The Hidden Language of LOIs: How to Avoid Traps and Decode Buyer Intentions

The Hidden Language of LOIs: How to Avoid Traps and Decode Buyer Intentions

In the dynamic world of business transactions, understanding the nuances of Letters of Intent (LOIs) can be the difference between a successful sale and a negotiation that falls short of expectations. LOIs serve as a beacon of interest from potential buyers, signaling their readiness to acquire your business. Yet, it’s crucial to recognize that the issuance of an LOI often places the buyer in a position of advantage. With a team of advisors at their disposal, buyers craft LOIs that subtly favor their stance in upcoming negotiations. This initial step, while seemingly straightforward, is laden with strategic implications that require careful consideration. For entrepreneurs contemplating the sale of their business, this post sheds light on the strategic considerations surrounding LOIs, offering insights to navigate these waters with confidence.

A. The Binding Nature of Non-Binding Agreements

 A common misconception about LOIs is their non-binding nature. While it’s true that LOIs are generally not considered final agreements, their terms significantly influence the negotiation landscape. Both explicit and implicit provisions within an LOI set the stage for purchase agreement discussions, making it challenging to renegotiate terms without substantial leverage. Moreover, legal precedents show that courts may interpret LOIs as binding under certain conditions, emphasizing the importance of approaching these documents with the same diligence as definitive agreements.

B. Deciphering Key Terms: Beyond the Surface

Structure – The structure of your transaction—whether an asset sale or a stock sale—carries profound commercial and tax implications. It’s essential to delve into the buyer’s assumptions and expectations, as these can reveal hidden requirements that impact the deal’s structure and financial outcomes. For instance, a buyer’s expectation for a step-up in the cost basis of assets can significantly influence the purchase price, even if not explicitly stated in the LOI.

Imagine you’re selling your business, and your LOI mentions that the buyer expects to receive the benefit from a “step-up” in cost basis when they buy your assets. This means they’re hoping to increase the value of the assets for tax purposes, which will allow the buyer to take depreciation and amortization deductions with respect to their future income taxes. Even if this tax advantage isn’t clearly stated in your initial agreement, the buyer might still expect it to be part of the deal based on the type of purchase they’re making. For example, if your company is an LLC taxed as a partnership or disregarded entity, generally a purchase of your equity in the company will be treated as a sale of assets. If your LOI mentions that the buyer is purchasing your LLC equity, they could argue that a “step-up” in cost basis should be presumed under the LOI. If for some reason the purchase is not able to deliver that “step-up” (say, because your company is actually taxed as a corporation), the buyer may seek a purchase price reduction. We have seen buyers successfully argue for such reductions on these facts in other transactions.

Funding – How your purchase price is funded can have profound implications on your tax liability and your ability to receive the price at all. You should consult with your tax advisor when evaluating the terms of any seller financing or earn-out. These items can be structured advantageously to the buyer while, for tax purposes, leaving you with disadvantageous tax treatment on portions of your purchase price. If your buyer offers equity interests as a part of the purchase price, ensure that your counsel and tax advisors have reviewed those portions of the LOI. Ask for a summary of terms and pro forma cap table with respect to those interests and discuss with your tax advisor if there are tax-efficient means of obtaining the interests.

Price Protections. When a buyer talks about wanting “customary” or “appropriate” protections for the purchase price in the LOI, it can be a bit confusing. Usually, when they say “customary,” they’re looking for a few specific things to protect the price they’re paying. This includes setting aside cash from the purchase price in an escrow account to cover losses that the buyer suffers from taking on undisclosed liabilities of your business or deficiencies in your business’s working capital. Buyers often want insurance from you (called “indemnities”) against any losses they may suffer for promises you made about the business that turned out to be untrue (representations and warranties). Sometimes, buyers might not spell out all their desired protections in detail in the LOI, saying they need to do more due diligence first. It’s a good idea to ask the buyer what they typically expect in terms of these protections. If your deal is big enough, it might be worth talking about getting third-party insurance coverages for the representations and warranties you make. You shouldn’t have to guess what the buyer wants for price protections in your LOI.

Closing Conditions. Closing conditions are the things your buyer need to happen, and are either done by you, or your buyer, to put your buyer in position to close the deal. The closing conditions in the LOI should be reviewed carefully both to ensure that the conditions are attainable if both parties act in good faith and to set expectations in case a buyer communicates new conditions pre-closing. Be mindful of any closing conditions requiring the action or approval of a third party. For example, many LOIs contain financing contingencies, which make the closing of the transaction dependent upon the Buyer securing acceptable financing. Closing conditions should be reviewed carefully with your counsel, who can help you understand what closing conditions are reasonable, and when to ask your buyer to revise or even remove conditions.

C. Don’t React to Your LOI, Be Proactive

In my experience, the most effective sellers have already marshalled their resources by the time their LOI arrives. If you are anticipating receipt of an LOI, you should have your team of advisors and internal experts assembled and ready to review it prior to it crossing your inbox. That core team should be composed of, at a minimum, your trusted financial advisor, tax advisor or accountant, and an experienced M&A attorney. You may need other internal experts (HR, IT, regulatory, facilities management, etc.) or stakeholders to participate in the LOI review process, and you should consider, with the counsel of your core team, involving them, subject to appropriate confidentiality agreements. Once you have an LOI to review, be prepared to review it and accept the commentary and guidance of your team. Collectively, by leveraging your knowledge of the business and the experience of your team, you can optimize your LOI negotiations with a buyer and set your deal on a path towards a successful closing. If you are evaluating an LOI, or would like to discuss how to prepare to receive one and build your LOI team, my office would be delighted to help you. I can be reached at [email protected]; tel: 704-916-1521.