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Resources for Sound Business Decisions.™

Letters of Intent: Setting the Stage for Contract Negotiations

Strategic and Tactical Considerations of Preliminary Transaction Documents in SMB Interest Transfers – Part 7 in a series.

This installment in our series about Preliminary Transaction Documents (Letter of Intent or Memorandum of Understanding focuses on: (a) the conditions that the buyer requires in order to finalize the agreement and (b) setting the stage for successful contract negotiations.

As a practical matter, a buyer is not going to complete a transaction unless the following conditions are met:

  1. Due diligence has been performed to the satisfaction of the buyer.
  2. Funding for the transaction needs to be in place and ready to be dispersed. Such funding can be from internal or external (debt or equity).
  3. The Definitive Agreement has been negotiated along with the other Transaction Documents that will be required to release funds and close the transaction.

The obtainment of all of the authorizations, approvals, consents, and permits that are necessary to properly convey the rights and title to the business interest that is being sold/purchased.

The above conditions are sometimes referred to as Conditions Precedent. In short, the deal can’t close unless they have been met.

Subject to Due Diligence

The process of due diligence can surface issues, red flags and deal-killers.

  • Issues can be resolved through problem-solving and creative negotiation.
  • Red flags can be investigated to determine if they are issues that can be resolved or deal-killers.
  • Deal-killers, as the name implies, are issues that are of great import for which there is no acceptable risk containment strategy. Misrepresentation, dishonesty, and the surfacing of materially adverse facts or events can cause a buyer to head for the exit.

There is a saying that “a deal doesn’t get done until it has died at least once.” That being said, there are deals that die and don’t get resurrected. Sometimes deals fail to close due to circumstances beyond the control of the buyer or seller.

Deals can also die when risks surface that can’t be mitigated for lack of a strategy or an unwillingness for either party to shoulder them. So, it is in the buyer’s interest to make certain that there is nothing in the Preliminary Doc that blocks the path to the exit door because of something that surfaces during the due-diligence process.

Securing the Necessary Funding

Funding a transaction can be as simple as the buyer writing a check from their personal or corporate account. It can also be complex with several tranches of funding.

Each outside funding source has its own procedures for evaluating the risk and deciding on whether to approve a funding proposal and the conditions that must be met before the funds can be released. Outside funding sources have a duty to perform their own due diligence and part of that diligence includes an investigation and evaluation of the buyer.

If the buyer is not able to obtain the necessary funding, there is no way the transaction can close. For that reason, a buyer might want to insert a clause in the Preliminary Doc that allows the buyer to gracefully walk away from the deal without penalty if funding proves to be a problem. Of course, in the eyes of a seller such a provision may cast doubt on the buyer’s ability to perform.

An alternative to including a funding condition in the Preliminary Doc is to include it in the Definitive Agreement. This can be preferable because:

  1. It sidesteps the seller’s concern about buyer’s capability to secure funding.
  2. The buyer is going to incur professional fees negotiating and reviewing funding documents as well as the due diligence required by the funding sources. These expenses are easier to justify when there is a Definitive Agreement in place and the buyer is satisfied with the due-diligence process. (Nothing prevents the buyer from working with their funding sources while the Definitive Agreement is being negotiated.)

A Letter of Intent or similar Preliminary Doc provides a framework for negotiating a definitive purchase agreement. It is not a short-form contract. If the Preliminary Doc contains too many details and specific points of agreement, it might cross the line that separates it from a contract. That is one more reason why a buyer needs to involve their attorney in the preparation of any Preliminary Transaction Document.

As a potential buyer, you never want to put yourself in the position where if you decide not to do the deal the seller says something to the effect of: “even though Preliminary Doc says it’s non-binding, we really had an agreement…!”

A Preliminary Doc lays out the broad terms of the deal and provides a framework to help the professionals perform their duties. Before the buyer’s and the seller’s legal advisors can finalize the Definitive Agreement, there are certain technical and complex issues that will need to be resolved. Some of these issues are sensitive and difficult. These issues can be appropriately described in the vernacular of the streets as “buzz-kills.”

Whether or not to include any of the so-called buzz-kill issues in a Preliminary Doc depends upon a number of variables such as the selling-side’s M&A experience, the timeframes for closing the deal and the degree of rapport between the buyer and seller. Issues include, but are not limited to:

  1. Representations, warranties and indemnifications. Representations and warranties are statements of fact. Indemnification places financial responsibility for breaches of the representations, warranties and other contractual elements on the party that breaches.
  2. Set asides. These are amounts of the purchase price that are held in escrow to fund any claims that arise after the closing.
  3. Right to offset. This allows the buyer to deduct the amount of any claims from monies that will become payable to the seller in the future.

These items can be addressed in the Preliminary Doc in a very general way by indicating that the Definitive Agreement will include them. This places these issues on the table without prematurely getting bogged down in complex negotiations. In this case, the issues are raised as points that will be addressed and negotiated in the Definitive Agreement. So, when the issues do come up for negotiation, they are not a surprise to the seller, especially if the seller is short on M&A experience.

The negotiation of representations, warranties and indemnifications is more likely to be successful when both parties are represented by experienced transaction attorneys. Legal professionals understand the alternatives and their appropriateness in a given situation, and they have the benefit of having seen the outcomes of many transactions.

As the saying goes, “it’s good to be smart, but it’s even better to be wise.”

<h6Authorizations, Approvals, Consents and Permits

In addition to the buyer’s and seller’s respective management and shareholders, there are governmental agencies and parties with rights by virtue of contract or the operation of law. The structure of the transaction can also increase the number of interests who need to sign off on the deal.

When the acquisition is structured as a stock transaction, the stock or equity in the business changes hands. Generally speaking, agreements, licenses, permits and business relationships remain in place unless there are provisions that require consents in the event of a change in ownership over a defined percentage. The buyer’s legal team will review all pertinent documents and arrangements to make sure that all necessary rights transfer at closing.

In an asset deal, all of the different contracts, permits, licenses and business relationships need to be transferred to the buyer or an entity created/controlled by the buyer. Here again, the buyer’s legal team will want to identify the necessary approvals, consents, assignments and such and prepare the documents that are necessary to transfer the rights and relationships to the new entity.

Much like the issues of reps, warranties and indemnifications, the Preliminary Doc can mention the issue of authorizations, approvals, consents and permits as items that will be negotiated and included in the Definitive Agreement.

As a professional courtesy, the initial Preliminary Doc is generally submitted to the Seller via their intermediary or advisor. Savvy buyers work hard to develop relationships with the intermediary and advisory community to insure deal flow opportunities. In addition, the sellers are observing the behavior of the buyer and setting their level of trust accordingly.

Upon receipt of the Preliminary Doc, the seller is going to want to take the time to huddle with their stakeholders and advisors in order to form a response.

In some cases, the Preliminary Doc can be the first time that the seller sees the deal concept. If this is the case, they may need more time to review and digest it.

It is also possible that the Preliminary Doc will serve as a “confirmation” of the ideas and deal concepts that the buyer has been discussing with the seller and their representatives. The best approach depends upon the rapport that the buyer shares with the seller and the buyer’s modus operandi and dealmaking preferences.

When a buyer submits a Preliminary Doc or Letter of Intent, all eyes are on whether the seller will accept the proposal, make a counter-proposal or reject it (with or without comment).

If the proposal is accepted, then focus shifts to the next steps. If a counter-proposal is made, attention is riveted on the details of the counter-proposal, its impact on the investment, and the formulation of a response. If the proposal is rejected with or without comment, the focus is on whether to continue to seek common ground or move on to another opportunity.

A savvy buyer keeps one eye on finalizing the Preliminary Doc and the other eye observing the behavior of the seller and the various members of their team.

The way the seller approaches difficult issues, handles questions and offers alternative ideas along with the amplitude of their emotional responses to problems can provide insight on how to best approach the issues that will naturally arise during the due-diligence and contract negotiation process.

  • Is the seller deliberative or impulsive?
  • Does the seller’s decision process seem autocratic or collaborative?
  • Does the seller respond to stress with emotion or creativity?

Knowing your opponent in any negotiation can provide an advantage that can be put to good use by crafting an M&A deal that creates value for your company and stakeholders.

In the next edition we will review the response of the Preliminary Doc on the part of the seller and then examine the other business issues from the seller’s point of view.

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.

By Robert B. Machiz

© 2011 MoneySoft, Inc. All rights reserved worldwide.