5 Key Terms to Look for in a Letter of Intent
In a company sale, both the buyer and seller will likely agree that documenting key terms in a letter of intent is a good idea. However, you’re likely to find that the content (and level of specificity) in a letter of intent can vary widely depending on the buyer’s style.
Purchase price and basic legal structure (i.e. stock sale vs. asset sale) comprise the bare minimum of subjects found in any letter of intent. Granted, some points will be resolved later. After all, the letter of intent is, by definition, not an exhaustive document. However, as the seller, it is wise to be more specific at this stage, lest you find yourself deep in legal documentation (and fees!) before realizing that there’s actually a major difference of opinion between yourself and the buyer on a key issue.
This article exists to stimulate thought (and provide some discussion topics for your next meeting with your legal counsel). Akin to a letter of intent, these suggestions are not an exhaustive checklist. However, the following five topics are items you may want to include in a letter of intent to help head-off a problem later:
Escrows, Caps, and Baskets
An escrow holds back a portion of the purchase price for a specified period of time (commonly 12-24 months) in case the seller breaches a representation, warranty, or covenant. This protects the buyer from adverse consequences caused by a seller’s misrepresentations—whether intentional or unintentional. Escrow amounts vary depending on the facts and circumstances of the company and transaction. Typically, a range of 5% to 20% of the purchase price is considered normal (there is often an inverse correlation between escrow percentage and size of transaction). A “cap” is the highest amount a seller might forfeit due to a breach in representation, warranty, or covenant. Often, representations and warranties are separated into different groups, and each group might have its own designated cap. A “basket” represents a threshold amount that must be met before the buyer can make a claim against the escrow amount. This protects the seller from being nickeled and dimed by the buyer for trivial amounts. There are well-established market norms for escrows, caps, and baskets. Documentation of these amounts upfront in the letter of intent may help avoid unanticipated conflict later in the transaction. Lastly, purchasing a reps and warranties insurance policy may be worth considering. The reps and warranties insurance policy will generally reduce the amount of the escrow.
Sources and Uses of Cash
In a successful transaction, all parties should aim to avoid surprises. Including a table of expected sources and uses of cash can help achieve this. A sources and uses table defines the sources of cash (i.e. the amount of equity investment coming from each party and the amount and type of debt financing, if any). The table also specifies the uses of cash (i.e. each recipient’s proceeds, amount of existing debt to be paid off at closing, transaction expenses, and amount of on-hand cash the company will have immediately following closing). By requesting a sources and uses table in the letter of intent, you’ll have a clear understanding of the flow of funds happening on closing day. At minimum, this can provide peace of mind that you’ll know exactly how the mechanics will work since a detailed sources and uses table will often surface any differences in perspective between buyer and seller.
Net Working Capital
For most sale transactions, it is expected that the seller delivers the business at closing with a normalized level of net working capital (typically defined as non-cash current assets minus non-debt current liabilities). The spirit of the net working capital mechanism is to assure the buyer that the company won’t be deficient of the assets required to sustain its current level of business (which has presumably influenced the purchase price). While it’s routine to wait to quantify the specific net working capital target until due diligence is complete and definitive documentation is drafted, it’s possible (and wise) to document in the letter of intent the structure of how the net working capital calculation will work.
Covenants not to compete and not to solicit employees, customers, and suppliers typically have three essential elements: (i) length of time, (ii) geographic territory, and (iii) industry definition. While it’s best to let the law gurus properly document the finer points of the covenant, it’s not a bad idea for the seller and buyer to agree on the timeline, territory, and industry definitions that are most applicable for the facts and circumstances of the company and transaction. Acknowledging these three points in the letter of intent begins your relationship with transparency and helps to avoid unwelcome surprises later in the process.
Management and Board Composition
Whether or not you’ll be actively involved in the company post-closing, you’ll likely agree with the buyer that the composition of the management team and board of directors is important for all parties. Articulating post-closing management and board roles in the letter of intent will help ensure that you and the buyer are on the same page. It can also give you a clue to how thoughtful the buyer has been on this subject prior to drafting the letter of intent. If sufficient consideration hasn’t been devoted to this topic, it is fair to wonder how seriously the buyer is approaching the transaction.
In addition to price and legal structure, the five issues above are present in most transactions. While every situation will involve a host of other items to consider, it’s prudent to look for these five concepts in the letter of intent. If they’re not already delineated, it’s worth a discussion as to why they can’t be addressed now.