The Art of Negotiating an Acquisition LOI for Startup Founders
I was the founder of a boutique investment bank called Pagemill Partners which was acquired by Duff & Phelps in 2011. Over the course of 13 years, while I was a full-time Managing Director we completed more than 250 transactions primarily representing sellers. This is my third blog in a series concerning the lessons I learned in the M&A business which may be useful to you. If you missed my past posts, I’ve linked to the first and the second.
The receipt of an LOI (Letter of Intent) is the first real indication that a buyer is really serious about moving forward with a potential transaction so it is an event that must be treated that way. The first thing to bear in mind is that all LOIs are not created equal. Depending on who the potential suitor is, the document can take the form of either an IOI (Indication on Interest) or an LOI. Generally speaking IOIs are used in earlier stages of an auction process and are usually associated more with Private Equity firms than with strategic buyers. They are normally offered up with very few deal terms and often include a range of valuation. Normally speaking, very little due diligence is completed in advance of the submission and the approval process for releasing an IOI is not very demanding. I historically put zero reliance on an IOI and I would advise you to do the same.
My focus for this blog will be on LOIs. My assumption will be that prior to receiving an LOI the potential buyer will have already completed significant due diligence and in the event that an agreement is reached, the exclusivity period would be solely for confirmatory due diligence. If this is not the case, then I fall back to the previous paragraph where I would encourage you to reduce the significance of the LOI.
For me and my clients, I wanted to ensure that very deep due diligence had been completed prior to the submission of the LOI as it significantly improved the likelihood of a deal being completed and also ensured that valuation had been thoroughly investigated by the buyer. It also allowed me to continue other potential suitor discussions.
When an LOI is received the strong tendency is to look only at the headlines (“the price”) without considering all of the other very important deal terms. My experience taught me that the best approach to take is to negotiate ALL of the key deal terms in advance prior to entering exclusivity because if you wait to negotiate them later you will come up short in every key area. This approach creates friction right out of the gate as the buyers want to negotiate all of the terms later since they know from experience that they will end up in a better legal position. Resist this temptation at all costs. All of the strategic buyers will say the same thing, “That is not the way we do it” or “We haven’t done enough due diligence to understand the exposure we may have”. Over the years, I heard all of these comments but frankly it was all bull crap and just a buyer trying to leverage a smaller company. In any event, the LOI is non-binding and if they find something very unusual they will want to renegotiate the point in the purchase agreement.
My experience taught me that the best approach to take is to negotiate ALL of the key deal terms in advance prior to entering exclusivity
As an example of how important this would be, consider the area of Intellectual Property (IP) Indemnification. For readers that are unfamiliar with this concept, the final purchase agreement will include areas where the sellers will need to provide compensation back to the buyers in the event that certain outcomes occur. With IP this usually involves concerns around patent infringement. Buyers hate to have this negotiated in advance but what happens if later they decide that they want indemnification beyond the purchase price and want to be able to go after one shareholder for all of the indemnity. In this case the deal will not close and your company will have wasted significant time and money. Best to get these terms understood and agreed to prior to entering exclusivity.
As I said earlier, based on my experiences, I am a strong believer that LOIs must be extremely detailed and fully negotiated in advance of entering the exclusivity period. Lawyers will fight over what is market and what is not market and they will say things like “ it is a question of risk allocation” but fundamentally know one thing for sure, this is all a negotiating strategy. I will review for you what are the key deal terms that I would want included in the LOI along with some feedback on where the current market practices are. Before I get there let me add one additional salient point. You need to make sure that your counsel is a top M&A lawyer working for a top firm in your geography as I can guarantee you that the other side will not skimp on their counsel. They will have the best lawyers representing them so you need to lawyer-up as well. Failure to do so will cost you dearly in the negotiation process, in particular in the reps and warranties area.
Let me now review some of the deal terms that should be included in a detailed LOI.
1) Purchase Price:
This is an obvious one but the LOI must also determine whether the deal will be in cash or stock or a combination. Do not accept a term that says it will be determined later. Generally speaking, I wanted all of my transactions in cash. Make sure that there are no contingencies as these are never acceptable. Some examples of contingencies could be bank or financing or unusual approvals outside of the norm.
2) Asset Deal or Stock Deal:
This is an extremely important deal point. Buyers want to buy assets and sellers generally want to sell shares. The principal reasons for both sides are tax but even if the deal is tax neutral I am an advocate of share sales as otherwise you normally have to go back to all of your customers and have their contracts assigned to a new entity. This creates too much risk and can significantly delay closing.
3) Length of Exclusivity Period:
Buyers want at least 60 days (sometimes 75) but I never agreed to more than 30. Do not get caught up in a lengthy due diligence process that will be extremely distracting. I generally also included a clause that stipulated that if the buyer did not provide a first draft of the purchase agreement within two weeks of signing the LOI and in which the deal terms were similar to the LOI, the exclusivity period expired.
4) Working Capital Target:
Again buyers will prefer to delay this negotiation but my experience dictates to do this before agreeing to exclusivity. I am an advocate of identifying each element of current assets and current liabilities to be included (or excluded). Ensure that you include an accrual for SR&ED for Canadian sellers. In addition, make sure that deferred revenue is excluded from the calculation of working capital as well as excluded from the definition of debt. For a buyer, there is no real liability other than if you have been paid for professional services in advance. The issue for them is that this represents cash that you have received in advance. Buyers don’t like that but this is a point I never lost and it can be material for you.
5) Escrow, Indemnification and Fundamental Reps:
My general position was a 10% escrow for a period of 12 months and the escrow was the sole remedy for any claims. This deal point is all about leverage. The market today is normally closer to 15 months and there is generally a carve out for fundamental reps and it is fair to say that often the escrow % could go up to 20%. The work to be done in advance of the LOI execution needs to also cover the fundamental reps which will carry a higher burden for the seller and mostly will exceed the escrow % threshold. Some of the fundamental reps were non-concerning to me such as title, taxes, compliance with laws and capitalization. Fraud and willful misrepresentation was also generally not contentious as both parties customarily agreed to go back to the purchase price. The most contentious and most valuable item was the rep for Intellectual Property. I normally was able to get the larger sellers to agree to 20% for 2 years. I will admit I also saw up to 50% but that was rare. The cleaner your IP is from a diligence perspective will directly impact your ability to negotiate favorable terms here. I always wanted to ensure that each seller was responsible for their own % of any escrow claims and that the buyer could not claim from one shareholder any indemnification amounts other than pro-rata. I was never party to any deal where indemnification went beyond the purchase price.
6) Earn Outs:
I am not a fan of earn outs and my standard feedback to my client was to assume that they have a zero value. The best buyers will not use earn outs as they want to be able to run the business any way they want to post-closing. In the event you need to use an earn out to bridge a valuation gap, make sure that it is only on a controllable item like revenue as you will find that post deal your P&L will be cluttered with parent company expenses not accounted for in your original plan.
7) Cash Free, Debt Free:
This is a structure where the seller keeps all of the cash but is responsible for paying off any debt prior to closing. Often the cleanest way to structure a transaction with a larger buyer in particular if your bank debt is larger than your cash position. Where there is excess cash, make sure that there is a clean way to distribute the money back to shareholders in a tax efficient manner. Also, as I said earlier be careful with the definition of debt as the buyer’s counsel will try to capture other non-debt items.
8) Approvals:
Pay close attention to this section as it can impact the length of time it takes to close the transaction. Obviously, I never accepted a financing contingency or a bank approval.
9) Jurisdiction:
I always fought for the jurisdiction to be the jurisdiction of my client. I stayed away from New York or Texas like the bubonic plague. I was always prepared to settle on Delaware for US clients. For Canadian clients I only accepted their province as the jurisdiction and there is no reason for you to do anything else.
10) Banker and Lawyer Fees:
As a matter of course and because I had a stake in this deal term, the banker and lawyer fees were always paid out at closing. Generally if there is an earn out the bankers only get paid on the consideration delivered at closing.
In summary, do all of your negotiating up front as part of the LOI process. Your legal costs will be reduced and the certainty of close will increase substantially. It may take a little longer to reach an agreement but the effort will be well worth it. Also, remember one very important point, the successful negotiation of the LOI only gets you to the 50 yard line! The hard work really starts once you go into exclusivity and it becomes time to negotiate the purchase agreement and finalize due diligence. If you have any comments or questions please feel free to reach out to me.
This is part of a series of lessons Scott Munro has learned over his 13 year stint as Managing Director of Pagemill Partners. Past articles include Exit Preparedness for Venture-Backed Startups — And Why It Matters and 10 Reasons Why Tech Deals Blow Up in Due Diligence.
