LOI 101: How the Letter of Intent Affects the Due Diligence Process
Author: Elliott Holland
You live by the LOI for months – make sure it outlines advantageous terms
Key takeaways
A strong letter of intent should include:
Favorable terms for defining working capital
A training and transition timeline that sets you up for success
An exclusivity period that gives you time for due diligence
A strategic price range, with room for change
Financing terms that are in your favor
Access to seller's premises and records to safeguard due diligence processes
The letter of intent (LOI) kicks off the due diligence process. It includes the purchase price, terms, exclusivity, closing conditions, and several other elements. Once the seller signs it, you can start digging into their business and finding out the information you need to close the deal. But if you want to get the most advantageous deal possible, you need to go in with a strong LOI.
Self-directed sellers often make the mistake of rushing through this step of the acquisition process or using unproven templates when outlining their intent to sellers. This degrades the strength of their position, and often, the seller may counter with an LOI with even worse terms.
In spite of this risk, most buyers overlook the importance of the LOI. After all, it's just the initial terms – things can be changed down the road, right? While that's true, you still need to ensure that the LOI has the right details. You will live by that document for months, and it will play a significant role in the due diligence process. Here's what you need to consider.
Working capital
You'll need some working capital to continue operations when buying a business, and you need to ensure that you address this to your advantage when drafting the LOI. The way you calculate the working capital can have a significant impact (hundreds of thousands or more) on the purchase price.
Be sure to think through how you define the working capital. How are you calculating the working capital target? How long of a time period do you want to include when calculating the business's working capital average? Beyond that, consider other elements you want to include, such as cash, accounts receivable, accounts payable, and inventory.
Training and transition periods
Once the deal is complete, the training and transition period can define its success. Do you need the current owner or their management team to stay on? If so, for how long? You can also think about the type of training you expect the seller (or their managers or employees) to provide. You need to ensure that you narrow in on the optimal amount of time. It should set you up for success without adding excessive costs to the purchase price.
Exclusivity period
The exclusivity period needs to be long enough to allow you to perform the due diligence you need to make a confident offer. You certainly don't want to get into a position where you aren't quite ready to make an offer but the exclusion period runs out and the seller quickly signs a deal with a new buyer. Make sure that you include deadlines that protect the integrity of your side of the deal.
Price range
A price range can be more effective than narrowing in on a single number. Sellers often look at the top end of the range when deciding whether or not to sign the LOI. But often, as you go through negotiations, you'll move toward the lower end of the range. This often isn't possible if you start too high or just include a single number in the LOI.
If you undershoot on price, the seller may not be willing to sign the LOI. If you overshoot, you may struggle to lower the price at the negotiation table regardless of what you discovered during due diligence. That's why you have to go in with a strategic number.
The offer in the LOI is based on the EBITDA, but this document uses the seller's version of their EBITDA. As you move through the due diligence process, you may discover that you disagree with their number. You may want to discount some of the seller's add-backs or adjust how the add-backs were calculated. The LOI should be clear that you're going to reevaluate this number and describe how the EBITDA plays into the offer price.
Terms
To reduce the amount of third-party financing you need, you may want to explore deals where the seller holds a note on the business. In a worst-case scenario, their note is in a subordinate position to the financing you get from a bank.
You may also want the seller to complete an earn-out. This helps to ease the transition period, but it can also ensure that you pay a lower price if the business doesn't meet certain targets or expectations during the earn-out stage.
Access to the seller's premise
This one is critical. Failure to identify the right terms can undermine the due diligence process. While you can learn a lot from financials, you also want to see what happens on-site. You don't want to end up with a seller who refuses to give you physical access to the premises based on overinflated privacy concerns.
Records
Think through which records you want to see. How granular do you want to get in the due diligence process? You need to review the right records to move forward confidently with your deal.
Guardian Due Diligence can give you the edge you need
Unfortunately, when a lot of first-time buyers or self-funded investors start this process, they work with their existing CPA, who likely doesn't have experience with mergers and acquisitions. Even if they have handled a few deals in the past, they may not have worked with mergers and acquisitions regularly. As a result, they might not include the most advantageous terms in the LOI. This can put unnecessary limits on the due diligence process and hurt negotiations.
Our proven LOI templates can help you start the deal on the right foot. Then, we can expertly manage your due diligence process to ensure you get the best deal possible. We help our clients save on purchase prices and move forward with confidence. Let's talk — contact us at Guardian Due Diligence today.