Letters of Intent: Benchmarks and Operations
Strategic and Tactical Considerations of Preliminary Transaction Documents in SMB Interest Transfers – Part 6 in a series.
The “active-period” of a Preliminary Transaction Document such as a Letter of Intent or Memorandum of Understanding begins when the buyer and seller sign the document. This active-period can span the days, if not months, from signing until the buyer and seller enter into a definitive agreement or the contemplated transaction is terminated.
During the active-period, the buyer will spend time and money performing due diligence, developing a post-closing integration or assimilation plan, and making arrangements to fund the transaction. Concurrently, the seller will be providing necessary information, answer the buyer’s questions, making personal plans for a new life after the sale, and continuing to operate and hopefully grow the business.
It is a pretty good bet that during the active-period there will be changes to the business. In business, change is a fact of life—it’s a constant. In today’s business environment, the wheel of change turns swiftly. As Heraclitus famously noted nearly twenty-five hundred years ago:
“You cannot step into the same river twice.”
Once the buyer and seller have signed-off on a Preliminary Doc, the buyer has what might be described as a “contemplated interest in the future of the business.” While a considerable amount of deal work needs to be done, the buyer is now factoring future ownership of the acquisition target into their business plans. The acquisition target is in the process of becoming part of the buyer’s future vision and strategy.
This “contemplated interest in the future of the business,” as used herein is a planning and psychological concept—not a legal principle.
For the most part, the purchase price package contained in a Preliminary Doc is based upon the buyer’s analysis of the expected economic returns and risks as well as the attractiveness of the acquisition relative to the buyer’s strategic vision. If the business deteriorates during the active period, the business may bring a lower valuation. In addition, negative changes might also make it more difficult or expensive to get the capital needed to fund the transaction whether the funds are internally or externally provided.
The key metrics upon which the buyer’s valuation and decision to pursue the transaction were made can be included as a performance clause in a Preliminary Doc concerning “assumed levels” for such items as:
- Sales revenues.
- Order backlogs.
- Earnings Before Interest, Taxes and Depreciation (EBITDA).
- Asset and Liabilities Balances.
The financial metrics can be provided to the buyer’s legal counsel who can include them in the Preliminary Doc.
By stating the financial and performance metrics upon which the buyer is predicating the purchase price package, the seller can operate the business during the active period in a manner that preserves (or creates value) for both parties. In addition, the metrics establish a baseline that will better enable the parties to correct or negotiate any changes to the business or discoveries during due diligence.
There are changes that are intentional and then there are changes that are not intentional or have an adverse effect on the interest that you are thinking of buying. Here are a few examples:
- A major customer is lost.
- A new competitor suddenly appears.
- Prices are cut and promoted to increase revenue before the closing.
- Seller initiates a “pre-pay” promotion wherein they receive the revenue now for services the buyer will have to provide in the future. Another variant of this would be a sales promotion “now” that includes an extended warranty in the “future.”
- One or more key employees leave the company.
- The business defaults on a key contract.
- The company changes its capital structure by either incurring additional debt or bringing on a new equity partner.
- Seller authorizes and distributes a large dividend that impairs the business’s working capital.
- Seller makes a large capital expenditure.
- A lawsuit or claim is filed against the company.
Any of the above events can significantly impact the buyer’s valuation and ability to get the deal funded. Therefore, a buyer may include provisions in the Preliminary Doc in order to mitigate the above risks:
- Notification of any “materially adverse” events or actions.
- Restrictions on certain activities.
- Operation of the business while the contemplated transaction is pending.
- Maintenance of specific financial metrics or baselines for earnings and/or asset levels.
- Provide regular interim financial statements and operating data.
Depending upon the scope of the Preliminary Doc, some or all of the above items can be addressed or deferred for negotiation and inclusion in the Definitive Agreement.
The buyer has a real interest in protecting the value of the business and its assets during the active-period. The buyer wants the seller to operate the business during the active-period to preserve value. While change is a constant, the buyer wants to be notified of material events on a timely basis so he may react appropriately to protect his interests. As one PE manager said: “Surprises are great for birthdays, but not in M&A.”
The next installment in this series on Preliminary Transaction Documents will explore how to set the stage for negotiating the definitive purchase agreement.
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.
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