David Cummings on Startups

Notes on the Letter of Intent in the Sale of a Business

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David Cummings

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After a potential acquirer has built a serious level of interest in the business, and is ready to attempt to get a deal done, they will provide a letter of intent (LOI) outlining the characteristics of the proposed deal as a starting point for negotiations. LOIs are like being almost pregnant — it really doesn’t mean much. It is an understanding of the deal two parties are working towards, much like a term sheet, but slightly more detailed and involved.

Here are a few notes when thinking through the letter of intent:

  • Standard due diligence and no shop periods should be of reasonable length (e.g. 30 – 45 days) to promote focused work by both parties (if things are going well, and more time is needed, it’s easy to ask for an extension)
  • Financial considerations around the cash and stock mix, if applicable, are very important, especially if there’s a lock up on the stock where it can’t be sold for a period of time (in this current market of uncertainty, cash is much more desirable)
  • Net working capital adjustments (e.g. the price goes up or down based on current assets) are always present, and should be considered carefully, especially if there’s serious deferred revenue (it’s a liability! — also note that debt will reduce the purchase price)
  • Escrow funds (the amount set aside in the event of an issue) as a percentage of the deal and how long they are held should be aggressively negotiated (e.g. 7% of the deal held for 12 months might be normal depending on the industry)
  • Other important, but less commonly discussed, items include things like indemnification where you agreed to defend the potential acquirer against future lawsuits for a period of time related to aspects of the business they are acquiring

A letter of intent is a major milestone in the process to sell a business. Once signed, both parties should work hard to get a deal done. The key is to not rush into signing the LOI, rather take your time and get the terms right up front, resulting in a much smoother process going forward.

What else? What are some other thoughts on the letter of intent process in the sale of a business?

Comments

One response to “Notes on the Letter of Intent in the Sale of a Business”

  1. Sanford Avatar
    Sanford

    Pardon, but deferred revenue is NOT debt. So when the deferred revenue is reduced on the balance sheet, cash does NOT come out of the company.

    If the company’s operating margins are positive, then deferred revenue is actually a very good thing!

    Deferred revenue is revenue that has been received (either cash or accounts receivable has been recorded in the balance sheet) but the service has not yet been rendered. As such, the transaction has not entered the P&L yet. it’s all recorded in the balance sheet. The debits are cash and/or accounts receivable and the credit is deferred revenue.

    So when the service has been rendered (at a later date..after the sale perhaps!), then the transaction is then recorded to REVENUE and the deferred revenue account is correspondingly reduced. So no cash of the company has been taken out and yet the “liability” has been reduced!

    The associated cost is also recognized at the same time that the transaction is moved to REVENUE. So again, if the operating margins are positive, then the company actually gains revenue and net income. and hopefully has collected on the accounts receivable.

    From that vantage, the more deferred revenue the better! Deferred revenue is actually a liability / equity hybrid with the operating margin eventually flowing to equity.

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