Letter of Intent: An Essential Tool for Employee Buy-outs

By
Tomas Duran and Bruce Dobb

By far the saddest call Concerned Capital receives is from employees or members of a ‘collectiva’ at a privately held company that have just learned their company was sold; in some cases, for a price with terms that these employees could easily have afforded with their savings. Sometimes the employees are already discussing purchasing the company but because they have not executed a “Letter of Intent” (LOI), a competitive marketplace and a secretive outside suitor beats them to the punch.

Trying to buy a company without first securing a signed Letter of Intent from the owner is like leaping out of an airplane with a parachute. The LOI creates an exclusive right to study the deal and arrange for the purchase. Without it, the employees may not survive in the transaction long enough to even get a chance at purchasing the company. Even in cases where their bid is more favorable tax-wise and affords a more optimal solution for the owner, an employee bid without an LOI is a high risk proposition.

Without an LOI, a third-party sale can occur during negotiations. Many employee ownership advocates spend lots of time discussing ownership structure, legal consequences and finance without having a signed LOI. All of these things can be addressed after an LOI is signed and the company is effectively taken off the market for a period of due diligence.

Elements of a Letter of Intent

An LOI is a signed document that declares the intentions of both parties to negotiate the purchase of a business in good faith. It’s the document created before the Purchase Agreement is signed and sent to escrow for closing. The following are the key elements of a Letter of Intent:
• Puts in writing the key deal points — price, terms and expected close date — can be defined as specific or given a range.
• Identifies deal breakers — i.e. if the owner plans to compete with a buyer in less than 12 months
• Identifies parties to the transaction (buyer may latter chose to modify or expand its numbers, subject to buyers approval). 
• Sets up a framework or ‘roadmap’ for the transaction to occur
• Grants exclusivity for a specific period of time to the buyer (the one binding element of an LOI )
• Can be used for financing to demonstrate ‘secured’ interest
• Creates a sense of obligation to complete a transaction as agreed to
• Allows for ‘due diligence’ on terms agreeable to both parties
• Establishes confidentiality
• Does NOT create a legal obligation to purchase the company

When employees make an offer to the business owner they have several distinct advantages. Goodwill and a history together may mean the owner is more willing to carry paper. The employees know the problems and where the bones are buried, but they also know secret assets of the company and understand the customer base and its needs better than anyone. And that means that they may be willing to take over the entire corporation ‘lock, stock and barrel’ providing the seller a tax break by converting the ordinary income from a sale of ‘assets only’ to capital gains which comes from the sale of stock.
The problem is that employees often don’t even get to the starting gate before the company is sold out from under them — especially if it’s an investment worthy company.

Finding sustainable companies that make money and have a solid chance of outliving their current management is a difficult task at best. Seasoned professionals in the field look at 10 companies before they decide to bid on one. Only 20% of companies listed ever sell. The famous industry adage is: ”Good companies are never sold — they’re always bought.” 
This situation pits employee buy-out advocates squarely against a cadre of speculators, investors and others who can act quicker, pay more and out-maneuver amateurs. To level the playing field, co-op advocates have to learn to beat the pros at their own game.

A Highly Competitive Marketplace:

As Holly Magister writes in “4 Reasons It’s So Hard To Buy A Good Business” (Forbes-February, 23, 2016) “When business buyers are looking for a good business to buy, they look for businesses which can run on their own without day-to-day input from an owners.” This is an axiom that every speculator, investor, acquisition scout and business broker understands and looks for. Of course co-op developers, employee ownership advocates and community organizers are all looking for these companies as well.

Concerned Capital believes the best place to start is to identify employee groups that want to own the company they work for. The Silver Tsunami myth is that harried ‘baby boomers’ will be more than glad to offer their companies for sale. Waiting for sellers to step forward means unnecessarily constricting the employee buy-out marketplace to financially troubled companies where the owner needs to sell or, alternatively, restricting it to a limited number of employee friendly owners who share ‘progressive politics’ with advocates. 
Employees often don’t even get to the starting gate before the company is sold out from under them — especially when it’s an investment worthy company because the marketplace for the sale of businesses is highly competitive.

Which brings us to:
The Parable of the Parachute Trainee:
A young trainee was getting ready for his first high altitude parachute jump. He drills and drills the three simple steps; Step one: look out of the plane to see if it’s clear and jump; Step two: count to three, pull rip cord to open chute; Step three: the open chute will be seen by cart driver and he’ll meet you where you land. 
The day arrived for his jump. The trainee goes to the plane door, makes sure it’s clear and jumps. He counts to three, pulls the rip cord and waits, but nothing happens. He pulls again and again; still no chute appears. Despondent, the trainee says to himself, “Damn, now the cart won’t know where to pick me up…”.

Trying to buy a company without first securing it with a signed “Letter of Intent” agreement with the owner is like worrying about the end goal while missing the fatal flaw in the process. You won’t survive in the transaction long enough to worry about the cart being there to meet you.

Tomás Durán and Bruce Dobb are partners at Concerned Capital, Inc. a boutique investment firm in downtown Los Angeles that helps businesses find government incentives and transition to new ownership.