Letter of Intent Considerations

There are multiple components to a letter of intent (LOI) when acquiring a lower-middle-market manufacturing company, and I’ve seen buyers either fumble or totally ignore some of them. Here are seven critical LOI components that will increase the likelihood of being selected when you have competition for the acquisition.

A clearly defined purchase price. The purchase price should never be something to be determined in due diligence or disclosed by way of a range. The buyer is asking the manufacturing business seller to take the business off the market and enter an exclusionary period. The seller has a right to know what the view of value is. The LOI is not binding on the buyer. This offers an out if the seller has misrepresented any information pre-LOI. If you’re not clear about the purchase price, no smart seller will take the business off the market to engage with you.

Equity injection and the financing source. If financing is needed, the amount of equity and injection and the financing source impacts the likelihood that the financing will be approved. Sellers don’t want to take the business off the market unless there is a high likelihood of success. And some lenders are cash-flow-based while others are asset-based. A deal might have great cash flow, but be asset-light. In those cases, it’s best to eliminate offers in which an asset-based lender is being used.

Surprises often kill a deal.

Terms for any requested seller’s note. If you’re asking for a seller’s note, be clear on the amount and terms including interest rate, payment timeline, balloon (if applicable) and any “standby” required by the lender. A standby is related to a lender requesting no payment on the seller’s note for a period of time, often on the life of the bank’s loan. This could mean as many as 10 years in the case of SBA 7A acquisition loans.

Due diligence timelines. Due diligence in the lower-middle market is usually 60 to 90 days, but can be 30 to 45 days for smaller deals. If you have competition for the acquisition, you’ll score points with the seller by providing a deadline for the submission of the asset purchase agreement (APA) or the stock purchase agreement (SPA).

Escrow requirement for representations, warranties. This is the most often ignored item in an LOI because buyers are sometimes afraid to bring it up at the time of the LOI. In the APA or SPA, the seller is making representations and warranties about the information that has been provided and the condition of the business. The buyer wants a portion of the purchase price held back for a defined period of time in case the information provided turns out to be wrong or fraudulent. This is completely customary in lower-middle-market mergers and acquisitions. For sellers, an attorney who is unfamiliar with representations and warranties escrow will prolong the deal process and might actually kill it.

Covering the hard things upfront benefits the buyer and seller.

Working capital requirement, calculation method. Perform your working capital estimate before submitting your LOI and include an estimated number. Also, tell the seller how you intend to calculate it to eliminate misunderstandings. Some will calculate this based on current assets less current liabilities (not including cash). Others might simplify this and use accounts receivable, plus inventory, less accounts payable. We proactively ask the client for balance sheets and include this in the data room so that buyers can easily calculate the working capital requirement of the business.

Seller involvement post-closing. There is normally a transition services or consulting agreement for lower-middle-market deals that are separate from the APA or SPA. However, provide the broad strokes of what you expect of the seller in your LOI. In one instance, the sellers lived in another state and only lightly touched their business. One of the twelve offers we received required the founders to work a 40-hour week for six months. Needless to say, that was not the offer they chose. Plus, there was a strong general manager in place and no need for the sellers to work full-time to facilitate a smooth transition. Buyers can and should have detailed conversations on transition timelines and activity levels in advance of submitting their offers.