an escrow account. This assures the seller that the buyer now has “some skin in the game,” even if it is only a token amount.
Naturally, the addition of earnest money or a down payment requires additional work by your counsel. There are a number of details to be addressed with respect to earnest money such as what happens if the deal falls off the tracks. What are the conditions, if any, under which the earnest money is paid or forfeited to the seller? (See the next section about break-up fees.)
Break-up Fees: A break-up fee (or termination fee) is a payment made by one party to the other in the event the party decides not to pursue the deal. The break-up fee can be payable to either the buyer or the seller depending upon how it’s structured.
A break-up fee payable to the seller may be introduced in larger deals where the buyer’s failure to successfully conclude the contemplated transaction will have a negative impact upon the selling company or when the process of selling will be very disruptive. A break-up fee payable to the seller demonstrates a high degree of seriousness on the part of the buyer.
A break-up fee payable to the buyer might be introduced if the seller will have the option to entertain superior offers after signing the Preliminary Doc or as reimbursement for due diligence and legal fees if the contemplated transaction can’t close due to an act of the seller.
If a break-up fee is to be included in the Preliminary Doc, the circumstances, treatment and conditions that would make it payable and how it will be paid need to be clearly understood and delineated.
Shop or No-Shop: Due diligence and contract preparation are expensive and time consuming. Typically, a buyer doesn’t want to have a seller continuing to market their company and entertain proposals from other potential buyers. For that reason, a Preliminary Doc may include a no-shop clause.
The opposite of a no-shop clause is called go-shop. A go-shop clause works to the advantage of the sellers, but can work against the interests of a committed buyer because the seller is free to pursue talks with other suitors. If another buyer makes a play for the company, the buyer might lose the deal or find themselves in a bidding war. A break-up fee payable to the buyer might be included if the seller insists on go-shop rights.
Clauses and provisions that are binding: Some of the clauses that are included in a Preliminary Doc can be drafted in such a way as to be binding or enforceable. Some clauses need to be enforceable by their very nature such as confidentiality, no-shop/go-shop and break-up fees. Once you have developed a purchase price package and considered the other business issues, your legal counsel will be able to advise you on further options and alternatives and structure a Preliminary Doc that will advance (and protect) your strategic interests.
Clauses and provisions that survive termination or expiration: There are times when the seller and buyer can’t close the deal for a number of reasons. Generally, these clauses pertain to confidentiality and handling of escrow deposits.
The next topic in this series about Preliminary Transaction Documents such as Letters of Intent will be the “other business issues” of operating the business during the “active period” and financials metrics.
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MoneySoft’s DealSense® Plus software system values and analyzes the economics of middle-market mergers and acquisitions. The latest version includes a Term Sheet that can be edited in Microsoft Word.
This Term Sheet can provide the framework for preparing Preliminary Transaction Documents such as Letters of Intent. The Term Sheet developed in DealSense Plus integrates valuation, deal structuring and ROI analysis with the terms of a proposed transaction so that the different functions of the M&A team such as finance, operations and legal can play from the same sheet of music.